Solutionsmanual Multinational Finance Butler
Solutionsmanual Multinational Finance Butler
Solutionsmanual Multinational Finance Butler
End-of-Chapter
Questions and Problems
to accompany
Multinational Finance
by Kirt C. Butler
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Kirt C. Butler, Solutions for Multinational Finance, John Wiley & Sons, 2016.
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Kirt C. Butler, Solutions for Multinational Finance, John Wiley & Sons, 2016.
2.7 What is moral hazard and how does it relate to IMF rescue packages?
Moral hazard occurs when the existence of a contract changes the behaviors of parties to the contract.
When the IMF assists countries in defending their currencies, it changes the expectations and hence
the behaviors of lenders, borrowers, and governments. For example, lenders might underestimate the
risks of lending to struggling economies if there is an expectation that the IMF will intervene during
difficult times.
2.8 What were the causes and consequences of the global financial crisis of 2008?
Securitization of U.S. home loans combined with lax U.S. credit standards to create a subprime crisis
in the market for collateralized debt obligations (CDOs). This subprime crisis impaired liquidity in the
CDO market and eventually spilled over to other markets including real estate, stocks, bonds, other
credit markets. Many governments had budget deficits from the drop in tax revenues and the increase
in expenses from fiscal stimulus programs. Some governments (e.g., Greece and Iceland) saw their
bond prices fall because of the increased perception of default risk.
Problem Solutions
2.1 List one or more trade pacts in which your country is involved. Do these trade pacts affect all
residents of your country in the same way? On balance, are these trade pacts good or bad for residents
of your country?
This open-ended question is intended to engage the student and bring their knowledge up-to-date. The
World Trade Organization (WTO) is a supranational organization that oversees the General
Agreement on Tariffs and Trade (GATT). Important regional trade pacts include the North American
Free Trade Agreement (NAFTA includes the U.S., Canada, and Mexico), the European Union (EU),
and the Asia-Pacific Economic Cooperation pact (APEC encompasses most countries around the
Pacific Rim including Japan, China, and the United States). Trade pacts are designed to promote trade,
but industries that have been protected by local governments can find that they are uncompetitive
when forced to compete in global markets.
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Kirt C. Butler, Solutions for Multinational Finance, John Wiley & Sons, 2016.
Problem Solutions
3.1 a. The bid is less than the offer, so Citicorp is quoting the currency in the denominator. Citicorp is
buying dollars at the DKK5.62/$ bid rate and selling dollars at the DKK5.87/$ offer rate.
b. In American terms, the bid price is $0.1704/DKK and the ask price is $0.1779/DKK. Citicorp
is buying and selling the kroner at these quotes.
c. In direct terms, the bid quote for the dollar is $0.1779/DKK and the ask price is $0.1704/DKK.
Citicorp is buying dollars at $0.1779/DKK (which is equivalent to DKK5.62/$) and selling
dollars at $0.1704/DKK (or DKK5.87/$).
d. The bank will receive the bid-ask spread on each dollar. When buying one million dollars at
DKK5.62/$ and selling one million dollars at DKK5.87/$, the bank’s profit on the bid-ask spread
will be (DKK5.87/$ – DKK5.62/$)($1,000,000) = DKK250,000.
3.2 The ask price is higher than the bid, so these are rates at which the bank is willing to buy or sell
dollars (in the denominator). You’re selling dollars, so you’ll get the bank’s dollar bid price. You
need to pay SKr10,000,000/(SKr7.5050/$) ≈ $1,332,445.
3.3 The U.S. dollar (in the denominator) is selling at a forward premium, so the Canadian dollar must
be selling at a forward discount. Annualized forward premia on the U.S. dollar are:
Bid ($) Ask ($)
Six months forward +0.681% +0.761%
Percent per annum on the Canadian dollar from the U.S. perspective are as follows:
Bid (C$) Ask (C$)
Six months forward –0.678% –0.758%
The premiums/discounts on the two currencies are opposite in sign and nearly equal in magnitude.
Forward premiums and discounts are of slightly different magnitude because the bases (U$ vs. C$)
on which they are calculated are different. Forward premiums/discounts are as stated above
regardless of where a trader resides.
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Kirt C. Butler, Solutions for Multinational Finance, John Wiley & Sons, 2016.
3.15 a. The sale is invoiced in pounds, so the expected future cash flow is:
+£1 million
─────────────────────────────┘
In euros, this positive pound cash flow is positively exposed to the value of the pound.
+€0.00/£ S€/£
€1.25/£
Short pound
+€0.00/£ S€/£
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4.11 Will an appreciation of the domestic currency help or hurt a domestic exporter?
A nominal appreciation in the domestic currency is likely to have little effect on domestic importers
and exporters. A real appreciation of the domestic currency can hurt domestic exporters by raising the
price of domestic goods relative to foreign goods. Domestic importers will see their purchasing power
increase relative to foreign competitors, and so are likely to be helped by a real appreciation of the
domestic currency.
4.12 Describe the behavior of real exchange rates.
Although real exchange rates revert to their long-run average, in the short run there can be substantial
deviations from purchasing power parity and the long-run average.
4.13 What methods can be used to forecast future spot rates of exchange?
Market-based forecasts are obtained from forward exchange rates or from interest rate parity when
forward prices are unavailable. Model-based forecasts can be generated from technical analysis
(analyzing patterns in exchange rates) or from fundamental analysis (from a larger set of economic
relationships).
4.14 How can the international parity conditions allow you to forecast next year’s spot rate?
In theory, any of the international parity conditions could be used: E[Std/f]/S0d/f = Ftd/f/S0d/f =
[(1+id)/(1+if)]t = [(1+E[pd])/(1+E[pf])]t. In practice, forward rates are usually used to predict spot rates.
At the least, forwards have the advantage of reflecting the opportunity costs of capital through the
interest rate parity relation, Ftd/f/S0d/f = [(1+id)/(1+if)]t.
Problem Solutions
4.1 a. S¥SFr = S¥/$S$/SFr = (¥200/$)($0.50/SFr) = ¥100/SFr
b. S¥SFr = S¥/$/SSFr/$ =(¥100/$)/(SFr1.60/$) = ¥62.5/SFr
4.2 SSFr/$ S$/¥ S¥/SFr = 1.0326 > 1. Spot rates are too high relative to the parity condition, so you should
sell the currencies in the denominators for the currencies in the numerators. This means that you
should (a) sell dollars for francs, (b) sell yen for dollars, and (c) sell francs for yen. Alternatively, (a)
buy francs with dollars, (b) buy dollars with yen, and (c) buy yen with francs. Triangular arbitrage
would yield a profit of 3.26 percent of the starting amount. For triangular arbitrage to be profitable,
transactions costs on a “round turn” cannot be more than 3.26 percent of the starting amount.
4.3 Each of these prices is a traded contract in the interbank forex market, and so arbitrage (either bilateral
or triangular) will ensure that the relations Ftd/f(Y)/Fd/f(X) = 1 and Ftd/eFte/fFtf/d = 1 hold within the
bounds of transaction costs.
4.4 The forward price is at a 9 bp discount over six months, or 18 bps on an annualized basis. The six-
month percentage premium is (F1£/$/S0£/$) – 1 = (£0.6352/$)/(£0.6361/$) – 1 = 0.9986–1 = –0.14%, or a
discount of 0.28% on an annualized basis. Because Ft£/$ = E[St£/$] according to forward parity (the
unbiased forward expectations hypothesis), the spot rate is expected to depreciate by 0.14 percent over
the next six months.
4.5 a. The percentage bid-ask spread depends on which currency is in the denominator.
Tokyo quote for the peso: (¥28.77/MXN – ¥28.74/MXN)/(¥28.74/MXN) = 0.00104, or 0.104%.
Mexico City quote for yen: (MXN0.03420/¥ – MXN0.03416/¥)/(MXN0.03416/¥) = 0.00117, or
0.117%.
b. The Mexican bank’s yen quote can be converted into a quote for the Mexican peso as follows:
S¥/MXN = 1/(MXN0.03416/¥) ≈ ¥29.27/MXN bid on the yen and ask on the peso.
S¥/MXN = 1/(MXN0.03420/¥) ≈ ¥29.24/MXN ask on the yen and bid on the peso.
So “MXN0.03416/¥ BID and MXN0.03420/¥ ASK” on the yen is equivalent to ¥29.24/MXN
BID and ¥29.27/MXN ASK on the Mexican peso.
The winning strategy is to buy pesos (and sell yen) from the Tokyo bank at the ¥28.77/MXN ask
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price for pesos and sell pesos (and buy yen) to the Mexican bank at the ¥29.24/MXN bid price
for pesos. Buying pesos in Tokyo yields (¥1,000,000)/(¥28.77/MXN) = MXN34,758. Selling
pesos in Mexico City yields (MXN34,758)(¥29.24/MXN) = ¥1,016,336. Your arbitrage profit is
16,336 yen, or about MXN559 at the Mexican bank’s ¥29.24/MXN bid price for pesos.
4.6 From the Fisher relation: (1 + iCNY) = (1 + E[pCNY])(1 + E[ʀCNY]) E[ʀCNY]) = (1 + iCNY)/(1 + E[pCNY])
– 1 = (1.071/1.05) – 1 = 0.0200, or 2 percent.
4.7 Interest rate parity requires that FtBRL/EUR/S0BRL/EUR = ((1+iBRL)/(1+iEUR))t, within the bounds of
transactions costs.
a. F1BRL/EUR = (BRL2.9488/EUR)(1.05/1.01)1 = BRL 3.0656/EUR
F2BRL/EUR = (BRL2.9488/EUR)(1.05/1.01)2 = BRL 3.1870/EUR
F3BRL/EUR = (BRL2.9488/EUR)(1.05/1.01)3 = BRL 3.3132/EUR
b. F1BRL/EUR = (BRL2.9488/EUR)(1.055/1.01)1 = BRL 3.0802/EUR
F2BRL/EUR = (BRL2.9488/EUR)(1.050/1.01)2 = BRL 3.1870/EUR
F3BRL/EUR = (BRL2.9488/EUR)(1.048/1.01)3 = BRL 3.2943/EUR
4.8 a. From interest rate parity, (¥210/$)/(¥190/$) = (1 + i¥)/(1.15) i¥ = 27.11%.
b. If forward rates are unbiased predictors of future spot rates, the dollar is likely to appreciate against
the yen by (¥210/$)/(¥190/$) – 1 = 10.526%..
4.9 a. In this problem, we know the spot and forward rates and U.S. inflation. The real and nominal
interest rates are not needed for part (a). F1$/£/S0$/£ = ($1.20/£)/($1.25/£) = 0.96 = (1 + p$)/(1 + p£) =
(1.05)/(1 + p£) => p£ = (1.05/0.96) – 1 = 9.375%
b. From the Fisher equation: i£ = (1 + p£)(1 + ʀ£) – 1 = (1.09375)(1.02) – 1 = 11.56%.
4.10 a. E[P1F] = P 0F(1 + pF) = 1.21
E[P 1D] = P 0D(1 + pD) = 110
E[S1D/F] = (S0D/F)(1 + pD)/(1 + pF) = (D100/F)(1.10/1.21) D90.91/F.
b. Because nominal exchange rates should adjust to reflect changes in relative purchasing power, the
expected real exchange rate is 100% of the beginning rate: E[X1D/F] = (E[S1D/F]/S0D/F)((1 + pF)/(1 +
pD)) = ((D90.91/F)/(D100/F))(1.21/1.10) = 1.00, or 100%.
c. E[P 2F]) = P 0F(1 + pF)2 = F1.4641
E[P 2D]) = P 0D(1 + pD)2 = D121
E[S2D/F] = S0D/F((1 + pD)/(1 + pF))2 = (D100/F)(1.10/1.21)2 D82.64/F
The real exchange rate is not expected to change: E[X2D/F] = (E[S2D/F]/E[S0D/F]) [(1 + pF)/(1 + pD)]2
= ((D82.64/F)(D100/F)) / (1.21/1.10)2 = 1.00, or 100%.
