Tutorial Final IF

Chapter - International Arbitrage and Interest Rate Parity

International Arbitrage and Interest Rate Parity

1. Assume the following information:

Current spot rate of New Zealand dollar = $.41

Forecasted spot rate of New Zealand dollar 1 year from now = $.43
One-year forward rate of the New Zealand dollar = $.42
Annual interest rate on New Zealand dollars = 8%
Annual interest rate on U.S. dollars = 9%

Given the information in this question, the return from covered interest arbitrage by U.S. investors
with $500,000 to invest is _______%.

SOLUTION: $500,000/$.41 = NZ$1,219,512 x (1.08)

= NZ$1,317,073 x .42 = $553,171
Yield = ($553,171 - $500,000)/$500,000 = 10.63%

2. Assume the bid rate of a Singapore dollar is $.40 while the ask rate is $.41 at Bank X. 
Assume the bid rate of a Singapore dollar is $.42 while the ask rate is $.425 at Bank Z.  Given
this information, what would be your gain if you use $1,000,000 and execute locational
arbitrage? That is, how much will you end up with over and above the $1,000,000 you started
with? 

SOLUTION: $1,000,000/$.41 = S2,439,024 x $.42 = $1,024,390

3. Assume the following information:

Spot rate today of Swiss franc = $.60

1-year forward rate as of today for Swiss franc = $.63
Expected spot rate 1 year from now = $.64
Rate on 1-year deposits denominated in Swiss francs = 7%
Rate on 1-year deposits denominated in U.S. dollars = 9%

SOLUTION: $1,000,000/$.60 = SF1,666,667 x (1.07)

= SF1,783,333 x $.63 = $1,123,500
Yield = ($1,123,500 - $1,000,000)/$1,000,000 = 12.35%

4. Assume the bid rate of a Swiss franc is $.57 while the ask rate is $.579 at Bank X.  Assume
the bid rate of the Swiss franc is $.560 while the ask rate is $.566 at Bank Y.  Given this
information, what would be your gain if you use $1,000,000 and execute locational
arbitrage?  That is, how much will you end up with over and above the $1,000,000 you started
with?
SOLUTION: $1,000,000/$.566 = SF1,766,784 x $.57 = $1,007,067. Thus, the profit is $7,067.

5. Assume the following information:

Current spot rate of Australian dollar = $.64

Forecasted spot rate of Australian dollar 1 year from now = $.59
1-year forward rate of Australian dollar = $.62
Annual interest rate for Australian dollar deposit = 9%
Annual interest rate in the U.S. = 6%

Given the information in this question, the return from covered interest arbitrage by U.S. investors
with $500,000 to invest is _______%.

SOLUTION: $500,000/$.64 = A$781,250 x (1.09)

= A$851,563 x $.62 = $527,969
Yield = ($527,969 - $500,000)/$500,000 = 5.59%

6. Assume the bid rate of an Australian dollar is $.60 while the ask rate is $.61 at Bank Q. 
Assume the bid rate of an Australian dollar is $.62 while the ask rate is $.625 at Bank V. 
Given this information, what would be your gain if you use $1,000,000 and execute locational
arbitrage?  That is, how much will you end up with over and above the $1,000,000 you started
with? 

SOLUTION: $1,000,000/$.61 = A$1,639,344 x $.62 = $1,016,393. thus, the profit is $16,393.

7. Bank A quotes a bid rate of $.300 and an ask rate of $.305 for the Malaysian ringgit (MYR).
Bank B quotes a bid rate of $.306 and an ask rate of $.310 for the ringgit. What will be the
profit for an investor who has $500,000 available to conduct locational arbitrage?

SOLUTION: $500,000/$.305 = MYR1,639,344 x $.306 = $501,639. Thus, the profit is $1,639.

8. National Bank quotes the following for the British pound and the New Zealand dollar:

Quoted Bid Price Quoted Ask Price

Value of a British pound (£) in $ $1.61 $1.62
Value of a New Zealand dollar (NZ$) in $ $.55 $.56
Value of a British pound in
New Zealand dollars NZ$2.95 NZ$2.96

SOLUTION: $10,000/$1.62 = £6,172.84 x 2.95

= NZ$18,209.88 x $.55
= $10,015.43.
Thus, the profit is $15.43.

