QUESTION ONE

A Kenyan entity intends to supply some product to an organization in south Africa through a contract.
The contract says that payment will be made in south African rands within 2 years from now. The
Kenyan firm`s marginal cost of production at the time of signing the contract is estimated at sh2,000,000
with a 20% mark up. Exchange rate is;

KSH/1SAR

Spot 8.025-8.125.

Details on market information between Kenya and South Africa are as follows.

Borrowing rate: Kenya is 18% and south Africa is 12%. Annual inflation rates: Kenya is 8% and south
Africa is 6%. Investment rates: Kenya is 6% and south Africa is 8%. No forward rate that exists for a 2-
year period. Required;

Using purchasing power parity, recommend the contract price to be used.

SOLUTION

Find the initial cost in Kenyan Shillings (Ksh) with the 20% markup: Initial Cost = Marginal Cost + 20%
Markup

Initial Cost = Ksh 2,000,000 + (0.20 * Ksh 2,000,000) = Ksh 2,400,000

Calculate the future cost in Kenyan Shillings after 2 years based on Kenyan inflation: Future Cost in Ksh =
Initial Cost * (1 + Kenyan Inflation Rate) ^2

Future Cost in Ksh = Ksh 2,400,000 * (1 + 0.08) ^2 ≈ Ksh 2,799,360

Calculate the future exchange rate using the relative PPP formula:

Future Exchange Rate = Spot Rate * (1 + South African Inflation Rate) / (1 + Kenyan Inflation Rate) Future
Exchange Rate = 8.125 * (1 + 0.06) / (1 + 0.08)

Future Exchange Rate ≈ 7.9745 SAR/Ksh

Determine the recommended contract price in SAR:

Contract Price in SAR = Future Cost in Ksh / Future Exchange Rate Contract Price in SAR = Ksh 2,799,360 /
7.9745 SAR/Ksh ≈ 351,038.9366 SAR.

QUESTION TWO
XYZ ltd exported goods to ABC ltd which is based in the USA. XYZ (Kenyan firm) expects to receive
800,000 USA dollars in 1yrs time. The current spot rate is 1Us dollars/Ksh 60. However, XYZ ltd created a
probability distribution for the forward spot rate in a year as follows:

Forward spot rate ksh/1us$ is 61 and probability is 0.2 Forward spot rate ksh/1Us$ is 63 and probability
is 0.5 Forward spot rate ksh/1Us$ is 67 and probability is 0.3

You are provided with the following information;

1). The future spot rate is estimated in a year's time to be Sh62 per Us dollar

2). One year put options on the Us dollar are available with an exercise price of SH 63 and a premium of
ksh 4 per us dollar.

3)The following are the money market annual rates.

Deposit; USA Annual rate is 12% and Kenyan annual rate is 18%. Borrowing; USA Annual rate is 6% and
Kenyan annual rate is 9%.

4) 1 year call options are available on the Us dollar with an exercise price of SH 60 and a premium of SH

3 per Us dollar.

Required;

1) Determine whether a forward market hedge, money market hedge or currency option hedge will be
the most appropriate hedging strategy for the company.

2) Advice the prospective investor of the most appropriate hedging strategy if no hedging took place

SOLUTION

To determine the most appropriate hedging strategy for XYZ Ltd, we need to consider the various
options available and the specific circumstances. Here are the possible hedging strategies and their
evaluation:

1) Forward Market Hedge:

XYZ Ltd expects to receive $800,000 in 1 year.

The forward spot rate probabilities are provided, with the most likely rate being 63 Ksh/USD.

If XYZ Ltd enters into a forward contract to sell $800,000 for Ksh at the forward rate, they can lock in a
known amount in Ksh in the future, providing certainty.

2) Money Market Hedge:

The money market rates are provided, with an annual deposit rate of 12% in the USA and 18% in Kenya,
and an annual borrowing rate of 6% in the USA and 9% in Kenya.

XYZ Ltd could use the money market to lock in a future amount of Ksh by investing or borrowing funds in
the respective markets.

3) Currency Option Hedge:

XYZ Ltd can purchase 1-year put options on the US dollar with an exercise price of 63 Ksh/USD and a
premium of 4 Ksh/USD.

They can also purchase 1-year call options on the US dollar with an exercise price of 60 Ksh/USD and a
premium of 3 Ksh/USD.