4.11 a. A 7 percent annualized rate with quarterly compounding is equivalent to 7%/4 = 1.75% per
quarter. From interest rate parity, the 3-month MR interest rate is FMR/$/SMR/$ =
(MR3.9888/$)/(MR4.0200/$) = (1+iMR)/(1+i$) = (1+iMR)/(1+0.0175) => iMR = 0.009603, or
0.9603% per three months. Annualized, this is equivalent to (0.9603%)×4 = 3.8412% per year
with quarterly compounding. Alternatively, the annual percentage rate is (1.009603)4–1 =
0.03897, or 3.897% per year.
b. $10,000,000 invested at the three-month U.S. rate yields $10,175,000. Changed into MR at the
forward rate, this is worth ($10,175,000)(MR3.9888/$) = MR40,586,040. You can finance your
$10,000,000 by borrowing MR40,200,000. Your obligation on this contract will be
(MR40,200,000)(1.009603) MR40,586,040 which is exactly offset by the proceeds from your
forward contract.
4.12 a. FtBt/$/S0Bt/$ = (1 + iBt)t/(1 + i$)t = (Bt 25.64/$)/(Bt 24.96/$) = (1 + iBt)/(1.06125)
1.02724 = (1 + iBt)/1.06125 iBt = 9.02%
b. F1Bt/$/S0Bt/$ = (Bt25.64/$)/(Bt24.96/$) = 1.027 < (1+iBt)/(1+i$) = (1.1)/(1.06125) = 1.037. So,
borrow at i$ and lend at iBt.
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–$1,000,000
– Bt24,960,000
–$1,061,250
–Bt27,456,000
This leaves a net gain at time 1 of $1,070,827 – $1,061,250 = $9,577, which is worth
$9,577/1.06125 = $9,024 in present value.
4.13 F1MXN/$/S0MXN/$ = (MXN11/$)/(MXN10/$) = 1.1 < 1.1132 = (1.18)/(1.06) = (1 + iMXN)/(1 + i$). The
ratio of interest rates is too high and must fall, so borrow at the relatively low dollar rate and invest
at the relatively high peso rate. Similarly, the forward premium is too low and must rise, so buy
dollars (and sell pesos) at the relatively low forward rate for the dollar and sell dollars (and buy
pesos) at the relatively high dollar spot rate.
- Borrow $1 million so that $1,060,000 is due in six months.
- Sell $1 million and buy MXN10,000,000 at the relatively high spot price.
- Invest MXN10,000,000 at 18% to yield MXN11,800,000 in six months.
- Cover by selling MXN11,800,000 at the MXN11/$ forward rate to yield $1,072,727.
This leaves a profit of $1,072,727 – $1,060,000 = $12,727 at time t = 1 in six months.
4.14 The Singapore dollar is at a forward premium; F1$/S$/S0$/S$ = ($0.51/S$)/($0.50/S$) = 1.02, or 2% per
year. This is bigger than warranted by the difference in interest rates (1 + i$)/(1 + iS$) = (1.06)/(1.04)
= 1.019231, so F1$/S$/S0$/S$ > (1 + i$)/(1 + iS$). The forward/spot ratio is too high and must fall, so sell
S$ (and buy dollars) at the relatively high S$ forward rate and buy S$ (and sell dollars) at the
relatively low S$ spot rate. Conversely, the ratio of interest rates is too low and must rise, so borrow
at the relatively low dollar interest rate and invest at the relatively high S$ rate. (Even though S$
interest rates are lower than dollar interest rates in nominal terms, S$ interest rates are high and
dollar interest rates are low relative to the forward/spot ratio.) Suppose you borrow ($1,000,000)/(1
+ i$) = $1,060,000 at i$ = 6.0%.
+$1,000,000
-$1,060,000
Convert to S$2,000,000 = ($1,000,000)/($0.50/S$) at S0$/S$ = $0.50/S$.
+S$2,000,000
-$1,000,000
Invest S$2,000,000 at the Singapore interest rate of iS$ = 4.0%.
+S$2,080,000
-S$2,000,000
Cover this S$ forward obligation by selling S$ in the forward market.
+$1,060,800
-S$2,080,000
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The result is a dollar profit of $1,060,800 – $1,060,000 = $800. These transactions are worth
undertaking only if the costs of executing the four transactions is less than $800.
4.15 a. s¥/SFr = (S0¥/SFr)/(S–1¥/SFr) –1 = (¥155/SFr)/(¥160/SFr) – 1 = –3.125%.
b. From relative purchasing power parity, the spot rate should have been:
E[S0¥/SFr] = (S–1¥/SFr) [(1 + p¥)/(1 + pSFr)] = (¥160/SFr) [(1.02)/(1.03)] = ¥158.45.
c. As a difference from the expectation, the real change in the spot rate is:
x¥/SFr = (Actual-Expected)/(Expected) = (S0¥/SFr – E[S0¥/SFr])/E[S0¥/SFr])
= (¥155/SFr–¥158.45/SFr)/¥158.45/SFr = –2.18%.
Alternatively, change in the real exchange rate is equal to:
x¥/SFr = ((S0¥/SFr)/(S–1¥/SFr)) ((1 + pSFr)/(1 + p¥)) – 1
= ((¥155/SFr)/(¥160/SFr)) ((1.03)/(1.02)) – 1 = –2.18%.
d. The franc depreciated by 2.18% in purchasing power.
e. In real terms, the yen rose by xSFr/¥ = ((S0SFr/¥) / (S–1SFr/¥)) ((1 + p¥) / (1 + pSFr)) – 1
= ((S0¥/SFr)–1 / (S–1¥/SFr)–1) ((1 + p¥) / (1 + pSFr)) – 1
= ((¥155/SFr)–1 / (¥160/SFr)–1 ) ((1.02)/(1.03)) – 1 = +2.23%
= ((SFr.0064516/¥)/(SFr.00625000/¥)) ((1.02)/(1.03)) – 1 = +2.23%.
Because the SFr fell by 2.18% in real terms, the yen rose by 1/(1 – 0.0218) 2.23%.
4.16 a. technical analysis
b. technical analysis
c. fundamental analysis
d. fundamental analysis
e. technical analysis
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Sd/f Sd/f
Sd/f Sd/f
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currency used to hedge against std/f2. If there is neither a currency nor a maturity mismatch, then
futures prices converge to spot prices at expiration and exposure to currency risk can be hedged
exactly (an r-square of one) with a futures contract.
Problem Solutions
5.1
Forward: +$.0180/S$
0 30 60 90
Futures:
$0.0002/S$ $0.0002/S$ $0.0002/S$ $0.0002/S$
0 1 2 ... 89 90
Your cumulative gain over the 90 days of the futures contract is $0.018/S$. This is the value of the
net cash inflow at expiration of the forward contract.
5.2 The U.S. MNC will need (S$3,000,000)/(S$125,000/contract) = 24 S$ futures contracts to cover its
forward exposure. The underlying position is long S$, so the MNC should sell 24 futures contracts.
A short S$ futures position gains from a S$ depreciation. If the spot rate closes at $0.5900/S$ on the
expiration date, then the gain accumulated over the three months of the contract (as the contracts
are marked-to-market each day) will be ($0.6075/S$ – $0.5900/S$)(S$3,000,000) = $52,500.
5.3 a.
¥9,000,000
today 6 months
b. Draw a payoff profile for this project with $/¥ on the axes.
V$/¥
S$/¥
–ILS500,000
b.
Buy shekels in the U.S. dollar futures market +ILS500,000
-$81,250
Sell Singapore dollars in the U.S. dollar futures +$81,250
market
-S$125,000
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–S$125,000
These ending values exactly hedge the currency exposures of the expected cash flows. Any
changes in spot rates SILS/$ and SS$/$ would be received over the 90-day life of the futures
contract according to the daily settlement procedures.
c. Cotton Bolls could take out a 90-day futures contract to sell S$ for Israeli shekels. Because the
ratio of exposed amounts (S$125,000/ILS500,000) = S$0.2500/ILS = FS$/ILS, the underlying
exposures can be matched exactly. The implied forward rate is S$0.25/ILS. Cotton Bolls would
save on commissions, having to buy one futures contract rather than two.
5.5 Hedge ratios and delta, cross, and delta-cross hedges:
a. The optimal hedge ratio for this delta hedge is given by:
NFut* = (amt in futures)/(amt exposed) = –β
(amt in futures) = (–β)(amt exposed) = (–1.025)(–DKK10bn) = DKK10.25bn,
so buy (DKK10.25bn)($0.80/DKK)/($50,000/contract) = 164,000 contracts.
b. The optimal amount in the futures position of this cross hedge is:
(amt in futures) = (–1.04)(–DKK10bn) = DKK10.4bn,
or (€0.75/DKK)(DKK10.4bn) = €7.8bn at the €0.75/DKK exchange rate.
c. The optimal amount in the futures position of this delta-cross hedge is:
(amt in futures) = (–1.05)(–DKK10bn) = DKK10.5bn.
This is equal to (DKK10.5bn)($0.80/DKK)/($100,000/contract) = 84,000 contracts.
d. Hedge quality can be ranked as follows: (1) delta hedge (r2 = 0.98), (2) cross hedge (r2 = 0.89),
and (3) delta-cross hedge (r2 = 0.86).
5.6 This problem to intended to convince you that it is basis risk in interest rates and not currency risk
that is the source of risk in a currency futures hedge of a transaction exposure.
a. Profit/loss on each of the positions is as follows:
Scenario #1 St$/S$ = $0.6089/S$ i$ = 6.24% iS$ = 4.04%
Futt,T = ($0.6089/S$) [(1.0624)/(1.0404)](51/365) $0.6107/S$
$/S$
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Problem Solutions
6.1 A call option to buy pounds sterling with krone is equivalent to a put option to sell krone for pound
sterling. With pounds in the denominator, it is most convenient to think of consider the pound call.
Option values at expiration as a function of the krone value of the pound are then:
Spot rate at expiration (DKK/£) 8.00 8.40 8.42 8.44 8.46 8.48
Pound call value at expiration (DKK/£) 0.00 0.00 0.00 0.00 0.01 0.03
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PutT£/DKK
£0.11834/DKK
ST£/DKK
£0.11834/DKK
6.3 A short krone put is equivalent to a short pound call. Here are their payoff profiles.
£/DKK DKK/£
PutT CallT
£0.11834/DKK DKK8.45/£
ST£/DKK STDKK/£
£0.11834/DKK
For long option positions, an option to buy pounds at KDKK/£ = DKK8.45/£ is equivalent to an
option sell DKK at K£/DKK = 1/KDKK/£ = 1/(DKK8.45/£) = £0.11834/DKK.
Conversely, for the short option positions an obligation to sell pounds at KDKK/£ = DKK8.45/£ is
equivalent to an obligation to buy DKK at K£/DKK = 1/KDKK/£ = 1/(DKK8.45/£) = £0.11834/DKK.
6.4 Buy a A$ call and sell a A$ put, each with an exercise price of F1$/A$ = $0.75/A$ and the same
expiration date as the forward contract. Payoffs at expiration look like this:
CallT$/A$ PutT$/A$ FT$/A$
6.5 The arguments are the same as for call options. As the variability of end-of-period spot rates
becomes more dispersed, the probability of the spot rate closing below the exercise price increases
and put options gain value. Here are the three sets of graphs:
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1
-2
-1
3
-
-
Sd/f
- 3 - 3
Sd/f
- 2
- 1
-2
-1
3
Sd/f
- 3 - 3
Sd/f
- 2
- 1
-2
-1
3
- 3 - 3
Sd/f Sd/f
Increasing variability in the distribution of end-of-period spot rates results in an increase in put
option value in each case. (For in-the-money puts, the increase in option value with decreases in the
underlying spot rate is greater than the decrease in value from proportional increases in the spot
rate.) Variability in the distribution of end-of-period spot exchange rates comes from exchange rate
volatility and from time to expiration.
