Dr. P.V. Viswanath
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# Exams, Summer 2005, Midterm

Midterm Exam

Notes:

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.
5. Problems 1 through 5 are compulsory (they add up to 110 points, i.e. you already have a 10 point bonus). If you try all of them, then you may try Problem 6 for extra credit.

1. (20 points) Please define any five of the following terms:

1. dirty float
2. optimum currency area
3. fiat money
4. sterilized intervention
5. swap rate
6. SWIFT
7. currency board

2. (30 points) Read the following article from the Wall Street Journal of June 21, 2005 and answer the following questions.

1. The article starts out talking about the fact that the euro has appreciated against the dollar. Then we are told, "Mr. Bozotti is shifting costly, less productive European manufacturing to Asia." What is the connection?
2. If you look at the graph of STMicro's stock price, and the dollar value of the euro, there is a clear negative correlation between the two, if you restrict yourself to the post 2004 period. If this were always the case, then STMicro might want to hedge against the euro. However, such a relationship does not seem to exist in the pre-2004 period. Can you guess why this might be so?
3. What is the implication of the comments made in b. above? How should STMicro hedge, if it is interested in minimizing the volatility of its stock price (measured in euros)? Against the euro, against the dollar? Explain your answer.

Strong Euro Bedevils EU Firms: Despite Currency Drop, Companies Struggle to Stay Competitive
By BRIAN LAGROTTERIA and CASSELL BRYAN-LOW, Staff Reporters of THE WALL STREET JOURNAL
June 21, 2005; Page A14

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.

1. Compute the implied bid and ask for the British Pound in American terms.
2. If the CAD/JPY rate were 89.78 bid/89.83 ask, would there be arbitrage opportunities?

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).

 Contract Month Last Price Sep 2005 1.8228 Dec 2005 1.8179 Mar 2006 1.8130 Jun 2006 1.8081 1.8032 1.7983
1. According to the Unbiased Expectations Hypothesis, what is the market's forecast for the value of the US dollar in terms of British pounds, on December 2005.
2. Assuming the Unbiased Expectations Hypothesis holds, what is the 3-month risk-free interest rate in the UK, today, if the 3-mth T-bill rate is 2.98% (Source: http://online.wsj.com/page/mdc/0,,2_0500-bondkir-10,00.html)?
3. Using the data in the table above, what would be your hypothesis regarding the relative growth rates in GNP in the UK versus the US, if you know that relative money growth rates are expected to be similar in the near future and money velocities are also similar? (You may assume that the unbiased expectations hypothesis holds.)

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/£.

1. Think of the swap as a floating for floating swap. Assuming a specific rate for the DEM floating rate, show the flows under the currency swap at the initiation of the swap, during the period that the swap is in effect and when the swap terminates.
2. If the market rate for a DEM floating rate note is estimated to be LIBOR plus 15% (if such a security were to exist), what can you say about the terms of the swap if the agreed-upon exchange rate is DM2.50/£ and the pound is expected to depreciate over the life of the note?

Midterm Solutions

1.

1. dirty float: A system of floating exchange rates in which a government may intervene to change the direction of the value of the country's currency; this differs from a managed float policy, in that it may not be the explicit and avowed policy of the government to intervene to affect currency rates.
2. optimum currency area: largest area in which it makes sense to have a single currency. Defined as that area for which the cost of having an additional currency -- higher costs of doing business and greater currency risk -- just balances the benefits of another currency -- reduced vulnerability to economic shocks associated with the option to change the area's exchange rate.
3. fiat money: a system where the currency that is legal tender is not back by commodities or other reserve currencies, but simply by the peoples' faith in the government.
4. sterilized intervention: intervention by central banks to affect the exchange rate, accompanied by open-market operations domestically to offset the impact of the currency market intervention on domestic money supply.
5. swap rate: The difference between spot and forward rates expressed in points, e.g., \$0.0001 per pound sterling (Source: Campbell Harvey http://www.duke.edu/~charvey/Classes/wpg/bfgloss.htm).
6. SWIFT: An acronym that stands for "Society for Worldwide Interbank Financial Telecommunications." This is a
dedicated computer network to support funds transfer messages internationally between member banks world-wide. Among other things, it is used to transfer funds between member banks.
7. currency board: a system where the central bank issues notes and coins that are convertible on demand and at a fixed rate into a foreign reserve currency.

