Questions and topics for discussion

1. Define the following terms:

a. Multinational corporation.

b. Spot exchange rate.

c. Forward exchange rate.

d. Direct quote versus indirect quote.

e. Letter of credit.

f. LIBOR.

g. ECU.

2. What is the theory of interest rate parity?

3. What is covered interest arbitrage?

4. Describe two techniques that a company can use to hedge against transaction exchange risk

5. Describe the factors that cause exchange rates to change over time

6. What are the advantages to a U.S. firm of financing its Foreign investments with funds raised abroad?

7. Describe how the concepts of relative purchasing power parity, interest rate parity, and international Fisher effect are related.

8. DISCLOSURE APPLICATION Use the "notes to consolidated financial statements" section of the Disclosure reports for Merck, Pepsico, and Ford Motor to compare the procedures used for the translation of foreign currencies and the impact of these procedures on net income and stockholders' equity

Self test problems

ST1. What is the premium between the spot rate and the 90-day forward rate for the Swiss franc on December 1, 1993? What does this imply about the future spot rate for Swiss francs? (See Tables 3-2 and 3-3)

ST2. Assume that the annualized discount on forward Canadian dollars is 3 percent The annualized U.S. interest rate is 8 percent, and the comparable Canadian interest rate is 12 percent. How can a U.S. trader use covered interest arbitrage to take advantage of this situation?

ST3. Chrysler is planning to sell its new minivan in Japan. Chrysler receives $12,000 for each van sold in the United States and wants to get the same net proceeds from its export sales

a. If the exchange rate of Japanese yen for U S dollars is ¥140 = $1, what price must Chrysler charge in Japan (in yen)?

b. What price will Chrysler have to charge in Japan if the value of the dollar falls to 120 yen?

ST4. The annualized yield on three-year maturity U.S. government bonds is 4 percent, while the yield on similar maturity Italian bonds is 9 percent. The current spot exchange late between the dollar and the lira is $0.000592/lira. What is the expected future spot rate for the lira in three years?

Problems

1. Japanese Motors exports cars and trucks to the U.S. market. On March 3, 1986, its most popular model was selling (wholesale) to U.S. dealers for $7,500. What price must Japanese Motors charge for the same model on December 1, 1993, to realize the same amount (of Japanese yen) as it did in 1986 (Refer to Table 3-2)

2. Valley Stores, a U.S. department store chain annually negotiates a contract with Alpine Watch Company, located in Switzerland, to purchase a large shipment of watches. On March 3, 1986, Valley purchased 10,000 watches for a total of 1.26 million Swiss francs. Refer to Table 3-2 and determine the following:

a. The total cost and cost per watch in U.S. dollars

b. The total cost and cost per watch in U.S. dollars of 12,000 watches purchased on December 1, 1993 assuming that Alpine's price per watch (in Swiss francs) remains unchanged

3. Determine the percentage change in the value of the U.S. dollar between March 3, 1986, and December 1, 1993, relative to the value of the following currencies (refer to Table 3-2)

a. India

b. Britain

c. Japan

d. ECU.

e. Germany.

4. Compute the indirect quote for the lira, rupee, krona, and yen as of December 1, 1993. (Refer to Table 3-2.)

5. If the 1-year U.S. Treasury bill rate is 7.0 percent, the spot rate between U.S. dollars and British pounds is £1 = $1.69, and the 90-day forward rate is £1 = $1.68, what rate of interest is expected on British Treasury bills, assuming interest rate parity between the dollar and pound exists?

6. Suppose the British short-term interest rates are 13 percent and the corresponding U.S. rate is 8 percent. Suppose at the same time that the discount on forward pounds is 3 percent per year. Do these conditions present an opportunity for covered interest arbitrage? If so, what steps should a trader in New York take? What annual rate will the trader earn?

