Dr. P.V. Viswanath
|Courses/ FIN 649|
Exams, Summer 2005, Midterm
1. (20 points) Please define any five of the following terms:
2. (30 points) Read the following article from the Wall Street Journal of June 21, 2005 and answer the following questions.
Strong Euro Bedevils EU Firms: Despite Currency Drop, Companies
Struggle to Stay Competitive
Despite the euro's 8.2% drop against the dollar since mid-March, European companies continue to grapple with the currency's overall strength.
STMicroelectronics NV is a case in point. Carlo Bozotti, chief executive of the Geneva-based chip maker, says the euro is among his biggest headaches. As growth slows in the chip industry and his bankers forecast that the euro, despite its recent slip, will remain relatively high for a while, Mr. Bozotti says he can't afford to wait any longer to take tough steps to boost competitiveness and profitability.
Mr. Bozotti is shifting costly, less productive European manufacturing to Asia. As part of these efforts, STMicroelectronics recently announced it would cut 2,300 jobs in Europe. Mr. Bozotti also wants to move all the manufacturing of what he calls "more mature," or commodity-type, chip products to Asia over the next five years.
STMicroelectronics' predicament shows that the still strong euro -- it remains 48% higher against the dollar than it was in late 2000 -- is a big handicap for companies that may only now be taking steps to restructure their businesses in the face of low growth and rising competition. Reasons for this delayed response vary, including European labor laws, which make restructuring difficult and, in some cases, management that simply didn't confront the combination of the market and currency downturn with enough rigor.
"The outside world is bored of blaming everything on the euro-dollar, but it is a huge problem. A huge problem," says Wolfgang Ziebart, the CEO of German chip maker Infineon AG, which recently displaced STMicroelectronics as Europe's largest semiconductor company by revenue. An Infineon spokeswoman said that the chip maker isn't making specific business changes as a result of the strong euro but that the company does engage in hedging strategies to help offset the impact.
While European chip makers have been hit particularly hard by the exchange rate, they aren't alone. Other companies that produce in the 12-nation euro zone and rely on overseas buyers, such as luxury watch and jewelry maker Bulgari SpA and German car maker Volkswagen AG, have also seen their growth either contained or reversed by the euro's strength in recent years.
Volkswagen, for instance, has been shifting the production of its Jetta models to Mexico from Europe since last year. The company also plans to increase production in Mexico of other models as part of efforts to make cars in the currency zones where it sells them.
In March, Mr. Bozotti took the helm of STMicroelectronics, the world's sixth-largest chip maker by revenue, when he succeeded the company's long-serving CEO, Pasquale Pistorio, and he has been scrambling to restore the company's competitiveness. STMicroelectronics makes chips for mobile phones, printers and cars, among other things. It counts Nokia Corp., the world's largest maker of handsets, among its customers.
As is the case with oil, microprocessors are priced in dollars. With 70% of STMicroelectronics' costs in euros, the unfavorable exchange rate has slashed the company's operating profit and even pushed it to an unexpected loss last quarter. STMicroelectronics' finance department does some currency hedging, but it hasn't been enough to offset the damage incurred from the dollar's weakness.
"The performance of our company in recent past quarters has not been satisfactory," Mr. Bozotti told analysts and investors at a recent conference in New York. "Our market-share gain has come to a halt."
To be sure, the euro is just one of several factors affecting Mr. Bozotti's business. The semiconductor industry generally is wrestling with overcapacity. STMicroelectronics has suffered criticism for a behind-the-curve culture when it comes to technology and a management that has preferred stability for its work force at the expense of growth for investors, repeatedly issuing profit warnings and missing targets. The company also is facing stiff pricing competition from Asia and the U.S., particularly with its memory chips, which store data on phones and cameras.
In a recent interview, the 53-year-old executive said moving plants and manufacturing to Asia and other initiatives should reduce STMicroelectronics' costs by more than $500 million annually. He said he is also refocusing research-and-development resources and is betting that a new generation of chips designed to power new gadgets, such as high-definition televisions and video-enabled cellphones, will help drive growth.
While investors welcome Mr. Bozotti's efforts to reinvigorate the business, some question whether the measures he is taking will go beyond the currency issue to tackle STMicroelectronics' fundamental weaknesses. "It's not a foregone conclusion that it will be a success," says William C. Conroy, an analyst at Sanders Morris Harris in Houston, of STMicroelectronics' restructuring. Sanders Morris doesn't have a banking relationship with STMicroelectronics. Mr. Conroy, who owns shares in the company, has a "hold" investment rating on the stock.
