International Finance Final

Identify the correct BOP account and entry for each of the following transactions. c. Hong Kong students pay tuition to the University of California, Berkeley.

Current account: Service export

Identify the correct BOP account and entry for each of the following transactions. e. A Japanese auto company pays the salaries of its executives working for its U.S. subsidiaries.

Current account: Service exports

Identify the correct BOP account and entry for each of the following transactions. f. A U.S. tourist pays for a restaurant meal in Bangkok.

Current account: Service imports

Identify the correct BOP account and entry for each of the following transactions. h. A U.K. corporation purchases a euro-denominated bond from an Italian MNE.

Does not enter the U.S. balance of payments

Dow Chemical has sold SFr 25 million in chemicals to Ciba-Geigy. Payment is due in 180 days. What is the hedged value of Dow's receivable using the forward market hedge?

Dow Chemical can use a forward contract to lock in a value of $20,237,500 = (25,000,000 * 0.8095) to receive in t = 180 days, i.e., sell SFr for $ now at 180-day forward exchange rate.

Dow Chemical has sold SFr 25 million in chemicals to Ciba-Geigy. Payment is due in 180 days. What alternatives are available to Dow to use currency options to hedge its receivable? Which option hedging strategy would you recommend?

Dow can buy a SFr put option at a put premium of 1% giving it the right but not the obligation to sell SFr25 million in 180 days at a price of $0.80/SFr. *(advanced) Dow can also use a currency collar, which would involve buying the put option and selling a call option in the amount of SFr25 million and receiving a 2% premium.

Dow Chemical has sold SFr 25 million in chemicals to Ciba-Geigy. Payment is due in 180 days. b. Explain how Dow can use the money market hedge?

Dow would borrow the present value of the SFr 25 million receivable, which equals SFr24,764,735 = (25,000,000/1.0095) at the 0.95% 180-day interest rate (1.9%/2). This franc amount translates into a dollar amount of $19,705,300 at the current spot rate of $0.7957/SFr. By investing these dollars at the semiannual rate of 2.625% (5.25%/2), Dow will have $20,222,564 at the end of 180 days (1.02625 * $19,705,300). It can then pay off the Swiss franc loan with the SFr25 million in collected receivables.

In 1995, one dollar bought ¥80. In 2000, it bought about ¥110. c. By what percent has the dollar risen in value between 1995 and 2000?

During this same period, the dollar appreciated by 37.5%, calculated as (110 - 80)/80.

Identify the correct BOP account and entry for each of the following transactions. g. A Colombian citizen smuggles cocaine into the United States, receives cash, and smuggles the dollars back into Colombia.

Errors and omissions, but should be a current account item

What are the main disadvantages for a firm to be located in a segmented market?

Firms located in a segmented market usually have a higher cost of capital (increasing marginal cost of capital) and less availability of capital. They can overcome these limitations by following a proactive strategy to internationalize their cost and availability of capital.

Futures are marked to market while forwards are not. Explain.

Futures accounts are valued daily according to market values while forwards are kept at their notional book values.

Relative purchasing power parity

Holds that the rate of exchange rate changes between a pair of countries is about equal to the difference in inflation rates of the two countries. Conceptually, exchange rate changes should be roughly equal to the inflation rate differential, which measures changes in purchase powers of two monies.

According to popular opinion, U.S. trade deficits indicate any or all of the following: a lack of U.S. competitiveness owing to low productivity, low-quality products, lower wages, superior technology, and unfair trade practices by foreign countries. Which of these factors are (is) likely to underlie the persistent U.S. trade deficits. Comment/Explain.

None of these factors underlie the persistent U.S. trade deficits. For example, Ireland is handicapped even more than the U.S. by these factors but nonetheless runs a trade surplus. Similarly, Latin American nations ran trade surpluses during the 1980s, when they were basket cases. Many will argue that the U.S. trade deficits reflect the U.S. savings deficit.

CIRP. Jason Smith is a foreign exchange trader with Citibank. He notices the following quotes. a. Ignoring transaction costs, is the interest rate parity holding? b. Is there an arbitrage possibility? If yes, what steps would be needed to make an arbitrage profit? Assuming that Jason Smith is authorized to work with $1,000,000 for this purpose, how much would the arbitrage profit be in dollars?

See study guide

Fisher international (UIRP). The one year interest rate is 12% on British pounds and 9% on U.S. dollars. If the current exchange rate is $1.68 = £1, what is the expected future exchange rate in one year?

See study guide

Rebecca Taylor, an international equity portfolio manager, recognizes that optimal country allocation strategy combined with an optimal currency strategy should produce optimal portfolio performance. To develop her strategy, Taylor produced the table below, which provides expected return data for the three countries and three currencies in which she may invest. The table contains the information she needs to make market strategy (country allocation) decisions and currency strategy (currency allocation) decisions. a. Rank the country for expected returns for a US-based investor. b. Explain one advantage a portfolio manager obtains in formulating a global investment strategy, by calculating both expected market returns and expected currency returns. c.* Discuss one additional analysis that you would recommend?

