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SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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TABLE OF CONTENTS Chapter

1. Globalization and the Multinational Firm Suggested Answers to End-of-Chapter Questions

2. International Monetary System Suggested Answers and Solutions to End-of-Chapter Questions and Problems

3. Balance of Payments Suggested Answers and Solutions to End-of-Chapter Questions and Problems

4. The Market for Foreign Exchange Suggested Answers and Solutions to End-of-Chapter Questions and Problems

5. International Parity Relationships Suggested Answers and Solutions to End-of-Chapter Questions and Problems

6. International Banking Suggested Answers and Solutions to End-of-Chapter Questions and Problems

7. International Bond Markets Suggested Answers and Solutions to End-of-Chapter Questions and Problems

8. International Equity Markets Suggested Answers and Solutions to End-of-Chapter Questions and Problems

9. Management of Economic Exposure Suggested Answers and Solutions to End-of-Chapter Questions and Problems

10. Management of Transaction Exposure Suggested Answers and Solutions to End-of-Chapter Questions and Problems

11. Management of Translation Exposure Suggested Answers and Solutions to End-of-Chapter Questions and Problems

12. Foreign Direct Investment Suggested Answers and Solutions to End-of-Chapter Questions and Problems

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CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM

SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS

QUESTIONS

1. Why is it important to study international financial management?

Answer: We are now living in a world where all the major economic functions, i.e., consumption, production, and investment, are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a situation that existed when the authors of this book were learning finance some twenty years ago. At that time, most professors customarily (and safely, to some extent) ignored international aspects of finance. This mode of operation has become untenable since then.

2. How is international financial management different from domestic financial management?

Answer: There are three major dimensions that set apart international finance from domestic finance. They are:

1. foreign exchange and political risks,

2. market imperfections, and

3. expanded opportunity set.

3. Discuss the three major trends that have prevailed in international business during the last two decades.

Answer: The 1980s brought a rapid integration of international capital and financial markets. Impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. The economic integration and globalization that began in the eighties is picking up speed in the 1990s via privatization. Privatization is the process by which a country divests itself of the ownership and operation of a business venture by turning it over to the free market system. Lastly, trade liberalization and economic integration continued to proceed at both the regional and global levels.

4. How is a country’s economic well-being enhanced through free international trade in goods and services?

Answer: According to David Ricardo, with free international trade, it is mutually beneficial for two countries to each specialize in the production of the goods that it can produce relatively most efficiently and then trade those goods. By doing so, the two countries can increase their combined production, which allows both countries to consume more of both goods. This argument remains valid even if a country can produce both goods more efficiently than the other country. International trade is not a ‘zero-sum’ game in which one country benefits at the expense of another country.

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Rather, international trade could be an ‘increasing-sum’ game at which all players become winners.

5. What considerations might limit the extent to which the theory of comparative advantage is realistic?

Answer: The theory of comparative advantage was originally advanced by the nineteenth century economist David Ricardo as an explanation for why nations trade with one another. The theory claims that economic well-being is enhanced if each country’s citizens produce what they have a comparative advantage in producing relative to the citizens of other countries, and then trade products. Underlying the theory are the assumptions of free trade between nations and that the factors of production (land, buildings, labor, technology, and capital) are relatively immobile. To the extent that these assumptions do not hold, the theory of comparative advantage will not realistically describe international trade.

6. What are multinational corporations (MNCs) and what economic roles do they play?

Answer: A multinational corporation (MNC) can be defined as a business firm incorporated in one country that has production and sales operations in several other countries. Indeed, some MNCs have operations in dozens of different countries. MNCs obtain financing from major money centers around the world in many different currencies to finance their operations. Global operations force the treasurer’s office to establish international banking relationships, to place short-term funds in several currency denominations, and to effectively manage foreign exchange risk.

7. Mr. Ross Perot, a former Presidential candidate of the Reform Party, which is a third political party in the United States, had strongly objected to the creation of the North American Trade Agreement (NAFTA), which nonetheless was inaugurated in 1994, for the fear of losing American jobs to Mexico where it is much cheaper to hire workers. What are the merits and demerits of Mr. Perot’s position on NAFTA? Considering the recent economic developments in North America, how would you assess Mr. Perot’s position on NAFTA?

Answer: Since the inception of NAFTA, many American companies indeed have invested heavily in Mexico, sometimes relocating production from the United States to Mexico. Although this might have temporarily caused unemployment of some American workers, they were eventually rehired by other industries often for higher wages. Currently, the unemployment rate in the U.S. is quite low by historical standard. At the same time, Mexico has been experiencing a major economic boom. It seems clear that both Mexico and the U.S. have benefited from NAFTA. Mr. Perot’s concern appears to have been ill founded.

8. In 1995, a working group of French chief executive officers was set up by the Confederation of French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French corporate governance structure. The group reported the following, among other things “The board of directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company, whose interests should be clearly distinguished from those of

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its shareholders, employees, creditors, suppliers and clients but still equated with their general common interest, which is to safeguard the prosperity and continuity of the company”. Evaluate the above recommendation of the working group.

Answer: The recommendations of the French working group clearly show that shareholder wealth maximization is not a universally accepted goal of corporate management, especially outside the United States and possibly a few other Anglo-Saxon countries including the United Kingdom and Canada. To some extent, this may reflect the fact that share ownership is not wide spread in most other countries. In France, about 15% of households own shares.

9. Suppose you are interested in investing in shares of Nokia Corporation of Finland, which is a world leader in wireless communication. But before you make investment decision, you would like to learn about the company. Visit the website of CNN Financial network (www.cnnfn.com) and collect information about Nokia, including the recent stock price history and analysts’ views of the company. Discuss what you learn about the company. Also discuss how the instantaneous access to information via internet would affect the nature and workings of financial markets.

Answer: As students might have learned from visiting the website, information is readily available even for foreign companies like Nokia. Ready access to international information helps integrate financial markets, dismantling barriers to international investment and financing. Integration, however, may help a financial shock in one market to be transmitted to other markets.

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CHAPTER 2 INTERNATIONAL MONETARY SYSTEM

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Explain Gresham’s Law.

Answer: Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce) money out of circulation. This kind of phenomenon was often observed under the bimetallic standard under which both gold and silver were used as means of payments, with the exchange rate between the two metals fixed.

2. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.

Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it exports to the latter. Under the classical gold standard, gold, which is the only means of international payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become more competitive in the export market, while U.K. products become less competitive. This change will improve U.S. balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.

3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?

Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for 12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.

4. Discuss the advantages and disadvantages of the gold standard.

Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted, countries cannot have high inflation; (2) any BOP disequilibrium can be

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corrected automatically through cross-border flows of gold. On the other hand, the main disadvantages of the gold standard are: (I) the world economy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standard itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic policies (like de-monetization of gold) that are incompatible with the gold standard.

5. What were the main objectives of the Bretton Woods system?

Answer: The main objectives of the Bretton Woods system are to achieve exchange rate stability and promote international trade and development.

6. One can say that the Bretton Woods system was programmed to an eventual demise. Comment on this proposition.

Answer: The answer to this question is related to the Triffin paradox. Under the gold-exchange system, the reserve-currency country should run BOP deficits to supply reserves to the world economy, but if the deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, eventually causing the downfall of the system.

7. Explain how the special drawing rights (SDR) is constructed. Also, discuss the circumstances under which the SDR was created.

Answer: SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the pressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency comprised of five major currencies, i.e., U.S. dollar, German mark, Japanese yen, French franc, and British pound. Currently, the dollar receives a 40% weight, mark 21%, yen 17%, franc 11%, and pound 11%. The weights for different currencies tend to change over time, reflecting the relative importance of each currency in international trade and finance.

8. Explain the arrangements and workings of the European Monetary System (EMS).

Answer: EMS was launched in 1979 in order to (I) establish a zone of monetary stability in Europe, (ii) coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the way for the eventual European monetary union. The main instruments of EMS are the European Currency Unit (ECU) and the Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency constructed as a weighted average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the procedure by which EMS member countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first computed by defining the par values of EMS currencies in terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much as the maximum allowable deviation, the country has to adjust its policies to maintain its par values relative to other currencies.

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9. There are arguments for and against the alternative exchange rate regimes.

a. List the advantages of the flexible exchange rate regime.

b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime.

c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate regime.

Answer:

a. The advantages of the flexible exchange rate system include: (I) automatic achievement of balance of payments equilibrium and (ii) maintenance of national policy autonomy.

b. If exchange rates are fluctuating randomly, that may discourage international trade and encourage market segmentation. This, in turn, may lead to suboptimal allocation of resources.

c. Economic agents can hedge exchange risk by means of forward contracts and other techniques. They don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime, governments often restrict international trade in order to maintain the exchange rate. This is a self-defeating measure. What’s good about the fixed exchange rate if international trade need to be restricted?

10. In an integrated world financial market, a financial crisis in a country can be quickly transmitted to other countries, causing a global crisis. What kind of measures would you propose to prevent the recurrence of a Asia-type crisis.

Answer: First, there should be a multinational safety net to safeguard the world financial system from the Asia-type crisis. Second, international institutions like IMF and the World Bank should monitor problematic countries more closely and provide timely advice to those countries. Countries should be required to fully disclose economic and financial information so that devaluation surprises can be prevented. Third, countries should depend more on domestic savings and long-term foreign investments, rather than short-term portfolio capital. There can be other suggestions.

11. Discuss the criteria for a ‘good’ international monetary system.

Answer: A good international monetary system should provide (I) sufficient liquidity to the world economy, (ii) smooth adjustments to BOP disequilibrium as it arises, and (iii) safeguard against the crisis of confidence in the system.

12. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate. Explain why this may be so.

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Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and out of a country in a short time period. This will make it very difficult for the country to maintain a fixed exchange rate.

CHAPTER 3 BALANCE OF PAYMENTS

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Define the balance of payments.

Answer: The balance of payments (BOP) can be defined as the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping.

2. Why would it be useful to examine a country’s balance of payments data?

Answer: It would be useful to examine a country’s BOP for at least two reasons. First, BOP provides detailed information about the supply and demand of the country’s currency. Second, BOP data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing perennial BOP deficits, it may signal that the country’s industries lack competitiveness.

3. The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits?

Answer: The current account deficits of U.S. may have reflected a few reasons such as (I) a historically high real interest rate in the U.S., which is due to ballooning federal budget deficits, that kept the dollar strong, and (ii) weak competitiveness of the U.S. industries.

4. In contrast to the U.S., Japan has realized continuous current account surpluses. What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses?

Answer: Japan’s continuous current account surpluses may have reflected a weak yen and high competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from appreciating more than it did. At the same time, foreigners’ exports to Japan were hampered by closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in

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the deficit country. It is not desirable especially when it is brought about by the mercantilist policies.

5. Comment on the following statement: “Since the U.S. imports more than it exports, it is necessary for the U.S. to import capital from foreign countries to finance its current account deficits.”

Answer: The statement presupposes that the U.S. current account deficit causes its capital account surplus. In reality, the causality may be running in the opposite direction: U.S. capital account surplus may cause the country’s current account deficit. Suppose foreigners find the U.S. a great place to invest and send their capital to the U.S., resulting in U.S. capital account surplus. This capital inflow will strengthen the dollar, hurting the U.S. export and encouraging imports from foreign countries, causing current account deficits.

6. Explain how a country can run an overall balance of payments deficit or surplus.

Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions. For example, an overall BOP deficit can be supported by drawing down the central bank’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central bank’s reserve holdings.

