SUBJECT: FI 403 INTERNATIONAL FINANCE 2

DATE:TIME :

DURATION: 3 HOURS

FI403CL Pua

Section A [40 marks]

1. Suppose that your firm is a U.S.-based importer of German automobile accessories. You pay for them in euros and sell them in dollars. You have just ordered next year's inventory. In one year your firm owes a payment of €100,000 to your German supplier. Today's spot exchange rate is €1.00 = \$1.20; the one-year forward rate is €1.00 = \$1.15. How can you fix the dollar cost of this order?
2. Enter into long position in the one-year euro futures contract at €1.00 = \$1.15. This will fix the cost of €100,000 at \$115,000.
3. Enter into short position in the one-year euro futures contract at €1.00 = \$1.15. This will fix the cost of €100,000 at \$115,000.
4. Since the spot price is more than the forward price, you should trade your dollars for euros today and pay your supplier early.
5. Sell a call option on the euro with a one-year maturity.

1. Explain the process of a money market hedge for a foreign currency obligation.
2. Estimate the size of your contractual foreign currency obligation in dollars using the forward rate. Find the present value of that using the U.S. dollar interest rate. Buy the present value of the foreign currency obligation at the spot exchange rate. Invest the proceeds at the foreign currency interest rate.
3. Estimate the size of your foreign currency obligation. Buy enough call options to meet this obligation. At maturity, exercise the calls.
4. Estimate the size of your contractual foreign currency obligation. Buy that much foreign currency at the spot rate, pay early.
5. Estimate the size and timing of your contractual foreign currency obligation. Find the present value of the obligation using the foreign currency discount rate. Buy the present value of the foreign currency obligation at the spot exchange rate. Invest the proceeds at the foreign currency interest rate.

1. For an exporter selling in one foreign currency, if the domestic currency is strong or expected to become strong:
2. The firm can hedge by selling their home currency forward.
3. The firm could hedge by buying foreign currency forward.
4. a) and b) are both correct
5. The firm could hedge by buying their home currency forward.

1. Economic exposure measures
2. The extent to which the value of the firm is affected by anticipated changes in exchange rates.
3. The extent to which the value of the firm will be affected by unexpected changes in exchange rates.
4. The affect of changes in exchange rates will have on the consolidated financial reports of a MNC.
5. The affect of unanticipated changes in exchange rates on the value of contractual obligations denominated in a foreign currency.

1. Operating exposure measures
2. The extent to which the foreign currency value of the firm's assets is affected by unanticipated changes in exchange rates.
3. The extent to which the firm's operating cash flows will be affected by unexpected changes in exchange rates.
4. The affect of changes in exchange rates will have on the consolidated financial reports of a MNC.
5. The affect of unanticipated changes in exchange rates on the dollar value of contractual obligations denominated in a foreign currency.

1. A firm with a highly elastic demand for its products
2. Will be unable to pass increased costs following unfavorable changes in the exchange rate without significantly lowering the quantity sold.
3. Will be able to raise prices following unfavorable changes in the exchange rate without significantly lowering the quantity sold.
4. Can easily pass increased costs on to consumers.
5. Will sell about the same amount of product regardless of price.

1. With regard to operational hedging versus financial hedging
2. Operational hedging provides a more stable long-term approach than does financial hedging.
3. Financial hedging, when instituted on a rollover basis, is a superior long-term approach to operational hedging.
4. Since they both have the same goal, stabilizing the firm's cash flows in domestic currency, they are fungible in use.
5. None of the above statements are correct.

1. Which of the following are identified by your text as a strategy for managing operating exposure:

1)Selecting low-cost production sites

2)Flexible sourcing policy

3)Diversification of the market.

4)Product differentiation and R & D efforts

5)Financial Hedging

1. 1), 3), and 5) only
2. 2) and 4) only
3. 1), 4), and 5) only
4. 1), 2), 3), 4), and 5).