6.6 The payoff profile of a purchased straddle at expiration is shown below.
VT¥/$
ST¥/$
K¥/$
A purchased straddle has more value the further from the exercise price it expires. This
combination will allow you to place a bet that the market has underestimated the volatility of the
yen/dollar exchange rate. Of course, if the market is informationally efficient, then volatility is
correctly priced in the market and this position (net of the costs of the options) will have zero net
present value.
6.7 ln [(¥110.517/$) / (¥100/$)] = ln(1.10517) = +0.10 = +10%
ln [(¥90.484/$) / (¥100/$)] = ln(0.90484) = –0.10 = –10%
6.8 ln [(¥156.64/$) / (¥105/$)] = ln(1.49181) = +0.40 = +40%
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16 percent. Although a variety of factors could lead to inaccurate implied volatilities, most
difficulties in volatility estimation are associated with low volume. (Hence the rule: “Beware of
prices in thinly traded markets.”) In this problem, it would be wise to calculate implied volatilities
from several other yen options with different exercise prices.
6A.4 a. Interest rate parity provides forward rates according to: Ftd/f / S0d/f = [(1 + id)/(1 + if)]t.
A problem arises because the options are on Danish krone but the krone appears in the numerator
(a violation of Rule #2 from Chapter 3) of the exchange rates. This is not unusual, as the pound is
often left in the denominator of a foreign exchange quote. Historically, the pound was composed
of shillings and pence rather than decimal units. (Nobody understands cricket, either.) For clarity,
the table below includes forward rates in £/DKK and quotes option prices in direct £/DKK terms
from a Londoner’s perspective. The current spot rate is S0£/DKK = 1/(DKK8.4528/£) =
£0.11830/DKK and the exercise price is K£/DKK = 1/(DKK8.5/£) = £0.11765/DKK.
0.018
0.016
0.014
0.012
0.010
0.008
0.006
0.004
0.002
0.000
0.0900 0.0950 0.1000 0.1050 0.1100 0.1150 0.1200 0.1250
-0.002
d. Here are put option payoff profiles for the options prior to expiration. The one-year option has a
higher value at high spot rates and a lower value at low spot rates. The one-month option has
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lower value at high spot rates and a higher value at lower spot rates. The darkened 45o line is the
intrinsic value of the option. European put option values can be below intrinsic value because they
cannot be exercised until expiration.
0.120
0.100
0.080
0.060
0.040
0.020
0.000
0.0000 0.0200 0.0400 0.0600 0.0800 0.1000 0.1200 0.1400 0.1600
-0.020
6A.5 Let’s restate these exercise prices as pound per krone rates before proceeding.
Exercise prices
Exercise prices (DKK/£) 8.2000 8.4000 8.6000 8.8000
Exercise prices (£/DKK) 0.12195 0.11905 0.11628 0.11364
Call option value 0.00114 0.00222 0.00377 0.00568
Put option value 0.00421 0.00244 0.00127 0.00058
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Problem Solutions
7.1 LP would pay LIBOR flat on the floating rate side and receive the 2-year T-note rate of
7.24percent (7.05% + 19 bp) on the fixed rate side. Because LP is now paying 8.25 percent on its
fixed rate debt, its interest shortfall would be (8.25% – 7.24%) = 1.01 percent. This is equal to
(1.01%)(360/365) = 0.996 percent per year in money market yield. LP’s net cost of floating rate
funds is then LIBOR + 99.6 bps in money market yield. In this example, the swap just barely beats
the market rate on new floating rate debt of LIBOR + 100 bps.
7.2 a. Ford pays fixed-rate zloty interest at a bond equivalent yield of 7.98% + 0.78% = 8.76 percent
and receives floating rate zloty interest at the 6-month LIBOR rate. After converting the 45
bps premium above LIBOR to a bond equivalent yield, Ford’s cost of fixed rate zloty debt is
8.76% + 0.45%(365/360) 9.22 percent in semiannually compounded bond equivalent yield.
b. PM receives fixed rate zloty interest from the swap bank at 7.98% + 0.24% = 8.22 percent. PM
pays floating rate zloty interest at 6-month LIBOR flat. After converting the difference
between PM’s fixed-rate outflows and inflows (9.83% – 8.22% = 161 bps) to a money market
yield, PM’s cost of floating rate zloty debt is LIBOR + (161 bps)(360/365) = LIBOR + 159
bps in money market yield.
c. The swap bank pays LIBOR to Ford and receives LIBOR from PM for no net gain or loss in
floating-rate zlotys. The swap bank receives 8.76 percent (sa) from Ford and pays 8.22% (sa)
to PM for a net gain of (8.76% – 8.22%) = 54 bps in bond equivalent yield on the notional
principal.
7.3 a. The six-month pound interest rate is (4.12%)/2 = 2.06%. The pound is selling at a six-month
forward discount of 0.58 percent, so the yen rate that corresponds to the 2.06 percent pound
rate in present value is (1 + i¥)/(1 + i£) = F1¥/£/S0¥/£ i¥ = (1 + i£)(F1¥/£/S0¥/£) – 1 = (1.0206)(1 –
0.0058) – 1 = 0.01468052, or about 1.468 percent per six months. Note in passing that the PV
annuity factors that correspond to these interest rates are PVIFA(i¥ = 1.46805,T = 6) =
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–£54,308 –£54,308
–£208,500 –£208,500
This leaves a net pound payment of (£208,500 + £54,308) = £262,808 every six months.
–£262,808 –£262,808
This is an all-in cost of (£262,808)(£10,000,000) = 0.0262808 per six months, or 5.256157
percent per year compounded semiannually.
b. Similarly, the all-in cost of BD’s swap can be verified from the cash flows of BD’s swap.
BD’s underlying fixed rate pound CFs are (7.45%/2)(£10,000,000) = –£372,500.
–£372,500 –£372,500
The swap offsets these pound cash flows with floating rate yen interest payments over LIBOR.
The corresponding yen spread over LIBOR is (165.6432 bps)(¥2.4 billion) = ¥39,754,371.
+£372,500 –£372,500
–Z71,940 – Z71,940
–Z1,612,795 – Z1,612,795
The total fixed-rate zloty payment is Z1,684,735 each year.
– Z1,684,735 – Z1,684,735
This is indeed an all-in cost (Z1,684,735)/(Z19,911,044) = 0.08461307 per year (or about 8.46
percent) on GE’s fixed-rate zloty debt.
b. SP’s underlying fixed rate zloty payments are (10.24%)(Z19,811,044) = Z2,038,891 per year.
–Z2,038,891 – Z2,038,891
The swap offsets these fixed-rate zloty CFs with floating rate dollar payments over LIBOR.
The corresponding $ spread over LIBOR is (0.02280855)($7,111,087) = $162,194 as a BEY.
+Z2,038,891 +Z2,038,891
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units. This central role allows Treasury to net transactions within the corporation and thereby
minimize the number and size of external market transactions. Treasury can also direct operating
units on transfer pricing issues and identify hurdle rates on new investments.
8.11 What are the five steps in a currency risk management program?
(1) Identify those currencies to which the firm is exposed and the distribution of future exchange
rates for each of these currencies. (2) Estimate the firm’s sensitivity to changes in these currency
values. (3) Determine the desirability of hedging, given the firm’s estimated risk exposures and
risk management policy. (4) Evaluate the cost/benefit performance of each hedging alternative,
given the forecasted exchange rate distributions. Select and implement the hedging instrument or
strategy. (5) Monitor the firm’s evolving exposures and revisit these steps as necessary.
8.12 What is the difference between passive and active FX risk management?
Active management selectively hedges FX exposures depending on the manager’s market view.
Passive management does not take a view, but applies the same hedging rule to each exposure.
8.13 What is the difference between technical and fundamental analysis?
Technical analysis uses exchange rate history to predict short-term exchange rate movements.
Fundamental analysis uses macroeconomic data to forecast long-term exchange rate movements.
8.14 Are small, medium, or large firms most likely to use derivatives to hedge currency risk? How do
firms benchmark their hedges?
Derivatives users tend to be large firms, and typically use the forward rate for benchmarking.
Problem Solutions
8.1 a. A 6 percent interest rate compounded quarterly is the same as a 1.5 percent quarterly rate. The net
amount payable at maturity is $9,990,000 after subtracting Paribas’ acceptance fee. Fruit of the
Loom will receive ($9,990,000)/(1.015) = $9,842,365 if it sells the acceptance to its bank.
b. The all-in cost of the acceptance is ($10,000,000)/($9,842,365) – 1 = 1.60 percent per quarter or
an effective annual rate of (1.0160)4 – 1= 0.0656, or 6.56% per year.
8.2 a. The 2%/month factoring fee of ($10 million)(0.02/month)(3 months) = $600,000 is due at the
time the receivables are factored. Fruit of the Loom is giving up accounts receivable with a face
amount of $10 million due in three months in exchange for a net amount of $9,400,000.
b. The all-in cost to Fruit of the Loom is ($10,000,000)/($9,400,000) – 1 = 0.06383 per quarter or an
effective annual rate of (1.06383)4 – 1 = 0.2808, or 28.08 percent per year. While this all-in cost
seems high, note that Fruit of the Loom has no collection expenses or credit risk on this
nonrecourse sale of receivables.
8.3 a. The net amount payable at maturity is $998,000 after subtracting the bank’s acceptance fee. A 5
percent annual rate compounded quarterly is the same as a 1¼ percent quarterly rate. Savvy Fare
will receive ($998,000)/(1.0125)2 = $973,510 if it sells the acceptance to its bank today.
b. The all-in cost of the acceptance to Savvy Fare is ($1,000,000)/($973,510) – 1 = 2.72 percent per
six months or an effective annual rate of (1.0272)2 – 1= 5.52 percent per year.
8.4 a. Cash flows faced by Savvy Fare include the following:
Face amount of receivable $1,000,000
Less 4% nonrecourse fee –$40,000
Less 1% monthly factoring fee over six months –$60,000
Net amount received $900,000
b. The all-in cost to Savvy Fare is ($1,000,000)/($900,000) – 1 = 11.11% per six months or an
effective annual rate of (1.1111)2 – 1 = 23.46 percent per year.
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Problem Solutions
8A.1 a. At $6,000 in taxable income, debt receives $4,000 and equity receives nothing.
At $16,000 in taxable income, debt receives $10,000 and equity receives $6,000.
b. Firm value as a combination of debt plus equity:
+ =
$6,000 $16,000
Firm value
Firm value rises from $10,000 when unhedged to $11,000 when hedged. Hedging results in a
$3,000 increase in debt value and a $2,000 decrease in equity value, for a net gain of $1,000. The
$1,000 net gain is from avoiding the ½ probability of a $2,000 deadweight bankruptcy cost.
Whether equity chooses to hedge in this circumstance depends on whether the gain in firm value
is more or less than the shift in value from equity to debt from the reduction in risk.
In this example, debt gains at equity’s expense. The $3,000 shift in value from equity to debt is
less than the $1,000 net gain to the firm, so equity bears the $2,000 net loss. In the absence of a
renegotiation of the debt contract, equity would leave its currency risk exposure unhedged.
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8A.2 a.
VBonds + VStock = VBonds + Stock
+ =
$4,000 $14,000
Firm value
VFIRM = VBONDS + VSTOCK = £10,000 + £4,000 = £14,000. This is the same as in b after including
indirect costs of financial distress with an expected value of [(½)(£9,000 – £6,000) + (½)(£19,000
– £18,000)] = £1,500 + £500 = £2,000.
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Problem Solutions
9.1 Net, then net again to optimize. Here are two equivalent solutions.
S$/€
S0$/€
b. Hedges:
i) A short euro forward hedge can exactly offset the underlying exposure.
