Show the formula you are using to answer the quantitative questions. Then, show the values that you are using for each of the variables in the formula, as well as how to obtained those values, if necessary. You do not have to show computations beyond this. However, make sure that the numerical value of your answer makes sense in the context of the question. Make all your assumptions explicit. If your approach is correct, you will get some credit, even if your arithmetic answer is wrong. So concentrate on getting your logic right.
Excessively verbose and irrelevant answers will be penalized. But answers without reasons will not be given any credit either.
Q. 1. (15 points) The following exchange rates are available: ¥64.00/SF; SF1.60000/$; ¥105/$. You have $100,000 available. Can you make money by triangular arbitrage? How? How much money will you make?
Q. 2. (15 points) Daniel Barenboim, a resident of Chicago, is convinced that the Israeli shekel is going to drop in the near future against the US dollar. The spot quote today, November 5, 2002 is NS4.734/$. Should he a) buy puts on the shekel, b) buy calls on the shekel, c) sell puts on the shekel or d) sell calls on the shekel? Explain your answer.
Q. 3. Pittsburgh Steel has received an order from a Mexican manufacturing company for stainless steel worth Ps. 15,000,000. The export sale would be denominated in Mexican pesos on a one-year open account basis. The current spot rate is Ps.10.00/$, and the forward peso sells at a discount of 8% per annum. However, the finance staff of Pittsburgh Steel forecasts that the peso will drop only 6% in value over the next year. Pittsburgh Steel can borrow pesos in Mexico City at 8% per annum.
Q. 4. (30 points) Provide brief definitions for any six of the following terms:
Q. 5: (10 points) A firm can manage operating exposure by diversifying financially or operationally. Give two examples of each.
Q. 6: (10 points) Give two reasons why a firm should hedge its foreign exchange exposure.
1. The two exchange rates, ¥64.00/SF and SF1.60000/$ imply a cross rate of 64(1.6) = ¥102.4/$. The actual rate is ¥105/$. Hence, I could buy yen at the more advantageous rate of ¥105/$. Starting with $100,000, this would give me ¥10,500,000. This could be converted into 10,500,000/102.4 = $102,539.06, for a profit of $2,539.06.
2. If Daniel thinks that the shekel is going to drop, then he can sell calls or buy puts. Selling calls on the shekel would give him an immediate cashflow, but would leave him open to large losses if the shekel appreciated. Buying a put on the other hand would mean an immediate cash outflow. On the other hand, he stands to make very large profits if the shekel indeed drops a lot.
3.a. The forward peso sells at a discount of 8% p.a. The current rate
is $0.1/Ps; at a discount of 8%, a peso would be worth (1-0.08)(0.1) =
0.0092. This means that Pittsburgh Steel could get 15m. x 0.0092 =
$1,380,000 one year hence.
b. If Pittsburgh hedges in the money market, it could borrow at 8% in
pesos. This would yield 15m/1.08 today. This could be converted at
the current rate of $0.1/Ps to yield $(0.1)(15/1.08) = $1,388,888 today.
4.a. eurodollar is a U.S. dollar denominated interest-bearing deposit in a
bank outside the U.S.
b. The yen carry trade refers to the practice of borrowing yen and investing in
safe U.S. government securities that earn a lot more, hoping that the exchange
rate will not change.
c. (exchange rate) pass-through is the extent to which refers to the extent to
which a manufacturer can change the foreign currency price of a good to
compensate for adverse exchange rate changes that have effectively reduced the
home currency price of his product.
d. A forward-forward swap is a where a trader takes a position in more than one
forward swap; normally, the position in the one swap will, to some extent,
offset the exposure in the other swap, such as where one leg of the
forward-forward swap is a long position in a 2-month forward, and another leg is
a short position in a three-month forward.
e. rho is the sensitivity of an option premium to changes in the home currency
interest rate.
f. natural hedging is the practice of protecting firm value by manipulating a
firm's operating or financing policies.
g.The international Fisher effect is a hypothesis that says that the difference
between the interest rates in two countries reflects the expected change in the
rate of exchange of the one currency for the other.
