Tutorial 3 Answers
[Note: answers in italics are my own comments – Loke]
1. Motives for Investing in Foreign Money Markets. Explain why an MNC may
invest funds in a financial market outside its own country.
ANSWER: The MNC may be able to earn a higher interest rate on funds invested in a
financial market outside of its own country. In addition, the exchange rate of the
currency involved may be expected to appreciate.
2. Motives for Providing Credit in Foreign Markets. Explain why some financial
institutions prefer to provide credit in financial markets outside their own country.
ANSWER: Financial institutions may believe that they can earn a higher return by
providing credit in foreign financial markets if interest rate levels are higher and if the
economic conditions are strong so that the risk of default on credit provided is low.
The institutions may also want to diversity their credit so that they are not too
exposed to the economic conditions in any single country.
3. Exchange Rate Effects on Investing. Explain how the appreciation of the Australian
dollar against the U.S. dollar would affect the return to a U.S. firm that invested in an
Australian money market security.
ANSWER: If the Australian dollar appreciates over the investment period, this
implies that the U.S. firm purchased the Australian dollars to make its investment at a
lower exchange rate than the rate at which it will convert A$ to U.S. dollars when the
investment period is over. Thus, it benefits from the appreciation. Its return will be
higher as a result of this appreciation.
4. Exchange Rate Effects on Borrowing. Explain how the appreciation of the
Japanese yen against the U.S. dollar would affect the return to a U.S. firm that
borrowed Japanese yen and used the proceeds for a U.S. project.
ANSWER: If the Japanese yen appreciates over the borrowing period, this implies
that the U.S. firm converted yen to U.S. dollars at a lower exchange rate than the rate
at which it paid for yen at the time it would repay the loan. Thus, it is adversely
affected by the appreciation. Its cost of borrowing will be higher as a result of this
appreciation.
5. Forward Contract. The Wolfpack Corporation is a U.S. exporter that invoices its
exports to the United Kingdom in British pounds. If it expects that the pound will
appreciate against the dollar in the future, should it hedge its exports with a forward
contract? Explain.
ANSWER: The forward contract can hedge future receivables or payables in
foreign currencies to insulate the firm against exchange rate risk. Yet, in this case, the
Wolfpack Corporation should not hedge because it would benefit from appreciation of
the pound when it converts the pounds to dollars.
6. Effects of a Forward Contract. How can a forward contract backfire?
ANSWER: If the spot rate of the foreign currency at the time of the transaction is worth less
than the forward rate that was negotiated, or is worth more than the forward rate that was
negotiated, the forward contract has backfired.
[Comments: this worked solution is a bit confusing. Basically:
 I enter into forward contract to buy USD at a fixed forward rate, but in the
future the spot USD has depreciated compared to the fixed forward rate, then
I lose on the forward; or
 I enter into forward to sell USD at a fixed forward rate, but in the future the
spot USD has appreciated compared to the fixed forward rate, then I also lose
on the forward.
]
7. International Diversification. Explain how the Asian crisis would have affected the
returns to a U.S. firm investing in the Asian stock markets as a means of international
diversification. [See the chapter appendix.]
ANSWER: The returns to the U.S. firm would have been reduced substantially as a
result of the Asian crisis because of both declines in the Asian stock markets and
because of currency depreciation. For example, the Indonesian stock market declined
by about 27% from June 1997 to June 1998. Furthermore, the Indonesian rupiah
declined again the U.S. dollar by 84%.
8. Suppose a currency increases in volatility. What is likely to happen to its bid-ask
spread? Why?
ANSWER. As a currency's volatility increases, it becomes riskier for traders to take
positions in that currency. To compensate for the added risks, traders quote wider
bid-ask spreads.
9. Who are the principal users of the forward market? What are their motives?
ANSWER. The principal users of the forward market are currency arbitrageurs,
hedgers, importers and exporters, and speculators. Arbitrageurs wish to earn risk-free
profits; hedgers, importers and exporters want to protect the home currency values of
various foreign currency-denominated assets and liabilities; and speculators actively
expose themselves to exchange risk to benefit from expected movements in exchange
rates.
[question – what is the difference between an arbitrageur and a speculator? The
speculator takes directional market risk (bets on one direction of the market) while
the arbitrageur is supposed to make market risk-free profits independent of market
direction.]