Mr. Bozotti says the euro isn't the company's only issue. "We clearly have challenges," he told investors at the recent conference in New York, citing industry overcapacity and falling memory prices. Addressing high costs, including the euro, is key to his strategy, he said.
3. (20 points) Here are some quotes from http://www.ozforex.com.au/cgi-bin/spotrates.asp, as of 4:15 p.m. on June 27, 2005.
4. (30 points) According to data from Catranis.com (http://sites.barchart.com/pl/cta/quote.htx?sym=BPU5&mode=i), the following were the last transactions prices for the GB pound (as of around 3:10 p.m. on June 27, 2005).
5. (10 points) According to http://www.ozforex.com.au/, the GB pound was trading at $1.8264 on June 28, 2004. If the rate on June 27, 2005 was 1.8231, what is the change in the real value of the GB pound in terms of dollars over the last year? According to the BBC, inflation in the UK over the last year has been steady at 2.7%, while in the US, (estimated from www.economagic.com data), inflation has been about 2.82%.
6. (10 points) (Source: http://my.dreamwiz.com/stoneq/products/ccs.htm; viewed June 27, 2005) A fund manager is seeking to purchase 3 yr DEM (Deutsche Mark) assets with a minimum credit rating of AA and a yield in excess of LIBOR plus 12. A review of the DEM Floating Rate Note market and even the DEM fixed rate bond market swapped into floating rate using an Asset Swap, shows that no such assets exist in reasonable volume. A 3 yr GBP AA rated Corporate bond can be purchased at a yield of GBP LIBOR plus 18bp for a total price of GBP 10,000,000. A foreign exchange dealer is willing to structure a currency swap for the fund manager, so that he can end up with a synthetic DEM floating rate asset. The prevailing exchange rate is DM2.50/£.
2.a. There seem to be two different issues in terms of the move of STMicroelectronics' manufacturing to Asia. The first one is that labor costs in Asia are lower. The second issue, which is more pertinent to the issue is that Mr. Bozotti believes that Asian currencies are less likely to strengthen vis-a-vis the dollar, so that effective manufacturing costs in dollar terms are likely to remain low and not rise over time.
b. In 2004 and thereafter, the Euro is strengthening in real terms, and as a result, STMicroelectronics' stock price is dropping, since its effective dollar-denominated manufacturing costs are rising. In the pre-2004 period, movements in the euro's value relative to the dollar may have been dominated by monetary shocks. In such a case, even if the euro were to appreciate in nominal terms, it probably did not appreciate in real terms. As a result, STMicro was able to pass on the higher Euro production costs, since it did not result in higher real dollar prices. Consequently, STMicro's stock price did not take a hit.
c. The implication is that STMicro should hedge against fluctuations in the euro exchange rate, but only if it foresees volatility in the real euro-dollar exchange rate. Since STMicro's stock price would be negatively affected by a higher euro, one strategy might be to buy euro futures.
3. a. This can be accomplished simply by taking the product of 1.2306 and 0.4439 or £0.5462/$ bid and (1.2311)(0.4444) or £0.5471/$ ask. In American terms this would become $1.8278/£ bid and $1.8306/£ ask.
b. If the quoted CAD/JPY rate were 89.78 bid and 89.83 ask, then we can compute the cross bid/ask rate first. Given the USD/CAD rate, the CAD/USD rates are 1/1.2311 bid and 1/1.2306 ask, i.e. 0.8123 bid and 0.8126 ask. From this, the cross CAD/JPY can be computed as (0.8123)(109.29) bid and (0.8126)(109.34) ask, i.e.88.7743 bid/88.851 ask. Hence the actual quoted rates for the Canadian dollar are too high, and do not overlap the cross rates. Hence it should be possible to make money by selling the Canadian dollar for Japanese yen at the quoted rate and buying it in the cross-market. Thus, a profitable strategy would be to sell one Canadian dollar for 89.78, buy (89.78)(1/109.34) or 0.8211 US dollars, which would then be converted into (0.8211)(1.2306) or 1.0105 Canadian dollars, for a profit of 1.05%!