6. There could be four reasons for hedging:
Show the formula you are using to answer the quantitative questions. Then, show the values that you are using for each of the variables in the formula, as well as how to obtained those values, if necessary. You do not have to show computations beyond this. However, make sure that the numerical value of your answer makes sense in the context of the question. Make all your assumptions explicit. If your approach is correct, you will get some credit, even if your arithmetic answer is wrong. So concentrate on getting your logic right.
Excessively verbose and irrelevant answers will be penalized. But answers without reasons will not be given any credit either.
1. (30 points) Define the following terms in brief:
Notional Principal
Global Depositary Receipt
Currency Matching
home country bias
counterparty risk
Forward Rate Agreement
2. (10 points each) Answer the following questions in brief:
How would you decide whether treasury operations should be run as a profit center or a cost center?
Under what circumstances would you use a pay floating/ receive fixed swap?
Why might a security market be segmented instead of being integrated into global capital markets? List two factors, with brief explanations of how they lead to market segmentation.
3. (20 points) Suppose Dow Chemical can borrow floating-rate francs directly at LIBOR plus 0.35%, while Michelin can borrow floating-rate francs at LIBOR plus 0.125%. Dow can borrow in dollars at a fixed rate of 7.5%, while Michelin can borrow in dollars at 7.7%. Finally, Dow can raise fixed-rate financing in French francs at a rate of 8.25%, while the cost to Michelin would be 8.1% for the same kind of financing. Dow's objective is to raise funds for a project that will have revenues mainly in French Francs, while Michelin is looking for new funds to expand its market share in the US. Furthermore, Michelin has already entered into a long-term contract to sell its tires in the US at a pre-determined price. Come up with a solution involving swaps that would allow Michelin and Dow to attain their mutual objectives. Your answer should address these issues:
In what currency would Michelin and Dow issue their debt?
Would they issue fixed rate debt or floating rate debt?
Would they engage in a swap or not? If yes, provide details of the swap. (You don't have to provide any calculations; however, you must explain your answer.)
4. (20 points) You work for the Nauru Metals Mining Corp., which has the opportunity to invest in a mining project in Australia, with a life of 10 years. Nauru's shareholders are primarily from the U.S. You also know that these shareholders do not hold internationally diversified portfolios. Furthermore, it is your opinion that Australia has country risk which is not really diversifiable considering how closely the Australian moves with the US economy. What is the required rate of return on the project? Explain your answer. Here is some information that your assistant has come up with:
The 10-year T-bond rate currently is 4.85%.
The 10-year Australian Government bond rate is 5.5%
The 6-month T-bill rate is 1.5%.
This is a new venture for Nauru in Australia; hence there is no historical information available on Nauru's investments in Australia. However, the beta of a portfolio consisting of Mine-Australia (a mutual fund investing in the 10 largest mining firms in Australia) is 0.9, against the Australian Stock Exchange Index. The beta of Mine-Australia against the NYSE Index is 0.35.
The market risk premium in the U.S. is currently estimated to be 6%, while the market risk premium in Australia is 8%
1.
Notional Principal
This is the predetermined dollar principal
in an interest
rate swap,
on which the exchanged interest
payments are based.
Global Depositary Receipt
A receipt denoting ownership of foreign-based corporation stock
shares
which are traded
in numerous capital
markets around the world.
Currency Matching
This refers to the theory/practice of matching inflows and outflows by
currency, so as to reduce a firm's net exposure to foreign exchange risk.
home country bias
This refers to the empirical fact that
investors seem to invest a greater proportion of their portfolio in
securities in their home country than would be optimal, if the decision were
made on a pure risk-return basis (for example, using a model like
Markowitz's).
counterparty risk
The risk
that the other party to an agreement will default.
