![Solutions to End-of-Chapter Questions and Problems
b. The contractual payment is a positive cash flow in Belgian francs, so Dow is
positively exposed to the value of the Belgian franc.
∆V$/BF
Dow’s exposure
∆V$/BF
c. The expected cash flow in dollars is E[CF 1$] = E[CF1BF] E[S1$/BF] = (BF40,000,000)
($0.025/BF) = $1,000,000. Actual dollar cash flow is CF1$ = CF1BFS1$/BF =
(BF40,000,000)($0.04/BF) = $1,600,000. This leaves an unexpected gain of
$600,000, or 60% of the expected value. As the value of the BF rises by 60% from
$0.025/BF to $0.040/BF, so too does the value of this Belgian franc cash inflow.
d. Sell 40 million Belgian francs forward and buy $1,000,000 at the forward price of
F1$/BF = $0.025/BF, or F1BF/$ = BF40/$.
+$1,000,000
−BF40,000,000
The Belgian franc is being sold forward, so Dow’s exposure to the value of the
Belgian franc in this forward contract is negative. The negative exposure on the
forward contract offsets the positive exposure on the underlying position. The net
result is no exposure to the Belgian franc exchange rate.
$/BF
∆V
Forward
exposure
$/BF
∆V
3.15 (Ftd/f-S0d/f)/S0d/f = [(1/Ftf/d)-(1/S0f/d)]/(1/S0f/d) = [(S0f/d/Ftf/d)-(S0f/d/S0f/d)]/(S0f/d/S0f/d)
= [(S0f/d /Ftf/d) - 1] = (S0f/d - Ftf/d) / Ftf/d.
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Chapter 4 The International Parity Conditions
Answers to Conceptual Questions
4.1 What is the law of one price? What does it say about asset prices?
The law of one price states that identical assets must have the same price wherever they are
bought or sold. The law of one price is enforced by arbitrage activity between identical
assets. In a perfect market without transaction costs, the law of one price must hold for
there to be no arbitrage opportunities.
4.2 Describe riskless arbitrage.
Riskless arbitrage is a profitable position obtained with no net investment and no risk.
Riskless arbitrage will drive the prices of identical assets into equilibrium and enforce the
law of one price.
4.3 What is the difference between locational, triangular, and covered interest arbitrage?
Locational arbitrage is conducted between two physical locations, such as between
currency prices at two different banks (such that ASf/d BSd/f ≠ 1 for banks A and B and
currencies d and f). Triangular arbitrage is conducted across three different cross exchange
rates (such that Sd/e Se/f Sf/d ≠ 1 for currencies d, e, and f). Covered interest arbitrage takes
advantage of a disequilibrium in the interest rate parity condition [(F td/ f) / (S0d/ f)] ≠ (1+id) /
(1+i f)]t between currency and Eurocurrency markets.
4.4 What is relative purchasing power parity?
Relative purchasing power parity is a form of the law of one price in which the expected
change in the spot rate is influenced by inflation differentials according to E[S td/f]/S0d/f =
[(1+id) / (1+if)]t.
4.5 How would you arrive at an estimate of a future spot exchange rate between two
currencies?
In theory, any of the international parity conditions could be used: E[S td/f] / S0d/f = [(1+id) /
(1+if)]t = [(1+pd) / (1+pf)]t = Ftd/f / S0d/f. In practice, forward exchange rates are used to
predict future spot rates.
4.6 What does the international Fisher relation say about interest rate and inflation
differentials?
If the law of one price holds and real interest rates are constant across currencies, nominal
interest rates reflect inflation differentials according to [(1+id) / (1+if)]t = [(1+pd) / (1+pf)]t.
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![Solutions to End-of-Chapter Questions and Problems
Problem Solutions
4.1 a. S¥DM = S¥/$S$/DM = (¥200/$)($0.50/DM) = ¥100/DM
b. S¥DM = S¥/$/SDM/$ =(¥100/$)/(DM1.60/$) = ¥62.5/DM.
4.2 SDM/$ S$/¥ S¥/DM = 1.0326 > 1. Triangular arbitrage would yield a profit of 3.26 percent of
the starting amount. For triangular arbitrage to be profitable, transactions costs on a
“round turn” cannot be more than this amount.
4.3 The forward price is at a 9 basis point discount over six months, or 18 bps on an
annualized basis. The six-month percentage discount is (F 1£/$/S0£/$)-1 = (£0.6352/$)/
(£0.6361/$)-1 = 0.9986-1 = 0.14%, or 0.28% on an annualized basis. Because Ft£/$ =
E[St£/$] according to forward parity (the unbiased forward expectations hypothesis), the
spot rate is expected to depreciate by 0.14% over the next six months.
4.4 a. The percentage bid-ask spread depends on which currency is in the denominator.
Tokyo quote for the peso: (¥28.7715/Ps–¥28.7356/Ps)/(¥28.7356/Ps) = 0.125%
Mexico City quote for yen: (Ps0.03420/¥–Ps0.03416/¥)/(Ps0.03416/¥) = 0.117%
b. The Mexican bank’s yen quote can be converted into a peso quote as follows:
S¥/Ps = 1/(Ps0.03416/¥) = ¥29.2740/Ps bid on the yen and ask on the peso.
S¥/Ps = 1/(Ps0.03420/¥) = ¥29.2398/Ps ask on the yen and bid on the peso.
So Ps0.03416/¥ BID and Ps0.03420/¥ ASK on the yen
is equivalent to ¥29.240/Ps BID and ¥29.274/Ps ASK on the peso.
The winning strategy is to buy pesos (and sell yen) from the Tokyo bank at the
¥28.7715/Ps ask price and sell pesos (and buy yen) to the Mexican bank at the
¥29.240/Ps bid price. Buying pesos in Tokyo yields (¥1,000,000)/(¥28.7715/Ps) =
Ps34,757. Selling pesos in Mexico City yields (Ps34,757)(¥29.2398/Ps) =
¥1,016,287. Your arbitrage profit is ¥16,287.
4.5 In this circumstance, the international parity conditions do not have anything to say about
the U.K. inflation rate. Nominal interest rates will adjust to expected inflation according
to the Fisher relation; (1+i) = (1+p)(1+r).
4.6 a. From interest rate parity, (¥210/$)/(¥190/$) = (1+i¥)/(1.15) ⇒ i¥ = 27.11%.
b. Because the forward rate of ¥210/$ is greater than the spot rate of ¥190/$, the dollar is
at a forward premium. If forward rates are unbiased predictors of future spot rates, the
dollar is likely to appreciate against the yen by (¥210/$)/(¥190/$)-1 = 10.526%.
4.7 a. In this problem, we know the spot and forward rates and U.S. inflation. The real and
nominal interest rates are not needed: F1£/$/S0£/$ = (£1.20/$)/(£1.25/$) = 0.96 =
E(1+p$)/E(1+p£) = (1.05)/E(1+p£) => E(p£) = (1.05/0.96)-1 = 9.375%
b. From the Fisher equation: i£ = (1+p£)(1+r£)-1 = (1.09375)(1.02)-1 = 11.56%.
4.8 a. E[P1D] = P0D(1+pD) = D100(1.10) = D110
E[P1F] = P0F(1+pF) = F1(1.21) = F1.21
E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F.
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b. E[P2D] = P0D(1+pD)2 = D100(1.10)2 = D121
E[P2F] = P0F(1+pF)2 = F1(1.21)2 = F1.4641
E[S2D/F] = E[P2D]/E[P2F] = D121/F1.4641
= S0D/F[(1+pD)/(1+pF)]2 = (D100/F)(1.10/1.21)2 = D82.64/F.
4.9 a. A 7% annualized rate with quarterly compounding is equivalent to 7%/4 = 1.75%
per quarter. From interest rate parity, the 3-month Finnish markka interest rate is
FFM/$/SFM/$ = (FM3.9888/$)/(FM4.0200/$) = (1+iFM)/(1+i$) = (1+iFM)/(1+0.0175) =>
iFM = 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
FM at the forward rate, this is worth ($10,175,000)(FM3.9888/$) = FM40,586,040.
You can finance your $10,000,000 by borrowing FM40,200,000. Your obligation on
this contract will be (FM40,200,000)(1.009603) ≈ FM40,586,040 which is exactly
offset by the proceeds from your forward contract.
4.10 a. FtBt/$/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+i Bt)/(1+i$) = (1.1)/(1.06125) =
1.037. So, borrow at i$ and lend at iBt.
+Bt24,960,000 Convert to baht at the spot exchange rate
−$1,000,000
Invest at the 10% baht interest rate +Bt27,456,000
−Bt24,960,000
Borrow at the 6.125% dollar interest rate
+$1,000,000
−$1,061,250
Cover baht forward
+$1,070,827
−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 = $9,024 in present value.
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![Solutions to End-of-Chapter Questions and Problems
=0.98440 = (1.0982)/(1.1156) = (1+i$)/(1+i£), so you should buy pounds at the
relatively low forward price, sell pounds at the relatively high spot price, invest in
dollars at the relatively high dollar interest rate, and borrow pounds at the relatively
low pound interest rate.
Appendix 4-A Continuous Time Finance
4A.1 Total two-period return is [V2/V0]-1 = [(1+i1)(1+i2)]-1. Mean geometric return is iavg =
[(1+i1)(1+i2)]1/2-1. Total wealth after two periods is the same as beginning wealth;
$100(1+1)(1-0.5) = $100. Notice that the order of the rates of return does not matter. A
loss of 50% followed by a gain of 100% leaves your initial value unchanged. For the
pair of returns (100%,-50%), the average period return is iavg = [(1+1)(1-0.5)]1/2-1 = 0.
With continuously compounded returns, periodic rates are given by ι1 = ln(1+i1) = ln(2)
= +0.69315 and ι2 = ln(1+i2) = ln(0.5) = -0.69315. The (arithmetic) average return using
continuously compounded rates is (ι1+ι2)/2 = (+0.69315-0.69315)/2 = 0. Either way,
your ending value is the same as your beginning value. These methods are equivalent.
4A.2 Inflation rates are pD = ln(1+pD) = ln(1.10) = 9.531% and pF = ln(1+pF) = ln(1.21) =
19.062% in continuously compounded returns. Expected price levels and spot rates are:
E[P1D] = P0D e(0.09531) = (D100)(1.10) = D110
E[P2D] = P0D e(2)(0.09531) = (D100)(1.21) = D121
E[P1F] = P0F e(0.19062) = (F1)(1.21) = F1.21
E[P2F] = P0F e(2)(0.19062) = (F1)(1.4641) = F1.4641
E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F
E[S2D/F] = E[P2D] / E[P2F] = D121 / F1.4641 = D82.64/F
Chapter 5 The Nature of Foreign Exchange Risk
Answers to Conceptual Questions
5.1 What is the difference between currency risk and currency risk exposure?
Risk exists whenever actual outcomes can deviate from expected outcomes. Currency risk
is the risk that currency values will change unexpectedly. Exposure to currency risk refers
to change in the value of an asset (such as an individual investment portfolio or the stock
price of a multinational corporation) with unexpected changes in currency values.
5.2 What are monetary assets and liabilities? What are nonmonetary assets and liabilities?
Monetary assets and liabilities have contractual payoffs. Nonmonetary assets (e.g., plant
and equipment) and liabilities have noncontractual payoffs.
5.3 What are the two components of economic exposure to currency risk?
Monetary (contractual) assets and liabilities can be exposed to currency risk. This is called
“transaction exposure.” The exposure of the firm’s real (noncontractual) or operating
assets is called “operating exposure.”
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![Kirt C. Butler, Multinational Finance, 2nd edition
can be generated from technical analysis (analyzing patterns in exchange rates) or from
fundamental analysis (from a larger set of economic relationships).
Problem Solutions
5.1 a. E[P1F] = P0F(1+pF) = 1.21
E[P1D] = P0D(1+pD) = 1.10
E[S1D/F] = (S0D/F)(1+pD)/(1+pF) = (D110/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[P2F]) = P0F(1+pF)2 = F1.4641
E[P2D]) = P0D(1+pD)2 = D121
E[P2F]) = P0F(1+pF)2 = F1.4641
E[P2D]) = P0D(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%.
5.2 a. s¥/DM = (S0¥/DM)/(S-1¥/DM)-1 = (¥155/DM)/(¥160/DM) -1 = -3.125%.
b. From relative purchasing power parity, the spot rate should have been:
E[S0¥/DM] = (S-1¥/DM) [(1+p¥)/(1+pDM)] = (¥160/DM) [(1.02)/(1.03)] = ¥158.45.
c. As a difference from the expectation, the real change in the spot rate is:
x¥/DM = (Actual-Expected)/(Expected) = (S0¥/DM -E[S0¥/DM])/E[S0¥/DM])
= (¥155/DM-¥158.45/DM)/¥158.45/DM = -2.18%.
Alternatively, from equation (5.2), change in the real exchange rate is equal to:
x¥/DM = ((S0¥/DM)/(S-1¥/DM)) ((1+pDM)/(1+p¥)) - 1
= ((¥155/DM)/(¥160/DM)) ((1.03)/(1.02)) - 1 = -2.18%.
d. The deutsche mark depreciated by 2.18% in purchasing power.
e. In real terms, the yen rose by xDM/¥ = ((S0DM/¥) / (S-1DM/¥)) ((1+p¥) / (1+pDM)) - 1
= ((S0¥/DM)-1 / (S-1¥/DM)-1) ((1+p¥) / (1+pDM)) - 1
= ((¥155/DM)-1 / (¥160/DM)-1 ) ((1.02)/(1.03)) - 1 = +2.23%
= ((DM.0064516/¥)/(DM.00625000/¥)) ((1.02)/(1.03)) - 1 = +2.23%.
Because the DM fell by 2.18% in real terms, the yen rose by 1/(1-0.0218) ≈ 2.23%.
5.3 a. The percentage change in the dollar is s Fl/$ = (S1Fl/$/S0Fl/$)-1 = (Fl1.55/$)/(Fl1.60/$)-1 =
-0.03125, or 3.125%. The price elasticity of demand is equal to -(∆Q/Q)/(∆P/P) = -
(+10%)/(-3.125%) = 3.2.
b. A 10% real depreciation in the export sales price (in this case, in the value of the
dollar) would result in a 32% increase in export sales if the price elasticity does not
change. Note that price elasticity is unlikely to be constant across such a wide range
of price changes.
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7.2 Discuss each cell in Figure 7.4. What should (or shouldn’t) a firm do when faced with a
foreign project that fits the description in each cell?
Top left: Both NPVs are negative so reject the foreign project.
Top right: NPVd>0 but NPVf<0; if the firm wants to speculate on foreign exchange rates,
there must be better alternatives than the proposed project for taking a speculative
position.
Bottom left: NPVd<0 but NPVf>0; anticipated changes in exchange rates are likely to
hurt the firm. Try financing the project in the local currency, hedging forward (with
forwards or futures), or swapping into foreign currency debt.
Bottom right: There are two possibilities here. If NPVd > NPVf > 0, then changes in
exchange rates are expected to help the parent. The home office may choose to leave the
foreign currency cash flows unhedged, although this captures the higher expected return
(NPVd > NPVf) but also exposes the firm to currency risk. If 0 < NPV d < NPVf, then the
parent can capture a higher expected return (NPV f > NPVd) and lower currency risk by
hedging its expected future foreign currency cash flows and locking in the relatively high
local-currency value of the project.
7.3 Why is it important to separately identify the value of any side effects that accompany
foreign investment projects?
Separately identifying the value of a project from the value of any side effects (such as
blocked funds, subsidized financing, or tax holidays) allows the firm to negotiate with
host governments and other parties on a more informed basis.
Problem Solutions
Cross-border capital budgeting when the international parity conditions hold.
7.1 a. Note that relative purchasing power parity holds.
(1+i$)/(1+iRen) = (1.15)/( 1.11745) ≈ (1+p$)/(1+pRen) = (1.06)/(1.03) ≈ 1.0291.
Discounting renminbi cash flows at the renminbi discount rate yields
NPVRen
= -Ren600m+Ren200m/1.11745+Ren500m/(1.11745)2+Ren300m/(1.11745)3
= Ren194.39 million
or NPV$ = (Ren194.39m)($0.5526/Ren) = $107.42 million at the spot exchange rate.
b. Relative purchasing power parity states that the spot rate should change according to
E[St$/Ren]/E[S0$/Ren] = [(1+E[p$])/(1+E[pRen])]t = (1.06/1.03)t = (1.029)t. That is,
renminbi should appreciate by approximately 2.9% per year relative to the dollar
because of lower Chinese inflation. Expected future spot rates of exchange are then
E[S1$/Ren] = ($0.5526)[(1.06)/(1.03)]1 = $0.5687/Ren
E[S2$/Ren] = ($0.5526)[(1.06)/(1.03)]2 = $0.5853/Ren
E[S3$/Ren] = ($0.5526)[(1.06)/(1.03)]3 = $0.6023/Ren
Based on these spot exchange rates, expected dollar cash flows are:
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![Solutions to End-of-Chapter Questions and Problems
E[CF0$] = (Ren600)($0.5526/Ren) = $331.56
E[CF1$] = (Ren200)($0.5687/Ren) = $113.74
E[CF2$] = (Ren500)($0.5853/Ren) = $292.63
E[CF3$] = (Ren300)($0.6024/Ren) = $180.69
The project should be accepted because
NPV$ = -$331.56m+$113.74m/(1.15)+$292.63m/(1.15)2+$180.69m/(1.15)3
= $107.42 million > $0
7.2 a. Expected future cash flows in euros are as follows:
Investment cash flows 0 1 2
Land -100000 121000 grows at 10% inflation rate
tax on capital gain -8400
Plant -50000 25000 market value at t=2
tax on capital gain -10000
NWC -50000 60500 grows at 10% inflation rate
tax on capital gain -4200
Operating cash flows 0 1 2
Rev (Price=100, Q=5,000) 550000 605000 grows at 10% inflation rate
Variable cost (20%) -110000 -121000
FC (20,000 at t=0) -22000 -24200 grows at 10% inflation rate
Depreciation -25000 -25000
Earnings before tax 393000 434800
Tax (at 40%) -157200 -173920
Net income 235800 260880
Net cash flow (Euros) 260800 285880 CF = NI + Depreciation
Sum of investment/disinvestment and operating cash flows
Total net CFs -200000 260800 469780
Euro
NPV at i = 20% 343569.4
b. If the international parity conditions hold, then 20% interest rates in both the foreign
and domestic currencies imply that forward (and expected future spot) prices will
equal the current spot rate of $10/Euro. So,
Sum of investment/disinvestment and operating cash flows
Expected dollar CFs -2000000 2608000 4697800
NPV at i$ = 20% $3,435,694
7.3 a. iW = (1+pW)(1+rW) - 1 = (1.50)(1.10)-1 = 65%
iL = (1+pL)(1+rL) - 1 = (1.00)(1.10)-1 = 10%
b. E[S1W/L] = (S0W/L) [(1+pW) / (1+pL)]t = (W100/L) [(1.50) / (1.00)] = W150/L
E[S2W/L] = (S0W/L) [(1+pW) / (1+pL)]t = (W100/L) [(1.50) / (1.00)]2 = W225/L
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c. All cash flows in work-units:
Investment cash flows 0 1 2
Land -200,000 450,000 grows at 50% inflation rate
tax on capital gain -125,000
Plant -200,000 0 market value at t=2
tax on capital gain 0
Operating cash flows 0 1 2
Rev (P0W=W200, Q=2,000) 600,000 900,000 grows at 50% inflation rate
Variable cost (20%) -120,000 -180,000
Fixed cost (W30,000 at t=0) -45,000 -67,500 grows at 50% inflation rate
Depreciation -100,000 -100,000
Earnings before tax 335,000 552,500
Tax (at 50%) -167,500 -276,250
Net income 167,500 276,250
Net operating CFW 267,500 376,250 CF = NI + Depreciation
Sum of investment/disinvestment and operating cash flows
Total NCFW -400,000 267,500 701,250
NPVW at 65% W19,697
NPVL = NPVW / S0W/L = L197
d. E[CFt ] = E[CFt ] / E[St ] ⇒ E[CF0L] = (-W400,000) / (W100/L) = -L4,000
L W W/L
E[CF1L] = (W267,500) / (W150/L) = L1,783
E[CF2L] = (W701,250) / (W225/L) = L3,117
⇒ NPVL = -L4,000 + (L1,783) / (1.10) + (L3,117) / (1.1)2 = L197
This is the same as in part c because the international parity conditions hold.