9. Assume the following information:

Quoted Bid Price Quoted Ask Price

Value of an Australian dollar (A$) in $ $0.67 $0.69
Value of Mexican peso in $ $.074 $.077
Value of an Australian dollar in
Mexican pesos 8.2 8.5
 Assume you have $100,000 to conduct triangular arbitrage. What will be your profit from
implementing this strategy?

SOLUTION: $100,000/$.077 = 1,298,701 pesos/ 8.5 = A$152,788 x $0.67 = $102,368

Profit = $102,368-$100,000

Chapter – Relationship among Inflation, Interest Rate & Exchange

rate

1. The inflation rate in the U.S. is 3%, while the inflation rate in Japan is 10%. The current
exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the
Japanese yen has adjusted in the manner suggested by purchasing power parity, the new
exchange rate for the yen will be:

SOLUTION: (1.03/1.10) x $.0075 = $.0070

2. The interest rate in the U.K. are 7%, while the interest rate in the U.S. is 5%. The spot
rate for the British pound is $1.50. According to the international Fisher effect (IFE), the
British pound should adjust to a new level of:

SOLUTION: (1.05/1.07) x (1.50) = $1.47.

3. Assume that U.S. one-year interest rate is 3% and one-year interest rate on Australian
dollars is 6%. U.S. expected annual inflation is 5%, while Australian inflation is expected
to be 7%. You have $100,000 to invest for one year and you believe that PPP holds. The
spot exchange rate of an Australian dollar is $0.689. What will be the yield on your
investment if you invest in the Australian market?

SOLUTION: (1+.05)/(1+.07) x $0.689 = $0.676. ($100,000/A$0.689) x (1+.06) = A$153,846 x

$0.676 = $104,000. ($104,000 - $100,000)/$100,000 = 4%
Chapter – Managing Exposure To Exchange Rate Fluctuations

1. Rework the previous problem, but assume that you have reduced the expected
correlation coefficient from 0.52 to [Link] weights (use increments of 5% such as
95/5, 90/10) result in the best tradeoff between expected risk and expected return?
                 
                 
Expected Correlation
Assumptions   Return   Expected Risk (σ)   (ρ)    
US equity fund   10.50%   18.60%      
Russian equity 0.38
fund   16.80%   36.00%      

Weight of Russian
Weight of US Equity   Equity
Fund in Portfolio   Fund in Portfolio
1.00   0.00
0.95   0.05
0.90   0.10
0.85   0.15
0.80   0.20
0.75   0.25

Calculated Expected Risk & Return.

Solution:

Expected Return   Expected Risk    

(percent)   (percent)   Return/Risk
0.5
10.50%   18.60%   65
0.5
10.82%   18.43%   87
0.6
11.13%   18.41%   05
0.6
11.45%   18.55%   17
0.6
11.76%   18.83%   24
0.6
12.08%   19.26%   27
 2. An investor is evaluating a two-asset portfolio which combines a U.S. equity fund with a
Russian equity fund. The expected returns, risks, and correlation coefficients for the coming
one year period are as follows:
                 
Expected Correlation
Assumptions   Return   Expected Risk (σ)   (ρ)    
US equity fund   10.50%   18.60%      
0.52
Russian equity fund   16.80%   36.00%      

Weight of Russian
Weight of US Equity   Equity
Fund in Portfolio   Fund in Portfolio
1.00   0.00
0.95   0.05
0.90   0.10
0.85   0.15
0.80   0.20

Calculated Expected Risk & Return.

Solution:

Expected Return   Expected Risk    

(percent)   (percent)   Return/Risk
0.5
10.50%   18.60%   65
0.5
10.82%   18.67%   79
0.5
11.13%   18.86%   90
0.5
11.45%   19.18%   97
0.6
11.76%   19.61%   00
Chapter - Managing Transaction Exposure

1. Samson Inc. needs €1,000,000 in 30 days. Samsong can earn 5 percent annualized on a
German security. The current spot rate for the euro is $1.00. Samson can borrow funds in
the U.S. at an annualized interest rate of 6 percent. If Samson uses a money market hedge,
how much should it borrow in the U.S.?

SOLUTION: 1 ,000 , 000 /[1+(5 %×30 /360)]=$ 995 , 851

2. Blake Inc. needs €1,000,000 in 30 days. It can earn 5 percent annualized on a German
security. The current spot rate for the euro is $1.00. Blake can borrow funds in the U.S. at
an annualized interest rate of 6 percent. If Blake uses a money market hedge to hedge the
payable, what is the cost of implementing the hedge?

