Dr. P.V. Viswanath
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# Exams/Tests

Pace University
Fin 649 International Corporate Finance
Summer 2006
Prof. P.V. Viswanath

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.

Test 1

1. (36 points) Please answer any three of the following questions (no more than half a page each):

1. Why does Hong Kong not produce and export wheat? What theory did we talk about in class that would help you answer this question?
2. Japan is a producer of rice; would you have expected this on the basis of the theory of factor proportions? If so, explain. If not, then why does Japan produce rice?
3. Suppose there are two countries, England and Portugal, producing two goods, wine and corn. Suppose the unit-labor requirements in wine production are: 1/3 hour per liter and 1/2 hour per liter for England and Portugal respectively, while the unit-labor requirements in corn are 1/4 hour per kg and 1/2 hour per kg. for England and Portugal respectively.
1. Which country has the absolute advantage in wine? In corn? Explain why.
2. Which country has the comparative advantage in wine? In corn? Explain why.
3. According to the theory of comparative advantage, how would these two countries take
4. John says: A firm that does not sell its products in a foreign country and that does not buy its inputs in a foreign country does not have to worry about exchange rates. Tom says: It has to worry about exchange rates even if none of its competitors in its industry sell abroad or buy their inputs abroad. Who is right and why?

2. (15 points; no more than one side) The following article appeared in the Wall Street Journal of June 1, 2006. Answer the following question after reading the article:

Trade theory explains why some countries produce and export one good, while other countries produce and export other goods. Multinational firms, such as GE and Credit Suisse, straddle several countries, as we see in the article. How would you explain the seeming contradiction between trade theory and the presence of multinational firms? How can we explain the GE-Credit Suisse venture using concepts from trade theory?

GE, Credit Suisse Set Project

General Electric Co. and Zurich-based Credit Suisse Group will team in a \$1 billion project to invest in infrastructure projects world-wide.

The companies will invest \$500 million each in the joint venture, which is intended to develop and finance utility work such as power generation and transmission projects, water projects, and gas storage and pipelines.

The venture also would pay for transportation projects world-wide such as airports and air-traffic control facilities, ports, railroads and toll roads, the companies said.

"Combining GE's and Credit Suisse's expertise, global footprint and financial strength is a compelling way to satisfy the thirst for infrastructure investment," said Dave Calhoun, GE's vice chairman for infrastructure projects.

This week, GE, Fairfield, Connecticut, also announced a \$250 million project to invest in health-care and infrastructure projects in India, and expansion of projects in China that include about \$50 million in eco-friendly research and development in Shanghai.

3. You have the following information on exchange rates as of 1:04 p.m., New York time (from https://www.ofx.com/en-au/exchange-rates/): AUD/USD indicates quote in US dollars per A\$.

 Major Rates Bid Ask AUD/USD 0.7400 0.7405 USD/CAD 1.1150 1.1155 EUR/USD 1.2827 1.2832 GBP/USD 1.8621 1.8626 USD/HKD 7.7592 7.7614 USD/JPY 113.10 113.15 USD/NOK 6.0567 6.0589 AUD/CHF 0.8993 0.8998
1. (5 points) Compute the cross rate between the Euro and the Canadian dollar (bid and ask).
2. (5 points) Compute the cross rate between the US dollar and the Swiss Franc (CHF) (bid and ask).
3. (10 points) If the Australian Dollar were quoted at C\$0.83/0.832, would there be arbitrage opportunities? If you used 100 Australian dollars to buy US dollars and then used those dollars to buy Canadian dollars, how many would you be able to buy?

4. (10 points) Here are the forward quotes for the JPY/USD as of 1:41 pm, New York time from https://www.ofx.com/en-au/exchange-rates/. Convert them into outright quotes. The spot quote is 0.00883/0.00883.

 Period Bid Ask 1 Month 0.000040 0.000040 2 Months 0.000070 0.000080 3 Months 0.000110 0.000120

5. (24 points) Answer any two of the questions below:

1. What is the difference between SWIFT, CHIPS and Fedwire?
2. What is the difference between forward contracts and futures contracts?
3. If your firm sold €120m. worth of goods with payment to be made in 3 months. Would you sell euros forward or buy them forward if you did not want to bear the risk of the exchange rate changing?

