Chapter 27 - Managing International Risks

CHAPTER 27

Managing International Risks

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. 117.565

b. 117.541

c. Yen is at premium (dollar is at discount)

d. Premium = 117.565 / 116.903 – 1

Premium = .00566, or .566%

e. From interest rate parity:

116.903 / 117.565 = (1 + ryen) / 1.015

ryen = .00928, or .928%

f. ¥117.429 = $1

g. Assuming the real exchange rate is expected to be constant, the expected

difference in inflation is:

117.429 / 117.565 – 1 = –.00116, or –.116%

The inflation rate in Japan over the three months is expected to be .116%
less than in the United States.

Est. Time: 06 – 10

2. a. The interest rate differential equals the forward premium or discount, i.e.,

b. The percentage difference between the forward rate and today’s spot rate
is equal to the expected change in the spot rate; i.e.,

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Chapter 27 - Managing International Risks

c. Prices of goods in different countries are equal when measured in terms

of the same currency. For example,

Dollar price of a product in the USA

= peso price of the good in Mexico / number of pesos per dollar.

It follows that the expected change in the spot rate equals the expected
inflation differential; i.e.,

d. Expected real interest rates in different countries are equal; i.e.,

Est. Time: 06 – 10

3. a.

R2,419 / $1 × 1.3 / 1.02 = R3,083 / $1

b. Real value of rupiah fell by 3,083 / 8,325 – 1 = .63, or 63%

Est. Time: 01 – 05

4. Using the condition that the interest rate differential equals the forward premium or
discount, the calculations are:

1 + rx / 1 + r$ = fx/$ / sx/$

r$ 1-year = [1.098 / (15.6 / 15)] − 1

r$ 1-year = .0558, or 5.58%

fx/$ 3-months = 15 × [1 + (.048 / 4)]

fx/$ 3-months = 15.1822

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Chapter 27 - Managing International Risks

rx 3-months = {(15.1822 / 15) × [1 + .045](1/4)}4 – 1

rx 3-months = .0967, or 9.67%

fx/$ 1-month = {[1 + .082] / [1 + .04]}(1/12) × 15

fx/$ 1-month = 15.05

Forward discount on nano 1-month = 12 × [(15 / 15.0496) – 1]

Forward discount on nano 1-month = –.0395, or –3.95%

Forward discount on nano 1-year =1 × [(15 / 15.60) – 1]

Forward discount on nano 1-year = –.0385, or –3.85%

Thus, we have:

1 Month 3 Months 1 Year

Dollar interest rate (annually compounded) 4.00% 4.50% 5.58%
Nano interest rate (annually compounded) 8.20% 9.67% 9.80%
Forward nanos per dollar 15.05 15.18 15.60
Forward discount on nano (% per year) 3.95% 4.80% 3.85%

Est. Time: 06 – 10

5. b. By buying pesos forward, the importer locks in the price today, thereby
eliminating exchange risk.

Est. Time: 01 – 05

6. Zero. Buying kronor in the forward market commits the U.S. company, but
does not require an up-front expenditure.
Est. Time: 01 – 05

7. It can borrow the present value of €1 million, sell the Euros in the spot market,
and invest the proceeds in an eight-year dollar loan.

Est. Time: 01 – 05

8. a. Rate of return = (100 / 1.03) / (100 / 1.0522) − 1

Rate of return =.0745, or 7.45%

b. Rate of return = (1.0745 × 115 / 120.22) − 1

Rate of return = .0278, or 2.78%

c. She can borrow against her dollar receipts, convert the proceeds to yen,

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Chapter 27 - Managing International Risks

and lend the yen for one year, so:

Rate of return = 1.0745 × (1.01 / 1.052) − 1

Rate of return = .0316, or 3.16%

Est. Time: 06 – 10

9. a. First, find the NPV using the euro interest rate of 6%:

NPV = €80 + 10 / 1.06 + 20 / 1.062 + 23 / 1.063 + 27 / 1.064 + 25 / 1.065

NPV = €6.61 million

To convert this calculation to dollars, multiply it by the spot exchange rate:

NPV = €6.61 × 1.2 = $7.94 million

b. The forward rate increases by the interest rate differential each year. The
following table shows the forward rates for each of the next five years and
adjusts the cash flow in each year.

Year 0 1 2 3 4 5
Forward rate $/€ 1.200 1.223 1.246 1.269 1.293 1.318
$ million -96 12.23 24.91 29.19 34.92 32.94
Example:

Forward rate2= 1.2(1.08 / 1.06)2 = 1.246

c. It doesn’t. The company can always hedge against a fall in the euro.