7.4 a.
t=1 Bt3.4m Bt3.4m Bt3.4m Bt6,913,840
−Bt4m t=2 t=3 t=4 t=5
iBt = 20%
Initial outlay = (Bt4m)
After-tax cash flows over t=2,…,5
=(Bt100m-Bt90m-Bt5m)(1-0.40)+(Bt1m*.40)=Bt3,400,000
Terminal CF= (Bt4m*(1.10)4) - {[(Bt4m*(1.10)4) - 0]*.4} = Bt3,513,840
NPV0Bt = Bt5,413,548
b. (1+iBt)=(1+rBt)(1+pBt) ⇒ rBt = (1.20/1.10)-1=0.0909091 ⇒ r¥ = 9.09091%
i¥ = (1.0909091)(1.05) - 1 = 0.1454545, or 14.54545%
c. E(S1Bt/¥) = (Bt0.25/¥)(1.20/1.1454545) = Bt.2619048/¥
E(S2Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)2 = Bt.2743764/¥
E(S3Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)3 = Bt.2874420/¥
E(S4Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)4 = Bt.3011297/¥
E(S5Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)5 = Bt.3154692/¥
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![Solutions to End-of-Chapter Questions and Problems
d. Recipe #1: NPV¥ = Bt5,413,548/(Bt0.25/¥) = ¥21,654,192
Recipe #2: NPV0¥ = ¥21,654,192 at i¥ = 14.54545%
t=1 ¥12,391,736 ¥11,828,475 ¥11,290,817 ¥21,916,055
−
¥15,272,727 t=2 t=3 t=4 t=5
The answers are the same because the international parity conditions hold.
Cross-border capital budgeting when international parity conditions do not hold.
7.5 a. Discount in renminbi.
NPVRen = [Σt E[CFtRen] / (1+iRen)t ]
= [-Ren600+Ren200/(1.1175)+Ren500/(1.1175)2+Ren300/(1.1175)3 ]
= Ren194.39
⇒ NPV = (S0$/Ren) (NPVRen) = ($0.5526/Ren)(Ren194.39) = $107.42
$
Discount in dollars.
NPV$ = Σt {E[St$/Ren]E[CFtRen] / (1+i$)t }
= [(-Ren600)($0.5526/Ren) + (Ren200)($0.5801/Ren)/(1.15)
+ (Ren500)($0.6089/Ren)/(1.15)2 + (Ren300)($0.6392/Ren)/(1.15)3
]
= $125.61 > $107.42
While the project has a positive NPV regardless of the perspective, the project has
more value from the parent’s perspective than from the project perspective. This is
because the expected future value of the dollar (renminbi) is less (more) than under
the equilibrium conditions. The parent company may choose to leave its cash
flows from the project unhedged in the hopes of benefiting from the expected
future spot exchange rates. This does expose the parent to currency risk.
b. Discount in renminbi.
NPVRen = [Σt E[CFtRen] / (1+iRen)t ]
= [-Ren600 + Ren200/(1.1175) + Ren500/(1.1175)2+Ren300/(1.1175)3]
= Ren194.39
⇒ NPV$ = (S0$/Ren) (NPVRen) = ($0.5526/Ren)(Ren194.39) = $107.42
Discount in $:
NPV$ = Σt {E[St$/Ren]E[CFtRen] / (1+i$)t }
= [(-Ren600)($0.5526/Ren) + (Ren200)($0.5575/Ren)/(1.15)
+ (Ren500)($0.5625/Ren)/(1.15)2 + (Ren300)($0.5676/Ren)/(1.15)3 ]
= $90.04 < $107.42
Although the project has a positive NPV from each perspective, the project has more
value in the local currency than it does in dollars. The parent should hedge the
renminbi cash flows either directly in the forward market, by borrowing a part of the
project in renminbi, or by swapping dollar debt for renminbi debt to hedge its
expected future renminbi cash flows from the project.
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![Solutions to End-of-Chapter Questions and Problems
Problem Solutions
8.1 India’s currency is the rupee (Rp). Thailand’s currency is the bhat (Bt). From equation
(8.1), interest rates in India are iRp = (iBt)(1-tBt)/(1-tRp) = (10%)(1-0.30)/(1-0.65) = 20%.
8.2 Parts a, b, and c follow: Part a. Part b. Part c.
HK India HK India HK
India
a Dividend payout ratio 100% 100% 100% 100% 100% 100%
b Foreign dividend withholding tax rate 0% 20% 0% 20% 0% 20%
c Foreign tax rate 18% 65% 18% 65% 18% 65%
d Foreign income before tax 10000 10000 20000 0 0 20000
e Foreign income tax (d*c) 1800 6500 3600 0 0 13000
f After-tax foreign earnings (d-e) 8200 3500 16400 0 0 7000
g Declared as dividends (f*a) 8200 3500 16400 0 0 7000
h Foreign dividend withholding tax (g*b) 0 700 0 0 0 1400
i Total foreign tax (e+h) 1800 7200 3600 0 0 14400
j Dividend to U.S. parent (d-i) 8200 2800 16400 0 0 5600
k Gross foreign income before tax (d) 10000 10000 20000 0 0 20000
l Tentative U.S. income tax (k*35%) 3500 3500 7000 0 0 7000
mForeign tax credit (i) 1800 7200 3600 0 0 14400
n Net U.S. taxes payable [max(l-m,0)] 1700 0 3400 0 0 0
o Total taxes paid (i+n) 3500 7200 7000 0 0 14400
p Net amount to U.S. parent (k-o) 6500 2800 13000 0 0 5600
q Total taxes as separate subs (sum(o)) $10,700 $7,000
$14,400
Parent’s consolidated tax statement
r Overall FTC limitation (sum(k)*35%) $7,000 $7,000 $7,000
s Total FTCs on a consolidated basis (sum(i)) $9,000 $3,600
$14,400
t Additional U.S. taxes due [max(0, r-s)] $0 $3,400 $0
u Excess tax credits [max(0,s-r)] $2,000 $0 $7,400
(carried back 2 years or forward 5 years)
8.3 a. Low transfer price ($1/btl) High transfer price ($10/btl)
P.R. U.S. Consolidated P.R. U.S. Consolidated
Revenue 100,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
COGS 100,000 100,000 100,000 100,000 1,000,000 100,000
Taxable income 0 900,000 900,000 900,000 0 900,000
Taxes 0 315,000 315,000 45,000 0 45,000
Net income 0 585,000 585,000 855,000 0 855,000
Effective tax on consolidated revenues 31.5% 4.5%
Effective tax on taxable income 35.0% 5.0%
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![Solutions to End-of-Chapter Questions and Problems
9.11 Does country risk affect investors’ required return in emerging markets?
Erb, Harvey, and Viskanta [“Political Risk, Financial Risk and Economic Risk,”
Financial Analysts Journal 52, November/December, 1996] found that the low
correlations of emerging markets tend to overcome the higher volatilities of these
markets, resulting in lower systematic risks than on comparable assets in developed
markets.
9.12 Complete the following sentence: “Equity returns from a country with high country
risk are likely to be _____ (more, less) volatile and have a _____ (higher, lower) beta
than those from a country with low country risk.”
Equity returns from a country with high country risk are likely to be more volatile and
have a lower beta than those from a country with low country risk.
Problem Solutions
9.1 There is not always a clear distinction between political and financial risks. Indeed,
financial risks often result from political decisions. In Russia’s case, the financial risks
of investment in Russian have been acerbated by the inability of the Russian
government to establish and enforce laws and regulations for the orderly conduct of
business. Organized crime and corruption have contributed to poor political,
economic, financial country risk ratings in Russia. Governments make a convenient
scapegoats, and this hedge fund manager clearly holds the Russian government
responsible for his losses.
9.2 Although the most obvious form of expropriation occurs when a host government
confiscates a company’s assets, in fact each type of political risk can be thought of as a
form of expropriation. Host governments can appropriate foreign assets for themselves
or for local companies through actions that differentially impair nonlocal firms,
including protectionism, blocked funds, or theft or misappropriation of intellectual
property rights.
9.3 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’ = ρiW’ (σi’/σW) = (0.3)(0.3/0.1)
= 0.9 > βi = ρiW (σi /σW) = (0.4)(0.2/0.1) = 0.8.
9.4 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).
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![Solutions to End-of-Chapter Questions and Problems
10.8 What are assets-in-place? What are growth options?
Assets-in-place are those assets in which the firm has already invested. Growth options
are the firm’s opportunities to lever its existing assets-in-place (including human assets
and core competencies) into new products and markets.
10.9 Why does the NPV decision rule have difficulty in valuing managerial flexibility?
The biggest difficulty lies in identifying the appropriate discount rate on investment. The
discount rate is difficult to determine because: a) options are always more volatile than
the asset or assets on which they are based; b) the volatility of an option changes with
change in the value(s) of the underlying asset(s); and c) returns on options are not
normally distributed.
10.10 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
10.1 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
NPV0D = ?
Invest at Pbeer = D75
Invest in one year NPV0D Pbeer=D75 = ?
Invest at Pbeer = D25
NPV0D Pbeer= D25 = ?
b. Equation (9.2) from the text must be modified to include fixed costs:
( P - V) Q - F
INVEST TODAY: NPV0 = − I0
i
NPV(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 (9.3) from the text must be modified to include fixed costs:
( P - V) Q - F
WAIT ONE YEAR: NPV0 = (1 + i) − I0
i
D
NPVPbeer= 75
= [(((D75/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10)/(1.10)]-D200,000,000
= D300,000,000 ⇒ invest
NPVPbeer=D25
= [(((D25/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10) / (1.10)]-D200,000,000
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+[Prob(P1=D25)](NPVP1=D25)
= (½) (D300,000,000) + (½)(D0)
= +D150,000,000 > NPV(invest today) > D0
d. Option Value = Intrinsic Value + Time Value
NPV(wait one year) = NPV(invest today) + Opportunity cost of investing today
D
150,000,000 = D100,000,000 + D50,000,000
e. Wait one period before deciding to invest.
10.2 a.
Abandon today
NPV0D = ?
D
Abandon at Pbeer = 35
Abandon in one year NPV0D Pbeer=D35 = ?
Abandon at Pbeer = D15
NPV0D Pbeer= D15 = ?
b. The problem states that the current price of beer is D15 in perpetuity. The statement
“in perpetuity” clearly cannot hold because prices in one year are stated to be
either D15 or D35 with equal probability. Let’s assume that the price is currently
D
15 per bottle and will either remain at D15 or will rise to D35 by time 1. For
simplicity, let’s also assume end-of-year beer prices and cash flows so that we
don’t have to worry about the path of beer prices during the year. In this setting,
the current price of D15/bottle is irrelevant to the abandonment decision. The
expected future price of D25 does matter. (If beer prices throughout the first year
either remain at D15 or rise at a constant rate to D35, then the expected price during
the first year is not D25 but rather ½[D15+½(D15+D35)] = D20.)
Note that if the project is abandoned today at a cost of D10,000,000, future profits
(and cash flow) from the project will be foregone. Hence, there is a minus sign in
front of operating cash flow in the NPV equations that follow.
At the expected end-of-year price of ½ (D15/btl+D35/btl) = D25/btl, the NPV of the
“abandon today” alternative is:
NPV(abandon today)
= -[((D25/btl-D20/btl)(1,000,000 btls)-D10,000,000)/0.10]-D10,000,000
= D40,000,000 > D0 ⇒ abandon today?
c. If Grolsch management waits one year before making its abandonment decision, beer
prices will be either D15 or D35 with certainty.
NPVP1=D35
= -[(((D35/btl-D20/btl)(1,000,000 btls) -D10,000,000) /0.10)/(1.10)]-D10,000,000
= -D55,454,545 ⇒ don’t abandon if price rises to D35
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![Solutions to End-of-Chapter Questions and Problems
NPVP1=D15
= -[(((D15/btl-D20/btl)(1,000,000 btls) -D10,000,000) /0.10)/(1.10)]-D10,000,000
= D126,363,636 ⇒ abandon if price falls to D15
NPV(wait one year)=[Prob(P1=D35)](NPVP1=D35)+[Prob(P1=D15)](NPVP1=D15)
= (½) (D126,363,636) + (½)($0)
= +D63,181,818 > NPV(abandon today) > D0
d. Option Value = Intrinsic Value + Time Value
NPV(wait one year) =NPV(abandon today)+Opportunity cost of abandoning today
+D63,181,818 = +D40,000,000 + D
23,181,818
e. Wait one year before making the abandonment decision.
10.3 Let’s assume that there are in total five breweries, so there are four additional brewery
investments if we choose to construct an exploratory brewery.
We already know from Problem 9.1 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.
a. Decision tree:
Invest in all five breweries today
NPV0D = D ?
If NPV0D > D0, continue to invest
Invest in first brewery
If NPV0D < D0, don’t invest further
b. At the expected end-of-year price of ½(D25/btl+D75/btl) = D50/btl, the NPV of a
single brewery is:
NPV(exploratory brewery)
= [((D50/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10] - D200,000,000
= D100,000,000
NPV(invest in all five breweries today) = (5) NPV(exploratory brewery)
= D500,000,000
c. If Grolsch management waits one year before making its investment decision, beer
prices will be either D25 or D75 with certainty in this problem. Of course, it won’t
know this until it invests in the first brewery.
NPVPbeer=D75
= [((D75/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10]-D200,000,000
= D350,000,000 ⇒ invest in additional capacity
If Pbeer=D75, investment in four additional breweries at time t=1 yields a net present
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![Kirt C. Butler, Multinational Finance, 2nd edition
value at time zero of (4)( D350,000,000/1.10) = D1,272,727,273.
NPVPbeer=D25
= [((D25/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10]-D200,000,000
= -D150,000,000 < $0 ⇒ don’t invest in additional capacity
If Pbeer=D25, do not invest in additional capacity. (In fact, you should look into
abandoning this losing venture. But that is a different problem.)
NPV(invest in exploratory brewery and continue to invest if it is positive-NPV)
= [Prob(P1=D75)] (NPVP1=D75) + [Prob(P1=D25)] (NPVP1=D25)
= (½)[(D350,000,000) +(4)(D350,000,000/1.10)] + (½)(-D150,000,000)
= +D736,363,636 > NPV(invest in all five today) = +D500,000,000 > D0
d. Option Value = Intrinsic Value + Time Value
NPV(wait one year) = NPV(invest today) + Opportunity cost of investing in
four additional breweries today
D
736,363,636 = D500,000,000 + D
236,363,636
The NPV of investing in all five breweries today is -D236,363,636. Grolsch would
not be taking advantage of 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.
10.4 a. NPV(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:
NPVC1=R12,000
= [((R18,000/car-R12,000/car)(10,000cars)/0.20]/1.20]-R100 million
= R150 million ⇒ invest,
or NPVC1=R18,000
= [((R18,000/car-R18,000/car)(10,000cars)/0.20]/1.20]-R100 million
= -R100 million ⇒ do not invest (so that NPV = R0).
NPV(wait one year)
= [Prob(C1=R12,000)](NPVC1=R12,000)
+ [Prob(C1=R18,000)](NPVC1=R18,000)
= (½)(R150,000,000) + (½)(R0)
= +75,000,000 > NPV(invest today) =R50,000 > R0
The time value of this real option reflects the opportunity cost of investing today:
Time value = option value less intrinsic value
= R75 million - R50 million = R25 million.
b. NPV(invest in all 10 plants today) = 10*NPV(invest in one plant today) = R500
million
NPV(invest in exploratory plant and continue to invest in 9 other plants if NPV>0)
= [Prob(C1=R12,000)](NPVC1=R12,000)
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= (½)[(R150 million)+(9)(R150 million/1.20)] + (½)(-R100 million)
= +R587.5 million > NPV(invest in all ten today) = R500 million > R0
The opportunity cost of investing in all ten plants today is equal to the time value of this
real investment option:
time value = option value less intrinsic value
= R587.5 million - R500 million = R87.5 million.
10.5 This provocative question goes 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 the industry. If a firm has a real investment option that only
it can exercise, such as a drug that effectively combats prostate cancer and for which
only it has patent approval, then the analysis in this chapter is appropriate. There will
be an optimal time to invest and perhaps to exit, and it may 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 may stay invested in unprofitable situations in the hope that
other less-profitable firms will exit first.
