Define and give an example of relative purchasing power parity

Short Questions & Definitions

Question: 1

a)     Define and give an example of relative purchasing power parity.Relative purchasing power parity explains the association between the two country’s inflation rates in specific period of time. The formula of relative purchasing power parity is:

b)      Are implied forward rates good predictors of future spot rates? Explain.The implied rate is the difference of interest rate for forward and the spot interest rate. The studies have shown that spot rate are a better predictor of future spot rate rather than forward rates.

c)      Define and give an example of reciprocal arbitrage.Reciprocal arbitrage is about purchasing security in one market and selling in another market in higher price. For example an investor purchases a security from foreign exchange and then sell it to another market on profit.

d)      What is uncovered interest parity used for?Uncovered interest rate parity explains that the difference between two county’s interest rates will equalize the exchange rate in the same period. It is the form of IRP and used with covered interest parity.

e)      What is the most important difference between an FX forward and futures contract?Future contracts are standardized whereas forward contracts are negotiated privately and that is one of the most important difference between FX forward & future contracts.

f)       What are American quotes? Give an example.American currency quotation is used as per unit measure for evaluating the foreign currency. In short it is the direct quotation in different exchange markets around the world.

g)      Explain what is meant by a money market hedgeIt is technique used for hedging the foreign exchange risk by using the money markets.

h)      Define synthetic debt and give an exampleSynthetic debt is the debt obligation for the individual who have invested in the CDSs (Credit Default Swaps)

i)       What is the difference between FX risk and exposure?The foreign exchange risk is the risk of changes in value of currency. There are many types of foreign exchange risk exposures such as economic exposure.

j)        Define and give an example of translation exposure.

The transaction exposure occurs when the payment is dominated in foreign currency.

Question: 2

Exchange Rate Regime

a)       Pegged exchange rate is known as one the most important type of exchange rate regime in which the key consideration is that currency value should be fixed against the value of other currencies (the currency of other countries). While on the other hand, the floating exchange rate is a regime where a nation set out their currency pricesby the forex market on the basis of supply and demand flow relatively to other currencies. SEK followed the regime of free floating while on the other hand DKK decided to pick up the pegged regime (Robinson, Henry, Pirie, Broihahn, & Cope, 2015).  

b)     Fixed and floating exchange rates has several advantages and disadvantages for monetary policy, consumers, importers, and exporters.

c)      There are some countries that are pegging their currencies in theEuro. For instance Denmark that has currency of DKK. While on the other hand other countries such as Iceland and Norway, are linked with the EU. These countries has full independence in economic affairs and monetary circulation. Therefore, DKK and SEK fortunes are sharply diverging. Basically, both DKK and SEK are facing different circumstances. Somehow, SEK is relatively in stable and better position as compared to the position of DKK. High investment and Swedish interest rates were the key factors that support SEK to be stable. While later changes in the policy caused risk of disruptive decline as a result of this SEK was influenced negatively.(Wheatley, 2018)

d)     The FT article suggest the alternative currency trade supported by the Russian government. As a result of increase in this trade there is possibility that SEK will face problems. SEK is concerned with Euro but Russian bonds support their own currency and decrease in federal reverse of foreign currency (for instance, currency reverse of UK and US).

e)      The FT article explains that association between markets and SEK. Article explained that SEK is associated with the Korea. But the target of Russian Federation is to maximize their bond market therefore, it is possibility that increase in the Russian bond market influence the SEK(Wheatley, 2018). Somehow, it does not mean that main target is to influence SEK in fact, SEK is getting effect indirectly as Russia just want to promote their bond market to get financial advantages. 

Question: 3

Champagne PPP

a)      Define the Law of One Price and Purchasing Power Parity.

LOOP (LAW of one price) explains that if no trade frictions e.g. tariffs exist and there is free competition in the market than same goods in different countries should be sold on same prices when express common currency. This law is the basis of purchasing power parity theory.  Purchasing Power Parity on the other hand evaluates the economic variables of different countries. In this law irrelevant exchange rate variations have no impact on the comparisons.

b)     What spot exchange rate would establish the Law of One Price in terms of champagne? What is this FX rate called?

If the FX rate of USD-BRL becomes 3.33 than the law of one price will be established with reference to champagne.  This FX rate will be called nominal exchange rate. Nominal exchange rate shows how much foreign currency can be converted into local currency.

c)      If the current spot FX rate is BRL 3.5709/USD (December 01, 2016) what is the real exchange rate? Is the BRL overvalued or undervalued?

BRL 3.3333/USD would be the real FX rate. Real exchange rate is comparing the price of the products that are same in both nations. As the spot rate is BRL 3.5709/USD then it can be said that BRL is undervalued currently.

d)     Inflation is expected to run between 4.5% in Brazil (official target rate of the Central Bank for 2017) and 5% (OECD forecast for 2018). In the US, the OECD expects it to run at about 2.2% in the next year. What is a good estimate of the future BRL/USD spot rate?

The future spot rate of BRL/USD is evaluated as follows:

Question: 4

Contractual Exposure: Aeroflot and the Russian Ruble

a)      What are the realistically available alternatives for Aeroflot to make payment?

