Exam 2 - Concept Questions

Absolute Purchasing Power Parity

$1 should have the same purchasing power everywhere.

4.1C: In general, what is the future value of $1 invested at r per period for t period?

$1*(1+r)^t

4.2D: In general, what is the present value of $1 to be received in t periods, assuming a discount rate of r per period?

$1*(1+r)^t

5.1A: Describe how to calculate the future value of a series of cash flows.

$100---->($100*1.08) + $100 = $208 ($208*1.08) + $100 = $324.64

Interest Rate Parity

% difference in the forward exchange rate and spot exchange rate is equal to the interest rate differential.

18.6B: What are some ways of hedging political risk?

Using local financing from gov in question, bc they can refuse to pay back debt when unfavorable activities take place.

4.1A: What do we mean by the future value of an investment?

What an investment will be worth after 1 or more periods.

5.3B: What is APR?

r * t

5.1C: Unless we are explicitly told otherwise, what do we always assume about the timing of cash flows in present & future value problems?

Cash Flows occur at the end of the month

18.6A: What is political risk?

Changes in value that are because of politics.

4.2B: The process of discounting a future amount back to the present amount back to present is the opposite of what?

Compounding into the future is the opposite off discounting back into the present.

18.1A: What are the differences between a Eurobond & a foreign bond?

Eurobonds- International bonds issued in multiple countries but denominated in a single currency (usually the issuer's currency). Foreign Bonds- International bonds issue in a single country. Usually denominated in that country's currency.

Relative Purchasing Power Parity

Expected % change in exchange rates is equal to the difference in there inflation rates.

E(St)

Expected exchange rate in t periods

Effective Annual Rate

The interest rate expressed as if it were compounded once per year. FOR SAVERS

18.2C: If we say that the exchange rate is SF 1.9, What do we mean?

SF 1.9 to every $1

Long-Run Exposure

Fluctuate bc of unanticipated changes in economic conditions.

hfc

Foreign country inflation rate

5.3C: What is the relationship between a stated interest rate & an effective interest rate? Which is more relevant for financial decisions?

Must be converted into Effective Annual Rates to compare offers.

5.3B: Are APR and EAR the same?

NO EAR= [1+(APR/m)]^m-1

18.5A: What are some different types of exchange rate risk?

1. Short-Run Exposure 2. Long-Run Exposure 3. Translation Exposure 4. Managing Exchange Rate Risk

5.3A: If an interest rate is given at 12% daily what do we call this rate?

A standard quoted interest rate.

Exchange Rate Risk

Relative currency values vary.

Translation Exposure

Accounting its net income and EPS for some period it must translate everything into dollars.

18.2B: What do we mean by the 3-month forward exchange rate?

Agreement to exchange currency three months in the future.

So

Current (time 0) spot exchange rate

4.2A: What do we mean by present value of an investment?

Current value of a future investment payout, discounted at the appropriate Discount rate.

Short-Run Exposure

Day to day fluctuations in exchange rates create short-run risks for international firms.

18.3B: According to relative PPP, what determines the change in exchange rates?

Difference in the inflation rates of the two countries.

18.4B: Do you expect that interest rate parity will hold more closely that purchasing power parity? Why?

IRP will hold more than PPP b/c 3 things for PPP are rariely ever equal for it to work.

5.3B: What is EAR?

Includes Compounding in the formula.

hus

Inflation rate in the US

Stated Interest Rate

Interest payment made each period. Also, quoted interest rate.

18.4A: What is interest rate parity?

Interest rate differential is = % difference between rate and spot exchange rate.

4.1B: What does it mean to compound interest? How does compound interest differ from simple interest.

Leaving interest earned in the account to earn more interest after time.

Managing Exchange Rate Risk

Many different currencies involved for many different subsidiaries.

18.1B: What are Eurodollars?

Money deposited in a financial center outside the country whose currency is involved.

18.2A: What is Triangle Arbitrage?

Moving through three different exchange rates to "buy low and sell high".

4.3B: What is the basic PV Equation

PV=FVt/(1+r)^t

18.5B: How can a firm hedge short-run exchange rate risk? Long -run exchange rate risk?

Short-Run - Forward exchange agreement to lock in an exchange rate. Long-Run - Try to match up currency inflows and outflows (purchase materials in the same country).

4.3A: What is the rule of 72?

The time it takes to double your money. 72/r%= #of Years.

18.3A: What does Absolute PPP say? Why might it not hold for many types of goods?

Three things must be true for PPP to work: 1. Transaction costs must be ZERO 2. No Barriers to trading (tarrifs) 3. Products must be identical. BIG MAC THEORY

5.1B: Describe how to calculate the present value of cash flows.

Year 5: $1,000*(1/1.06)^5 = 747.26 Year 4: $1,000*(1/1.06)^4 = 792.09 Year 3: $1,000*(1/1.06)^3 = 839.62 Year 2: $1,000*(1/1.06)^2 = 890.00 Year 1: $1,000*(1/1.06)^1 = 943.40 ________________________________________________ Total Present Value = $4,212.37 ________________________________________________ --------------------------------------