Chapter 11
Corporate Governance and the International Market for Corporate Control
Answers to Conceptual Questions
11.1 What does the term “corporate governance” mean? 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 which 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 large influence on top executive
turnover and the market for corporate control.
11.2 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 and collaborative alliances.
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![Kirt C. Butler, Multinational Finance, 2nd edition
are likely to see a $200,000 appreciation in the value of their shares. Stated as a
percentage return in the combined firm, this is an increase of ($200,000)/($4,400,000) =
4.5% to Agile shareholders.
11.3 The BP-Amoco deal was lauded in the financial press for combining BP’s strengths in
oil exploration and development with Amoco’s refining and distribution capabilities.
Amoco stock jumped about 26 percent to a record high of 521/8 immediately after
announcement of the deal. BP stock price rose modestly, along with other oil issues.
This share price behavior is typical of a domestic acquisition in that the target firm
was a clear winner while the acquiring firm neither gained nor lost.
11.4 a. 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.
b. First-time entrants often have interesting opportunities but also face new risks.
Returns are not significantly different from zero for firms entering the international
arena through a foreign acquisition for the first time (Doukas and Travlos [1988]).
c. Acquisitions into unrelated businesses in other countries tend to result in losses for
the shareholders of acquiring firms (Markides and Ittner [1994]). If you want to
increase your international operations, stick to what you know best - chemicals.
d. Although prior international experience is valuable, you have to start somewhere.
Acquisitions of companies in related businesses tend to result in gains to acquiring
firms (Markides and Ittner [1994]). Experience in southern Europe will also prove
useful in Portuguese-speaking Brazil and the rest of Spanish-speaking Latin
America. Not all of your VP’s ideas are bad.
11.5 A real increase in the value of the domestic currency increases the purchasing power
of domestic residents. Froot and Stein [1991] suggest that an informational asymmetry
between inside managers and outside investors can make outside capital more
expensive than inside capital, which can preferentially benefit bidders that see their
currency rise in real terms. If an increase in the real value of the domestic currency
forces foreign companies to access capital markets to fund acquisitions whereas
domestic companies can fund acquisitions with cash, then domestic companies enjoy
an advantage in the presence of this informational asymmetry.
11.6 Several deals were rumored in early 1999. Suitors for Nissan’s equity or Volvo’s
assets included Ford Motor Company of the U.S., Daimler-Chrysler of Germany, and
Renault of France. A search of your library database will reveal whether any of these
deals actually came to fruition.
11.7 a. Recent restructurings include the 1995 merger of Mitsubishi Bank with the Bank
of Tokyo, the 1998 merger of Sumitomo Trust with Long-Term Credit Bank, and
the 1998 merger of Mitsui Trust with Chuo Trust. Japan recently passed a “bridge
bank” law to assist troubled banks, so other mergers and acquisitions (either
privately arranged or forced by the government) are sure to follow.
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![Solutions to End-of-Chapter Questions and Problems
Problem Solutions
13.1 a.
Taxes
20% tax rate 40% tax rate
R250,000
R200,000
R0 R1,000,000 R2,000,000
R500,000 Taxable income R1,500,000
b. Expected taxes with no hedging:
(½) [(R500,000)(0.20)] + (½)[(R1,000,000)(0.20) + (R500,000)(0.40)]
= (½) (R100,000) + (½) (R400,000) = R250,000.
c. Expected taxes with hedging: (R1,000,000)(0.20) = R200,000 < R250,000.
d. Hedging allows Widget to minimize its expected tax liability. This increase in
expected future cash flows to equity results in an increase in equity value.
13.2 a. Expected taxable income is (½)($250,000) + (½)(-$250,000) = $0.
E[PV(taxes)|unhedged] = (½)($125,000)-(½)($125,000)/(1.25) = $12,500. The
present value of current taxes is $125,000. The present value of the tax shield
received in one year is only ($125,000)/(1.25) = $100,000.
E[PV(taxes)|hedged] = Tax rate times expected taxable income = (½)($0) = $0, an
expected tax savings of $12,500.
b. Expected taxable income is (½)($250,000) + (½)(-$250,000) = $0.
E[PV(taxes)|unhedged] = (½)($125,000)-(½)($125,000)/(1.00) = $0.
E[PV(taxes)|hedged] = (tax rate) times (expected taxable income) = (½)($0) = $0.
The present value of the tax shield from tax loss carryforwards increases at lower
discount rates. If the discount rate is zero, time doesn’t matter and future tax shields
have the same magnitude as current tax payments.
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c. Expected taxable income is (½)($250,000) + (½)(-$250,000) = $0.
E[PV(taxes)|unhedged] = (½)($125,000)-(½)($125,000)/(1.25)2 = $22,500. The
present value of current taxes is $125,000. The present value of the tax shield
received in one year is only ($125,000)/(1.25)2 = $80,000.
E[PV(taxes)|hedged] = (tax rate) times (expected taxable income) = (0.50)($0) = $0, a
savings in expected tax payments of $22,500.
13.3 a. At $6,000 in taxable income, debt receives $6,000 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:
VBonds + VStock = VBonds + Stock
+ =
$10,000 $10,000 $10,000
$6,000 $16,000
Firm value
c. Unhedged E[VBonds] = (½)($6,000-$2,000) + (½)($10,000) = $7,000
+ E[VStock] = (½)($0) + (½)($6,000) = $3,000
E[VFirm] = (½)($6,000-$2,000) + (½)($16,000) = $10,000
Hedged E[VBonds] = $10,000
+ E[VStock] = $1,000
E[VFirm] = $11,000
Firm value rises from $10,000 when unhedged to $11,000 when hedged. Hedging
results in a $3,000 increase in the value of debt and a $2,000 decrease in the value of
equity, for a net gain of $1,000. The $1,000 net gain is captured by 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 choose to leave its
currency risk exposure unhedged.
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![Solutions to End-of-Chapter Questions and Problems
13.4 a.
VBonds + VStock = VBonds + Stock
+ =
$10,000 $10,000 $10,000
$4,000 $14,000
Firm value
b. Unhedged E[VBonds] = (½)($4,000-$2,000) + (½)($10,000) = $6,000
+ E[VStock] = (½)($0) + (½)($4,000) = $2,000
E[VFirm] = (½)($4,000-$2,000) + (½)($14,000) = $8,000
In this example, hedging can keep the firm solvent and avoid all of the costs of
bankruptcy. Firm value is then (½)($6,000) + (½)($16,000) = $11,000 with certainty
as in Problem 17.2. Payoffs are as follows:
Hedged E[VBonds] = $10,000
+ E[VStock] = $1,000
E[VFirm] = $11,000
Hedging avoids the $2,000 indirect cost as well as the ½ probability of a $2,000
direct cost, resulting in a stakeholder gain of $3,000. Bondholders would prefer to
hedge and lock in $10,000, resulting in a gain of $4,000 over the unhedged situation.
Equity locks in a value of $1,000, resulting in an expected loss of $1,000 relative to
the unhedged situation. If equity is risk neutral, they will prefer to remain unhedged
and face a 50 percent chance of having a $4,000 payout.
Equity can gain from hedging: If equity can renegotiate the bond contract in these
examples, then they can more evenly share the gain in firm value with the debt.
Alternatively, equity can pre-negotiate a smaller promised payment to debt (resulting
in a lower required return and hence cost of capital) by establishing and maintaining a
risk-hedging program. Again, this will allow equity to share in any gain from
reducing the probability and costs associated with financial distress.
13.5 a. If firm value is £9,000, equity will not exercise its option to buy the firm at a price of
£10,000. In this case, equity receives nothing and debt receives £9,000. If the firm is
worth £19,000, equity pays bondholders £10,000 and retains the residual £9,000.
Firm value is E[VFIRM] = E[VBONDS] + E[VSTOCK] = [(½)(£9,000) + (½)(£10,000)] +
[(½)(£0)+(½)(£9,000)] = £9,500 + £4,500 = £14,000.
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Hedged, firm value is VFIRM = VBONDS + VSTOCK = £10,000 + £4,000 = £14,000. The
reduction in the variability of firm value results in a reduction in call option value and
a £500 shift in value from equity to debt.
b. Unhedged, firm value is decomposed as: E[VFIRM] = E[VBONDS] + E[VSTOCK] = [(½)
(£9,000-£1,000) + (½)(£10,000)] + [(½)(£0) + (½)(£9,000)] = £9,000 + £4,500 =
£13,500. With hedging, VFIRM = VBONDS + VSTOCK = £10,000 + £4,000 = £14,000. As in
the previous example, there is a reduction in the variability of firm value and an
accompanying £500 transfer of wealth from equity to debt. Hedging also avoids the
deadweight £1,000 bankruptcy cost and yields a higher expected payoff in the
amount of (½)(£1,000) = £500. In this example, debt captures the expected gain of
£500. Equity may capture some of the gain if hedging results in lower interest
payments on the next round of debt.
c. Unhedged, firm value is E[VFIRM] = E[VBONDS] + E[VSTOCK] = [(½)(£6,000-£1,000) +
(½)(£10,000)] + [(½)(£0) + (½)(£8,000)] = £7,500 + £4,000 = £11,500. If the firm
hedges, then VFIRM = VBONDS + VSTOCK = £10,000 + £2,000 = £12,000. 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.
Chapter 14 Transaction Exposure to Currency Risk
Answers to Conceptual Questions
14.1 What is transaction exposure to currency risk?
Transaction exposure is change in the value of monetary (contractual) cash flows due
to an unexpected change in exchange rates.
14.2 What is a risk profile?
A risk profile graphically displays change in the value of an underlying currency
exposure to change in the value of the underlying currency, such as ∆Vd/f as a
function of ∆Sd/f. Risk profiles can be displayed in levels or in changes in levels.
14.3 In what ways can diversified multinational operations provide a natural hedge of
transaction exposure to currency risk?
Geographically diversified multinational corporations have relatively low transaction
exposure to currency risk when they have cash inflows and outflows in a wide variety
of currencies. Geographically diversified operations provide opportunities to reduce
the multinational corporation’s currency risk exposures through multinational netting
and leading and lagging of intracompany transactions.
14.4 What is multinational netting? Why is it used by multinational corporations?
In multinational netting, a corporation’s exposure to currency risk is found by
consolidating and then netting the exposures of individual assets and liabilities.
Multinational netting reduces the transactions costs of hedging individual currency
risk exposures in external financial markets.
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![Solutions to End-of-Chapter Questions and Problems
Borrow an amount such that $X is due
$
in one period at an interest rate of i
$
+($X)/(1+i ) Money market hedge
-($X)
Convert to euros at today’s spot rate $/€
$X = F1 (€
1m)
+(€
€ $/€ $/€ $
1m)/(1+ i ) s.t. (F1 /S0 )=(1+ i )/(1+ i )
€
⇒
-(€
1m)
$ $ $/€ €
-($X)/(1+i ) s.t. [($X)/(1+i )]/S0 = (€1m)/(1+ i )
$/€ $ $/€ €
⇒ [F1 (€ 1m)/(1+i )]/S0 = (€ 1m)/(1+ i )
$/€ $/€ $ €
⇒ 1 /S0 ) = [(1+i )/(1+ i )]
(F
€
Invest this amount at i
+(€
1m)
€
-(€
1m)/(1+ i )
iv) short euro call option
$/€
V ∆
V
$/€
Net position
$/€
∆
S
$/€
S
Short euro call Short euro call
14.4 a. Not necessarily. From interest rate parity, F tA$/$/S0A$/$ = [(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.
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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 $5 million forward. Hedging an anticipated transaction makes
good business sense when the anticipated transaction is highly likely to occur. If
Rupert is not sure that he’ll actually incur this additional dollar exposure, he should
probably wait before hedging.
f. Rupert should buy the U.S. dollar forward against the Australian dollar. Futures
contracts on the AS/$ 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.
g. 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 3-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.
h. 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.
i. Rupert can swap existing Australian dollar debt for U.S. dollar debt such that his
obligation in U.S. dollars is $5 million per quarter.
Chapter 15 Operating Exposure to Currency Risk
Answers to Conceptual Questions
15.1 What is operating exposure to currency risk and why is it important?
A firm has operating exposure to currency risk when the value of its nonmonetary
(real) cash flows changes with unexpected changes in currency values.
15.2 In a discounted cash flow framework, in what ways can operating risk affect the
value of the multinational corporation.
Operating exposure (indeed, currency exposure generally) affects value either
through the cash flows or the discount rate in the valuation equation Vd = Σt E[CFtd]/
(1+id)t.
15.3 What is an integrated market? a segmented market? Why is this distinction important
in multinational financial management?
Purchasing power parity holds in an integrated market for goods, services, or
financial assets. This means that equivalent assets trade for the same price. A market
is segmented if purchasing power parity does not hold. Companies operating in
segmented markets have prices that are locally determined. Companies operating in
integrated markets face prices that are globally determined.
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16.5 Which translation method is the most realistic from the perspective of finance theory?
The current/noncurrent method is the least realistic, because it values long-term debt at
historical exchange rates. The choice between the temporal method (as in FAS #8) and
the current rate method (as in FAS #52) depends on whether real assets are more
realistically translated at historical or current exchange rates. The temporal method
translates real assets at historical rates assuming real assets are unaffected by currency
risk. The current rate method (FAS #52) assumes real assets are exposed one-for-one
to exchange rate risk. For most firms, the truth is somewhere between these two
positions.
16.6 Did the switch from FAS #8 to FAS #52 in the United States improve the quality or
informativeness of corporate earnings? How can we tell?
Collins and Salatka [“Noisy Accounting Earnings Signals and Earnings Response
Coefficients,” Contemporary Accounting Research 10, Spring 1994] and Bartov
[“Foreign Currency Exposure of Multinational Firms,” Contemporary Accounting
Research 14, Winter 1997] studied the relation of stock returns to earnings surprises
and found that FAS #52 improved the informativeness or information quality of
accounting earnings for U.S. multinationals with foreign operations.
16.7 According to finance theory, what determines whether an exposure to currency risk
should be hedged?
Finance theory states that the firm should only consider hedging risk exposures that
are related to firm value. There is no value in hedging noncash transactions that do not
cost or risk cash.
16.8 List three information-based reasons for hedging a translation exposure to currency
risk.
Information-based reasons include: (a) satisfying loan covenants, (b) meeting profit
forecasts, and (c) retaining a credit rating. Each justification relies on informational
asymmetries between corporate insiders and outsiders, presumably arising from costly
or restricted access to information on the part of investors or information providers.
16.9 How can corporate hedging of translation exposure reduce the agency conflict
between managers and other stakeholders? In what other ways can agency conflicts be
reduced?
If managers are evaluated based on accounting performance rather than on the value
they add to the firm, then allowing them to hedge can remove this source of risk from
their deliberations and help align managerial incentives with shareholder objectives.
16.10 Identify several cross-border differences in corporate hedging of translation exposure?
What might account for these differences.
Studies have documented higher derivatives usage as well as a greater willingness to
hedge translation exposure to currency risk outside the U.S. than within the United
States. It could be that non-U.S. managers are either more exposed to currency risk or
more risk averse given their exposures.
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![Solutions to End-of-Chapter Questions and Problems
17.4 Does the required return on a project depend on who is investing the money or on where
the money is being invested?
The required return on an investment project should be an asset-specific discount rate
that reflects the opportunity cost of capital on the project. That is, it depends on where the
money is going and not from where it came.
17.5 Does the value of a foreign project depend on the way it is financed?
Yes. Additional debt brings additional tax shields from the tax deductibility of interest
payments as well as additional costs of financial distress. The adjusted present value
approach to project valuation attempts to separate the value of the unlevered project from
the value of these financial side-effects.
17.6 When is the adjusted present value approach to project valuation most useful?
When the financial side-effects are easy to separate from the project. This includes many
of the special circumstances listed in the chapter on “Cross-Border Capital Budgeting”
including blocked funds, subsidized financing, negative-NPV tie-in projects,
expropriation risk, and government-sponsored tax holidays.
17.7 What is a targeted registered offering and why is it useful to the corporation?
Targeted registered offerings are securities issues 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.
17.8 What is project financing and when is it most appropriate?
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.
17.9 What evidence is there on the international determinants of corporate capital structure?
How is the international evidence similar to the domestic U.S. evidence?
Rajan and Zingales (1995) find that leverage is positively related to the tangibility of firm
assets (i.e. the proportion of fixed assets), the presence of growth options (i.e. the asset
market-to-book ratio), and firm size. Leverage is negatively related to profitability. These
relations are shared by several markets including the domestic U.S. market.
Problem Solutions
17.1 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%.
17.2 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%.
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17.3 a. The required return on Oilily’s equity within the French market is R F+β(E[RM]-RF)
= 5% + (1.4)(11%-5%) = 13.4%. Oilily’s weighted average cost of capital is i WACC
= (B/VL)iB(1-TC)+(S/VL)iS = (0.4)(7%)(1-0.33)+(0.6)(13.4%) = 9.916%.
b. Required return on Oilily’s stock is R = 5%+(1.2)(12%-5%) = 13.4% for an
international investor. Using international sources, Oilily’s cost of capital is i WACC
= (B/VL)iB(1-TC) + (S/VL)iS = (½)(6%)(1-0.33) + (½)(13.4%) = 8.710%.
c. Let’s assume that the BFr1 billion operating cash flow is before interest expense.
In the French market, Oilily’s value is V 0 = CF1 / (i-g) = BFr10,000,000/(0.09916-
0.04) = BFr169,033,130. If Oilily can raise funds in the global market, Oilily’s
value is V0 = CF1 / (i-g) = BFr10,000,000/(0.08710-0.04) = BFr212,314,225.
Oilily can increase its value by over 25% by financing in international markets
because of this market’s higher tolerance for debt and lower required returns.
17.4 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)(15%-5%) = 17%. Grand
Pet’s weighted average cost of capital is: i WACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.25)
(6%)(1-0.33) + (0.75)(17%) = 13.755%.
b. The debt ratio is now (B/VL) = 50/(50+100) = 0.33. The required return on Grand
Pet’s equity in international markets is R = R F+β(E[RW]-RF) = 5%+(0.8)(10%-5%)
= 9%. Using international sources of capital, Grand Pet’s cost of capital is: i WACC =
(B/VL)iB(1-TC)+(S/VL)iS = (0.33)(5%)(1-0.33) + (0.67)(9%) = 7.117%.
c. Let’s assume that the £1 billion operating cash flow is before interest expense, so
that the weighted average cost of capital is the appropriate discount rate on these
cash flows to debt and equity. In the U.K. market, Grand Pet’s value is
V0 = CF1 / (i-g) = £1,000,000,000/(0.13755-0.03) = £9,298,000,000.