1. In many cases, it is not possible to completely eliminate both transaction exposure and translation exposure. If a conflict such as this arises, which exposure should be viewed as the most important to effectively manage?
1. Translation exposure
2. Transaction exposure
3. Economic exposure
4. None of the above

1. The two methods for dealing with (hedging) translation exposure are
1. Balance sheet hedge and derivatives hedge.
2. Current rate hedge and derivatives hedge.
3. Derivatives hedge and temporal hedge
4. Transactions hedge and balance sheet hedge

1. The international debt crisis was caused by
1. Interest rates that became too high, burdening debtor nations.
2. International banks lending more to Third World sovereign governments than they should have.
3. Sovereign governments raising taxes too quickly.
4. Eurodollar defaults

1. Your firm borrows €1,000,000 at LIBOR + ½ percent on a six-month rollover basis. If six-month LIBOR is 5 percent over the first six-month period and 6% over the second six-month period, how much in interest will your firm pay over the first year of the loan?
1. 5½ % or €55,000
2. 12% or €120,000
3. 6% or €60,000
4. none of the above

1. Other things equal, investors will generally ______on bearer bonds than on registered bonds of comparable terms.
1. demand a higher credit rating
2. demand a higher yield
3. accept a lower yield
4. a) and b) are both correct

1. The credit rating of an international borrower:
1. Depends on the volatility of the exchange rate.
2. Depends on the volatility, but not absolute level, of the exchange rate.
3. Is usually never higher than the rating assigned to the sovereign government of the country in which it resides.
4. Is unrelated to the rating assigned to the sovereign government of the country in which it resides.

1. If the domestic currency is strong or expected to become strong:
1. A firm can choose to locate production facilities in a foreign country where costs are low due to either the undervalued currency or underpriced factors of production.
2. A firm should curtail R & D efforts until the exchange rate situation improves.
3. A firm should abandon international sales and focus on domestic market share.
4. The firm should focus on profiting in the currency futures market based on its forecasts.

1. Consider a plain vanilla interest rate swap. The Eun Corporation can borrow at 8% fixed and can borrow floating at LIBOR. The Resnick Corporation is somewhat less creditworthy and can borrow at 10% fixed and can borrow floating at LIBOR + 1%. Eun wants to borrow floating and Resnick wants to borrow fixed. Both corporations wish to borrow \$10 million for 5 years. Which of the following swaps is mutually beneficial to each party and meets their financing needs?
1. Eun borrows \$10 million externally for 5 years at LIBOR; agrees to swap LIBOR to Resnick for 8.5% fixed for 5 years on a notational principal of \$5 million; Resnick borrows \$10 million externally at 10%.
2. Eun borrows \$10 million externally for 5 years at LIBOR; agrees to pay 8.5% to Resnick for LIBOR fixed for 5 years on a notational principal of \$5 million; Resnick borrows \$10 million externally at 10%.
3. Since the QSD = 0 there is no mutually beneficial swap
4. Eun borrows \$10 million externally at 8% fixed for 5 years; agrees to swap LIBOR to Resnick for 8.5% fixed for 5 years on a notational principal of \$5 million; Resnick borrows \$10 million externally at LIBOR + 1%.

1. A Eurodollar is:
1. What the Europeans call the euro.
2. Deposits of U.S. dollars held in Europe, but not elsewhere.
3. A time deposit of U.S. dollars in an international bank located outside the United States.
4. A time deposit of euros.

1. Regarding a bearer bond
1. Possession is evidence of ownership
2. The owner's name is on the bond and registered with the issuer.
3. The owner's name registered with the issuer but not on the bond.
4. There is a serial number on the bond and the owner's name is assigned to that serial number

1. Six-month U.S. dollar LIBOR is currently 4.375%; your firm issued floating-rate notes indexed to six-month U.S. dollar LIBOR plus 50 basis points. What is the amount of the next semi-annual coupon payment per U.S. \$1,000 of face value?
1. \$43.75
2. \$48.75
3. \$24.375
4. \$46.875

1. With regard to a swap bank acting as a dealer in swap transactions, interest rate risk refers to
1. The risk that arises from the situation in which the floating-rates of the two counterparties are not pegged to the same index.
2. The risk that interest rates changing unfavorably before the swap bank can lay off to an opposing counterparty on the other side of an interest rate swap entered into with the first counterparty.
3. The risk the swap bank faces from fluctuating exchange rates during the time it takes for the bank to lay off a swap it undertakes with one counterparty with an opposing transaction.
4. The risk that a counterparty will default.