4.a. Given the unbiased expectations hypothesis, the futures prices is equal to the expected future spot price. Hence the expected future (in December 2005) of the UK pound in US dollars is 1.8179; from this, we can estimate expected future value of the US dollar in terms of UK pounds as 1/1.8179 or £0.55.
b. According to the International Fisher Effect, the expected change in the interest rate is equal to the home interest rate less the foreign interest rate. Using this information, we can compute the riskfree rate in the UK if we knew the current spot rate. This is not given to us; however, we can use extrapolation (if we assume that the expected percentage depreciation in the pound is constant as a function of time. Given that it is now about three months to the expiry of the September contract, and the December contract is three months away from the expiry of the December, contract, this allows us to estimate the expected percentage change in the spot rate over the next three months as current spot rate as (1.8179-1.8228)/1.8228 = -0.002688. which is the actual expected rate of depreciation of the UK pound from September to December. This can then be used to estimate the UK three-month risk-free interest rate as the US rate + 0.2688% or 2.98+0.2688 or 3.2488% p.a. approximately.
c. Using the monetary approach to exchange rate determination, we know that the expected change in exchange rates equals the difference in expected money supply growth rates less the expected differential in GNP growth rates (assuming that money velocities are not changing). Hence, if relative money growth rates are expected to be similar in the near future between the UK and the US, we would expect that the growth of GNP in the US would be greater than that in the UK by about 0.2688% every three months, or 1.08% per annum.
5. The GB pound was trading at $1.8264 one year ago. Since then inflation in the UK has been about 2.7% p.a., while inflation in the US has been about 2.82%. Hence, if the real exchange rate had not changed at all, the spot rate today should reflect an appreciation of the GB pound to the extent of 2.82-2.7 or 0.12%. Or, more precisely, the nominal rate today should be 1.8264(1.0282)/(1.027) = $1.8285/£. The actual rate now is 1.8231; hence, in real terms, the GB pound has suffered a depreciation of (1.8231-1.8285)/1.8285 or 0.297% p.a.
a. Assuming that the terms are pay LIBOR + 18 bp and receive LIBOR+15 bp, we have the following cashflows (with an exchange rate of DM 2.5/£ throughout) (see part b. as to why we choose LIBOR+15 bp):
The initial cashflows are as follows:
The swap agreement nets out the initial £ flow and replaces it with an equivalent DM flow. Over the life of the bond, the fund manager pays the £ coupons (LIBOR plus 18bp) to the bank counterparty and receives DM LIBOR plus 15bp. At maturity, the following flows occur irrespective of the prevailing exchange rate:
b. The pound is expected to depreciate over the life of the deal; hence if the agreed-upon exchange rate is DM2.5/£, which is the current spot rate, and the swap of the GBP floating bond for the DM floating bond were on even terms, the fund manager would obtain LIBOR + 18bp. However, if the "market" rate for a DM floating bond is LIBOR plus 15bp, then it would make sense for the swap to be on those terms; i.e. the fund manager would pay LIBOR + 18 bp and receive LIBOR + 15 bp.
1. (20 points) Please define any five of the following terms:
2. (20 points) Shown below is the balance sheet of MMM Corporation's subsidiary in Poznan, Poland, on December 31, 1996, denominated in thousands of Polish zloty.
MMM Corporation of Poznan, Poland
The subsidiary was created in January 1, 1996, so it had been in operation for only one year, and all earnings from 1996 were retained as cash. The exchange rate on January 1, 1996, was $0.35/zloty. The exchange rate on December 31, 1996, was $0.40/zloty. The average exchange rate for the period was $0.36/zloty. The inventory is shown at historical cost. The firm also had one unusual nonmonetary liability: MMM had already collected 150 thousand zloty from a Polish firm that ordered a large amount of supplies, and MMM promised to deliver the supplies within the next year.
3. (20 points) Smithy Inc., a U.S. firm, has just invested £500,000 in a riskless note that will come due in 90 days and is yielding 4.62% annualized (source: Moneyline, July 6, 2005). The current spot value of the pound is $1.7555 (http://www.fx-forex-trading.com/charts_gbp.html, viewed July 6, 2005), and the 90-day forward rate is 1.74975 (http://www.ozforex.com.au/cgi-bin/forwardRates.asp, viewed July 6, 2005).