Evaluation:

If the expected future spot rate is 62 Ksh/USD, it's slightly less favorable than the most likely forward
rate of 63 Ksh/USD.

The forward market hedge could provide certainty in terms of the amount of Ksh to be received. The
currency option hedge with a put option could offer a floor price of 63 Ksh/USD, protecting against a
drop in the exchange rate, and a call option could offer participation in favorable movements.

Recommendation:

Given the slightly less favorable expected future spot rate, using a forward market hedge might be the
most appropriate strategy to lock in a known amount of Ksh.

Alternatively, using a currency option hedge with a combination of put and call options might provide a
balance between protection and participation in rate movements. This choice would depend on XYZ
Ltd's specific risk tolerance and exchange rate expectations.

2) Advice if No Hedging Took Place:

If XYZ Ltd chooses not to hedge and the expected future spot rate of 62 Ksh/USD materializes, they
would receive 62 Ksh for each USD, which would result in 62 Ksh/USD * $800,000 = 49,600,000 Ksh. This
would be the outcome if no hedging took place.

However, not hedging exposes XYZ Ltd to exchange rate risk, and if the exchange rate were to move
against them, they could receive a lower amount in Ksh. The decision on whether to hedge or not should

take into account the company's risk tolerance and exchange rate expectations. It's important to consult
with a financial expert and weigh the potential costs and benefits of each strategy.

QUESTION THREE
Explain how currency swaps could be used to hedge against the foreign exchange operating exposure of
a firm.

SOLUTION

Identify Exposure: First, the firm needs to identify its foreign exchange operating exposure, which is the
risk of fluctuating exchange rates affecting its cash flows and profitability. For example, if a company
does business in multiple currencies, it may be exposed to adverse currency rate movements that can
impact its revenues and costs.

Currency Swap Agreement: The firm enters into a currency swap agreement with a counterparty. In a
typical currency swap, two parties exchange a principal amount of their own currencies. The primary
purpose of the swap is not to exchange the currencies for their use but to hedge against currency rate
fluctuations.

Cash Flow Management: Suppose a U.S.-based firm has a subsidiary in Europe, which generates revenue
in euros. To hedge against euro exchange rate fluctuations, the firm can enter into a currency swap
where it agrees to exchange the euro revenues for U.S. dollars at a predetermined exchange rate. This
locks in the exchange rate and provides certainty in future cash flows.

Reducing Risk: By using the currency swap, the firm reduces its exposure to currency risk. If the euro
weakens against the U.S. dollar, the firm benefits because it can exchange euros for dollars at the
agreed-upon, more favorable rate. If the euro strengthens, the firm is still protected, as it can exchange
euros for dollars at the predetermined rate.

Customization: Currency swaps can be customized to suit the specific needs of the firm. For example,
the firm can choose the size and duration of the swap based on its exposure and risk management
objectives.

Costs and Considerations: It's important to note that currency swaps may involve costs such as interest
rate differentials between the two currencies. Additionally, the firm should carefully choose its
counterparty to minimize counterparty risk.

QUESTION FOUR

Exhaustively discuss practical challenges that could be encountered when making international capital
investment decisions.

SOLUTION

Exchange rate risk. Fluctuations in exchange rates can be affect the value of the investments. Changes in
currency values may lead to losses or gains for international investors, making it difficult to predict
returns accurately. To mitigate the exchange rate risk, investors can use currency hedges which also
come with their costs and complexities this can impact investment decisions. Currency fluctuations also
affects the liquidity of investments and it may be difficult to buy or sell assets in foreign currency if the
exchange rates become unfavorable. Taxation and tariffs. Complex tax structures can impacts the
financial aspects of international investments. High tax rates can discourage investors to make capital
investment decision. Imposed tariffs can negatively impact international capital investment because
tariffs are created as a barrier to enter into international markets. Legal and compliance issues.
Compliance with local laws and international regulations can be complex. Economic risk. High Inflation
rates can lead to depreciation of the value of currency. This affects the real value of the investment.
High interest rates on the debt used to finance these investments can leads to low returns. Economic
stability impacts the performance of investments. Competition, high Competition from the already
existing investors who are well developed and have their roots in the international market can also
affect the investment decisions. New investors may be discouraged to invest when the competition is
too high.

