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5K views23 pagesMultinational Business Finance, 14th Edition, Eiteman,Solution Manual

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Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia, one year from now. The present charge

for a luxury suite plus meals in Malaysian ringgit (RM) is RM1,000/day. The Malaysian ringgit presently trades

at RM5.2522/GBP. She determines that the pound cost today for a 30-day stay would be about GBP6,000. The

hotel informs her that any increase in its room charges will be limited to an increase in the Malaysian cost of

living. Malaysian inflation is expected to be 3% per annum, while U.K. inflation is expected to be 1%.

a. How many pounds might Theresa expect to need one year hence to pay for her 30-day vacation?

b. By what percent will the pound cost have gone up? Why?

Assumptions

Charge for suite plus meals in Malaysian ringgit (RM)

Spot exchange rate (MYR/GBP)

GBP cost today for a 30 day stay

Malaysian ringgit inflation rate expected to be

GBP inflation rate expected to be

Value

1,000.00

5.2522

$5,711.89

3.000%

1.000%

a. Theresa might expect to need one year hence to pay for her 30-day vacation in GBP

Spot exchange rate (ringgit per GBP)

Malaysian ringgit inflation rate expected to be

GBP inflation rate expected to be

5.2522

3.000%

1.000%

Expected spot rate one year from now based on PPP (RM/$)

5.356204

Expected hotel charges to be paid one year from now for a 30-day stay in MYR

30,900.00

$5,769.01

New dollar cost

Original dollar cost

Percent change in US$ cost

$5,769.01

$5,711.89

1.000%

The GBP cost has risen by the UK inflation rate. This is a result of your estimation of the future GBP costs and

the exchange rate changing in proportion to inflation (relative purchasing power parity).

The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In

January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.20/$.

During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in

the United States during that same period was 2.2% annualized.

a. What should have been the exchange rate in January 2003 if PPP held?

b. By what percentage was the Argentine peso undervalued on an annualized basis?

c. What were the probable causes of undervaluation?

Assumptions

Spot exchange rate, fixed peg, early January 2002 (Ps/$)

Spot exchange rate, January 29, 2003 (Ps/$)

US inflation for year (per annum)

Argentine inflation for year (per annum)

Value

1.0000

3.2000

2.20%

20.00%

a. What should have been the exchange rate in January 2003 if PPP held?

Beginning spot rate (Ps/$)

Argentine inflation

US inflation

PPP exchange rate

1.00

20.00%

2.20%

1.17

Actual exchange rate (Ps/$)

PPP exchange rate (Ps/$)

Percentage overvaluation (positive) or undervaluation (negative)

c. What were the probable causes of undervaluation?

The rapid decline in the value of the Argentine peso was a result of not only inflation,

but also a severe crisis in the balance of payments (see Chapter 4).

3.20

1.17

-63.307%

William Leon is attempting to determine whether Japanese and Australian financial conditions are at parity. The current spot rate is a flat

108.33/A$, while the one-year forward rate is 106.50/A$. Forecast inflation is 5.00% for Japan and 6.80% for the Australia. The one-year

Japanese yen deposit rate is 7.85%, and the one-year Australian dollar deposit rate is 9.70%.

a. Diagram and calculate whether international parity conditions hold between Japan and Australia.

b. Find the forecasted change in the Japanese yen/Australian dollar (/A$) exchange rate one year from now.

Assumptions

Forecast annual rate of inflation for Japan

Forecast annual rate of inflation for Australia

One-year interest rate for Japan

One-year interest rate for Australia

Spot exchange rate (/A$)

One-year forward exchange rate (/A$)

Value

5.000%

6.800%

7.850%

9.700%

108.33

106.50

a.

Approximate Form

Forward rate as

an unbaised

predictor (E)

Forecast change in

spot exchange rate

1.7%

(Australian dollar expected to weaken)

International

Fisher Effect (C)

Forward premium

on foreign currency

1.7%

(Japanese yen at a premium)

Interest rate

parity (D)

Difference in nominal

interest rates

-1.9%

(higher in Australia)

Purchasing

power

parity (A)

Forecast difference

in rates of inflation

-1.8%

(Australia higher than Japan)

Fisher

effect (B)

As is the always the case with parity conditions, the future spot rate is implicitly forecast to be equal to the forward rate, the implied rate

from the international Fisher effect, and the rate implied by purchasing power parity. According to the calculations, the markets are indeed

in equilibrium -- parity -- and the future spot rate is projected to be JPY106.50/AUD..

b.

