Dr. P.V. Viswanath
|Courses/ FIN 649|
Exams, Fall 2005, FIN 649
1. (20 points) Please define any five of the following terms:
2. Read the following article and answer these questions:
THE GREAT THRIFT SHIFT
America is spending while the rest of the world is saving. But for how long? Zanny Minton Beddoes investigates
ON MARCH 10th 2005, Ben Bernanke—a former Princeton professor who at the time was a governor of America's central bank—addressed a gathering of economists in Richmond, Virginia, on America's gaping current-account deficit. Its causes, he argued, were to be found abroad rather than in American profligacy. In particular, Mr Bernanke mused, the world might be suffering from a “global saving glut”. The phrase immediately caught on. Like the famous remark about “irrational exuberance” by Alan Greenspan, the chairman of the Federal Reserve, it has since helped to shape the global economic debate.
The idea's appeal lies in the way it ties together two of the most vexing questions about today's economic landscape: why are interest rates so low? And why can America borrow eye-popping amounts from foreigners with seeming impunity? According to the IMF's latest World Economic Outlook, the global economy will grow by 4.3% this year, slower than in 2004 but still a healthy clip. Strong economic growth is normally accompanied by higher interest rates, but long-term interest rates are at their lowest levels since the 1960s.
At the same time Americans are spending over $700 billion a year more than their economy produces, the equivalent of more than 6% of annual output. As a share of America's economy, this external deficit has more than doubled since 1999. Yet it has had none of the dire consequences for the dollar that Cassandras have been predicting. For the first six months of 2005, the greenback was rising. Although it has slid in recent weeks, the drop has hardly been dramatic.
A “global saving glut” could explain both oddities. If savings are somehow super-abundant, the usual relationship between a strong economy and higher interest rates may no longer hold. And if the spare cash is mainly abroad, that should allow America to finance its deficit with ease. Rather than signalling American profligacy, the current-account deficit might simply be the counterpart to foreign thrift.
This idea turns much conventional economic wisdom on its head. Policymakers usually worry about too little rather than too much thrift. With populations ageing, the broad consensus has been that people need to build up nest eggs to finance their retirement. Economists reckoned that globalisation would lead to a shortage of capital and hence higher interest rates as millions of Indian and Chinese workers were absorbed into the world economy. If Mr Bernanke is right, all this will need re-examining.
His suggestion that the causes of global imbalances lie elsewhere conveniently deflects attention from monetary and fiscal decisions made by American policymakers. It suggests that Mr Greenspan's loose monetary policy and George Bush's tax cuts are not responsible for the imbalances in the world economy. That may seem a little self-serving, coming from a man who has subsequently moved from the Federal Reserve to become chairman of Mr Bush's Council of Economic Advisers.
Taken at face value, the notion of a global saving glut is not borne out by the facts. “Glut” suggests an unusually large amount, as in a summer glut of strawberries. In fact, figures published in the IMF's latest World Economic Outlook show that the rate of global saving as a proportion of global output, measured at market exchange rates, has mostly been heading downhill over the past 30 years, with a particularly steep plunge between 2000 and 2002 (see chart 1). Although it has since risen slightly, the global saving rate is now close to its average for the past two decades, rather than unusually high.
In search of a glut
On both counts the world has seen big changes. Traditionally, most of the saving in an economy is done by households, whereas most of the investing tends to be done by firms. But in the past few years firms have become net savers as their profits have exceeded their investments. That change has been most pronounced and long-lasting in Japan, where corporate saving soared after the bubble economy collapsed in the early 1990s. Burdened with bad debts after a period of massive overinvestment, Japanese firms have been net savers for a decade.
The late 1990s saw a similar shift in many emerging Asian economies, where corporate investment plunged after the Asian financial crisis. After the stockmarket bubble burst in 2000, American and European firms' investment also fell. Although American firms began investing again a couple of years ago, the level of corporate investment is still relatively low, given how strongly the economy—and profits—have been growing. Firms in industrial countries as a whole are still saving more than they invest, despite record profits (see chart 2). The only significant country bucking the trend is China, where investment has been rising sharply. But saving has been growing faster still.