4. (20 points) Answer any two of the following questions:
5. (30 points) Read the following article from the Wall Street Journal of June 23, 2005 and answer the following questions.
Yuan Is Overvalued
The U.S. has intensified its pressure on China over the yuan, with Treasury Secretary John Snow warning Beijing to revalue before October or risk being labeled a "currency manipulator" -- a designation that could lead to the imposition of retaliatory trade barriers.
This pressure all hinges on the argument that the Chinese currency is artificially undervalued, thus giving Chinese exports an unfair advantage and robbing America of many jobs. That's a view widely shared in the financial markets. Forward contracts for the yuan trade at a premium over the current spot exchange rate, reflecting the general expectation of a revaluation. And foreign capital has been flooding into China in anticipation of this, putting significant upward pressure on the money supply and property market. Given Beijing's healthy foreign-exchange reserves, and the consistent current- and capital-account surpluses of recent years, perhaps it's understandable that the market should believe a freely convertible yuan would rise in value against the dollar.
But that overlooks the fact that while the yuan is already convertible on the current account (albeit at a fixed rate set by China's central bank), the capital account remains heavily controlled. Traders can freely convert yuan into dollars and vice versa; while Chinese and foreign tourists can, by and large, buy and sell yuan for their travel needs. Foreign companies operating in China can also repatriate dividends largely without restrictions, by selling yuan for foreign currency. But all capital-account transactions must be cleared with the State Administration of Foreign Exchange. While there are few controls on inward foreign direct investment and repatriation of capital earned through properly registered foreign direct investments, foreigners face extensive restrictions on investing in China's domestic capital markets. Most crucially, Chinese citizens are also heavily restricted from investing abroad.
Such capital controls are not unusual. Many countries had capital controls at one stage or another in their economic development. Britain didn't remove all foreign-exchange controls until 1979. South Korea only partially lifted its capital controls in 1996. Taiwan still restricts foreign investment in its stock market. India and Malaysia also maintain tight capital controls.
Like it or not, capital controls are absolutely necessary for China at this stage in its economic development. That's because the country's economic development is, to an almost unprecedented extent, driven by rapid capital formation or fixed asset investments (FAI). FAI accounted for 45% of China's gross domestic product in 2004, a far higher percentage than any other major country has ever experienced during its economic development. For instance, the FAI to GDP ratio in the U.S. never rose much higher than 20%, even during the peak period of its industrialization between 1889-1913, and the post World War II reconstruction phase of 1946-55. In Japan, the highest the ratio ever reached was about 32% in the 1960s and 1970s. In Germany, it only reached about 21% during the heavy investment periods from 1891-1913 and again from 1952-58.
The reason why China is able to invest so much more is because, in addition to the inflow of foreign direct investment, it enjoys a very high savings rate of 43% of income in 2004. And because of the controls on the country's capital account, Chinese savers have little choice but to invest their money at home, instead of seeking higher returns overseas.
By almost all measures, Beijing's economic growth is inefficient and wasteful. Data show that it takes an average of $5-7 in investments to produce every dollar's worth of GDP in China, as opposed to an average of $1-2 dollars in most developed countries. Much more energy and other types of resources are also consumed to produce the same amount of GDP as in other countries. Beijing's FAI is largely financed by bank loans, and the amount of bad loans in its banking system is a good indicator of the inefficient use of capital. An inefficient economy can still produce high growth rates if you throw enough capital at it, as China does. But only because the capital is prevented from seeking more productive uses overseas by the existence of capital controls.
China's unique growth model relying on FAI or capacity expansion produces two pronounced effects for the world economy. On the one hand, it creates insatiable demand pushing up world-wide prices for the raw materials and commodities of which China is a net importer. On the other hand, relentless capacity expansion leads to overcapacity which depresses the prices of finished products, of which China is a net exporter. In this way, China in effect subsidizes the rest of the world by buying dear and selling cheap. However, this biflation, or the combination of the inflation of prices of raw materials and the deflation of prices of finished products, squeezes the cash-flow and profitability of Chinese producers. Therefore, China's growth has historically produced low corporate profits and returns on capital in general. Whereas in any other country, the stock market generally performs in tandem with the economy, Chinese stocks have historically generated exceedingly low or negative returns for investors in spite of sustained economic growth. Companies also see their stocks trade at a substantial premium on domestic stock exchanges to overseas markets, indicating that the return on capital in China is at a discount to that outside the country.
