Dr. P.V. Viswanath



Economics/Finance on the Web
Student Interest

  Courses/ FIN 649  

Exams, Summer 2004, FIN 649


Practice Midterm, Summer 2004


  1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  3. You may bring in sheets with formulas, but no worked-out examples, or definitions, or anything else.
  4. You must explain all your answers. For the quantitative questions, you must show your formulas and youc computation, else you may get no credit at all.

1. Define any five of the following terms:

  1. bid rate
  2. fiat money
  3. real exchange rate
  4. asset market model of exchange rate determination
  5. European Monetary System
  6. Fisher Effect
  7. International Fisher Effect
  8. settlement risk
  9. swap rate

Answer any three of questions 3 through 7 using no more than one page, each.

3. By some estimates $185b. to $260b. in currency is held outside the United States.

  1. What is the value to the US of the seigniorage associated with these overseas dollars?
  2. Who in the US benefits from this seignorage?

4. This is from the NY Times of June 16, 2004. "OPEC indicated that its members would step in to make up for any shortfall in Iraqi crude following a sabotage attack on a pipeline there today." What, do you think, was the impact of the sabotage attack on the US dollar? What would be the impact of the promise by OPEC to make up the shortfall?

5. The New York Times of June 15, 2004 carried this news item: "Nicolas Sarkozy, France's finance minister, has given up any immediate privatisation of EdF and Gaz de France, the electricity and gas utilities, in a further concession to mounting union protests against any change to these state entities." How would the euro be affected by this action? Do you think the euro would be affected more or less by this announcement than the franc would have been if France had not switched to the euro, but continued to use the franc instead?

6. What are some of the reasons for deviations from purchasing power parity?

7. Several countries during the 1982-88 period had a small interest rate differential with the US (e.g. Pakistan, Hungary and Venezuela); nevertheless, they had large average annual depreciations of their exchange rates. Is this consistent with the International Fisher Effect? If not, how would you explain this deviation? If yes, explain why you think so.

8. During 1995, the Mexican peso exchange rate rose from Mex$5.33/US$ to Mex$7.64/US$. At the same time, US inflation was apprixmately 3% in contrast to Mexican inflation of about 48.7%.

  1. By how much did the nominal value of the peso change during 1995?
  2. By how much did the real value of the peso change over this period?

9. Suppose today's exchange rate is $0.90/€. The six-month interest rates on dollars and euros are 6% and 3% respectively. The six-month forward rate is $0.8978. A foreign exchange advisory service has predicted that the euro will appreciate to $0.9290 within six months.

  1. How would you use forward contracts to profit in this situation?
  2. How would you use money-market instruments (borrowing and lending) to profit?
  3. Which alternatives (forward contracts or money market instruments) would you prefer? Why?

10. You are given the following exchange rate and interest rate quotes:

Currency 90-Day Interest Rates (annualized) Spot Rates 90-day Forward Rates
Dollar 4.99%-5.03%    
Swiss France 3.14%-3.19% $0.711-22 $0.727-32
  1. Can you find an arbitrage opportunity?
  2. What steps must you take to capitalize on it?
  3. What is the profit per $1m. arbitraged?

Solution to Practice Midterm

1. Definitions:

  • bid rate: the bid rate of a currency is the price which the person quoting (e.g. a dealer) is willing to pay for it – the price at which anybody can sell it.
  • fiat money: nonconvertible paper money; it has value primarily because people are willing to accept it.
  • real exchange rate: the nominal exchange rate, adjusted for inflation.
  • asset market model of exchange rate determination: a theory that says that the exchange rate between two currencies is the price that just balances the relative supplies of, and demands for, assets denominated in those currencies.
  • European Monetary System: A monetary system formed by the major European countries under which the members agreed to maintain their exchange rates within a specific margin around agreed-upon, fixed, central exchange rates (Exchange Rate Mechanism, ERM). These central exchange rates were denominated in currency units per ECU. The EMS began operating in March 1979 and essentially collapsed in August 1993, when the Exchange Rate Mechanism was abandoned.
  • Fisher Effect: The Fisher Effect says that the nominal interest rate can be written as the sum of the real interest rate and the expected rate of inflation.
  • International Fisher Effect: The IFE says that the interest rate differential between two countries is a good predictor of the future change in the spot rate between their currencies. The IFE is what we get if we put the Fisher Effect and the PPP together, and if we assume that real interest rates are equalized across countries.
  • settlement risk (Herstatt risk): this is the risk that a bank will deliver currency on one side of a foreign exchange deal only to find that its counterparty has not sent any money in return (perhaps because it has gone bankrupt).
  • swap rate: the difference between spot and forward rates expressed in points (e.g. $0.0001 per pound sterling).