Est. Time: 11 – 15

10. a. The dollar is selling at a forward premium on the rand.

b. 4 × (10.9308 / 11.0976 – 1) = −.06012 = −6.012%

Annual percentage discount is 6.012%.

c. Using the expectations theory of exchange rates, the forecast is:

ZAR11.0976 = $1

d. ZAR100,000 × $1 / ZAR11.0976 = $9,010.96

Est. Time: 06 – 10

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Chapter 27 - Managing International Risks

11. We can utilize the interest rate parity theory:

(1 + rreal) / (1 + r$) = ƒreal/$ / sreal/$

rreal = [(2.5874 / 2.5218) × 1.002] – 1

rreal = .0281, or 2.81%

If the three-month rand interest rate were substantially higher than 2.81%, then
you could make an immediate arbitrage profit by buying rands, investing in a
three-month rand deposit, and selling the proceeds forward.

Est. Time: 01 – 05

12. If international capital markets are competitive, the real cost of funds in Japan
must be the same as the real cost of funds elsewhere. That is, the low Japanese
yen interest rate is likely to reflect the relatively low expected rate of inflation in
Japan and the expected appreciation of the Japanese yen. Note that the parity
relationships imply that the difference in interest rates is equal to the expected
change in the spot exchange rate. If the funds are to be used outside Japan, then
Ms. Stone should consider whether to hedge against changes in the exchange
rate and how much this hedging will cost.

Est. Time: 01 – 05

13. Suppose, for example, that the real value of the euro declines relative to the
dollar. Competition may not allow Lufthansa to raise trans-Atlantic fares in dollar
terms. Thus, if dollar revenues are fixed, Lufthansa will earn fewer euros. This
will be offset by the fact that Lufthansa’s costs may be partly set in dollars, such
as the cost of fuel and new aircraft. However, wages are fixed in euros. So the
net effect will be a fall in euro profits from its trans-Atlantic business. However,
this is not the whole story. For example, revenues may not be wholly in dollars.
Also, if trans-Atlantic fares are unchanged in dollars, there may be extra traffic
from German passengers who now find that the euro cost of travel has fallen. In
addition, Lufthansa may be exposed to changes in the nominal exchange rate.
For example, it may have bills for fuel that are awaiting payment. In this case, it
would lose from a rise in the dollar.
Note that Lufthansa is partly exposed to a commodity price risk (the price of fuel
may rise in dollars) and partly to an exchange rate risk (the rise in fuel prices may
not be offset by a fall in the value of the dollar). In some cases, the company can,
to a great extent, fix the dollar cash flows, such as by buying oil futures.
However, it still needs at least a rough-and-ready estimate of the hedge ratios,
i.e., the percentage change in company value for each 1% change in the
exchange rate. Lufthansa can then hedge in either the exchange markets
(forwards, futures, or options) or the loan markets.

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Chapter 27 - Managing International Risks

Est. Time: 06 – 10

14. Suppose a firm has a known foreign currency income (e.g., a foreign currency
receivable). Even if the law of one price holds, the firm is at risk if the overseas
inflation rate is unexpectedly high and the value of the currency declines
correspondingly. The firm can hedge this risk by selling the foreign currency
forward or by borrowing foreign currency and selling it spot. Note, however, that
this is a relative inflation risk, rather than a currency risk; e.g., if you were less
certain about your domestic inflation rate, you might prefer to keep the funds in
the foreign currency.
If the firm owns a foreign real asset your worry is that changes in the exchange
rate may not affect relative price changes. In other words, you are exposed to
changes in the real exchange rate. You cannot so easily hedge against these
changes unless, say, you can sell commodity futures to fix income in the foreign
currency and then sell the currency forward.

Est. Time: 06 – 10

15. The dealer estimates the following relationship in order to calculate the hedge
ratio (delta):
Expected change in company value = a + (δ × change in value of yen)
For the Ford dealer:
Expected change in company value = a + (5 × change in value of yen)
Thus, to fully hedge exchange rate risk, the dealer should sell yen forward in an
amount equal to five times the current company value.