The realistically available alternatives for Aeroflot to make payment other than airline services revenue are to promotion of tourism and revenue generated from the oil industry in Russia.Company can earn revenue through investing in the energy sector as it is one of the most important sector in the Russia. 

b)      Which is the best strategy to minimize Aeroflot’s expected expense for making the final payment?

The best strategy to minimize the expected expense is to increase the time span as a result of this company will have to pay relatively less amount in the final payment. Furthermore, Aeroflot can renegotiate the contract and discount options to cut cost and expense that will reduce final payment.

c)      Suppose Aeroflot decid   

Consequences

As a result of depreciation in the value of RUB Aeroflot company will face financial issues. If they are earning in RUB but they have to make payment to the Boeing order in USD then company will have to pay more RUBs as a result of depreciation.

 Options

According to the given scenario Aeroflot has three key options to meet its obligations that are presented below:

Highest expected rate RUB 35/USD

Most likely rate RUB 31.50/USD

Lowest expected rate RUB 29/USD

   Optimal hedging strategy

The optimal hedging strategy represents the ratio of assets and liabilities. In accordance to this assets of company are less than liabilities that indicate that company is following negative optimal hedging strategy. 

d)     Recommendation

In this situation I would recommend to the Aeroflot Company to rethink about the purchases. In case of weak ruble or recession company will face decrease in their revenue that result in the decrease of affordability of the company to purchase new assets. Company should make purchases when their chances that company can earn more revenue or ensure profitability through purchasing new assets.

Question: 5

Operating Exposure Management at Western Minin

Evaluate the advantages and disadvantages of various exchange-hedging instruments and techniques. Also, distinguish financial from non-financial risk management approaches. You may present your result in tabular form separating instruments from techniques

There are many advantages of hedging techniques. Some of the key advantages are mentioned below:

·         Hedge allow the organizations or businesses to manage the harsh market conditions.

·         Through hedging techniques profit can be locked by the companies

·         Using options and futures for managing short term risk is a good strategy

·         Through hedging the company becomes safe from exchange rate, inflation rate and interest rate changes

The key disadvantages of using hedge instruments are:

·         Various hedging technique are costly and have impact on profit.

·         Short term businessmen cannot use the hedging strategy easily

·         Options & futures require large capital requirement(Sercu, 2009).

The financial risks usually involve market risk, liquidity risk and credit risk however the non-financial risk include political risk, risk of competition and economic risks etc. In short there is significant difference in financial & non-financial risk management.

b)     What are the different types of foreign exchange risk WMC faces in its operations? How do they affect the company? Which exposures do they hedged, which ones did they decide not to hedge anymore?

There are many foreign exchange risks which the WMC was facing in its operations. The first risk is the transaction exposure. As most of the transactions of WMC involve US dollars. The second major foreign exchange risk exposure faced by the company is economic exposure. The transaction exposure risk & economic exposure risk have significant impact on the profitability of the company. The company managed the transaction exposure risk through hedging.

c)    Explain why borrowing in US dollars and forward sales of US dollar revenues by Australian mining companies in the 1980s had backfired. What about the 1990? You might want to research the evolution of the USD/AUD exchange rate

The borrowing in US dollars backfired because in 1980’s Australian dollar decline rapidly against US dollar. The Australian dollar decline increases the serving cost of US Debt (Melville, 2017).

d)     WMC decided to borrow in a basket of currencies rather than exclusively in US dollars or Australian dollars. What are they trying to accomplish? What are the advantages and disadvantages of this course off action?

WMC decided to borrow basket of currencies because they want to diversify their risk. It is evident that if they are going to borrow in only one currency than the level of risk is higher. Investing in different currencies will minimize the risk because if one currency show sudden volatility than risk can be managed by securing profit from other currencies which are stable.

e)   Define economic exposure. How would you go about hedging WMC’s 20 7 economic exposure? What do you think of WMC’s decision not to hedge its economic exposure?

The economic exposure results from uncertainty in the foreign currency transactions because the organization is present in the specific market from a long term. The economic exposure can be managed through currency swaps (Robinson, Henry, Pirie, Broihahn, & Cope, 2015).

Question: 6

Economic Exposure Management at BMW

1.   What is the nature of BMW’s FX exposure? What fundamental financial principle should BMW use to neutralize the impact of FX rate movements on their results

In recent years BMW have experienced massive growth. India, Russia, China and Europe becomes the largest market for the company. Due to the exchange rate changes the profit of the company often experience decline. By moving production facilities to various countries not only foreign exchange risk is managed appropriately but also the organization become more responsive to its customers.

2.      How did BMW decide to tackle the problem? Do you see any problems with BMW’s approach and implementation?

BMW tackle the problem of foreign risk exposure by opening production facilities in its major markets. The strategy which the BMW implemented proved successful which means that there was no major problem in the strategy.

3.      What differences if any exist in BMW’s approach to FX exposure management in North America and Asia?

There are no major difference in managing FX exposure in North America & Asia. The corporation has invested in US and Asian countries. However company increase it’spurchasing in US dollars especially in North American region (Melville, 2017).