3. a. Seignorage is the profit that accrues to the government that issues the currency. Essentially, it's the ability to create purchasing power. The fact that invdividuals outside the US are willing to hold these dollars means that they have essentially transferred that much purchasing power to the US. Presumably these individuals obtained the currency in exchange for services or goods that they provided; however, by holding the currency instead of spending it, they have not obtained a quid pro quo. The value of the seignorage is therefore simply the value of the dollars themselves. This would be strictly true, however, if these individuals were willing to hold the dollars forever.

Assume, however, that these dollars would be exchanged for US goods and services at some future point in time. Then the value of seignorage would be the time value of that money that is obtained by the US. Thus, if dollar interest rates are 6%, the value of seignorage on $185b. worth of currency that is expected to be held for a year would be $185 x 0.06 or $11.1b.

b. Who actually obtains the value of this seignorage depends on how the government uses the resources freed up by seignorage. For example, if taxes are cut, then the beneficiaries of the tax cut would realize the value of the seignorage.

4. The sabotage attack would have the effect of increasing the price of oil. To the extent that this increases the US demand for foreign oil, and therefore, for foreign currencies, it would negatively affecet the value of the US dollar. However, to the extent that trade in oil is conducted in dollars, this might increase the amount of dollars used. As a result, the net effect on the value of the dollar cannot be theoretically determined.

5. If we assume that the privatisation would have led to more efficient operatoin of the utilities, the postponement should be bad news for those holding the euro, from an asset market model point of view. If France were still using the franc, the impact on the franc would have been even greater than the current impact on the euro, since French utilities represent a much smaller proportion of the assets, whose values are determined in euros.

6. PPP might not hold for some of the following reasons:

  • The price indices used to measure PPP may use different weights or different goods and services.
  • Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky, because prices could change during the time that an item is in transit between countries.
  • Since some goods and services used in the indices are not traded, there could be price discrepancies between countries.
  • Relative price changes could lead to exchange rate changes even in the absence of an inflation differential.
  • Government intervention could lead to a disequilibrium exchange rate.

7. As these countries have had fairly high inflation combined with controls that held their interest rates below those that would prevail in a free market. The large average annual depreciation can be explained by their rapid inflation, whereas the absence of the international Fisher effect is due to the interest rate controls. The International Fisher Effect refers to interest rates set in a free market. It has nothing to say about controlled interest rates.

8.a. During 1995, the peso fell from $0.1876 (1/5.33) to $0.1309 (1/7.64), which is equivalent to a devaluation of 30.24% ((0.1309 - 0.1876)/0.1876)

b. Using Equation 4.7, the real value of the peso by the end of 1995 was $0.1890:

Based on this real exchange rate, the peso has appreciated during 1995 by 0.72% ((0.1890 - 0.1876)/0.1876). In other words, the real exchange rate stayed virtually constant, implying the purchasing power parity held during the year.