$/€
V v$/€
Long exposure Long exposure
V0 $/€
Net exposure s$/€
ii) Short euro futures have the same exposure as the forward, except that the gain or loss on the
futures contract is settled daily rather than at maturity.
iii) A money market hedge
Borrow an amount such that €1 million is
due in one period at an interest rate of i€
Money market hedge
+(€1m)/(1+i€)
-(€1 million)
-($x)/(1+i$)
In the absence of transactions costs, this money market hedge has the same payoff as a
forward contract according to interest rate parity; F1$/€ = S0$/€(1 + i$)/(1 + i€).
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iv) A long euro put option hedge eliminates the downside risk of the underlying exposure and
results in a net position that replicates the payoff of a long euro call.
V$/€ Long exposure
9.3 a. Not necessarily. From interest rate parity, FtA$/$/S0A$/$ = [(1 + iA$)/(1 + i$)]t, the forward
premium says only that interest rates are higher in Australia than in the United States.
b. Rupert is short the U.S. dollar, so he might want to leave some of his exposure uncovered if he
expects the dollar to close below the forward price. How much he leaves uncovered depends on
his risk tolerance and on his corporate hedging policy.
c. By hedging at a forward price of A$1.6035/$, Rupert avoids having to buy U.S. dollars at the
higher expected spot price.
d. Rupert should ask himself: “Do I feel lucky?” Overhedging in this way is a form of currency
speculation. Rupert is surely better off sticking to the beer business.
e. This differs from the situation in d. because Rupert has a legitimate business reason for buying
more than $5 million forward. Hedging an anticipated transaction makes good business sense
when the anticipated transaction is highly likely to occur. If Rupert is not sure that he’ll actually
incur this additional dollar exposure, he probably should wait before hedging.
9.4 a. Rupert should buy the U.S. dollar forward against the Australian dollar. Futures contracts on
the AS/$ exchange rate are traded on a number of exchanges, including the Chicago Mercantile
Exchange. Futures are marked-to-market daily, so Rupert will have to put up an initial margin
and then settle any changes in the value of the contract on a daily basis.
b. Rupert can replicate a long U.S. dollar forward position by: (1) borrowing Australian dollars,
(2) converting to U.S. dollars, and (3) investing in U.S. dollars. The bid-ask spread on both spot
and three-month forward exchange is 10 basis points (0.10%), so the additional transaction
costs on a money market hedge will primarily depend on the spreads of borrowing Australian
dollars and lending U.S. dollars.
c. Rupert can purchase a long dollar call; that is, an option to buy U.S. dollars. Buying U.S.
dollars is equivalent to selling Australian dollars, so a long call on U.S. dollars is equivalent to
a long put option on Australian dollars.
d. Rupert can swap existing Australian dollar debt for U.S. dollar debt such that his inflow in U.S.
dollars is $5 million per quarter from the swap contract.
9.5 a. You are receiving £100,000 in one year, so sell £100,000 forward and buy dollars at the
forward exchange rate; V1$ = V1£ F1$/£ = (£100,000)($1.20/£) = $120,000. You have eliminated
your exposure to the value of the pound.
b. A money market hedge borrows in one currency, invests in another, and nets the transactions
in the spot market. The result is the equivalent of a forward contract. The forward contract that
you want to replicate is a forward sale of £100,000. This can be replicated as follows:
Borrow (£100,000)/(1+i£) = £89,638 at the i£ = 11.56% pound sterling interest rate.
+£89,638
─────────────────────────────┘
–£100,000
Convert to (£89,638)($1.25/£) = $112,047 at S0$/£ = $1.25/£.
+$112,047
─────────────────────────────┘
–£89,638
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b. Let’s put the koruna (the foreign currency) in the denominator as E[S1€/CZK] = (1/(CZK40/€)) =
€0.025/CZK The contractual payment is a positive cash flow in koruna, so Hippity Hops is
positively exposed to the value of the koruna in the denominator.
+€0.025/CZK s€/CZK
+€0.000/CZK S€/CZK
€0.025/CZK
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+€0.000/CZK S€/CZK
€0.025/CZK
Forward hedge
e. A long CZK exposure can be hedged with a long CZK put option as follows.
Underlying
V€/CZK
exposure v€/CZK
Net
+€0.025/CZK position
+€0.020/CZK
Net s€/CZK
position
+€0.000/CZK S€/CZK
–€0.005/CZK Long put option hedge
€0.025/CZK
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series of short-term forward contracts). Although these contractual hedges are easy to do and undo,
contractual cash flows are less than satisfactory in hedging the uncertain cash flows of the firm’s
real assets.
10.9 List operating strategies for hedging operating exposures, and compare their advantages and
disadvantages with those of financial market hedges.
Operating strategies for hedging currency risk exposures include: (a) product sourcing decisions,
(b) plant location decisions, and (c) market selection and promotion strategies. Although operating
hedges are likely to be more effective than financial market hedges for managing operating
exposures, they are also more costly and more difficult to reverse.
10.10 What is the price elasticity of demand? Why is it important?
The price elasticity of demand is defined as minus the percentage change in quantity demanded for
a given percentage change in price, –(ΔQ/Q)/(ΔP/P). The price elasticity of demand determines
whether and how much revenues will increase or decrease with a given change in price.
Problem Solutions
10.1 Operating exposure to currency risk is more difficult to measure than transaction exposure because
the values of exposed real assets do not vary one-for-one with exchange rate changes as exposed
monetary assets and liabilities do. Weak relations (i.e. low r-squares) between asset and currency
values make financial market hedges of operating exposures less than perfect. Operating hedges
might be more effective, but they are also more difficult to implement.
10.2 a. Monetary assets = Cash ($) + Accts receivable ($) + Accts receivable (€)
= $40,000 + $30,000 + $60,000 = $130,000.
Monetary liabilities = Wages ($) + Accts payable ($) + Bank note (€) + Bank note (€)
= $40,000 + $70,000 + $10,000 + $50,000 = $170,000.
Net monetary assets = Monetary assets less monetary liabilities
= $130,000 – $170,000 = –$40,000.
b. Monetary assets exposed to currency risk = Accts receivable (euros) = $60,000.
Monetary liabilities exposed to currency risk = Bank note due (€) + Bank note (€)
= $10,000 + $50,000 = $60,000.
Net monetary assets exposed to currency risk
= Exposed monetary assets less exposed monetary liabilities
= $60,000 – $60,000 = $0,
so there is no net transaction exposure to the euro.
c. The negative euro exposure of the euro bank note offsets the positive exposure of the euro
receivables, and hence reduces the firm’s net exposure to the euro.
d. Even though the firm has no net transaction exposure, this exporter’s real assets (i.e. plant and
equipment) are likely to have a positive operating exposure to the euro.
10.3 a. Sterling & Co. has exposed monetary assets of $30,000 and exposed monetary liabilities of
$45,000+$90,000 = $135,000. Net monetary assets of –$105,000 are exposed to the dollar.
b. A 10 percent dollar appreciation will change the pound value of Sterling & Co. by
(0.10)(£0.66667/$)(–$105,000) = –£7,000. Exposed monetary assets and liabilities change in
value one-for-one with changes in exchange rates, so the r-square of this relation is +1, or 100
percent.
c. The sensitivity of plant and equipment to the value of the dollar is β$ = ρr,s(σr/σs) =
(0.10)(0.20/0.10) = +0.2. A 10 percent appreciation of the dollar is likely to increase the pound
value of Sterling’s plant and equipment by 0.2(10%) = 2 percent or $1,600, from £80,000 to
£81,600. The relation between real asset value and the exchange rate is not very strong. The r-
square is (0.10)2 = 0.01, so 1 percent of the variation in real asset value is explained by
variation in the value of the dollar.
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d. Equity exposure is equal to the net exposure of monetary assets and liabilities plus the
exposure of real assets, or (–£7,000) + £1,600 = –£5,400.
e. Sterling’s use of long-term dollar liabilities tends to offset the positive exposure of its real
assets. However, the quality or effectiveness of this hedge is poor because the low r-square on
the real asset side does not exactly match the one-for-one exposure on the liability side.
f. The sunk entry costs of this operating hedge are high. Opening a U.S. plant would entail
renting or buying a U.S. site, hiring local (U.S.) artisans or bringing U.K. expatriates into the
United States, and perhaps moving an existing supervisor from the United Kingdom to the
United States as well. It will be difficult for Sterling & Co. to manage its U.S. operations as
effectively as it manages its U.K. operations. Sterling should undertake this operating hedge if
and only if it makes good business sense. The dollar exposure should not be the deciding
factor.
10.4 Low exposures to currency risk for U.S. firms means that U.S. investors are more likely than
investors in other countries to be able to diversify away currency risk. This also suggests that
currency risk management might be more important outside the United States than within the
United States.
10.5 Advanced problem on pricing strategy: The price elasticity of demand
a. If Dow maintains its £4 price, value will fall by 25 percent in pounds and by 40 percent in
dollars. This sets the benchmark for proposed changes in the pound price.
20% £ depreciation
from $1.50/£ to $1.20/£
Maintain £4 price
Sales volume
Base case $1.50/£ remains constant
Translated accounts £ $ £ $
Price £4.00 $6.00 £4.00 $4.80
Cost £2.00 $3.00 £2.50 $3.00
Sales volume 20,000 20,000 20,000 20,000
Revenues £80,000 $120,000 £80,000 $96,000
–COGS –40,000 –60,000 –50,000 –60,000
Taxable income 40,000 60,000 30,000 36,000
–Tax (at 50%) –20,000 –30,000 –15,000 –18,000
Net cash flow 20,000 30,000 15,000 18,000
Value of Tao £200,000 $300,000 £150,000 $180,000
Percentage change –25% –40%
b. If Dow maintains its $6 price (resulting in a £5 price in the U.K.), value will fall by 37.5
percent in pounds and by 50 percent in dollars. With price elastic demand, Dow should
maintain its £4 price to minimize the impact on its dollar value.
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c. If Dow maintains its $6 price, value will rise by 12.5 percent in pounds and fall by 10 percent
in dollars. With price inelastic demand, Dow should maintain its $6 price to minimize the
impact on its dollar value.
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11.9 What are the advantages and disadvantages of valuing assets and liabilities at historical cost? At
market value?
From a financial point of view, assets and liabilities are ideally reported at market values because
market values reflect true values formed by a consensus of market participants. However, market
values are not observable for nontraded assets such as privately held equity. In these cases,
historical costs provide reliable, verifiable values that can be consistently applied across business
situations.
11.10 Why is it difficult to distinguish a hedge from a speculative position? How does a hedge qualify
for hedge accounting rules under ASC 815?
Whether a derivatives position is a hedge or a speculative position depends on whether the
derivatives position is taken to offset an underlying exposure. The difficulty is that underlying
exposures range from clearly exposed positions (such as a foreign currency accounts payables) to
less obviously exposed positions (such as an anticipated but still speculative sale denominated in a
forward currency). To qualify for hedge accounting treatment, a hedge must be clearly defined,
measurable, and effective. The linkage between the exposed position and the hedge must then be
carefully and fully documented.
Problem Solutions
11.1 Finlandiva Value Value at Value at Translation
Assets in € $1.00/€ $0.80/€ gain/loss
€
Cash 50,000 $50,000 $40,000 –$10,000
€
A/R 30,000 $30,000 $24,000 –$6,000
€
Inventory 20,000 $20,000 $16,000 –$4,000
€
P&E 900,000 $900,000 $720,000 –$180,000
€
Total assets 1,000,000 $1,000,000 $800,000 –$200,000
Liabilities
€
A/P 125,000 $125,000 $100,000 –$25,000
€
ST debt 75,000 $75,000 $60,000 –$15,000
€
LT debt 750,000 $750,000 $600,000 –$150,000
€
Net worth 50,000 $50,000 $40,000 –$10,000
€
Total liabilities & net worth 1,000,000 $1,000,000 $800,000 –$200,000
a) Net exposed assets:
= ($50,000 + $30,000 + $20,000 + $900,000) – ($125,000 + $75,000 + $750,000)
= $1,000,000 – $950,000 = +$50,000.
b) Translation gain or loss (note that the dollar is in the numerator)
= (–0.2)(+$50,000) = –$10,000.