7. Explain official reserve assets and its major components.

Answer: Official reserve assets are those financial assets that can be used as international means of payments. Currently, official reserve assets comprise: (I) gold, (ii) foreign exchanges, (iii) special drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most important official reserves.

8. Explain how to compute the overall balance and discuss its significance.

Answer: The overall BOP is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall BOP is significant because it indicates a country’s international payment gap that must be financed by the government’s official reserve transactions.

9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S. treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment on the U.S. balance of payments.

Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in the long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to foreigners. If foreign funds are used productively and contributes to the competitiveness of U.S. industries, however, U.S. BOP may improve in the long run.

10. Describe the balance of payments identity and discuss its implications under the fixed and flexible exchange rate regimes.

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Answer: The balance of payments identity holds that the combined balance on the current and capital accounts should be equal in size, but opposite in sign, to the change in the official reserves: BCA + BKA = -BRA. Under the pure flexible exchange rate regime, central banks do not engage in official reserve transactions. Thus, the overall balance must balance, i.e., BCA = -BKA. Under the fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central bank will accommodate it via official reserve transactions.

11. Exhibit 3.3 indicates that in 1991, the U.S. had a current account deficit and at the same time a capital account deficit. Explain how this can happen?

Answer: In 1991, the U.S. experienced an overall BOP deficit, which must have been accommodated by the Federal Reserve’s official reserve action, i.e., drawing down its reserve holdings.

12. Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments:

(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account kept in New York City.

(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card.

(3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift to his parents living in Bombay.

(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from the U.S. bank account maintained by the British company.

Answer:

_________________________________________________________________

Transactions Credit Debit

_________________________________________________________________

Japanese purchase of U.S. T bonds √

Japanese payment using NYC account √

U.S. citizen having a meal in Paris √

Paying the meal with American Express √

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Gift to parents in Bombay √

Receipts of the check by parents (goodwill) √

Export of programming service √

British payment out its account in U.S. √

_________________________________________________________________

13. Construct the balance of payment table for Japan for the year of 1998 which is comparable in format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial Statistics published by IMF or research for useful websites for the data yourself.

Answer:

A summary of the Japanese Balance of Payments for 1998 (in $ billion)

Credits Debits

Current Account

(1) Exports 646.03

(1.1) Merchandise 374.04

(1.2) Services 62.41

(1.3) Factor income 209.58

(2) Imports -516.50

(2.1) Merchandise -251.66

(2.2) Services -111.83

(3.3) Factor income -153.01

(3) Unilateral transfer 5.53 -14.37

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Balance on current account 120.69

[(1) + (2) + (3)]

Capital Account

(4) Direct investment 3.27 -24.62

(5) Portfolio investment 73.70 -113.73

(5.1) Equity securities 16.11 -14.00

(5.2) Debt securities 57.59 -99.73

(6) Other investment 39.51 -109.35

Balance on financial account -131.22

[(4) + (5) + (6)]

(7) Statistical discrepancies 4.36

Overall balance -6.17

Official Reserve Account 6.17

Source: IMF, International Financial Statistics Yearbook, 1999.

Note: Capital account in the above table corresponds the ‘Financial account’ in IMF’s balance of payment statistics. IMF’s Capital account’ is included in ‘Other investment’ in the above table.

CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Give a full definition of the market for foreign exchange.

Answer: Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.

2. What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange?

Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve

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their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 16 percent of FX trades. The other 84 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market.

3. Who are the market participants in the foreign exchange market?

Answer: The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks. International banks provide the core of the FX market. Approximately 700 banks worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment banks, whose size and frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs.

Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly judge the future direction of price movements in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers.

FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.

Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its currency against. Intervention is the process of using foreign currency reserves to buy one’s own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower its price.

4. How are foreign exchange transactions between international banks settled?

Answer: The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. As an example of how the network of correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer’s account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its books to

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offset the debit of U.S. importer’s account, reflecting the decrease in its correspondent bank account balance.

5. What is meant by a currency trading at a discount or at a premium in the forward market?

Answer: The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price.

6. Why does most interbank currency trading worldwide involve the U.S. dollar?

Answer: Trading in currencies worldwide is against a common currency that has international appeal. That currency has been the U.S. dollar since the end of World War II. However, the deutsche mark and Japanese yen have started to be used much more as international currencies in recent years. More importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a market against all other currencies.

7. Banks find it necessary to accommodate their client’s needs to buy or sell foreign exchange forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure it has created for itself by accommodating a client’s forward transaction?

Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To illustrate, suppose a bank customer wants to buy dollars three months forward against British pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months until they are needed to deliver against the dollars it has sold forward. The British pounds received will be used to liquidate the sterling loan.

8. A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CD1.3436-CD1.3441. What is implied about the trader’s beliefs by his prices?

Answer: The trader must think the Canadian dollar is going to depreciate against the U.S. dollar and therefore he is trying to reduce his inventory of Canadian dollars by discouraging purchases of CD by standing willing to buy $ at only CD1.3435/$1.00 and offering to sell from inventory at the slightly lower than market price of CD1.3440/$1.00.

*9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?

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Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.

Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.

PROBLEMS

1. Using Exhibit 4.4, calculate a cross-rate matrix for the French franc, German mark, Japanese yen, and the British pound. Use the most current European term quotes to calculate the cross-rates so that the triangular matrix result is similar to the portion above the diagonal in Exhibit 4.6.

Solution: The cross-rate formula we want to use is:

S(k/j) = S(k/$)/S(j/$).

The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.

Dollar Pound Yen D-Mark

France 6.4071 10.0488 .05250 3.3538

Germany 1.9104 2.9964 .01565

Japan 122.05 191.42

U.K 0.6376

2. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward cross exchange rates between the German mark and the Swiss franc using the most current quotations. State the forward cross-rates in “German” terms.

Solution: The formulas we want to use are:

FN(DM/SF) = FN($/SF)/FN($/DM)

or

FN(DM/SF) = FN(SF/$)/FN(DM/$).

We will use the top formula that uses American term forward exchange rates.

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F30(DM/SF) = .6408/.5246 = 1.2215

F90(DM/SF) = .6453/.5270 = 1.2245

F180(DM/SF) = .6518/.5307 = 1.2282

3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points.

Spot 1.3431-1.3436

One-Month 1.3432-1.3442

Three-Month 1.3448-1.3463

Six-Month 1.3488-1.3508

Solution:

One-Month 01-06

Three-Month 17-27

Six-Month 57-72

4. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask spreads in points.

Solution:

Spot 5

One-Month 10

Three-Month 15

Six-Month 20

5. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward premium or discount for the Canadian dollar in European terms.

Solution: The formula we want to use is:

fN,$vCD = [(FN(CD/$) - S(CD/$))/S(CD/$)] x 360/N

f30,$vCD = [(1.4709 - 1.4715)/1.4715] x 360/30 = -.0049

f90,$vCD = [(1.4694 - 1.4715)/1.4715] x 360/90 = -.0057

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f180,$vCD = [(1.4676 - 1.4715)/1.4715] x 360/180 = -.0053

6. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward premium or discount for the British pound in American terms using the most current quotations.

Solution: The formula we want to use is:

fN,£v$ = [(FN($/£) - S($/£))/S($/£] x 360/N

f30,£v$ = [(1.5685 - 1.5683)/1.5683] x 360/30 = .0015

f90,£v$ = [(1.5694 - 1.5683)/1.5683] x 360/90 = .0028

f180,£v$ = [(1.5714 - 1.5683)/1.5683] x 360/180 = .0040

7. Given the following information, what are the DM/S$ currency against currency bid-ask quotations?

Bank Quotations American Terms European Terms

Bid Ask Bid Ask

Deutsche Marks .6784 .6789 1.4730 1.4741

Singapore Dollar .6999 .7002 1.4282 1.4288

Solution: Equation 4.12 from the text implies S(DM/S$b) = S($/S$b) x S(DM/$b) = .6999 x 1.4730 = 1.0310. The reciprocal, 1/S(DM/S$b) = S(S$/DMa) = .9699. Analogously, it is implied that S(DM/S$a) = S($/S$a) x S(DM/$a) = .7002 x 1.4741 = 1.0322. The reciprocal, 1/S(DM/S$a) = S(S$/DMb) = .9688. Thus, the DM/S$ bid-ask spread is DM1.0310-DM1.0322 and the S$/DM spread is S$0.9688-S$0.9699.

8. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting DM1.6230/$1.00 and Credit Suisse is offering SF1.4260/$1.00. You learn that UBS is making a direct market between the Swiss franc and the mark, with a current DM/SF quote of 1.1250. Show how you can make a triangular arbitrage profit by trading at these prices. (Ignore bid-ask spreads for this problem). Assume you have $5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What DM/SF price will eliminate triangular arbitrage?

Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to Dresdner Bank at DM1.6230/$1.00. This trade would yield DM8,115,000 = $5,000,000 x 1.6230. The Deutsche Bank trader would then sell the deutsche marks for Swiss francs to Union Bank of Switzerland at a price of DM1.1250/SF1.00, yielding SF7,213,333 = DM8,115,000/1.1250. The Dresdner

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trader will resell the Swiss francs to Credit Suisse for $5,058,438 =SF7,213,333/1.4260, yielding a triangular arbitrage profit of $58,438.

If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of deutsche marks, the trade would yield SF7,130,000 = $5,000,000 x 1.4260. The Swiss francs would in turn be traded for deutsche marks to UBS for DM8,021,250 = SF7,130,000 x 1.1250. The marks would be resold to Dresdner Bank for $4,942,237 =DM8,021,250/1.6230, or a loss of $57,763. Thus, it is necessary to conduct the triangular arbitrage in the correct order.

The S(DM/SF) cross exchange rate should be 1.6230/1.4260 = 1.1381. This is an equilibrium rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.) A profit results from the triangular arbitrage when dollars are first sold for marks, because Swiss francs are purchased for marks at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only DM1.1250/SF1.00 instead of the no-arbitrage rate of DM1.1381/SF1.00. Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for marks at too low a rate, resulting in too few marks, i.e. each Swiss franc is sold for DM 1.1250/SF1.00 instead of the higher no-arbitrage rate of DM1.1381/SF1.00.

CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Give a full definition of arbitrage.

Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.

2. Discuss the implications of the interest rate parity for the exchange rate determination.

Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as:

S = [(1 + I£)/(1 + I$)]E[St+1|It].

The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, It, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.

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3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.

Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk premium is insignificant and (ii) foreign exchange markets are informationally efficient.

4. Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?

Answer: The absolute version of purchasing power parity (PPP):

S = P$/P£.

The relative version is:

e = π$ - π£.

PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket.

5. Discuss the implications of the deviations from the purchasing power parity for countries’ competitive positions in the world market.

Answer: If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market.

6. Explain and derive the international Fisher effect.

Answer: The international Fisher effect can be obtained by combining the Fisher effect and the relative version of PPP in its expectational form. Specifically, the Fisher effect holds that

E(π$) = I$ - ρ$,

E(π£) = I£ - ρ£.

Assuming that the real interest rate is the same between the two countries, i.e., ρ$ = ρ£, and substituting the above results into the PPP, i.e., E(e) = E(π$)- E(π£), we obtain the international Fisher effect: E(e) = I$ - I£.

7. Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding?

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Answer: This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in the current market rates, it would be difficult to beat the market.

8. Explain the random walk model for exchange rate forecasting. Can it be consistent with the technical analysis?

Answer: The random walk model predicts that the current exchange rate will be the best predictor of the future exchange rate. An implication of the model is that past history of the exchange rate is of no value in predicting future exchange rate. The model thus is inconsistent with the technical analysis which tries to utilize past history in predicting the future exchange rate.