9. a. By buying euros forward for six months and selling it in the spot market, you can lock in an expected profit of $0.0312 (0.9290 - 0.8978) per euro bought forward. This is a semiannual return of 3.48% (0.0312/0.8978). Whether this profit materializes depends on the accuracy of the advisory service's forecast.

b. By borrowing dollars at 6% (3% semiannually), converting them to euros in the spot market, investing the euros at 3% (1.5% semiannually), selling the euro proceeds at an expected price of $0.9290/ ?, and repaying the dollar loan, you will earn an expected semiannual return of 1.77%:

Return per dollar borrowed = (1/0.90) x 1.015 x 0.9290 - 1.03 = 1.77%

c. The return per dollar in the forward market is substantially higher than the return using the money market speculation. Other things being equal, therefore, the forward market speculation would be preferred.

10. We can consider the profit from starting with a dollar, converting it to SFrs, investing it for 90 days, contracting to sell it forward in 90 days and discounting the resulting dollars back to the present. We can then do the same thing, starting with Swiss Francs instead.

The first set of transactions will allow us to convert SFr1 today to $0.711, which can be invested to yield (0.711)(1+0.0499/4) = SFr 0.7198697 in 90 days. If we contract to sell this forward, we can get $(0.711)(1+0.0499/4)/(0.732) = $0.9834286 in 90 days. Discounting this back, we get $(0.711)(1+0.0499/4)/[(0.732)(1+0.0319/4)] = $0.9756478. Clearly, this is not profitable.

The second set of transactions will allow us to convert $1 today to SFr(1/0.722), which will yield SFr(1/0.722)(1+0.0314/4) in 90 days. This can be sold forward to yield $(1/0.722)(1+0.0314/4)(0.727). We can borrow $(1/0.722)(1+0.0314/4)(0.727)/(1+0.0503/4) = $1.0022266 today and repay the loan with the dollars that will be available to us in 90 days from the previous transactions. This will yield us a profit of 0.2227%.



  1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  3. You may bring in a formula sheet containing only formulas, no worked out examples, nothing else.
  4. You must explain all your answers. For the quantitative questions, you must show your formulas and your computation, else you may get no credit at all.

Do any one of questions 8 and 9. Do any three of problems 1, 2, 3 and 4.

1. (10 points) On June 23, 2004, the Philippine Peso/US$ rate was 56.20-28/$. The Zloty/Peso rate was 0.0669-71 Zloty/Peso. The Zloty/Dollar rate is 3.7660-7710 Zloty/$. (Source: Yahoo) Can you make money through arbitrage? Show exactly how you would accomplish it. If it's not possible to make money, show that, as well.

2. (10 points) The current 3-month risk-free rates (annualized) in the different countries are as follows (rates at which you can borrow). Assume that you can also lend in these same markets at the same rates, less 5 basis points.


The 3-month forward exchange rate between the euro and the dollar is 1.206350-7920 $/€. The 3-month forward exchange rate between the pound and the dollar is 1.797390-99450 $/UK Pounds. The 3-month forward exchange rate between the pound and the dollar is 1.488850-91290 €/UK Pounds.

The spot rates are
EUR/USD 1.2086 1.2091 $/€
GBP/USD 1.8131 1.8136 $/UK Pounds
GBP/EUR 1.4997 1.5002 €/UK Pounds
(Sources: http://www.ozforex.com.au, Bloomberg, Yahoo)

If you started out with $100, converted them to GBP, then invested in the London market for 3 months, contracted to convert those pounds forward into dollars, and then borrowed today against those future dollars, would you have made money or lost money? How much?

3. (10 points) (Use the data from question 2 to solve the problems posed in this question.) Use the EUR/USD forward rate (use the ask rate for the euro from the perspective of an investor in the US) to predict the inflation rate in the Euro currency area over the next three months, assuming that the inflation rate in the US is expected to be 5% on an annualized basis. What parity relationships are you using?

4. (10 points) A New Zealand company is looking to raise NZD 100 million by issuing 10 year bonds. In the New Zealand domestic market, it could issue at a yield of LIBOR plus 25bp. Alternatively it can issue in Australia where there is a shortage of quality bonds, at a yield of 7.50%. However, it does not want to issue fixed rate debt. Suppose it can enter into a 10 year Cross Currency Swap for a notional amount of NZD 100 million agreeing to receive AUD 7.50% and pay NZD LIBOR plus 20bp. If the prevailing spot rate is 1NZD = 0.90AUD, show all its cashflows over the 10 year period, detailing how much it pays to each party, separately, and how much it gets from each party, separately, i.e. I don't just want net flows. Assume that coupons are paid annually.