11.2 Vincent’s Folly Value Value at Value at Translation
Assets in C$ C$1.60/$ C$1.50/$ gain/loss
Cash & equivalents C$320,000 $200,000 $213,333 $13,333
Accounts receivable C$160,000 $100,000 $106,667 $6,667
Inventory C$640,000 $400,000 $426,667 $26,667
Plant and equipment C$480,000 $300,000 $320,000 $20,000
Total assets C$1,600,000 $1,000,000 $1,066,667 $66,667
Liabilities
Accounts payable C$320,000 $200,000 $213,333 $13,333
Wages payable C$160,000 $100,000 $106,667 $6,667
Net worth C$1,120,000 $700,000 $746,667 $46.667
Liabilities & net worth C$1,600,000 $1,000,000 $1,066,667 $66,667
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will increase the dollar value of the euro receivable and–at the same time–increase the dollar
value of the peso payable. Conversely, if the dollar appreciates, then the peso and euro
depreciations will reduce the dollar value of the euro receivable at the same time that it
reduces the dollar value of the peso payable. With no change in the S€/MXN exchange rate, the
dollar value of Silver Saddle’s net exposure to currency risk is ($60,000-$30,000) = $30,000.
Of course, the peso payable will not be a perfect hedge of one-half of the euro receivable
because there is a chance that the euro-per-peso spot rate S€/MXN will change. (For those of you
that studied the chapter on currency futures, note that Silver Saddle’s offsetting euro and peso
exposures are similar to a currency futures cross-hedge where the exposure of the Mexican
peso payable partially offsets the exposure of the euro receivable.)
11.5 a. Capitalizing the long Canadian dollar (short U.S. dollar) position results in:
Assets Liabilities and Owners’ Equity
Current assets Current liabilities
Accounts receivable $60,000 Accounts payable $30,000
(€60,000 at $1.00/€) (MXN300,000 at MXN0.10/$)
Forward asset $22,000 Forward liability $22,000
(long C$20,000 at $1.10/C$) (short $22,000)
Fixed assets Long-term liabilities & equity
Furnishings (beds & blankets) $30,000 Long-term debt $170,000
Property and buildings $910,000 Owners’ equity $800,000
Total assets $1,022,000 Total liabilities & equity $1,022,000
b. Current ratio Debt-to-assets
Before $60,000/$30,000 = 2.000 $200,000/$1,000,000 = 0.200
After $82,000/$52,000 = 1.577 $222,000/$1,022,000 = 0.217
c. The debt-to-assets and current ratios have deteriorated. Indeed, Silver Saddle is more risky
after this speculative transaction than before because she now has a new exposure to the
Canadian dollar. There is no underlying exposure that is hedged by this speculative
transaction, so the transaction cannot be qualified as a hedge.
11.6 a. The translated value is V1$ = V1W / S1W/$ = (W1 billion) / (W1250/$) = W800,000.
b. The parent firm sees a translation loss of $200,000. The market value of the asset remained $1
million, so this translation loss is not an economic loss.
c. Selling W1 billion forward creates a $200,000 gain on the forward hedge. This exactly offsets
the $200,000 translation loss on the underlying exposure. However, the net result in economic
terms is a $200,000 gain on the forward hedge without a corresponding loss on the underlying
exposure. The forward “hedge” actually increases the real or economic exposure of the firm to
currency risk.
d. This forward hedge nevertheless would qualify for the hedge accounting rules under ASC 815
because it is tied to an underlying exposure–even though it is a translation and not an
economic exposure.
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Problem Solutions
12.1 Although the answer to this question will be specific to the chosen country, country risks that turn
up usually include factors from the ICRG political risk categories. These factors include political risk
(leadership, government corruption, internal or external political tensions), economic risk (inflation,
current account balance, or foreign trade collection experience), and financial risk (currency controls,
expropriations, contract renegotiations, payment delays, loan restructurings or cancellations). Of
course, other political risk information providers use these same types of factors.
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Problem Solutions
Cross-border capital budgeting under the international parity conditions.
13.1 a. Relative purchasing power parity for this risky asset is driven by expected inflation:
(1+iILS)/(1+iCNY) = (1.15)/( 1.11745) (1+E[pILS])/(1+E[pCNY]) = (1.06)/(1.03) 1.0291.
Discounting yuan cash flows at the yuan discount rate yields
VCNY = –CNY600m + CNY200m/(1.11745)1 + CNY500m/(1.11745)2 + CNY300m/(1.11745)3
= CNY194.39 million
ILS CNY
or V |i = (CNY194.39m)(ILS 0.5526/CNY) = ILS 107.42 million at the spot rate.
b. Relative purchasing power parity states that the spot rate should change according to
E[StILS/CNY]/E[S0ILS/CNY] = [(1 + E[pILS])/(1 + E[pCNY])]t = (1.06/1.03)t = (1.029)t. That is, the yuan
should appreciate by approximately 2.9% per year relative to the shekel because of lower Chinese
inflation. Expected future spot rates of exchange are then
E[S1ILS/CNY] = (ILS 0.5526)[(1.06)/(1.03)]1 = ILS 0.5687/CNY
E[S2ILS/CNY] = (ILS 0.5526)[(1.06)/(1.03)]2 = ILS 0.5853/CNY
E[S3ILS/CNY] = (ILS 0.5526)[(1.06)/(1.03)]3 = ILS 0.6023/CNY
Based on these spot exchange rates, expected Israeli shekel cash flows are:
E[CF0ILS] = (–CNY600m)(ILS 0.5526/CNY) = –ILS 331.56m
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This is the same as in part c because the international parity conditions hold.
13.4 a. Initial outlay = Bt4m at time t = 1
After-tax cash flows over t = 2,…,5
= (Bt100m – Bt90m – Bt5m)(1 – 0.40) + (Bt1m×(0.4)) = Bt3,400,000
Terminal value (at t = 5) = (Bt4m×(1.10)4) – {[(Bt4m×(1.10)4) – 0]×(0.4)} = Bt3,513,840
0 –Bt4,000,000 Bt3,400,000 Bt3,400,000 Bt3,400,000 Bt6,913,840
├───────────────────────┼────────────────────────┼────────────────────────┼────────────────────────┼────────────────────────┼
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The parent company may choose to leave its cash flows from the project unhedged in the
hopes of benefiting from the expected higher-than-equilibrium future exchange rates. This
does expose the parent to currency risk.
b. Discount in yuan: VCNY = [t E[CFtCNY] / (1 + iCNY)t ]
= [–CNY600m + CNY200m/(1.1175) + CNY500m/(1.1175)2 + CNY300m/(1.1175)3]
= CNY194.39
VILS|iILS = (S0ILS/CNY) (VCNY) = (ILS 0.5526/CNY)(CNY194.39m) = ILS 107.42 million
Discount in ILS: VILS|iILS = t {E[StILS/CNY]E[CFtCNY] / (1 + iILS)t }
= [(–CNY600m)(ILS 0.5526/CNY) + (CNY200m)(ILS 0.5575/CNY)/(1.15)
+ (CNY500m)(ILS 0.5625/CNY)/(1.15)2 + (CNY300m)(ILS 0.5676/CNY)/(1.15)3 ]
= ILS 90.02m < ILS 107.42 million
Although the project has a positive NPV from each perspective, the project has more value in the
local currency than it does in shekels. The parent should hedge the yuan cash flows either directly
in the forward market, by borrowing a part of the project in yuan, or by swapping shekel debt for
yuan debt to hedge its expected future yuan cash flows from the project.
13.6 a. Interest rate parity requires a 2.913 percent forward premium according to FtILS/CNY/S0ILS/CNY =
(1+iFILS)t/(1+iFCNY)t = (1.0812)t/(1.0506)t = (1.02913)t. Forward rates are as follows:
F1ILS/CNY = (ILS 0.5526)[(1.0812)/(1.0506)]1 = ILS 0.5687/CNY
F2ILS/CNY = (ILS 0.5526)[(1.0812)/(1.0506)]2 = ILS 0.5853/CNY
F3ILS/CNY = (ILS 0.5526)[(1.0812)/(1.0506)]3 = ILS 0.6023/CNY
V |i = t { FtILS/CNY E[CFtCNY]) / (1 + iILS)t }
ILS ILS
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The probabilities of the possible states of nature sum to 1.0. The probability of receiving the cash
flow in year t is (0.9)t. The expected cash flow in the presence of expropriation risk is this
probability times the expected cash flow from Problem 13.1. The NPV in yuan is then VCNY = –
CNY600m + CNY200m(0.9)1/(1.11745) + CNY500m(0.9)2/(1.11745)2 + CNY300m(0.9)3/(1.11745)3
= CNY42.15 million, or VILS|iCNY = (CNY42.15)(ILS 0.5526/CNY) = ILS 23.29 million at the spot
exchange rate. The value of the expropriation side effect is thus V(Side effect) = V(Project with
side effect) – V(Project without side effect) = (CNY42.15 – CNY194.40) = –CNY152.24, or (ILS
23.29m – ILS 107.42m) = –ILS 84.13million.
Alternatively, the side effect can be valued explicitly as follows. There is a 0.1 chance of losing
the first and all later cash flows, an additional (0.1)(0.9) = 0.09 risk of losing the 2nd year cash
flow given the 1st year cash flow was received, and an additional (0.1)(0.9) 2 = 0.081 risk of losing
the 3rd year cash flow given the 2nd year cash flow was received. Hence, the probability of not
receiving CFt is (1–(0.9)t):
P[losing CF1CNY] = 1 – (.9)1 = 0.100
P[losing CF1CNY] = 1 – (.9)2 = 0.100 + 0.090 = 0.190
P[losing CF1CNY] = 1 – (.9)3 = 0.100 + 0.090 + 0.081 = 0.271
The expected loss in present value due to expropriation risk is then (0.10)(CNY200m)/(1.11745) +
(0.19)(CNY500m)/(1.11745)2 + (0.271)(CNY300m)/(1.11745)3 = CNY152.24 million, or
(CNY152.24)(ILS 0.5526/CNY) = ILS 84.13 million.
13.11 VCNY = CNY194.39 million without the side effect. The airport project reduces this value by CNY100
million, but the NPV with the side effect is still positive. You should accept the project, even if the
Chinese authorities are not willing to renegotiate.
13.12 Step 1: Calculate the value of blocked funds assuming they are not blocked.
If blocked funds had been invested at the risky after-tax croc rate of 40%(1 – 0.5) = 20% per year,
they would have grown in value to Cr8,030(1.20)3 + Cr13,860(1.20)2 + Cr19,628(1.20)
Cr57,388. Discounted at the 20 percent after-tax croc rate, this would have been worth Cr27,675 in
present value. This is equivalent to discounting blocked funds back to the beginning of the project
at the 20% risky after-tax croc discount rate, so this is a zero-NPV investment at the 20 percent
after-tax croc interest rate.
Step 2: Calculate the opportunity cost of blocked funds.
With blocked funds earning no interest, the accumulated balance of Cr41,518 has an after-tax
present value of (Cr41,518) / (1.20)4 = Cr20,022. The opportunity cost of blocked funds is
(Cr20,022 – Cr27,675) = –Cr7,653.
Step 3: Calculate project value including the opportunity cost of blocked funds.
VPROJECT WITH SIDE EFFECT = VPROJECT WITHOUT SIDE EFFECT + VSIDE EFFECT = Cr0 – Cr7,653 = –Cr7,753.
The opportunity cost of blocked funds at the 20 percent (forgone) risky after-tax discount rate is even
higher than the Cr7,433 value in the text example using a iFCr(1–T) = (37.5%)(1–0.5) = 18.75% risk-
free after-tax discount rate. Funds blocked in Hook’s risky Treasury make the Neverland project look
even worse than when Hook’s treasure chest is riskless.
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14.8 What is a targeted registered offering and why is it useful to the corporation?