See study guide for full details. a. National equity returns in US dollar terms, United Kingdom = first; United States = second; Japan = third. b. Computing expected currency premium helps the portfolio manager to decide whether to hedge currency risk. c.* One possible additional analysis is: Compute and evaluate risk-adjusted performance measures: (Ri - Rf)/beta, or (Ri - Rf)/SD

Absolute purchasing power parity

States that the exchange rate between the two countries should be determined by the relative purchasing power of two monies measured inversely by the ratio of two general price indices.

Fisher domestic. The nominal interest rate in France is 3.9%, and expected French inflation is 2.1%. What is the real interest rate in France?

i Fr = 3.9%, PiFr = 2.1% 1+r = (1=i$)/(1+pi); real r Fr = (1.039/1.021) -1 = 1.76%

A US firm borrows yen at 4% for one year. The current spot exchange rate is 100yen/$ but is expected to change to 95yen/$ during the year. What is the expected dollar cost (in percentage) of the yen borrowing?

i$ = (1+0.04)(1+0.0526) -1 = 9.47% where: change in yen = [(1/95) - (1/100)]/(1/100) = (100-95)/95 = 0.0526

The US firm borrows euros at 5% for one year. The spot exchange rate is 1.3$/euro, and one-year forward exchange rate is 1.35$/euro. What is the percentage dollar cost (exchange risk-covered) of the euro borrowing?

i$ = (1+05)(1+0.03846) -1 =9.038% where: the forward premium on euro = (1.35-1.3)/1.3 = 0.03846

Systematic risk

is the risk of share price changes that cannot be avoided by diversification. In other words, it is the risk that the stock market as a whole will rise or fall, and the price of shares of an individual company will rise and fall with the market. Systematic risk is sometimes called market risk.

Under the gold standard all national governments promised to follow the "rules of the game." This meant defending a fixed exchange rate. What did this promise imply about a country's money supply?

o The money supply should change in proportion to changes in the amount of gold held by the government. o Given the fixed parity between gold and currency, a country's money supply was limited to the amount of gold held by its central bank or treasury.

Graph the seller's profit or loss for the call option described in #4. What is the break-even spot exchange rate?

see study guide for graph

Instead of its previous policy of always hedging its foreign currency receivables, Sun Microsystems has decided to hedge only when it believes the dollar will strengthen. Otherwise, it will go uncovered. Comment on this new policy.

Sun is engaging in selective hedging, which is really partial speculation. Sun faces the risk that it will be unhedged when foreign currencies weaken and be hedged when they strengthen. The purpose of hedging is to reduce risk, not to boost profits.

What is the "exchange rate pass through"? What is its relevance for hedging?

The "exchange rate pass through" refers to the notion that exchange rate changes can lead to price changes. That is, a depreciation of the local currency can cause cost increase and output price changes of, say, an importing firm, depending on the ability of the firm to pass the cost increase onto customers through price increases. If the exchange rate pass through is full, the exchange rate changes may not affect net cash flow or the value of the firm, hence the hedging may be superfluous.

Eurodollar Deposits. Why would anyone, individual or corporation, want to deposit U.S. dollars in a bank outside of the United States, when the natural location for such deposits would be a bank within the United States?

The depositor can receive a higher interest rate on Eurodollar deposits than on domestic currency deposits. In certain foreign locations, it can also help hide asset (or income) from US taxes.

Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1: Where would you invest?

The dollar return from a three-month investment in Japan can be found by converting dollars to yen at the spot rate, investing the yen at 1.75% (7%/4), and then selling the proceeds forward for dollars. This yields a dollar return equal to 142 x 1.0175/139 = 1.0395 or 3.95%. This return significantly exceeds the 2.25% (9%/4) return available from investing in the United States. Invest in yen.

In 1995, one dollar bought ¥80. In 2000, it bought about ¥110. a. What was the dollar value of the yen in 1995? What was the yen's dollar value in 2000?

The dollar value of the yen in 1995 was $0.0125 = 1/80. By 2000, the yen had fallen to $0.00909.

Explain how matching currency cash flows can offset operating exposure. Give an example of matching currency cash flows.

The essence of this approach is to create operating or financial foreign currency cash outflows to match equivalent foreign currency inflows, for all time periods. - Often foreign currency debt is incurred in the same currency in which operating cash flows are received.

Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1: Where would you borrow?

The flip side of a lower return in the US is a lower borrowing cost. Borrow in the US, i.e., in dollar.

Why would one company with interest payments due in pounds sterling want to swap those payments for interest payments due in U.S. dollars?

The usual motivation for a currency swap is to replace cash flows scheduled in an undesired currency with flows in a desired currency. Firms often raise capital in currencies in which they do not possess significant revenues or other natural cash flows. The reason they do so is cost; specific firms may find capital costs in specific currencies attractively priced to them under special conditions. Having raised the capital, however, the firm may wish to swap its repayment into a currency in which it has future operating revenues. It may also be the case that the firm may have cash inflows in an undesired currency and wish to swap them into a preferred currency.