Spot exchange rate (/A$)

One-year forward exchange rate (/A$)

Forcasted change in exchange rates

108.33

106.50

1.7%

Terry Lamoreaux has homes in both Sydney, Australia and Phoenix, United States. He travels

between the two cities at least twice a year. Because of his frequent trips he wants to buy some new,

high quality luggage. He's done his research and has decided to go with a Briggs & Riley brand

three-piece luggage set. There are retails stores in both Phoenix and Sydney. Terry was a finance

major and wants to use purchasing power parity to determine if he is paying the same price no

matter where he makes his purcahse.

a. If the price of the 3-piece luggage set in Phoenix is $850 and the price of the same 3-piece set in

Sydney is $930, using purchasing power parity, is the price of the luggage truly equal if the spot

rate is A$1.0941/$?

b. If the price of the luggage remains the same in Phoenix one year from now, determine what the

price of the luggage should be in Sydney in one-year time if PPP holds true. The US Inflation rate

is 1.15% and the Australian inflation rate is 3.13%.

Assumptions

Price of 3-Piece Luggage set in US$

Price of 3-Piece Luggage set in A$

Spot exchange rate, (A$/$)

US inflation for year (per annum)

Australian inflation for year (per annum)

Value

850.00

930.00

1.0941

1.15%

3.13%

Price of 3-Piece Luggage set in US$

Price of 3-Piece Luggage set in A$

Spot rate as determined by PPP

Spot rate = Price in A$ / Price in US$

850.00

930.00

1.0941

b. What should be the price of the luggage set in A$ in 1-year if PPP holds?

Beginning spot rate (A$/$)

Australian inflation

US inflation

PPP exchange rate

Price of 3-Piece Luggage set in US$

PPP exchange rate

Price of 3-piece luggage set in Sydney (A$)

However, purchasing power parity is not always an accurate predictor of exchange rate

movements, particularly in the short-term.

1.0941

3.13%

1.15%

1.1155

850.00

1.1155

948.19

Starbucks opened its first store in Zagreb, Croatia in October 2010. The price of a tall vanilla latte

in Zagreb is 25.70kn. In New York City, the price of a tall vanilla latte is $2.65. The exchange rate

bewteen Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power

parity, is the Croatian kuna overvalued or undervalued?

Assumptions

Spot exchange rate (Kn/$)

Price of vanilla latter in Zagreb (kn)

Price of vanilla latter in NYC ($)

Implied PPP of Croatian latte in USD

Percentage overvaluation (positive) or undervaluation (negative)

Value

5.6288

25.70

2.65

4.57

9.70

112.408%

Assume that the export price of a Toyota Corolla from Osaka, Japan is 2,150,000. The exchange rate is 87.60/$. The

forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to answer the

following questions on exchange rate pass through.

a. What was the export price for the Corolla at the beginning of the year expressed in U.S. dollars?

b. Assuming purchasing power parity holds, what should the exchange rate be at the end of the year?

c. Assuming 100% pass-through of exchange rate, what will the dollar price of a Corolla be at the end of the year?

d. Assuming 75% pass-through, what will the dollar price of a Corolla be at the end of the year?

Steps

Initial spot exchange rate (/$)

Initial price of a Toyota Corolla ()

Expected US dollar inflation rate for the coming year

Expected Japanese yen inflation rate for the coming year

Desired rate of pass through by Toyota

Value

87.60

2,150,000

2.200%

0.000%

75.000%

a. What was the export price for the Corolla at the beginning of the year?

Year-beginning price of an Corolla ()

Spot exchange rate (/$)

Year-beginning price of a Corolla ($)

2,150,000

87.60

24,543.38

b. What is the expected spot rate at the end of the year assuming PPP?

Initial spot rate (/$)

Expected US$ inflation

Expected Japanese yen inflation

Expected spot rate at end of year assuming PPP (/$)

c. Assuming complete pass through, what will the price be in US$ in one year?

Price of Corolla at beginning of year ()

Japanese yen inflation over the year

Price of Corolla at end of year ()

Expected spot rate one year from now assuming PPP (/$)

Price of Corolla at end of year in ($)

d. Assuming partial pass through, what will the price be in US$ in one year?

Price of Corolla at end of year ()

Amount of expected exchange rate change, in percent (from PPP)

Proportion of exchange rate change passed through by Toyota

Proportional percentage change

Effective exchange rate used by Toyota to price in US$ for end of year

Price of Toyota at end of year ($)

87.60

2.20%

0.00%

85.71

2,150,000

0.000%

2,150,000

85.71

25,083.33

2,150,000

2.200%

75.000%

1.650%

86.178

24,948.34

Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage

possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars

and Japanese yen. He faced the following exchange rate and interest rate quotes.

Assumptions

Arbitrage funds available

Spot rate (/$)

180-day forward rate (/$)

180-day U.S. dollar interest rate

180-day Japanese yen interest rate

Value

$5,000,000

118.60

117.80

4.800%

3.400%

Yen Equivalent

593,000,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i - i $)

Forward premium on the yen

CIA profit potential

-1.400%

1.358%

-0.042%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to

lock-in a covered interest arbitrage (CIA) profit.

