Chapter 6 Hull Importing Company

Effects of Intervention on Import expense a) Hull expects the at Mexicos central bank will increase interest rates and that Mexicos inflation will not be affected. Offer any interest on how the pesos value may change and how Hulls profits would be affected as a result.

Higher interest rates without an increase in inflation would adversely affect Hull, because its expenses would increase, but it would not be able to pass on the higher cost to its customers. When Mexicos central bank will increase the interest rates, the investors of neighbor country want to invest in Mexico. The value of Pesos will increase due to increase demand of investors. This higher value also increases the expense of Hull Company, and Hull profits would be affected due to its higher cost of importing. As a result consumers would then switch to different gift Item Company.

b) Hull used to closely monitor government intervention by the Bank of England (the British central bank) on the value of the pound. Assume that the bank of England intervenes to strengthen the pounds value with respect to the dollar by 5 percent. Would this have a favorable or unfavorable effect on Hulls business?

If the British pounds value is increased, Hulls expenses are increased, causing an adverse effect. This intervention create both positive and negative situation, 5% are not small amount. If the value of pound will increase 5%, expense will also increase which would be unfavorable effect for Hull business. Because of importing company, Hull has been unable to pass on higher cost to its customer. But it would be favorable for Hull business, if expense is decrease due to decrease the value of pound by the Brithish Central bank.

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Chapter 7 Zuber, Inc.

(Using covered interest Arbitrage) A) Would you be willing to invest the funds in Poland without covering your position? Explain.

The expected value of the yield on investing funds in this country would be 14 percent, versus only 9 percent in the U.S. However, there is much uncertainty about the foreign yield. If the currency depreciates by a large amount, it will wipe out some of the principal invested. Given that Zuber did not want to target these funds for a speculative purpose, it would not be wise to invest these funds in the country without covering.

B) Suggest how you could attempt covered interest arbitrage. What is the expected return from using covered interest arbitrage?

Covered interest arbitrage would involve exchanging dollars for the currency today, investing the currency in the countrys Treasury securities, and negotiating a forward contract to sell the currency in one year in exchange for dollars. Given that $10 million is available, this amount would be converted into 25 million units of the foreign currency, which would accumulate to 28.5 million units (at 14 percent) by the end of the year, and be converted into $11,115,000 at the time (based on a forward rate of $.39). This reflects a return of 11.15 percent.

C) What risks are involved in using covered interest arbitrage here?

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The risks of covered interest arbitrage are as follows: The Treasury of the country could default on its securities issued. The bank may not fulfill its obligation on the forward contract (the bank was just recently privatized and does not have a track record as a privatized institution). The government could restrict funds from being converted into dollars. (Since the country has only allowed foreign investments recently, it does not have a track record. There is some uncertainty about its future laws on international finance.) D) If you had to choose between investing your funds in U.S. Treasury bills at 9 percent or using covered interest arbitrage, what would be your choice? Defend your answer.

While covered interest arbitrage would be expected to achieve a yield of 11.15 percent (versus only 9 percent in the U.S.), the risks are significant, and especially considering that the country is still experimenting with cross-border transactions. Since some students will probably suggest going for the higher returns, this question may allow for an interesting class discussion

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Chapter 8 Flame Fixtures, Inc.

(Business application of purchasing power parity) a) Describe a scenario that could cause flame to save even more than 20 percent on production costs. If the peso depreciates by more than the inflation differential, then the dollar cost to Flame will be even lower than expected. b) Describe a scenario that could cause flame to actually incur higher production costs than if it simply had the parts produced in the United States. If the peso depreciates by less than the inflation differential, then the dollar cost to Flame will be even higher than expected. Consider a scenario in which the Mexican inflation rate is 80 percent or so, causing the bill in pesos to be 80 percent higher. Yet, if the peso depreciated by a relatively small amount over this period (say 20 percent or so), the dollar cost to Flame will increase substantially. Since there are other factors in addition to inflation that also affect the pesos exchange rate, the peso will not necessarily depreciate by an amount that fully offsets the high inflation. c) Do you think that Flame will experience stable dollar outflow payments to Coron over time? Explain,(Assume that the number of parts ordered is constant over time) Stable dollar payments would only occur if the peso depreciated by an amount that offset its high inflation rate. It is unlikely that there will be a perfect offset in any given period. Therefore, Flames dollar payments would be unstable, and so would its profits.
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d) Do you think that Flames risk changes at all as a result of its new relationship with Coron Company? Explain. The risk would increase, because its payments for parts would now be more volatile, and so would its profits. Given that it does not have much liquidity, it will suffer a cash squeeze if the peso does not depreciate much while Mexican inflation is high. Over the long run, there may be periods in which this happens. Flame would be locked into this arrangement with Coron for ten years, and therefore cannot back out, even if the pesos depreciation does not offset the inflation differential.

Chapter 19 Ryco Chemical Company

(Using countertrade ) a) Describe a counter trade strategy that could reduce Rycos exposure to Brazilian inflation. Ryco could attempt to work out a countertrade agreement. Ryco could provide chemicals that Concellos needs in exchange for the chemicals that Ryco normally purchases from Concellos. Ryco could benefit because its cost of importing some chemicals would no longer be tied to Brazilian inflation. Instead its cost would be tied to its own cost of producing the chemicals it must exchange for the imports. If Concellos would agree to the countertrade agreement, Ryco may be able to stabilize its cost of imports, which could reduce the uncertainty surrounding cash flows and profitability. b) Would Concellos be willing to consider this strategy? Is there any favorable effect on Concellos that may motivate it to accept the strategy? Concellos is exposed to the weak currency (called the real). If it purchases the chemicals used in production from Ryco, its cost will not be affected by the reals exchange rate (as it could purchase the U.S. goods through a countertrade agreement). Thus, it may be able to stabilize its cost of imports in this matter.

c) Assume that both parties agree on counter trade. Why would the cost of obtaining imports still rise over time for concellos? Would concellos earn lower profits as a result?
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Concellos cost of obtaining imports is the cost of producing the chemicals it uses for exchange (based on the countertrade agreement). Given high inflation in Brazil, these production costs will rise. However, it may be able to raise its prices on its final products by the inflation rate to cover its higher costs of production. Overall, it will be able to offset these higher costs easier than offsetting the higher costs that would result from exchange rate effects. Since its competitors base their prices on local cost of production (as they are not exposed to a weak exchange rate risk), Concellos would now incur costs that are more similar to those of its competitors.

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