If Grand Pet can raise funds in the global market, Grand Pet’s value is
V0 = CF1 / (i-g) = £1,000,000,000/(0.07117-0.03) = £24,291,000,000.
Grand Pet can increase its value by over 150% by raising funds internationally.
17.5 a. All-equity value is APV = VU-CF0 = (CF1 )/(1+iU)-Initial investment
= (BFr112 million/1.10)-BFr100 million = BFr1,818,182.
b. Borrowing BFr50 million at 6% results in an interest payment of i BB = BFr3
million. The present value of the tax shield is (T CibB)/1+iB) = (BFr990,000/1.06) ≈
BFr933,962. The APV of the investment is then BFr1,818,182 + BFr933,962 =
BFr2,752,144.
c. All-equity value is APV = VU-CF0 = BFr12 million/0.10-BFr100 million =
BFr20,000,000. The value of the perpetual tax shield is T CB = (0.33)(BFr50
million) = BFr16,500,000. The levered firm worth BFr36,500,000.
17.6 a. All-equity value is
APV = VU-CF0 = (CF1 )/(1+iU)-Initial investment
= £108 million/1.08-£100 million = £0.
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 ≅ $0.6107/S$
Profit on futures: +($0.6107/S$-$0.6107/S$) +$0.0000/S$
Profit on spot: -($0.6089/S$-$0.6089/S$) - $0.0000/S$
Net gain $0.0000/S$
Scenario #2 St$/S$ = $0.6089/S$ i$ = 6.24% iS$ = 4.54%
Futt,T$/S$ = ($0.6089/S$) [(1.0624)/(1.0454)](51/365) ≅ $0.6102/S$
Profit on futures: +($0.6102/S$-$0.6107/S$) -$0.0004/S$
Profit on spot: -($0.6089/S$-$0.6089/S$) - $0.0000/S$
Net gain -$0.0004/S$
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 ≅ $0.6111/S$
Profit on futures: -($0.6111/S$-$0.6107/S$) +$0.0004/S$
Profit on spot: +($0.6089/S$-$0.6089/S$) - $0.0000/S$
Net gain +$0.0004/S$
The profit spread is ±$0.0004/S$. This is about the same as in the example of
Figure 18.5. This shows that basis risk exists even if the spot exchange rate does
not change.
b. 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$/S$ = ($0.6089/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.6107/S$
Profit on futures: +($0.6107/S$-$0.6107/S$) +$0.0000/S$
Profit on spot: -($0.6089/S$-$0.6089/S$) - $0.0000/S$
Net gain $0.0000/S$
Scenario #2 St$/S$ = $0.6255/S$ i$ = 6.24% iS$ = 4.04%
Futt,T$/S$ = ($0.6255/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.6273/S$
Profit on futures: +($0.6273/S$-$0.6107/S$) -$0.0166/S$
Profit on spot: -($0.6255/S$-$0.6089/S$) - $0.0166/S$
Net gain $0.0000/S$
Scenario #3 St$/S$ = $0.5774/S$ i$ = 6.24% iS$ = 4.04%
Futt,T$/S$ = ($0.6089/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.5791/S$
Profit on futures: -($0.5791/S$-$0.6107/S$) +$0.0315/S$
Profit on spot: +($0.5774/S$-$0.6089/S$) - $0.0315/S$
Net gain $0.0000/S$
Part b shows that the futures hedge provides a perfect hedge against changes in
the spot rate of exchange if the basis does not change.
Chapter 19 Currency Options and Options Markets
Answers to Conceptual Questions
19.1 What is the difference between a call option and a put option?
A call option is an option to buy the underlying asset at a predetermined exercise price.
A put option is an option to sell the underlying asset at the exercise price.
19.2 What are the differences between exchange-traded and over-the-counter currency
options?
Exchange-traded currency options are standardized as to currencies, maturity, exercise
prices, and settlement procedures. Over-the-counter options traded by commercial and
investment banks can be tailored to fit the needs of the client.
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19.3 In what sense is a currency call option also a currency put option?
Because an option to buy one currency is simultaneously an option to sell another
currency, currency options are both a call (on one currency) and a put (on the other
currency).
19.4 In what sense is a currency forward contract a combination of a put and a call?
A currency forward contract to buy currency f at a forward price of F Td/f at time T can
be replicated by purchasing a European call option on currency f with the same
expiration date and an exercise price K d/f = FTd/f and simultaneously selling a put option
at the same exercise price and maturity date. Conversely, a short forward contract on
currency f is a combination of a written call on f and a purchased put on f with the same
expiration date and exercise price.
19.5 What are the six determinants of a currency option value?
The determinants of currency option values are riskless domestic and foreign interest
rates, the exercise price, the underlying spot (or futures) price, the expiration date, and
the volatility of the underlying exchange rate.
19.6 What determines the intrinsic value of an option? What determines time value of an
option?
The intrinsic value is the value if exercised today. For a call on the spot rate S d/f,
intrinsic value is equal to max(Sd/f-Kd/f,0). For a put option, intrinsic value is equal to
max(Kd/f-Sd/f,0). Time value is the difference between the market value and the intrinsic
value of an option and reflects the additional value of waiting until expiration before
exercise. Time value primarily depends on time to expiration and volatility in the
underlying exchange rate. Foreign and domestic interest rates play a lesser role for
most currency options.
19.7 In what ways can you estimate currency volatility?
Exchange rate volatility is a key determinant of currency option value because it is not
directly observable in the marketplace. The other determinants of option value (foreign
and domestic interest rates, exercise price, time to expiration, and underlying exchange
rate) are usually observable. Volatility can be estimated from historical volatilities (the
recent history of exchange rate movements) or implied volatilities (volatilities implied
by the five observable determinants of option values and the observed market price of
an option).
Problem Solutions
19.1 ln [(¥110.517/$) / (¥100/$)] = ln(1.10517) = +0.10 = +10%
ln [(¥90.484/$) / (¥100/$)] = ln(0.90484) = -0.10 = -10%
19.2 ln [(¥156.64/$) / (¥105/$)] = ln(1.49181) = +0.40 = +40%
ln [(¥70.38/$) / (¥105/$)] = ln(0.50819) = -0.40 = -40%
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b. A short krone put is equivalent to a short pound call. Here are their payoff profiles.
−∆PutT£/DKr −∆Call TDKr/£
£.11834/DKr DKr8.45/£ DKr8.48/£
∆ST£/DKr ≡ ∆STDKr/£
− DKr.03/£
−£.11834/DKr
c. These are payoff profiles for a short krone put and a the equivalent short pound call.
−∆PutT£/DKr −∆Call TDKr/£
+£.1464/DKr
+£.00204/DKr
∆ST£/DKr ≡ ∆STDKr/£
DKr8.45/£ DKr8.5964/£
£.11834/DKr
−£.11633/DKr
£.11633/DKr
Appendix 19-A Currency Option Valuation
19A.1
Option determinants are as follows: i¥ = i$ = 0.05, T = ½ year = 0.5, S ¥/$ = $80, K¥/$ =
$100, and σ = 0.10. Assume these are continuously compounded rates. (If not, the
transformation from holding period to continuously compounded returns is i = ln(1+i).)
d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T)
= [ln((¥80/$)/(¥100/$)) + (0.05-0.05+(0.10)2/2)(0.5)] / (0.10)(0.5)1/2 = -3.1204
d2 = d1 - σ√T = -3.1204 - (0.10)(0.5)1/2 = -3.1911
f d
Calld/f = e- i T [Sd/f N(d1)] - e- i T [Kd/f N(d2)]
= e(-0.05*.5)[(¥80/$)(0.0009)]-e(-0.05*.5)[(¥100/$)(0.0007)] = ¥0.0013/$.
This deep-out-of-the-money dollar call has almost no chance of being exercised.
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19A.2
Option determinants: Same as above, except σ = 0.20.
d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T)
= [ln((¥80/$)/(¥100/$)) + (0.05-0.05+(0.20)2/2)(0.5)] / (0.20)(0.5)1/2 = -1.5071
d2 = d1 - σ√T = -1.5071 - (0.20)(0.5)1/2 = -1.6486
f d
Calld/f = e- i T [Sd/f N(d1)] - e- i T [Kd/f N(d2)]
= e(-0.05*.5)[(¥80/$)(0.0659)]-e(-0.05*.5)[(¥100/$)(0.0496)] = ¥0.3015/$.
If the true volatility is 20% per year and this option is priced as if the volatility is 10%
per year, then the option will be undervalued by (¥0.3015/$-¥0.0013/$) = ¥0.3002/$.
19A.3
The implied variance of the $/¥ exchange rate is about 0.000877 from the currency
option pricing model. Taking the square root to find the standard deviation implied in
the option price, we get 0.0296 or 2.96% per year. As verification, here are the
calculations:
d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T)
= [ln(($.008345/¥)/($.0084/¥))+(0.04-0.04+(0.0296)2/2)(2.5/12)]/(0.0296)(2.5/12)1/2
= -0.1169
d2 = d1 - σ√T = -0.1169 - (0.0296)(2.5/12)1/2 = -0.1637
f d
Calld/f = e- i T [Sd/f N(d1)] - e- i T [Kd/f N(d2)]
= e(-0.04*2.5/12)[($.008345/¥)(0.5465)]-e(-0.04*2.5/12)[($.0084/¥)(0.4535)]
= $.000118/¥.
This is an unusually low volatility. Annual dollar/yen volatilities are typically between
8% and 16%. 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.
19A.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 £/DKr and quotes option prices in direct £/DKr terms from a Londoner’s
perspective. The current spot rate is S0£/DKr = 1/(DKr8.4528/£) = £0.11830/DKr and
the exercise price is K£/DKr = 1/(DKr8.5/£) = £0.11765/DKr.
1-month 3-month 6-month 1-year
Forward rate (DKr/£) 8.4404 8.4157 8.3787 8.3053
Forward rate (£/DKr) .11848 .11883 .11935 .12040
Call option value (£/DKr) .00180 .00294 .00412 .00583
Put option value (£/DKr) .00100 .00178 .00247 .00326
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b. Here is a sample calculation for the three-month (= one period) call and put values.
d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T)
= [ln((£0.11830/DKr)/(£0.11765/DKr))+(0.0174-0.0130+(0.05)2/2)(1)]/(0.05)(1)1/2
= +0.2244
d2 = d1 - σ√T = +0.2244 - (0.05)(1)1/2 = +0.1744
d
Calld/f = e- i T [Ftd/f N(d1) - Kd/f N(d2)]
= e(-0.0174*1)[(£0.11883)(0.5888)-(£0.11765)(0.5692)] = £0.00294/DKr.
c. Here are the call option payoff profiles for the four options prior to expiration. The
one-year option is plotted as the highest line in the graph.. The one-month option is
the lowest (curved) line in the graph. The darkened forty-five degree line is the
intrinsic value of the option.
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 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.
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Spot (or cash basis) stock markets settle trades immediately (typically within a few days).
Forward (or futures) stock markets settle trades on a specified future date.
Problem Solutions
21.1 No interest accrues on the 31st of the month with the 30/360 convention.
21.2 With the actual/365 convention, 31 days out of 182.5 days would have accrued by July
31st. This is (31/182.5) = 16.986% of the semiannual interest payment.
21.3 Three days of interest accrue on the 28th of February during years that are not leap years.
During leap years, one day of interest accrues on the 28th of February and two days of
interest accrue on the 29th of February.
21.4 Matsushita’s global bonds selling at par:
a. According to the U.S. bond equivalent yield convention, the promised yield of a bond
selling at par is equal to the coupon yield. For the Matsushita bond, this is 7¼%
compounded semiannually.
b. According to the effective annual yield quotation commonly used in Europe, the
promised yield is the solution to (1.03625)2-1 = 7.3814%.
c. According to the Japanese bond quotation convention, the yield is computed
according to:
100% - Price 100%
yield = Coupon rate + Years to maturity Price
= (7.25% + [(100%-100%)/2])(100%/100%) = 7.25%.
21.5 Matsushita’s global bonds selling at 101% of par:
a. The promised yield on a semiannual basis is the solution to:
101 = (3.625)/(1+r) + (3.625)/(1+r)2 + (3.625)/(1+r)3 + (103.625)/(1+r)4
for an effective semiannual yield of r = 3.354%. The U.S. bond equivalent yield
convention would quote this as 6.708% compounded semiannually.
b. According to the effective annual yield quotation, the promised yield is
(1.03354)2−1 = 6.8205%.
c. According to the Japanese bond quotation convention, the yield is (7.25% +
[(100%-101%)/2])(100%/101%) = 6.75495%.
21.6 Countries with large stock markets tend to have large government bond markets. After
deleting the countries that appear only in the list of stock markets, the correlation between
stock and bond market capitalizations in Table 21.1 is 0.87. The correlation between their
ranks is 0.83. Italy has a large government bond market relative to its stock market.
Switzerland has a large stock market capitalization relative to its government bond
market.
21.7 Electronic databases that can be used to search for information on recent alliances include
ABI/Inform and the Dow Jones News Retrieval Service.
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22.10 Describe some of the barriers to international portfolio diversification.
Barriers to international portfolio diversification include a) market frictions such as
government controls, taxes, and transactions costs, b) unequal access to market prices in
foreign markets, and c) unequal access to information on foreign assets. Investor
irrationality also can be a barrier to international portfolio diversification.
Problem Solutions
22.1 E[RP] = (½)(0.166)+(½)(0.158) = 0.1620, or 16.2%
Var(RP) = (½)2(0.290)2+(½)2(0.295)2 + 2(½)(½)(0.567)(0.290)(0.295) = 0.067
⇒ σP = (0.0670)1/2 = 0.2589, or 25.89%
SI = (RP - RF)/σP = (0.1620-0.068)/(0.2589) = 0.363, which is superior in return/risk
performance to either the French (0.338) or Germany (0.305) markets alone.
22.2 E[RP] = (½)(0.177)+(½)(0.158) = 16.75%
Var(RP) = (½)2(0.357)2+(½)2(0.295)2 + 2(½)(½)(0.330)(0.357)(0.295) = 0.071
⇒ σP = (0.071)1/2 = 0.2664, or 26.64%
SI = (0.1671-0.068)/(0.2664) = 0.373, which is superior in return/risk performance to
either the German (0.305) or Japanese (0.305) markets alone.
22.3 E[RP] = (½)(0.136)+(½)(0.133) = 13.45%
Var(RP) = (½)2(0.161)2+(½)2(0.101)2 + 2(½)(½)(0.360)(0.161)(0.101) = 0.012
⇒ σP = (0. 012)1/2 = 0.1094, or 10.94%
SI = (0.1345-0.0681)/(0.1094) = 0.608, which is superior in return/risk performance to
either stocks (0.422) or bonds (0.644) alone.
22.4 E[RP] = (1/3)(0.177)+(1/3)(0.176)+(1/3)(0.143) = 16.53%
Var(RP) = (1/3)2(0.357)2+(1/3)2(0.299)2+(1/3)2(0.164)2+2(1/3)2(0.317)(0.357)(0.299)
+ 2(1/3)2(0.325)(0.357)(0.164) + 2(1/3)2(0.557)(0.299)(0.164) = 0.0449
⇒ σP = (0. 0449)1/2 = 0.2119, or 21.19%
SI = (0.1653-0.068)/(0.2119) = 0.459, which is superior in return/risk performance to
the Japanese (0.305), U.S. (0.457), or U.K. (0.361) indices alone.
22.5 ρU.S.G = +1: σpt = (XU.S.σU.S. + XGσG) = (0.5)(0.1) + (0.5)(0.2) = 0.15
ρU.S.G = -1: σpt = (XU.S.σU.S. - XGσG) = (0.5)(0.1) - (0.5)(0.2) = -0.05
ρU.S.G = 0: σpt = (XU.S.2σU.S.2 + XG2σG2)½ = [(0.5)2(0.1)2 + (0.5)2(0.2)2] ½ = 0.11
ρU.S.G = 0.3: σpt = (XU.S.2σU.S.2 + XG2σG2 + 2XU.S.XGσU.S.σGρU.S.G) ½
= [0.520.12 + 0.520.22 + 2(0.5)(0.5)(0.1)(0.2)(0.3)] ½ = 0.1245
22.6 E[Rp] = XAE[RA] + XBE[RB] + XCE[RC] = 0.2(0.08) + 0.3(0.1) + 0.5(0.13) = 11.1%
22.7 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. In an
informationally efficient market, it is not possible to predict these high-performing
assets ex ante.
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22.8 sd/f = (Std/f/St-1d/f)-1= (€0.7182/$)/(€0.7064/$)-1 = 1.0168-1 = 1.68%
Rd = Rf + ∆Sd/f + Rf∆Sd/f = 0.1600 + 0.0168 + (0.1600)(0.0168) = 17.95%
22.9 (1+R$) = (1+RPeso)(1+s$/Peso )
⇒ R$ = (1.12 )[($.0440/Peso)/($.0425/Peso)]-1 = (1.12)(1.0353)-1 = 15.95%.
22.10 Note that variance is in units of %2 and not % as stated in the problem. Suppose that
the correct values are Var(RPeso) = 0.248 and Var(s$/Peso) = 0.327. Then Var(R$) =
Var(RPeso) + Var(s$/Peso) + Var(RPesos$/Peso) + 2Cov(RPeso,s$/Peso) = 0.248 + 0.327 + 0 + 0 =
0.575.
Chapter 23 International Asset Pricing
Answers to Conceptual Questions
23.1 What is the capital market line? Why is it important?
The capital market line describes the most efficient combination of risky and riskless
assets.
23.2 What is the security market line? Why is it important?
The security market line describes a linear relation between systematic risk and
required return.
23.3 What is beta? Why is it important?
Beta measures an asset’s sensitivity to changes in the market portfolio.
23.4 Does political risk affect required returns?
If political risk is country-specific, then it is diversifiable and does not affect required
return. If political risk is related to returns on the relevant (domestic or international)
market portfolio, then it does affect required returns.
23.5 What assumptions must be added to the traditional CAPM in order to derive the
international version of the CAPM?
Two additional assumptions are necessary: a) investors in each country have the same
consumption basket so that inflation is measured against the same benchmark in
every country, and b) purchasing power parity holds so that both real prices and real
interest rates are the same in every country and for every individual.