For example, in a swap contract, this refers to the risk for each party to
the swap that the other party will not fulfill his/her obligations, leaving
the first party exposed.
Forward Rate Agreement
An agreement to borrow
or lend at a specified future date at an interest
rate that is fixed
today.
2. a. There are arguments for and against treating treasury operations as a profit center. The argument for treating it as a profit center is simply that, just as other divisions must turn a profit in order to add value, and be retained in the firm, so must treasury. If treasury operations are not turning a profit, perhaps they should be out-sourced.
Some people argue that treasury's function is to reduce and control risk. Profit-driven trading is not part of its business. This does not make sense, as stated, since the ultimate purpose of all parts of the business is to make money. However, it could be argued that putting a money value on the risk-reducing functions of treasury is difficult and, hence, incorrect decisions may be taken based on these "profits" computed on the basis of non-market prices. A related problem is that use of a profit center approach might lead treasury operatives to take excessive risk in order to meet profit goals, thus undermining one of the primary functions of Treasury -- i.e. risk management. A profit center approach might also lead to unwillingness of the Treasury Department to provide services to the operating units of the firm.
b. If a firm issues fixed rate debt and expects rates to go down, it would engage in a pay-floating/ receive-fixed swap strategy. However, it could make sense for a firm to use a swap strategy even if it did not have a particular view on interest rates. If a firm could issue fixed-rate debt at an advantageous rate, but saw its revenues as being sensitive to changes in short-term interest rates, it would want to engage in a pay-floating/ receive-fixed strategy as well.
c. Capital markets could become segmented because of market imperfections, such as:
If foreign investors perceive investments in a country to be subject to high political risk (such as the risk of expropriation), they will not want to invest in that country for any reasonable expected return. This might force local firms to raise capital locally.
Similarly, if there is no clear corporate law in a country, or if there are no clear accounting principles that firms operating in that country are required to follow, investors will shy away from investing there, since the risks cannot be evaluated clearly. This again, will lead to local firms having to raise funds locally. Such a situation is particularly likely to occur if there are restrictions on local investors' ability to invest abroad, as well.
3. Since Michelin has already entered into a long-term contract to sell its tires in the US at a pre-determined price, it would want to pay fixed dollars, using the principle of currency-matching. Analogously, given Dow is raising funds for a project that will have revenues mainly in French Francs, it would like to pay floating French Francs. This can be done in two ways.
One, Dow could issue floating French Franc denominated debt at a cost of LIBOR + 0.35%, while Michelin could issue fixed rate dollar debt at a cost of 7.7%. Two, Dow could issue fixed dollar debt and Michelin could issue floating French Franc debt and then swap; the resulting costs would be 7.5% for the dollar debt, as opposed to the 7.7% in the first alternative, and LIBOR + 0.125% for the French Franc debt, compared to the LIBOR + 0.35% in the first alternative. Clearly, the second alternative is preferable.
4. The basic rule is to require a rate of return on a project that is consistent with that project's risk. The CAPM provides a way of computing this required return. Since the required rate of return = Rf + b(Market Risk Premium), we need to determine these quantities.
Since Nauru's shareholders are US based, we would use a US risk free rate. Since the project has a life of 10 years, the appropriate rate is not the T-bill rate, but rather the 4.85% T-bond rate. The best beta estimate is that of Mine-Australia against the NYSE Index, which is 0.35. The market risk premium to be used, once again, is the US market risk premium of 6%. This gives us a required rate of return of 4.85 + 0.35(6) = 6.95.
However, if Australian country risk is not considered diversifiable, then we would need to incorporate country risk, as well. This could be done by taking the excess of the Australian Government Treasury rate over that of the US T-bond rate and either adding all of it to the 6.95% obtained above, or simply adding the product of the project's beta and this excess to the rate obtained above. If we use the second approach, on the argument that the project is only exposed to Australian country risk to the extent of the project's beta risk, then the required rate of return becomes 6.95 + 0.35(5.5-4.85) = 7.1775%