Explain the concept of the world beta of a security.

The world beta measures the sensitivity of returns to a security to returns to the world market portfolio. It is a measure of the systematic risk of the security in a global setting. Statistically, the world beta can be defined as: Cov(Ri,RM)/Var(RM), where Ri and RM are returns to the i-th security and the world market portfolio, respectively. The world beta of a security is smaller than its domestic market beta given imperfect correlations of national capital markets.

Why are the sovereign debtors of the Eurozone considered to have a problem that is different from these of any other heavily indebted country outside a single currency area? What lessons can economists draw from the exchange rate experiences of the European Monetary System?

Their debt is denominated in euros, which the Eurozone nations individually do not have the right to print. A country like the U.S. denominates its debt in U.S. dollars, which it has exclusive rights to print. The individual sovereign states of the European Union do not have that right or capability, as all euro issuances are by the European Central Bank, which maintains its independence of any individual state within the EU. Lesson: Monetary union is inconsistent with independent monetary policies by sovereign states: it requires coordination of monetary policies.

What is the motivation on the part of countries which adopted the Currency Board system?

They adopted the currency board system because they wanted to fix the value of their currency to that of an international currency such as the US dollar. In effect, this reflects their desire to let its economy decided by the monetary policy of the US rather than their own government.

A current-account surplus is not always a sign of health; a current account deficit is not always a sign of weakness. Comment.

A current-account surplus represents an excess of domestic savings over domestic investment. This excess savings could reflect a lack of domestic investment opportunities. For example, Japan's current-account surplus has grown since 1990, reflecting a prolonged economic slump and relatively poor domestic growth opportunities. Similarly, the Asian crisis that began in the summer of 1997 forced the various Asian nations to slow down their growth and led to outflows of capital. The flip side of a capital outflow, of course, is a current-account surplus. At the same time, countries growing rapidly are likely to face current-account deficits, as economic growth generates domestic investment opportunities that can't all be financed through domestic savings. In other words, the faster a nation grows relative to other nations, the more likely it is to have a current-account deficit; conversely, slow economic growth is more likely to lead to a current-account surplus.

How would you define and measure multinational corporations?

A firm is called a MNC if it has controlling real assets or operating facilities in multiple countries. Operationally, it can be measured by the extent of "foreign content," proxied by foreign sales ratios, foreign asset ratios, and foreign employee ratios, or their averages, augmented by the number of countries in which the firm has operations.

Describe the differences between foreign bonds and Eurobonds.

A foreign bond issue is one offered by a foreign borrower to investors in a national capital market. Yankee bond is a foreign bond (foreign firms or governments issue dollar bonds in US), as is Samurai bond (foreign entities issue yen bond in Japan). Eurobond issues are denominated in a particular currency, but sold to investors in offshore capital markets outside the country which issues the denominating currency. [Eurobonds make up over 80 percent of the international bond market. The two major reasons for this stem from the fact that the U.S. dollar is the currency most frequently sought in international bond financing. First, Eurodollar bonds can be brought to market more quickly than Yankee bonds because they do not have to meet the strict SEC registration requirements. Second, Eurodollar bonds are typically bearer bonds that provide anonymity to the owner and thus allow a means for evading taxes on the interest received.]

Define market segmentation

A national capital market is segmented if the adjusted required rate of return on securities in that market differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets. Capital markets become segmented because of such factors as excessive regulatory control, taxes, perceived political risk, anticipated foreign exchange risk, lack of transparency, information asymmetry, cronyism, insider trading, unfamiliarity, and many other market imperfections.

Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1: What is the arbitrage profit if any?

Absent transaction costs that would wipe out the yield differential, it makes sense to borrow dollars in New York at 2.25% and invest them in Tokyo at 3.95%.

What is meant by an option that is in-, at-, or out-of-the-money?

An option is in/out of the money if its intrinsic value (on the basis of comparing market values of underlying assets, S, relative to strike price, X) is positive or zero. The intrinsic value is positive when S is greater than X for a call, and when S is smaller than X for a put. At-the-money option is when S is equal to X.

In contrast to simple examples in the text, many firms do not hedge their transaction exposures fully. Explain three (3) reasons why they may remain partly or fully unhedged.