4.800%

$

5,000,000

Spot (/$)

118.60

593,000,000.00

Japanese yen

START

1.0240

1.0170

3.400%

Japanese yen interest rate (180 days)

5,120,000

Forward-180 (/$)

117.80

603,136,000

603,081,000

55,000

END

Takeshi Kamada generates a CIA profit by investing in the higher interest rate currency, the dollar, and simultaneously

selling the dollar proceeds forward into yen at a forward premium which does not completely negate the interest

differential.

Takeshi Kamada, Credit Suisse (Tokyo), observes that the /$ spot rate has been holding steady, and both dollar and

yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered

interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi's research associates -- and their

computer models -- are predicting the spot rate to remain close to 118.00/$ for the coming 180 days. Using the same

data as in the previous problem, analyze the UIA potential.

Assumptions

Arbitrage funds available

Spot rate (/$)

180-day forward rate (/$)

Expected spot rate in 180 days (/$)

180-day U.S. dollar interest rate

180-day Japanese yen interest rate

Value

$5,000,000

118.60

117.80

118.00

4.800%

3.400%

Yen Equivalent

593,000,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i - i $)

Expected gain (loss) on the spot rate

UIA profit potential

-1.400%

1.017%

-0.383%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to

potentially gain on an uncovered basis (UIA).

4.800%

$5,000,000

Spot (/$)

118.60

593,000,000.00

Japanese yen

START

1.0240

1.0170

3.400%

Japanese yen interest rate (180 days)

$5,120,000

in 180 days (/$)

118.00

604,160,000

603,081,000

1,079,000

END

a) Takeshi Kamada generates an uncovered interest arbitrage (UIA) profit of 1,079,000 if his expectations about the

future spot rate, the one in effect in 180 days, prove correct.

b) The risk Takeshi is taking is that the actual spot rate at the end of the period can theoretically be anything, better or

worse for his speculative position. He in fact has very little "wiggle room," as they say. A small movement will cost

him a lot of money. If the spot rate ends up any stronger than about 117.79/$ (a smaller number), he will lose money.

(Verify by inputting 117.70/$ in the expected spot rate cell under assumptions.)

Heidi Hi Jensen, a foreign exchange trader at J.P. Morgan Chase, can invest $5 million, or the foreign currency

equivalent of the bank's short term funds, in a covered interest arbitrage with Denmark. Using the following quotes

can Heidi make covered interest arbitrage (CIA) profit?

Assumptions

Arbitrage funds available

Spot exchange rate (kr/$)

3-month forward rate (kr/$)

US dollar 3-month interest rate

Danish kroner 3-month interest rate

Value

$5,000,000

6.1720

6.1980

3.000%

5.000%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$)

Forward discount on the krone

CIA profit potential

2.000%

-1.678%

0.322%

This tells Heidi Hi Jensen that he should borrow dollars and invest in the higher yielding currency the Danish kroner,

for CIA profit.

3.000%

START

$

5,000,000.00

Spot (kr/$)

6.1720

kr 30,860,000.00

1.0075

END

1.0125

5,037,500.00

5,041,263.31

$

3,763.31

Forward-90 (kr/$)

6.1980

kr 31,245,750.00

5.000%

Danish kroner interest (3-month)

Heidi Hi Jensen generates a covered interest arbitrage (CIA) profit because she is able to generate an even higher

interest return in Danish kroner than she "gives up" by selling the proceeds forward at the forward rate.

Heidi Hi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note

that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make

CIA profit one way or another.)

Assumptions

Arbitrage funds available

Spot exchange rate (kr/$)

3-month forward rate (kr/$)

US dollar 3-month interest rate

Danish kroner 3-month interest rate

Value

$5,000,000

6.1720

6.1980

4.000%

5.000%

kr Equivalent

kr 30,860,000

a)

a)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$)

Forward discount on the krone

CIA profit potential

1.000%

-1.678%

-0.678%

This tells Heidi that she should borrow Danish kroner and invest in the LOWER interest rate currency, the dollar,

gaining on the re-exchange of dollars for kroner at the end of the period.

4.000%

$

5,000,000.00

Spot (kr/$)

6.1720

kr 30,860,000.00

START

1.0100

1.0125

5.000%

Danish kroner interest (3-month)

5,050,000.00

F-90 (kr/$)

6.1980

kr 31,299,900.00

kr 31,245,750.00

kr 54,150.00

END

a) Heidi Hi Jensen generates a covered interest arbitrage profit of kr54,150 because, although U.S. dollar interest

rates are lower, the U.S. dollar is selling forward at a premium against the Danish krone.

Heidi Hi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note

that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make

CIA profit one way or another.)