*9. Derive and explain the monetary approach to exchange rate determination.

Answer: The monetary approach is associated with the Chicago School of Economics. It is based on two tenets: purchasing power parity and the quantity theory of money. Combing these two theories allows for stating, say, the $/£ spot exchange rate as:

S($/£) = (M$/M£)(V$/V£)(y£/y$),

where M denotes the money supply, V the velocity of money, and y the national aggregate output. The theory holds that what matters in exchange rate determination are:

1. The relative money supply,

2. The relative velocities of monies, and

3. The relative national outputs.

PROBLEMS

1. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany. Currently, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?

Solution: The market conditions are summarized as follows:

I$ = 4%; iDM = 3%; S = DM1.60/$; F = DM1.56/$.

If $1,000,000 is invested in the U.S., the maturity value in six months will be

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$1,040,000 = $1,000,000 (1 + .04).

Alternatively, $1,000,000 can be converted into DM and invested at the German interest rate, with the DM maturity value sold forward. In this case the dollar maturity value will be

$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)

Clearly, it is better to invest $1,000,000 in Germany with exchange risk hedging.

2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar.

(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.

(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to £35,000.

Evaluate each payment method. Which method would you prefer? Why?

Solution: The problem situation is summarized as follows:

A/P = £35,000 payable in three months

iNY = 0.35%/month, compounding monthly

iLD = 2.0% for three months

S = $1.45/£; F = $1.40/£.

Option a:

When you buy £35,000 forward, you will need $49,000 in three months to fulfill the forward contract. The present value of $49,000 is computed as follows:

$49,000/(1.0035)3 = $48,489.

Thus, the cost of Jaguar as of today is $48,489.

Option b:

The present value of £35,000 is £34,314 = £35,000/(1.02). To buy £34,314 today, it will cost $49,755 = 34,314x1.45. Thus the cost of Jaguar as of today is $49,755.

You should definitely choose to use “option a”, and save $1,266, which is the difference between $49,755 and $48489.

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3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Solution: Let’s summarize the given data first:

S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%

Credit = $1,500,000 or £1,000,000.

a. (1+I$) = 1.02

(1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280

Thus, IRP is not holding exactly.

b. (1) Borrow $1,500,000; repayment will be $1,530,000.

(2) Buy £1,000,000 spot using $1,500,000.

(3) Invest £1,000,000 at the pound interest rate of 1.45%;

maturity value will be £1,014,500.

(4) Sell £1,014,500 forward for $1,542,040

Arbitrage profit will be $12,040

c. Following the arbitrage transactions described above,

The dollar interest rate will rise;

The pound interest rate will fall;

The spot exchange rate will rise;

The forward exchange rate will fall.

These adjustments will continue until IRP holds.

4. Suppose that the current spot exchange rate is FF6.25/$ and the three-month forward exchange rate is FF6.28/$. The three-month interest rate is 5.6% per annum

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in the U.S. and 8.8% per annum in France. Assume that you can borrow up to $1,000,000 or FF6,250,000.

a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the magnitude of arbitrage profit.

b. Assume that you want to realize profit in terms of French francs. Show the covered arbitrage process and determine the arbitrage profit in French francs.

Solution: The market data is summarized as follows:

S = FF6.25/$ = $0.16/FF;

F = FF6.28/$ = $0.1592/FF;

I$ = 1.40%; iFF = 2.20%

(1+I$) = 1.014 < (1+iFF)(F/S) = (1.022)(.1592/.16) = 1.0169

a. (1) Borrow $1,000,000; repayment will be $1,014,000.

(2) Buy FF6,250,000 spot for $1,000,000.

(3) Invest in France; maturity value will be FF6,387,500.

(4) Sell FF6,387,500 forward for $1,017,118.

Arbitrage profit will be $3,118 = $1,017,118 - $1,014,000.

b. (1) Borrow $1,000,000; repayment will be $1,014,000.

(2) Buy FF6,250,000 spot for $1,000,000.

(3) Invest in France; maturity value will be FF6,387,500.

(4) Buy $1,014,000 forward for FF6,367,920.

Arbitrage profit will be FF19,580 = FF6,387,500-FF6,367,920.

Note that only step (4) is different.

5. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollar and the Turkish lira?

Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to international Fisher effect (IFE), we have

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E(e) = i$ - iLira

= 5.93% - 70.0% = -64.07%

The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.

6. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, respectively. How would you forecast the exchange rate to be at around November 1, 2000?

Solution: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to forecast the exchange rate.

E(e) = E(π$) - E(πR$)

= 2.6% - 20.0%

= -17.4%

E(ST) = So(1 + E(e))

= (R$1.95/$) (1 + 0.174)

= R$2.29/$

CHAPTER 11 INTERNATIONAL BANKING

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Briefly discuss some of the services that international banks provide their customers and the market place.

Answer: International banks can be characterized by the types of services they provide that distinguish them from domestic banks. Foremost, international banks facilitate the imports and exports of their clients by arranging trade financing. Additionally, they serve their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments and by assisting in hedging exchange rate risk in foreign currency receivables and payables through forward and options contracts. Since international banks have established trading facilities, they generally trade foreign exchange products for their own account.

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Two major distinguishing features between domestic banks and international banks are the types of deposits they accept and the loans and investments they make. Large international banks both borrow and lend in the Eurocurrency market. Moreover, depending upon the regulations of the country in which it operates and its organizational type, an international bank may participate in the underwriting of Eurobonds and foreign bonds. In the United States, only investment banks and the investment banking operations of bank holding companies are allowed to participate in the underwriting of international bonds.

International banks frequently provide consulting services and advice to their clients in the areas of exchange hedging strategies, interest rate and currency swap financing, and international cash management services. Not all international banks provide all services. Banks that do provide a majority of these services are known as universal banks or full service banks.

2. Briefly discuss the various types of international banking offices.

Answer: The services and operations which an international bank undertakes is a function of the regulatory environment in which the bank operates and the type of banking facility established.

A correspondent bank relationship is established when two banks maintain a correspondent bank account with one another. The correspondent banking system provides a means for a bank’s MNC client to conduct business worldwide through his local bank or its contacts.

A representative office is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in its dealings with the bank’s correspondents. It is a way for the parent bank to provide its MNC clients with a level of service greater than that provided through merely a correspondent relationship.

A foreign branch bank operates like a local bank, but legally it is a part of the parent bank. As such, a branch bank is subject to the banking regulations of its home country and the country in which it operates. The primary reason a parent bank would establish a foreign branch is that it can provide a much fuller range of services for its MNC customers through a branch office than it can through a representative office.

A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major part by a foreign subsidiary. An affiliate bank is one that is only partially owned, but not controlled by its foreign parent. Both subsidiary and affiliate banks operate under the banking laws of the country in which they are incorporated. U.S. parent banks find subsidiary and affiliate banking structures desirable because they are allowed to engage in security underwriting.

Edge Act banks are federally chartered subsidiaries of U.S. banks which are physically located in the United States that are allowed to engage in a full range of international banking activities. A 1919 amendment to Section 25 of the Federal

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Reserve Act created Edge Act banks. The purpose of the amendment was to allow U.S. banks to be competitive with the services foreign banks could supply their customers. Federal Reserve Regulation K allows Edge Act banks to accept foreign deposits, extend trade credit, finance foreign projects abroad, trade foreign currencies, and engage in investment banking activities with U.S. citizens involving foreign securities. As such, Edge Act banks do not compete directly with the services provided by U.S. commercial banks. Edge Act banks are not prohibited from owning equity in business corporations as are domestic commercial banks. Thus, it is through the Edge Act that U.S. parent banks own foreign banking subsidiaries and have ownership positions in foreign banking affiliates.

An offshore banking center is a country whose banking system is organized to permit external accounts beyond the normal economic activity of the country. Offshore banks operate as branches or subsidiaries of the parent bank. The primary activities of offshore banks are to seek deposits and grant loans in currencies other than the currency of the host government.

In 1981, the Federal Reserve authorized the establishment of International Banking Facilities (IBF). An IBF is a separate set of asset and liability accounts that are segregated on the parent bank’s books; it is not a unique physical or legal entity. IBFs operate as foreign banks in the U.S. IBFs were established largely as a result of the success of offshore banking. The Federal Reserve desired to return a large share of the deposit and loan business of U.S. branches and subsidiaries to the U.S.

3. How does the deposit-loan rate spread in the Eurodollar market compare with the deposit-loan rate spread in the domestic U.S. banking system? Why?

Answer: The deposit-loan spread in the Eurodollar market is narrower than in the domestic U.S. banking system. That is, in the Eurodollar market the deposit rate is greater than the deposit rate of dollars in the U.S. banking system and the lending rate is less. The Eurodollar market can operate at a lower cost than can the U.S. banking system because it is not subject to Federal Reserve Bank reserve requirements on deposits or FDIC deposit insurance.

4. What is the difference between the Euronote market, the Euro-medium-term-note market, and the Eurocommercial paper market?

Answer: Euronotes are short-term notes underwritten by a group of international investment or commercial banks called a “facility.” A client-borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a discount from face value, and pay back the full face value at maturity. Euronotes typically have maturities of from three to six months. Euro-medium-term notes (Euro MTNs) are typically fixed-rate notes issued by a corporation with maturities ranging from less than a year to about 10 years. Like fixed-rate bonds, Euro-MTNs have a fixed maturity and pay coupon interest at periodic dates. Unlike a bond issue, in which the entire issue is brought to market at once, permission is received for a Euro-MTN issue which is then partially sold on a continuous basis through an issuance facility that allows the borrower to obtain funds only as needed on a flexible basis. Eurocommercial paper is an unsecured short-term promissory note issued by a corporation or a bank and placed

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directly with the investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from face value. Maturities typically range from one to six months.

5. Briefly discuss the cause and the solution(s) to the international bank crisis involving less developed countries.

Answer: The international debt crisis began on August 20, 1982 when Mexico asked more than 100 U.S. and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more than 20 other developing countries announced similar problems in making the debt service on their bank loans. At the height of the crisis, Third World countries owed $1.2 trillion!

The international debt crisis had oil as its source. In the early 1970’s, the Organization of Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide. Throughout this time period, OPEC raised oil prices dramatically and amassed a tremendous supply of U.S. dollars, which was the currency generally demanded as payment from the oil importing countries.

OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly $100 billion. Eurobanks were faced with a huge problem of lending these funds in order to generate interest income to pay the interest on the deposits. Third World countries were only too eager to assist the equally eager Eurobankers in accepting Eurodollar loans that could be used for economic development and for payment of oil imports. The high oil prices were accompanied by high interest rates, high inflation, and high unemployment during the 1979-1981 period. Soon, thereafter, oil prices collapsed and the crisis was on.

Today, most debtor nations and creditor banks would agree that the international debt crisis is effectively over. U.S. Treasury Secretary Nicholas F. Brady of the Bush Administration is largely credited with designing a strategy in the spring of 1989 to resolve the problem. Three important factors were necessary to move from the debt management stage, employed over the years 1982-1988 to keep the crisis in check, to debt resolution. First, banks had to realize that the face value of the debt would never be repaid on schedule. Second, it was necessary to extend the debt maturities and to use market instruments to collateralize the debt. Third, the LDCs needed to open their markets to private investment if economic development was to occur. Debt-for-equity swaps helped pave the way for an increase in private investment in the LDCs. However, monetary and fiscal reforms in the developing countries and the recent privatization trend of state owned industry were also important factors.

