International Finance - Assignment Example

?International Finance Table of Contents Table of Contents 2 Answer 3 Answer 2 5 Answer 3 7 Answer 4 8 Answer 5 8 Answer 6 9 Answer 7 10 Identification and Management of Risk 11 International Parity Theories 13 References 14 Answer 1 a) Spot rate ?/SFr = SFr1.9816 Or SFr/? = ?0.5046 Similarly 1-year forward rate (SFr/?) = ?0.5226 (Siegel et al, 1997, p.132) > (?0.5226 – ?0.5046) / ?0.5046 > 0.036 or 3.6% Therefore, SFr trades at a forward premium relative to GBP (?) or GBP trades at a forward discount relative to SFr. The forward premium is linked to differences in short-term interest rates in two countries. According to the interest rate parity, the relationship between the forward premium or discount and interest rate differential is given by (Wang, 2009, p.51) The Forward rate and spot rate are in ? and Ih is the interest rate in UK and If is the interest rate in Switzerland. Therefore, if the interest rate parity holds, then the interest rate in Switzerland is lower than interest rate in UK because if the foreign interest rate is lower than home interest rate the forward rate (foreign currency in terms of home currency) exhibits a premium (Madura, 2009, p.215). b) UK interest rate = 4.0000% Singapore interest rate = 3.1875% Spot Rate (?/S$) = S$3.7348 or (S$/?) = ?0.2678 > {(1 + 0.04) / (1 + 0.031875)} - 1 > 0.007874 or 0.79% (annualized) Therefore, Forward Rate (S$/?) = ?0.2678 (1 + 0.007874) > ?0.2699 or S$3.7051 c) Taking the equation from part b), > 0.036 = {(1 + 0.04) / (1 + ISFr)} - 1 > 1+ ISFr = 1.04 / 1.036 = 1.00386 > ISFr = 0.0039 or 0.39% Answer 2 i. Kennedy Plc, a Canadian company, faces foreign exchange rate risk because it is expecting to make and receive payments in US$ within three months i.e. 90 days. The payments to suppliers in 3 months will be US$10,560,000. If US$ strengthens in 3 months, the company is likely to face losses on account of increased amount of payment. In other words, if the spot rate US$1.6875 declines, the company will face losses. The receipts in 3 months amount to US$1,560,000. The risk here is due to weakening of US$ within 3 months i.e. rise in spot rate US$1.6885. The net cash flow is US$9,000,000. The 90-days forward rate (C$/US$) = US$1.6930/1.6960 So the company can hedge its cash flows in US$ by selling and buying the 90-days forward contracts on C$. For cash payments, it can sell the 90-days forward contract to buy US$ at 1.6930. At the expiry, the company will have to sell C$6,237,448 to buy the US$10,560,000. Furthermore, for the receipts the company will have to buy C$ at 1.6960 where it will be selling US$1,560,000 to buy C$919,811. Keeping in view the costs of transactions, the company can sell the 90-days forward contract to hedge the net cash flows of US$9,000,000 at bid rate of C$/US$ 1.6930. The amount payable will be C$5,316,007. ii. Money market hedge on payables will involve taking money market position to cover the future payment. Kennedy Plc can either use its own funds for the hedge or it can borrow the funds in home currency (C$) and make a short-term investment for 90 days in foreign currency. C$ borrowing rate = 3.5625% US$ deposit rate = 2.25% It needs US$10,560,000 in 90 days, therefore, the amount needed to be deposited in US$ is US$10,560,000 / (1 + (0.0225 * (90/360))) = US$10,500,932 Deposit amount in C$ = US$10,500,932/ 1.6875 = C$6,222,774 This amount can be borrowed at an annual interest rate of 3.5625%. C$ amount of loan repayment after 3 months = C$6,222,774* (1+ (0.035625 *(90/360))) = C$6,278,196 Therefore, the company would borrow C$6,222,774 at 3.5625% p.a. for 90 days. Convert the amount into US$ at spot rate of 1.6875, which will amount to US$10,500,932. Deposit this amount at US$ money market deposit rate 2.25% p.a. for 90 days. This will give the amount to be paid i.e. US$10,560,000. At the end of 90 days, Kennedy will make the loan repayment of C$6,278,196. This hedge will allow the company to fix the amount to be paid after three months. To hedge the receivables: Amount expected to be received = US$1,560,000 Borrowing rate of US$ = 2% p.a. Deposit rate of C$ = 3.875% Amount to borrow = US$1,560,000 / (1 + (0.02 * (90/360))) = US$1,552,239 Convert the funds to C$ = US$1,552,239 / 1.6885 = C$919,301 This amount can be invested in money market at 3.875% p.a. C$919,301* (1 + (0.03875 * (90/360))) = C$928,207. Therefore, using the money market hedge the receivables will be worth C$928,207. iii. There is a certain difference in both types of hedging techniques. As in both the cases the cash flows are known beforehand, so the company can choose whichever is more feasible. In the absence of transaction costs and existence of interest rate parity, both types of hedges would have yielded same results because the forward premium or discount shows the interest rate differential between the two countries’ currencies. Answer 3 i. Spot rate as on 21st February (GBP/NKr) = NKr10.4291 Pound value of the Receipts in NKr = NKr 15,000,000 / 10.4291 = GBP 1,438,283 ii. The receipts in NKr in 3 months are exposed to exchange rate fluctuations. The receipts are subject to the risk of weakening of NKr at the time of receipts because this will result into lesser value of amount in GBP. iii. Assuming the spread in the average 3-months forward rate as 0.0020, the bid-ask forward rates are (GBP/NKr): 10.4337/10.4377. In case of using forward hedge, the receipts can be hedged by buying the 3 months forward contract at NKr10.4377. Value of forward hedge = NKr 15,000,000 / 10.4377 = GBP 1,437,098. iv. The problem with using forward hedge is it is based on the speculation that the exchange rate will move in a particular direction, in this case rising of the rate. If the exchange rate moves in opposite direction against the expectations, then the hedge might result in a loss. Answer 4 1. Convert NZ$100,000,000 into UK ? at spot rate NZ$1.9398 NZ$100,000,000 / 1.9398 = ?51,551,706. 