Arguments against Corporate Currency Risk Management. (1). Shareholders can diversify their portfolios to manage the risk in a way that satisfies their individual preferences and risk tolerance. (2). Currency risk management is costly while it may not increase the expected cash flows of the firm. (3). Management often conducts hedging activities that benefit management at the expense of the shareholders. (agency cost) (4). Managers cannot outguess the market. If markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be zero. (5). Management's motivation to reduce variability is sometimes driven by accounting reasons. Foreign exchange losses appear in the income statement as a separate line item or as a footnote, but the higher costs of protection are buried in operating or interest expenses. (6). Efficient market theorists believe that investors can see through the "accounting veil," and therefore have already factored the foreign exchange effect into a firm's market valuation. Hedging would only add cost. Arguments for Currency Risk Management* (unassigned) 1. Reduction in risk of future cash flows improves the planning capability of the firm. 2. With smoother cash flow, the firm may be able to undertake specific investments or activities that it might otherwise not consider. 3. Reduction of risk in future cash flows reduces the likelihood that the firm's cash flows will fall below a certain level sufficient to make debt-service payments. Hedging reduces the probability of default. 4. Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm as well as in executing the hedging. 5. Markets are usually in disequilibrium because of structural and institutional imperfections, as well as unexpected external shocks (such as an oil crisis or war). Management is in a better position than shareholders to recognize disequilibrium conditions, and to take advantage of one-time opportunities to enhance firm value through selective hedging.

As the value of the US dollar rises, what is likely to happen to the US balance of payment on current account? Explain.

As the dollar rises in value, other things being equal, U.S. goods and services become relatively more expensive in foreign currency terms, while foreign goods and services become relatively less expensive in dollar terms. The result is a smaller surplus or larger deficit on the current account. Of course, this conclusion could be reversed if the reason for the rise in the real value of the dollar was a significant increase in U.S. productivity, which would facilitate exports. However, other things do not remain equal. In fact, exchange rates equate currency supplies and demands. They do not determine the distribution of these currency flows between trade flows (the current-account balance) and capital flows (the financial-account balance). This view of exchange rates predicts that there is no simple relation between the exchange rate and the current-account balance. Trade deficits do not cause currency depreciation, nor does currency depreciation by itself help reduce a trade deficit: Both exchange rate changes and trade balances are determined by more fundamental economic factors. These more fundamental factors are a nation's savings and investment decisions.

Stock returns, in a currency unit, are generally less correlated across countries than within a country. Why can this be?

Asset returns are less correlated probably because countries are different from each other in terms of industry structure, resource endowments, macroeconomic policies, and have non-synchronous business cycles. Assets from a same country are subject to the same business cycle and macroeconomic policies, thus causing high correlations among their returns.

Dell Computers would like to borrow pounds, and Virgin Airlines wants to borrow dollars. Because Dell is better known in the United States, it can borrow on its own dollars at 7 percent and pounds at 9 percent, whereas Virgin can on its own borrow dollars at 8 percent and pounds at 8.5%. b. What savings are realized by Dell and Virgin?

Assuming no interest rate adjustments, Dell would pay 8.5% on the £10 million and Virgin would pay 7% on its $16 million. Given that its alternative was to borrow pounds at 9%, Dell would save 0.5% on its borrowings, or an annual savings of £50,000. Similarly, Virgin winds up paying an interest rate of 7% instead of 8% on its dollar borrowings, saving it 1% or $160,000 annually.

Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimate of the one year forward exchange premium (discount) at which the pound will be selling relative to the French franc?

Based on the numbers, Japan's real interest rate is about 5% (8% 3%). From that, we can calculate France's nominal interest rate as about 17% (12% + 5%), assuming that arbitrage will equate real interest rates across countries. Since UK's nominal interest rate is 14%, for interest rate parity to hold, the pound should sell at around a 3% forward premium relative to the French franc. Note: forward premium on pound against to euro ≈ French interest rate - UK interest rate = 17 - 14 = 3%.

Identify the correct BOP account and entry for each of the following transactions. b. Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to Copenhagen.

Current account (positive): Goods exports FOB

Identify the correct BOP account and entry for each of the following transactions. d. The U.S. Air Force buys food in South Korea to supply its air crews.

Current account: Good imports

Beta (in the Capital Asset Pricing Model).

Beta is a measure of the systematic risk of a firm, which cannot be diversified away. Beta measures the amount of fluctuation expected in a firm's share price, relative to the stock market as a whole. Thus a beta of 0.8 would indicate an expectation that the share price of a given company would rise or fall at 80% of the rise or fall of the stock market in general. A beta of 1.6 would indicate an expectation that the share price of a given company would rise or fall at 60% more than the rise or fall in the market. If the market rose, say, 20% during a year, a stock with a beta of 1.6 would be expected to rise (0.20)(1.6) = 0.32, or 32%.

In 1995, one dollar bought ¥80. In 2000, it bought about ¥110. b. By what percent has the yen fallen in value between 1995 and 2000?

Between 1995 and 2000, the yen fell by 27.27%, calculated as (0.00909 - 0.0125)/0.0125.

Magnetronics, Inc., a U.S. company, owes its Taiwanese supplier NT$205 million in three months. The company wishes to hedge its NT$ payable. The current spot rate is NT$1 = US$0.03987, and the three-month forward rate is NT$1 = US$0.04051. Magnetronics can also borrow/lend U.S. dollars at an annualized interest rate of 12% and Taiwanese dollars at an annualized interest rate of 8%. b. What is the U.S. dollar cost by money market hedge? Describe the procedure it would use to get this price.