Solutions to Test 1

1. a. The production of wheat requires land. Hong Kong has very little land; hence, it would not make sense for Hong Kong to produce wheat. This is predicted by the factor-endowments or factor-proportions theory.

b. Considering that Japan does not have a lot of land, one might, on similar grounds, not expected Japan to produce rice. On the other hand, the climate is very conducive to the production of rice, and Japan is not as congested as Hong Kong. Hence it is not entirely unexpected that Japan produce rice. However, it is also true that the Japanese government taxes imported rice. This protects local rice producers. Hence, Japan probably produces more rice than would have been expected on simple factor-proportions grounds.

c. i) England has an absolute advantage in the production of wine, as well as in the production of corn.
ii. However, it has a comparative advantage only in the production of corn, since it is twice as efficient as Portgual, in this arena. Hence, Portugal has a comparative advantage in the production of wine.
iii) According to the theory of comparative advantage, England would produce and export corn, while Portugal would product and export wine and import corn from England.

d. Tom is correct. Even if none of its competitors in its industry sell abroad or buy their inputs abroad, it might still be subject to exchange rate risk because producers of goods that are substitutes might be foreign companies or they might purchase their inputs from foreign producers. Hence if the domestic currency appreciates, the local currency cost of their goods would increase and hence the price of the substitute good. This would then cause consumers to shift consumption from the substitute good to the good in question.

2. In this case, there is no inconsistency. India and China are relatively short on capital and know-how. GE and Credit Suisse are providing it. However, it is possible that the joint venture is involved in infrastructure projects in other developed countries, as well. This could be simply due to the fact that they are the least-cost and most-efficient producers, given their experience.

3. a.
The cross-rates are easily computed as (1.2827)(1.1150) and (1.2832)(1.1155), which works out to 1.430211 and 1.43141.

b. Given the bid-ask rates for the Australian dollar in terms of the US dollar (viz. 0.74 and 0.7405), we can get the bid-ask rates for the US dollar in terms of the Australian dollar by simply taking the inverse and switching the order, i.e. the bid-ask rates now will be 1/0.7405 and 1/0.74, which works out to 1.35044 and 1.351351. Then multiplying these numbers by the AUD/CHF rate, we get the bid-ask rates for the US dollar in terms of the Swiss Franc, as in the previous question, viz. 1.21445 and 1.215946.

c. We are told that the bid-ask rates for the USD in terms of Canadian dollars is 1.115/1.1155; similarly, we know that the AUD/USD rate is 0.74/0.7405. Using this, we can see that the implied AUD/CAD rates are 0.8251 and 0.82603. Note that the direct rates are C\$0.83/0.832, which do not overlap the cross rates. Hence, there are arbitrage profits to be made (see below).

If you had A\$100, this could be used to buy (0.74(100) or \$74.00, which in turn could be used to buy (74)(1.115) or C\$82.51. If these were then converted back into Australian dollars, we would get (82.51)/0.832 or A\$99.17, which is not profitable.

However, if we started with A\$100 and bought Canadian dollars, we'd get 100(0.83) or C\$83; these could be converted into US\$83/1.1155 or US\$74.406, which would then fetch 74.406/0.7405 or A\$100.48, which is more than we started with.

4. The corresponding ourtight quotes are computed simply by adding the spot quotes to the points quotes.

 Period Bid Ask 1 Month 0.008870 0.008870 2 Months 0.008900 0.008910 3 Months 0.008940 0.008950

5. a. SWIFT is a means for traders to communicate with each other, CHIPS is a clearing system, and Fedwire is a system for keeping accounts and netting transactions between members of the system.

b. Futures contracts are standardized versions of forward contracts; the biggest difference between the two is that the former are marked-to-market daily, while the latter are not.

c. You would sell euros forward. If all went well, you would be receiving euros in 3 months, which you would want to convert (sell) into dollars at that time. However, if you waited three months to do that, you would be at the mercy of exchange rate changes. Selling the euros forward removes that uncertainty.