5. (15 points) Suppose Intel Corporation can issue 5-year fixed rate debt at 10% or floating rate debt at 6-month LIBOR + 30bp. AT&T can issue fixed at 11.20% and floating at 6-month LIBOR + 100 bp. Suppose AT&T wishes to issue fixed rate debt, while Intel wishes to issue floating rate debt. Create a swap that would allow them to accomplish that, using a swap, in a more profitable way than if they did it directly. Assume that they split the savings equally.

6. (10 points) Here are the rates at which GM and Quantas can borrow in A$ and US$.

  US$ A$
GM 6% 12.5%
Quantas 7.2% 13%

GM wants to borrow in US$ and Quantas in Australian $. If this can be done more profitably using a swap, explain how. If this is not possible, explain why not.

7. Here are some historical exchange rates (http://www.chartflow.com/ozforex/) for the Czech koruna against the US dollar for January 2003 ($/koruna).
Where 1 Unit of CZK= X Units of USD
31/12/2002 0.0331
03/01/2003 0.0331
06/01/2003 0.0333
07/01/2003 0.0334
08/01/2003 0.0333
09/01/2003 0.0334
10/01/2003 0.0333
13/01/2003 0.0333
14/01/2003 0.0332
15/01/2003 0.0333
16/01/2003 0.0331
17/01/2003 0.0337
21/01/2003 0.0341
22/01/2003 0.0343
23/01/2003 0.0338
28/01/2003 0.0346
29/01/2003 0.0346
30/01/2003 0.0344
31/01/2003 0.0341

a. (5 points) Has the koruna appreciated or depreciated against the dollar over the month of January 2003? Measure the change in percentage terms.

b. (10 points) According to the Czech National Bank website (http://www.czso.cz), the inflation rate for the month of January 2003 was 0.6% (non-annualized). Over the same time period, the inflation rate in the US was 2.60%, annualized (source: http://inflationdata.com/inflation/inflation_rate/CurrentInflation.asp). What is the real exchange rate at the end of January 2003, if you start with the end-December 2002 rate as your base?

Answer any one of questions 8 and 9.

8. (5 points) The New York Times Internet Edition (June 23, 2004) carried the following news item:

China's top economic planning body gave a mixed message on Wednesday on inflationary pressures and the outlook for interest rates, saying that upward pressure on general prices remained high but the the price rises of basic goods had been brought under control.

Would this have caused the yuan to appreciate or depreciate?

9. (5 points) The New York Times of June 23, 2004 also carried this news item:

Wireless carrier Nextel Communications on Wednesday made its flagship "push to talk" feature available in Mexico. In doing so, the company was following up on a pledge to go global that it began articulating as early as May 2003. With push-to-talk service, sometimes described as walkie-talkie service, there's no time spent dialing or making a connection to the network, so the calls are shorter and cost less. The service has been available to customers of Nextel and its partners in Canada, Argentina, Brazil and Peru, since May.

Would this have caused the Mexican peso to appreciate or depreciate vis-a-vis the peso in the short run? In the long run?

10. (25 points) Define any five of the following terms in brief:

  1. dollarization
  2. sterilized intervention
  3. beggar-thy-neighbor devaluation
  4. optimum currency area
  5. International Fisher Effect
  6. right of offset
  7. inverse floater
  8. nostro account

Solutions to Midterm

1. The PP/$ rate is 56.20/56.28. Hence 100 PP can be converted into $100/56.28, using the bid rate for the peso. This can be further converted into Zloty at the Zloty ask rate of 3.766. This yields (3.766)(100/56.28). This, in turn, can be converted into (3.766/.0671)(100/56.28) or 99.7249 PP, which is, of course, not profitable.