4.      Why did BMW decide to consolidate FX risk management globally in its Munich group treasury? What principle are they implementing and what are its advantages for the group?

Through consolidating risk management globally the corporation can manage the risk more efficiently. In different parts of the world, the factors that cause the risk are different, therefore through this approach the corporation can not only manage the risk more efficiently but also the organization can sustain in the long run.

5.      BMW’s and Western Mining’s pursued to very different strategies to address FX exposure. What are their respective FX risk management strategies? Why did each company 20 choose their respective strategy?

BMW and WMC implement different strategies because the situation of both the organizations is different. The organization implement those strategies which they consider best for their operations (Sercu, 2009).

Question: 7

Russia’s Alternative Currency Bonds

a)      Dual or Multiple-currenc

  Eurobond

Eurobond are the bonds issued by the Europe. Eurobonds can be sold like other bonds in different countries but with the face value stated in Euros(Wheatley, 2018).

  Dual or Multiple-currency

Dual or multiple currency bonds are the bonds that are usually issued for international businesses. In such bonds money can be raised and redeem in different currencies. For these bonds, bondholders are not oblige to buy and sell bonds in the same currency. For instance a bond raised in dollars with redemption taken place in Euro(Wheatley, 2018). An example of this is Russia bond that allow payments (internet payment, maturity payment) in alternative currencies. These bonds are consist of or bundled in two parts. We can unbundled the bonds into constituent parts as new bond maturity and reopening of the bond.  

b)     Comparison

Multiple- currency bonds are the bonds that can be raised and redeemed in different currencies. While alternative currency payment provision is the innovation that support the bondholders to deal with alternative currencies. Alternative currencies innovative idea help out the bondholders get interest amount on the purchased bonds in their own currency while living in other countries(Wheatley, 2018).  

c)      alternative currency payment

Basically, the idea was presented as a solution for the problem commonly faced by the bondholders. It was claimed that many bondholders (Russian bondholders) are from different geographical sector. Interest payments in roubles poses risk factor(Wheatley, 2018). Therefore, alternative currency payment was introduced. Basically, the idea was that Russia would prevent and protect the hard currency payments for bondholders in case of sanctions by the UK and US. As result of this bonds prices were raised as risk factor was reduced.

d)     Risk factors

e)      investment recommendations

Considering all the information presented in the article and risk associated with each type of bond I will recommend ClnvO to invest in the alternative currency bonds. According to my analysis alternative currency bonds has relatively less risk for currency devaluation or depreciation. Because in this type bonds we will have right to select the alternative currency for interest payments. While also considering other benefits associated with this type of bonds I will strongly recommend that ClnvO should invest in alternative currency bonds(Wheatley, 2018).

f)       Bonus Problem 

Russian Federation issuing these debt securities with the purpose to secure a better position in the international market. These bonds has also direct impact on the federal financial reserves of the other countries particularly UK and US(Wheatley, 2018). We all know that decrease in financial federal reserves and increase in debt both cases to influence overall interest rate and inflation rate in the country(Wheatley, 2018). Russia get the currencies of other countries by selling Eurobonds and other securities. Basically, $4 billion bond sales recorded by the Russia will defies United Kingdom Spat as bids roll in. Somehow, it causes to increase overall national debt of Russia because bonds are the liability or debt for Russia and asset for investors.Thus it ties with the foreign currency reserve and Russian national debt.

Question: 8

Arbitrage in Montreal

1.      What principle links the four prices? What is the relevant mathematical formulation?

The relevant mathematical formulation for linking the four prices is the IRP (Interest Rate Parity) theorem:

In the theorem S stand for spot rate, F stand for forward rate, IF stand for the interest rate of foreign currency and ID stand for interest rate of domestic currency.

2.      Identify any arbitrage opportunities and explain how they might have come about.

Spot rate                                              CAD 1.1520/USD

6M forward rate                                  CAD 1.1635/USD

6M CAD money market rate              10%

6M USD money market rate               7.50%

 Now putting the values in theorem

It can be seen that the theorem did not proved true which indicates that the arbitrage opportunity does exist.

How would you build up an arbitrage position? Describe your strategy and its mechanics.

Solution

Amount 10000000 will be converted into dollars

Therefore borrow $8680555.55

Repayment of interest

Now $8680555.55 will be converted in CAD on spot rate that is equivalent to 10000000

Now 10500000 will be sold on Forward Rate

Profit

4.      Calculate your profit resulting from the preceding arbitrage strategy.

As the main currency is Canadian Dollar the profit is evaluated in CAD 

References

Melville, A. (2017). International Financial Reporting: A Practical Guide (6 ed.). Pearson Higher Ed.

Robinson, T. R., Henry, E., Pirie, W. L., Broihahn, M. A., & Cope, A. T. (2015). International Financial Statement Analysis, Third Edition (CFA Institute Investment Series) (3 ed.). John Wiley & Sons.

Sercu, P. (2009). International Finance: Theory into Practice. Princeton University Press.