Re-test 1

1. (15 points) The Oz Forex Foreign Exchange site provided the following quotes (https://www.ofx.com/en-au/exchange-rates/) around 12:30 on Monday, November 1, 2004.

The AUD/USD quote is a direct quote from the American point of view, while the USD/CAD quote is an indirect quote from the American point of view. Compute the cross-rate between the Australian dollar and the Canadian dollar.

b. (15 points) The Oz Forex Foreign Exchange site provided the following foreign exchange quotes (https://www.ofx.com/en-au/exchange-rates/) around 12:30 on Monday, November 1, 2004.

 Bid Ask USD/JPY 106.36 106.41 EUR/USD 1.2738 1.2743

Discover arbitrage opportunities, if any, if the EUR/JPY quote were 135.65/135.8.

Solutions to Re-test 1

4. a. A\$1 can purchase US\$0.7459, which can be converted into C\$(0.7459)(1.2224) or C\$0.9118. C\$1 can purchase US\$(1/1.2229), which can buy A\$(1/1.2229)(1/0.7464) or A\$1.0956. Hence to get A\$1, you need to give up C\$(1/1.0956) or C\$0.9128. Hence the bid price for the A\$ in Canada is C\$0.9118, while the ask price is C\$0.9128.

b. 1 euro can buy US\$1.2738, which can buy (1.2738)(106.36) or 135.48 yen, which, in turn can be converted into 135.48/135.9 euros, which is less than 1 euro. However, 100 yen can buy US\$(100/106.41), which can buy (100/106.41)/1.2743 euros, i.e. 0.73747 euros. These can be sold for (0.73747)(135.65) or 100.038 yen, which is a profit of .038 yen per 100 yen. Hence, there is an arbitrage opportunity, and it can be availed of by using yen to buy dollars, using the dollars to buy euros and then using the euros to buy yen again.

Test 2

Test 2

1. (15 points)  "Read the article below, which is part of an article from the New York Times of June 9, 2006, and answer this question:
The article has the following quoted: "The dollar reached a one-month high against the euro as investors digested the possibility of more lucrative investments that come with higher United States rates.”
This seems to suggest that if rates are higher in the United States, investors would want to move their investments from Europe to the United States, leading to greater demand for the dollar.  However, it is not uncommon for higher interest rates to cause equity prices to fall.  For example, in the June 13th New York Times, in an article entitled, “Broad Economic Worries Drive a Global Sell-off,” it was reported “Fears about higher interest rates, rising inflation and a slowing economy sent stocks sharply and broadly lower yesterday.”  So why is the increase in US interest rates not causing US securities to look less attractive and hence reduce the demand for the US dollar?

European Bank Raises Rate but Doesn't Signal Future Moves

By CARTER DOUGHERTY

MADRID, June 8 — The European Central Bank raised its benchmark interest rate Thursday by a quarter-point, to 2.75 percent, but avoided saying that it would sharply tighten credit to control inflation.

Jean-Claude Trichet, president of the central bank, said the bank would continue to increase borrowing costs gradually, a course it began in December as part of a long-expected worldwide trend toward higher rates.

Also on Thursday, central banks in South Africa, India, Denmark and South Korea all increased their interest rates, after Turkey did the same on Wednesday. The United States Federal Reserve, which has recently expressed concerns about inflation, now appears likely to follow suit this month.

Major stock indexes fell sharply in Asia and Europe on Thursday, while closing little changed in the United States after plunging earlier in the day. The dollar reached a one-month high against the euro as investors digested the possibility of more lucrative investments that come with higher United States rates.

After two years of holding its benchmark rate at 2 percent, the European Central Bank has raised it three times, by a quarter-point each time, over the last nine months. Mr. Trichet said the bank would decide on the pace and magnitude of further increases based on the developing European outlook for inflation and growth, and not on any preset course.

"We are always free to do what we judge is appropriate," he said.

He said the 18 members of the bank's rate-setting body had discussed the possibility of raising rates by a half percentage point on Thursday, but that the "overwhelming sentiment" in the group was for the smaller increase.