In reverse, $100 can be converted into 5620 PP, or (5620)(0.0699) Zloty, which can be converted into $(5620)(0.0699)(3.771) or $99.70, which is also not profitable. In other words, there are no profitable arbitrage opportunities, which is hardly surprising.

2. $100 can be converted into 100/1.8136 pounds. These can be invested for three months to yield (100/1.8136)(1+0.0465/4) in three months. This can, in turn, be converted forward into dollars. It is possible to borrow $(1.79739)(100/1.8136)(1+0.0465/4)/(1+0.0125/4) = $99.9385 against this amount at the current moment. This shows, however, that there is no arbitrage opportunity using this route; you would have lost 6.25 cents per $100.

3. An investor in the US can buy the euro forward at 1.20792 $/€. The spot rate is 1.2091. If we treat the forward rate as an unbiased predictor of the future spot rate, then the predicted inflation rate in the euro area, if, should satisfy the condition (1+ if)0.25 = (1.2091)(1.05)0.25/1.20792, or if = 5.41%, given that the US inflation rate is expected to be 5% p.a. over the same three months.

This assumes that, one, PPP holds, and, two, the forward rate is an unbiased predictor of the future spot rate.

4. Investors in the NZ company's bonds <-----7.5%----- NZ company <-----7.5%----- Swap party

NZ company ----- LIBOR + 20 bps-----> Swap party

5. The spread between the rates that Intel and AT&T can issue fixed is 120 bps. The spread between the floating rates that the two companies can get is 70 bp. Hence they have the opportunity to save 120 - 70 or 50 bps between themselves. If Intel issues fixed at 10%, AT&T issues floating at LIBOR + 100 bp, and Intel pays AT&T LIBOR +100 bps, while AT&T pays Intel 10.95%, they will both benefit.

Intel will end up having borrowed at 10 - 10.95 + LIBOR + 100 bps or LIBOR + 5 bps, which is 25 bps less than what it could have done by itself in the floating rate market. AT&T will end up having borrowed at 10.95%, which is 25 bps less than the 11.2% it would have had to pay, had it issued fixed on its own.

6. There is a spread of 120 basis points between the US dollar borrowing rates for Quantas and GM. However, there is a spread of only 50 basis points in the Australian dollar borrowing market. However, according to this scenario, GM has a comparative advantage borrowing in US dollars, while Qantas has a comparative advantage borrowign in Australian $. If GM wants to borrow in US dollars and Qantas in Australian $, it would be best for them to do it separately. A swap would not help. If Qantas borrowed in US $ at a rate of 7.2%, for GM to find a swap profitable, Qantas would have to offer GM a net discount of at least 120 basis points on the fixed rate, since GM can already borrow at 6% (120 points lower than Qantas US dollar borrowing rate). However, since Qantas only stands to save 50 basis points on the other side of the swap, it cannot offer so much. Hence with their borrowing needs, a swap is not profitable.

7. a. The koruna has appreciated over the month by (0.0341 - 0.0331)/0.0331 or 3.02% (non-annualized).

b. The koruna has appreciated even more in real terms, because the inflation rate in the Czech Republic was 0.6% in January (non-annualized), while in the US during the same time, it was (1.026)1/12-1 or 0.214%. The real exchange rate would be (0.0341/1.00214)/(1/1.006) = $0.03423/koruna.

8. China's currency, the yuan, does not float. Hence the answer below has to be interpreted under two scenarios. One, assume that it does, in fact, float; or two, that we're talking about the impact in the forward market -- since there is a non-zero probability of a devaluation, the forward market can react to the news.

Whether the yuan would appreciate on the news or not depends on what the market thought previously. If the announcement were believed, and inflation had been a problem in that the price uncertainty, as well as the need to negotiate contracts taking inflation into account, were affecting economic growth, this news would be seen positively by the market and the yuan would rise in value.