A weak appetite for investment might help explain low interest rates, but not the rising imbalances between America and the rest of the world. To understand those, two other factors have to be considered: differences in countries' economic structures, and differences in policymakers' reactions to the investment bust.
America is at one extreme. Its corporate thrift shift was smaller than that of Japan or other Asian economies, but policymakers in Washington reacted far more dramatically. Between 2001 and 2003, America enjoyed its biggest fiscal stimulus of the post-war period, and short-term interest rates were slashed. Declining interest rates fuelled a boom in house prices, encouraging people to borrow against their properties. Economic growth remained strong and the current-account deficit soared.
Asia's emerging markets faced a much bigger bust, and had fewer policy tools to deal with it. After the 1997-98 financial crisis, investment fell by ten percentage points of GDP. Unable to slash interest rates for fear of further capital flight, they suffered serious recessions. That left exports as their main source of growth. To protect exports and to build up vast war chests of reserves, many East Asian governments kept their currencies cheap for years after the financial crises. Firms stayed reluctant to invest, the saving surpluses remained large and the foreign-exchange reserves piled up.
Japan and Europe lie between those two extremes. Politicians in Tokyo tried stimulative policies and talked of structural reform, but proved notoriously ineffective at dealing with their investment bust. The economy fell into deflation and Japan, already the world's biggest exporter of savings, became an even bigger one. Its current-account surplus rose from 1.4% of GDP in 1996 to 3.7% last year.
In Europe, the record has been mixed. Some countries, such as Germany, resemble Japan, with rising saving surpluses and weak domestic demand. Others look more like America. In Britain, fiscal and monetary policy became looser. Spain's current-account deficit is almost as big as America's. Broadly, the countries that saw the biggest rises in house prices also saw the biggest drops in saving.
In short, a good part of the rising imbalances of the past few years can be explained by a series of investment busts—after periods of overinvestment—and sharp differences in the way policymakers responded to them. But particularly since 2000, two other factors have also become important: more saving in China, and the soaring price of oil.
China's investment rate, at 46% of GDP, is the world's highest by far and has been rising fast, but its saving rate has been rising even faster. Between 2000 and 2004, China's national saving rate rose by an extraordinary 12 percentage points of GDP to 50% of GDP. The country has kept its currency cheap and exported ever more capital to the rest of the world.
At the same time, high oil prices have brought a financial windfall to the world's oil exporters which so far they seem to have chosen to save rather than spend. As a group, the oil-exporting countries are now the biggest counterparts to America's current-account deficit (see chart 3).
These shifts have been large and complicated, and they have had important and unusual consequences. The first is that capital now flows primarily from poor countries to rich countries. In 2004, emerging economies, including the newly industrialised economies of East Asia, sent almost $350 billion to rich countries. Yet according to the economic textbooks, capital seeking the highest returns should flow from rich (and capital-intensive) countries to poorer ones that have less of it.
The second consequence is that outside China, less saving by households rather than investment by firms has become the engine of global economic growth. The world economy continues to hum because consumers, particularly American ones, are content to become ever more indebted. That willingness appears closely related to the rapid rise in house prices across much of the globe.
These patterns are a long way from historical norms. Can they last? In the long term, the answer is clearly no. Household saving cannot keep on falling, and America's foreign borrowing cannot keep on rising. The question is when and how the tide might turn.
One camp argues that the saving glut Mr Bernanke has identified is a temporary and largely cyclical phenomenon. As investment recovers in Japan and Europe and strengthens further in America, interest rates will rise. If the investment recovery is concentrated outside America, the surplus savings sloshing in its direction may quickly dwindle. If foreign investors then start fretting about America's dependence on foreign funds, those savings could drain away even more rapidly, sending the dollar down sharply and interest rates up. That would be the classic “hard landing” commentators worry about.
But a growing group of analysts now suggests that the “saving glut” is the result of long-term structural shifts and is likely to last for years, perhaps decades. Some argue that ageing populations in rich countries will mean lower interest rates, because older economies with mature workforces will need less capital and their citizens will save more in preparation for retirement. Others reckon that the Asian economies will continue to export their savings for many years, for mercantilist reasons (keeping their currencies cheap to create jobs in export industries) as well as demographic ones (China, for instance, is ageing faster than America).