Est. Time: 06 – 10

16. Answers may vary. Assuming the euro either appreciates to $1.40 or
depreciates to $1.30, the future cash flows from the two strategies are as follows:

Euro Appreciates to Euro Depreciates to

Sell Euro Forward
$1.40/Euro $1.30/Euro
i. Do not receive order
1,000,000(1.3620) 1,000,000(1.3620)
(must buy euros at future
– 1,000,000(1.40) = – $38,000 – 1,000,000(1.30) = $62,000
spot rate to settle contract)
ii. Receive order (deliver)
(inflow of 1,000,000 euros to 1,000,000(1.3620) = $1,362,000 1,000,000(1.3620) = $1,362,000
settle contract)
Buy 6-Month Euro Appreciates to Euro Depreciates to
Put Option $1.40/euro $1.30/euro
i. Do not receive order $0 1,000,000(1.3620)

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Chapter 27 - Managing International Risks

(if euro depreciates, buy – 1,000,000(1.30) = $62,000

euros at future spot rate and
exercise put)
ii. Receive order
(sell euros received at the
1,000,000(1.40) = $1,400,000 1,000,000(1.3620) = $1,362,000
higher of the spot or put
exercise price)

Note that, if the firm is uncertain about receiving the order, it cannot completely
remove the uncertainty about the exchange rate. However, the put option does
place a downside limit on the cash flow although the company must pay the
option premium to obtain this protection.

Est. Time: 16 – 20

17. a. Pesos invested = 1,000 × 500 pesos = 500,000 pesos

Dollars invested = 500,000 /13.6083 = $36,742.28

b. Total return in pesos = (550 – 500) / 500 = .10, or 10%

Dollars received = (550 × 1,000) / 13.9248 = $39,497.87

Total return in dollars = ($39,497.87 – 36,742.28) / $36,742.28

Total return in dollars = .0750, or 7.50%

c. There has been a return on the investment of 10% but a loss on the
exchange rate.

Est. Time: 06 – 10

18. To determine whether arbitrage opportunities exist, we use the interest rate
theory. For example, we check to see whether the following relationship
between the U.S. and Costaguana holds:
1 + rpulgas fpulgas / $
=
1 + r$ spulgas / $

For the different currencies, we have:

Ratio of Interest Ratio of Forward Rate
Rates to Spot Rate
Costaguana 1.194175 1.194200

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Chapter 27 - Managing International Risks

Westonia 1.019417 1.019231

Gloccamorra 1.048544 1.064327
Anglosaxophonia 1.010680 .991304

For Anglosaxophonia and Gloccamorra, there are arbitrage opportunities

because interest rate parity does not hold. For example, one could borrow
$1,019.42 at 3% today, convert $1,000 to 2,300 wasps, and invest at 4.1%. This
yields 2,394.3 wasps in one year. With a forward contract to sell these for
dollars, one receives (2,394.3/2.28) = $1,050 dollars in one year. This is just
sufficient to repay the $1,019.42 loan: $1,019.42 × 1.03 = $1,050.The $19.42
difference between the amount borrowed ($1,019.42) and the amount converted
to wasps ($1,000) is risk-free profit today.

Est. Time: 11 – 15

19. A major point in finance is that risk is undesirable particularly when it can be
reduced or eliminated. This is the purpose of hedging. At the time the hedge was
initiated, the hedger’s opinion was that sterling was priced correctly (otherwise
the hedge would not have been placed) and that any deviations from the
expected value were unacceptable.

Est. Time: 01 – 05

20. Converting the cash flows to dollars, the NPVs are computed as:

NPVG = –78 + 12.877 / 1.1 + 19.134 / 1.12 + 18.953 / 1.13 + 25.033 / 1.14 +
24.797 / 1.15 + 24.563 / 1.16
NPVG = $10.12

NPVS = –80 + 13.462 / 1.1 + 20.386 / 1.12 + 20.582 / 1.13 + 24.244 / 1.14 +
24.477 / 1.15 + 24.712 / 1.16
NPVS = $10.26

Sample calculations for the year 1 cash flows (as shown above) for Germany and
Switzerland, respectively:

10 × 1.3 × 1.05 / 1.06 = 12.877

20 / 1.5 × 1.05 / 1.04 = 13.462

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Chapter 27 - Managing International Risks

Since both projects have a positive NPV, both should be accepted. If the firm
must choose, then the Swiss plant is the better choice. Note that the NPV
calculation is in dollars and implicitly assumes currency hedging.

Est. Time: 11 – 15

21. Alpha has revenues in euros and expenses in dollars. If the value of the euro
falls, its profit will decrease. In the short run, Alpha could hedge this exchange
risk by entering into a forward contract to sell euros for dollars.
Omega has revenues in dollars and expenses in euros. If the value of the euro
falls, its profit will increase. In the short run, Omega could hedge this exchange
risk by entering into a forward contract to sell dollars for euros.

Est. Time: 06 – 10

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McGraw-Hill Education.