Targeted registered offerings are securities sold to foreign financial institutions that then make a
market in the corporation’s securities in the foreign market. They are useful for gaining access to
foreign investors and their capital.
14.9 What is project finance, and when is it an appropriate source of funds?
Project financing is a way of unbundling a project from the firm’s other assets and liabilities. A
separate legal entity is created that is heavily financed with debt. Project financing is appropriate for
real assets that generate a steady stream of cash flows that can be used to service the debt.
14.10 Discuss the evidence on the determinants of capital structure?
Rajan and Zingales (1995) find that leverage is positively related to the tangibility of firm assets (i.e.,
the proportion of fixed assets) and firm size. Leverage is negatively related to profitability and the
presence of growth options (i.e., the asset market-to-book ratio). Several national markets including
the domestic U.S. market share these characteristics.
Problem Solutions
14.1 a. r = rF + β (E[rW] – rF) = 5% + (1.2)(12% – 5%) = 13.4%
b. r = rF + β (E[rM] – rF) = 5% + (1.4)(11% – 5%) = 13.4%
14.2 a. r = rF + β (E[rW] – rF) = 5% + (0.8)(10% – 5%) = 9%
b. r = rF + β (E[rM] – rF) = 5% + (1.2)(10% – 5%) = 11%
14.3 a. Total risk is conventionally measured by standard deviation of return. The foreign asset with a
standard deviation of σi' = 0.3 has greater total risk than the domestic asset with a standard
deviation of σi = 0.2.
b. The foreign asset also has greater systematic risk: βi' = ρi'W (σi'/σW) = (0.3)(0.3/0.1) = 0.9 > βi = ρiW
(σi /σW) = (0.4)(0.2/0.1) = 0.8.
14.4 a. The required return on L’Occitane’s equity within the French market is rF + β(E[rM] – rF) = 5%
+ (1.4)(11% – 5%) = 13.4%. L’Occitane’s weighted average cost of capital is iWACC =
(B/VL)iB(1 – TC) + (S/VL)iS = (0.4)(7%)(1 – 0.33) + (0.6)(13.4%) = 9.916%.
b. Required return on L’Occitane’s stock is r = 5% + (1.2)(12% – 5%) = 13.4% for an
international investor, in which case iWACC = (B/VL)iB(1 – TC) + (S/VL)iS = (½)(6%)(1 – 0.33)
+ (½)(13.4%) = 8.710%.
c. The operating cash flow is before interest expense. In France, L’Occitane’s value is V = CF1/(i
– g) = (€10million)/(0.09916 – 0.04) = €169,033,130. In the global market, L’Occitane’s value
is V = CF1/(i – g) = €10,000,000/(0.08710 – 0.04) = €212,314,225. If we are to believe these
numbers (and that markets can be this segmented), then L’Occitane can increase its value by
26 percent by financing in international markets because of the international market’s higher
tolerance for debt and lower required returns.
14.5 a. Grand Pet’s debt ratio is (B/VL) = 33/(33 + 100) = 0.25. The required return on Grand Pet’s
equity is r = rF + β(E[rM] – rF) = 5% + (1.2)(10% – 5%) = 11%. Grand Pet’s weighted average
cost of capital is iWACC = (B/VL)iB(1 – TC) + (S/VL)iS = (0.25)(6%)(1 – 0.33) + (0.75)(11%) =
9.255%.
b. The debt-to-equity ratio is 0.50 (one part debt to two parts equity), so (B/VL) = 1/(1 + 2) =
0.33. Equity required return is r = rF + β(E[rW] – rF) = 5% + (0.8)(10% – 5%) = 9%, and the
weighted average cost of capital is iWACC = (B/VL)iB(1 – TC) + (S/VL)iS = (0.33)(6%)(1 – 0.33)
+ (0.67)(9%) = 7.340%.
c. In the U.K. market, Grand Pet’s value is
V = CF1 / (i – g) = (£1 billion)/(0.13755 – 0.03) ≈ £15.987 billion.
If Grand Pet raises funds in the global market, Grand Pet’s value is
V = CF1 / (i – g) = (£1 billion)/(0.12007 – 0.03) ≈ £23.041 billion.
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If we are to believe these numbers (and that markets can be this segmented), then Grand Pet
can increase its value 44 percent by raising funds internationally.
14.6 a. The required return should depend on the use and not on the source of funds. Firms should use
an asset-specific discount rate that reflects the opportunity cost of capital. The government’s
borrowing cost has little relevance toward how these funds are used. Riskier projects should
have higher required returns.
b. In the CAPM, the security market line (SML) identifies the required return as a function of the
systematic risk of an asset. Consider the two investments L (low risk) and H (high risk) below.
Each has an expected return of 10 percent, although their required returns from the security
market line are 7.50 percent at β = 0.5 and 12.5 percent at β = 1.5, respectively.
E[r] SML
10% L H
5%
Beta
0.5 1.0 1.5
On a risk-adjusted basis, project L should be accepted and project H should be rejected. Using
a 5 percent hurdle rate for both low-risk and high-risk projects will inappropriately favor
projects with high expected returns whether or not they are low-risk or high-risk projects. Over
time, the asset portfolios of Chinese companies using the CD rate as their hurdle rate will tilt
toward high-return, high-risk projects. From a capital markets perspective, some of these risky
projects (such as project H) will be value-destroying.
c. At the government’s 5 percent hurdle rate, this investment has an “apparent” NPV of
(0.1m)/0.05 – 1.5m = 0.5 million yuan. However, this fails to account for the investment’s
risk. At the market required return of 10 percent (with β = 1), this asset’s value is (0.1m)/0.1
= 1 million yuan at a cost of 1.5 million yuan, for a risk-adjusted loss in value of NPV = –
500,000 yuan.
d. Without close monitoring of the returns on investment, the manager has an incentive to
accept the government’s funds on this negative-NPV project because it increases the market
value of her division by 1 million yuan. With a larger empire, the manager might be able to
justify a higher salary.
14.7 a. E[r] = rF + β(E[rW] – rF) = 3% + 1.2(5%) = 9%
b. E[r] = rF + β(E[rW] – rF) + δ(E[rRegion] – E[rW]) = 3% + 1.2(5%) + 1.5(4%) = 15%
c. E[r] = E[rW] + CR = {rF + (E[rW] – rF)} + CR = (3% + 5%) + 4% = 12%
d. E[r] = E[rW] + S = {rF + (E[rW] – rF)} + S = (3% + 5%) + 2% = 10%
e. E[r] = rF + S (σBr-stocks/σBr-bonds) = 3% + 2% (30%/10%) = 9%
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Problem Solutions
15.1 From Equation 15.1, pre-tax interest rates in Costa Rican colons (CRC) relative to Chilean pesos
(CLP) are iCRC = (iCLP)(1 – tCLP)/(1 – tCRC) = (7%)(1 – 0.20)/(1 – 0.30) = 8%. After-tax returns are then
5.6 percent in both countries; iCRC(1 – tCRC) = 8%(1 – 0.30) = (iCLP)(1–tCLP) = (7%)(1 – 0.20) = 5.6%.
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16.10 What are the shortcomings of option pricing methods for valuing real assets?
Difficulties include: (a) identifying the underlying asset or assets; (b) specifying the return-generating
process of the underlying asset(s); and (c) the fact that the values of real options are not directly
observable in the marketplace.
Problem Solutions
16.1 a. A decision tree represents possible paths to future states of the world as branches on a tree. For
Grolsch’s invest in Dubiety, the decision tree looks like:
Invest today VD = ?
Invest at Pbeer = D75
VD(Pbeer = D75) = ?
Invest in one year
Invest at Pbeer = D25 VD(Pbeer = D25) = ?
b. Equation (16.2) from the text must be modified to include fixed costs:
INVEST TODAY: V = [(P – VC)Q – FC]/i – I0
V(invest today) = [((D50/btl – D10/btl)(1,000,000 btls) – D10,000,000)/0.10] – D200,000,000
= D100,000,000 invest today?
c. Equation 16.3 from the text must be modified to include fixed costs:
WAIT ONE YEAR: V = [[(P – VC)Q – FC]/i] / (1 + i) – I0
V|Pbeer = D75 = [(((D75/btl – D10/btl)(1,000,000 btls) – D10,000,000)/0.10)/(1.10)] – D200,000,000
= D300,000,000 invest
V|Pbeer = D25 = [(((D25/btl – D10/btl)(1,000,000 btls) – D10,000,000)/0.10) / (1.10)] – D200,000,000
= –D154,545,455 < $0 don’t invest
V(wait one year) = [Prob(P1 = D75)](V|P1 = D75) + [Prob(P1 = D25)](V|P1 = D25)
= (½) (D300,000,000) + (½)(D0) = +D150,000,000 > V(invest today) > D0
d. Option Value = Intrinsic Value + Time Value
V(wait one year) = V(invest today) + Opportunity cost of investing today
D D D
150,000,000 = 100,000,000 + 50,000,000
e. Wait one period before deciding to invest.
16.2 We know from Problem 16.1 that investment in a single brewery today has value. The issue is
whether to invest in all five breweries today or invest in a single exploratory brewery and then
make a decision on the four additional breweries in one year after receiving information about the
price of beer produced by the exploratory brewery.
a. Decision tree
Invest in all five breweries today VD = D500 million
Invest in 4 more if Pbeer = D75
VD(Pbeer = D75) = ?
Invest in one brewery
Don’t invest if Pbeer = D25 VD(Pbeer = D25) = ?
b. At the expected end-of-year price of D50/btl, the NPV of a single brewery is D100m as in Problem
16.1. The PV of the perpetual stream of cash inflows is either [(D75 – D10)(1m) – D10m)/0.10] =
D
550m or [((D25 – D10)(1m) – D10m)/0.10] = D50m with equal probability, for an expected value
of D300m. Net of the required D200m investment, this has a net present value of D100m.
Therefore, V(invest in all 5 breweries today) = 5×V(invest in 1 today) = D500 million.
c. If Grolsch management waits one year before making its investment decision, beer prices will be
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either D25 or D75 with certainty in this problem. Of course, it won’t know this until it invests in
the first, exploratory brewery. The NPV of each of the four additional breweries at a price of
D
75/bottle is D300,000,000, as in Problem 16.1. At a price of D25/bottle, the optimal strategy is to
forgo further investment. The NPV of sequential investment is then:
V(invest in exploratory brewery and continue to invest if it is positive-NPV)
= V(invest in one brewery today) + 4 [Prob(Pbeer = D75)] (V|invest in 1 year if Pbeer = D75)
= D100m + 4(½)(D300m) = D700 million > D0 Invest in an exploratory brewery
Alternatively, V (invest in exploratory brewery)
= [Prob(Pbeer = $25)](V|Pbeer = $25) + [Prob(Pbeer = $75)](V|Pbeer = $75)
= (½) [(D25 – D10)(1m) – D10m)/(0.1) – D200m]
+ (½) [ (((D75 – D10)(1m) – D10m)/(0.1) – D200m) + (4)(D300m) ]
= (½) [–D150m] + (½)[(D350m) + (4)(D300m)]
= D700 million > D0 Invest in an exploratory brewery
d. Option Value = Intrinsic Value + Time Value
V(wait one year) = V(invest today) + Opportunity cost of investing in
four additional breweries today
D D D
700,000,000 = 500,000,000 + 200,000,000
The NPV of investing in all five breweries today is – 200,000,000. By investing today, Grolsch
D
would forgo the flexibility provided by the timing option on this sequential investment.
e. Invest in an exploratory brewery today and continue to invest if warranted by the quality (and
hence market price) of the output. Endogenous uncertainty has created an incentive to hasten the
first investment.
16.3 a. V(invest today) = [((R18,000/car–R15,000/car)(10,000cars))/0.20] – R100 million
= R50 million invest today?