Assumptions

Arbitrage funds available

Spot exchange rate (kr/$)

3-month forward rate (kr/$)

US dollar 3-month interest rate

Danish kroner 3-month interest rate

Value

$5,000,000

6.1720

6.1980

3.000%

6.000%

kr Equivalent

kr 30,860,000

b)

b)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$)

Forward discount on the krone

CIA profit potential

3.000%

-1.678%

1.322%

This tells Heidi Hi Jensen that she should borrow US dollars and invest in the HIGHER interest rate currency, the

kroner, gaining on the re-exchange of kroner for dollars at the end of the period.

3.000%

START

$5,000,000

Spot (kr/$)

6.1720

kr 30,860,000.00

1.0075

1.0150

$

$

$

END

5,037,500.00

5,053,710.87

16,210.87

F-90 (kr/$)

6.1980

kr 31,322,900.00

6.000%

Danish kroner interest (3-month)

b) If the Danish kroner interest rate increases to 6.00%, while the U.S. dollar interest rate stays at 3.00% and spot and

forward rates remain the same, Heidi Hi Jensen's CIA profit is $16,210.87.

Casper Landsten is a foreign exchange trader for a bank in New York. He has $1 million (or its Swiss franc equivalent)

for a short-term money market investment and wonders whether he should invest in U.S. dollars for 90 days or make a

covered interest arbitrage (CIA) investment in the Swiss franc. He faces the following quotes:

Assumptions

Arbitrage funds available

Spot exchange rate (CHF/USD)

3-month forward rate (CHF/USD)

USD 3-month interest rate

Swiss franc 3-month interest rate

Value

$1,000,000

0.9502

0.9410

3.800%

5.300%

SFr. Equivalent

SFr. 950,200

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i CHF. - i USD

Forward premium on the Swiss franc

CIA profit potential

1.500%

3.911%

5.411%

This tells Casper he should invest in the higher yeilding CHF in order to earn covered interest arbitrage (CIA) profits.

3.80%

START

$

1,000,000.00

Spot (CHF/USD)

0.9502

SFr. 950,200.00

1.0095

END

1.0133

1,009,500.00

1,023,156.38

$

13,656.38

Forward-90 (CHF/USD)

0.9410

SFr. 962,790.15

5.30%

Swiss franc interest rate (3-month)

a) Casper Landsten makes a net profit, a covered interest arbitrage profit, of $1,538.46 on each million he invests in

the Swiss franc market (by going around the box). He should therefore take advantage of it and perform covered

interest arbitrage.

b) Assuming a $1 million investment for the 90-day period, the annual rate of return on

this near risk-less investment is:

5.46%

Using the same values and assumptions as in Problem 12, Casper Landsten decides to seek the full 3.80% return

available in U.S. dollars by not covering his forward dollar receiptsan uncovered interest arbitrage (UIA)

transaction. Assess this decision.

Assumptions

Arbitrage funds available

Spot exchange rate (CHF/USD)

3-month forward rate (CHF/USD)

Expected spot rate in 90 days (CHF/USD)

USD 3-month interest rate

Swiss franc 3-month interest rate

Value

$1,000,000

0.9502

0.9410

1.2700

3.800%

5.300%

SFr. Equivalent

SFr. 950,200

Since Casper is in the US market (starting point), if he were to undertake uncovered interest arbitrage he would be

first exchange dollars for Swiss francs, investing the Swiss francs for 90 days, and then exchanging the Swiss franc

proceeds (principle and interest) back into US dollars at whatever the spot rate of exchange is at that time. In this case

Casper will have to -- at least in his mind -- make some assumption as to what the exchange rate will be at the end of

the 90 day period.

START

1,000,000

Spot (CHF/USD)

0.9502

CHF 950,200

3.80%

1.0095

END

1,009,500.00

1,009,531.46

31.46

0.9537

CHF 962,790

1.0133

$

$

$

5.30%

Swiss franc interest rate (3-month)

If Casper assumed the spot rate at the end of 90 days will be CHF0.9537/USD (the IRP implied 3-month forward rate),

the UIA transaction would produce the full 3.80% return available in USD.

For UIA transaction to result in higher USD proceeds at the end of the 3-month period, the ending spot rate of

exchange would have to be less than CHF0.9537/USD (a stronger CHF will result in more USD when the final

exhchange is made).

Should Casper do it? Well, depends on his bank's policies on uncovered transactions, and his beliefs on the future spot

exchange rate. But, given that he is invested in a foreign currency with a lower interest rate, not a higher one, so he is

placing all of his 'bets' on the exchange rate, it is not a speculation for the weak of heart.

One month after the events described in Problems 12 and 13, Casper Landsten once again has $1 million (or its Swiss

franc equivalent) to invest for 90 days. He now faces the following foreign exchange and interest rates. Should he

again enter into a CIA investment?

