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CHAPTER 22
INTERNATIONAL FINANCIAL
MANAAGEMENT
ANSWERS TO QUESTIONS:
1. The theory of interest rate parity states that the annual percentage differential in the forward
market for a currency quoted in terms of another currency is equal to the approximate difference
in interest rates in the two countries.
2. Covered interest arbitrage is a riskless technique used by foreign exchange traders to take
advantage of profit opportunities arising if interest rate parity does not hold. For example, if a
U. S. trader (1) sells U.S. dollars and buys spot British pounds, (2) invests the pounds to earn 14
percent, (3) sells forward pounds, and (4) converts back to dollars at the end of the forward
period, the trader will earn 10 percent instead of the 8 percent available in the U.S. markets.
3. A forward market hedge (or a futures market hedge) consists of executing a contract in the
forward exchange (or the futures exchange) market at a known forward (or futures) rate rather
than at the uncertain spot rate prevailing on the payment date. A money market hedge consists
of borrowing funds, exchanging them for a foreign currency at the spot rate, and investing them
in interest-bearing securities denominated in the foreign currency. By investing in securities
that mature on the same date payment is due to the seller, the buyer will have the necessary
amount of foreign currency to pay the seller.
4. Exchange rates between currencies change over time based on the supply of and demand for
each currency. Primary sources of supply of a country's currency include importers who need to
convert their domestic currency into foreign currency to pay for purchases, investors who wish
to make investments in foreign countries, and speculators who expect the currency to decline in
value relative to other currencies. Primary sources of demand include foreign buyers who must
pay for their purchases in the domestic currency, foreign investors who wish to make
investments in the country, and speculators who expect the currency to increase in value
relative to other currencies. Exchange rates are affected by all economic and political
conditions that influence the demand for and supply of a country's currency. These include
differential inflation and interest rates among countries, government trade policies, and the
political stability of the government.
5. Advantages to U.S. firms of financing foreign investments with funds raised abroad:
a. Avoids any restrictions imposed by the U.S. government on the amount of funds U.S.
firms can invest abroad.
b. Helps to minimize any losses that might occur if the foreign currency is devalued
or if the foreign government imposes restrictions on the outflow of funds from the
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country.
c. Avoids the disclosure requirements (and associated costs) imposed by the SEC when
debt securities are issued in the U.S.
6. Refer to Figure 22-1.
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SOLUTIONS TO PROBLEMS:
1. F/S = (1+ ih)/(1 + if)
1 + ih = (1.07).25 = 1.0171
F = $1.68
S = $1.69
$1.68/$1.69 = 1.0171/(1 + if)
1 + if = 1.0231
if = 2.31% for .25 years, or (1.0231)4 -1 = 9.57% per annum
2. The conditions do present an opportunity for covered interest arbitrage. The trader
in New York should sell U.S. dollars and buy spot British pounds and invest the
pounds to earn 13%. Simultaneously, the New York trader should sell forward pounds
at the prevailing 3% annual discount. Then, at the end of the forward period, the
trader should convert pounds back to dollars. As a result, the New York trader would
earn approximately 10% instead of the 8% rate available in the U. S. domestic money
markets.
3.
a. Zurich Bank CD: 1/2 x 12.5% = 6.25%
Exchange
Value of Investment
Date
Rate
U.S. Dollars
Day 0 (Today)
.4200
5,000,000
Day 180 (Maturity) .4200
5,312,500
Swiss Francs (CHF)
» 11,904,761.9
«
12,648,809.52*
*11,904,761.9 x (1.0625) = 12,648,809.52
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Note: In this problem, because the exchange rate is assumed to remain constant over
the 180 day period, the $5,312,500 figure can be calculated simply by multiplying
$5,000,000 by 1.0625.
PNB CD: 1/2 x 10.0% = 5.0%
Day 0 (Today)
= $5,000,000
Day 180 (Maturity)
= $5,000,000 (1 + 0.05)
= $5,250,000
Net gain = $5,312,500 - $5,250,000 = $62,500
b.