If the “saving glut” really is here to stay, there are two main possibilities. The first is that America's consumers will continue to barrel along and the imbalances between America and the rest of the world will increase further. The second is that Americans themselves will start saving again, perhaps because the housing market falters or because high petrol prices begin to bite. With the rest of the world still determined to save too, that would send the global economy into a tailspin.
3. (10 points for each question) Answer any three of the following questions, using no more than one page:
4. You have the following information on spot rates as of the close of Oct. 21, 2005 (all information from Moneyline):
One-month, three-month and six-month US treasuries yield 3.476, 3.879 and 4.165% respectively. (Note these are bond-equivalent yields, based on a 365-day year.) The corresponding rates for the euro-currency area are 2.11, 2.19 and 2.28%, respectively. (These are actually brokered deposits in euros, but you may use them as the equivalent of rates on government securities.)
1. (10 points) You have the following balance sheet for Elektrobit, SA, a european subsidiary of Elektrobit, Inc. for 2004. All numbers are in euros.
The average rate for 2004 was $1.30 per euro; the rate at the beginning of the year was $1.25; the rate at the end of the year was $1.35. Retained earnings are translated at the average rate that is prevalent during the year that the earnings are retained; consequently, the components of accumulated retained earnings are to be translated at varying rates, depending on when the earnings were retained. On average, accumulated retained earnings are to be translated at a rate of $1.20 per euro. The historical rate at which common stock and capital in excess of par value are to be translated is $1.00 per euro. What is the amount of the cumulative translation adjustment for 2004?
2. Here are the last available dollar/yen bid and ask rates, as of 8:06 p.m. New York time on Sunday, November 20, 2005, according to https://www.ofx.com/en-au/exchange-rates/
3. a. On November 20, 2005, the 3-month forward euro/dollar rate is quoted as 1.182640 (bid) and 1.184180 (ask). The spot rate is 1.1768/1.1779. Walmart, Inc. has agreed to buy 20m. euros worth of goods from Plasticene, S.A., a German firm. In order to get a good deal, Walmart has agreed to pay in euros. The account has to be settled in 3 months time (or less). If Walmart pays in three months, it will have to pay an additional 2%.
(10 points) The euro/yen spot rate, as of November 20, 2005 (9:42 p.m.)
is 140.42 (ask)/140.49 (bid). The
3-month forward rate is quoted in points as -0.8310 (ask) and -0.7690
(bid). What would the outright
forward rate quote be?
4. a. (10 points)
Suppose IBM, a U.S. company would like to borrow in euros. It can only obtain a rate of 7% fixed
and LIBOR + 1% floating. Rhone-Poulenc,
S.A., can however borrow in euros at a rate of 6.5% fixed and LIBOR floating.
It would, on the other hand,
like to borrow in dollars; unfortunately, it can only borrow at a rate
of 6% fixed and LIBOR + 1% floating, while IBM can borrow at 5.5% fixed
and LIBOR + 0.5% floating. Suppose
IBM desires to borrow fixed, while Rhone-Poulenc would like to borrow
floating. Is there a mutually
profitable swap deal that they can come up with? Compute the range of profitable deals
that they could make, assuming that both IBM and Rhone-Poulenc have comparable
b. (5 points) If they do not have comparable risks, and, in fact, IBM is less risky, how would that affect the deal?
5. (15 points) Define five of the following terms:
6. (30 points) Answer part (a) and any two of the remaining three questions.
1. According to FASB 52, all items are to be translated at the current rate. However, Common Stock and Capital in excess of par value are to be translated at the historical rate, which is $1 in this case. Retained earnings are to be translated at the appropriate rate in force when they were transferred to the balance sheet, which is $1.2 for accumulated previous years' retained earnings. For this year, it would be 1.3, which is the average over the year for the current year. After these translations, we see that the amount of the cumulative adjustment that is necessary in order to make the assets and the liabilities side match is $29,256.05.