2. At 10:09 p.m. on June 14, 2006, the following rates were shown on http://www.ozforex.com.au.

 EUR/USD 1.2616 1.2621 GBP/USD 1.8462 1.8467 EUR/GBP 0.6829 0.6834

The EUR/USD forward rate for 3 months was

 3 Months 1.26859 1.27024

The GBP/USD forward rate for 3 months was

 3 Months 1.8481 1.85071

According to Bloomberg, on the same date, the yield on 3-month US T-bills was 4.88%, on 3-month German bills was 2.86% and that on British 3-month bills was 4.5%.

1. If you had \$100 on June 14th, and wanted to invest it in British 3-month bills, but at the same time, hedge yourself against adverse changes in the pound-dollar rate, what rate of return would you get? How does this compare with you return from investing in US T-bills? Comment on the similarity or difference between the two numbers.
2. Assuming you can borrow and lend at the given rates, can you make money, without bearing any risk? Prove your answer with computations (i.e. show exactly what you would do to generate the arbitrage profits, if any).
3. What is your estimate of what the EUR/USD rate will be on September 14, 2006?
4. The (annualized) inflation rate in the US is currently 4.17% (computed for May 2006 by http://inflationdata.com.  Suppose you believe that inflation will be about the same in the US for the next three months.  What is your estimate of the inflation rate in the euro-currency area for the next three months?
5. The EUR/USD rate on 30/04/2006 was 1.2635, while on 31/05/2006, it was 1.2858.  If you believe that the PPP held over the month of May, estimate the actual rate of inflation in the euro-currency area over the month of May. You can use the 4.17% US inflation estimate from inflationdata.com.

3. Answer any four of the following questions:

1. Why are a central bank’s independence and reputation important for the stability of that country’s currency value?
2. If a country changes its political system drastically, and its political leaders change its economic policies, with the result that its GDP increases over a five year period.  How would you expect its currency to behave over that five year period?
3. What is dollarization and how might it be used?
4. Your friend believes that prices tend to equalize across countries – even goods that cannot be transported over borders.  Do you agree?  Explain.
5. What are some reasons why interest rate parity might not hold?

Solutions to Test 2

1. If interest rates on dollar-denominated securities are higher, then money will flow into dollars and the dollar will rise in value. However, this is true only if the real interest rate in dollars is higher; it will not be true if only the nominal interest rate rises, but the real interest rate doesn't. In this case, we see that the United States Federal Reserve is watching out for inflation; hence the move towards higher US interest rates seems to bespeak a higher real interest rate. Furthermore, the market seems to be interpreting the Fed's moves as boding well for the real economy in the US. As such, it probably expects that real rates on other investments will also rise.

This is in contrast to what happens in many other cases (such as in the June 13th article), where the move to a higher interest rate might signal a warning of higher inflation or even more likely, a choking off of growth by the Fed to forestall the higher inflation that might accompany runaway growth.

2. a. The \$100 would have to be converted in GBP to yield £54.15065 (100/1.8467); this can be invested at the rate of 4.5% for three months to yield (54.15065)(1+0.045/4) or £54.75984 in three months. This can be sold forward to generate \$101.2017 (1.8481x54.75984), which reflects a return of 4.806655%. If invested directly in US treasury-bills, the investor would get 4.88%.

b. The previous procedure is clearly not going to generate arbitrage profits, since the 101.2017 would have to be discounted at a rate (4.88) that's higher than the actual rate of return (4.807%). However, if you can borrow and lend at the given rates, we might be able to make money by doing the opposite, i.e. lending in the US, buying pounds forward and borrowing in the UK market. If we did this, the proceeds would be as follows: invest \$100 in US treasuries to generate 100(1+0.0488/4) = \$101.22; this could be sold forward to generate £54.6925 (101.22/1.85071). Borrowing against this, we can generate £54.0841 (54.6925/(1+0.045/4); converting this in the spot market yields \$99.85, which of course means that arbitrage is not possible.

c. The forward rate can be used as an estimate of the future spot rate. Hence an estimate would be (1.26859+1.27024)/2 = 1.269415.

d. The forward rate gives us an estimate of the expected future spot rate. This allows us to compute the expected change in the exchange rate. According to the dynamic version of PPP, this should equal the expected differential in inflation rates [E(et+1-et)/et = E(p\$- p)]. In other words, the differential in the inflation rates is predicted to be 1.269415/1.2618 - 1 or 0.006035; annualized, this works out to (1.006035)12-1 or 7.487%. If the expected inflation in the US will be 4.17%, then this implies that E(p)= 4.17 - 7.487 or -3.317%. That is, we'd expect deflation equal to 3.317 in the euro-currency area.