Borrow US$, convert them into NT$, invest the NT$ for three months, sell NT$ for US$ forward now, and use the investment proceeds to settle the NT$ payable. To estimate the dollar cost of this money market hedge, we must work backwards to figure out how many NT$ are needed today. At a quarterly interest rate of 2%, Magnetronics must invest NT$200,980,392 = 205,000,000/1.02 now to pay off NT$ A/P in three months. At the current spot rate (NT$1 = U.S.$0.03987), this translates into NT$200,980,392*0.03987 = US$8,013,088 today. At a quarterly U.S interest rate of 3%, this loan will cost US$8,013,088*1.03 = US$8,253,481 to repay in three months. Since this is less than the cost of satisfying the payable using the forward market, use the money market hedge and lock in a cost of U.S.$8,253,481 as of t=90 days.

Magnetronics, Inc., a U.S. company, owes its Taiwanese supplier NT$205 million in three months. The company wishes to hedge its NT$ payable. The current spot rate is NT$1 = US$0.03987, and the three-month forward rate is NT$1 = US$0.04051. Magnetronics can also borrow/lend U.S. dollars at an annualized interest rate of 12% and Taiwanese dollars at an annualized interest rate of 8%. a. What is the U.S. dollar cost for Magnetronics by forward hedge?

Buy NT$ three-month forward now NT$205,000,000*0.04051= US$8,304,550

Magnetronics, Inc., a U.S. company, owes its Taiwanese supplier NT$205 million in three months. The company wishes to hedge its NT$ payable. The current spot rate is NT$1 = US$0.03987, and the three-month forward rate is NT$1 = US$0.04051. Magnetronics can also borrow/lend U.S. dollars at an annualized interest rate of 12% and Taiwanese dollars at an annualized interest rate of 8%. c. If the firm wanted to use option hedge, should it buy a call or put on NT$?

Buy a call on NT$.

Identify the correct BOP account and entry for each of the following transactions. a. A German-based pension fund buys U.S. government 30-year bonds for its investment portfolio.

Capital account (inflow): portfolio investment liabilities

What are the six main causes of market segmentation?

Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions. The most important imperfections are: • Asymmetric information between domestic and foreign-based investors • Lack of transparency • High securities transaction costs • Foreign exchange risks • Political risks • Corporate governance differences • Regulatory barriers

Citigroup sells a call option on euros (contract size is €500,000) at a premium of $0.04 per euro. If the exercise price is $1.34 and the spot price of the euro at expiration is $1.36, what is Citigroup's profit (loss) on the call option?

Citicorp sells a Euro call X = $ 1.34/€ Contract size = 500,000€ Premium = $0.04/€ Sn = $ 1.36/€ at expiration date Buyer's gain (at Sn = $ 1.36/€) If Sn > X, exercise call, Gain of $0.02/€. Add : Call Premium of $0.04 /€ Net $-0.02/ € Net gain for buyer = -0.02(500,000) = $-10,000 Net gain for seller = +$10,000

An alternative arrangement for managing operating exposure between firms with a continuing buyer-supplier relationship is risk sharing. Explain how risk sharing works.

Contracts, including sales and purchasing contracts, between parties operating in different currency areas can be written such that any gain or loss caused by a change in the exchange rate will be shared by the two parties. This is often done by putting a price adjustment clause in the contract.

Suppose DEC buys a Swiss franc futures contract (size is SFr 125,000) at a price of $0.83. If the spot rate for the Swiss franc at the date of settlement is SFr 1 = $0.8250, what is DEC's gain or loss on this contract?

Dell buys a SFr futures Contract size = SFr 125,000 Futures price = $ 0.83 / SFr Sn = $ 0.8250 / SFr at settlement Gains or Losses = (Sn - F) (contract size ) = (0.8250 - 0.83) (125,000) = $ -625 see study guide for graph

Would exchange rate changes always increase the risk of foreign investment? Discuss the condition under which exchange rate changes may actually reduce the risk of foreign investment.

Exchange rate changes need not always increase the risk of foreign investment. When the covariance between exchange rate changes and the local market returns is sufficiently negative to offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce the risk of foreign investment.

How would stock options granted to a firm's management and employees be viewed by the shareholder wealth maximization model compared to the stakeholder wealth maximization model?

Executive stock options are used in Shareholder Wealth Maximizing firms to align the interests of managers with those of shareholders, in the belief that those managers will then make decisions which will enhance the wealth of stockholders, including those executives.

Define greenfield investment versus foreign direct investment.

FDI involves corporate investments in real assets located aboard and includes both greenfield investment and international mergers and acquisitions. The greenfield investment involves construction of plants and equipment or R&D facilities from the scratch.

China's overall savings rate is now nearly 50% of GDP, the highest in the world. China's domestic investment rate, at 43%, is also high, but not as high as its savings rate. What do these facts imply about China's current-account balance?

If a nation's saving exceeds its domestic investment, that nation will run a current-account surplus equal to its net saving surplus. Given the figures presented, China should run a current-account surplus equal to 7% of GDP, the difference between its saving and domestic investment.