2. Sell 6-month forward contract on UK ? at 1.9637. 3. Invest ?51,551,706 at six months interest rate at 5.75%. Amount to be received after 6 months = ?51,551,706 * (1 + (0.0575 * (180/360))) = ?53,033,818. 4. Convert this amount to NZ$ ?53,033,818 * 1.9637 = NZ$104,142,508 5. The profit to earned is NZ$104,142,508 - NZ$100,000,000 = NZ$4,142,508 Answer 5 i. Considering the spread of exchange on closing quote of $0.0012, the bid-ask quotes for June futures contract on (?/$) are $1.9576/1.96. ii. The company is due to receive ?150 million in June. However, it faces risk of strengthening of ? against $ which will result in the rise in the exchange rate. Therefore, in order to hedge the receipts, the company has decided to sell the futures on sterling. The size of one sterling future contract is ?62,500. So the hedge will require selling 2400 contracts at price of $1.9576. iii. If the actual exchange rate in June turns out to be $1.80/?, then the gain for the company will be ?150,000,000 * ($1.9576 – $1.8) = $23,640,000 Answer 6 There are mainly three types of foreign exchange risks or exposures: Translation Exposure: This is also known as accounting risk, which a firm faces when it has subsidiary operations in other countries. When the foreign exchange movements adversely affect the translated values of assets and liabilities of the subsidiaries, it becomes an unwanted exposure for the parent company’s consolidated financial statements. This risk can be hedged by using currency futures, currency swaps etc. Transaction Exposure: This exposure is related to the future payments and receipts in foreign currency. Companies many a times limit this type of exposure by requiring the cash flows to be received and made in the home currency rather than foreign currency. Another way to minimize this risk is netting out the exposure by a lot of different currencies or only in one currency (Jacque, 1997, p.177). This is done by large corporations with significant amounts of international operations. Other techniques for alleviating short-term currency risks are currency forwards, currency futures, money market hedge, option hedge and cross hedge (Kelley, 2001, pp.32-34). Economic Exposure: This exposure is faced by corporations with large international presence and relates more with the net present value of future cash flows of a firm. The management of economic exposure involves the use of complex instruments and strategies besides the foreign exchange management (Ajami and Goddard, 2006, pp.110-111). The South African Company’s 25% of sales receipts are in US$, however, the costs are incurred in local currency only. The company does not have any foreign subsidiaries as yet, so no translation exposure. Therefore, it mainly faces the transaction exposure for its sales receipts. As its business will expand and the frequency of trades in foreign currencies will rise, it is highly likely that there will be an economic exposure to the firm’s business operations. As of now, it faces only transaction exposure and it should hedge it through the use of various techniques described above. Answer 7 Purchasing Power Parity (PPP) implies that the prices of goods in terms of common currency between two countries should be equal. The ratio of PPP shows the relative price differences of similar products across two countries (Nguyen, 2005). The law of one price for single product can be applied to a basket of traded goods through Consumer Price Index, where the goods and their assigned weights are similar. However, in actual scenario, this does not happen as the products included in the basket are different across the countries and so do their weights. This problem is addressed in the relative PPP theory where the exchange rates percentage change is equal to the inflation differential between the two countries. There have been other errors surrounding this theory that cause the deviations in PPP theory i.e. transportation costs, taxes and tariffs, costs of non-tradable goods such as rents, utilities etc. Other barriers are information asymmetry and pricing of goods. PPP assumes that the traders have all the information related to the prices in the markets (Anbarasu, 2010, p.151). However, deviations from PPP have allowed the firms to price their products differently from each other due to demand elasticity and difference in prices of inputs. The search for this deviation in PPP can lead to high competition among global firms but it also leads to enhanced exposure to the uncertainty in the exchange rates across currencies. Identification and Management of Risk a) (i) 4S basically faces transaction exposure as it has to contract the air