9. In the short run, this would probably increase demand for the Nextel service, and hence increased demand for the dollar relative to the peso, which means a depreciation of the peso. However, since all communications would become easier, this should improve the efficiency of the Mexican economy, thus causing the peso to rise, in the long-run (taken from answer given by a student, Christopher Lee). There is one other issue, however. If the net effect is to increase imports rather than exports, it might cause the peso to depreciate.


  1. dollarization refers to the complete replacement of the local currency with the US dollar.
  2. Sterilized Intervention -- this refers to intervention in the foreign exchange markets, where the money supply effects of the intervention are offset by actions in the short-term borrowing and lending market. Thus, supporting the dollar against the euro by selling the euro or selling euro-denominated securities would have the effect of decreasing the availability of dollars, and therefore reducing the money supply. Hence the Fed might buy Treasury bills and pay out dollars to keep the money supply unaffected.
  3. beggar-thy-neighbor devaluation -- this refers to the competitive devaluations that nations engaged in during the thirties, in which they cheapened their currenceis to increase their exports at others' expense and to reduce imports, thus paving the way for a trade war.
  4. Optimum Currency area: the optimum size for an area to have a single currency. The larger the area, the easier trade will be between the different parts of the area; on the other hand, monetary policy cannot be tailored as easily to the growth needs of each part of the area. The optimal currency area represents the best trade-off.
  5. International Fisher Effect: A parity relation that equates changes in exchange rates and interest rate differentials.
  6. right-of-offset: this gives each party to a swap the right to offset any nonpayment of principal or interest with a comparable non-payment.
  7. inverse floater: a floating rate instrument, whose interest rate moves inversely with market interest rates.
  8. nostro account: this refers to working balances maintained by a bank with its correspondent in another country to facilitate delivery and receipt of currencies.

Final Exam


  1. If your answers are not legible or are otherwise difficult to follow, I reserve the right not to give you any points.
  2. If you cheat in any way, I reserve the right to give you no points for the exam, and to give you a failing grade for the course.
  3. You may bring in a formula sheet containing only formulas, no worked out examples, nothing else.
  4. You must explain all your answers. For the quantitative questions, you must show your formulas and your computation, else you may get no credit at all.
  1. (15 points) Define the following terms:
    1. samurai bonds
    2. keiretsu
    3. securitization
    4. note issuance facility
    5. development bank

  2. (20 points) An US investment manager hedges a portfolio of long-term German government bonds with a six-month forward contract. The current value of the portfolio is $100m. The current spot rate is 1.2365/1.2376 US$/€, and the 180-day forward rate is 1.234020/1.235620 US$/€. At the end of the six months, the Bunds have risen in value by 4.75% (in euro terms), and the spot rate is now 1.3575 US$/€.
    1. Assuming the manager wishes to hedge the full extent of his currency exposure, what is the notional value of the forward currency amount (euros) that he should hedge?
    2. If the German bonds earn interest at the annual rate of 5% paid semi-annually, what is the investment manager's total dollar return on the hedged bonds?
    3. What would the return on the bonds have been without hedging?
    4. Considering that the euro appreciated over the six months, was it a wise decision to hedge the bonds?
  3. (15 points) IBM's German affiliate can issue a dollar-denominated bond with a face value of $100m. and a maturity of 10 years at a cost of 5.7%. Alternatively, it can issue euro-denominated debt of the same maturity, priced to yield 4.3%. Assume that there is no interest deductibility for tax purposes.
    1. If the euro is expected to appreciate at the rate of 1% per year, estimate the effective dollar cost, in percentage terms, of the euro-denominated debt. (You can either use the formula in the book, or you can use an approximation.)
    2. Would you issue the dollar-denominated bond or the euro-denominated bond? Your answer should be consistent with your answer in part (a).
  4. (15 points) Suppose a Brazilian project has a beta of 0.85. Because there is no data on the foreign proxy, it was necessary to compute this beta using a US firm as proxy. You are afraid that you might not have adjusted sufficiently for country risk. Use the following information to come up with a cost-of-capital for the foreign project. Assume that only equity is going to be used.
    1. The volatility of returns on the Brazilian stock market is 28% per annum, while that of the US stock market is 15%.
    2. Brazilian government debt yields 10%, while US government debt yields 4%.
    3. The NYSE Index is supposed to appreciate by 10% in the coming year; the dividend yield on the stocks in the index is about 1.5%.
    4. You believe that the impact of country risk on a project is proportional to the project's beta.
  5. (15 points) United Airlines wants to hedge €80m. in ticket sales receivable in 90 days. It faces the following exchange and interest rates:
    1. Spot rate: 1.2365/1.2376 US$/€
    2. Forward rate: 1.234690/1.235810 US$/€
    3. Euro 90-day interest rate (annualized): 2.14% - 2.09%
    4. US dollar 90-day interest rate (annualized): 1.28% - 1.23%