Treasury Secretary Brady’s solution was to offer creditor banks one of three alternatives: (1) convert their loans to marketable bonds with a face value equal to 65 percent of the original loan amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5 percent; or, (3) lend additional funds to allow the debtor nations to get on their feet. The second alternative called for an extension the debt maturities by 25 to 30 years and the purchase by the debtor nation of zero-coupon U.S. Treasury bonds with a corresponding maturity to guarantee the bonds and make them marketable. These bonds have come to be called Brady bonds.

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6. What warning did David Hume, the 18th-century Scottish philosopher-economist, give about lending to sovereign governments?

Answer: (From the February 21, 1989 article “LDC Lenders Should Have Listened To David Hume” by Thomas M. Humphrey in The Wall Street Journal.)

Hume thought no good could result from borrowing:

If the abuses of treasures [held by the state] be dangerous by engaging the state in rash enterprise in confidence of its riches; the abuses of mortgaging are more certain and inevitable: poverty, impotence, and subjection to foreign powers.

Nations, presuming they can find the necessary lenders, are tempted to borrow without limit and to squander the funds on unproductive projects:

It is very tempting to a minister to employ such an expedient as enables him to make a great figure during his administration without over burthening the people with taxes or exciting any immediate clamorous against himself. The practice, therefore, of contracting debt will almost infallibly be abused in every government. It would scarcely be more imprudent to give a prodigal son a credit in every banker’s shop in London than to empower a statesman to draw bills in this manner upon posterity.

Eventually, however, interest must be paid and the burden of debt service charges will fall heavily on the poor:

The taxes which are levied to pay the interest of these debts are . . . an oppression on the poorer sort.

Those same taxes “hurt commerce and discourage industry” and thus inhibit economic development and condemn the borrowing nation to continuing poverty. The debt burden will also pauperize the prosperous merchant and landowning classes that constitute the main bulwark of political freedom and stability. With the pauperization of the middle class:

No expedient at all remains for resisting tyranny: Elections are swayed by bribery and corruption alone: And the middle power between king and people being totally removed, a grievous despotism must infallibly prevail. The landholders [and merchants] despised for their oppressions, will be utterly unable to make any opposition to it.

PROBLEMS

1. Grecian Tile Manufacturing of Athens, Georgia borrows $1,500,000 at LIBOR plus a lending margin of 1.25 percent per annum on a six-month rollover basis from a London bank. If six-month LIBOR is 4 ½ percent over the first six-month interval and 5 3/8 percent over the second six-month interval, how much will Grecian Tile pay in interest over the first year of its Eurodollar loan?

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Solution: $1,500,000 x (.045 + .0125)/2 + $1,500,000 x (.05375 + .0125)/2

= $43,125 + $49,687.50 = $92,812.50.

2. A bank sells a “three against nine” $3,000,000 FRA for a six-month period beginning three months from today and ending nine months from today. The purpose of the FRA is to cover the interest rate risk caused by the maturity mismatch from having made a three-month Eurodollar loan and having accepted a nine-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent. There are actually 183 days in the six-month period. Assume that three months from today the settlement rate is 4 7/8 percent. Determine how much the FRA is worth and who pays whom--the buyer pays the seller or the seller pays the buyer.

Solution: Since the settlement rate is less than the agreement rate, the buyer pays the seller the absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.04875-.055) x 183/360]/[1 + (.04875 x 183/360)]

= $3,000,000 x [-.003177/(1.024781)]

= $9,300.52.

3. Assume the settlement rate in problem 2 is 6 1/8 percent. What is the solution now?

Solution: Since the settlement rate is greater than the agreement rate, the seller pays the buyer the absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.06125-.055) x 183/360]/[1 + (.06125 x 183/360)]

= $3,000,000 x [.006250/(1.031135)]

= $18,183.85.

4. The Fisher effect (Chapter 5) suggests that nominal interest rates differ between countries because of differences in the respective rates of inflation. According to the Fisher effect and your examination of the long-term and short-term Eurocurrency interest rates presented in Exhibit 6.4, order the five countries from highest to lowest in terms of the size of the inflation premium imbedded in the nominal interest rates for 1998.

Solution: According to the Fisher effect, both the short-term and the long-term interest rates suggest that the inflation premiums for the four countries (or zone) ordered from highest to lowest are: Great Britain, the United States, the Euro-zone, and Japan.

5. A bank has a $500 million portfolio of investments and bank credits. The daily standard deviation of return on this portfolio is .666 percent. Capital adequacy standards require the bank to maintain capital equal to its VAR calculated over a ten-day holding period. What is the capital charge for the bank?

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Solution: VAR = $500 million x .00666 x 2.236 x √10 = $24.49 million.

Appendix 6A Question

1. Verbally explain how Eurocurrency is created.

Answer: The core of the international money market is the Eurocurrency market. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issues the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of the United States. As an illustration, assume a U.S. Importer purchases $100 of merchandise from a German Exporter and pays for the purchase by drawing a $100 check on his U.S. checking account (demand deposit). If the funds are not needed for the operation of the business, the German Exporter can deposit the $100 in a time deposit in a bank outside the U.S. and receive a greater rate of interest than if the funds were put in a U.S. time deposit. Assume the German Exporter deposits the funds in a London Eurobank. The London Eurobank credits the German Exporter with a $100 time deposit and deposits the $100 into its correspondent bank account (demand deposit) with the U.S. Bank (banking system) to hold as reserves. Two points are noteworthy. First, the entire $100 remains on deposit in the U.s. Bank. Second, the $100 time deposit of the German Exporter in the London Eurobank represents the creation of Eurodollars. This deposit exists in addition to the dollars deposited in the U.S. Hence, no dollars have flowed out of the U.S. banking system in the creation of Eurodollars.

CHAPTER 12 INTERNATIONAL BOND MARKETS

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Describe the differences between foreign bonds and Eurobonds. Also discuss why Eurobonds make up the lions share of the international bond market.

Answer: The two segments of the international bond market are: foreign bonds and Eurobonds. A foreign bond issue is one offered by a foreign borrower to investors in a national capital market and denominated in that nation’s currency. A Eurobond issue is one denominated in a particular currency, but sold to investors in national capital markets other than the country which issues the denominating currency.

Eurobonds make up over 80 percent of the international bond market. The two major reasons for this stem from the fact that the U.S. dollar is the currency most frequently sought in international bond financing. First, Eurodollar bonds can be

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brought to market more quickly than Yankee bonds because they are not offered to U.S. investors and thus do not have to meet the strict SEC registration requirements. Second, Eurobonds are typically bearer bonds that provide anonymity to the owner and thus allow a means for evading taxes on the interest received. Because of this feature, investors are generally willing to accept a lower yield on Eurodollar bonds in comparison to registered Yankee bonds of comparable terms, where ownership is recorded. For borrowers the lower yield means a lower cost of debt service.

2. Briefly define each of the major types of international bond market instruments, noting their distinguishing characteristics.

Answer: The major types of international bond instruments and their distinguishing characteristics are as follows:

Straight fixed-rate bond issues have a designated maturity date at which the principal of the bond issue is promised to be repaid. During the life of the bond, fixed coupon payments that are some percentage rate of the face value are paid as interest to the bondholders. This is the major international bond type. Straight fixed-rate Eurobonds are typically bearer bonds and pay coupon interest annually.

Floating-rate notes (FRNs) are typically medium-term bonds with their coupon payments indexed to some reference rate. Common reference rates are either three-month or six-month U.S. dollar LIBOR. Coupon payments on FRNs are usually quarterly or semi-annual, and in a accord with the reference rate.

A convertible bond issue allows the investor to exchange the bond for a pre-determined number of equity shares of the issuer. The floor value of a convertible bond is its straight fixed-rate bond value. Convertibles usually sell at a premium above the larger of their straight debt value and their conversion value. Additionally, investors are usually willing to accept a lower coupon rate of interest than the comparable straight fixed coupon bond rate because they find the call feature attractive. Bonds with equity warrants can be viewed as a straight fixed-rate bond with the addition of a call option (or warrant) feature. The warrant entitles the bondholder to purchase a certain number of equity shares in the issuer at a pre-stated price over a pre-determined period of time.

Zero coupon bonds are sold at a discount from face value and do not pay any coupon interest over their life. At maturity the investor receives the full face value. Another form of zero coupon bonds are stripped bonds. A stripped bond is a zero coupon bond that results from stripping the coupons and principal from a coupon bond. The result is a series of zero coupon bonds represented by the individual coupon and principal payments.

A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays coupon interest in that same currency. At maturity, the principal is repaid in a second currency. Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a dual currency bond includes a long-term forward contract.

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Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs, instead of a single currency. They are frequently called currency cocktail bonds. They are typically straight fixed-rate bonds. The currency composite is a portfolio of currencies: when some currencies are depreciating others may be appreciating, thus yielding lower variability overall.

3. Why do most international bonds have high Moody’s or Standard & Poor’s credit ratings?

Answer: Moody’s Investors Service and Standard & Poor’s provide credit ratings on most international bond issues. It has been noted that a disproportionate share of international bonds have high credit ratings. The evidence suggests that a logical reason for this is that the Eurobond market is only accessible to firms that have good credit ratings to begin with.

4. What factors does Standard & Poor’s analyze in determining the credit rating it assigns a sovereign government?

Answer: In rating a sovereign government, S&P’s analysis centers around an examination of the degree of political risk and economic risk. In assessing political risk, S & P examines the stability of the political system, the social environment, and international relations with other the countries. Factors examined in assessing economic risk include the sovereign’s external financial position, balance of payments flexibility, economic structure and growth, management of the economy, and economic prospects. The rating assigned a sovereign is particularly important because it usually represents the ceiling for ratings S&P will assign an obligation of an entity domiciled within that country.

5. Discuss the process of bringing a new international bond issue to market.

Answer: A borrower desiring to raise funds by issuing Eurobonds to the investing public will contact an investment banker and ask it to serve as lead manager of an underwriting syndicate that will bring the bonds to market. The lead manager will usually invite other banks to form a managing group to help negotiate terms with the borrower, ascertain market conditions, and manage the issuance. The managing group, along with other banks, will serve as underwriters for the issue, i.e., they will commit their own capital to buy the issue from the borrower at a discount from the issue price. Most of the underwriters, along with other banks, will be part of a selling group that sells the bonds to the investing public. The various members of the underwriting syndicate receive a portion of the spread (usually in the range of 2 to 2.5 percent of the issue size), depending upon the number and type of functions they perform. The lead manager receives the full spread, and a bank serving as only a member of the selling group receives a smaller portion.

6. You are an investment banker advising a Eurobank about a new international bond offering it is considering. The proceeds are to be used to fund Eurodollar loans to bank clients. What type of bond instrument would you recommend that the bank consider issuing? Why?

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Answer: Since the Eurobank desires to use the bond proceeds to finance Eurodollar loans, which are floating-rate loans, the investment banker should recommend that the bank issue FRNs, which are a variable rate instrument. Thus there will a correspondence between the interest rate the bank pays for funds and the interest rate it receives from its loans. For example, if the bank frequently makes term loans at indexed to 3-month LIBOR, it might want to issue FRNs, also, indexed to 3-month LIBOR.

7. What should a borrower consider before issuing dual currency bonds? What should an investor consider before investing in dual currency bonds?

