An exchange rate tells you _________________

FOR Shahimermaid

International Finance Exam

You should attach one Word or PDF document and one Excel spreadsheet (if you use Excel to solve one or more of the problems) to your email. Please do not submit more than this and do not submit zip files. The Word (or PDF) document should have your final answers for each problem highlighted or in bold print and all your work should be in a manner that is easy for me to read. The Excel spreadsheet should have a separate worksheet for each problem which requires the use of Excel. The computations on the spreadsheet should support the answers that are on your Word document and should be easy for me to follow. Please title each document “Smith, John exam” with your last name substituted for “Smith” and your first name substituted for “John”. Do not include the quotation marks. It is fine for you to do all or part of your work longhand, scan your answer sheet and submit the scanned document in PDF format as long as it will be easy to read (dark enough) when I print it out.

All coupon-paying bonds pay make their interest payments semiannually unless the problem states otherwise.

For all problems where the final answer is in a currency, please carry out your answer at least two decimal places. For all problems where the final answer is a percentage, please carry out your answer to the nearest basis point.

Problems – 11 points each

You must show all your work for each problem

I will give partial credit where appropriate

1. The (annualized) interest rate on six-month treasuries is 5% in the U.S. and 8% in Great Britain. Inflation is expected to run at a constant 3% in the U.S. and at a constant 6% in Great Britain for the next ten years. The spot exchange rate is 1.94 $/₤ and the 180-day forward rate is 1.90 $/₤. You work for an American Company that has a subsidiary in Great Britain. Your company uses a WACC of 14% to evaluate projects of this sort. The subsidiary in Great Britain is considering an expansion that will cost ₤7 million, but will generate an additional ₤3 million of revenue per year for five years. The cost of the expansion can be depreciated on a straight-line basis over the five years and will have no salvage value. The applicable tax rate is 35%.

Convert the pound cash flows to dollars at the expected future spot rates by assuming that Relative Purchasing Power Parity will hold. Discount the cash flows and calculate the NPV in dollars.

NPV in dollars _________________

2. You walk into an international bank with $1,000 and observe the following exchange rates:

Bid Ask

1.98 $/₤ 1.99 $/₤

1.33 $/Euro 1.35 $/Euro

1.42 Euro/₤ 1.44 Euro/₤

Can you make money through triangular arbitrage? If you can, show how you would do it and how much money you would make. If not, demonstrate that it is impossible to do it.

When triangular arbitrage is present, it is generally not available for long. If it were present in the above situation, what market forces would cause it to disappear?

3. A month ago, your company submitted a bid to repair London Bridge, which your 5-year old daughter and her friends had told you was falling down. Your company deals in dollars, but your bid had to be made in British pounds. You were awarded the contract with a bid of ₤ 10,175,000. You are due to receive 10% of this value today and the rest in 90 days. You will be paid in pounds. You are concerned though that the $/₤ exchange rate may move in a direction that is unfavorable to you during the next 90 days, and you wish to hedge your position as best as is possible. Your banker tells you there two ways that you can hedge – with a forward contract or a money market hedge.

Use some or all of the following information to construct both types of hedges and determine which the best one to use is. Also, tell me the present value of the dollar difference between the two hedges.

At the time you prepared your bid, the spot rate was 1.982 $/₤.

Today, the spot rate is 1.937 $/₤.

Today’s 90-day forward rate is 1.92 $/₤.

You can borrow or lend pounds at 10% (annualized)

You can borrow or lend dollars at 5% (annualized)

4. Your company, International Widget Manufacturers, is headquartered in New Orleans, but is considering expanding its operations to France. It will cost €14 million to build a plant in Paris to make widgets, but if you do, you will be able to sell 1.5 million widgets per year for the next seven years. The project ends at that time. During the first year, your widgets will be priced at €3 each. They will cost €1 each to make. The price of the widgets is expected to increase at the rate of 3 percent per year while the cost to produce them is expected to remain constant. The cost to build the plant can be depreciated over the life of the project on a straight-line basis. IWM is in the 35 percent marginal tax bracket (both in France and the U.S.), and its nominal cost of capital in the U.S. is 13%. Based on the International Fisher Effect and the fact that you consider France to be a safe country to invest in, you believe that the real cost of capital for your company is the same both in France and in the U.S. You expect the inflation rate in the U.S. to be 4% per year during the seven years of this project. You expect the inflation rate in France (and throughout Europe) to be 3% per year over the same time period. Today, it costs $1.30 to buy one euro. Find the following:

A. Find the relavent cash flows in euros and use the appropriate euro discount rate to calculate the euro NPV.

B. Using the euro cash flows you calculated above, use Relative Purchasing Power Parity to forcast the dollar/euro exchange rates over the life of this project and convert the euros to dollars. Then use the appropriate U.S. discount rate to find the dollar NPV.