QUESTION FIVE

Discuss four techniques that a company might use to protect itself against the foreign exchange risks
associated with foreign exchange trade.

SOLUTION

Forward Contracts: Companies can enter into forward contracts with financial institutions to lock in the
exchange rate for a future date. This helps mitigate the risk of unfavorable currency fluctuations.

Currency Hedging: Currency hedging involves using financial instruments like options and futures to
protect against exchange rate volatility. By buying options, a company can secure the right to exchange
currency at a predetermined rate, thus limiting potential losses.

Netting: Netting involves consolidating all foreign currency payables and receivables within a company
and then offsetting them to reduce exposure. This minimizes the need for external currency
transactions.

Diversification: Diversifying business operations and revenue streams across different countries and
currencies can act as a natural hedge. When one currency weakens, profits in other regions may offset
losses.

QUESTION SIX(A)

QUESTION SIX(A)

Discuss Reasons why Business entities go Global Market Expansion:

SOLUTION

Expanding into new markets offers companies the opportunity to reach a broader customer base, which
is particularly advantageous when their domestic market is saturated or declining. By entering untapped
regions or demographics, businesses can potentially boost sales and revenue. This diversification
strategy can help mitigate risks associated with over-reliance on a single market while also capitalizing
on growth opportunities in different geographical areas or market segments.

Risk mitigation: Going global can spread risk across a broader geographic and economic spectrum,
making a business more resilient to unforeseen challenges and uncertainties. Therefore, operating in
multiple markets can help spread risk, reducing the impact of economic downturns or political instability
in one region.

Competitive Advantage: Competition is very tough and internationalization is chosen for survival. In
order to make the most of this situation, you can target countries that are little or no exploited in your
sector in order to benefit from the status of the first mover. This status allows time to establish yourself,
adapt, and educate the population to use your product or service. Properly executed, being first in a
market builds credibility abroad and becomes the trend setter in your new market. Currency
diversification: Operating in multiple countries can help businesses hedge against currency fluctuations.
Revenue streams in different currencies can offset losses due to exchange rate volatility. It also allows
businesses achieve economies of scale and gain a competitive edge.

Economies of scale in global operations stem from large-scale production advantages, including cost
savings via bulk purchasing, standardization, shared infrastructure, and optimized distribution. Buying
materials in bulk and standardizing processes enables lower supplier costs and reduced production
complexity, lowering per-unit expenses. Shared infrastructure and optimized distribution minimize
facility and transportation costs. Such economies enhance efficiency, competitiveness, and cost-effective
offerings to customers.

QUESTION SIX (B)

Assess Reasons Associated with The Difficulties of Entities Operating in Developing Countries Extending
Their Operations Internationally.

SOLUTION

Limited Access to Capital: Businesses in developing countries often encounter challenges when seeking
the capital required for international expansion. Unlike their counterparts in developed nations, these
firms may have restricted access to loans, venture capital, or alternative funding channels. This financial
limitation can hinder their ability to invest in overseas ventures, expand operations, or compete globally.

Supply Chain Challenges: International supply chains, with logistical and transportation issues, can be
complex. Ensuring a reliable supply chain is crucial for businesses expanding abroad. Market Entry
Barriers: Entering new markets can be costly and complex. Tariffs, import quotas, and trade restrictions
imposed by the target country can increase business costs and make products less competitive.
Developing country entities may find it difficult to absorb these additional expenses. Cultural and
language barrier: Language barriers can hinder effective communication between the company's
employees and local staff. Misunderstandings may arise, affecting day-to-day operations, decision-
making, and even safety protocols while varying cultural norms, values, and practices in
developing countries can lead to misunderstandings or conflicts with employees, customers, and
partners. This can impact business relationships and reputation.

Talent and skills gap: In many developing nations, businesses face the challenge of bridging talent and
skills gaps. Finding skilled employees meeting international standards is tough due to educational
disparities and limited specialized training access. Companies in these regions invest heavily in training
to upskill the local workforce, promoting economic growth by enabling global labor market
participation. Addressing this gap is crucial for corporate success and fosters broader economic
development and competitiveness.

QUESTION SEVEN(A)

Discuss in details the factors that influence supply and demand of currencies in international
transactions.