2. a. Selling one euro will realize $1.1772, which in turn will realize (1.1772)(119.18) or 140.2987 yen. In the reverse direction, selling 1 yen will generate $(1/119.23), which will realize (1/1.1777)(1/119.23) pounds. Inverted, we have 140.4172 yen. Hence, the cross-quote is 140.2987 bid/140.4172 ask, which would be an direct quote for pounds in Japan.
b. If the actual quoted rate is 140.30, bid and 140.35, ask, there would be no arbitrage opportunities, since the actual quote is nested within the implied cross-quote. Of course, a person intending to sell pounds would rather go with the actual quote, as would somebody selling yen; they would get a better rate than with the implied cross-quote.
3. a. If Walmart did not have the option of borrowing or lending, it would essentially have to use the information in the forward rate. The forward premium can be computed as 1.18418/1.1779 -1, annualized. This works out to 2.1236%. This means that, all other things being the same, if the forward rate can be considered to the market's expectation of the future spot rate, there is an expectation of a 2.1236% appreciation of the pound. Taking into account the fact that there is an additional 2% fee (or 8% annualized), this means that Walmart will be paying 10.1236% more for the privilege of waiting three months. In other words, Walmart is getting to borrow from its supplier at the annualized rate of 10.1236%, with payment of principal to be made in euros. If Walmart's borrowing rate (where it would be borrowing euros) is more than this, then the deal is a good one, and it should wait three months to pay; else it should pay up now.
3. b. Suppose Walmart wanted to wait three months before paying, but it did not want to be exposed to the risk of the euro/dollar rate moving against it. It could do two things. It could buy euros forward, or it could enter into a money market hedge.
If it bought euros forward, it would have to pay $1.18418 per euro, or
$(20)(1.18418), i.e. $23.6836m. Including the 2% additional charge, its
total payment would be $24.15727m.
However, if it decided to pay today, it would need to pay $20(1.1779)m. or $23.558m. If it decided to borrow this money today and pay up today, it would end up owing $23.558(1+0.054/4) or $23.823 in three months time. This would still be preferable to going the forward market route. Hence, the optimal thing to do would be to pay the account now. Note, that this is consistent with what we said in part a. Note, however, that the two aren't exactly the same. In part a., we were talking about the rate at which Walmart could borrow for repayment in euros. In this case, we're talking about repayment in dollars.
b. The outright forward quote rate would be 140.42-0.8310 or 139.589 (ask) and 140.49-0.7690 or 139.721 (bid).
4.a. The table below shows the different possibilities. (The cells marked in blue indicate the desired borrowing strategies for IBM and Rhone-Poulenc, outside any swap considerations.) IBM desires to borrow fixed in euros, whereas Rhone-Poulenc desires to borrow floating in dollars. However, this strategy would cost IBM 7%, and Rhone-Poulenc, LIBOR + 100%. If Rhone-Poulenc borrowed at a fixed rate in euros on IBM's behalf, it would be able to save IBM 50bp, whereas if IBM borrowed on Rhone-Poulenc's behalf, it would save Rhone-Poulenc 50 bp. Hence there are several strategies that are feasible. They could have a simple swap; else, depending on their relative bargaining power, there could be a side payment from IBM to Rhone-Poulenc or from Rhone-Poulenc to IBM. However, either way, the side payment would have to be less than 50 bp. Thus, for example, IBM could borrow floating dollars at LIBOR + 50 bp and swap with Rhone-Poulenc, such that Rhone-Poulenc would pay LIBOR + 65bp, while IBM would pay 6.5%, or equivalently, Rhone-Poulenc would pay LIBOR, while IBM would pay 5.85%.
b. If the risks were not the same, then they would have to be taken into account. For example, suppose the true risk-adjusted floating dollar borrowing rate for Rhone-Poulenc were LIBOR + 65 bp, i.e. the French company is riskier and therefore lenders should be charging an additional 15 bp for that additional risk, then the swap suggested at the end of 4.a. would be the best swap that could be offered to Rhone-Poulenc by IBM. If IBM had additional bargaining power, it might suggest that Rhone-Poulenc pay LIBOR, while it would pay anywhere from 5.85% to 5.5%.
5.Dual currency bond: A bond that has the issue's proceeds and interest payments stated in foreign currency and the principal repayment stated in dollars.