C. Calculate the IRR of this project using the euro cash flows you found in (A) above.

D. Calculate the IRR of this project using the dollar cash flows you found in (B) above.

5. You are the CFO of a U.S.–based multinational firm. You need to borrow $1 million for six months to meet some working capital needs. You can borrow in the following currencies at the following rates which were quoted to you earlier today by your bank:

Dollars at 5.5%

Euros at 9.7%

Mexican Pesos at 11.6%

One dollar is currently worth 13.5 Mexican pesos and one dollar is also worth 0.75 euros.

You realize that the cost of borrowing in a currency other than your home currency involves exchanging your dollars into that currency when it is time to repay the loan in six months. With this in mind, at what future €/$ and Peso/$ exchange rates will you be indifferent between borrowing in all three currencies? That is, what do those exchange rates need to be in six months in order for the cost of borrowing in all three countries to have been exactly the same?

Multiple Choice – 3 points each

You do not need to show any work – there will be no partial credit

1. If the home currency depreciates, who benefits?

A) local importers

B) local exporters

C) everyone benefits

D) no one benefits

2. American Depositary Receipts (ADRs) allow

A) U.S. investors to purchase an interest in foreign stocks on U.S. exchanges

B) U.S. investors to purchase an interest in foreign stocks on foreign exchanges

C) Foreign investors to purchase an interest in U.S. stocks on U.S. exchanges

D) Multinational Corporations to hedge exchange rate risk

3. The value of the Australian dollar (A$) today is $0.73. Yesterday, the value of the Australian dollar was $0.69. The Australian dollar _______ by _______%.

A) depreciated; 5.80

B) depreciated; 4.00

C) appreciated; 5.80

D) appreciated; 4.00

4. The demand for U.S. exports tends to increase when:

A) economic growth in foreign countries decreases.

B) the currencies of foreign countries strengthen against the dollar.

C) U.S. inflation rises.

D) none of these

5. Most of the world’s countries currently have a _________exchange rate.

A) fixed

B) floating

C) pegged

D) variable

6. Graylon, Inc., based in the U.S., exports products to a German firm and will receive a payment of €200,000 in three months. On June 1, the spot rate of the euro was $1.12, and the 3-month forward rate was $1.10. On June 1, Graylon negotiated a forward contract with a bank to sell €200,000 forward in three months. The spot rate of the euro on September 1 is $1.15. Graylon will receive $_______ for the euros.

A) 224,000

B) 220,000

C) 200,000

D) 230,000

7. The 90-day forward rate for the euro is $1.07, while the current spot rate of the euro is $1.05. What is the annualized forward premium or discount of the euro?

A) 1.9 percent discount.

B) 1.9 percent premium.

C) 7.6 percent premium.

D) 7.6 percent discount.

8. Your company expects to receive 5,000,000 Japanese yen 60 days from now. You decide to hedge your position by selling Japanese yen forward. The current spot rate of the yen is $.0089, while the forward rate is $.0095. You expect the spot rate in 60 days to be $.0090. How many dollars will you receive for the 5,000,000 yen 60 days from now?

A) $44,500.

B) $45,000.

C) $526 million.

D) $47,500.

9. If the U.S. Federal Reserve Bank wants to lower short-term interest rates, it will usually

A) buy treasury bonds from its primary dealers

B) sell treasury bonds to its primary dealers

C) print more dollars

D) sell dollars in the foreign exchange market

10. If interest rate parity exists, then _______ is not feasible.

A) forward realignment arbitrage

B) triangular arbitrage

C) covered interest arbitrage

D) locational arbitrage

11. In which case will locational arbitrage most likely be feas​ible?

A) One bank’s ask price for a currency is greater than another bank’s bid price for the currency.

B) One bank’s bid price for a currency is greater than another bank’s ask price for the currency.

C) One bank’s ask price for a currency is less than another bank’s ask price for the currency.

D) One bank’s bid price for a currency is less than another bank’s bid price for the currency.

12. Assume the British pound is worth $1.60, and the Canadian dollar is worth $.80. What is the value of the Canadian dollar in pounds?

A) 2.0.

B) 2.40.

C) .80.

D) .50.

13. Given a home country and a foreign country, purchasing power parity (PPP) suggests that:

A) a home currency will depreciate if the current home inflation rate exceeds the current foreign interest rate.

B) a home currency will appreciate if the current home interest rate exceeds the current foreign interest rate.

C) a home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate.

D) a home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate.

14. Which of the following are true statements regarding a county’s currency depreciating?

A) Depreciation means that the government has intentionally caused the value of the currency to lower.

B) If your currency is depreciating, another country’s currency must be appreciating vs. yours.

C) Your currency can’t depreciate unless it first appreciated.

D) none of the above statements are true.

15. An currency swap will save money for both companies if

A) Each company wants to borrow in the currency where the other enjoys a comparative advantage

B) Each company wants to borrow in the currency where the other enjoys an absolute advantage

C) Each company wants to borrow in the currency where they enjoy a comparative advantage

D) Each company wants to borrow in the currency where they enjoy an absolute advantage