Exchange
Value of Investment
Date
Rate
U.S. Dollars
Day 0 (Today)
.4200
5,000,000
Day 180 (Maturity)
.3990*
5,046,875
«
CHF
» 11,904,761.9
12,648,809.52
*0.4200 x (1 - .05) = 0.3990
Net gain = $5,046,875 - $5,250,000 = -$203,125
c.
Exchange
Date
Rate
Day 0 (today)
.4200
Day 180 (Maturity)
.4155
Value of Investment
U.S. Dollars
5,000,000
5,255,580
«
CHF
»
11,904,761.9
12,648,809.52
Net gain = 5,255,580 - 5,250,000 = $5,580
d. Exchange restrictions. Brokerage fees to execute currency
exchange contracts.
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4.
Last year: Euro700,000/Euro1.2 per dollar = $583,333
This year: Euro900,000/Euro1.0 per dollar = $900,000
5. a. Forward rate equals an unbiased estimate of the future spot
rate: $0.19/Shekel
b. Purchasing Power Parity:
Using Fisher effect relationship, expected inflation is:
In the U.S.: (1.11/1.02 ) - 1 = 0.0882 or 8.82%
In Israel: (1.15/1.02) - 1 = 0.12745 or 12.75%
S1/ $0.20 = 1.0882/1.12745
S1 = $0.193/Shekel
c. International Fisher Effect:
S1/$0.20 = 1.11/1.15
S1 = $0.193/Shekel
Note: information on the call option premium cannot be used to
determine the expected future spot rate.
6. Direct Quote for Won = 1/350 = $0.00286
Shoesmith Wave Forecast:
S. Korean inflation = 9% per year for 5 years
U.S. inflation = 3% per year for 5 years
S5/$0.00286 = (1.03)5/(1.09)5
S5 = $0.00215/won or 464 won/$
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International Fisher Effect Forecast:
Note: One percent of the yield differential is attributable to political risk
differences. Net of this risk, the S. Korean interest rate is 10 percent
per Annum.
S5/$0.00286 = (1.06)5/(1.10)5
S5 = $0.00238/won or 421 won/$
7. a. Buy £ forward at $1.47: Cost = $1.47/£ x £200,000 = $294,000
b. Money market hedge:
1. Invest £200,000/1.045 = £191,388 in Britain at 4.5% per 180
days.
2. In order to invest £191,388, you need to borrow in the U.S.
£191,388 x $1.50/£ = $287,082.
3. Hence borrow $287,082 at 5 percent per 180 days for a net cost
of $301,436.
c. Assuming the forward rate is an unbiased estimate of the future spot rate, the
expected cost is $1.47/£ x £200,000 = $294,000.
d. The forward hedge is preferred because it has the lowest net cost and the
lowest risk. However, by undertaking this hedge, Jennette will miss out on any
strengthening of the dollar during the period that credit is granted.
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8. Borrow HKD100,000.
Pay back at the end of the year HKD100,000 x 1.18 = HKD118,000.
Convert HKD100,000 to U.S. dollars at HKD7/$ = $14,286
At the end of the year you need HKD118,000/HKD8/$ = $14,750
Nominal interest cost = ($14,750 - $14,286)/$14,286 = 3.25%
Real cost 3.25% - 2% U.S. inflation = 1.25%
9. Proceeds needed in dollars = $1.4 million x 1.03 x 1.03 = $1.4853 million
Expected future spot rate: Use the International Fisher Effect relationship for an
unbiased estimate of the expected future spot rate:
S1 /( $0.66 / CHF) = (1.055)2 / (1.045)2
S1 = $0.673 / CHF
Expected price to charge in CHF = $1.4853 million / ($0.673/CHF) = CHF2.207
million.
10.
F / S = (1 + ih) / (1 + if)
$0.5743 / $0.58 = (1 + 0.031) / (1 + if)
if = 0.0412 or 4.12%
Since the CHF is expected to decline in value relative to the dollar, Swiss
securities must offer higher rates to offset the expected loss of value of the CHF.
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