Exposure netting: Offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure.
Currency collar: A contract that provides protection against currency moves outside an agreed-upon range. It can be created by simultaneously buying an out-of-the-money put option and selling an out-of-the-money call option of hte same size.
Temporal method: A currency translation method. Under this method, the choice of exchange rate depends on the underlying method of valuation. Assets and liabilities valued at historical (market) cost are translated at the historical (current) rate.
Eurocurrency: A currency deposited in a bank outside the country of its origin.
Indirect quotation: A quote that gives the foreign currency price of the home currency.
6. a. It is possible. This might happen if there are transactions costs. If IBM intends to borrow floating dollars for other purposes, it might borrow an additional amount, to accommodate Rhone-Poulenc; this additional borrowing would, probably, be less expensive than if Rhone-Poulenc borrowed its own floating dollars. Swapping through a broker might, then, be cheaper for both parties.
b. Settlement risk is the risk that a settlement in a transfer system
does not take place as expected. It exists because both legs of any transaction
can only rarely be executed simultaneously. Even if credit risk could
be avoided by putting in right-of-offset terms into the transaction, liquidity
risk is much more difficult to avoid.
c. In a coupon swap, one party pays a fixed rate calculated at the time
of the trade and the other side pays a floating rate that resets periodically
against a designated index. On the other hand, in a basis swap, two parties
exchange floating interest payments based on difference reference rates.
d. FASB 8 led to volatility in reported earnings mainly because profits and losses due to currency fluctuations had to be reported in the income statement and taken into account in reported earnings. As a result, market movements in exchange rate markets were reflected in reported earnings. Furthermore, the fact that monetary liabilities, such as long-term debt had to be translated at current exchange rates, while fixed assets that might be financed by those same liabilities, had to be translated at historical exchange rates, caused a mis-match and added to the volatility of reported earnings.
1. (20 points) Please define any four of the following terms:
2. Altima, Inc. is thinking of making an investment in Croatia in the textile sector. This project requires an investment of $70m. and is expected to yield about $10m. in US currency every year for the next ten years. You have the following information:
.Answer the following questions:
3. (10 points each) Answer any two of the following questions in brief:
4. (10 points each) Read the following article, "Tested by the mighty euro," which appeared in The Economist of Mar. 18th 2004 and answer the questions below:
A STRONG currency may be a central banker's dream, but it can be a nightmare for companies. If they export to countries with weakening currencies, their goods become less competitive while imports into their home market become more so. Export sales fade while repatriated profits count for less.
So, given that the great majority of European blue-chip firms are big exporters and that the euro has risen by some 50% against the dollar since its low in July 2001, why are European businessmen not depressed? France's business-confidence index has been rising since last June. Germany's IFO confidence index rose for nine consecutive months until a small blip in February. Only the Italians are gloomy, owing to their financial scandals.
European businesses have been able to cope with a strengthening euro because of strong global growth and their use of foreign investments and hedging to protect against currency risk. Many big European companies have produced decent results for 2003, as the pick-up in global activity compensated for currency losses.
The extent of each firm's currency woes also depends on where its exports go. Some big firms export mostly within the euro zone. Germany, France and Italy are each other's most important export markets. But companies with a global reach, such as German carmakers and French luxury-goods firms, are more vulnerable.
In addition to using financial derivatives for currency hedging, many firms have built “natural hedges” by moving some production abroad, at the expense of euro-zone output. DaimlerChrysler, for instance, produces all of its M-class Mercedes in Alabama, and so the weaker dollar has meant windfall profits on exports back to Europe. But, as the euro has risen, for most of its exported models Mercedes, like its rival BMW, has had to increase its prices in America.
There are other indirect effects. Passenger aircraft are priced in dollars, so Airbus has to grit its teeth and can take only slight consolation from the $4 billion of parts it buys from America each year. Airbus's boss, Noël Forgeard, says, somewhat bombastically, that he will rely on the high margins from Airbus's new super-jumbo, on sale from 2006, as his ultimate hedge against the weak dollar.