If China were to lift its capital controls and allow the yuan to become freely convertible, the price differentials between the Chinese and overseas stock markets would be likely to disappear because of arbitrage by investors. The resulting outward capital flow would likely cause the yuan to devalue, rather than revalue -- as many American political leaders seem to hope. Without capital controls, China's economic growth would stall because the major engine of its growth, FAI, would run out of fuel as capital becomes more scarce. And, given Beijing's growing economic importance, a stalled Chinese economy would have a devastating effect on the global economy.
If, on the other hand, China decides -- perhaps in response to the pressure from Washington -- to revalue the yuan, it will have to maintain or perhaps even "manipulate" its capital controls in order to maintain the present upward pressure on the yuan. Any flotation of the yuan would also have to be under the current regime of foreign-exchange control, including capital controls. While such a strategy does bring certain benefits, such as allowing the central bank to bring the growth of money supply and the overheated economy under better control, it is also likely to be highly disruptive to trade and investment, and consequently to China's economic growth because Beijing's dependency on trade is almost twice as high as the U.S. or Japan measured by trade volume as a percentage of GDP. Whereas traders and investors can generally hedge against currency volatility or risks with a fully convertible currency, they cannot do so efficiently and at low cost when the currency is subject to capital controls because of the absence of a real market in the currency.
Of course, China could instead decide to repeg the yuan at a higher level against the dollar. But a modest revaluation would only encourage more speculative inflow of capitals, exacerbating the pressure on China's money supply, because once moved, the peg would lose its credibility and become subject to more ferocious speculative attacks. The political pressure will not let up either. If however China repegs sharply, its economy will significantly slow down with major consequences for global growth.
That leaves China with only one option if it does decide to bow to pressure to change its exchange rate -- letting the yuan float within a managed band against a basket of currencies under the current foreign-exchange regime of continued convertibility on the current account but capital account controls. Floating the yuan within a band against a basket of convertible currencies offers the advantage of trade and investment stability as traders and investors will be able to hedge their currency risks to the extent the market knows what the basket is. But it doesn't mean the yuan will necessarily rise in value against the dollar, especially given the greenback's recent strength.
However there is little economic rationale for China to revalue its currency or to move its peg to the dollar since the yuan is not fundamentally undervalued if real market forces are brought to bear. The currency peg has worked well for China in the past decade. It has also served the world economy -- including the U.S. -- well by maintaining economic stability and subsidizing high levels of American consumption, through China's heavy investments in U.S. government securities.
In the long run, the best course would be for China to gradually open up its capital account. But it will do so slowly for fear that the inefficiencies in its economy would stifle economic growth if it was forced to freely compete for capital against more efficient economies. That's why Zhou Xiaochuan, governor of the People's Bank of China, is right to say that China must first reform its banking system to make its economy more efficient before lifting foreign-exchange controls. Only then can China increase the rate of return on capital and make Chinese growth more balanced, as opposed to being so heavily reliant on FIA. And that, in turn, will create the conditions for the yuan to become fully convertible.
2. a. The translation exposure of the Polish subsidiary of MMM Corp.
was equal to Zl. 500 as far as the equity is concerned. As far as the
retained earnings are concerned, there are Zl. 100 of exposure. Hence
the total exposure is 500 + 100 or Zl. 600.
b. If the dollar were the functional currency, then according to FASB
52, the temporal method is to be used for currency translations. In this
case, the exposure would be equal to the difference between the local
currency value of monetary assets and monetary liabilities. In this case,
it works out to (250+100) - (250+350+550) = -Zl. 800.
3. a. At maturity, this note will pay off £505,775 (500,000 x 1
+ 0.0462/4). The hedged dollar value of this note at maturity is $884,979.81
(505,775 x 1.74975).
4. a. This would be an example of production shifting. The existence
of excess capacity in its North American plants would allow Nissan to
move production between its US and Mexican plants to take advantage of
exchange rate fluctuations.
5. a. In the absence of a forward or futures currency market in the yuan,
it would be necessary for the firm to use other strategies to hedge, such
as production and marketing strategies. For example, if the firm produced
in the US and sold in China, this could include moving production partially
to China, increasing the brand value of its products in China, as well
as raising funding partly in China, so that the debt servicing would be