Assumptions

Arbitrage funds available

Spot exchange rate (CHF/USD)

3-month forward rate (CHF/USD)

US dollar 3-month interest rate

Swiss franc 3-month interest rate

Value

$1,000,000

0.9452

0.9410

6.800%

4.300%

SFr. Equivalent

SFr. 945,200

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected

change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less

than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i CHF - i USD

Forward premium on the Swiss france

CIA profit

-2.500%

1.785%

-0.715%

This tells Casper Landsten he should borrow U.S. dollars and invest in the lower yielding currency, the Swiss franc,

and then sell the Swiss franc principal and interest forward three months locking in a CIA profit.

6.80%

START

$1,000,000

Spot (CHF/USD)

0.9452

CHF 945,200.00

1.017000

END

1.0107500

1,017,000.00

1,015,261.32

$

(1,738.68)

F-90 (CHF/USD)

0.9410

CHF 955,360.90

4.30%

Swiss franc interest rate (3-month)

Casper can make a covered interest arbitrage profit of USD1,738.68 on each million USD-equaivalent Swiss franc (by

going around the box). He should therfore take advantafe of it and perform covered interest arbitrage.

Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and

petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the

U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has

immediate use of either $3 million (or the Norwegian krone equivalent). He is faced with the following market rates, and

wonders whether he can make some arbitrage profits in the coming 90 days.

Assumptions

Arbitrage funds available

Spot exchange rate (Nok/$)

3-month forward rate (Nok/$)

U.S. dollar 3-month interest rate

Norwegian krone 3-month interest rate

Value

$3,000,000

6.0312

6.0186

5.000%

4.450%

Krone Equivalent

18,093,600

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change

in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the

forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i Nok - i $)

Forward premium on the krone

CIA profit

-0.550%

0.835%

0.285%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling

the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

4.450%

18,093,600.00

Spot (Nok/$)

6.0312

3,000,000.00

Borrow US$

START

1.0111250

1.01250000

5.000%

U.S. dollar interest rate (3-month)

18,294,891.30

Forward-90 (Nok/$)

6.0186

$

3,039,710.25

$

3,037,500.00

$

2,210.25

END

Ari Karlsen can make $2,210.25 for Statoil on each $3 million he invests in this covered interest arbitrage (CIA) transaction.

Note that this is a very slim rate of return on an investment of such a large amount.

Annualized rate of return:

0.2947%

The separation of over 3,000 nautical miles and five time zones, money and foreign exchange markets in both

London and New York are very efficient. The following information has been collected from the respective

areas:

Assumptions

Spot exchange rate ($/)

One-year Treasury bill rate

Expected inflation rate

London

1.3264

3.900%

Unknown

New York

1.3264

4.500%

1.250%

a. What do the financial markets suggest for inflation in Europe next year?

b. Estimate today's one-year forward exchange rate between the dollar and the euro.

a. What do the financial markets suggest for inflation in Europe next year?

According to the Fisher effect, real interest rates should be the same in both Europe and the US.

Since the nominal rate = [ (1+real) x (1+expected inflation) ] - 1:

1 + real rate = (1 + nominal) / (1 + expected inflation)

1 + nominal rate

1 + expected inflation

So 1 + real =

and therefore the real rate in the US is:

The expected rate of inflation in Europe is then:

103.900%

?

103.210%

0.669%

b. Estimate today's one-year forward exchange rate between the dollar and the euro.

Spot exchange rate ($/)

US dollar one-year Treasury bill rate

European euro one-year Treasury bill rate

One year forward rate ($/)

1.3264

4.500%

3.900%

1.3341

104.500%

101.250%

103.210%

3.210%

You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are

negotiating over the rental of a chateau. The chateau's owner wishes to preserve his real income

against both inflation and exchange rate changes, and so the present weekly rent of 9,800

(Christmas season) will be adjusted upwards or downwards for any change in the French cost of

living between now and then. You are basing your budgeting on purchasing power parity (PPP).

French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is

expected to be 2.5%. The current spot rate is $1.3620/. What should you budget as the U.S. dollar

cost of the one week rental?

Assumptions

Spot exchange rate ($/)

Expected US inflation for coming year

Expected French inflation for coming year

Current chateau nominal weekly rent ()

Value

$1.3620

2.500%

3.500%

9,800.00

Value

1.3488

Nominal monthly rent, in euros, one year from now

10,143.00

Cost of rent one year from now in US dollars

13,681.29

Note: students may inquire as to whether the euro, a currency for a multitude of countries which

may actually have substantial differencies in inflation locally, really will react to inflationary

pressures and differentials as PPP would predict. A good question.