Explain why and how a firm's cost of capital may decrease when the firm's stock is cross-listed on foreign stock exchanges.

If a stock becomes internationally tradable upon overseas listing, the required return on the stock is likely to go down because the stock will be priced according to the international systematic risk rather than the local systematic risk. It is well known that for a typical stock, the international systematic risk is lower than the local systematic risk.

A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt or yen debt. b.* Suppose the company is a multinational firm with sales in Japan and inputs that are primarily determined in dollars. How should this affect its financing choice?

In this case, the firm clearly has a long economic exposure to yen. By financing in yen, the MNC can offset its yen economic exposure.

Suppose nations attempt to pursue independent monetary and fiscal policies. How will exchange rates behave?

Independent monetary and fiscal policies generally will lead to volatile exchange rates as market participants receive and assess new information on these policies.

A pound call that has an exercise price of $1.50 and expires in 2 months has a premium of $0.25 per pound. Assuming the current spot exchange rate of $1.55 per pound, what is the intrinsic value of the pound call? Time value?

Intrinsic value = 1.55- 1.50 = 0.05$/pound Time value = option value - intrinsic value = 0.25 - 0.05 = $0.20/pound

As the value of US current account deficit increases, what is likely to happen to the value of US dollar? Explain.

It all depends on what is driving the increase in the U.S. current-account deficit. If the deficit increases because the U.S. economy is growing strongly, then the dollar is likely to rise in value as foreign capital comes in to take advantage of growth opportunities. On the other hand, if the current-account deficit rises because the government budget deficit is increasing, then the value of the dollar is likely to decline because of the adverse implications of a budget deficit for future economic growth. The current-account deficit could also be increasing because the exchange rate is set at too high a level. If so, then the dollar's future prospects would be dim as well. Similarly, if the U.S. current-account deficit is rising because foreign central banks are intervening to hold down the values of their currencies, then the U.S. dollar should fall sooner or later.

A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt or yen debt. a. Suppose the company is an MNC with sales in the U.S. and inputs purchased in Japan. How should this affect its financing choice?

It appears that based on its sourcing of inputs in Japan, the company is short yen. Other things being equal, borrowing yen will exacerbate its short position in yen. Borrow dollar. Since the company has dollar revenue, this is another reason why they should borrow dollar to offset dollar operating revenue. It should also consider generating cash inflow in yen to offset yen cost.

In Germany and Scandinavia, among others, labor unions have representation on boards of directors or supervisory boards. How might such union representation viewed under shareholder wealth model as opposed to the stakeholder wealth model?

Labor union representation is an example toward the corporate stakeholder model (or corporate wealth maximization model), which may make the board responsive to stakeholders rather than just shareholders. Under the stakeholder model, such a statute would be viewed favorably, which under the shareholder wealth model such a statue would be viewed as undue interference into the right of shareholders to manage the assets into which they alone have invested money.

Are multinational firms riskier than purely domestic firms? What data would you need to address this question?

MNCs are riskier than domestic firms because of foreign exchange risk and political risk, which may not always be fully hedgeable or diversifiable. However, some of these may be offset by risk reduction by MNCs due to diversification of their international operations.

Mr. James K. Silber, an avid international investor, just sold a share of Nestlé, a Swiss firm, for SF5,080. The share was bought for SF4,600 a year ago. The exchange rate is SF1.60 per U.S. dollar now and was SF1.78 per dollar a year ago. Mr. Silber received SF120 as a cash dividend immediately before the share was sold. Compute the rate of return on this investment in terms of U.S. dollars.

Mr. Silber must have paid $2,584.27 (=4,600/1.78) for a share of Néstle a year ago. When the share was liquidated, he must have received $3,250 [=(5,080+120)/1.60]. Therefore, the rate of return in dollar terms is: R($) = [(3,250-2,584.27)/2584.27] = 25.76%.

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

Once capital markets are integrated internationally, vast amounts of money may flow in and out of a country in a short time period. This makes it very difficult for monetary authorities to maintain a fixed exchange rate. The fixed exchange rate implies coordinated monetary policy that keeps money supply and interest rate compatible internationally. That is, with capital market integration and fixed exchange rates, monetary independence may not be possible. [Alternatively, with capital market integration and monetary independence, exchange rates need to be flexible. In sum, of the three objectives (market integration, exchange rate stability, monetary independence), a country can achieve two, not all three simultaneously.]

Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects?

One solution for this problem is to cross-list your firm's stock in overseas markets like London and New York that are not segmented. But you should be aware of the associated costs such as the cost of adjusting financial statements, fees charged by the listing exchanges, etc. A more substantive strategy is to obtain financing from offshore markets.

PPP. An economic analysis firm has just published projected inflation rates for the U.S. and Germany for the next five years. U.S. inflation is expected to be 6% per year, and German inflation is expected to be 2% per year. If the current exchange rate is $1.40/€, what should the exchange rates be in three years?