Problems
1. Bid/ask Spread. Utah Bank’s bid price for Canadian dollars is $.7938 and it’s ask
price is $.81. What is the bid/ask percentage spread?
ANSWER: ($.81 – $.7938)/$.81 = .02 or 2%
[Note: as for all FX related calculation problems, make sure you are clear which is
the base currency (the currency being bought/sold) versus the quotation currency (the
currency quoted as the price to buy/sell the base currency). In this case the base
currency is CAD, quote currency is USD. Hence the prices quoted above are prices in
USD to buy or sell one unit of CAD. Be very clear on this!
Secondly, note that the bid price is the price that the Bank is willing to buy (bid) for
the base currency. The ask or offer price is the price that the Bank is willing to sell
(offer or asking price) the base currency. In other words, bid and ask is from the
perspective of the Bank quoting the rates to you, the customer.]
2. Indirect Exchange Rate. If the direct exchange rate of the euro is worth $1.25, what is
the indirect rate of the euro? That is, what is the value of a dollar in euros?
ANSWER: 1/1.25 = .8 euros.
[Note: This question is likely from the point of view of an American-based (dollar)
investor. Hence direct quotes are number of home currency (dollars) per one unit of
the foreign currency (euro). That is, direct quotation means home currency is the
quote currency, foreign currency is the base currency.
Note also that this method of converting from direct to indirect and vice-versa by
taking the reciprocal only applies if you assume no bid/ask spread. Once you have
bid/ask spread then you cannot simply take the reciprocal to convert!]
3. Cross Exchange Rate. Assume Poland’s currency (the zloty) is worth $.17 and the
Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen?
That is, how many yen equal a zloty?
ANSWER: $.17/$.008 = 21.25
1 zloty = 21.25 yen
[Note: you can work this out algrebraically
USD/Zloty x 1/(USD/Yen) = USD/Zloty x Yen/USD = Yen/Zloty]
4. Foreign Exchange. You just came back from Canada, where the Canadian dollar was
worth $.70. You still have C$200 from your trip and could exchange them for dollars at
the airport, but the airport foreign exchange desk will only buy them for $.60. Next week,
you will be going to Mexico and will need pesos. The airport foreign exchange desk will
sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and
is on his way to Canada. He is willing to buy your C$200 for 1300 pesos. Should you
accept the offer or cash the Canadian dollars in at the airport? Explain.
ANSWER: Exchange with the tourist. If you exchange the C$ for Mexico pesos
(MPs) at the foreign exchange desk, the cross-rate, MP/C$ = $.60/$.10 = 6 or C$1.00
= MP6.00. Thus, the C$200 would be exchanged for 1300 1200 pesos (computed as
200 × 6). If you exchange Canadian dollars for pesos with the tourist, you will receive
1300 pesos.
[Note: USD/CAD x 1/(USD/MP) = MP/CAD = 6.0 MP/CAD
Also, the tourist is offering an exchange rate = 1300/200 = 6.5 MP/CAD
Hence you get more MP for each CAD you exchange with the tourist.
Just as a note – you will most likely do better exchange with the tourist than with the
foreign exchange counter. The money changer always charges a bid/ask spread to
both you and the tourist. By exchanging directly with the tourist, you are both
effectively ‘cutting out the middleman’, which benefits both sides.]
5. Forward Premium. Compute the forward discount or premium for the Mexican peso whose
90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or
premium.
ANSWER:
Annualized forward discount/premium for Mexican peso = (F - S) / S
=($.102 - $.10) / $.10 × (360/90)
= 0.08, or 8%, which reflects a 8% premium
6. Suppose Dow Chemical receives quotes of $0.009369-71 for the yen and $0.03675-6
for the Taiwan dollar (NT$).
a. How many U.S. dollars will Dow Chemical receive from the sale of ¥50 million?
ANSWER. Dow must sell yen at the bid rate, meaning it will receive from this sale
$468,450 (50,000,000 x 0.009369).
[Note: the reasoning process is :
The rate quoted by the Bank is USD quote currency, Yen is base currency.
Since I am the customer, the bid rate is the side that pays me less USD per one Yen.]
b. What is the U.S. dollar cost to Dow Chemical of buying ¥1 billion?