The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok

subsidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai

baht-denominated (B) debt. The treasuer of EAC-Thailand is considering a one-year bank loan for $250,000. The

current spot rate is B32.06/$, and the dollar-based interest is 6.75% for the one year period. One year loans are 12.00%

in baht.

a. Assuming expected inflation rates of 4.3% and 1.25% in Thailand and the United States, repectively, for the

coming year, according to purchase power parity, what would the effective cost of funds be in Thai baht terms?

b. If EAC's foreign exchange advisers believe strongly that the Thai government wants to push the value of the

baht down against the dollar by 5% over the coming year (to promote its export competitiveness in dollar

markets), what might the effective cost of funds end up being in baht terms?

c. If EAC could borrow Thai baht at 13% per annum, would this be cheaper than either part (a) or part (b) above?

Assumptions

Current spot rate, Thai baht/$

Expected Thai inflation

Expected dollar inflation

Loan principal in U.S. dollars

Thai baht interest rate, 1-year loan

US dollar interest rate, 1-year loan

Value

32.06

4.300%

1.250%

$250,000

12.000%

6.750%

First, it is necessary to forecast the future spot exchange rate for the baht/$.

PPP forecast of Thai baht/$

33.0258

Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for

part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.

6.750%

$

250,000

Spot (Baht/$)

32.0600

8,015,000.00

Thai baht

1.06750

12.000%

Thai baht borrowing rate (one year)

Implied cost = (Repaid/Initial proceeds) - 1

266,875

33.0258

8,813,760.38

Baht needed to repay

U.S. dollar loan

9.966%

a) Assuming a purchasing power parity forecast of the future spot rate, B33.0258/$, it will take 8,813,760 baht to

repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 9.966%.

b) Assuming a future spot rate for the baht which is 5% weaker than the current spot rate (B32.06/$ ( 1 - .05), or

B33.7474/$), the implied cost is 12.369%. (This is found by plugging in this new forecast spot rate in the expected

spot rate cell on the right-hand-side of the box.)

Current

32.0600

Pct Chg

-5.00%

New spot = old spot ( 1 - .05)

Forecast

33.7474

c) Part a and part b are both cheaper than borrowing at 12.00%. However, both are highly risky given that the future

spot rate is not known until a full year has passed.

Imagine that the mythical solid gold falcon, initially intended as a tribute by the Knights of Malta to the King of Spain

in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14

inches high and solid gold, weighing approximately 48 pounds. Assume that gold prices have risen to $440/ounce,

primarily as a result of increasing political tensions. The falcon is currently held by a private investor in Istanbul, who

is actively negotiating with the Maltese government on its purchase and prospective return to its island home. The sale

and payment are to take place one year from now in March 2004, and the parties are negotiating over the price and

currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon's

specie value its gold value.

The current spot exchange rate is 0.39 Maltese lira (ML) per 1.00 U.S. dollar. Maltese inflation is expected to be about

8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only

1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year (assuming

purhcasing power parity), or receiving a guaranteed dollar payment (assuming a gold price of $420 per ounce)?

Total number of ounces in weight

Price of gold, $/ounce

Falcon value based on price of gold

$

$

Now

48

768

440.00

337,920.00

$

$

In One Year

48

768

420.00

322,560.00

The purchasing power parity forecast of the Maltese lira/dollar exchange rate:

Current spot rate, Maltese lira/$

Expected Maltese inflation

Expected dollar inflation

PPP forecast of Maltese lira/$

0.3900

8.500%

1.500%

0.4169

If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a

larger amount ($322,560) than accepting Maltese lira assuming PPP ($316,116).

Current Value

337,920

Spot (ML/$)

0.3900

131,788.80

Maltese lira

Investor Receives

in March 2004

Assuming PPP

$

316,116

0.4169

131,788.80

Clayton Moore is the manager of an international money market fund managed out of London. Unlike many money

funds that guarantee their investors a near risk-free investment with variable interest earnings, Clayton Moore's fund is

a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund

is pound-denominated. Clayton is currently evaluating a rather interesting opportunity in Malaysia. Since the Asian

Crisis of 1997, the Malaysian government enforced a number of currency and capital restrictions to protect and

preserve the value of the Malaysian ringgit. The ringgit was fixeded to the U.S. dollar at RM3.80/$ for seven years.

In 2005, the Malaysian government allowed the currency to float against several major currencies. The current spot

rate today is RM3.13485/$. Local currency time deposits of 180-day maturities are earning 8.900% per annum. The

London eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot

rate on the British pound is $1.5820/, and the 180-day forward rate is $1.5561/.

Assumptions

Principal investment, British pounds

Spot exchange rate ($/)

180-day forward rate ($/)

Malaysian ringgit 180-day yield

Spot exchange rate, Malaysian ringgit/$

$

$

Values

1,000,000.00

1.5820

1.5561

8.900%

3.1384

The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed

against the dollar, hence the ending Malaysian ringgit/$ rate is the same as the current spot rate. The pound,

however, is not fixed to either the dollar or ringgit. Clayton Moore can purchase a forward against the dollar,

allowing him to cover the dollar/pound exchange rate.