Pi of $ = 6%, Pi of Euro = 2%, S0 = $0.95/Euro, E(St) = ? $/Euro: E(St)/So = ((1+pi$)/(1+piEuro))^t Time E(St) 1 $/Euro 2 3 $1.571/Euro

The law of one price

Refers to the situation that a tradable good should be selling for the same price in a given currency across countries. It requires a commodity arbitrage in frictionless world markets. If it applies to all goods and services (assuming no trade barriers and no non-tradables), then it leads to the absolute PPP.

Why was the foundation of the Bretton Woods system, and why did it eventually fail? What lessons can economists draw from the breakdown of the Bretton Woods system?

The Bretton Woods system (1945-1971) was essentially the fixed exchange rate regime where currencies were pegged to the US dollar, which in turn is pegged to gold at a fixed price for central bank transactions. The regime failed in 1971 because of widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks, as well as US-specific factors. The U.S. dollar was the main reserve currency held by central banks, and was the key to the web of exchange rate values. The US ran persistent and growing deficits in its balance of payments (due to Vietnam war expenses, tax cut), requiring a heavy outflow of dollars to finance the deficits. Eventually the high level of dollars held by foreigners forced the US to devalue the dollar, because the US was no longer able to guarantee conversion of dollars into its diminishing store of gold (due to depletion of international reserves). Lesson: There is a cost of the fixed exchange rate system. The fixed exchange rate system can be sustained only if countries agree to subordinate their monetary policy to the goal of maintaining the fixed exchange rate. The fixed exchange rate system will break down if countries pursue their own monetary policies independently. The basic lesson from Bretton Woods, therefore, is that stabilizing exchange rates requires international monetary coordination, and inconsistent with independence or freedom for every country to do their own thing.

What is a "euro-euro" deposit?

The Eurodollar deposit is the US dollar-denominated deposit outside of the U.S regulatory jurisdiction. The Euroeuro deposit is the Euro-denominated deposit outside of the Eurozone regulatory jurisdiction.

What is the J-curve as used in the BOP literature?

The J curve is an empirical phenomenon that a country's balance of trade paradoxically worsens after devaluation of its currency and improves only in time, in contrast to popular expectation of improving balance of trade based on static theory that currency devaluation should improve the country's BOT.

"If the law of one price holds, it follows that the absolute PPP holds." Comment.

The LOP is a necessary, but not a sufficient, condition for PPP. Even if the LOP holds (due to no trade barriers), it does not follow that the PPP holds if some goods are non-tradable.

The United Kingdom, Sweden and Denmark, which are members of EU, have chosen not to adopt the euro, but rather to maintain their national currencies. What are their motivations?

The United Kingdom chose not to adopt the euro because of the extensive use of the U.K. pound in international trade and financial transactions. The British are also very proud of their long tradition in financial matters. They are afraid that they may lose monetary and financial policy sovereign to the European Central Bank in Frankfurt. The British are also worried about continued concentration of decision making in Brussels, where the main European Union institutions are located. Denmark is also worried about losing its economic independence, as a small country surrounded by big neighbors. Denmark's currency, the krone, is mostly tied to the euro anyway, so it does not suffer a misalignment with the primary currency unit of the surrounding economies. Sweden has strong economic ties to Denmark, Norway, and the United Kingdom, none of which adopted the euro so far. Sweden, like the others, is afraid of over-concentration of power within European Union institutions.

Comment on the following headline from the New York Times, "Germany raises interest rates, and the value of dollar declines" (October 10, 1997).

The increase in German interest rates made German assets more attractive to investors. In the process of shifting funds from the United States to Germany, investors sold dollars to buy the DM they needed to invest in German assets. (An alternative--and consistent--explanation is that the rise in interest rates reflected a tightening of German monetary policy, leading investors to anticipate less German inflation in the future, which would increase their desire to hold DM and thereby boost its value via PPP.)

What is the real exchange rate?

The nominal exchange rate divided by PPP exchange rate. If the nominal exchange rates follow the absolute PPP exactly, the real exchange rate is one. Changes measure the effect of exchange rate on the competitiveness of a firm in one country relative to another country.

Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1: Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?

The profit would be a 1.7% (3.95% - 2.25%) return per dollar borrowed.

In early 1989, Japanese interest rates were about 4 percentage points below U.S. rates. The wide difference between Japanese and U.S. interest rates prompted some U.S. real estate developers to borrow in yen to finance their projects. Comment on this strategy, and spell out the sequence of the transactions.

This is called "yen carry trade." The U.S. developers were either comparing apples and oranges (i.e., ignoring currency differences) or gambling that the 400 basis point interest differential did not reflect market expectations of dollar depreciation. The (uncovered) yen carry trade is risky because it is open to currency risk. International Fisher parity indicates that low interest rate currencies are expected to appreciate against high interest rate currencies. This is indeed what happened in the case of the yen. Yen carry trade transactions: Borrow yen at yen interest rate for one year now; Convert yen to dollar at spot now; Invest dollar now at dollar interest rate for one year; At loan maturity (in one year), convert dollar back to yen at then prevailing spot rate; Pay off yen loan. This can incur loss if the yen strengthens more than the interest rate differential (i.e., low cost of yen borrowing vis-à-vis dollar interest rate).