Louis Vuitton Moët Hennessy (LVMH), a French luxury-goods firm, announced a 9% rise in operating profits earlier this month. If the euro had remained at its 2002 levels, the rise would have been 20%, says Patrick Houel, the group's finance director. All LVMH's production costs are in euros, while revenue splits three ways between euros, dollars and other currencies.
For DSM, a Dutch specialty-chemicals group, a one percentage-point move in the dollar exchange-rate has a €7m-11m impact on profits. About four-fifths of its sales are in dollars, but two-thirds of production is in the euro zone. For the moment, says the chairman, Peter Elverding, DSM's only hedge is to borrow in cheap dollars. The company may also move more of its production outside the euro zone. In 2000 it bought Catalytica, an American pharmaceuticals firm, partly in order to reduce its currency risk.
Across the board, European firms lost between 8-10% in revenue growth because of the weakness of the dollar last year, says Walter Kemmsies of J.P. Morgan. Even so, European firms have been lucky—in particular, the recovery of the capital-expenditure cycle is soothing the euro pain, says Joachim Fels, an economist at Morgan Stanley. The euro's appreciation coincided with rising demand for European goods. German exports to China, for instance, increased by 30% last year says Mr Fels.
But how long can this surprisingly happy situation continue? The latest numbers from the European Central Bank and Eurostat show the volume of exports of capital goods from the euro zone falling at an annual rate of 10.5% in the fourth quarter of last year, even as trade inside the euro zone grew. Meanwhile imports from outside the zone grew by almost 4% last year. By the end of 2003 the euro zone's import prices had fallen by 12% from their peak in November 2000.
In theory, the many disadvantages to European firms of the strong euro come with one notable advantage: they now enjoy greater purchasing power in the merger and acquisition markets of countries with weakening currencies. Yet, curiously, they have bought hardly any American businesses in the past two years, whereas American takeovers in the euro zone have been rising, according to Jimmy Elliott, head of North American mergers and acquisitions at J.P. Morgan. This suggests that exchange-rate opportunism is probably not, in fact, a big driver of merger activity—and, perhaps, that the global ambition, risk-appetite and balance sheets of American firms have recovered from their recent battering more quickly than those of their European counterparts.
Overall, though, few American firms have gained much from the strong euro because few of them are big exporters—although those that are have done nicely.
Last week McDonald's reported its 10th consecutive monthly sales gain, a shift attributed partly to the weaker dollar. Its European sales were up by 27% in February, but by only 9% in “constant currency” terms. The same is true for drugs firms, such as Merck, Pfizer, Bristol-Myers Squibb and Eli Lilly; all have big overseas sales, but incur manufacturing costs in euros.
Chinese firms are reaping the currency bonanza too, with the weakness of the dollar-pegged yuan spurring growing exports of Chinese goods (clothes, toys and cheap knick-knacks) into Europe. Euro-China trade used to balance, but last year, according to Allan Jianjun Zhang, director of the China Business Centre at PricewaterhouseCoopers, China enjoyed a surplus of more than $16 billion.
In their budgeting for the coming year, now reaching its conclusion, most European firms are assuming that the dollar will stay around $1.20 to the euro. But BMW, for one, thinks that the euro is now overvalued, and has stopped hedging against further falls in the dollar. On the other hand, plenty of European businessmen fear that the dollar has further to fall. Still, at today's exchange rate, the euro is not much above the $1.17 at which it was launched in January 1999. Then nobody called the new-born currency too strong. In fact, many claimed it was too weak.
The relevant beta is, of course, not Altima's current beta, since it may not reflect the risk of its Croatian subsidiary. Using the Croatian textile industry as a proxy, we get the required rate of return on Altima's equity investment in the Croatian investment to be
3.5% + 0.85(5.5) + 1.0(6) = 14.175%
The cost of debt is r = rL(1+c)(1-ta) + c = 13(1-.04)(1-0.4) - 0.04 = 7.448%
The target debt-equity ratio is 60%. Hence the hurdle rate is
(0.6)(7.448) + 0.4(14) = 10.0688%
Using this cost of capital, the present value of the project is (10/.100688)[1-(1/1.100688)10] = 61.2645m. If the project requires an initial investment of $70m., Altima should not go ahead with the project.