23.6 What is the hedge portfolio in the international version of the CAPM?
The hedge portfolio is a combination of domestic T-bills and a hedge against the
currency risk of the world market portfolio. (While the text does not go into detail, one
way to construct the currency hedge is through forward currency contracts.)
23.7 What is the difference between an integrated and a segmented capital market?
An integrated capital market is one in which the law of one price holds. Some sort of
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market imperfection is necessary for their to be segmented capital markets.
23.8 What is home asset bias?
Home asset bias is the tendency of domestic investors to invest in domestic securities.
23.9 What is Roll’s Critique of the CAPM? Does it apply to the IAPM? Does it apply to
APT?
Roll’s Critique concerns the testability of the CAPM. Roll observed that if security
performance is measured relative to an ex post efficient index then the algebra of the
CAPM assures that the relation between systematic risk and mean return holds by
construction. On the other hand, if security performance is measured relative to an ex
post inefficient index then beta is unlikely to be related to expected return.
23.10 What is the APT? In what ways is it both better or worse than the IAPM?
The arbitrage pricing model assumes that individual security returns are related to K
factors according to the linear relationship Rj = µj + β1jF1 + ... + βKjFK + ej. The good
news is that APT is not a tautology like the CAPM and hence is not subject to Roll’s
Critique. The bad news is that APT says nothing about what systematic risk factors are
priced. (The CAPM is constructed such that the only relevant systematic risk factor is
the return on the market portfolio.)
23.11 What five APT factors did Chen, Roll, and Ross identify in their study of the U.S.
stock market?
The 5 factors are: 1) industrial production, 2) expected inflation, 3) unexpected
inflation, 4) risk premia (measured by the spread between corporate and government
bond yields), and 5) the term structure of interest rates (long-term government - T-bill
yield).
23.12 Are individual stock returns more closely related to national or industry factors? What
implication does this have for portfolio diversification?
According to the Beckers, Connor, and Curds [1996] study presented in the text (as
well as other recent studies), individual stock returns are most closely related to
domestic stock market indices. Industry factors play a less prominent role. This
suggests that diversification across countries is more effective in reducing portfolio
risk than industry diversification.
23.13 What is the value premium? What is the size effect? Do international stocks exhibit
these characteristics? Are these factors evidence of market inefficiency?
The value premium refers to the tendency of value (high equity book-to-market)
stocks to outperform growth (low equity book-to-market) stocks. The size effect refers
to the tendency of small stocks to outperform large stocks. Fama and French [1998]
found that these factors are present in a study of 13 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.
23.14 What is momentum? Can it lead to profitable investment opportunities for
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![Solutions to End-of-Chapter Questions and Problems
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.
23.15 Are individual stocks exposed to currency risk? Does currency risk affect required
returns?
Individual stocks (especially firms with international operations) are often exposed to
currency risk. Jorion’s study (presented in the text) suggests that currency risk is not
priced in the U.S. stock market. However, the academic literature has not reached a
consensus on this point. The Dumas and Solnik article “The World Price of Foreign
Exchange Risk” mentioned in the footnote (Journal of Finance 50, No. 2, June 1995,
pages 445-479) comes to a different conclusion. In any case, managers will continue
to care about currency risk because they cannot diversify their wealth in the same way
that outside shareholders can.
Problem Solutions
23.1 a. RS = RF + βS (RM - RF) = 8% + [16.5% - 8%] (1.5) = 20.75%.
b. RS = RF + βS (RM - RF) = 4% + [16.5% - 8%] (1.2) = 14.2%.
23.2 a. ßDC = ρDC,Germany (σDC/σGermany) = (0.44)(0.105/0.046) ≈ 1.00 relative to the MSCI
German stock market index.
b. RDC = RF + βDC (E[RM]-RF) = 0.05 + (1.00)(0.06) ≈ 0.110, or 11.0%
c. ßGermany,World = ρGermany,World (σGermany/σWorld) = (0.494) (0.0526/0.0413) = 0.63
relative to the world market index.
23.3 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) = µ + βProdFProd+βOilFOil+βSpotFspot
= 14%+(1.5)(2%)+(-0.80)(10%)+ (0.01)(-5%)
= 14% + 3% - 8% - 0.05% = 8.95%.
c. With an expectation of 8.95% and an actual return of only 4%, BP underperformed
its expectation by 4.95% during the period.
23.4 a. According to Paribas’ factor sensitivities, Paribas 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 Paribas’ trading basket in the denominator of the foreign
exchange quote. (Conversely, the negative sign on this last factor means that
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Paribas is likely to rise with an appreciation of the euro in the numerator of the
spot rate quote.)
b. E(R) = µ + 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% and an actual return of only 22%, Paribas
underperformed its expectation by 4.3% during the period.
23.5 a. E(R) = µ + βFM + βZFZ + βDFD = 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% and an actual return of 12%, Amazon.com
outperformed its expectation by 3.15% during the period.
23.6 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.
23.7 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 U.S., winners lost
some of their accumulated gain during the subsequent year. Momentum strategies
hold promise for international markets.
c. At the time of this writing, momentum effects had not been investigated in Latin
American markets. Momentum appears to have a strong international component
in the Rouwenhorst study, so there is a strong possibility that they will be found in
Latin American stock markets as well.
Chapter 24 Managing an International Investment Portfolio
Answers to Conceptual Questions
24.1 List the various ways in which you might invest in foreign securities.
International portfolio diversification can be obtained through several paths including:
a) investment in MNCs, b) direct investment in individual foreign securities (through
direct purchase in the foreign market, direct purchase in the domestic market through
ADRs or American shares, globally diversified mutual funds or funds specializing in
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Multinational Finance Solutions
- 1. Solutions to End-of-Chapter Questions and Problems Solutions to End-of-Chapter Questions and Problems in Multinational Finance by Kirt C. Butler 1
- 2. Kirt C. Butler, Multinational Finance, 2nd edition Second Edition 2
- 3. Solutions to End-of-Chapter Questions and Problems PART I Overview and Background Chapter 1 Introduction to Multinational Finance Answers to Conceptual Questions 1.1 Describe the ways in which multinational financial management is different from domestic financial management. Multinational financial management is conducted in an environment that is influenced by more than one cultural, social, political, or economic environment. 1.2 What is country risk? Describe several types of country risk one might face when conducting business in another country. Country risks refer to the political and financial risks of conducting business in a particular foreign country. Country risks include foreign exchange risk, political risk, and cultural risk. 1.3 What is foreign exchange risk? Foreign exchange (or currency) risk is the risk of unexpected changes in foreign currency exchange rates. 1.4 What is political risk? Political risk is the risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate. 1.5 In what ways do cultural differences impact the conduct of international business? Because they define the rules of the game, national business and popular cultures impact each of the functional disciplines of business from research and development right through to marketing, production, and distribution. 1.6 What is the goal of financial management? How might this goal be different in different countries? How might the goal of financial management be different for the multinational corporation than for the domestic corporation? The goal of financial management is to make decisions that maximize the value of the enterprise to some group of stakeholders. The society in which business is conducted determines who these stakeholders are. The relative importance of stakeholders varies by country. Equity shareholders are important in every free-market country. Commercial banks are more important in some countries (e.g., Germany and Japan) than in some other countries (e.g., the United States and the United Kingdom). In socialist countries, the welfare of employees and the general population assume a more prominent role. 1.7 List the MNC’s key stakeholders. How does each have a stake in the MNC? Stakeholders narrowly defined include shareholders, debtholders, and management. More broadly defined, stakeholders also would include employees, suppliers, customers, host governments, and residents of host countries. 3
- 4. Kirt C. Butler, Multinational Finance, 2nd edition Chapter 2 World Trade and the International Monetary System Answers to Conceptual Questions 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? Figure 2.1 lists the major international trade pacts. 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. 2.2 Do countries tend to export more or less of their gross national product today than in years past? What are the reasons for this trend? Most countries export more of their gross national product today than in years past. Reasons include: a) the global trend toward free market economies, b) the rapid industrialization of some developing countries, c) the breakup of the former Soviet Union and the entry of China into international trade, d) the rise of regional trade pacts and the General Agreement on Tariffs and Trade, and e) advances in communication and in transportation. 2.3 How has globalization in the world’s goods markets affected world trade? How has globalization in the world’s financial markets affected world trade? Some of the economic consequences of globalization in the world’s goods markets include: a) an increase in cross-border investment in real assets (land, natural resource projects, and manufacturing facilities), b) an increasing interdependence between national economies leading to global business cycles that are shared by all nations, and c) changing political risk for multinational corporations as nations redefine their borders as well as their national identities. The demise of capital flow barriers in international financial markets has had several consequences including: a) an increase in cross-border financing as multinational corporations raise capital in whichever market and in whatever currency offers the most attractive rates, b) an increasing number of cross-border partnerships including many international mergers, acquisitions, and joint ventures, and c) increasingly interdependent national financial markets. 2.4 What distinguishes developed, less developed, and newly industrializing economies? Developed economies have a well-developed manufacturing base. Less developed countries (LDCs) lack this industrial base. Countries that have seen recent growth in their industrial base are called newly industrializing countries (NICs). 4
- 5. Solutions to End-of-Chapter Questions and Problems 2.5 Describe the International Monetary Fund’s balance-of-payments accounting system. The IMF publishes a monthly summary of cross-border transactions that tracks each country’s cross-border flow of goods, services, and capital. 2.6 How would an economist categorize systems for trading foreign exchange? How would the IMF make this classification? In what ways are these the same? How are they different? Economists have traditionally classified exchange rate systems as either fixed rate or floating rate systems. The IMF has adapted this system to the plethora of systems in practice today. The IMF’s classification scheme includes “more flexible,” “limited flexibility,” and “pegged” exchange rate systems. 2.7 Describe the Bretton Woods agreement. How long did the agreement last? What forced its collapse? After World War II, representatives of the Allied nations convened at Bretton Woods, New Hampshire to stabilize financial markets and promote world trade. Under Bretton Woods’ “gold exchange standard,” currencies were pegged to the price of gold (or to the U.S. dollar). Bretton Woods also created the International Monetary Fund and the International Bank for Reconstruction and Development (the World Bank). The Bretton Woods fixed exchange rate system lasted until 1970, when high U.S. inflation relative to gold prices and to other currencies forced the dollar off the gold exchange standard. 2.8 What factors contributed to the Mexican peso crisis of 1995 and to the Asian crises of 1997? In each instance, the government tried to maintained the value of the local currency at artificially high levels. This depleted foreign currency reserves. Local businesses and governments were also borrowing in non-local currencies (primarily the dollar), which heavily exposed them to a drop in the value of the local currency. 2.9 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. Problem Solutions 2.1 This problem will take a bit of research for the student. Places to start include the Russian ruble crisis of 1998 and continuing currency troubles in South America. 5
- 6. Kirt C. Butler, Multinational Finance, 2nd edition PART II International Currency and Eurocurrency Markets Chapter 3 The Foreign Exchange and Eurocurrency Markets Answers to Conceptual Questions 3.1 What is Rule #1 when dealing with foreign exchange? Why is it important? Rule #1 says to “Keep track of your currency units.” It is important because foreign exchange prices have a currency in both the numerator and the denominator. Most prices (for instance, a $15,000/car price on a new car) have a non-currency asset in the denominator and a currency in the numerator. 3.2 What is Rule #2 when dealing with foreign exchange? Why is it important? Rule #2 says to “Always think of buying or selling the currency in the denominator of a foreign exchange quote.” The importance of this rule is related to that of Rule #1. Foreign exchange quotes have a currency in both the numerator and the denominator. The rule “buy low and sell high” only works for the currency in the denominator. 3.3 What are the functions of the foreign exchange market? Currency markets transfer purchasing power from one currency to another, either today (in the spot market) or at a future date (in the forward market). When used with Eurocurrency markets, foreign exchange markets allow investors to move value both across currencies and over time. Foreign exchange markets also facilitate hedging and speculation. 3.4 Define allocational, operational, and informational efficiency. Allocational efficiency refers to how efficiently a market channels capital toward its most productive uses. Operational efficiency refers to how large an influence transactions costs and other market frictions have on the operation of a market. Informational efficiency refers to whether or not prices reflect value. 3.5 What is a forward premium? A forward discount? Why are forward prices for foreign currency seldom equal to current spot prices? A currency is trading at a forward premium when the nominal value of that currency in the forward market is higher than in the spot market. A currency is trading at a forward discount when the nominal value of that currency in the forward market is lower than in the spot market. Forward exchange rates will be different than spot exchange rates whenever investors expect currency values to change in nominal terms. Problem Solutions 3.1 a. The bid rate is less than the offer rate, so Citicorp is quoting the currency in the denominator. Citicorp is buying dollars at the FF5.62/$ bid rate and selling dollars at the FF5.87/$ offer rate. b. In American terms, the bid is $0.1704/FF and the ask is $0.1779/FF. Citicorp is buying and selling French francs at these quotes. c. In direct terms, the bid quote for the dollar is $0.1779/FF and the ask is $0.1704/FF. 6
- 7. Solutions to End-of-Chapter Questions and Problems d. Sell $1,000,000 (FF5.62/$) = FF5,620,000 = amount you receive Buy $1,000,000 (FF5.87/$) = FF5,870,000 = amount you pay Your net loss is FF 250,000. What you lose, Citicorp gains. 3.2 The ask price is higher than the bid, so these are the 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 SK10,000,000/(SK7.5050/$) = $1,332,445.04. 3.3 The U.S. dollar (in the denominator) is selling at a forward premium, so the Canadian dollar must be selling at a forward discount. Percent per annum on the Canadian dollar from the U.S. perspective are as follows: Bid Ask One month forward -0.486% -1.456% Three months forward -0.873% -1.034% Six months forward -0.678% -0.758% Annualized forward premia on the U.S. dollar are: Bid Ask One month forward +0.486% +1.457% Three months forward +0.875% +1.036% Six months forward +0.681% +0.761% The premiums/discounts on the two currencies are opposite in sign and nearly equal in magnitude. Forward premiums and discounts are of slightly different magnitude because the bases (U$ vs. C$) on which they are calculated are different. Forward premiums/discounts are as stated above regardless of where a trader resides. 3.4 Days Difference Basis point % premium/discount Annualized % forward forward ($/¥) spread per period premium or discount 30 -0.00008895 -0.8895 -0.9820% -11.7845% 90 -0.00028441 -2.8441 -3.1401% -12.5604% 180 -0.00056825 -5.6825 -6.2740% -12.5479% 360 -0.00113707 -11.3707 -12.5541% -12.5541% 3.5 1984 DM1.80/$ or $0.56/DM 1987 DM2.00/$ or $0.50/DM 1992 DM1.50/$ or $0.67/DM 1997 DM1.80/$ or $0.56/DM a. 1984-87 The dollar appreciated 11.1%; ((DM2.0/$)-(DM1.8/$)/(DM1.8/$)=+0.111 1987-92 The dollar depreciated 25%; ((DM1.5/$)-(DM2.0/$)/(DM2.0/$)=-0.25 1992-97 The dollar appreciated 25%; ((DM1.8/$)-(DM1.5/$)/(DM1.5/$)=+0.20 b. 1984-87 The mark depreciated 10.7%; ($0.50/DM)/($0.56/DM) - 1= -0.107 1987-92 The mark appreciated 34.0%; ($0.67/DM)/($0.50/DM) - 1= +0.340 1992-97 The mark depreciated 16.4%; ($0.56/DM)/($0.67/DM) - 1 = -0.164 7