Discuss the reasons for deviations from the PPP in two categories.

Trade barriers and Non-tradables

Explain how back-to-back loans can hedge foreign exchange operating exposure.

Two firms in different countries lend their home currency to each other and agree to repay each other the same amount at a later date. This can be viewed as a loan between two companies (independent entities or subsidiaries in the same corporate family) with each participant, both making a loan and receiving 100% collateral in the other's currency. A back-to-back loan appears as both a debt (liability side of the balance sheet) and an amount to be received (asset side of the balance sheet) on the financial statements of each firm.

Contrast the US and Chinese BOP.

US: Current account deficit, capital account surplus, small negative overall BOP China: Current account surplus, capital account surplus, large surplus overall, resulting in increase in its international reserves. The relative current account balance in the US and China may reflect their respective domestic savings relative to investment (savings shortfall for US and surplus in China) among other factors.

Dell Computers would like to borrow pounds, and Virgin Airlines wants to borrow dollars. Because Dell is better known in the United States, it can borrow on its own dollars at 7 percent and pounds at 9 percent, whereas Virgin can on its own borrow dollars at 8 percent and pounds at 8.5%. a. Suppose Dell wants to borrow £10 million for two years, Virgin wants to borrow $16 million for two years, and the current ($/£) exchange rate is $1.60. What swap transaction would accomplish this objective? Assume the counter parties would exchange principal and interest payments with no rate adjustments.

Virgin would borrow £10 million for two years and Dell would borrow $16 million for two years. The two companies would then swap their proceeds and payment streams.

International Equities and Currencies. As the newest member of the asset allocation team in your firm, you constantly find yourself being quizzed by your fellow group members. The topic is international diversification. One analyst asks you the following question: Security prices are driven by a variety of factors, but corporate earnings are clearly one of the primary drivers. And corporate earnings—on average—follow business cycles. Exchange rates, as they taught you in college, reflect the market's assessment of the growth prospects for the economy behind the currency. So if securities go up with the business cycle, and currencies go up with the business cycle, why do we see currencies and securities prices across the globe not going up and down together? How would you answer the question?

What sounds so simple at first glance is not. First, exchange rate values change as a result of many factors, not just business cycles. Expected changes in inflation, real interest rates, political and country risk, and current account balances, to name a few, all influence the movement of exchange rates. Second, even if business cycles were a primary driver of currency values, business cycles are not perfectly correlated globally. In fact, one way to appreciate this phenomenon is to consider that in 2001-2002 most of the major industrial economies were either in recession or near recession, but currencies still fluctuated widely. For example, the Japanese yen first depreciated against the dollar in the early part of 2002, but still appreciated significantly by mid-year.

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

• A MNC that has a product market presence or manufacturing facilities in several countries may cross-list its shares on the exchanges of these same countries because there is typically investor demand for the shares of companies that are known within a country. • A company may cross-list its shares on foreign exchanges to broaden its investor base and therefore to increase the demand for its stock. • An increase in demand will generally increase the stock price and improve its market liquidity. • International financing or listing may lower the cost of capital. • A broader investor base may also mitigate the possibility of a hostile takeover. • Cross-listing a company's shares establishes name recognition and thus facilitates sourcing new equity capital in these foreign capital markets. • If a firm has revenue abroad, international financing helps manage the firm's foreign exchange exposure.

Japan has a lower ratio of stock market capitalization relative to GDP than the US. Provide two reasons as to why this may be so.

• Common law countries such as the US (and UK, Canada, Australia, etc.) have a higher ratio of stock market cap relative to GDP than civil law countries such as Japan (and Germany, France, Italy, Denmark, etc.) due to better investor protections. • The lower ratio of stock market cap in Japan is also related to its governance, such as stakeholder model (bank-centered, supplier concerns), which may in turn be related to the Japanese business groups (e.g., keiretsu).

The Fed adopts an easier monetary policy. How is this likely to affect the value of the dollar?

• If the Fed switches to an easier monetary policy, the value of the dollar will drop, as will short-term interest rate. • However. as fear of inflation rises, and the dollar value will decline and long-term interest rates may rise. • On the real side, if the growth in the money supply stimulated the economy to grow more rapidly than it otherwise would, the value of the dollar could rise, and so could real interest rates. The probability of this happening is not very high, however. • Dollar may rise due to its reputation as a safe-haven currency during the financial crisis.

What are some basic differences between the financing patterns of U.S. and Japanese firms? What might account for some of these differences?

• US firms use more internal financing (US; 60-70%) while Japanese firms reply more on external financing • Debt ratios are higher in Japan than in the US • Japanese firms rely more on bank loans than US firms These differences reflect different industrial organization (e.g., business group in Japan - keiretsu) and different corporate governance schemes.