FI403CL Pua

Section B [60 marks]

Question 1 [20 marks]

Nifty International Hotel is considering investing in a new Australia hotel. The required initial investment is \$1.5 million (or AUD 1.86 million at the current exchange rate of \$0.8064 = AUD 1). The total profits earned for the initial 10 years will be reinvested. After which, Nifty would like to sell out to its partner. Based on the projected earnings, Nifty’s share of this hotel will be worth AUD 3.86 million in 10 years.

1. What factors are relevant in evaluating this investment? [8 marks]
2. How will the fluctuations in the value of the Australian Dollar affect this investment? [6 marks]
3. How would you, as the Finance Executive, forecast the \$:AUD exchange rate 10 years ahead? [6 marks]

a.

Economic Exposure – value of the firm, as measured by present value of its expected future cash flows, will be change when exchange rates change.

2 types of economic exposure – Transaction exposure (exchange gains or losses on foreign currency-denominated contractual obligations) & Operating exposure (currency fluctuations that alter a company’s future revenues and costs i.e. operating cash flows)

Exchange risk – variability in the firm’s value that is caused by uncertain exchange rate changes

b. If appreciate – value converted to USD will be higher; if depreciate – value converted to USD will be lower

Operationally – appreciate – more costly for people to spend their holidays in Australia – depreciate – more competitive and may fetch higher price than expected

c. Forecasts of inflation and exchange rates, identify and highlight risks of competitive exposure, estimate and hedge whatever exposure that remains

For each valid point – 1 mark

For each point with illustration / examples – 2 marks

Total max of : 20 marks

Question 2 [20 marks]

Suppose Company A (in the United States) would like to borrow fixed-rate yen, whereas JP Bank (in Japan) would like to borrow floating-rate dollars. Company A can borrow fixed-rate yen at 5.5% or floating-rate dollars at LIBOR+0.8%; JP Bank can borrow fixed-rate yen at 4.0% or floating rate dollars at LIBOR+0.5%.

1. What is the range of possible cost savings that Company A can realize through an interest rate / currency swap with JP Bank? [5 marks]
2. Illustrate with diagram on how a swap can be done between Company A and JP Bank. [10 marks]
3. Assuming a notional principal equivalent to \$125 million and a current exchange rate of ¥116.83:\$1, what does these possible cost savings translate in yen terms? [5 marks]

a.

Borrower / Fixed-Rate / Floating Rate
A / 5.5% / LIBOR+0.8%
JP / 4.0% / LIBOR+0.5%
Difference / 1.5% / 0.3%

b. Rate difference can be distributed as per student’s illustration.

Question 3 [20 marks]

Timber Co is trying to decide how to go about hedging DM 50 million of its sales receivable in 180 days. Suppose it faces the following exchange and interest rates.

Spot Rate / \$0.6533 – 42 / DM
Forward rate (180 days) / \$0.6678 – 99 / DM
DM 180-day interest rate (annualized) / 4.01% - 3.97%
USD 180-day interest rate / 8.01% - 7.98%
1. What is the hedged value of Timber Co’s sales if using a forward market hedge? [2 marks]
2. What is the hedged value of Timber Co’s sales if using a money market hedge? [2 marks] Assume that the first rate is the rate which money can be borrowed and the second one the rate at which it can be lent.
3. Suppose the expected spot rate in 180 days is \$0.77/DM with a most likely range of \$0.74 – \$0.80 / DM. Should Timber Co hedge? What factors should enter into its decision? [16 marks]
1. \$0.6699 x DM 50 million
2. 4.01%
3. Borrow USD at 8.01% annualized for 180 days. Convert to DM at \$0.6542. Invest the DM for 180 days at 3.97% and use the loan proceeds to pay back the loan. [6 marks]

Other factors: Volatility of currencies, inflation rate risk, country risk – each point 1 mark, with examples 2 marks, max of 9 marks

FI403CL Pua