SOLUTION:
1. Borrow $995,851 from a U.S. bank (€1,000,000 x $1.00 x [1 + (.05 x 30/360)]
2. Convert $995,851 to €995,851, given the exchange rate of $1.00 per euro.
3. Use the euros to purchase a German security that offers 0.42% interest over 30 days.
4. Repay the U.S. loan in 30 days, plus interest; the amount owed is $1,000,830 (computed as
$995,851 x [1 + (.06 x 30/360)].

3. Celine Co. will need €500,000 in 90 days to pay for German imports. Today’s 90-day
forward rate of the euro is $1.07. There is a 40 percent chance that the spot rate of the
euro in 90 days will be $1.02, and a 60 percent chance that the spot rate of the euro in 90
days will be $1.09. Based on this information, the expected value of the real cost of
hedging payables is $________.

SOLUTION:
E[ RCH p ]=−$35,000×0.40+$25,000×0.60=$ 1,000

4. Money Corp. frequently uses a forward hedge to hedge its Malaysian ringgit (MYR)
receivables. For the next month, Money has identified its net exposure to the ringgit as
being MYR1,500,000. The 30-day forward rate is $.23. Furthermore, Money’s financial
center has indicated that the possible values of the Malaysian ringgit at the end of next
month are $.20 and $.25, with probabilities of .30 and .70, respectively. Based on this
information, the revenue from hedging minus the revenue from not hedging receivables
is________.

SOLUTION:
RCH (1)  ( MYR1,500,000  $0.20)  ( MYR1,500,000  $0.23)  $45,000
RCH (2)  ( MYR1,500,000  $0.25)  ( MYR1,500,000  $0.23)  $30,000
E [ RCH ]  (.30)( 45,000)  (.7)(30,000)  7,500

5. Hanson Corp. frequently uses a forward hedge to hedge its British pound (£) payables.
For the next quarter, Hanson has identified its net exposure to the pound as being
£1,000,000. The 90-day forward rate is $1.50. Furthermore, Hanson’s financial center has
indicated that the possible values of the British pound at the end of next quarter are $1.57
and $1.59, with probabilities of .50 and .50, respectively. Based on this information, what
is the expected real cost of hedging payables?
SOLUTION:
 RCH (1)=( £ 1, 000 ,000×$ 1.50)−( £ 1, 000 ,000×$ 1.57 )=−$ 70, 000
RCH (2)=( £ 1, 000 ,000×$ 1.50 )−( £ 1, 000 , 000×$ 1.59 )=−$ 90, 000
E[ RCH ]=(.50 )(−70 ,000 )+(.50)(−90 ,000)=−80 ,000

The following information refers to questions 6 and 7.

U.S. Jordan
360-day borrowing rate 6% 5%
360-day deposit rate 5% 4%

6. Perkins Corp. will receive 250,000 Jordanian dinar (JOD) in 360 days. The current spot
rate of the dinar is $1.48, while the 360-day forward rate is $1.50. How much will Perkins
receive in 360 days from implementing a money market hedge (assume any receipts
before the date of the receivable are invested)?

SOLUTION:
1. Borrow JOD238,095.24 (JOD250,000/1.05) = JOD238,095.24.
2. Convert JOD238,095.24 to $352,380.95 (JOD238,095.24  $1.48) = $352,380.95.
3. Invest $352,380.95 at 5% to accumulate $370,000 ($352,280.95  1.05) = $370,000.

7. Pablo Corp. will need 150,000 Jordanian dinar (JOD) in 360 days. The current spot rate
of the dinar is $1.48, while the 360-day forward rate is $1.46. What is Pablo’s cost from
implementing a money market hedge (assume Pablo does not have any excess cash)?

SOLUTION:
1. Need to invest JOD144,230.76 (JOD150,000/1.04) = JOD144,230.76.
2. Need to convert $213,461.52 to obtain the JOD144,230.76 dinar (JOD144,230.76  $1.48) =
$213,461.52.
3. At the end of 360 days, need $226,269.22 ($213,461.52 x 1.06) = $226,269.21.