Initial Investment

1,000,000.00

Spot ($/)

1.5820

$

1,582,000

Spot (M$/$)

3.1384

4,964,948.80

Malaysian ringgit

---------------> 180 days ---------------->

---------------> 180 days ---------------->

1.0445

6.188%

Investment Proceeds

1,061,884.84

Fwd-180 ($/)

1.5561

$

1,652,399

3.1384

5,185,889.02

Ringgit proceeds

8.900%

Malaysian ringgit deposit rate (180 days)

If Clayton Moore invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM/$

exchange rate (managed by the government), and sells the dollar proceeds forward, he should expect a return of

6.188% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market.

Interestingly, if Clayton chose to NOT sell the dollars forward, and accepted the uncovered risk of the $/ exchange

rate as well, he may or may not do better than 6.188%. For example, if the spot rate remained unchanged at $1.5820/,

Clayton's return would only be 4.450%. This demonstrates that much of the added return Clayton is earning is arising

from the forward rate itself, and not purely from the nominal interest differentials.

In 1999 the Economist magazine reported the creation of an index or standard for the evaluation of African currency values using the local prices of beer. Beer

was chosen as the product for comparison because McDonald's had not peneterated the African continent beyond South Africa, and beer met most of the same

product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated

the process of creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of the Economist, for Africa.

The index compares the cost of a 375 milliliter bottle of clear lager beer across sub-Sahara Africa. As a measure of PPP the beer needs to be relatively

homogeneous in quality across countries, needs to possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually

provide a measure of relative purchasing power. The beers are first priced in local currency (purchased in the taverns of the local man, and not in the highpriced tourist centers), then converted to South African rand. The prices of the beers in rand are then compared to form one measure of whether the local

currencies are undervalued (-%) or overvalued (+%) versus the South African rand. Use the data in the exhibit and complete the calculation of whether the

individual currencies are under- or over-valued.

Country

South Africa

Botswana

Ghana

Kenya

Malawi

Mauritius

Namibia

Zambia

Zimbabwe

Beer

Castle

Castle

Star

Tusker

Carlsberg

Phoenix

Windhoek

Castle

Castle

Local

currency

Rand

Pula

Cedi

Shilling

Kwacha

Rupee

N$

Kwacha

Z$

Beer Prices

Local

currency

2.30

2.20

1,200.00

41.25

18.50

15.00

2.50

1,200.00

9.00

Notes:

1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99.

2. Implied PPP exchange rate = Price in local currency / 2.30.

3. Under or overvalued to rand = Implied PPP rate / spot rate on 3/15/99.

In

rand

---2.94

3.17

4.02

2.66

3.72

2.50

3.52

1.46

Implied

PPP rate

---0.96

521.74

17.93

8.04

6.52

1.09

521.74

3.91

Spot

rate

(3/15/99)

---0.75

379.10

10.27

6.96

4.03

1.00

340.68

6.15

Under or

overvalued

to rand (%)

---27.9%

37.6%

74.6%

15.6%

61.8%

8.7%

53.1%

-36.4%

Grupo Bimbo, headquartered in Mexico City, is one of the largest bakery companies in the world. On January 1st, when the

spot exchange rate is Ps10.80/$, the company borrows $25.0 million from a New York bank for one year at 6.80% interest

(Mexican banks had quoted 9.60% for an equivalent loan in pesos). During the year, U.S. inflation is 2% and Mexican

inflation is 4%. At the end of the year the firm repays the dollar loan.

a. If Bimbo expected the spot rate at the end of one year to be that equal to purchasing power parity, what would be the cost

to Bimbo of its dollar loan in peso-denominated interest?

b. What is the real interest cost (adjusted for inflation) to Bimbo, in peso-denominated terms, of borrowing the dollars for

one year, again assuming purchasing power parity ?

c. If the actual spot rate at the end of the year turned out to be Ps9.60/$, what was the actual peso-denominated interest cost

of the loan?

Borrowing principal

Current spot rate, pesos/dollar (Ps/$)

Mexican inflation (actual)

US dollar inflation (actual)

25,000,000

10.800

4.00%

2.00%

Actual spot rate end of year (Ps/$)

Actual spot rate end of year (Ps/$)

11.01

9.60

9.60

6.800%

$

25,000,000

Spot (Ps/$)

10.80

270,000,000

Mexican pesos

1.0680

26,700,000

11.01

294,014,118

Pesos needed to repay

U.S. dollar loan

9.600%

Quoted Mexico peso borrowing rate (one year)

Implied cost = (Repaid/Initial proceeds) - 1

8.894%

a. If the ending spot rate was Ps11.01/$ as PPP would predict, the actual peso-based interest cost would be 8.894%.

b. The real peso-denominated interest cost (corrected for inflation) would be:

The calculation shown at right is the precise or

exact answer. The approximate form, found

simply by subtracting inflation from nominal

interest, would be 4.894%.