SOLUTION

Interest rates. These rates set by a nation's central bank influences the currency's demand. The higher
the interest rates the higher its demand rises due to the higher returns it provides. When the currency's
demand increases or reduces it automatically affects it's supply. Geopolitical conflicts. Fluctuations of a
currency due to political tensions, wars between countries that are transacting may result to the
reduction of the respective currencies due to unstable economic patterns due to the conflicts that cause
uncertainty. Inflation rates. A currency's value will increase when the inflation rates are lower thus
causing less erosion of its purchasing power. This increases the demand of a currency thus affecting its
supply to rise. Government policies. When a government's fiscal and monetary policies such as taxation
and trading regulations can impact the money markets. Expansionary monetary and fiscal policies
weaken the value of a currency leading to lowered demand even though it's supply might be high.

Trade balance. The demand and supply of a currency can be affected by the difference between imports
and exports. A trade deficit i.e. Where the imports are more than the exports can lower the demand of a
currency whereas a trade surplus will increase its demand. Economic indicators. These include
unemployment rates, GDP growth that can affect the supply and demand of a currency. Where there's
increased economic growth automatically leads to a stronger currency causing rise in its demand and
supply. Natural disasters and crises. Unexpected natural crises and disasters and global health crises
affecting currency markets and international transactions will weaken a currency where it's more
affected causing low demand for the currency. Market sentiment. When a country's economic and
political stability has negative perspective and sentiment from the public, the demand and supply for its
currency reduces but when a country's said to be growing it's currency will be more attractive thus
higher demand and supply.

QUESTION SEVEN (B)

With regard to foreign currency risk management, discuss the following hedging methods:
1) Leading and lagging

2) Netting

3) Matching receipts and payments

4) Invoicing in own currency SOLUTION

Leading and Lagging. Leading involves accelerating or making an advance payment in foreign exchange
as predetermined by the expected possible behavior of the exchange rates. This is taking advantage of
an expected favorable exchange rate. Lagging on the other hand involves delaying a payment in foreign
exchange to avoid an expected unfavorable behavior of the exchange rates. This enhances gaining
profits from exploiting forecasts of currency rates. Netting. This is also known as internal compensation
as an enterprise by making and receiving payments in the same currency may reduce it's exchange rates.
It's achieved by offsetting the receivables and the payables within a company in different currencies.
Only the difference is exchange when the net amount is calculated in the receivables and payables
reducing transaction costs and exchange rates exposure.

Matching receipts and payments. This hedging method involves the alignment of a company's incoming
and outgoing cash flows in different currencies. This is done to minimize all the risks associated with the
fluctuations of the exchange rates set for international transactions. This also reduces transaction costs
while simplifying cash flow management. Invoicing in own currency. This method of hedging entails
international transactions being conducted by invoicing in own currency ie. Preferring to trade in own
currency rather than the trading partner's currency. This simplifies the transaction process while
reducing

the exchange rate risk exposure for the company doing the invoicing. This method also provides
predictable cash flows.

QUESTION EIGHT

Discuss foreign exchange contracts and use suitable illustrations to demonstrate forward exchange rates
and forward exchange contracts (Practical components)

SOLUTION

Foreign exchange contracts are agreements between two parties to exchange two different currencies
at a specified future date and at a predetermined exchange rate. The contract is meant to hedge against
foreign exchange rate fluctuations and to manage the risks associated with currency movements. A
forward exchange rate is a rate at which two parties agree to exchange currencies on a specified future
date. It is determined by the prevailing spot exchange rate and the interest rate differentials between
the two currencies.

Illustration
Suppose a company based in the United States needs to pay €1 million to a supplier in Germany in six
months. Concerned about potential currency fluctuations, the company decides to enter into a forward
exchange contract with a bank to buy €1 million at a six-month forward rate of 0.84 USD/EUR. If the
spot rate at the time of the contract is 0.85 USD/EUR, the company can lock in the exchange rate of 0.84
USD/EUR for future transactions, protecting itself from any unfavorable movements in the exchange
rate. In this way, the company secures a fixed cost for the purchase, effectively reducing the risks
associated with foreign currency fluctuations. If the spot rate at the time of the transaction in six months
is higher than the forward rate (0.84 USD/EUR), the company benefits from the forward contract by
paying less than it would have without the contract. Conversely, if the spot rate is lower than the
forward rate, the company still pays the agreed-upon rate, protecting itself from potential losses due to
adverse currency movements.