- 8. Kirt C. Butler, Multinational Finance, 2nd edition 3.6 a. FM5,000,000 / (FM4.0200/$) = $1,243,781. Tokyo’s bid price for FM is their ask price for dollars. So, FM4.0200/$ is equivalent to $0.2488/FM. b. FM20,000,000 / (FM3.9690/$) = $5,039,053 FM3.9690/$ is equivalent to $0.2520/FM Payment is made on the second business day after the three-month expiration date. 3.7 You initially receive P0$ = P0¥/S0¥/$ = (¥104,000,000)/(¥1.04/$) = $1 million. When you buy back the yen, you must pay P1$ = P1¥/S1¥/$ = (¥104,000,000)/(¥1.00/$) = $1.04 million. Your dollar loss is $40,000. 3.8 When buying one currency, you are simultaneously selling another. Hence, a bid price for pesetas is an ask price for dollars. The peseta quotes yield S Pts/$ = 1/S$/Pts = 1/ ($0.007634/Pts) = Pts130.99/$ and SPts/$ = 1/($0.007643/Pts) = Pts130.84/$, so quotes for the dollar (in the denominator) are Pts130.84/$ BID and Pts130.99/$ ASK. 3.9 a. (1+s¥/$) = 0.90 = 1/(1+s$/¥)⇔s$/¥ = (1/0.90)-1 = +0.111, or an 11.1% appreciation. b. (1+sRbl/$) = 11 = 1/(1+sRbl/¥)⇔s$/Rbl = (1/11)-1 = -0.909, or a 90.9% depreciation. 3.10 The 90-day dollar forward price is 33 basis points below the spot price: F 1SFr/$-S0SFr/$ = (SFr0.7432/$-SFr0.7465/$) = -SFr0.0033/$. The percentage dollar forward discount is (F1SFr/$-S0SFr/$)/S0SFr/$ = (SFr0.7432/$–SFr0.7465/$)/(SFr0.7465/$) = -0.442% per 90 days. This is (-0.442%)*4 = -1.768% on an annualized basis. 3.11 Banks make a profit on the bid-ask spread. A bank quoting $0.5841/DM BID and $0.5852/DM ASK is buying marks (in the denominator) at $0.5841/DM and selling marks at $0.5852/DM ASK. A bank quoting $0.5852/DM BID and $0.5841/DM ASK is selling dollars (in the numerator) at $0.5852/DM BID and buying dollars at $0.5841/DM ASK. 3.12 FF at a forward discount 30 day: ($0.18519/FF-$0.18536/FF)/$0.18536/FF = -0.092% 90 day: ($0.18500/FF-$0.18536/FF)/$0.18536/FF = -0.194% 180 day: ($0.18498/FF-$0.18536/FF)/$0.18536/FF = -0.205% 3.13 a. S1$/¥ = S0$/¥ (1+ s$/¥) = ($0.0100/¥)(1.2586) = ($0.012586/¥) b. (1+ s¥/$) = S1¥/$/S0¥/$ = (1/S1$/¥) / (1/S0$/¥) = 1 / (S1$/¥/S0$/¥) = 1 / (1+ s$/¥) = 1 / (1.2586) = 0.7945, so s$/¥ = 0.7945 - 1 = -.2055, or = -20.55% 3.14 a. The sale is invoiced in Belgian francs, so the expected future cash flow is: +BF40,000,000 8
- 9. Solutions to End-of-Chapter Questions and Problems b. The contractual payment is a positive cash flow in Belgian francs, so Dow is positively exposed to the value of the Belgian franc. ∆V$/BF Dow’s exposure ∆V$/BF c. The expected cash flow in dollars is E[CF 1$] = E[CF1BF] E[S1$/BF] = (BF40,000,000) ($0.025/BF) = $1,000,000. Actual dollar cash flow is CF1$ = CF1BFS1$/BF = (BF40,000,000)($0.04/BF) = $1,600,000. This leaves an unexpected gain of $600,000, or 60% of the expected value. As the value of the BF rises by 60% from $0.025/BF to $0.040/BF, so too does the value of this Belgian franc cash inflow. d. Sell 40 million Belgian francs forward and buy $1,000,000 at the forward price of F1$/BF = $0.025/BF, or F1BF/$ = BF40/$. +$1,000,000 −BF40,000,000 The Belgian franc is being sold forward, so Dow’s exposure to the value of the Belgian franc in this forward contract is negative. The negative exposure on the forward contract offsets the positive exposure on the underlying position. The net result is no exposure to the Belgian franc exchange rate. $/BF ∆V Forward exposure $/BF ∆V 3.15 (Ftd/f-S0d/f)/S0d/f = [(1/Ftf/d)-(1/S0f/d)]/(1/S0f/d) = [(S0f/d/Ftf/d)-(S0f/d/S0f/d)]/(S0f/d/S0f/d) = [(S0f/d /Ftf/d) - 1] = (S0f/d - Ftf/d) / Ftf/d. 9
- 10. Kirt C. Butler, Multinational Finance, 2nd edition Chapter 4 The International Parity Conditions Answers to Conceptual Questions 4.1 What is the law of one price? What does it say about asset prices? The law of one price states that identical assets must have the same price wherever they are bought or sold. The law of one price is enforced by arbitrage activity between identical assets. In a perfect market without transaction costs, the law of one price must hold for there to be no arbitrage opportunities. 4.2 Describe riskless arbitrage. Riskless arbitrage is a profitable position obtained with no net investment and no risk. Riskless arbitrage will drive the prices of identical assets into equilibrium and enforce the law of one price. 4.3 What is the difference between locational, triangular, and covered interest arbitrage? Locational arbitrage is conducted between two physical locations, such as between currency prices at two different banks (such that ASf/d BSd/f ≠ 1 for banks A and B and currencies d and f). Triangular arbitrage is conducted across three different cross exchange rates (such that Sd/e Se/f Sf/d ≠ 1 for currencies d, e, and f). Covered interest arbitrage takes advantage of a disequilibrium in the interest rate parity condition [(F td/ f) / (S0d/ f)] ≠ (1+id) / (1+i f)]t between currency and Eurocurrency markets. 4.4 What is relative purchasing power parity? Relative purchasing power parity is a form of the law of one price in which the expected change in the spot rate is influenced by inflation differentials according to E[S td/f]/S0d/f = [(1+id) / (1+if)]t. 4.5 How would you arrive at an estimate of a future spot exchange rate between two currencies? In theory, any of the international parity conditions could be used: E[S td/f] / S0d/f = [(1+id) / (1+if)]t = [(1+pd) / (1+pf)]t = Ftd/f / S0d/f. In practice, forward exchange rates are used to predict future spot rates. 4.6 What does the international Fisher relation say about interest rate and inflation differentials? If the law of one price holds and real interest rates are constant across currencies, nominal interest rates reflect inflation differentials according to [(1+id) / (1+if)]t = [(1+pd) / (1+pf)]t. 10
- 11. Solutions to End-of-Chapter Questions and Problems Problem Solutions 4.1 a. S¥DM = S¥/$S$/DM = (¥200/$)($0.50/DM) = ¥100/DM b. S¥DM = S¥/$/SDM/$ =(¥100/$)/(DM1.60/$) = ¥62.5/DM. 4.2 SDM/$ S$/¥ S¥/DM = 1.0326 > 1. Triangular arbitrage would yield a profit of 3.26 percent of the starting amount. For triangular arbitrage to be profitable, transactions costs on a “round turn” cannot be more than this amount. 4.3 The forward price is at a 9 basis point discount over six months, or 18 bps on an annualized basis. The six-month percentage discount is (F 1£/$/S0£/$)-1 = (£0.6352/$)/ (£0.6361/$)-1 = 0.9986-1 = 0.14%, or 0.28% on an annualized basis. Because Ft£/$ = E[St£/$] according to forward parity (the unbiased forward expectations hypothesis), the spot rate is expected to depreciate by 0.14% over the next six months. 4.4 a. The percentage bid-ask spread depends on which currency is in the denominator. Tokyo quote for the peso: (¥28.7715/Ps–¥28.7356/Ps)/(¥28.7356/Ps) = 0.125% Mexico City quote for yen: (Ps0.03420/¥–Ps0.03416/¥)/(Ps0.03416/¥) = 0.117% b. The Mexican bank’s yen quote can be converted into a peso quote as follows: S¥/Ps = 1/(Ps0.03416/¥) = ¥29.2740/Ps bid on the yen and ask on the peso. S¥/Ps = 1/(Ps0.03420/¥) = ¥29.2398/Ps ask on the yen and bid on the peso. So Ps0.03416/¥ BID and Ps0.03420/¥ ASK on the yen is equivalent to ¥29.240/Ps BID and ¥29.274/Ps ASK on the peso. The winning strategy is to buy pesos (and sell yen) from the Tokyo bank at the ¥28.7715/Ps ask price and sell pesos (and buy yen) to the Mexican bank at the ¥29.240/Ps bid price. Buying pesos in Tokyo yields (¥1,000,000)/(¥28.7715/Ps) = Ps34,757. Selling pesos in Mexico City yields (Ps34,757)(¥29.2398/Ps) = ¥1,016,287. Your arbitrage profit is ¥16,287. 4.5 In this circumstance, the international parity conditions do not have anything to say about the U.K. inflation rate. Nominal interest rates will adjust to expected inflation according to the Fisher relation; (1+i) = (1+p)(1+r). 4.6 a. From interest rate parity, (¥210/$)/(¥190/$) = (1+i¥)/(1.15) ⇒ i¥ = 27.11%. b. Because the forward rate of ¥210/$ is greater than the spot rate of ¥190/$, the dollar is at a forward premium. If forward rates are unbiased predictors of future spot rates, the dollar is likely to appreciate against the yen by (¥210/$)/(¥190/$)-1 = 10.526%. 4.7 a. In this problem, we know the spot and forward rates and U.S. inflation. The real and nominal interest rates are not needed: F1£/$/S0£/$ = (£1.20/$)/(£1.25/$) = 0.96 = E(1+p$)/E(1+p£) = (1.05)/E(1+p£) => E(p£) = (1.05/0.96)-1 = 9.375% b. From the Fisher equation: i£ = (1+p£)(1+r£)-1 = (1.09375)(1.02)-1 = 11.56%. 4.8 a. E[P1D] = P0D(1+pD) = D100(1.10) = D110 E[P1F] = P0F(1+pF) = F1(1.21) = F1.21 E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F. 11
- 12. Kirt C. Butler, Multinational Finance, 2nd edition b. E[P2D] = P0D(1+pD)2 = D100(1.10)2 = D121 E[P2F] = P0F(1+pF)2 = F1(1.21)2 = F1.4641 E[S2D/F] = E[P2D]/E[P2F] = D121/F1.4641 = S0D/F[(1+pD)/(1+pF)]2 = (D100/F)(1.10/1.21)2 = D82.64/F. 4.9 a. A 7% annualized rate with quarterly compounding is equivalent to 7%/4 = 1.75% per quarter. From interest rate parity, the 3-month Finnish markka interest rate is FFM/$/SFM/$ = (FM3.9888/$)/(FM4.0200/$) = (1+iFM)/(1+i$) = (1+iFM)/(1+0.0175) => iFM = 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 FM at the forward rate, this is worth ($10,175,000)(FM3.9888/$) = FM40,586,040. You can finance your $10,000,000 by borrowing FM40,200,000. Your obligation on this contract will be (FM40,200,000)(1.009603) ≈ FM40,586,040 which is exactly offset by the proceeds from your forward contract. 4.10 a. FtBt/$/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+i Bt)/(1+i$) = (1.1)/(1.06125) = 1.037. So, borrow at i$ and lend at iBt. +Bt24,960,000 Convert to baht at the spot exchange rate −$1,000,000 Invest at the 10% baht interest rate +Bt27,456,000 −Bt24,960,000 Borrow at the 6.125% dollar interest rate +$1,000,000 −$1,061,250 Cover baht forward +$1,070,827 −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 = $9,024 in present value. 12
- 13. Solutions to End-of-Chapter Questions and Problems 4.11 F1AA/$/S0AA/$ = (AA22/$)/(AA20/$) = 1.1 < 1.1132 = (1.18)/(1.06) = (1+ i AA)/(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 austral rate. The forward premium is too low and must rise, so buy australs (and sell dollars) at the relatively low dollar forward rate and sell dollars (and buy australs) at the relatively high dollar spot rate. • Borrow $100,000 at the dollar interest rate so that $106,000 is due in six months. • Buy AA2,000,000 at the relatively high spot price. • Invest this in Argentina at 18% to yield AA2,360,000 at the end of six months. • Cover by selling AA2,360,000 at the AA22/$ forward rate to yield $107,273. This leaves a profit of $107,273-$106,000 = $1,272.73. 4.12 The Singapore dollar is at a forward premium; F1$/S$/S0$/S$ = ($0.51/S$)/($0.50/S$) = 1.02, or 2% per year. This is less than is 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 ($1,000,000)/(1+i$) = $1,060,000 at the i$ = 6.0% dollar interest rate. +$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. 13
- 14. Kirt C. Butler, Multinational Finance, 2nd edition +$1,060,800 -S$2,080,000 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. 4.13 a. You are receiving £100,000 in one year, so sell £100,000 forward and buy dollars. In one year, you will receive £100,000 from your album sale. You can then convert this amount into (£100,000)($1.20/£) = $1,200,000 through the forward contract. 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/£. +$112,047 -£89,638 Invest in dollars at the U.S. dollar rate of i$ = 9.82%. +$123,050 -$112,047 The net result is a forward contract to buy dollars with pounds. +£100,000 -$123,050 Note that this is on more favorable terms than the forward contract. Forward prices are not in equilibrium with the interest rate differential. In this situation, it is cheaper to hedge through the money markets than through the forward market. c. These markets are not in equilibrium. F1$/£/S0$/£ = ($1.20/£)/($1.25/£) = 0.96 < 14
- 15. Solutions to End-of-Chapter Questions and Problems =0.98440 = (1.0982)/(1.1156) = (1+i$)/(1+i£), so you should buy pounds at the relatively low forward price, sell pounds at the relatively high spot price, invest in dollars at the relatively high dollar interest rate, and borrow pounds at the relatively low pound interest rate. Appendix 4-A Continuous Time Finance 4A.1 Total two-period return is [V2/V0]-1 = [(1+i1)(1+i2)]-1. Mean geometric return is iavg = [(1+i1)(1+i2)]1/2-1. Total wealth after two periods is the same as beginning wealth; $100(1+1)(1-0.5) = $100. Notice that the order of the rates of return does not matter. A loss of 50% followed by a gain of 100% leaves your initial value unchanged. For the pair of returns (100%,-50%), the average period return is iavg = [(1+1)(1-0.5)]1/2-1 = 0. With continuously compounded returns, periodic rates are given by ι1 = ln(1+i1) = ln(2) = +0.69315 and ι2 = ln(1+i2) = ln(0.5) = -0.69315. The (arithmetic) average return using continuously compounded rates is (ι1+ι2)/2 = (+0.69315-0.69315)/2 = 0. Either way, your ending value is the same as your beginning value. These methods are equivalent. 4A.2 Inflation rates are pD = ln(1+pD) = ln(1.10) = 9.531% and pF = ln(1+pF) = ln(1.21) = 19.062% in continuously compounded returns. Expected price levels and spot rates are: E[P1D] = P0D e(0.09531) = (D100)(1.10) = D110 E[P2D] = P0D e(2)(0.09531) = (D100)(1.21) = D121 E[P1F] = P0F e(0.19062) = (F1)(1.21) = F1.21 E[P2F] = P0F e(2)(0.19062) = (F1)(1.4641) = F1.4641 E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F E[S2D/F] = E[P2D] / E[P2F] = D121 / F1.4641 = D82.64/F Chapter 5 The Nature of Foreign Exchange Risk Answers to Conceptual Questions 5.1 What is the difference between currency risk and currency risk exposure? Risk exists whenever actual outcomes can deviate from expected outcomes. Currency risk is the risk that currency values will change unexpectedly. Exposure to currency risk refers to change in the value of an asset (such as an individual investment portfolio or the stock price of a multinational corporation) with unexpected changes in currency values. 5.2 What are monetary assets and liabilities? What are nonmonetary assets and liabilities? Monetary assets and liabilities have contractual payoffs. Nonmonetary assets (e.g., plant and equipment) and liabilities have noncontractual payoffs. 5.3 What are the two components of economic exposure to currency risk? Monetary (contractual) assets and liabilities can be exposed to currency risk. This is called “transaction exposure.” The exposure of the firm’s real (noncontractual) or operating assets is called “operating exposure.” 15
- 16. Kirt C. Butler, Multinational Finance, 2nd edition 5.4 Under what conditions is accounting exposure to currency risk important to shareholders? Accounting (or translation) exposure is the exposure of financial statements to currency risk. Accounting exposure is important to shareholders if it is related to economic exposure (that is, related to expected future cash flows). It is also important if managers change their actions (and thereby firm cash flow) in response to accounting exposure. 16
- 17. Solutions to End-of-Chapter Questions and Problems 5.5 Will an appreciation of the domestic currency help or hurt a domestic exporter? An importer? 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. 5.6 What does the efficient market hypothesis say about market prices? In an informationally efficient market, assets are correctly priced. It is not possible to consistently earn abnormal returns (beyond that obtainable by chance) on assets of similar risk. The efficient market hypothesis says that spot and forward exchange rates should be correctly priced, so that it is not possible to consistently make abnormal returns by speculating in foreign exchange. 5.7 What are real (as opposed to nominal) changes in currency values? Real exchange rate changes reflect changes in currencies’ relative purchasing power. 5.8 Are real exchange rates in equilibrium at all times? Real exchange rates show large and persistent deviations from purchasing power parity. These deviations can last for several years. 5.9 What is the effect of a real appreciation of the domestic currency on the purchasing power of domestic residents? A real appreciation of the domestic currency increases the wealth and purchasing power of domestic residents relative to foreign residents. It can also hurt the economy by raising the price of domestic goods relative to foreign goods. 5.10 Describe the behavior of nominal exchange rates. For daily measurement intervals, both nominal and real exchange rate changes are random with a nearly equal probability of rising or falling. As the forecast horizon is lengthened, the correlation between interest and inflation differentials and nominal spot rate changes rises. Eventually, the international parity conditions exert themselves and the forward rate begins to dominate the current spot rate as a predictor of future nominal exchange rates. Finally, exchange rate volatility is not constant. Instead, volatility comes in waves. 5.11 Describe the behavior of real exchange rates. Although real exchange rates tend to revert to their long run average, in the short run there can be substantial deviations from purchasing power parity and from the long run average. 5.12 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. These forward predictions can be slightly improved by adjusting them for persistent deviations from forward parity or from interest rate parity. Forecasts can also be based on econometric models. Model-based forecasts 17
- 18. Kirt C. Butler, Multinational Finance, 2nd edition can be generated from technical analysis (analyzing patterns in exchange rates) or from fundamental analysis (from a larger set of economic relationships). Problem Solutions 5.1 a. E[P1F] = P0F(1+pF) = 1.21 E[P1D] = P0D(1+pD) = 1.10 E[S1D/F] = (S0D/F)(1+pD)/(1+pF) = (D110/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[P2F]) = P0F(1+pF)2 = F1.4641 E[P2D]) = P0D(1+pD)2 = D121 E[P2F]) = P0F(1+pF)2 = F1.4641 E[P2D]) = P0D(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%. 5.2 a. s¥/DM = (S0¥/DM)/(S-1¥/DM)-1 = (¥155/DM)/(¥160/DM) -1 = -3.125%. b. From relative purchasing power parity, the spot rate should have been: E[S0¥/DM] = (S-1¥/DM) [(1+p¥)/(1+pDM)] = (¥160/DM) [(1.02)/(1.03)] = ¥158.45. c. As a difference from the expectation, the real change in the spot rate is: x¥/DM = (Actual-Expected)/(Expected) = (S0¥/DM -E[S0¥/DM])/E[S0¥/DM]) = (¥155/DM-¥158.45/DM)/¥158.45/DM = -2.18%. Alternatively, from equation (5.2), change in the real exchange rate is equal to: x¥/DM = ((S0¥/DM)/(S-1¥/DM)) ((1+pDM)/(1+p¥)) - 1 = ((¥155/DM)/(¥160/DM)) ((1.03)/(1.02)) - 1 = -2.18%. d. The deutsche mark depreciated by 2.18% in purchasing power. e. In real terms, the yen rose by xDM/¥ = ((S0DM/¥) / (S-1DM/¥)) ((1+p¥) / (1+pDM)) - 1 = ((S0¥/DM)-1 / (S-1¥/DM)-1) ((1+p¥) / (1+pDM)) - 1 = ((¥155/DM)-1 / (¥160/DM)-1 ) ((1.02)/(1.03)) - 1 = +2.23% = ((DM.0064516/¥)/(DM.00625000/¥)) ((1.02)/(1.03)) - 1 = +2.23%. Because the DM fell by 2.18% in real terms, the yen rose by 1/(1-0.0218) ≈ 2.23%. 5.3 a. The percentage change in the dollar is s Fl/$ = (S1Fl/$/S0Fl/$)-1 = (Fl1.55/$)/(Fl1.60/$)-1 = -0.03125, or 3.125%. The price elasticity of demand is equal to -(∆Q/Q)/(∆P/P) = - (+10%)/(-3.125%) = 3.2. b. A 10% real depreciation in the export sales price (in this case, in the value of the dollar) would result in a 32% increase in export sales if the price elasticity does not change. Note that price elasticity is unlikely to be constant across such a wide range of price changes. 18