If you wait one year before deciding, then NPV will be either:
V|C1 = R12,000 = [((R18,000/car – R12,000/car)(10,000cars)/0.20]/1.20] – R100 million
= R150 million invest,
or V|C1 = R18,000 = [((R18,000/car – R18,000/car)(10,000cars)/0.20]/1.20] – R100 million
= –R100 million do not invest (so that V = R0).
V(wait one year)
= [Prob(C1 = R12,000)](V|C1 = R12,000) + [Prob(C1 = R18,000)](V|C1 = R18,000)
= (½)(R150,000,000) + (½)(R0) = R75,000,000 > V(invest today) =R50,000 > R0
The time value of this real option reflects the opportunity cost of investing today:
Time value = option value – intrinsic value = R75 million – R50 million = R25 million.
b. V(invest in 10 plants today) = 10×V(invest in one plant today) = R500 million
V(invest in an exploratory plant and then invest in 9 additional plants if V>0)
= [Prob(C1 = R12,000)](V|C1 = R12,000) + [Prob(C1 = R18,000)](V|C1 = R18,000)
= (½)[(R200 million) + (9)(R150 million)] + (½)(–R100 million)
= +R725 million > V(invest in all 10 today) = R500 million > R0
The opportunity cost of investing in all 10 plants today equals the time value of this real option:
Time value = Option value – Intrinsic value = R725 million – R500 million = R225 million.
Alternatively, V(invest in an exploratory plant and then invest in 9 additional plants if NPV > 0)
= V(invest in one plant today) + 9 [Prob(C1 = R12,000)] (V|invest in 1 year if C1 = R12,000)
= R50m + 9(½)(150m) = +R725 million > R0 Invest in an exploratory plant
16.4 a. At expected production of 150 oz, the NPV of investment in a single mine is
V(now-or-never) = [(¥5,000/oz – ¥1,000/oz)(150 oz)] – ¥600,000 = ¥0.
The NPV of investing in all five mines as a now-or-never decision also is ¥0.
b. If you invest in an exploratory mine and then reconsider based on the revealed information about
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yield, then the NPV of the first mine is ¥0. The NPV of each additional mine can be calculated
conditional on the yield of the first mine:
V|(Q=200 oz) = [(¥5,000/oz–¥1,000/oz)(200 oz)] – ¥600,000 = ¥200,000
V|(Q=100 oz) = [(¥5,000/oz–¥1,000/oz)(100 oz)] – ¥600,000 = –¥200,000
so don’t invest at the lower guano yield. Then,
V(sequential investment) = V (exploratory mine) + Prob(Q = 200 oz)×(4)×V| (Q = 200 oz)
= ¥0 + (½)[(4)(¥200,000)] = ¥400,000.
c. The best strategy is to invest in an exploratory mine today and continue to invest if yield is high.
16.5 a. At expected production of 150 oz, the NPV of investment in a single mine is V(now-or-never) =
[(¥5,000/oz – ¥1,000/oz)(150 oz)(1 – 0.3) + ¥600,000(0.3)]/(1.10) – ¥600,000 ≈ –¥54,545.
The NPV of investing in all 5 mines as a now-or-never decision is –¥272,727
b. If you invest in an exploratory mine and then reconsider based on the revealed information about
yield, then the NPV of the first mine is –¥54,545. The NPV of each additional mine can be
calculated conditional on the yield of the first mine:
V|(Q = 200 oz)
= [(¥5,000/oz – ¥1,000/oz)(200 oz)(1 – 0.3) + ¥600,000(0.3)]/(1.10)2 – ¥600,000/(1.10)
≈ ¥66,116
V|(Q = 100 oz)
= [(¥5,000/oz – ¥1,000/oz)(100 oz)(1 – 0.3) + ¥600,000(0.3)]/(1.10)2 – ¥600,000/(1.10)
≈ –¥165,289
You won’t invest at the lower guano yield. Then,
V(sequential investment) = V (exploratory mine) + Prob(Q = 200 oz)×(4)×V| (Q = 200 oz)
≈ –¥54,545 + (½)[(4)(¥66,116)] ≈ ¥77,686
c. Although taxes reduce the value of this real option, the optimal strategy is still to invest in an
exploratory mine and continue to invest if yield is high.
16.6 a. Abandon today VD = ?
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+D63,181,818 = +D40,000,000 + D
23,181,818
e. Wait one year before making the abandonment decision.
16.7 a. There are 22 = 4 equally likely price paths in the price lattice, resulting in three possible outcomes.
Quantity Quality
KES
20k/ct => KS20,000,000 with p = 0.25
1k cts KES
40k/ct
2k cts
KES
20k/ct => KS40,000,000 with p = 0.50
KES
40k/ct
=> KS80,000,000 with p = 0.25
Expected revenue = (KS20m)(0.25) + (KS40m)(0.5) + (KS80m)(0.25) = KS 45 million
Expected variable production costs are (KS10k)[(1k + 2k)/2] = KS 15m
V(all 5 mines now-or-never) = 5×[KS45m – KS15m – KS20m] = 5×[KS10m] = KS 50m
Alternatively, V(all 5 mines now-or-never)
= 5[[¼(20k – 10k)(1k) + ¼(20k – 10k)(2k) + ¼(40k – 10k)(1k) + ¼(40k – 10k)(2k)] – 20m]
= 5×[KS 10m] = KS 50 million
b. If you invest in an exploratory mine and then reconsider your investment decision based on the
revealed information, then the NPV of the first mine is KS 10 million. The NPV of each
additional mine is then one of the following:
V|(Q = 1k oz and P = 20k) = [(20k/ct – 10k/ct)(1k ct)] – 20m = –10m so don’t invest
V|(Q = 2k oz and P = 20k) = [(20k/ct – 10k/ct)(2k ct)] – 20m = 0m so don’t invest
V|(Q = 1k oz and P = 40k) = [(40k/ct – 10k/ct)(1k ct)] – 20m = +10m so invest
V|(Q = 2k oz and P = 40k) = [(40k/ct – 10k/ct)(2k ct)] – 20m = +40m so invest
V(sequential investment) = 10m + 4×[(0.25)(10m) + (0.25)(40m)] = KS 60 million
c. The NPV of immediate investment in all 5 mines is KS 50 million. This is KS 10 million less than
the NPV of the sequential investment opportunity. The forgone time value of KS 10 million is the
opportunity cost of investing in all 5 mines today.
16.8 This provocative question goes well beyond the material in the chapter. It turns out that the impact
of a real investment opportunity depends on whether it is firm-specific or shared with other firms
in an industry. If a firm has a real investment option that only it can exercise, such as a patent-
protected drug that effectively combats prostate cancer, then the analysis in this chapter is
appropriate. There will be an optimal time to invest and perhaps to exit, and it might pay to make a
sequential investment to gain more information.
In a situation in which the entire industry shares an investment option (such as Grolsch’s proposed
investment in Eastern Europe), investment returns are sensitive to competitors’ actions. When exit
costs are zero, the effect of a shared investment opportunity is spread across all firms in the
industry and results in a lower value to each firm. When there are exit costs, competitive response
to uncertainty is asymmetric and firms must be more cautious in their investment decisions. As in
the case of hysteresis, firms might stay invested in unprofitable situations in the hope that other
less-profitable firms will exit first.
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Chapter 17 Corporate Governance and the International Market for Corporate Control
Answers to Conceptual Questions
17.1 Define corporate governance. Why is it important in international finance?
Corporate governance refers to the way in which major stakeholders influence and control the modern
corporation. Typically, there is a supervisory board (e.g., the board of directors in the U.S.) that
represents the most influential stakeholders (debtholders in bank-based systems and equity in market-
based systems). The supervisory board monitors the management team that manages the day-to-day
operations of the corporation. The form of corporate governance determines the particular
stakeholders that are represented on the board and has a major influence on top executive turnover and
the market for corporate control.
17.2 In what ways can one firm gain control over the assets of another firm?
Direct means of acquiring control over another firm’s assets include an outright purchase of those
assets, a purchase of equity, and through merger or consolidation. Indirect means include joint
ventures or other collaborative alliances.
17.3 What is synergy?
When the whole is greater than the sum of the parts in a corporate acquisition.
17.4 Describe several differences in the role of commercial banks in corporate governance in China,
Germany, Japan, and the United States.
The largest commercial banks in China are partially privatized state owned enterprises (SOEs) in
which the Chinese government maintains a controlling interest. The four largest banks account for
nearly half of Chinese banking assets, and these banks and the government have a strong voice in the
boardrooms of other partially privatized SOEs. Firms in China’s private sector are less reliant on the
government and on the large state-owned commercial banks. Banks in Germany have few constraints
on their participation in corporate boardrooms. They are major investors of equity capital, and also
serve as brokers and investment bankers. Banks in Japan cannot own more than 5 percent of the
equity of any single company, but are in a prominent role in corporate boardrooms through their
interactions with other keiretsu members. Commercial banks in the United States have a more limited
role in corporate boardrooms than in many other countries because of historical constraints on their
banking activities including equity ownership, brokerage, and investment banking activities.
17.5 Describe four ways that banks can influence corporate boardrooms in countries–such as Germany–
that offer universal banking?
Universal banking refers to a financial system in which banks offer a full range of banking and
financial services. They can influence corporate boardrooms in four ways: (1) supply debt capital via
commercial loans, (2) invest in equity, (3) actively vote the shares of their trust (pension fund) and
brokerage customers, and (4) serve as investment bankers for debt and equity issues to the public.
17.6 How does the legal environment affect minority investors? Include a description of tunneling in your
answer.
Minority investors in countries with poor legal protections are exposed to tunneling, which is the
expropriation of corporate assets from minority shareholders by controlling shareholders,
management, or both. Because of this risk, countries with poor legal protections for minority investors
experience lower industrial growth and less efficient capital allocation than countries with enforceable
legal protections.
17.7 Why are hostile acquisitions less common in Germany and Japan than in the United Kingdom and the
United States?
Corporate governance in Germany and Japan is characterized by debt and equity ownership that is
concentrated in the hands of one or more major stakeholders. Management in Germany and Japan is
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much more closely tied to this major stakeholder than their counterparts in the United Kingdom and
the United States. Consequently, acquisitions in Germany and Japan are difficult to accomplish
without the consent and cooperation of this major stakeholder or stakeholders. The relatively
dispersed equity ownership in the United Kingdom and the United States allow hostile suitors to
appeal directly to the public markets through a tender offer. Tender offers in the United Kingdom and
the United States may or may not be in cooperation with current management.
17.8 How is turnover in the ranks of top executives similar in China, Germany, Japan, and the United
States? How is it different?
The why and when of top executive turnover is similar in these countries. Top executives in non-
performing companies are likely to be replaced. The how of top executive turnover differs, however.
Top executive turnover is initiated and executed by the lead bank in Germany, by the keiretsu
(perhaps by the main bank) in Japan, and by the public market for corporate control in China and the
United States. State-owned companies in China are an exception, in that politically connected CEOs
in state-owned enterprises are more entrenched than similar CEOs in the private sector.
17.9 Who are the likely winners and losers in domestic mergers and acquisitions that involve two firms
incorporated in the same country? How are the returns to acquiring firm shareholders related to the
method of payment (cash versus stock) and the acquiring firm’s free cash flow or profitability?
In the United States, target shareholders gain while acquiring firm shareholders may or may not win.
Acquiring shareholders are more likely to win than lose in non-U.S. domestic markets. Bidding firm
shareholders are more likely to win: (a) when cash is offered rather than stock, and (b) when the firm
does not have a lot of free cash flow
17.10 In what ways are the winners and losers in cross-border mergers and acquisitions different than in
domestic U.S. mergers and acquisitions?
Shareholders of the bidding firm are more likely to win in a cross-border merger or acquisition. Target
firm shareholders win in either case.
17.11 How are gains to bidding firms related to exchange rates?
Empirical studies find that a strong domestic currency leads to both more foreign acquisitions and to
higher bidder returns.