According to the International Fisher condition, the interest rate differential is an ubiased predictor of the future change in spot rates. This tells us that E(r\$- r) = 4.88-2.86 = 2.02% = E(p\$- p); hence E(p)= 4.17 - 2.02 = 2.15%

e. Over the month of may, the dollar depreciated against the euro by 1.2858/1.2635 - 1 or 1.7649%; annualized, this works out to a rate of 23.36%. Since the rate of inflation in the dollar area was 4.17%, this implies that there must have been deflation to the tune of 23.36-4.17 or 19.19%. Of course, this doesn't make sense and is not, in fact, what happened. The implication is that our numbers are not precise, or alternatively, that PPP did not hold over this period.

3.a. If a central bank is independent, it is able to resist political pressures to engage in deficit financing and politically-induced inflation. Hence, it will acquire a reputation for maintaining a stable currency.

b. It is likely that in the beginning the markets might be unsure as to what is going to happen, and that there would be a lot of uncertainty leading to volatility in the currency markets. However, with time, the markets would feel reassured and volatility would go down, along with a higher currency.

c. Dollarization is when a stronger foreign currency (like the dollar) is used as the currency in a different country, instead of the country having its own currency. The reason might be a lack of trust on the part of investors vis-a-vis that country's former local currency. Dollarization would prevent the central bank from controlling the money supply, since it would be dependent on the dollar, which is controlled by the US Fed. People, therefore, would have confidence in the currency being used and economic growth would, hopefully, take off.

d. Even goods that cannot be transported across borders would have a tendency to equalize for various reasons. For one thing, even if the good itself cannot be transported, the buyers of the good can move across borders to buy and consume the good on the spot.

e. Interest rate parity may not hold for at least four different reasons: transactions costs, differences in political risks across countries, liquidity differences between foreign and domestic securities and potential tax advantages to foreign exchange gains versus interest earnings, which might make it more profitable for individuals to invest in foreign currency and hedge them, rather than invest locally.

Test 3

1.  "Read the article below, "China Cosco May Offer a Harbor If Shipping Runs Into Rough Seas," from the Wall Street Journal of July 11, 2006 and answer the following questions:

1. (15 points) Considering that freight rates are normally denominated in dollars, China Cosco, as a freight shipping line, obviously has revenues that exposed to the dollar. Can you identify any natural hedges that Cosco has against the dollar-yuan exchange risk?
2. (15 points) If your US listed firm were considering an investment in China Cosco, how would you come up with a hurdle rate for that investment? Specifically, would you add on a country risk premium? Why or why not?

HONG KONG -- As freight rates weaken across the world's major shipping routes, China Cosco Holdings might offer investors a comparatively safe harbor in the highly cyclical container-shipping business.

China Cosco operates 136 container ships, and its fleet has the largest capacity of any shipping line based on the Chinese mainland. Unusually, its 100%-owned shipping unit, Cosco Container Lines, or Coscon, has whittled down its unit costs despite higher fuel prices.

China Cosco also has a large container-ports business, Cosco Pacific, which generates a steady stream of profits to help offset its parent's more volatile shipping income. Cosco Pacific operates container terminals at seven of China's eight biggest ports and ranks fifth world-wide by number of containers handled.

The shipping and the ports businesses have benefited from the stellar growth in China's merchandise exports. China Cosco's net profit last year rose 31% from the year before to 4.71 billion yuan (\$589.8 million), thanks to China's booming maritime trade. Its revenue increased 22% to 39.17 billion yuan.