    1. What is the hedged value of United's ticket sales using a forward market hedge?
    2. What is the hedged value of American's ticket sales using a money -market hedge? Make sure to use the appropriate rate when borrowing and lending.
    3. Which hedging strategy is more appropriate? Is there an arbitrage opportunity?
  6. (10 points) Here's an article from the March 5, 2004 Investors Chronicle:

    Like many UK companies, Gooch & Housego is becoming "increasingly concerned" by the fall in value of the US dollar, and has no currency hedging policies in place. But Gooch does have some protection: it buys a lot of components and raw materials in dollars, and partly financed the purchase of US subsidiaries Cleveland Crystals and Neos Technologies with dollar loans. But the currency squeeze is hurting because North American sales are roughly twice as high as those in the UK - GBP10.43m against GBP5.49m last year. If 2002-03 results had been calculated at 2001-02 average dollar rates, turnover would have been GBP900,000 higher and operating profits GBP149,000 better at GBP2.41m.

    1. Explain exactly how Gooch has protection for its currency exposure, in spite of not having any currency hedges in place.
    2. Why should it be bad for Gooch to have higher sales in the US?

  7. (10 points) An article in the July 1, 2004 Business Review Weekly of Australia has the following comment from Professor Paul Kerin of the Melbourne Business School, regarding the ability of firms to pass through cost increases or decreases due to changes in exchange rates. Does the slowness of the pass-through mean that it is more important for firms to hedge their currency exposure or less important?

    A typical finding is that of the Reserve Bank's Jacqueline Dwyer and Ricky Lam: "The pass-through of changes in the landed import price to the retail price is very slow. It takes about four years before most of the estimated long-run price effect is realised". Within the first one or two years, the pass-through rate was less than a third.

    Several factors explain this slow pass-through. Because exchange rates are volatile, retailers are rarely sure whether a rate change is a temporary blip or a permanent step; it is costly to change thousands of prices in many stores, so they sensibly wait and see. Of course, opportunism is also at play. One former senior retailer says: "I don't know a senior retailer worth his salt who would change prices to reflect a rising dollar, certainly not on exclusive or private label lines. As to the rest, there is no way they would lead the market down, although they would watch it closely."

  8. (Bonus: 10 points) Discuss in point form, the effect of offshoring on firm's exchange rate exposure.

Solutions to Final Exam


  1. samurai bonds: These are yen bonds sold in Japan by a non-Japanese borrower.
  2. keiretsu: a large industrial group, often with a major bank at the center.
  3. securitization: in general, refers to converting assets into securities that can be traded in financial markets. Most usually, refers to the replacement of nonmarketable loans provided by financial intermediaries with negotiable securities issued in the public capital markets.
  4. note issuance facility: a facility provided by a syndicate of banksa that allows borrowers to issue short-term notes, which are then placed by the syndicate. Borrowers usually have the right to sell their notes to the bank syndicate at a price that yields a prearranged spread over LIBOR.
  5. development bank: a bank, whose lending is directed to investments that might not otherwise be funded by private capital

2. a. The manager should hedge not the present value of the portfolio, but the value of the portfolio at the horizon date. Hence, in this case, the manager should hedge the expected value of the portfolio in six months, including both the coupon payment, as well as the expected capital gain.