8. Lorre Company needs 200,000 Canadian dollars (C$) in 90 days and is trying to
determine whether or not to hedge this position. Lorre has developed the following
probability distribution for the Canadian dollar:

Possible Value of Canadian Dollar in 90 Days Probability

$0.54 15%
0.57 25%
0.58 35%
0.59 25%

SOLUTION: Since Lorre locks into the $.575 with a forward contract, the first two cases would
have been cheaper had Lorre not hedged (15% + 25% = 40%).

9. Quasik Corporation will be receiving 300,000 Canadian dollars (C$) in 90 days.

Currently, a 90-day call option with an exercise price of $.75 and a premium of $.01 is
available. Also, a 90-day put option with an exercise price of $.73 and a premium of $.01
is available. Quasik plans to purchase options to hedge its receivable position. Assuming
that the spot rate in 90 days is $.71, what is the net amount received from the currency
option hedge?
SOLUTION: ($.73 - $.01) x 300,000 = $216,000.
 10. FAB Corporation will need 200,000 Canadian dollars (C$) in 90 days to cover a payable
position. Currently, a 90-day call option with an exercise price of $.75 and a premium of
$.01 is available. Also, a 90-day put option with an exercise price of $.73 and a premium
of $.01 is available. FAB plans to purchase options to hedge its payable position.
Assuming that the spot rate in 90 days is $.71, what is the net amount paid, assuming
FAB wishes to minimize its cost?

SOLUTION: ($.71 + $.01) x 200,000 = $144,000. Note: the call option is not exercised since the
spot rate is less than the exercise price.

Chapter - Multinational Capital Budgeting

1. An MNC is considering establishing a two-year project in New Zealand with a $30 million
initial investment.  The firm’s cost of capital is 12%.  The required rate of return on this
project is 18%.  The project is expected to generate cash flows of NZ$12 million in Year 1
and NZ$30 million in Year 2, excluding the salvage value.  Assume no taxes, and a stable
exchange rate of $.60 per NZ$ over the next two years.  All cash flows are remitted to the
parent.  What is the break-even salvage value?

SOLUTION:
1.  NZ$12,000,000 x $.60 = $7,200,000 $7,200,000/(1.18) = $6,101,695
2. NZ$30,000,000 x $.60 = $18,000,000 $18,000,000/(1.18)2 = $12,927,320
$19,029,015

Break-even
salvage   = [Initial outlay - PV of cash flows] (1 + k)m
  value
= [$30,000,000 - $19,029,015] (1.18)2
= $15,276,000

Break-even salvage
  value in NZ$ = $15,276,000/$.60 = NZ$25,459,999

The following information refers to questions 2 through 4.

Assume that Baps Corporation is considering the establishment of a subsidiary in Norway. The initial
investment required by the parent is $5,000,000. If the project is undertaken, Baps would terminate
the project after four years. Baps’ cost of capital is 13%, and the project is of the same risk as Baps’
existing projects. All cash flows generated from the project will be remitted to the parent at the end of
each year. Listed below are the estimated cash flows the Norwegian subsidiary will generate over the
project’s lifetime in Norwegian kroner (NOK):

Year 1 Year 2 Year 3 Year 4

NOK10,000,000 NOK15,000,000 NOK17,000,000 NOK20,000,000

The current exchange rate of the Norwegian kroner is $.135. Baps’ exchange rate forecast for the
Norwegian kroner over the project’s lifetime is listed below:
 Year 1 Year 2 Year 3 Year 4
$.13 $.14 $.12 $.15

2. What is the net present value of the Norwegian project?

SOLUTION:
Year 0 Year 1 Year 2 Year 3 Year 4
Cash flow to parent -$5,000,000 $1,300,000 $2,100,000 $2,040,000 $3,000,000
PV of parent cash flow 1,150,442 1,644,608 1,413,822 1,839,956
Cumulative NPV -3,849,558 -2,204,950 -791,128 1,048,828

3. Assume that NOK8,000,000 of the cash flow in year 4 represents the salvage value. Baps is
not completely certain that the salvage value will be this amount and wishes to determine the
break-even salvage value, which is $___________.

SOLUTION: Even if there is no salvage value, the NPV would still be positive, as shown below:

Year 0 Year 1 Year 2 Year 3 Year 4

Cash flow to parent -$5,000,000 $1,300,000 $2,100,000 $2,040,000 $1,800,000
PV of parent cash flow 1,150,442 1,644,608 1,413,822 1,103,974
Cumulative NPV -3,849,558 -2,204,950 -791,128 312,846

4. Baps is also uncertain regarding the cost of capital. Recently, Norway has been involved in
some political turmoil. What is the net present value (NPV) of this project if a 16% cost of
capital is used instead of 13%?