Answer: A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays coupon interest in that same currency. At maturity, the principal is repaid in a second currency. Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a dual currency bond includes a long-term forward contract. If the second currency appreciates over the life of the bond, the principal repayment will be worth more than a return of principal in the issuing currency. However, if the payoff currency depreciates, the investor will suffer an exchange rate loss. Dual currency bonds are attractive to MNCs seeking financing in order to establish or expand operations in the country issuing the payoff currency. During the early years, the coupon payments can be made by the parent firm in the issuing currency. At maturity, the MNC anticipates the principal to be repaid from profits earned by the subsidiary. The MNC may suffer an exchange rate loss if the subsidiary is unable to repay the principal and the payoff currency has appreciated relative to the issuing currency. Consequently, both the borrower and the investor are exposed to exchange rate uncertainty from a dual currency bond.

PROBLEMS:

1. You firm has just issued five year floating-rate notes indexed to six-month U.S. dollar LIBOR plus 1/4%. What is the amount of first coupon payment your firm will pay per U.S. $1,000 of face value, if six-month LIBOR is currently 7.2%?

Solution: 0.5 x (.072 + .0025) x $1,000 = $37.25.

2. The discussion of zero-coupon bonds in the text gave an example of two zero-coupon bonds issued by Commerzbank. The DM300,000,000 issue due in 1995 sold at 50 percent of face value and the DM300,000,000 due in 2000 sold at 33 1/3 percent of face value; both were issued in 1985. Calculate the implied yield-to-maturity of each of these two zero-coupon bond issues.

Solution: The bonds due in 1995 sold at 50% percent of face value. Since they were issued in 1985, they had a ten year maturity. Assuming a DM1,000 par value, their yield-to-maturity is: (DM1,000/DM500)1/10 - 1 = .07177 or 7.177% per annum.

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The bonds due in year 2000 sold at 33 1/3%. They have a 15 year maturity. Their yield-to-maturity is: (DM1,000/DM333.33)1/15 - 1 =.07599 or 7.599% per annum.

3. Consider 8.5 percent Swiss franc/U.S. dollar dual currency bonds that pay $666.67 at maturity per SF1,000 of par value. What is the implicit SF/$ exchange rate at maturity? Will the investor be better or worse off at maturity if the actual SF/$ exchange rate is SF1.35/$1.00?

Solution: Implicitly, the dual currency bonds call for the exchange of SF1,000 of face value for $666.67. Therefore, the implicit exchange rate built into the dual currency bond issue is SF1,000/$666.67, or SF1.50/$1.00. If the exchange rate at maturity is SF1.35/$1.00, SF1,000 would buy $740.74 = SF1,000/SF1.35. Thus, the dual currency bond investor is worse off with $666.67 because the dollar is at a depreciated level in comparison to the implicit exchange rate of SF1.50/$1.00.

MINI CASE: SARA LEE CORP.’S EUROBONDS

The International Finance in Practice boxed reading in the chapter discussed a three-year $100 million Eurobond issue by Sara Lee Corporation. The article also mentions other bond issues recently placed by various foreign divisions of Sara Lee. What thoughts do you have about Sara Lee’s debt financing strategy?

Suggested Solution to Sara Lee Corp.’s Eurobonds

Sara Lee is the ideal candidate to issue Eurobonds. The company has worldwide name recognition, and it has an excellent credit rating that allows it to place new bond issues easily. By issuing dollar denominated Eurobonds to Swiss investors, Sara Lee can bring new issues to market much more quickly than if it sold domestic dollar denominated bonds. Moreover, the Eurodollar bonds likely sell at a lower yield than comparable domestic bonds.

Additionally, it appears as if Sara Lee is raising funds in a variety of foreign currencies. Sara Lee most likely has large cash inflows in these same currencies that can be used to meet the debt service obligations on these bond issues. Thus Sara Lee is finding a use for some of its foreign currency receipts and does not have to be concerned with the exchange rate uncertainty of these part of its foreign cash inflows.

CHAPTER 13 INTERNATIONAL EQUITY MARKETS

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

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1. Get a current copy of The Wall Street Journal and find the Dow Jones Global Indexes listing in Section C of the newspaper. Examine the 12-month changes in U.S. dollars for the various national and regional indices. How do the changes from your table compare with the 12-month changes from the sample provided in the textbook as Exhibit 8.8? Are they all of similar size? Are the same national indexes positive and negative in both listings? Discuss your findings.

Answer: This question is designed to provide an intuitive understanding of the benefits from international diversification of equity portfolios. It is very unlikely that the student will find many, if any, national market indexes that have 12- month returns that are even close to the same level as in Exhibit 8.8. Over different time periods, different market forces will affect each national market in unique ways and the exchange rates will be different. Some markets that previously yielded a positive return will now show a negative return, and vice versa. Similarly, some markets that had yielded a large positive (negative) return may now show only a small positive (negative) return.

2. As an investor, what factors would you consider before investing in the emerging stock market of a developing country?

Answer: An investor in emerging market stocks needs to be concerned with the depth of the market and the market’s liquidity. Depth of the market refers to the opportunities to invest in the country. One measure of the depth of the market is the concentration ratio of a country’s stock market. The concentration ratio frequently is calculated to show the market value of the ten largest stock traded as a fraction of the total market capitalization of all equities traded. The lower the concentration ratio, the less deep is the market. That is, most value is concentrated in only a few companies. While this does not necessarily imply that the largest stocks in the emerging market are not good investments, it does, however, suggest that there are few opportunities for investment in that country and that proper diversification within the country may be difficult. In terms of liquidity, an investor would be wise to examine the market turnover ratio of the country’s stock market. High market turnover suggests that the market is liquid, or that there are opportunities for purchasing or selling the stock quickly at close to the current market price. This is important because liquidity means you can get in or out of a stock position quickly without spending more than you intended on purchase or receiving less than you expected on sale.

3. Compare and contrast the various types of secondary market trading structures.

Answer: There are two basic types of secondary market trading structures: dealer and agency. In a dealer market, the dealer serves as market maker for the security, holding an inventory of the security. The dealer buys at his bid price and sells at his asked price from this inventory. All public trades go through the dealer. In an agency market, public trades go through the agent who matches it with another public trade. Both dealer and agency markets can be continuous trade markets, but non-continuous markets tend to be only agency markets. Over-the-counter trading, specialist markets, and automated markets are types of continuous market trading systems. Call markets and crowd trading are each types of non-continuous trading market systems. Continuous trading systems are desirable for actively traded issues, whereas call

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markets and crowd trading offer advantages for smaller markets with many thinly traded issues because they mitigate the possibility of sparse order flow over short time periods.

4. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than one national exchange, and, (b) to source new equity capital from foreign investors as well as domestic investors.

Answer: A MNC that has a product market presence or manufacturing facilities in several countries may cross-list its shares on the exchanges of these same countries because there is typically investor demand for the shares of companies that are known within a country. Additionally, a company may cross-list its shares on foreign exchanges to broaden its investor base and therefore to increase the demand for the its stock. An increase in demand will generally increase the stock price and improve the its market liquidity. A broader investor base may also mitigate the possibility of a hostile takeover. Additional, cross-listing a company’s shares establishes name recognition and thus facilitates sourcing new equity capital in these foreign capital markets.

5. Why might it be easier for an investor desiring to diversify his portfolio internationally to buy depository receipts rather than the actual shares of the company?

Answer: A depository receipt can be purchased on the investor’s domestic exchange. It represents a package of the underlying foreign security that is priced in the investor’s local currency and in a trading range that is typical for the investor’s marketplace. The investor can purchase a depository receipt directly from his domestic broker, rather than having to deal with an overseas broker and the necessity of obtaining foreign funds to make the foreign stock purchase. Additionally, dividends are received in the local currency rather than in foreign funds that would need to be converted into the local currency.

6. Why do you think the empirical studies about factors affecting equity returns basically showed that domestic factors were more important than international factors, and, secondly, that industrial membership of a firm was of little importance in forecasting the international correlation structure of a set of international stocks?

Answer: While national security markets have become more integrated in recent years, there is still a tremendous amount of segmentation that brings about the benefit to be derived from international diversification of financial assets. Monetary and fiscal policies differ among countries because of different economic circumstances. The economic policies of a country directly affect the securities traded in the country, and they will behave differently than securities traded in another country with other economic policies being implemented. Hence, it is not surprising that domestic factors are found to be more important than international factors in affecting security returns. Similarly, industrial activity within a country is also affected by the economic policies of the country; thus firms in the same industry group, but from different countries, will not necessarily behave the same in all countries, nor should we expect the securities issued by these firms to behave alike.

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PROBLEMS

1. On the Milan bourse, Fiat stock closed at EUR31.90 per share on Friday, September 10, 1999. Fiat trades as and ADR on the NYSE. One underlying Fiat share equals one ADR. On September 10, the $/EUR spot exchange rate was $1.0367/EUR1.00. At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR?

Solution: The no-arbitrage ADR U.S. dollar price is: EUR31.90 x $1.0367 = $33.07.

2. If Fiat ADRs were trading at $35 when the underlying shares were trading in Milan at EUR31.90, what could you do to earn a trading profit? Use the information in problem 1, above, to help you and assume that transaction costs are negligible.

Solution: As the solution to problem 1 shows, the no-arbitrage ADR U.S. dollar price is $33.07. If Fiat ADRs were trading at $35, a wise investor would sell short the relatively overvalued ADRs and use the proceeds to buy the relatively undervalued Fiat shares on the Milan exchange. The profit would be $35 - $33.07 = $1.93 per ADR.

CHAPTER 9 MANAGEMENT OF ECONOMIC EXPOSURE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. How would you define economic exposure to exchange risk?

Answer: Economic exposure can be defined as the possibility that the firm’s cash flows and thus its market value may be affected by the unexpected exchange rate changes.

2. Explain the following statement: “Exposure is the regression coefficient”.

Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s future cash flows and the market value to random changes in exchange rates. Statistically, this sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the regression coefficient.

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3. Suppose that your company has an equity position in a French firm. Discuss the condition under which the dollar/franc exchange rate uncertainty does not constitute exchange exposure for your company.

Answer: Mere changes in exchange rates do not necessarily constitute currency exposure. If the French franc value of the equity moves in the opposite direction as much as the dollar value of the franc changes, then the dollar value of the equity position will be insensitive to exchange rate movements. As a result, your company will not be exposed to currency risk.

4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.

Answer: The competitive effect: exchange rate changes may affect operating cash flows by altering the firm’s competitive position.

The conversion effect: A given operating cash flows in terms of a foreign currency will be converted into higher or lower dollar (home currency)amounts as the exchange rate changes.

5. Discuss the determinants of operating exposure.

Answer: The main determinants of a firm’s operating exposure are (1) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (2) the firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.

6. Discuss the implications of purchasing power parity for operating exposure.

Answer: If the exchange rate changes are matched by the inflation rate differential between countries, firms’ competitive positions will not be altered by exchange rate changes. Firms are not subject to operating exposure.

7. General Motors exports cars to Spain but the strong dollar against the peseta hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from the Italian and French car makers, such as Fiat and Renault, whose currencies remain stable relative to the peseta. What kind of measures would you recommend so that GM can maintain its market share in Spain.

Answer: Possible measures that GM can take include: (1) diversify the market; try to market the cars not just in Spain and other European countries but also in, say, Asia; (2) locate production facilities in Spain and source inputs locally; (3) locate production facilities, say, in Mexico where production costs are low and export to Spain from Mexico.

8. What are the advantages and disadvantages of financial hedging of the firm’s operating exposure vis-a-vis operational hedges (such as relocating manufacturing site)?

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Answer: Financial hedging can be implemented quickly with relatively low costs, but it is difficult to hedge against long-term, real exposure with financial contracts. On the other hand, operational hedges are costly, time-consuming, and not easily reversible.

9. Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge against exchange rate exposure.

Answer: To establish multiple manufacturing sites can be effective in managing exchange risk exposure, but it can be costly because the firm may not be able to take advantage of the economy of scale.

10. Evaluate the following statement: “A firm can reduce its currency exposure by diversifying across different business lines”.

Answer: Conglomerate expansion may be too costly as a means of hedging exchange risk exposure. Investment in a different line of business must be made based on its own merit.

11. The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.

Answer: A firm can have a natural hedging position due to, for example, diversified markets, flexible sourcing capabilities, etc. In addition, to the extent that the PPP holds, nominal exchange rate changes do not influence firms’ competitive positions. Under these circumstances, firms do not need to worry about exchange risk exposure.

PROBLEMS

1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, we are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

(b) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty.

(c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging.

Solution: (a) Let us compute the necessary parameter values:

E(P) = (.6)(2800)+(.4)(2250) = 1680+900 = $2,580

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E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

= .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)

= -5.28-7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

You have a negative exposure! As the pound gets stronger(weaker) against the dollar, the dollar value of your British holding goes down(up).

(b) b2Var(S) = (-5500)2(.0024) =72,600($)2

(c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your British asset that is due to the exchange rate volatility.

2. A U.S. firm holds an asset in France and faces the following scenario:

State 1

State 2

State 3

State 4

Probability

25%

25%

25%

25%

Spot rate

$.30/FF

$.25/FF

$.20/FF

$.18/FF

P*

FF1500

FF1400

FF1300

FF1200

P

$450

$350

$260

$216

In the above table, P* is the French franc price of the asset held by the U.S. firm and P is the dollar price of the asset.

(a) Compute the exchange exposure faced by the U.S. firm.

(b) What is the variance of the dollar price of this asset if the U.S. firm remains unhedged against this exposure.

c. In case the U.S. firm hedges against this exposure using the forward contract, what is the variance of the dollar value of the hedged position?

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Solution: (a)

E(P) = .25(.30+.25+.20+.18) = $.2325

E(P) = .25(450+350+260+216) = $319

Var(S) = .25[(.30-.2325)2+(.25-.2325)2+(.2-.2325)2+(.18-.2325)2]

= .0022

Cov(P,S) = .25[(450-319)(.30-.2325)+(350-319)(.25-.2325)

(260-319)(.20-.2325)+(216-319)(.18-.2325)]

= 4.18

b = Cov(P,S)/Var(S) = 4.18/.0022 = FF1,900.

(b) Var(P) = .25[(450-319)2+(350-319)2+(260-319)2+(216-319)2]

= 8,053($)2.

(c) Var(P) - b2Var(S) = 8053-(1900)2(.0022) = 111($)2.

This means that most of the volatility of the dollar value of the French asset can be removed by hedging exchange risk.

CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. How would you define transaction exposure? How is it different from economic exposure?

Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and short-term.

2. Discuss and compare hedging transaction exposure using the forward contract vs. money market instruments. When do the alternative hedging approaches produce the same result?

Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand,

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money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.

3. Discuss and compare the costs of hedging via the forward contract and the options contract.

Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging, however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging, however, may be realized ex post when the hedger regrets his/her hedging decision.

4. What are the advantages of a currency options contract as a hedging tool compared with the forward contract?

Answer: The main advantage of using options contracts for hedging is that the hedger can decide whether to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the downside risk while retaining the upside potential.

5. Suppose your company has purchased a put option on the German mark to manage exchange exposure associated with an account receivable denominated in that currency. In this case, your company can be said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.

Answer: Your company in this case knows in advance that it will receive a certain minimum dollar amount no matter what might happen to the $/DM exchange rate. Furthermore, if the German mark appreciates, your company will benefit from the rising mark.

6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?

Answer: There can be many possible reasons for this. First, many firms may feel that they are not really exposed to exchange risk due to product diversification, diversified markets for their products, etc. Second, firms may be using self-insurance against exchange risk. Third, firms may feel that shareholders can diversify exchange risk themselves, rendering corporate risk management unnecessary.

7. Should a firm hedge? Why or why not?

Answer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations by hedging which stabilizes corporate earnings.

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8. Using an example, discuss the possible effect of hedging on a firm’s tax obligations.

Answer: One can use an example similar to the one presented in the chapter.

9. Explain contingent exposure and discuss the advantages of using currency options to manage this type of currency exposure.

Answer: Companies may encounter a situation where they may or may not face currency exposure. In this situation, companies need options, not obligations, to buy or sell a given amount of foreign exchange they may or may not receive or have to pay. If companies either hedge using forward contracts or do not hedge at all, they may face definite currency exposure.

10. Explain cross-hedging and discuss the factors determining its effectiveness.

Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging would depend on the strength and stability of the relationship between the two assets.

PROBLEMS

1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced DM 10 million payable in six months. Currently, the six-month forward exchange rate is $1.50/DM and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.43 in six months.

(a) What is the expected gain/loss from the forward hedging?

(b) If you were the financial manager of Cray Research, would you recommend hedging this DM receivable? Why or why not?

(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?

Solution: (a) Expected gain($) = 10,000,000(1/1.50-1/1.43)

= 10,000,000(.6667-.6993)

= -$326,000.

(b) There is no easy answer here. Hedging is expected to reduce the dollar receipt by $326,000. If I were willing to sacrifice $326,000 or more to eliminate exchange risk, I would hedge. Otherwise, I would not. It depends on the degree of my risk aversion.

(c) Since I eliminate risk without sacrificing dollar receipt, I would be more likely to hedge.

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2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is ¥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable.

(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

(b) Conduct the cash flow analysis of the money market hedge.

Solution: (a). Let’s first compute the PV of ¥250 million, i.e.,

250m/1.0175 = ¥245,700,245.7

So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity value will be exactly equal to ¥25 million which is the amount of payable.

To buy the above yen amount today, it will cost:

$2,340,002.34 = ¥250,000,000/105.

The dollar cost of meeting this yen obligation is $2,340,002.34 as of today.

(b)

___________________________________________________________________

Transaction CF0 CF1

____________________________________________________________________

1. Buy yens spot -$2,340,002.34

with dollars ¥245,700,245.70

2. Invest in Japan - ¥245,700,245.70 ¥250,000,000

3. Pay yens - ¥250,000,000

Net cash flow - $2,340,002.34

____________________________________________________________________

3. You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call

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option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.

(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.

(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?

(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.

Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 = $250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price, you don’t expect to exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of buying SF5,000 will be the sum of $3,150 and $253.75, i.e., $3,403.75.

(b) $3,150 = (.63)(5,000).

(c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised.

(d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 = $3,200 + $253.75.

This is the maximum you will pay.

4. McDonnell Douglas just signed a contract to sell a DC 10 aircraft to Air France. Air France will be billed FF50 million which is payable in one year. The current spot exchange rate is $0.20/FF and the one-year forward rate is $0.19/FF. The annual interest rate is 6.0% in the U.S. and 9.5% in France. McDonnell Douglas is concerned

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with the volatile exchange rate between the dollar and the franc and would like to hedge exchange exposure.

(a) It is considering two hedging alternatives: sell the franc proceeds from the sale forward or borrow francs from the Credit Lyonnaise against the franc receivable. Which alternative would you recommend? Why?

(b) Other things being equal, at what forward exchange rate would McDonnell Douglas be indifferent between the two hedging methods?

Solution: (a) In the case of forward hedge, the future dollar proceeds will be (50,000,000)(0.19) = $9,500,000.

In the case of money market hedge (MMH), the firm has to first borrow the PV of its franc receivable, i.e.,

50,000,000/1.095 =FF45,662,100. Then the firm should exchange this franc amount into dollars at the current spot rate to receive: (FF45,662,100)(0.20) = $9,132,420, which can be invested at the dollar interest rate for one year to yield:

$9,132,420(1.06) = $9,680,365.

Clearly, the firm can receive $180,365 more by using MMH.

(b) According to IRP, F = S(1+i$)/(1+iF). Thus the “indifferent” forward rate will be:

F = 0.20(1.06)/1.095 = $0.1936/FF.

5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss client a choice of paying either $10,000 or SF 15,000 in three months.

(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to buy up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate?

(b) If the spot exchange rate turns out to be $0.62/SF, which currency do you think the Swiss client will choose to use for payment? What is the value of this free option for the Swiss client?

(c) What is the best way for Baltimore Machinery to deal with the exchange exposure?

Solution: (a) The implied exercise (price) rate is: 10,000/15,000 = $0.6667/SF.

(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62).

Since the Swiss client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously SF1,129 (=SF16,129-SF15,000).

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(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000.

6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen.

(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges.

(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.

(c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge?

Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124)

= $4,147,465.

(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08) = $75,600.

At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).

The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.

(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges.

CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

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QUESTIONS

1. Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method.

Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation.

2. How are translation gains and losses handled differently according to the current rate method in comparison to the other three methods, that is, the current/noncurrent method, the monetary/nonmonetary method, and the temporal method?

Answer: Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the “cumulative translation adjustment” account. Nothing passes through the income statement. The other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.

3. Identify some instances under FASB 52 that a foreign entity’s functional currency would be the same as the parent firm’s currency.

Answer: Three examples under FASB 52, where the foreign entity’s functional currency will be the same as the parent firm’s currency, are: i) the foreign entity’s cash flows directly affect the parent’s cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entity’s products are responsive on a short-term basis to exchange rate changes, where sales prices are determined through worldwide competition; and, iii) the sales market is primarily located in the parent’s country or sales contracts are denominated in the parent’s currency.

4. Describe the remeasurement and translation process under FASB 52 of translating into the reporting currency the books of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is different than its functional currency.

Answer: For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second, translate from the functional currency into the reporting currency using the current rate method of translation.

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5. It is, generally, not possible to completely eliminate both translation exposure and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one exposure actually creates the other. Discuss which exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises. Also, discuss and critique the common methods for controlling translation exposure.

Answer: Since it is, generally, not possible to completely eliminate both transaction and translation exposure, we recommend that transaction exposure be given first priority since it involves real cash flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash flows, and will only have a realizable effect on net investment upon the sale or liquidation of the assets.

There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the “hedge” may result in the loss of real cash flows.

PROBLEMS

1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 14.7 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.

Solution: The following table provides a translation exposure report for Centralia Corporation and its affiliates under FASB 8, which is essentially the temporal method of translation. The difference between the new report and Exhibit 14.7 is that nonmonetary accounts such as inventory and fixed assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these accounts will not change values when exchange rates change and they do not create translation exposure.

Examination of the table indicates that under FASB 8 there is negative net exposure for the Mexican peso and the Spanish peseta, whereas under FASB 52 the net exposure for these currencies is positive. There is no change in net exposure for the Canadian dollar and the French franc. Consequently, if the Spanish peseta depreciates against the dollar from Ptas140.00/$1.00 to Ptas150.00/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller amount than exposed

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liabilities, instead of vice versa. The associated reporting currency imbalance will be $239,333, calculated as follows:

Reporting Currency Imbalance=

Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates,

December 31, 1997 (in 000 currency units)

Canadian

Dollar

Mexican

Peso

Spanish

Peseta

French

Franc Assets Cash CD200 PS 1,800 Ptas 105,000 FF 0 Accounts receivable 0 2,700 133,000 0 Inventory 0 0 0 0 Net fixed assets 0 0 0 0 Exposed assets CD200 PS 4,500 Ptas 238,000 FF 0 Liabilities Accounts payable CD 0 Ps 2,100 Ptas 173,600 FF 0 Notes payable 0 5,100 119,000 1,400 Long-term debt 0 8,100 448,000 0 Exposed liabilities CD 0 Ps15,300 Ptas 740,600 FF1,400 Net exposure CD200 (Ps10,800) (Ptas502,600) (FF1,400)

2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet for Centralia Corporation and its affiliates after a depreciation of the Spanish peseta from Ptas140.00/$1.00 to Ptas150.00/$1.00 that is the counterpart to Exhibit 14.8 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.

Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the Spanish peseta depreciated there would be a reporting currency imbalance of $239,333. Under FASB 8 this is carried through the income statement as a foreign exchange gain to the retained earnings on the balance sheet. The following table shows that consolidated retained earnings increased to $4,190,000 from $3,950,000 in Exhibit 14.8. This is an increase of $240,000, which is the same as the reporting currency imbalance after accounting for rounding error.

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Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates,

December 31, 1997 (in $000): Post-Exchange Rate Change.

Centralia Corp.

(parent)

Mexican

Affiliate

Spanish

Affiliate

Consolidated Balance Sheet

Assets

Cash

$ 950a

$ 600

$ 700

$ 2,250

Accounts receivable

1,450b

900

887

3,237

Inventory

3,000

1,500

1,500

6,000

Investment in Mexican affiliate

-c

-

-

-

Investment in Spanish affiliate

-d

-

-

-

Net fixed assets

9,000

4,600

4,000

17,600

Total assets

$29,087

Liabilities and Net Worth

Accounts payable

$1,800

$ 700b

$1,157

$ 3,657

Notes payable

2,200

1,700

1,043e

4,943

Long-term debt

7,110

2,700

2,987

12,797

Common stock

3,500

-c

-d

3,500

Retained earnings

4,190

-c

-d

4,190

Total liabilities and net worth

$29,087

aThis includes CD200,000 the parent firm has in a Canadian bank, carried as $150,000. CD200,000/(CD1.3333/$1.00) = $150,000.

b$1,750,000 - $300,000 (= Ps900,000/(Ps3.00/$1.00)) intracompany loan = $1,450,000.

c,dInvestment in affiliates cancels with the net worth of the affiliates in the consolidation.

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eThe Spanish affiliate owes a French bank FF1,400,000 (x Ptas26.79/FF1.00 = Ptas37,506,000). This is carried on the books,

after the exchange rate change, as part of Ptas156,506,000 = Ptas37,506,000 + Ptas119,000,000.

Ptas156,506,000/(Ptas150/$1.00) = $1,043,373.

3. In Example 14.2, a forward contract was used to establish a derivatives “hedge” to protect Centralia from a translation loss if the peseta depreciated from Ptas140/$1.00 to Ptas150/$1.00. Assume that an over-the-counter call option on the dollar with a striking price of Ptas145 can be purchased for Ptas1.50. Show how the potential translation loss can be “hedged” with an option contract.

Solution: As in example 14.2, if the potential translation loss is $110,667, the equivalent amount in functional currency that needs to be hedged is Ptas481,400,00. If in fact the peseta does depreciate to Ptas150/$1.00, Ptas481,400,000 can be purchased in the spot market for $3,209,333. At a striking price of Ptas145/$1.00, the Ptas481,400,000 can be used to purchase $3,320,000, yielding a gross profit of $110,667. At the initial exchange rate of Ptas140/$1.00, the call option cost ($3,320,000 x Ptas1.50)/Ptas140 = $35,571. Thus, at an exchange rate of Ptas150/$1.00, the call option will effectively hedge $110,667 - $35,571 = $75,096 of the potential translation loss. At terminal exchange rates of Ptas145/$1.00 to Ptas150/$1.00, the call option hedge will be less effective. An option contract does not have to be exercised if doing so is disadvantageous to the option owner. The call will not be exercised at exchange rates of less than Ptas145/$1.00, in which case the “hedge” will lose the $35,571 cost of the option.

MINI CASE: SUNDANCE SPORTING GOODS, INC.

Sundance Sporting Goods, Inc. is a U.S. manufacturer of high-quality sporting goods--principally golf, tennis and other racquet equipment, and also lawn sports, such as croquet and badminton-- with administrative offices and manufacturing facilities in Chicago, Illinois. Sundance has two wholly owned manufacturing affiliates, one in Mexico and the other in Canada. The Mexican affiliate is located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional currency for the affiliate. The current exchange rates are: $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800. The nonconsolidated balance sheets for Sundance and its two affiliates appear in the accompanying table.

Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates,

December 31, 1997 (in 000 currency units)

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Sundance, Inc.

(parent)

Mexican

Affiliate

Canadian

Affiliate Assets

Cash

$ 1,500

Ps 1,420

CD 1,200

Accounts receivable

2,500a

2,800e

1,500f

Inventory

5,000

6,200

2,500

Investment in Mexican affiliate

2,400b

-

-

Investment in Canadian affiliate

3,600c

-

-

Net fixed assets

12,000

11,200

5,600

Total assets

$27,000

Ps21,620

CD10,800

Liabilities and Net Worth

Accounts payable

$ 3,000

Ps 2,500a

CD 1,700

Notes payable

4,000d

4,200

2,300

Long-term debt

9,000

7,000

2,300

Common stock

5,000

4,500b

2,900c

Retained earnings

6,000

3,420b

1,600c

Total liabilities and net worth

$27,000

Ps21,620

CD10,800

aThe parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parent’s accounts receivable as $400,000, translated at Ps3.30/$1.00. The remainder of the parent’s (Mexican affiliate’s) accounts receivable (payable) are denominated in dollars

(pesos).

bThe Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $2,400,000. This represents the sum

of the common stock (Ps4,500,000) and retained earnings (Ps3,420,000) on the Mexican affiliate’s books, translated at Ps3.30/$1.00.

cThe Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $3,600,000. This represents the sum of the common stock (CD2,900,000) and the retained earnings (CD1,600,000) on the Canadian affiliate’s books, translated at

CD1.25/$1.00.

dThe parent firm has outstanding notes payable of ¥126,000,000 due a Japanese bank. This sum is carried on the parent firm’s books as

$1,200,000, translated at ¥105/$1.00. Other notes payable are denominated in U.S. dollars.

eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican

affiliate’s books as Ps396,000, translated at A1.00/Ps3.30. Other accounts receivable are denominated in Mexican pesos.

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fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This sum is carried on the Canadian

affiliate’s books as CD300,000, translated at W800/CD1.25. Other accounts receivable are denominated in Canadian dollars.

You joined the International Treasury division of Sundance six months ago after spending the last two years receiving your MBA degree. The corporate Treasurer has asked you to prepare a report analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked you to address in your analysis the relationship between the firm’s translation exposure and its transaction exposure. After performing a forecast of future spot rates of exchange, you decide that you must do the following before any sensible report can be written.

a. Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52.

b. i. Prepare a translation exposure report for Sundance Sporting Goods, Inc., and its two affiliates.

b. ii. Using the translation exposure report you have prepared, determine if any reporting currency imbalance will result from the change in exposure currency exchange rates. Your forecast is that exchange rates will change from $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800 to $1.00 = CD1.30 = Ps3.30 = A1.03 = ¥105 = W800.

c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in the future. Determine how any reporting currency imbalance will affect the new consolidated balance sheet for the MNC.

d. i. Prepare a transaction exposure report for Sundance and its affiliates. Determine if any transaction exposures are also translation exposures.

d. ii. Investigate what Sundance and its affiliates can do to control its transactions and translation exposure. Determine if any of the translation exposure should be hedged.

Suggested Solution to Sundance Sporting Goods, Inc.

Note to Instructor: It is not necessary to assign the entire case problem. Parts a. and b.i. can be used as self-contained problems, respectively, on basic balance sheet consolidation and the preparation of a translation exposure report.

a. Below is the consolidated balance sheet for the MNC prepared according to the current rate method prescribed by FASB 52. Note that the balance sheet balances. That is, Total Assets and Total Liabilities and Net Worth equal one another. Thus, the assumption is that the current exchange rates are the same as when the affiliates were established. This assumption is relaxed in part c.

Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,

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December 31, 1997 (in $000): Pre-Exchange Rate Change

Sundance, Inc.

(parent)

Mexican

Affiliate

Canadian

Affiliate

Consolidated

Balance Sheet Assets

Cash

$ 1,500

$ 430

$ 960

$ 2,890

Accounts receivable

2,100a

849e

1,200f

4,149

Inventory

5,000

1,879

2,000

8,879

Investment in Mexican affiliate

-b

-

-

-

Investment in Canadian affiliate

-c

-

-

-

Net fixed assets

12,000

3,394

4,480

19,874

Total assets

$35,792

Liabilities and Net Worth

Accounts payable

$ 3,000

$ 358a

$1,360

$ 4,718

Notes payable

4,000d

1,273

1,840

7,113

Long-term debt

9,000

2,121

1,840

12,961

Common stock

5,000

-b

-c

5,000

Retained earnings

6,000

-b

-c

6,000

Total liabilities and net worth

$35,792

a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.

b,cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.

dThe parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).

eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps396,000 (= A120,000 x Ps3.30/A1.00).

fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD300,000 (= W192,000,000/(W800/CD1.25)).

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b. i. Below is presented the translation exposure report for the Sundance MNC. Note, from the report that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean won. If any of these exposure currencies appreciates (depreciates) against the U.S. dollar, exposed assets denominated in these currencies will increase (fall) in translated value by a greater amount than the exposed liabilities denominated in these currencies. There is negative net exposure in the Japanese yen. If the yen appreciates (depreciates) against the U.S. dollar, exposed assets denominated in the yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated in the yen.

Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 1997 (in 000 currency units)

Japanese

Yen

Mexican

Peso

Canadian

Dollar

Argentine

Austral

Korean

Won

Assets

Cash

¥ 0

Ps 1,420

CD 1,200

A 0

W 0

Accounts receivable

0

2,404

1,200

120

192,000

Inventory

0

6,200

2,500

0

0

Fixed assets

0

11,200

5,600

0

0

Exposed assets

¥ 0

Ps21,224

CD10,500

A120

W192,000

Liabilities

Accounts payable

¥ 0

Ps 1,180

CD 1,700

A 0

W 0

Notes payable

126,000

4,200

2,300

0

0

Long-term debt

¥ 0

7,000

2,300

0

0

Exposed liabilities

¥126,000

Ps12,380

CD 6,300

A 0

W 0

Net exposure

(¥126,000)

Ps 8,844

CD 4,200

A120

W192,000

b. ii. The problem assumes that Canadian dollar depreciates from CD1.25/$1.00 to CD1.30/$1.00 and that the Argentine austral depreciates from A1.00/$1.00 to

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A1.03/$1.00. To determine the reporting currency imbalance in translated value caused by these exchange rate changes, we can use the following formula:

= Reporting Currency Imbalance.

From the translation exposure report we can determine that the depreciation in the Canadian dollar will cause a

reporting currency imbalance.

Similarly, the depreciation in the Argentine austral will cause a

reporting currency imbalance.

In total, the depreciation of the Canadian dollar and the Argentine austral will cause a reporting currency imbalance in translated value equal to -$129,231 -$3,495= -$132,726.

c. The new consolidated balance sheet for Sundance MNC after the depreciation of the Canadian dollar and the Argentine austral is presented below. Note that in order for the new consolidated balance sheet to balance after the exchange rate change, it is necessary to have a cumulative translation adjustment account balance of -$133 thousand, which is the amount of the reporting currency imbalance determined in part b. ii (rounded to the nearest thousand).

Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,

December 31, 1997 (in $000): Post-Exchange Rate Change

Sundance, Inc.

(parent)

Mexican

Affiliate

Canadian

Affiliate

Consolidated

Balance Sheet Assets

Cash

$ 1,500

$ 430

$ 923

$ 2,853

Accounts receivable

2,100

845e

1,163f

4,108

Inventory

5,000

1,879

1,923

8,802

Investment in Mexican affiliate

-b

-

-

-

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Investment in Canadian affiliate -c - - - Net fixed assets

12,000

3,394

4,308

19,702

Total assets

$35,465

Liabilities and Net Worth

Accounts payable

$3,000

$ 358a

$1,308

$ 4,666

Notes payable

4,000b

1,273

1,769

7,042

Long-term debt

9,000

2,121

1,769

12,890

Common stock

5,000

-b

-c

5,000

Retained earnings

6,000

-b

-c

6,000

CTA

-

-

-

(133)

Total liabilities and net worth

$35,465

a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.

b,cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.

dThe parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).

eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps384,466 (= A120,000 x Ps3.30/A1.03).

fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD312,000 (=W192,000,000/(W800/CD1.30)).

d. i. The transaction exposure report for Sundance, Inc. and its two affiliates is presented below. The report indicates that the Ps1,320,000 accounts receivable due from the Mexican affiliate is not also a translation exposure because this is netted out in the consolidation. However, the ¥126,000,000 notes payable of the parent is also a translation exposure. Additionally, the A120,000 accounts receivable of the Mexican affiliate and the W192,000,000 accounts receivable of the Canadian affiliate are both translation exposures.

Transaction Exposure Report for Sundance Sporting Goods, Inc. and

its Mexican and Canadian Affiliates, December 31, 1997

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Affiliate

Amount

Account

Translation

Exposure

Parent

Ps1,320,000

Accounts Receivable

No

Parent

¥126,000,000

Notes Payable

Yes

Mexican

A120,000

Accounts Receivable

Yes

Canadian

W192,000,000

Accounts Receivable

Yes

d. ii. Since transaction exposure may potentially result real cash flow losses while translation exposure does not have an immediate direct effect on operating cash flows, we will first address the transaction exposure that confronts Sundance and its affiliates. The analysis assumes the depreciation in the Canadian dollar and the Argentine austral have already taken place.

The parent firm can pay off the ¥126,000,000 loan from the Japanese bank using funds from the cash account and money from accounts receivable that it will collect. Additionally, the parent firm can collect the accounts receivable of Ps1,320,000 from its Mexican affiliate that is carried on the books as $400,000. In turn, the Mexican affiliate can collect the A120,000 accounts receivable from the Argentine importer, valued at Ps384,466 after the depreciation in the austral, to guard against further depreciation and to use to pay off the peso liability to the parent. The Canadian affiliate can eliminate its transaction exposure by collecting the W192,000,000 accounts receivable as soon as possible, which is currently valued at CD300,000.

The elimination of these transaction exposures will affect the translation exposure of Sundance MNC. A revised translation exposure report follows.

Revised Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates,

December 31, 1997 (in 000 currency units)

Japanese

Yen

Mexican

Peso

Canadian

Dollar

Argentine

Austral

Korean

Won

Assets

Cash

¥ 0

Ps 484

CD 1,500

A 0

W 0

Accounts receivable

0

2,404

1,200

0

0

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Inventory

0

6,200

2,500

0

0

Fixed assets

0

11,200

5,600

0

0

Exposed assets

¥ 0

Ps20,288

CD10,800

A 0

W 0

Liabilities

Accounts payable

¥ 0

Ps 1,180

CD1,700

A 0

W 0

Notes payable

0

4,200

2,300

0

0

Long-term debt

0

7,000

2,300

0

0

Exposed liabilities

¥ 0

Ps12,380

CD6,300

A 0

W 0

Net exposure

¥ 0

Ps 7,908

CD4,500

A 0

W 0

Note from the revised translation exposure report that the elimination of the transaction exposure will also eliminate the translation exposure in the Japanese yen, Argentine austral and the Korean won. Moreover, the net translation exposure in the Mexican peso has been reduced. But the net translation exposure in the Canadian dollar has increased as a result of the Canadian affiliate’s collection of the won receivable.

The remaining translation exposure can be hedged using a balance sheet hedge or a derivatives hedge. Use of a balance sheet hedge is likely to create new transaction exposure, however. Use of a derivatives hedge is actually speculative, and not a real hedge, since the size of the “hedge” is based on one’s expectation as to the future spot exchange rate. An incorrect estimate will result in the “hedge” losing money for the MNC.

CHAPTER 15 FOREIGN DIRECT INVESTMENT

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Recently, many foreign firms from both developed and developing countries acquired high-tech U.S. firms. What might have motivated these firms to acquire U.S. firms?

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Answer: Many foreign firms might have been motivated to gain access to technical know-how residing in U.S. firms and at the same time monopolize its use. Refer to the reverse-internalization hypothesis discussed in the text.

2. Japanese MNCs, such as Toyota, Toshiba, Matsushita, etc., made extensive investments in the Southeast Asian countries like Thailand, Malaysia and Indonesia. In your opinion, what forces are driving Japanese investments in the region?

Answer: Most likely, these Japanese MNCs have invested heavily in Southeast Asia in order to take advantage of under priced labor services and cheaper land and other factors of production. Refer to the life-cycle theory of FDI.

3. Since the NAFTA was established, many Asian firms especially those from Japan and Korea made extensive investments in Mexico. Why do you think these Asian firms decided to build production facilities in Mexico?

Answer: Asian firms might have been motivated to gain access to NAFTA of which Mexico is a member and circumvent the external trade barriers maintained by NAFTA.

4. How would you explain the fact that China emerged as the second most important recipient of FDI after the United States in recent years?

Answer: China attracted a great deal of FDI recently because foreign firms want to (I) take advantage of inexpensive labor and resources, and also (ii) gain access to the Chinese market that is often not accessible otherwise.

5. Explain the internalization theory of FDI. What are the strength and weakness of the theory?

Answer: According to the internalization theory, firms that have intangible assets with a public good property tend to undertake FDI to take advantage of the assets on a large scale and, at the same time, prevent misappropriation of returns from the assets that may occur during arm’s length transactions in foreign countries. The theory can be effective in explaining green field investments, but not in explaining mergers and acquisitions.

6. Explain Vernon’s product life-cycle theory of FDI. What are the strength and weakness of the theory?

Answer: According to the product life-cycle theory, firms undertake FDI at a particular stage in the life-cycle of the products that they initially introduced. When a new product is introduced, the firm chooses to keep production at home, close to customers. But when the product become mature and foreign demands develop, the firm may be induced to start production in foreign countries, especially in low-cost countries, to serve the local markets as well as to export the product back to the home country. As can be inferred from the boxed reading on Singer in the text, the product life-cycle theory can explain historical development of FDI quite well. In recent years, however, the international system of production has become too complicated to be explained neatly by the life-cycle theory. For example, new products are often

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introduced simultaneously in many countries and production facilities may be located in many countries at the same time.

7. Why do you think the host country tends to resist cross-border acquisitions, rather than green field investments?

Answer: The host country tends to view green field investments as creating new production facilities and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of existing domestic firms, without creating new job opportunities.

8. How would you incorporate political risk into the capital budgeting process of foreign investment projects?

Answer: One approach is to adjust the cost of capital upward to reflect political risk and discount the expected future cash flows at a higher rate. Alternatively, one can subtract insurance premium for political risk from the expected future cash flows and use the usual cost of capital which is applied to domestic capital budgeting.

9. Explain and compare forward vs. backward internalization.

Answer: Forward internalization occurs when MNCs with intangible assets make FDI in order to utilize the assets on a larger scale and at the same time internalize any possible externalities generated by the assets. Backward internalization, on the other hand, occurs when MNCs acquire foreign firms in order to gain access to the intangible assets residing in the foreign firms and at the same time internalize any externalities generated by the assets.

10. What can be the reason for the negative synergistic gains for British acquisitions of U.S. firms?

Answer: Negative synergies for British acquisitions of U.S. firms may reflect that British managers might have been motivated to invest in U.S. firms in order to pursue their own interests, such as building corporate empire, rather than shareholders’ interests. Negative synergies can be viewed as agency costs.

11. Define country risk. How is it different from political risk?

Answer: Country risk is a broader measure of risk than political risk, as the former encompasses political risk, credit risk, and other economic performances.

12. What are the advantages and disadvantages of FDI as opposed to a licensing agreement with a foreign partner?

Answer: The main advantage of FDI over licensing agreement with a foreign partner is that it provides protection against possible interlopers. The main disadvantage of FDI is that it is costly and time consuming to establish foreign presence in this manner and FDI is probably more vulnerable to political risk.

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13. What operational and financial measures can a MNC take in order to minimize the political risk associated with a foreign investment project?

Answer: First, MNCs should explicitly incorporate political risk in the capital budgeting process and adjust the project’s NPV accordingly. Second, MNCs can form joint-ventures with local partners or form a consortium with other MNCs to reduce risk. Third, MNCs can purchase insurance against political risk from OPIC, Lloyd’s, etc.

14. Study the experience of Enron in India, and discuss what we can learn from it for the management of political risk.

Answer: This question can be used as a mini-case or mini-project. Students can utilize various business/financial publications, such as Wall Street Journal, Financial Times, and Business week, to study the issue.

15. Discuss the different ways political events in a host country may affect local operations of an MNC.

Answer: The answer can be organized based on the three types of political risk: Namely, transfer risk, operational risk, and control risk. Transfer risk arises from the uncertainty about cross-border flows of capital, payments, know-how, etc. Operational risk arises from the uncertainty about the host country’s policies affecting the local operations of MNCs. Control risk arises from the uncertainty about the host country’s policy regarding ownership and control of local operations of MNCs.

16. What factors would you consider in evaluating the political risk associated with making FDI in a foreign country.

Answer: Factors to be considered include: (1) the host country’s political and government system; (2) track record of political parties and their relative strength; (3) the degree of integration into the world system; (4) the host country’s ethnic and religious stability; (5) regional security; and (6) key economic indicators.

17. Mini Project: Suppose you are hired as a political consultant by Coca-Cola, which is considering investing in the bottling facilities in four countries: Mexico, Argentina, China, and Russia. Pick a country out of the four and analyze the political risk associated with investing there. Prepare a final report to Coca-Cola using a similar format as Exhibit 15.10.

Answer: This is an open-ended question. Students can collect basic economic data for the country of their choice from such sources as International Financial Statistics, various publications of the World Bank, Economist, Financial Times, etc.

Both China and Russia are shedding their socialist economic system and are in the process of establishing market economies. Often, the “rules of the game” are not clearly stipulated for foreign investors like Coca-Cola. Corruption is a major problem in both countries. In addition, the property rights, tangible or intangible, and the tax codes are not well established, adding to the risk of doing business in these countries.

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In contrast, Argentina and Mexico, which used to be inward-looking and highly protectionist countries, have made significant progress in liberalizing their economies. In the case of Mexico, joining NAFTA will no doubt accelerate this liberalization process. As we have seen during the 1994-5 peso crisis, however, gross mismanagement of the economy can negatively affect foreign investors in Mexico. Also, there is substantial uncertainty about the long-term viability of the current political system in Mexico. Argentina, on the other hand, appears to be the most safe among the four countries. The country has successfully made the transition from the protectionist to the open economy and is well positioned to become a second Chile, a well publicized success story.


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