ANSWER. Dow must buy at the ask rate, meaning it will cost Dow $9,371,000
(1,000,000,000 x 0.009371) to buy ¥1 billion.
c. How many NT$ will Dow Chemical receive for U.S.$500,000?
ANSWER. Dow must sell at the bid rate for U.S. dollars (which is the reciprocal of the ask
rate for NT$, or 1/0.03676), meaning it will receive from this sale of U.S. dollars
NT$13,601,741 (500,000/0.03676).
[Note: another way to think of this is, you are selling USD means you are buying NT$.
Hence you need to buy NT$ at the ask side, which is more expensive.]
d. How many yen will Dow Chemical receive for NT$200 million?
ANSWER. To buy yen, Dow must first sell the NT$200 million for U.S. dollars at the bid
rate and then use these dollars to buy yen at the ask rate. The net result from these
transactions is ¥784,334,649.45 (200,000,000 x 0.03675/0.009371).
[Note: You can’t simply reciprocal the rates as in problems (3) and (4) since now you
have bid/ask spreads. Safest way is to work it out step-by-step as in the worked solution
above. Just don’t be careless!
 I start with NT$, which I need to sell at the bid (cheaper) rate to get USD:
# of USD received = 200,000,000 x 0.03675
 I now use the USD to buy JPY at the ask (more expensive rate).
# of Yen received = # of USD received / ask rate
= 200,000,000 x 0.03675/0.009371
]
e. What is the yen cost to Dow Chemical of buying NT$80 million?
ANSWER. Dow must sell the yen for dollars at the bid rate and then buy NT$ at the ask
rate with the U.S. dollars. The net yen cost to Dow from carrying out these transactions is
¥313,886,220.51 (80,000,000 x 0.03676/0.009369)
[Note:
In the first step, how many USD do you need to buy NT$80 mio?
# of USD that you need to buy NT$ = 80,000,000 x ask = 80,000,000 x 0.03676
In the second step, you need to sell Yen to buy USD, which you do at the Yen bid:
# of Yen that you need to buy USD = # of USD / bid
= 80,000,000 x 0.03676 / 0.009369
For these kinds of questions, work it out step-by-step. Just be very careful about
which side (bid/ask) you take, as well as whether you multiply or divide. ]
7. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against
the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank
lending and borrowing rates exist:
Lending Rate
U.S. dollar
Singapore dollar
7.0%
22.0%
Borrowing Rate
7.2%
24.0%
Diamond Bank considers borrowing 10 million Singapore dollars in the interbank
market and investing the funds in dollars for 60 days. Estimate the profits (or losses)
that could be earned from this strategy. Should Diamond Bank pursue this strategy?
ANSWER:
Borrow S$10,000,000 and convert to U.S. $:
S$10,000,000 × $.43 = $4,300,000
Invest funds for 60 days. The rate earned in the U.S. for 60 days is:
7% × (60/360) = 1.17%
Total amount accumulated in 60 days:
$4,300,000 × (1 + .0117) = $4,350,310
Convert U.S. $ back to S$ in 60 days:
$4,350,310/$.42 = S$10,357,881
The rate to be paid on loan is:
.24 × (60/360) = .04
Amount owed on S$ loan is:
S$10,000,000 × (1 + .04) = S$10,400,000
This strategy results in a loss:
S$10,357,881 – S$10,400,000 = –S$42,119
Diamond Bank should not pursue this strategy.
[Note: this diagram represents this kind of uncovered interest arbitrage :
Deposit US$
Interest earned
in US$ @
7% p.a.
US$ Deposit
matures ->
receive P+I
60 days
Convert spot
to USD at
$0.43/S$
Convert to
SGD at
$0.42/S$
60 days
Borrow
S$10 mio
Interest payable
in S$ @
24% p.a.
S$ Loan matures
-> pay P+I
Note that the FX rates in this question are quoted without bid/ask spread, whereas the
borrowing/lending rates are quoted with bid/ask spreads. In the exam, be prepared
that both might have bid/ask spreads. Just remember, as the customer you always
receive the worse rate:
FX quote
Interest rate
quote
]
Buy at the more expensive (offer) rate
for the base currency
Borrow at the higher interest rate
Sell at the cheaper (bid) rate for the
base currency
Lend at the lower interest rate