Nominal interest

Actual inflation

Real peso-interest

8.8940%

4.0000%

4.7058%

b. If the actual end of year spot rate was Ps9.60/$ (just plug it into the spreadsheet for the EOY Spot rate), the actual pesodenominated interest cost would be -5.067%. (Yes, a negative interest rate.)

AvtoVAZ OAO, a leading auto manufacturer in Russia, was launching a new automobile model in 2001, and is in the midst of completing a complete pricing

analysis of the car for sales in Russia and export. The new car, the Kalina, would be initially priced at Rubles 260,000 in Russia, and if exported, $8,666.67 in

U.S. dollars at the current spot rate of Rubles 30 = $1.00. AvtoVAZ intends to raise the price domestically with the rate of Russian inflation over time, but is

worried about how that compares to the export price given U.S. dollar inflation and the future exchange rate. Use the following data table to answer the pricing

analysis questions.

Calendar year

Kalina Price (rubles)

Russian inflation (forecast)

U.S. inflation (forecast)

Exchange rate (rubles = USD 1.00)

2001

260,000

2002

2003

2004

2005

2006

14.0%

2.5%

12.0%

3.0%

11.0%

3.0%

8.0%

3.0%

8.0%

3.0%

30.00

a. If the domestic price of the Kalina increases with the rate of inflation, what would its price be over the 2002-2006 period?

b. Assuming that the forecasts of US and Russian inflation prove accurate, what would the value of the ruble be over the coming years if its value versus the

dollar followed purchasing power parity?

c. If the export price of the Kalina were set using the purchasing power parity forecast of the ruble-dollar exchange rate, what would the export price be over

the 2002-2006 period?

d. How would the Kalina's export price evolve over time if it followed Russian inflation and the exchange rate of the ruble versus the dollar remained relatively

constant over this period of time?

e. Vlad, one of the newly hired pricing strategists, believes that prices of automobiles in both domestic and export markets will both increase with the rate of

inflation, and that the ruble/dollar exchange rate will remain fixed. What would this imply or forecast for the future export price of the Kalina?

f. If you were AvtoVAZ, what would you hope would happen to the ruble's value versus the dollar over time given your desire to export the Kalina? Now if you

combined that 'hope' with some assumptions about the competition -- other automobile sales prices in dollar markets over time -- how might your strategy

evolve?

g. So what did the Russian ruble end up doing over the 2001-2006 period?

Calendar year

2001

2002

2003

2004

2005

2006

260,000

296,400

331,968

368,484

397,963

429,800

power parity (PPP) holds

30.00

33.37

36.28

39.10

41.00

42.99

8,666.67

8,883.33

9,149.83

9,424.33

9,707.06

9,998.27

8,666.67

9,880.00

11,065.60

12,282.82

13,265.44

14,326.68

An added note is to recognize that if this was the case, PPP is definitely not 'holding' in the academic sense.

e. Vlad is actually not saying anything different than what questions c) and d) addressed. If the export price is based on the initial dollar price of $8,667.67 then

rising with dollar inflation, it reaches $9,998.27 in 2006 (same as part c)). Alternatively, if the pricing follows the price in the domestic market, in rubles, rising

with Russian inflation, it reaches Rubles 429,800 in 2006, and when converted to U.S. dollars at an assumed fixed rate of exchange of Rubles 30 = $1.00, the

same $14,326.68 as in part d).

If export price rises at dollar inflation

8,666.67

8,883.33

9,149.83

9,424.33

9,707.06

9,998.27

299,948

f. Exporters generally would prefer that their own currency weakens over time versus the currency of the customer -- making their product offering increasingly

affordable (cheaper), and hopefully increasing sales volume. Since AvtoVAZ's costs are all in Russian rubles, earning a hard currency like the dollar which

would be slowly strengthenging against the ruble might increase profit margins (depending on what happens to costs over time from other factors).

If most of the competition in the target dollar markets were dollar-based manufacturers, their costs and prices might be rising with dollar inflation. The answers

to parts c) and d) provide some ideas or possible boundaries on what you might consider. At fixed exchange rates, the dollar price would rise quite high by

2006 (to $14,326.68), whereas if rate of exchange had remained fixed the export price would be much lower in 2006 ($9,998.27). Of course pricing strategies

can and should be changed over time with changing market conditions, but the general consensus of analysts would be to expect to increase the at a rate

somewhere inbetween c) and d) forecasts.

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