7. Mammouth Mutual Fund of New York has $5 million to invest in certificates of deposit (CDs) for the next six months (180 days). It can buy either a Philadelphia National Bank (PNB) CD with an annual yield of 10 percent or a Cologne (Germany) Bank CD with a yield of 12.5 percent. Assume that the CDs are of comparable default risk. The analysts of the mutual fund are concerned about exchange rate risk. They were quoted the following exchange rates by the interna­tional department of a New York City bank:

Germany (Deutsche mark)

Spot $0.4200

30-day forward 0.4190

90-day forward 0.4170

180-day forward 0.4155

a. If the Cologne Bank CD is purchased and held to maturity, determine the net gain (loss) in U.S. dollars relative to the PNB CD, assuming that the exchange rate in 180 days equals today's spot rate.

b. Suppose the German mark declines in value by 5 percent relative to the U.S. dollar over the next 180 days. Determine the net gain (loss) of the Cologne Bank CD in U.S. dollars relative to the PNB CD for an uncovered position.

c. Determine the net gain (loss) from a covered position.

d. What other factor or factors should be considered in the decision to purchase the Cologne Bank CD?

8. Last year, the French marketing subsidiary of International Pharmaceuticals Corpo­ration (IPC), a New Jersey-based drug manufacturer, earned 700,000 French francs. This year, partly due to a weaker U.S. dollar, the French subsidiary will earn 900,000 French francs. Last year, the exchange rate was 10 francs per dollar, and this year, it is 7 francs per dollar. Calculate how many U.S. dollars the French subsidiary contributes to IPC's earnings in each year.

9. The 30-day Treasury bill rate in the United Stales is 8 percent (annualized). Use the data in Tables 3-2 and 3-3 on spot and 30-day forward rates for Swiss francs to determine the equilibrium 30-day interest rate (annualized) in Switzerland, assum­ing interest rate parity holds.

10. As of today, the following information is available

United States France

Real rate of interest required by investors 2.0% 2.0%

Nominal interest rate 11.0 15.0

Spot rate $0.20/FF

One-year forward rate $0.19/FF

Call option premium at a strike price of $0.20 2%

Using this information, make three independent forecasts of the one year future spot rate for FF (Use exact, not approximation, relationships)

11. Shoesmith Wave, Inc , a new and largely unproven, economic forecasting service expects the inflation rate in Italy to average 9 percent per year over the next five years. In comparison Shoesmith expects a U.S. inflation rate over this same period to be 3 percent per year. The yield on five year U.S. government bonds is 6 percent per year. The yield on five-year Italian government bonds is 11 percent per year. One percentage point of this yield differential can be accounted for by political risk differences between the United States and Italy, with the United States perceived as having the lower political risk. The current exchange rate is 1220 lira per dollar.

Forecast the future five year spot rate for the lira (versus the dollar) using the Shoesmith Wave forecast and the forecast from the financial markets

12. The Jennette Corporation, a firm based in Mt. Pleasant, South Carolina, has an account payable with a British firm coming due in 180 days. The payable requites Jennette to pay £200,000. Winthrop Jennette, the firm's founder and CEO, is an astute manager. He has asked his CFO, Aitis Montgomery, to advise him on the various options for dealing with the exchange risk inherent in this payable. He wishes to know the expected dollar cost of (1) a forward hedge, (2) a money market hedge and (3) remaining unhedged.

The following information is available to Artis. The spot rate of the pound today is $1.50. The current 180-day forward rate of the pound is $1.47. Interest rates are as follows:

United Kingdom United States

180-day deposit rate 45% 45%

180-day borrowing rate 50% 50%

a. What is the expected dollar cost of the forward hedge?

b. What is the expected dollar cost of the money market hedge?

c. What is the expected dollar cost of remaining unhedged?

d. Which alternative do you recommend? What are the risks associated with this recommendation?

13. On January 1, the cost of borrowing French francs for one year was 18 percent. During the year the U.S. inflation rate was 2 percent and the French inflation rate was 9 percent. The exchange rate on January 1 was FF7/$. On December 31 the exchange rate was FF7/$. If you borrowed FF100,000 on January 1, converted this to dollars and used these funds for one year, and then paid off the FF loan on December 31, what was the real cost of borrowing FF for one year?