Yet China Cosco, the Hong Kong-listed flagship of the state-run China Ocean Shipping (Group), has seen its shares languish along with those of its competitors, as investors worry about overcapacity.

Now some analysts believe China Cosco's shares are poised to recover.

"The stock's been overly tarred," says Peter Hilton of Credit Suisse in Hong Kong. "It's shaping up as the one stock in the sector that's fair value and possibly a little bit cheap."

Credit Suisse last week upgraded its rating for China Cosco to "outperform" from "neutral" and targets a 12-month share price of 4.40 Hong Kong dollars (57 U.S. cents). J.P. Morgan, noting the company's strong "fundamentals," rates it as "overweight," with a 12-month price target of HK\$4.80.

"If global trade remains strong, I think a lot of shipping stocks will come back, especially China Cosco Holdings," says J.P. Morgan analyst Christie Ju.

China Cosco's shares closed yesterday at HK\$3.88, down from HK\$3.95 on Friday but up 10% from the start of the year.

Industry watchers warn that a glut in capacity looms for containerized cargo. Many shipping lines that ordered new vessels when business was brisk are just starting to take delivery. Coscon plans to expand the capacity of its own fleet by about 24% by the end of this year compared to the end of 2005, says Thomas Kim of investment bank UBS.

The risk is that when all these new container ships finally enter service, their owners might slash freight rates to attract business, triggering an industry-wide price war.

Late last month, when China Cosco announced an order for eight container ships, it forecast that world-wide demand for container shipping would maintain a "growing trend in the next few years." Company officials didn't respond to requests for further comments.

Mr. Kim says freight rates peaked near the end of the third quarter of last year. "We believe we're at the very early stages of the container shipping down-cycle," he says.

Global freight rates declined on average by 12.6% in this year's first quarter from the year earlier. Rates on routes between Asia and Europe fell the most, by an average of 21.8%, according to Macquarie Securities.

Mr. Kim believes that downward pressure on rates will continue for at least the next 12 months, as the supply of ships outstrips demand for them. He doesn't expect supply and demand to come back into balance until possibly the second half of 2008.

Order backlogs at shipyards exacerbate the shipping industry's cyclical ups and downs. Companies tend to order new ships when their business is booming, and banks are eager to lend. By the time new vessels are built, however, demand for them has often peaked and started to decline.

The effects of overcapacity, together with higher costs for bunker fuel, used in shipping, could wipe out profits for many container lines in 2007, says Mr. Hilton of Credit Suisse. He believes China Cosco should be one of the few to remain profitable, thanks mostly to its robust ports business, Cosco Pacific.

Container shipping accounted for four-fifths of China Cosco's 2005 revenues, with port operations contributing most of the remainder. This year, with freight rates falling, port operations are likely to comprise a relatively bigger share of its total business.

Hong Kong-listed Cosco Pacific is 52%-owned by China Cosco, with its remaining shares trading on the open market. Investors who want to avoid exposure to shipping lines altogether could consider this ports play as an alternative. Its shares yesterday closed at HK\$17.55 each, up five cents.

UBS last month upgraded its rating for China Cosco to "neutral" from "reduce," citing new port investments and a profitable sale of 600,000 shipping containers by Cosco Pacific as the main reason.

Container volumes at China's eight largest ports swelled by 21% during the January-May period compared with the same period a year earlier, and this trend is "a highly encouraging sign" for Cosco Pacific in 2006, Macquarie wrote last month in an investor note.

2. (9 points each) At 10:09 p.m. on July 10, 2006, the following rates were shown on http://www.ozforex.com.au. (Some of these rates are hypothetical.)

 EUR/USD 1.2743 1.2748 GBP/USD 1.8425 1.843 EUR/GBP 0.6912 0.6917

The EUR/USD forward rate for 3 months was

 3 Months 1.26859 1.27024

The GBP/USD forward rate for 3 months was (WSJ)

 3 Months 1.8457 1.8558

According to the WSJ, the yield on 3-month US T-bills was 5.022% ask and 5.011% bid; on the comparable 3-month Euro T-bills was 2.90% ask and 2.88% bid; and that on British 3-month bills was 4.602% bid.  (Assume that the ask rate on the British 3-month T-bill was 4.6%.)