- 19. Solutions to End-of-Chapter Questions and Problems c. Dollar revenues would go up by 32% with a 32% increase in volume. Letting initial quantity sold and export price be Q and P, respectively, the guilder value of export sales would increase by (Rnew)/(Rold)-1 = ((1.32Q)(0.90P) / (Q)(P))-1 = +18.8%. 5.4 σt2 = (0.0034) + (0.40)(0.05)2 + (0.20)(0.10)2 = 0.0064 ⇒ σt = 0.08, or 8%. PART III The Multinational Corporation’s Investment Decisions Chapter 6 Multinational Corporate Strategy Answers to Conceptual Questions 6.1 Why are product or factor market imperfections preconditions for foreign direct investment? Without some sort of product or factor market imperfection, the multinational corporation cannot enjoy an advantage over local firms. For the MNC to add value to the marketplace, it must bring something that local firms cannot. These competitive advantages are protected by market imperfections. 6.2 Describe the elements of the eclectic paradigm. What does the eclectic paradigm attempt to do? The eclectic paradigm attempts to categorize the types of advantages enjoyed by the multinational corporation that give it a competitive advantage over local firms. The major categories are ownership-specific advantages, location-specific advantages, and market internalization advantages. 6.3 What are ownership-specific advantages? Ownership-specific advantages are firm-specific property rights or intangible assets including patents, trademarks, organizational and marketing expertise, production technology and management, and the general organizational abilities of employees. 6.4 What are location-specific advantages? Location-specific advantages arise from the MNC’s access to natural and man-made resources, high labor productivity and low real wage costs, transportation and communication systems, governmental investment incentives, and preferential tax treatments that are specific to a particular location or locale. 6.5 What are market internalization advantages? Market internalization advantages allow the multinational corporation to internalize or exploit the failure of an arms-length market to efficiently accomplish a task. That is, contracting to accomplish a task is more effective or less expensive when conducted within the firm than through the markets. 6.6 Describe the evolution of the MNC using product cycle theory. 19
- 20. Kirt C. Butler, Multinational Finance, 2nd edition According to product cycle theory, the firm’s products evolve through four stages: infancy, growth, maturity and decline. The MNC attempts to extend the lucrative mature stage by enhancing revenues through access to new product markets and reducing operating costs through access to new factor markets. 6.7 Describe three broad modes of entry into international markets. Which of these modes requires the most resource commitment on the part of the MNC? Which has the greatest risks? Which offers the greatest growth potential? Export entry, contract-based entry, and investment entry. Investment entry requires the most resource commitment and exporting the least. The other side of the coin is that expected returns are often higher with investment-based entry than with exporting (so long as the project is positive-NPV and the MNC can pull it off). The advantages and disadvantages of contract-based entry depend on the particular contract. 6.8 What are the relative advantages and disadvantages of foreign direct investment, acquisitions/mergers, and joint ventures? The resource commitments of FDI and foreign acquisition are generally higher than joint ventures. a. FDI allows the MNC relatively permanent access to foreign product and factor markets. The cost of a new investment in an unfamiliar business culture can be high, however. b. Acquisitions of stock or of assets may be difficult or impossible in countries with investment restrictions or ownership structures (such as the German banking system or the Japanese keiretsu industrial structure) that impede foreign acquisitions. Acquisition premiums can also be prohibitive. c. Joint ventures can allow the MNC to gain quick access to foreign markets and to new production technologies. It can also come with risks, such as the risk of losing control of the MNC’s intellectual property rights to the joint venture partner. 6.9 Describe several defensive strategies that MNCs use during the mature stage of their products’ life cycles. Strategies to preserve and enhance revenues include preservation of market share, follow the leader, follow the customer, and lead the customer. Strategies to reduce operating costs include seeking low-cost raw materials and labor, economies of scale, economies of vertical integration, reduction of operating inefficiencies (process efficiency seekers), knowledge seekers, and political safety seekers. Financial considerations include the possibility of obtaining financial economies of scale, access to new capital markets, new sources of low-cost financing, indirect diversification benefits, financial strength and lower risk through international asset diversification, and reduced taxes through multinational operations. 6.10 How can the MNC protect its competitive advantages in the international marketplace? The text lists several ways to protect competitive advantages such as the firm’s intellectual property rights. The most important of these protections lies in finding the right partner. Other ways that the MNC can protect itself include: i) limit the scope of the technology 20
- 21. Solutions to End-of-Chapter Questions and Problems transfer to include only non-essential parts of the production process, ii) limit the transferability of the technology by contract, iii) limit dependence on any single partner, iv) use only assets near the end of their product life cycle, v) use only assets with limited growth options, vi) trade one technology for another, vii) remove the threat by acquiring the stock or assets of the foreign partner. Problem Solutions 6.1 Rather than make up an entry strategy, let’s look at how Motorola has entered Southeast Asia. In the 1960s, Motorola established sales agencies in Japan and Hong Kong as its initial entry mode. In the early 1980s, Motorola decided that it needed direct investment in the region in order to diversify its design and manufacturing capabilities. Development costs are high in the semiconductor industry and economies of scale on a successful product can be substantial. For this reason, Motorola and other semiconductor manufacturers have favored the international joint venture as a way to enter new markets and reduce the costs and risks of product innovation. Here is a partial list of Motorola’s international joint ventures: • Beginning in 1987, Motorola has had a joint venture with Toshiba to manufacture semiconductors. Joint ventures help Motorola to keep research and development costs down while keeping an eye on their Japanese competitors. • In 1990, Motorola built a design and manufacturing facility in Hong Kong as a platform to service the rest of Southeast Asia. • Since late 1996, Motorola has manufactured Mac clones in a joint venture with China’s state-owned Nanjing Power Computing of China based on its Power PC chip. • Motorola has joined a strategic alliance called “Iridium” with Globalstar, Loral, and Qualcomm to place satellites in very low orbits around the earth. These low-orbit satellites will provide hand-held mobile telephone service around the globe. Cellular communication is particularly important to countries such as China without a network of phone lines in place. Motorola currently derives more than 50% of its sales from outside the United States. Chapter 7 Cross-Border Capital Budgeting Answers to Conceptual Questions 7.1 Describe the two recipes for discounting foreign currency cash flows. Under what conditions are these recipes equivalent? Recipe #1: Discount foreign currency cash flows at a foreign currency discount rate. Recipe #2: Discount domestic currency cash flows at a domestic currency discount rate. These two recipes are equivalent if the international parity conditions hold and there are no market frictions such as repatriation restrictions. These recipes can give different values if PPP does not hold or if there are repatriation restrictions. 21
- 22. Kirt C. Butler, Multinational Finance, 2nd edition 7.2 Discuss each cell in Figure 7.4. What should (or shouldn’t) a firm do when faced with a foreign project that fits the description in each cell? Top left: Both NPVs are negative so reject the foreign project. Top right: NPVd>0 but NPVf<0; if the firm wants to speculate on foreign exchange rates, there must be better alternatives than the proposed project for taking a speculative position. Bottom left: NPVd<0 but NPVf>0; anticipated changes in exchange rates are likely to hurt the firm. Try financing the project in the local currency, hedging forward (with forwards or futures), or swapping into foreign currency debt. Bottom right: There are two possibilities here. If NPVd > NPVf > 0, then changes in exchange rates are expected to help the parent. The home office may choose to leave the foreign currency cash flows unhedged, although this captures the higher expected return (NPVd > NPVf) but also exposes the firm to currency risk. If 0 < NPV d < NPVf, then the parent can capture a higher expected return (NPV f > NPVd) and lower currency risk by hedging its expected future foreign currency cash flows and locking in the relatively high local-currency value of the project. 7.3 Why is it important to separately identify the value of any side effects that accompany foreign investment projects? Separately identifying the value of a project from the value of any side effects (such as blocked funds, subsidized financing, or tax holidays) allows the firm to negotiate with host governments and other parties on a more informed basis. Problem Solutions Cross-border capital budgeting when the international parity conditions hold. 7.1 a. Note that relative purchasing power parity holds. (1+i$)/(1+iRen) = (1.15)/( 1.11745) ≈ (1+p$)/(1+pRen) = (1.06)/(1.03) ≈ 1.0291. Discounting renminbi cash flows at the renminbi discount rate yields NPVRen = -Ren600m+Ren200m/1.11745+Ren500m/(1.11745)2+Ren300m/(1.11745)3 = Ren194.39 million or NPV$ = (Ren194.39m)($0.5526/Ren) = $107.42 million at the spot exchange rate. b. Relative purchasing power parity states that the spot rate should change according to E[St$/Ren]/E[S0$/Ren] = [(1+E[p$])/(1+E[pRen])]t = (1.06/1.03)t = (1.029)t. That is, renminbi should appreciate by approximately 2.9% per year relative to the dollar because of lower Chinese inflation. Expected future spot rates of exchange are then E[S1$/Ren] = ($0.5526)[(1.06)/(1.03)]1 = $0.5687/Ren E[S2$/Ren] = ($0.5526)[(1.06)/(1.03)]2 = $0.5853/Ren E[S3$/Ren] = ($0.5526)[(1.06)/(1.03)]3 = $0.6023/Ren Based on these spot exchange rates, expected dollar cash flows are: 22
- 23. Solutions to End-of-Chapter Questions and Problems E[CF0$] = (Ren600)($0.5526/Ren) = $331.56 E[CF1$] = (Ren200)($0.5687/Ren) = $113.74 E[CF2$] = (Ren500)($0.5853/Ren) = $292.63 E[CF3$] = (Ren300)($0.6024/Ren) = $180.69 The project should be accepted because NPV$ = -$331.56m+$113.74m/(1.15)+$292.63m/(1.15)2+$180.69m/(1.15)3 = $107.42 million > $0 7.2 a. Expected future cash flows in euros are as follows: Investment cash flows 0 1 2 Land -100000 121000 grows at 10% inflation rate tax on capital gain -8400 Plant -50000 25000 market value at t=2 tax on capital gain -10000 NWC -50000 60500 grows at 10% inflation rate tax on capital gain -4200 Operating cash flows 0 1 2 Rev (Price=100, Q=5,000) 550000 605000 grows at 10% inflation rate Variable cost (20%) -110000 -121000 FC (20,000 at t=0) -22000 -24200 grows at 10% inflation rate Depreciation -25000 -25000 Earnings before tax 393000 434800 Tax (at 40%) -157200 -173920 Net income 235800 260880 Net cash flow (Euros) 260800 285880 CF = NI + Depreciation Sum of investment/disinvestment and operating cash flows Total net CFs -200000 260800 469780 Euro NPV at i = 20% 343569.4 b. If the international parity conditions hold, then 20% interest rates in both the foreign and domestic currencies imply that forward (and expected future spot) prices will equal the current spot rate of $10/Euro. So, Sum of investment/disinvestment and operating cash flows Expected dollar CFs -2000000 2608000 4697800 NPV at i$ = 20% $3,435,694 7.3 a. iW = (1+pW)(1+rW) - 1 = (1.50)(1.10)-1 = 65% iL = (1+pL)(1+rL) - 1 = (1.00)(1.10)-1 = 10% b. E[S1W/L] = (S0W/L) [(1+pW) / (1+pL)]t = (W100/L) [(1.50) / (1.00)] = W150/L E[S2W/L] = (S0W/L) [(1+pW) / (1+pL)]t = (W100/L) [(1.50) / (1.00)]2 = W225/L 23
- 24. Kirt C. Butler, Multinational Finance, 2nd edition c. All cash flows in work-units: Investment cash flows 0 1 2 Land -200,000 450,000 grows at 50% inflation rate tax on capital gain -125,000 Plant -200,000 0 market value at t=2 tax on capital gain 0 Operating cash flows 0 1 2 Rev (P0W=W200, Q=2,000) 600,000 900,000 grows at 50% inflation rate Variable cost (20%) -120,000 -180,000 Fixed cost (W30,000 at t=0) -45,000 -67,500 grows at 50% inflation rate Depreciation -100,000 -100,000 Earnings before tax 335,000 552,500 Tax (at 50%) -167,500 -276,250 Net income 167,500 276,250 Net operating CFW 267,500 376,250 CF = NI + Depreciation Sum of investment/disinvestment and operating cash flows Total NCFW -400,000 267,500 701,250 NPVW at 65% W19,697 NPVL = NPVW / S0W/L = L197 d. E[CFt ] = E[CFt ] / E[St ] ⇒ E[CF0L] = (-W400,000) / (W100/L) = -L4,000 L W W/L E[CF1L] = (W267,500) / (W150/L) = L1,783 E[CF2L] = (W701,250) / (W225/L) = L3,117 ⇒ NPVL = -L4,000 + (L1,783) / (1.10) + (L3,117) / (1.1)2 = L197 This is the same as in part c because the international parity conditions hold. 7.4 a. t=1 Bt3.4m Bt3.4m Bt3.4m Bt6,913,840 −Bt4m t=2 t=3 t=4 t=5 iBt = 20% Initial outlay = (Bt4m) After-tax cash flows over t=2,…,5 =(Bt100m-Bt90m-Bt5m)(1-0.40)+(Bt1m*.40)=Bt3,400,000 Terminal CF= (Bt4m*(1.10)4) - {[(Bt4m*(1.10)4) - 0]*.4} = Bt3,513,840 NPV0Bt = Bt5,413,548 b. (1+iBt)=(1+rBt)(1+pBt) ⇒ rBt = (1.20/1.10)-1=0.0909091 ⇒ r¥ = 9.09091% i¥ = (1.0909091)(1.05) - 1 = 0.1454545, or 14.54545% c. E(S1Bt/¥) = (Bt0.25/¥)(1.20/1.1454545) = Bt.2619048/¥ E(S2Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)2 = Bt.2743764/¥ E(S3Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)3 = Bt.2874420/¥ E(S4Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)4 = Bt.3011297/¥ E(S5Bt/¥) = (Bt0.25/¥)(1.20/1.1454545)5 = Bt.3154692/¥ 24
- 25. Solutions to End-of-Chapter Questions and Problems d. Recipe #1: NPV¥ = Bt5,413,548/(Bt0.25/¥) = ¥21,654,192 Recipe #2: NPV0¥ = ¥21,654,192 at i¥ = 14.54545% t=1 ¥12,391,736 ¥11,828,475 ¥11,290,817 ¥21,916,055 − ¥15,272,727 t=2 t=3 t=4 t=5 The answers are the same because the international parity conditions hold. Cross-border capital budgeting when international parity conditions do not hold. 7.5 a. Discount in renminbi. NPVRen = [Σt E[CFtRen] / (1+iRen)t ] = [-Ren600+Ren200/(1.1175)+Ren500/(1.1175)2+Ren300/(1.1175)3 ] = Ren194.39 ⇒ NPV = (S0$/Ren) (NPVRen) = ($0.5526/Ren)(Ren194.39) = $107.42 $ Discount in dollars. NPV$ = Σt {E[St$/Ren]E[CFtRen] / (1+i$)t } = [(-Ren600)($0.5526/Ren) + (Ren200)($0.5801/Ren)/(1.15) + (Ren500)($0.6089/Ren)/(1.15)2 + (Ren300)($0.6392/Ren)/(1.15)3 ] = $125.61 > $107.42 While the project has a positive NPV regardless of the perspective, the project has more value from the parent’s perspective than from the project perspective. This is because the expected future value of the dollar (renminbi) is less (more) than under the equilibrium conditions. The parent company may choose to leave its cash flows from the project unhedged in the hopes of benefiting from the expected future spot exchange rates. This does expose the parent to currency risk. b. Discount in renminbi. NPVRen = [Σt E[CFtRen] / (1+iRen)t ] = [-Ren600 + Ren200/(1.1175) + Ren500/(1.1175)2+Ren300/(1.1175)3] = Ren194.39 ⇒ NPV$ = (S0$/Ren) (NPVRen) = ($0.5526/Ren)(Ren194.39) = $107.42 Discount in $: NPV$ = Σt {E[St$/Ren]E[CFtRen] / (1+i$)t } = [(-Ren600)($0.5526/Ren) + (Ren200)($0.5575/Ren)/(1.15) + (Ren500)($0.5625/Ren)/(1.15)2 + (Ren300)($0.5676/Ren)/(1.15)3 ] = $90.04 < $107.42 Although the project has a positive NPV from each perspective, the project has more value in the local currency than it does in dollars. The parent should hedge the renminbi cash flows either directly in the forward market, by borrowing a part of the project in renminbi, or by swapping dollar debt for renminbi debt to hedge its expected future renminbi cash flows from the project. 25
- 26. Kirt C. Butler, Multinational Finance, 2nd edition 26
- 27. Solutions to End-of-Chapter Questions and Problems Cross-border capital budgeting when there are investment or financial side effects. 7.6 Expected future cash flows are not received until one year later, so +Ren200 +Ren500 +Ren300 1 yr 2 yrs 3 yrs 4 yrs -Ren600 NPVren = -Ren600m+Ren200m/(1.11745)2+Ren500m/(1.11745)3+Ren300m/(1.11745)4 = Ren110.90 million, or NPV = (Ren110.90)($0.5526/ren) = $61.28 million at the spot exchange rate. $ 7.7 The after-tax cost of debt is (5.06%)(1-0.4) = 3.036%. The after-tax annual savings in interest expense is (Ren600m)(0.0506-0.0403)(1-0.4) = Ren3.708 million. The present value of a three-year annuity of Ren3.708 million discounted at 3.036% is Ren10.48 million. 7.8 NPVRen = Ren194.39 million without the side effect. The airport project reduces this value by Ren100 million, but the NPV is still positive. Accept the project even if the Chinese authorities are not willing to renegotiate. 7.9 This is a cumulative risk in that, once expropriated, you will not receive any later cash flows from your investment. The probability of receiving the cash flow in year t is (0.9)t times the expected cash flow in problem 7.1. So, NPVren = -Ren600m + Ren200m(0.9)1/(1.11745) + Ren500m(0.9)2/(1.11745)2 + Ren300m(0.9)3/(1.11745)3 = Ren42.15 million or NPV$ = (Ren42.15)($0.5526/Ren) = $23.29 million at the spot exchange rate. 7.10 Step 1: Calculate the value of blocked funds assuming they are not blocked. If blocked funds had been invested at the risky croc rate of 40% per year, they would have grown in value to Cr8,000(1.40) 3 + Cr13,819.5(1.40)2 + Cr19,573.5(1.40) ≈ Cr76,441. Discounted at the 40% rate, this would have been worth Cr19,898 in present value. This is equivalent to discounting blocked funds back to the beginning of the project at the 40% risky croc discount rate, so this is a zero-NPV investment at the 40% croc interest rate. Step 2: Calculate the opportunity cost of blocked funds. With blocked funds earning no interest, the accumulated balance of Cr41,393 has a present value of (Cr41,393) / (1.40)4 = Cr10,775 at the 40% required return. The opportunity cost of blocked funds is then Cr19,898-Cr10,775 = Cr9,123. Step 3: Calculate project value including the opportunity cost of blocked funds. Vproject with side effect = Vproject without side effect + Vside effect = -Cr137 - Cr9,123 = -Cr9,260. At the 40% (foregone) risky discount rate, the opportunity cost of blocked funds is higher than the Cr9,077 value in the text example. At the 40% risky rate, blocked funds make the Neverland project look even worse than when Hook’s treasure chest is riskless. 27