Problem Solutions
17.1 a. E b. D c. F d. A e. B f. G g. C
17.2 The pre-acquisition value of the two firms is $3 billion + $1 billion = $4 billion. Synergy is 10 percent
of this value, or (0.1)($4 billion) = $400 million. After subtracting the (0.2)($1 billion) = $200 million
acquisition premium, Agile shareholders are likely to see a $200 million appreciation in the value of
their shares.
17.3 Managers like free cash flow because it makes expansion possible without resort to external
capital markets for financing. Unfortunately, the existence of free cash flow also makes it more
likely that management will waste resources on new ventures in which it has no business (Jensen
[1986]). When cash flow is scarce, managers are more likely to pick winning ventures.
17.4 A real increase in the value of the domestic currency increases the purchasing power of domestic
residents. When the domestic currency is strong, domestic firms are more likely to acquire foreign
targets, and shareholders of the acquiring firm are more likely to benefit from the acquisition.
17.5 Non-performing loans in Japan forced consolidation of Japanese banking in the 2000s. The three
largest financial institutions in Japan at the time of this writing were Mitsubishi UFJ Financial
Group (including the former Bank of Tokyo-Mitsubishi, UFJ, Sanwa Bank, Tokai Bank, & Tokyo
Trust), Sumitomo Mitsui Banking Corp (Sumitomo Bank and Sakura Bank), and Mizuho Holding
Financial Group (Fuji Bank, Dai-Ichi Kangyo Bank, and Industrial Bank of Japan).
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are exceptions. For example, stock markets in China and India are large relative to their bond markets.
18.5 a. NAV = (CNY 20 billion) / (CNY 6.25/$) = $3.2 billion NAV, or $32.00/share.
b. The fund is worth ($30/share)(100,000,000 shares) = $30 billion in the U.S., or a 6.25 percent
discount to NAV in China. As to whether this is a good investment, the answer is “it depends.”
If it were possible to buy the depository receipts in New York and sell the corresponding A-
shares in China, then an arbitrage profit could be earned. The China Securities Regulatory
Commission has announced its intention to integrate these markets, but as of 2011 this goal had
not yet been accomplished. In the long term, these prices will converge. In the short term, the
A-share premium could get bigger or smaller. Let the buyer beware.
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19.10 Are real world financial markets perfect? If not, in what ways are they imperfect?
Following the definition of a perfect financial market, financial market imperfections can be
categorized as market frictions (government controls, taxes, transactions costs), investor irrationality,
and unequal access to market prices or information.
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Problem Solutions
19.1 E[rP] = (½)(0.110) + (½)(0.180) = 0.145, or 14.50%
σP = [(½)2(0.281)2 + (½)2(0.421)2 + 2(½)(½)(0.72)(0.281)(0.421)]1/2 ≈ (0.1069)1/2 ≈ 0.327,
or 32.7%
SI = (rP – rF)/σP = (0.145 – 0.015)/(0.327) ≈ 0.40, which is superior in return/risk performance to
either the Canadian (0.34) or Chinese (0.39) markets alone.
19.2 E[rP] = (½)(0.091) + (½)(0.072) = 0.0815, or 8.15%
σP = [(½)2(0.311)2 + (½)2(0.235)2 + 2(½)(½)(0.87)(0.311)(0.235) ]1/2 ≈ (0.0698)1/2 ≈ 0.264,
or 26.4%
SI = (0.0815 – 0.015)/(0.264) ≈ 0.25, which is superior in return/risk performance to either the
German (0.24) or U.K. (0.24) markets alone.
19.3 E[rP] = (½)(0.023) + (½)(0.066) = 0.0445, or 4.45%
σP = [(½)2(0.066)2 + (½)2(0.209)2 + 2(½)(½)(–0.24)(0.066)(0.209)]1/2 ≈ (0.0104)1/2 ≈ 0.102,
or 10.2%
SI = (0.0445 – 0.015)/(0.102) = 0.29, which is superior to the performance of globally diversified
stocks (0.24) or bonds (0.12) alone.
19.4 E[rP] = (⅓)[(0.035) + (0.072) + (0.066)] ≈ 0.577, or about 5.77%
σP = [ (⅓)2[(0.200)2 + (0.235)2 + (0.196)2]
+2(⅓)2[(0.61)(0.035)(0.072) + (0.57)(0.035)(0.066) + (0.85)(0.072)(0.066)] ]1/2
≈ (0.0349)1/2 ≈ 0.1868, or about 18.7%
SI = (0.0577 – 0.015)/(0.1868) ≈ 0.23, which is well above that of Japan (0.10) and close to those
of the U.K. (0.24) and the U.S. (0.26) markets.
19.5 U.S.G = +1: σP = (XU.S.σU.S. + XGσG) = (0.5)(0.1) + (0.5)(0.2) = 0.15
U.S.G = –1: σP = | XU.S.σU.S. – XGσG | = |(0.5)(0.1) – (0.5)(0.2)| = 0.05
U.S.G = 0: σP = (XU.S.2σU.S.2 + XG2σG2)½ = [(0.5)2(0.1)2 + (0.5)2(0.2)2] ½ = 0.11
U.S.G = 0.3: σP = [XU.S.2σU.S.2 + XG2σG2 + 2XU.S.XGσU.S.σGU.S.G]½
= [(0.5)2(0.1)2 + (0.5)2(0.2)2 + 2(0.5)(0.5)(0.1)(0.2)(0.3)] ½ = 0.1245, or 12.45%
19.6 E[rp] = XAE[rA] + XBE[rB] + XCE[rC] = (0.2)(0.08) + (0.3)(0.1) + (0.5)(0.13) = 11.1%
19.7 At least some individual stocks will have return/risk performance above the market portfolio just
by chance. Similarly, in any given period individual country indices will surpass the world market
portfolio when returns are measured ex post.
19.8 sd/f = (Std/f/St–1d/f) – 1= (€0.7182/$)/(€0.7064/$) – 1 = 1.0168 – 1 = 1.68%
r€ = r$ + s€/$ + rfs€/$ = 0.1600 + 0.0168 + (0.1600)(0.0168) = 17.94%
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national stock markets. Size and value premiums are not necessarily evidence of informational
inefficiency, as they could reflect systematic (nondiversifiable) risks such as relative financial distress.
In a study of returns to international assets, Asness et al. (2013) found a significant value factor stock
returns, as well as in returns to bonds, commodities, and currencies.
20.11 What is momentum? Can it lead to profitable investment opportunities for international investors?
Momentum refers to the tendency of recent winners (stocks with positive returns over a recent period)
to outperform recent losers. Momentum effects have been found in U.S. (Jegadeesh and Titman,
1992) and European (Rouwenhorst, 1998) stock markets. In particular, recent winners outperform
recent losers for about one year, after which time the winners tend to underperform losers. Because of
the curious reversal of fortunes after one year, momentum effects are harder to reconcile with the
efficient market hypothesis. If momentum effects persist in the future, they offer the possibility of
positive risk-adjusted investment opportunities. Asness et al. (2013) found significant momentum
effects in international stock returns, as well as in returns to bonds, commodities, and currencies.
20.12 What additional factors appear to be priced in required returns?
The text mentions liquidity (Lee, 2011), profitability and passive-versus-aggressive investment (Fama
and French, 2015), and idiosyncratic risk (Ang et al., 2009). Asness et al. (2013) found value and
momentum factors in a variety of international asset classes including returns to stocks, bonds,
commodities, and currencies. The search is ongoing.
Problem Solutions
20.1 a. rS = rF + βS (rM – rF) = 8% + [16.5% – 8%] (1.5) = 20.75%.
b. rS = rF + βS (rM – rF) = 4% + [12.5% – 4%] (1.2) = 14.2%.
20.2 a. ßBMW = BMW,DAX (BMW/DAX) = (0.44)(0.105/0.046) 1.00 relative to the DAX index.
b. rBMW = rF + βBMW (E[rM]–rF) = 0.05 + (1.00)(0.06) 0.110, or 11.0%
c. ßDAX,World = DAX,World (DAX/World) = (0.494) (0.0413/0.0526) = 0.3879 relative to the world.
20.3 a. According to BP’s factor sensitivities, BP shares should rise with an increase in world
industrial production, a decrease in the price of oil, or an increase in the value of currencies in
BP’s trading basket in the denominator of the spot rate.
b. E(r) = α + βProd FProd + βOil FOil + βSpot FSpot
= 14% + (1.5)(2%) + (–0.80)(10%) + (0.01)(–5%)
= 14% + 3% – 8% – 0.05% = 8.95%.
c. With an expectation of 8.95 percent and an actual return of only 4 percent, BP underperformed
its expectation by 4.95 percent during the period.
20.4 a. According to Elf’s factor sensitivities, Elf shares should rise with an increase in industrial
production or with an increase in the price of oil. Share price should fall with an increase in
the term premium, the risk premium, or the value of the foreign currencies in Elf’s trading
basket in the denominator of the foreign exchange quote. (Conversely, the negative sign on
this last factor means that Elf is likely to rise with an appreciation of the euro in the numerator
of the spot rate quote.)
b. E(r) = α + βProd FProd + βOil FOil + βTerm FTerm + βRisk FRisk + βSpot FSpot
= 12% + (1.10)(10%) + (0.60)(10%) + (–0.05)(10%) + (–0.10)(10%) + (–0.02)(10%)
= 12% + 11% + 6% – 0.5% – 1% – 0.2% = 27.3%.
c. With an expectation of 27.3 percent and an actual return of –12 percent, Elf underperformed
its expectation by 39.3 percent during the period.
20.5 a. E(r) = α + βM FM + βSMB FSMB + βHML FHML = 10% +(1.0)(–1%) + (0.1)(–1%) + (0.05)(–1%) =
10.00% – 1.00% – 0.10% – 0.05% = 8.85%.
b. With an expectation of 8.85 percent and an actual return of 12 percent, Amazon outperformed
its expectation by 3.15 percent during the period.
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20.6 a. Over a single year, it is difficult to say which manager is likely to see higher returns. Returns
to value (and other) investment strategies vary from year to year.
b. If the value premium persists over the next 10 years as it has in the past, then the value-
oriented strategy of investing in stocks with high equity book-to-market value ratios is likely
to lead to higher returns over 10-year investment horizons.
c. It is difficult to say whether higher returns to value strategies are truly superior risk-adjusted
returns or merely a systematic risk for which investors demand compensation, such as a
premium for relative financial distress.
20.7 a. Momentum strategies invest in recent winners (stocks with high returns over a recent period)
and avoid or short-sell recent losers. In Jegadeesh and Titman’s [1992] study of U.S. stocks,
the return difference between winner and loser portfolios was 9.5 percent over the year
following formation of the winner and loser portfolios. During the second year after portfolio
formation, U.S. winners lost about one-half of this accumulated gain.
b. In Rouwenhorst’s [1998] study of 12 European markets, winners beat losers by 12 percent
over the first year after portfolio formation. As in the United States, winners lost some of their
accumulated gain during the subsequent year. Momentum strategies hold promise for
international markets.
c. Momentum appears to have a strong international component in Rouwenhorst’s study, so there
is a strong possibility that momentum would be found in Latin American stock markets.
d. It would not be a surprise if momentum gradually disappeared as financial markets pursue
momentum-based strategies and learn from their past pricing errors. Many other financial
anomalies have disappeared once they were identified. Hedge funds in particular are well-
positioned to take advantage of momentum-based trading strategies. The more liquid the
market, the more likely that anomalies such as momentum will disappear.
20.8 a. By placing an equal weight on each asset, smaller cap firms will receive a larger weight. Smaller
firms have higher expected returns, so this will increase the expected portfolio return. The equal-
weighted portfolio also will benefit from the value premium (the higher expected return of firms
with high equity book-to-market ratios) to the extent that value firms also tend to be smaller firms.
b. The answer is “it depends” on whether the investor believes that size and value premiums reflect
compensation for bearing higher systematic risks.
c. Performance should be benchmarked to a similarly constructed equal-weighted portfolio.
Otherwise, the comparison would be “apples and oranges.”
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