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Homework #2

Q.1 (20 points) For each oI the Iollowing transactions, say whether it is a source oI
transaction exposure, economic exposure, both, or neither.

a. Firm`s imported supplies denominated in local currency
<Answer> economic exposure
b. nterest received Irom Ioreign investments
<Answer> both
c. Firm`s exports denominated in Ioreign currency
<Answer> both
d. omestic sales, while Iacing with Ioreign competition in local markets
<Answer> neither


Q.2 (20 points) Assume the Iollowing inIormation.

Spot rate oI Canadian dollar: $0.82
180-day Iorward rate oI Canadian dollar: $0.85
180-day Canadian interest rate: 3.5
180-day U.S. interest rate: 2

(1)iven this inIormation, what would the 180-day net yield to a U.S. investor who
uses covered interest arbitrage? (10 points)
<Answer>
First, assume the investor invests $820,000.
$820,000/$0.82 C$1,000,000
C$1,000,000 ` (1.35) C$1,350,000
C$1,350,000 ` $0.85 $1,147,500

Yield ($1,147,500 - $820,000)/$820,000 3.99390.., which exceeds the
yield in the U.S. over the 180-day period.

(2)hat should happen to the spot rate and the Iorward rate, so the covered interest
rate parity can be restored? (10 points)
<Answer> The Canadian dollar`s spot rate should rise, and its forward rate
should fall; in addition, the Canadian interest rate may fall and the U.S.
interest rate may rise.






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Q.3 (10 points) Explain how the international Fisher eIIect can be derived Irom the
purchasing power parity and the uncovered interest rate parity.

<Answer> Purchasing power parity suggests a relationship between the inflation
differential of two countries and the percentage change in the spot exchange rate
over time. And the uncovered interest rate parity means a parity condition stating
that the difference in interest rates between two countries is equal to the expected
change in exchange rates between the countries` currencies. If this parity does not
exist, there is an opportunity to make a profit. IFE suggests a relationship between
the interest rate differential of two countries and the percentage change in the spot
exchange rate over time. IFE is based on nominal interest rate differentials, which
are influenced by expected inflation. Thus, the IFE is closely related to PPP and UIP.



Q.4 (10 points) LaSalle Corporation sells both in home and Ioreign countries. The Iirm
Iinds that a change in the exchange rate has a greater impact on cash outIlows than on
cash inIlows. n order to reduce economic exposure, what would you recommend
regarding the volume oI sales to Ioreign countries? Explain the reason Ior your
recommendation.

<Answer> I`d recommend reducing the volume of sales to foreign countries.
Because change in the exchange rate has a greater impact on cash outflows, to
balance between cash outflows and inflows, by reducing the volume of sales to
foreign countries, cash inflows also are reduced. So, the firm can then reduce its
exposure by restructuring its operations to balance its exchange-rate-sensitive cash
flows.





Q.5 (20 points) Fresno Corporation will have to pay 200,000 in 180 days. t has the
Iollowing inIormation.
O Spot rate oI pound as oI today: $1.50.
O 180-day Iorward rate oI pound as oI today: $1.47.
O A call option on pounds that expires in 180 days has an exercise price oI $1.48 and a
premium oI $0.07.
O A put option on pounds that expires in 180 days has an exercise price oI $1.49 and a
premium oI $0.08.
O nterest rates are as Iollows:

U.K. U.S.
180-day deposit rate 2.5 4.5
180-day borrowing rate 3.0 5.0

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O Fresno Corporation Iorecasted the Iuture spot rate in 180 days as Iollows
Possible Outcome Probability
$1.43 20
$1.46 60
$1.52 20

(A) etermine which hedging instrument is better in this situation between a Iorward
hedge and an option hedge. (10 points)
<Answer>
1. Forward hedge
Purchase 200,000 in 180 days forward: 200,000 ` $1.47 294,000


2. Money market hedge
1) Need to invest 160,000 (200,000/1.25 160,000)
2) Need to borrow $240,000 (160,000`$1.50 $240,000)
3) Will need $252,000 to repay the loan in 180 days ($240,000`1.05 $252,000)


3. Call option hedge (Exercise price $1.48; premium $0.07)

Option Amount Paid Total
Possible Premium Exercise Per Unit Amount Probability
Spot rate per Unit Option? (including Paid for
the premium) 200,000

$1.43 $0.07 No $1.50 $300,000 20
$1.46 $0.07 No $1.53 $306,000 60
$1.52 $0.07 Yes $1.55 $310,000 20

4. Unhedged Strategy
Total
Possible Amount Probability
Spot rate Paid for
200,000

$1.43 $286,000 20
$1.46 $292,000 60
$1.52 $304,000 20


The money market hedge is preferable to the unhedged strategy because there is an
100 chance that it will outperform the unhedged strategy and may save as much
as $52,000.

And this situation forward hedging is better than option hedging.
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(B) Compute the real cost oI hedging Ior the instrument that was determined to be the
better one in (A) . 10 points)
<Answer>
Purchase
Forward Unhedged Real
Hedging Strategy Probability Cost

$294,000 $286,000 20 $8,000 ($294,000-$286,000)
$294,000 $292,000 60 $2,000 ($294,000-$292,000)
$294,000 $304,000 20 - $10,000($294,000-$304,000)






Q6. (10 points) Assume that Vermont Company has net receivables oI 300,000 Mexican
peso in 180 days. The interest rate in Mexico is 8 percent over 180 days, and the U.S.
interest rate is 4 percent over 180 days. The spot rate oI the Mexican peso is $0.10.

escribe the steps to take Ior money market hedging, and compute the nominal revenue
Irom the receivable with money market hedging.
<Answer>
1. Borrow Mexican peso 277,777.778
(Mexican peso 300,000/1.08 Mexican peso 277,777.778)
2. Convert Mexican peso 277,777.778 to $ 27,777.778(at $0.10 per Mexican peso)
3. nvest the $27,777.778 at 4 to earn $28,888.8889 by the end oI 180 days.

Nominal revenue is $28,888.889 - $30,000(Mexican peso 300,000*$0.10) -$1,111.111


Q.7 (10 points) Assume the Iollowing inIormation is available as oI today.

U.S. Germany
Real rate oI interest required by investors 1 1
Nominal interest rate -- 5
Spot rate -- $.88
One-year Iorward rate -- $.86

Find out the nominal interest rate in U.S. n your process Ior deriving the nominal
interest rate, clearly explain which principle you are using.
<Answer>
Following the international Fisher effect
$0.86 $0.88`(1+0.05-0.01) ; ie, expected inflation in germany) /(1+ x-0.01)
(1+x-0.01) $0.88`1.04/$0.86(0.9152/0.861.06418605) > x 0.07418605
Then, nominal interest rate in U.S is about 7