SOLUTION:
Year 0 Year 1 Year 2 Year 3 Year 4
Cash flow to parent -$5,000,000 $1,300,000 $2,100,000 $2,040,000 $3,000,000
PV of parent cash flow 1,120,690 1,560,642 1,306,942 1,656,873
Cumulative NPV -3,879,310 -2,318,668 -1,011,726 645,147

5. Explain Subsidiary versus Parent Perspective

 Tax Differentials
 Restricted Remittances
 Excessive Remittances
Exchange Rate Movements

6. Petrus Company has a unique opportunity to invest in a two-year project in Australia. The
project is expected to generate 1,000,000 Australian dollars (A$) in the first year and
2,000,000 Australian dollars in the second. Petrus would have to invest $1,500,000 in the
project. Petrus has determined that the cost of capital for similar projects is 14%. What is the
net present value of this project if the spot rate of the Australian dollar for the two years is
forecasted to be $.55 and $.60, respectively?

SOLUTION:
Year 0 Year 1 Year 2
Cash flow to parent -$1,500,000 $550,000 $1,200,000
PV of parent cash flow 482,456 923,361
Cumulative NPV -1,017,544 -94,183
7. Senser Co. established a subsidiary in Russia two years ago. Under its original plans, Senser
intended to operate the subsidiary for a total of four years. However, it would like to reassess
the situation, since exchange rate forecasts for the Russian ruble indicate that it may
depreciate from its current level of $.033 to $.028 next year and to $.025 in the following
year. Senser could sell the subsidiary today for 5 million rubles to a potential acquirer. If
Senser continues to operate the subsidiary, it will generate cash flows of 3 million rubles next
year and 4 million rubles in the following year. These cash flows would be remitted back to
the parent in the U.S. The required rate of return of the project is 16 percent. Should Senser
continue operating the Russian subsidiary?

ANSWER:

End of Year 2 End of Year 3 End of Year 4

Rubles remitted 3,000,000 4,000,000
Selling price 5,000,000
Exchange rate $.033 $.028 $.025
Cash flow from divestiture $165,000
Cash flows forgone $84,000 $100,000
PV of forgone CF (16%) $72,413.79 $74,316.29

$165,000 ($72,413.79 $74,316.29)

= +−=dNPV

$18,269.92

Senser Co. should consider divesting its subsidiary, since the present value of the cash flows is less
than the price it could sell the subsidiary for today.

Chapter - Financing International Trade

 1. Explain 4 Payment Methods for International Trade
 Prepayment
 Letters of Credit
 Drafts
 Consignment

2. Explain 4 Trade Finance Methods

 Accounts Receivable Financing
 Factoring
 Letters of Credit
 Banker’s Acceptances
 Working Capital Financing
 Medium-Term Capital Goods Financing (Forfaiting)
 Countertrade

3. Explain Agencies that Motivate International Trade

 Export-Import Bank of the U.S.
 Private Export Funding Corporation (PEFCO)
 Overseas Private Investment Corporation (OPIC)

Chapter - Country Risk Analysis

1. Explain 4 Political Risk Factors

 Attitude of Consumers in the Host Country
 Actions of Host Government
 Blockage of Fund Transfers
 Currency Inconvertibility
 War
 Bureaucracy
 Corruption

2. Explain Financial Risk Factors Economic Growth

 Macro-Assessment of Country Risk

 Micro-Assessment of Country Risk

3. Explain 4 Techniques to Assess Country Risk

 Checklist Approach
 Delphi Approach
 Quantitative Analysis
 Inspection
 Visits
 Combination of Techniques

Chapter - International Cash Management

1. Explain Multinational Management of Working Capital
 Subsidiary Expenses
 Subsidiary Revenue
 Subsidiary Dividend Payments

2. Explain Techniques to Optimize Cash Flows

 Accelerating Cash Inflows
 Minimizing Currency Conversion Costs
 Managing Blocked Funds
 Managing Intersubsidiary Cash Transfers

3. Explain Complications in Optimizing Cash Flow

 Company-Related Characteristics
 Government Restrictions
 Characteristics of Banking Systems