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.

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.

6.

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:

 Investor buys bond: -£ 10,000,000 Cross Currency Swap: +£ 10,000,000 -DM 25,000,000

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:

 Bond Redeems to Investor: +£ 10,000,000 Cross Currency Swap: -£ 10,000,000 +DM25,000,000

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.

Final Exam

Notes:

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. (20 points) Please define any five of the following terms:

1. price elasticity of demand
2. exposure netting
3. cylinder
4. currency of determination
5. production shifting
6. range forward

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
December 31, 1996
(In thousands of Polish zloty)

 Assets Liabilities Cash 250 Accounts Payable 250 Accounts Receivable 100 Short-term Debt 350 Inventory 300 Long-Term Debt 550 Real Estate 450 Prepaid Deliverables 150 Plant 400 Equity Equipment 400 Common Stock 500 Retained Earnings 100 Total 1900 Total 1900

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.

1. What was the translation exposure of MMM Corporation of Poznan, Poland, on December 31, 1996, if the zloty was the functional currency? If there were no changes in the balance sheet over 1997, what was the translation gain (loss) if the exchange rate was \$0.35/zloty on December 31, 1997, based on this exposure? Where does this gain (loss) appear on the financial statements?
2. What was the translation exposure of MMM Corporation of Poznan, Poland, on December 31, 1996, if the dollar was the functional currency? If there were no changes in the balance sheet over 1997, what was the translation gain (loss) if the exchange rate was \$0.35/zloty on December 31, 1997, based on this exposure? Where does this gain (loss) appear on the financial statements?

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).

1. What is the hedged dollar value of this note at maturity?
2. What is the annualized dollar yield on the hedged note?
3. Smithy anticipates that the value of the pound in 90 days will be \$1.77. Should it hedge? Why or why not?
4. Suppose that Smithy has a payable of £980,000 coming due in 180 days. SHould this affect its decision of whether to hedge its sterling note? How and why?
5. The yield on 3-month US Treasuries is 3.15%. Would investing in US Treasuries be preferable to investing in the UK note?

4. (20 points) Answer any two of the following questions:

1. The article, "Nissan Game Plan Working" in Ward's Auto World, Detroit: Dec 2004, Vol.40, Iss. 12, has the following quote: "With the new Canton, MS, plant in full production, along with Smyrna, TN, and two plants in Mexico, Nissan has ample production capacity in North America of 1.28 million units to meet demand." How might this be a way of addressing Nissan's exchange rate exposure?
2. According to the Feb 4, 1997 (pg. A.15) issue of The Wall Street Journal, "A Japan Airlines subsidiary has cut labor costs by a third by employing foreign crews based outside of Japan and doing maintenance work in China and Singapore." Explain how this could be a strategy to reduce exchange rate exposure.
3. Advertising Age of December 9, 2002 reports: "Procter & Gamble Co. is launching Ariel Style, a detergent designed to preserve clothes' color and shape, this month in the fashion-conscious French market with a TV, print, outdoor and direct marketing campaign by Publicis' Saatchi & Saatchi. If successful, the new version of international brand Ariel, called Tide in the U.S., is slated for a global rollout." What are the implications for managing economic currency exposure?

5. (30 points) Read the following article from the Wall Street Journal of June 23, 2005 and answer the following questions.

1. Note the difficulties pointed out by the author of the article regarding the difficulties for firms to hedge against changes in the value of the yuan, because of the "absence of a real market in the currency." If you were the CFO of a firm with exposure to the yuan, how would you hedge your exposure, under the circumstances?
2. It is generally believed that if the yuan were to float, it would increase in value, relative to the dollar. If you believe this argument, then would it make sense for firms, which produce in the US and sell in China, to hedge their operating exposure yuan? Would it make sense for a firm which has manufacturing operations in China and primarily sells its goods abroad, to hedge its operating exposure?
3. If you are a CFO, who is not entirely sure of the validity of the conventional wisdom and think that Mr. Weijian Shan might be correct, how would this affect your decision to hedge your firm's exposure to the yuan?