b. Suppose we assume that the $100m. current portfolio value was estimated conservatively, using the bid euro rate of 1.2376 US$/€; then the euro value would be 100/1.2376 or €80.80m. With the semi-annual coupon, this would have grown to 80.80(1.025)€. If this had been hedged at the forward rate, this would be equal to $1.23402(80.80)(1.025) = $99.71m. Assuming the €(0.0475)(80.80m) capital gain had not been hedged, this would be worth, in dollars converted at the later spot rate, (1.3575)(0.0475)(80.80m) = $5.210. The total value of the portfolio would be 99.71 + 5.21 or $104.92m., for a total return of 4.92%

If some of the expected capital gain had been hedged, that would have to be taken into account.

c. If nothing had been hedged, the value of the portfolio would have been (80.80)(1.025 + 0.0475)(1.3575) = $117.638m. for a total return of 17.638%.

d. A hedging decision has to be evaluated on the basis of information that was available ex-ante. Hence the fact that the dollar weakened ex-post is irrelevant.

3. a. The cost of the euro-denominated debt can be computed using the formula, , where rL=2.15%, n = 20, and c = 0.5%. Solving, we find that r = 5.32% p.a. This can also be approximately computed by simply adding the 1% appreciation rate to the 4.3% interest rate on the euro-debt.

b. It would be better to use the euro-denominated debt, since its total cost would be 5.32%, compared to the 5.7% on the dollar-denominated debt.

4. Since you have used a US firm as a proxy, you may not have adjusted sufficiently for country risk. The excess of the return on Brazilian government debt over US government debt is 10 - 4 or 6%. Adjusted for the difference in equity market volatilities, this becomes 6(28/15) or 11.2%. The expected return on the US market portfolio is 10+1.5 or 11.5%. Since the impact of country risk is assumed to be proportional to firm beta, it is appropriate to simply add the country risk premium of 11.2% to the expected market return of 11.5%.

Hence the required rate of return on the project would be 4% + 0.85(22.7-4)% = 19.9%

5. a. Using a forward hedge, UA's ticket sales are worth 80(1.23469)m or $98.7752m, available in 90 days.

b. If a money-market hedge is to be used, we would borrow in euros against the ticket sales. This would yield 80/(1+0.0214/4)m. These can be converted into dollars today at the spot rate to yield $[80/(1+0.0214/4)](1.2365)m. These can be invested in dollars to yield, in 90 days, $[80/(1+0.0214/4)](1.2365)(1+0.0123/4) or $98.696m.

c. Since the amount is less than the amount obtainable by engaging in a forward hedge, the forward hedge would be preferable. There is no arbitrage opportunity, either. If the $98.696m. to be available in 90 days were sold forward, the would fetch 98.696/1.23510 or 79.86m., which is less than the 80m. we started out with.

We can also show that there is no arbitrage opportunity going in the opposite direction. If the 80m. were converted in forward dollars, they would generate $(80)(1.23469) or $98.7752. It is possible to borrow $98.7752/(1+0.0128/4) against this today. This can be converted into €[98.7752/(1+0.0128/4)]/(1.2376), which can be invested for 90 days to obtain €(1+0.0209/4)[98.7752/(1+0.0128/4)]/(1.2376) = €79.973, which is less than the original €80m.

6. a. Gooch is a UK company, which has sales in the US, and hence is exposed to the dollar. However, it has some protection for its currency exposure because it pays for some of its raw materials and components in dollars. This reduces the net dollar exposure. Furthermore, the financing of the purchase of its US subsidiaries in dollars also means that whatever it might lose in GBP revenue if the dollar weakens it would gain by having a lower interest rate in pound terms on its financing.

b. Higher sales in the US is clearly not bad, but it does increase Gooch's exposure to fluctuations in the value of the dollar.

7. The slowness of the pass-through means that retailers would not be able to offset unfavorable changes in the exchange rate (for imported goods) by increasing the local price of their goods. This means greater exposure to exchange rate fluctuations. As such, it would be more important for firms to hedge their currency exposure.