Dr. P.V. Viswanath
|Courses/ FIN 649|
SCHOOL OF BUSINESS
1. (36 points) Please answer any three of the following questions (no more than half a page each):
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 $50 million in eco-friendly research and development in Shanghai.
3. You have the following information on exchange rates as of 1:04 p.m., New York time (from https://www.ofx.com/en-au/exchange-rates/): AUD/USD indicates quote in US dollars per A$.
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.
5. (24 points) Answer any two of the questions below:
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.
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.
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.
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.
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.
Discover arbitrage opportunities, if any, if the EUR/JPY quote were 135.65/135.8.
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.
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:
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.
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
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
2. At 10:09 p.m. on June 14, 2006, the following rates were shown on http://www.ozforex.com.au.
The EUR/USD forward rate for 3 months was
The GBP/USD forward rate for 3 months was
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%.
3. Answer any four of the following questions:
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.
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:
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.
The EUR/USD forward rate for 3 months was
The GBP/USD forward rate for 3 months was (WSJ)
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%.)
3. (15 points each) Answer the following questions:
Solutions to Test 3
1. a. A major element of costs is fuel, which is also dollar
denominated. This is a natural hedge.
2. a. You'd get (£450)($1.8457/£) or $830.565
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.