1. If you represent a US corporation and are owed BP 450, payable in three months, how much would you receive if you hedged it in the forward market.
2. How much would you receive if you hedged it in the money market?
3. You believe that after adjusting for exchange rate differences, the interest rates in the US are very low, compared to those in the Euro currency area. Come up with a trading strategy to make risk-free arbitrage profits, based on your beliefs.
4. If you implemented your strategy, and the interest and exchange rates were as above, how much would you make or lose, if you started out with \$100?
5. If the inflation rate in the US (annualized) is expected to be 5% over the next three months, what would your estimate of inflation in the euro-currency area over the next three months be? (Make sure you annualize your numbers.)

3. (15 points each) Answer the following questions:

1. If the demand for a firm's products that exports to foreign markets is very elastic, would that make the firm more or less exposed to foreign exchange risk? Explain.
2. If a firm has factories in several countries so that it is able to shift production from one country to another at relatively short notice, would that render the firm more or less exposed to foreign exchange risk? Explain.
3. How could you use borrowing decisions to hedge against operating exposure? Explain with an example.

Solutions to Test 3

1. a. A major element of costs is fuel, which is also dollar denominated. This is a natural hedge.
b. I would come up with a hurdle rate, first under the assumption that the project were a US project. I would then probably add a country premium because China is a major country, and it's probably not possible to diversify Chinese country risk.
To get the base hurdle rate, I'd need to get a beta for China Cosco. China Cosco is listed in Hong Kong, so it should not be difficult to get pricing and returns data. It would be appropriate to obtain dollar-denominated returns data, then regress it against the US market portfolio proxy (we saw that it doesn't make a big difference whether a US market proxy is used or a global market proxy is used). The CAPM would then be used to come up with a required rate of return on equity.
To get a required rate of return on debt, we might be able to get information on China Cosco's debt, if it exists and is publicly traded. Else, we should be able to use a synthetic rating approach to get an estimate of the required after-tax rate of return on China Cosco's debt.
These two rates would then be combined using the target capital ratio (that is appropriate) for China Cosco's level of risk.

2. a. You'd get (£450)(\$1.8457/£) or \$830.565
b. You could borrow at a yield of 4.602%; this means that the £450 could be converted into £(450)/(1.04602)1/4or £444.9667 today. This can be converted into 444.9667(1.8425) or \$819.85116 today. This could be lent in dollars to generate, in 3 months, \$819.85116(1.05011)1/4or \$829.9343.
c. If interest rates are supposed to be lower in the US than in the Euro currency area, you'd want to borrow in the US and lend in the Euro currency area. That is, borrow in dollars, convert into euros, lend in euros and convert into dollars in the forward market.
d. If I borrowed \$100, this could be converted into €(100/1.2743) or €78.474; this can be lent in euros to generate in three months, €78.474(1.0288)1/4or €79.033. This can be sold forward to assure (in 3 months) \$79.033(1.26859) or 100.26. However, the \$100 borrowed have to be repaid as (100)(1.05022)1/4, which equals \$101.2325. Hence this is not going to be a profitable deal!
e. According to the theory that real rates are equalized, we have (1.050110)/(1.05) = (1.0288)/(1+y), where y is the inflation rate in the euro-currency area. This implies that y = 2.86922%. We don't have to worry about annualization here, since we're assuming that all rates are expressed as yields, so we'd be taking both sides to the fourth rate.

3. a. Very elastic demand means that if there is a given percentage change in price, there is a greater percentage change in demand. This means that the firm will not have much of an ability to pass through any increase in costs due to exchange rate changes. This means, in turn, that the firm will be very sensitive to changes in exchange rates.

b. If a firm has factories in several countries, it would be able to shift production easily. This means it would be able to shift production from a country whose currency has strengthened to a country whose currency has not. As a result, it will be less vulnerable to exchange rate changes.

c. If a firm has revenues denominated in a given currency, it could borrow in that currency providing a natural hedge against exchange rate changes.