travels and hotel accommodation in advance where the air travel costs are made in USD and the hotel accommodation in various local currencies such as euro, Swiss francs, dollars and dirham (Morocco). The revenue receipts are in sterling only and therefore not exposed to the exchange risk. Air Travel Payments Exposure: The risk exposure to the payments for air travel stems from the fact that the prices are set one year in advance so the contracts are also made one year ahead. Therefore, 4S can hedge the payments 1 year in advance for the contract to purchase air travel, assuming that 4S makes the payments at the beginning of the contract for the whole year. The hedge can be made by selling 1-year forward contract on (GBP/USD) to lock in the payment in USD. Hotel Accommodation: Assuming 4S plans and schedules the tours in advance and therefore, the contract is based on that schedule, the payments to the various parties in each country will be made periodically. If the payments are made in the exposed foreign currencies on a quarterly basis i.e. every three months, 4S can hedge the payments in each currency by getting into the three months forward hedge or if more flexible, can use the money market hedge. (ii) If the biggest competitor of 4S decides not to hedge its exposure, then 4S faces competitive exposure, which is a risk of potential cost advantage for the competitor in case the currency moves in its favor. The competitors’ businesses of 4S would have been tied to USD and other exposed currencies, 4S would have to predict the movement of currencies and the competitors’ reaction to these movements. b) Annual Euro Price List to European Customers: Blit Ltd presently is exposed to only HK$ but issuing the Euro price list to the Continental European customers will increase the transaction exposure of the company’s receipts to euro and may result in losses of revenues if euro strengthens against sterling. Increased Competition from US: Competition in US from US-based manufacturers will expose Blit Ltd to economic exposure. The tough competition faced by Blit will affect the future cash flows of the firm. The changing competition in the sector in US would definitely have long-term effect on the firm’s business. Relocation of manufacturing facility to Italy: This will expose Blit to translation exposure as the business as euro is not the reporting currency of Blit and all the cash flows will have to be translated from euro to sterling. International Parity Theories Appropriate decision-making in the management of foreign exchange exposures require sound understanding of the equilibrium relations between prices, inflation rates, interest rates, and currency spot and forward rates (Copeland, 2004, p.851). Many multinational companies often value their businesses in home currency that has implications that the forecasted cash flows in foreign currency need to be translated into home currency at forward exchange rate on an annual basis. Management of foreign exchange is an important part of international business. The equilibrium relationships prices, spot rates, forward rates, interest and inflations rates depend on unrealistic assumptions and mostly do not hold in real life situations but a study of them is essential in understanding the basic framework in which the international business is done. Therefore, in order to take international business decisions, the financial theorists often try to explain the factors in determination of exchange rates and their fluctuations. The three parity theories are purchasing power parity, interest rate parity and international Fisher effect. These theories focus on the economic explanations of exchange rates. The decisions are based on these basic theories coupled with other psychological and real economic factors (Gallagher and Andrew, 2007, p.596). For example, for the investments of a firm in a country, which is facing political turmoil, it is highly likely that the future returns from that investment will be negatively affected. So the firm will not only take decision of liquidating its investments but also would dump that country’s currency in the foreign exchange markets. References Ajami, R.A. and Goddard, J., 2006. International business: theory and practice. 2nd ed. USA: M.E. Sharpe. Anbarasu, J., 2010. Global Financial Management. Ane Books Pvt Ltd. Copeland, T.E., 2004. Financial Theory and Corporate Policy. India: Pearson Education India. Gallagher, T.J. and Andrew, J.D., 2007. Financial Management; Principles and Practice. USA: Freeload Press, Inc. Jacque, L.L., 1997. Management and Control of Foreign Exchange Risk. Springer. Kelley, M.P., 2001. Foreign Currency Risk: Minimizing Transaction Exposure. [Pdf] Available at: http://www.vsb.org/docs/valawyermagazine/jj01kelley.pdf [Accessed 14 March 2012]. Madura, J., 2009. International Financial Management. 10th ed. USA: Cengage Learning. Nguyen, N.M., 2005. Note: Purchasing Power Parity. [Pdf] Available at: http://people.hbs.edu/mdesai/IFM05/PPP%20Nguyen.pdf [Accessed 14 March 2012]. Siegel, J.G. et al, 1997. Schaum's quick guide to business formulas: 201 decision-making tools for business, finance, and accounting students. USA: McGraw-Hill Professional. Wang, P., 2009. The Economics of Foreign Exchange and Global Finance. 2nd ed. UK: Springer. Read More