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CODE : P17





1. There are FIVE questions in this paper.

2. Attempt all the FIVE questions.

3. Marks are shown at the end of each question.

4. Submit all your working with your answer book(s).

5. Cleary state any assumption made in your answers.

6. Mathematical tables will be provided where needed.

7. This question paper comprises 6 printed pages.


(a) Your aunt who lives in the United States of America (USA) has US $10,000 to
invest for three months. She is contemplating between investing in the USA and
the UK and has approached you for advice. She tells you that she has managed to
collect the following information:

 Currently the spot rate of British pound is $ 1.800 while the 90-day forward
rate is $1.78.
 The annual interest rates are 4% and 6% in the USA and UK respectively.

(i) Advice your aunt on where to invest the $10,000 to maximize the yield with
no foreign exchange risk. (5 marks)

(ii) Given the USA interest rate, the UK interest rate and the spot rate, what would
be the equilibrium 90-day forward exchange quotation? (2 marks)

(iii) Given the spot rate, the 90-day forward rate and the USA interest rate,
what is the equilibrium UK interest rate? (2 marks)

(b) Two counter parties agree to enter a foreign currency swap between American
dollars and Swiss francs. One dollar is currently worth 1.4 francs. The American
dollar payer will provide $500,000. The interest rate on the dollar is 9 percent,
and the Swiss franc rate is 8 percent. The swap calls for a life of three years with
annual payments.

(i) How much will the provider of the dollar pay at the outset? (2 marks)

(ii) If the interest rates do not change, what is the annual dollar interest
payment for the foreign borrower of dollars? (2 marks)

(iii) If a net payment is recorded for interest in year one and exchange rates do
not change, what will be the net payment? (3 marks)

(iv) What will be the total payment in Swiss francs by the borrower of USA
dollars for year 3? (2 marks)

(v) What will be the total payment in USA dollars by the borrower of Swiss
francs for year 3? (2 marks)
(Total; 20 marks)


(a) A UK Company is considering an investment either in Tanzania or Kenya. The

project would involve a current outlay of £200,000 on equipment and £50,0000
on working capital. The expected economic life of the project is 3 years. The
profits from the project in each country would be as follows:

Year Sales Variable Contributio Fixed Profit
(Millions of Costs n (Millions Costs (Millions
TZS) (Millions of TZS) (Millions of TZS)
of TZS) of TZS)
1 500 300 200 60 140
2 600 360 240 60 180
3 700 420 280 60 220

The fixed costs include an annual charge of TZS 10 million for depreciation.

Year Sales Variable Contributio Fixed Profit
(Millions of Costs n (Millions Costs (Millions
KES) (Millions of KES) (Millions of KES)
of KES) of KES)
1 60 36 24 8 16
2 70 42 28 8 20
3 80 48 32 8 24

The fixed costs include an annual charge of KES 2 million for depreciation.

The current spot exchange rates of the Tanzanian Shilling and Kenyan Shilling
are: TZS 2040/£ and KES 210/£ respectively. The annual rates of inflation in the
three countries in the coming three years are estimated as follows:


1 2 5 4
2 3 6 5
3 4 7 8

The UK Company requires a 20% return on any foreign investment.

Evaluate whether the UK Co. should invest in Tanzania or Kenya. Ignore
taxation. (11 marks)

(b) What is political risk in as far as foreign direct investments is concerned?
Provide examples of political risk faced by multinationals carrying out foreign
direct investments in different countries and explain how these companies
manage such risks prior to and during investment. (9 marks)
(Total; 20 marks)


(a) Suxess Company, a London based company has £11 million of fixed rate loans at
an interest rate of 13% per year which are due to mature in one year. The
company’s treasury believes that inters rates are going to fall, but does not wish to
redeem the loans because large penalties exist for early redemption. Suxess
Company’s bank has offered to arrange an interest rate swap for one year with a
company that has obtained floating rate finance at London Interbank Offered Rate
(LIBOR) plus 1¼%. The bank will charge each of the companies an arrangement
fee of £21,000 and the proposed terms of the swap are that Suxess Company will
pay LIBOR plus 1.5% to the other company and receive from the company
11.75%. The corporate tax is at 35% per annum and the arrangement fee is a tax
allowable expense.


Assuming the LIBOR is 10% at the beginning of the year, calculate the net
interest rate incurred, savings in interest with the swap arrangement, and state
whether the swap would be beneficial to Suxess Company if;

(i) The LIBOR remains at 10% for the whole year. (5 marks)

(ii) The LIBOR falls to 9% after six months. (5 marks)

(b) The theory of comparative advantage assumes that all countries are better off if
each specializes in the production of those goods, which it can produce more
efficiently and buys those goods, which other countries produce more efficiently.

Discuss the two main elements on which the theory of comparative advantage is
based. (4 marks)

(c) What are the main uses of currency options and what are their major drawbacks?
(Total: 20 marks)


(a) A successful exchange system is necessary to stabilize the international payment

system. Discuss the three main conditions that are necessary for an exchange
system to be successful. (4 marks)

(b) A floating or flexible exchange rate is an exchange rate which fluctuates

according to market forces. What are the main advantage and disadvantages of a
floating or flexible exchange rate system? (6 marks)

(c) Harith International Company has recently purchased a consignment of a cleaning

fluid from a UK supplier for £30,000 payable in three month’s time. Recently the
company has experienced foreign exchange losses on similar deals and the
financial director has decided that henceforth all transaction exposure will be
covered. After discussions with the company’s bank in Dar es Salaam the
following data have been made available:

Foreign Exchange Market

Spot Rate 1500 - 1505
Three Months 1 - 2 premium

Money Market
Base rates are 18% per annum in both the UK and Tanzania. Harith International
Company can borrow at 2% above and deposit at 2% below the relevant base rate
in either country.

Option Market
The bank has offered a call option on the £30,000 at an exercise price of TZS
1,490. The option premium is TZS 300,000.

(i) Calculate the net cost of the transaction assuming it was covered in:
 The forward foreign exchange market (2.5 marks)
 The money market (2.5 marks)
(ii) Explain to the financial director the nature of the foreign exchange risk cover
provided by the call option and calculate the exact future spot rate at which the
option will start to give a cheaper cost than the forward contract. (5 marks)
(Total: 20 marks)


(a) Explain the advantages and disadvantages of each of the following ways of
conducting international business:

(i) Exporting (4 marks)

(ii) Licensing (4 marks)

(iii) Joint venture (4 marks)

(b) On July 1st 2005 a Tanzanian firm exported Tshs. 100m worth of maize to a
company in Uganda. The consignment is invoiced in Ugandan shilling at the
prevailing spot rate of Ushs. 1.6/Tshs. The settlement is due six months from the
invoice date.


(i) Suppose the spot exchange rate in six months is Ushs. 1.7/Tshs. What exchange
rate gain or loss will be made by the Tanzanian exporter? (4 marks)

(ii) Suppose a six-month forward contract alternative is available at Ushs. 1.59/Tshs.

Show how risk can be reduced using the forward contract. (4 marks)
(Total: 20 marks)