China's Yuan Is Overvalued
By WEIJIAN SHAN, Wall Street Journal, June 23, 2005

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.

Solution to Final Exam

1. Definitions:

1. price elasticity of demand: the percentage change in the demand for a good in response to a one percent change in the price of the good.
2. 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 shoudl be offset by gains (losses) on the second exposed currency.
3. cylinder: the payoff profile of a currency collar created through a combined put purchase and call sale.
4. currency of determination: the currency whose value determines a given price.
5. production shifting: a strategy based on the allocation of production among several plants in line with changing dollar costs of production, increasing production in a nation whose currency has devalued and decreasing production in a country where there has been a revaluation.
6. range forward: (same as 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 the same size. In effect, the purchase of the put option is financed by the sale of the call option.

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.
If there were no changes in the balance sheet in 1997, then we can compute the translation gain and loss over the year, given that the end-of-year exchange rate was \$0.35/Zl.
To begin, we have to note that the Cumulative Translation Adjustment as of the end of 1996 would have been 500(0.40-0.35) + 100(0.40-0.36) = \$29.
As far as 1997 is concerned, the additional translation adjustment would be 600(0.35-0.40) = -\$30, for a total of -\$1. These translation adjustments would appear in the Balance Sheet

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.
The translation adjustment for 1997 would be -800(0.35-0.40) = \$40. However, in this case, this would be shown as a gain due to changes in the exchange rate and would add \$40 to net income. This would then be carried to retained earnings in the balance sheet.

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).
b. The dollar investment in the note today is \$877,750 (500,000 x 1.7555). The 90-day return is 1.0082367% (884,979.81/877,750 - 1). Annualized, this dollar return is 3.295% (0.0082367% x 4).
c. If it does not hedge, then it will obtain an expected value of 505,775(1.77) = \$895,221.75 at maturity; this is greater than the amount it will obtain, if it does hedge. However, the hedged value is certain, while the payoff from the unhedged note is uncertain. Whether Smithy should hedge or not will depend on how certain Smithy's CFO is about the forecast, and the impact of the exchange rate uncertain and consequent uncertainty of the future value of the investment on the firm's stock price.
d. In this case, Smithy would be better off either not hedging or only hedging partially; this is because the GBP payoff from the invest could be setoff against the £980,000 payable coming due in 180 days. However, neither the amount or the timing constitutes a perfect offset, so Smithy should still consider how definite it is about the future spot rate forecast.
e. Since the hedged return on the UK bill is 3.295%, which is greater than the return on the T-bill, Smithy should not invest in the T-bill.

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.
b. As the yen appreciated, Japan Airlines could switch to foreign crews, who would cost less in yen because of the cheaper foreign currency.
c. By creating a new local brand, Procter and Gamble would decrease the price elasticity of demand for its detergent in Europe and thus allow it to pass through any euro currency price increase necessitated by an appreciation of the dollar.

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 in yuan.
b. If it were true that a floating yuan would rise in value against the dollar, instead of depreciating, then a firm which produces in the US and sells in China would be better off not hedging against the yen. The rise in the yuan would only make the company's products more competitive in China. A firm that produces in China and sells abroad would, on the other hand, wish to hedge against this potential rise in the yuan. However, in this case, since the direction of movement of the currency is "known" and it is only whether the yuan would be floated or not that is in doubt, it might make sense for the firm to take an option position and to buy calls on the yuan.
If the market tended to believe more in the possibility of a floating yuan depreciating as opposed to the "correct" scenario envisaged by Mr. Weijian Shan, hedging should be cheaper since the option/futures price would include an overestimate of a depreciating yuan.
c. In this case, both kinds of firms would probably wish to hedge.