- 28. Kirt C. Butler, Multinational Finance, 2nd edition Chapter 8 Taxes and Multinational Corporate Strategy Answers to Conceptual Questions 8.1 What is tax neutrality? Why is it important to the multinational corporation? Is tax neutrality an achievable objective? A neutral tax is one that does not interfere with the natural flow of capital toward its most productive use. Domestic tax neutrality is intended to ensure that incomes arising from operations (whether foreign or domestic) are taxed similarly by the domestic government. Foreign tax neutrality is intended to ensure that taxes imposed on the foreign operations of domestic companies are similar to those facing local competitors in the host countries. 8.2 What is the difference between an implicit and an explicit tax? In what way do before- tax required returns react to changes in explicit taxes? Explicit taxes are taxes that are explicitly assessed on income of various forms. Examples include corporate and personal income taxes, dividend taxes, interest taxes, sales and property taxes, and so forth. Implicit taxes come in the form of higher pre-tax required returns in higher tax jurisdictions. 8.3 How are foreign branches and foreign subsidiaries taxed in the United States? Income from foreign branches is taxed as it is earned. Income from a controlled foreign corporation (a subsidiary that is incorporated in a foreign country and more than 50% owned by a U.S. parent) is taxed only when funds are repatriated to the U.S. parent. Income from foreign corporations that are between 10% and 50% owned by a U.S. parent is called Subpart F income and is taxed as it is earned on a pro rata basis according to sales or gross profit. 8.4 How has the U.S. Internal Revenue Code limited the ability of the multinational corporation to reduce taxes through multinational tax planning and management? There are two principal limitations on multinational tax planning: the overall foreign tax credit (FTC) limitation and the use of income baskets for active and passive income and other kinds of income. The overall FTC limitation is equal to total foreign-source income times the U.S. tax rate. Excess foreign tax credits may be carried two years back or five years forward. Income baskets limit the usefulness of excess FTCs, because FTCs from one income basket may not be used to reduce taxes in another income basket. 8.5 Are taxes the most important consideration in global location decisions? If not, how should these decisions be made? Locations that are tax-advantaged usually come with disadvantages in other areas. For example, low explicit tax rates generally result in low pre-tax rates of return because investors’ demand for high after-tax rates imposes an implicit tax on income from low- tax jurisdictions. Governments also use low tax rates to overcome locational disadvantages such as a poor physical, legal or telecommunication infrastructure, an uneducated workforce, or high political risk. 28
- 29. Solutions to End-of-Chapter Questions and Problems Problem Solutions 8.1 India’s currency is the rupee (Rp). Thailand’s currency is the bhat (Bt). From equation (8.1), interest rates in India are iRp = (iBt)(1-tBt)/(1-tRp) = (10%)(1-0.30)/(1-0.65) = 20%. 8.2 Parts a, b, and c follow: Part a. Part b. Part c. HK India HK India HK India a Dividend payout ratio 100% 100% 100% 100% 100% 100% b Foreign dividend withholding tax rate 0% 20% 0% 20% 0% 20% c Foreign tax rate 18% 65% 18% 65% 18% 65% d Foreign income before tax 10000 10000 20000 0 0 20000 e Foreign income tax (d*c) 1800 6500 3600 0 0 13000 f After-tax foreign earnings (d-e) 8200 3500 16400 0 0 7000 g Declared as dividends (f*a) 8200 3500 16400 0 0 7000 h Foreign dividend withholding tax (g*b) 0 700 0 0 0 1400 i Total foreign tax (e+h) 1800 7200 3600 0 0 14400 j Dividend to U.S. parent (d-i) 8200 2800 16400 0 0 5600 k Gross foreign income before tax (d) 10000 10000 20000 0 0 20000 l Tentative U.S. income tax (k*35%) 3500 3500 7000 0 0 7000 mForeign tax credit (i) 1800 7200 3600 0 0 14400 n Net U.S. taxes payable [max(l-m,0)] 1700 0 3400 0 0 0 o Total taxes paid (i+n) 3500 7200 7000 0 0 14400 p Net amount to U.S. parent (k-o) 6500 2800 13000 0 0 5600 q Total taxes as separate subs (sum(o)) $10,700 $7,000 $14,400 Parent’s consolidated tax statement r Overall FTC limitation (sum(k)*35%) $7,000 $7,000 $7,000 s Total FTCs on a consolidated basis (sum(i)) $9,000 $3,600 $14,400 t Additional U.S. taxes due [max(0, r-s)] $0 $3,400 $0 u Excess tax credits [max(0,s-r)] $2,000 $0 $7,400 (carried back 2 years or forward 5 years) 8.3 a. Low transfer price ($1/btl) High transfer price ($10/btl) P.R. U.S. Consolidated P.R. U.S. Consolidated Revenue 100,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 COGS 100,000 100,000 100,000 100,000 1,000,000 100,000 Taxable income 0 900,000 900,000 900,000 0 900,000 Taxes 0 315,000 315,000 45,000 0 45,000 Net income 0 585,000 585,000 855,000 0 855,000 Effective tax on consolidated revenues 31.5% 4.5% Effective tax on taxable income 35.0% 5.0% 29
- 30. Kirt C. Butler, Multinational Finance, 2nd edition 30
- 31. Solutions to End-of-Chapter Questions and Problems b. If produced in the U.S., Quack’s U.S. tax liability would be: (Revenue-Expenses)(tax rate) = ($1,000,000-$50,000)(0.35) = $332,500, or 33.25% of consolidated revenues. After-tax earnings are then $617,500. Based only on tax considerations, Quack will pay less in taxes and have more after-tax cash flow if it produces Metafour in Puerto Rico. This is true even if it uses the relatively unaggressive transfer price of $1/btl on sales to the U.S. parent corporation. Chapter 9 Country Risk Answers to Conceptual Questions 9.1 Define country risk? Define political risk? Define financial risk? Give an example of each different type of country risk. Country risk refers to the political and financial risks of conducting business in a particular foreign country. Political risk is the risk that a host government will unexpectedly change the rules of the game under which businesses operate, such as through an election outcome. Financial risk refers to unexpected events in a country’s financial, economic, or business life that impact financial prices, such as an oil price shock in an oil-producing country. 9.2 What factors might contribute to political and to financial risk in a country according to the ICRG country risk rating system? Political Risk Services’ International Country Risk Guide (ICRG) rates countries on political, economic, and financial factors. Political risk factors include a country’s leadership, corruption, and political tensions. Economic risk factors include inflation, current account balance, and foreign trade collection experience. Financial risk factors include currency controls, expropriations, contract renegotiations, payment delays, and loan restructurings. 9.3 What is the difference between a macro and a micro country risk? Give an example of each different type of country risk. Micro country risks are specific to an industry, company, or project within a host country, such as a ruling that a particular company is dumping its products (selling below cost) in another country. Macro country risks affect all foreign firms within a host country, such as an unexpected change in a host country’s tax rates. 9.4 How is expropriation included in a discounted cash flow analysis of a proposed foreign investment? Does expropriation impact expected future cash flows? From a discounted cash flow perspective, is it likely to impact the discount rate on foreign investment? 31
- 32. Kirt C. Butler, Multinational Finance, 2nd edition Expropriation occurs when a government seizes foreign assets. This risk clearly affects expected cash flows. It can affect the discount rate when investors cannot diversify their investment portfolios against this risk; that is, when it is a systematic risk. 9.5 What is protectionism and how can it impact the multinational corporation? Protectionism refers to protection of local industries through tariffs, quotas, and regulations in ways that discriminate against foreign businesses. 9.6 What are blocked funds? How might they arise? Blocked funds are cash flows generated by a foreign project that cannot be immediately repatriated to the parent firm. They most commonly arise from capital flow restrictions imposed by the host government. 9.7 What are intellectual property rights? How are they at risk when the multinational corporation has foreign operations? Intellectual property rights include patents, copyrights, and proprietary technologies and processes. Host governments sometimes protect local businesses at the expense of foreign firms. The multinational corporation must work to minimize the exposure of its intellectual property rights to theft or expropriation by foreign firms or governments. 9.8 What is an investment agreement? What conditions might it include? An investment agreement specifies the rights and responsibilities of a host government and a corporation in the structure and operation of an investment project in the host country. The agreement should specify the investment and financial environments including taxes, concessions, obligations, and restrictions on the multinational corporation’s operations. It also should specify a jurisdiction for the arbitration of disputes. 9.9 What constitutes an insurable risk? List several insurable political risks. Insurable risks have four elements: (a) The loss is identifiable in time, place, cause, and amount. (b) A large number of individuals or businesses are exposed to the risk, ideally in an independently and identically distributed manner. (c) The expected loss over the life of the contract is estimable, so that reasonable premiums can be set by the insurer. (d) The loss is outside the influence of the insured. 9.10 What operational strategies does the multinational corporation have to protect itself against political risk? In addition to negotiating the environment (perhaps through an investment agreement), the MNC can (a) limit the scope of technology transfer to foreign affiliates, (b) limit dependence on a single partner, (c) enlist local partners to represent the firm in the local environment, (d) use more stringent investment criteria when appropriate, and (e) plan for disaster recovery. 32
- 33. Solutions to End-of-Chapter Questions and Problems 9.11 Does country risk affect investors’ required return in emerging markets? Erb, Harvey, and Viskanta [“Political Risk, Financial Risk and Economic Risk,” Financial Analysts Journal 52, November/December, 1996] found that the low correlations of emerging markets tend to overcome the higher volatilities of these markets, resulting in lower systematic risks than on comparable assets in developed markets. 9.12 Complete the following sentence: “Equity returns from a country with high country risk are likely to be _____ (more, less) volatile and have a _____ (higher, lower) beta than those from a country with low country risk.” Equity returns from a country with high country risk are likely to be more volatile and have a lower beta than those from a country with low country risk. Problem Solutions 9.1 There is not always a clear distinction between political and financial risks. Indeed, financial risks often result from political decisions. In Russia’s case, the financial risks of investment in Russian have been acerbated by the inability of the Russian government to establish and enforce laws and regulations for the orderly conduct of business. Organized crime and corruption have contributed to poor political, economic, financial country risk ratings in Russia. Governments make a convenient scapegoats, and this hedge fund manager clearly holds the Russian government responsible for his losses. 9.2 Although the most obvious form of expropriation occurs when a host government confiscates a company’s assets, in fact each type of political risk can be thought of as a form of expropriation. Host governments can appropriate foreign assets for themselves or for local companies through actions that differentially impair nonlocal firms, including protectionism, blocked funds, or theft or misappropriation of intellectual property rights. 9.3 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’ = ρiW’ (σi’/σW) = (0.3)(0.3/0.1) = 0.9 > βi = ρiW (σi /σW) = (0.4)(0.2/0.1) = 0.8. 9.4 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). 33
- 34. Kirt C. Butler, Multinational Finance, 2nd edition Chapter 10 Real Options and Cross-Border Investment Answers to Conceptual Questions 10.1 What is a real option? A real option is an option on a real asset. 10.2 In what ways can managers’ actions seem inconsistent with the “accept all positive-NPV projects” rule? Are these actions truly inconsistent with the NPV decision rule? The text discusses three apparent violations of the NPV rule: 1) use of inflated hurdle rates, 2) failure to abandon investments that are losing money, and 3) entry into new or emerging markets and technologies. Each of these apparent violations arises when the NPV decision rule is applied naively - without considering all of the opportunity costs of investing and without considering managerial flexibility in the face of high uncertainty and changing market conditions. The inconsistencies arise from a failure to take into account all of the opportunity costs of investing. Once all opportunity costs are included, managers’ actions are less likely to be inconsistent with the NPV rule. 10.3 Are managers who do not appear to follow the NPV decision rule irrational? Managers must consider how they might respond to future events. Managers are not acting irrationally if, through attempting to value their flexibility in responding to an uncertain world, their actions appear to be inconsistent with the NPV decision rule. They are irrational (or at least near-sighted) if they apply the NPV decision rule in an inflexible way that does not take into account all of the opportunity costs of investing. 10.4 Why is the timing option important in investment decisions? Investments must compete not only with other projects but with versions of themselves initiated at each future date. 10.5 What is exogenous uncertainty? What is endogenous uncertainty? What difference does the form of uncertainty make to the timing of investment? Exogenous uncertainty is outside the control of the firm. Endogenous uncertainty exists when the act of investing reveals information about price or cost. Exogenous uncertainty creates an incentive to delay investment whereas endogenous uncertainty creates an incentive to speed up investment. 10.6 In what ways are the investment and abandonment options similar? The abandonment option is the flip side of the investment option. Each entails an upfront investment that changes the stream of future cash flows. 10.7 What is a switching option? What is hysteresis? In what way is hysteresis a form of switching option? A switching option is a sequence of alternating puts and calls. For example, hysteresis occurs when firms fail to enter apparently profitable markets and, once entered, persist in operating at a loss. Hysteresis is a combination of an option to invest and an option to abandon and as such is a form of switching option. 34
- 35. Solutions to End-of-Chapter Questions and Problems 10.8 What are assets-in-place? What are growth options? Assets-in-place are those assets in which the firm has already invested. Growth options are the firm’s opportunities to lever its existing assets-in-place (including human assets and core competencies) into new products and markets. 10.9 Why does the NPV decision rule have difficulty in valuing managerial flexibility? The biggest difficulty lies in identifying the appropriate discount rate on investment. The discount rate is difficult to determine because: a) options are always more volatile than the asset or assets on which they are based; b) the volatility of an option changes with change in the value(s) of the underlying asset(s); and c) returns on options are not normally distributed. 10.10 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 10.1 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 NPV0D = ? Invest at Pbeer = D75 Invest in one year NPV0D Pbeer=D75 = ? Invest at Pbeer = D25 NPV0D Pbeer= D25 = ? b. Equation (9.2) from the text must be modified to include fixed costs: ( P - V) Q - F INVEST TODAY: NPV0 = − I0 i NPV(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 (9.3) from the text must be modified to include fixed costs: ( P - V) Q - F WAIT ONE YEAR: NPV0 = (1 + i) − I0 i D NPVPbeer= 75 = [(((D75/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10)/(1.10)]-D200,000,000 = D300,000,000 ⇒ invest NPVPbeer=D25 = [(((D25/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10) / (1.10)]-D200,000,000 35
- 36. Kirt C. Butler, Multinational Finance, 2nd edition = -D154,545,455 < $0 ⇒ don’t invest NPV(wait one year) = [Prob(P1=D75)](NPVP1=D75)+[Prob(P1=D25)](NPVP1=D25) = (½) (D300,000,000) + (½)(D0) = +D150,000,000 > NPV(invest today) > D0 d. Option Value = Intrinsic Value + Time Value NPV(wait one year) = NPV(invest today) + Opportunity cost of investing today D 150,000,000 = D100,000,000 + D50,000,000 e. Wait one period before deciding to invest. 10.2 a. Abandon today NPV0D = ? D Abandon at Pbeer = 35 Abandon in one year NPV0D Pbeer=D35 = ? Abandon at Pbeer = D15 NPV0D Pbeer= D15 = ? b. The problem states that the current price of beer is D15 in perpetuity. The statement “in perpetuity” clearly cannot hold because prices in one year are stated to be either D15 or D35 with equal probability. Let’s assume that the price is currently D 15 per bottle and will either remain at D15 or will rise to D35 by time 1. For simplicity, let’s also assume end-of-year beer prices and cash flows so that we don’t have to worry about the path of beer prices during the year. In this setting, the current price of D15/bottle is irrelevant to the abandonment decision. The expected future price of D25 does matter. (If beer prices throughout the first year either remain at D15 or rise at a constant rate to D35, then the expected price during the first year is not D25 but rather ½[D15+½(D15+D35)] = D20.) Note that if the project is abandoned today at a cost of D10,000,000, future profits (and cash flow) from the project will be foregone. Hence, there is a minus sign in front of operating cash flow in the NPV equations that follow. At the expected end-of-year price of ½ (D15/btl+D35/btl) = D25/btl, the NPV of the “abandon today” alternative is: NPV(abandon today) = -[((D25/btl-D20/btl)(1,000,000 btls)-D10,000,000)/0.10]-D10,000,000 = D40,000,000 > D0 ⇒ abandon today? c. If Grolsch management waits one year before making its abandonment decision, beer prices will be either D15 or D35 with certainty. NPVP1=D35 = -[(((D35/btl-D20/btl)(1,000,000 btls) -D10,000,000) /0.10)/(1.10)]-D10,000,000 = -D55,454,545 ⇒ don’t abandon if price rises to D35 36
- 37. Solutions to End-of-Chapter Questions and Problems NPVP1=D15 = -[(((D15/btl-D20/btl)(1,000,000 btls) -D10,000,000) /0.10)/(1.10)]-D10,000,000 = D126,363,636 ⇒ abandon if price falls to D15 NPV(wait one year)=[Prob(P1=D35)](NPVP1=D35)+[Prob(P1=D15)](NPVP1=D15) = (½) (D126,363,636) + (½)($0) = +D63,181,818 > NPV(abandon today) > D0 d. Option Value = Intrinsic Value + Time Value NPV(wait one year) =NPV(abandon today)+Opportunity cost of abandoning today +D63,181,818 = +D40,000,000 + D 23,181,818 e. Wait one year before making the abandonment decision. 10.3 Let’s assume that there are in total five breweries, so there are four additional brewery investments if we choose to construct an exploratory brewery. We already know from Problem 9.1 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. a. Decision tree: Invest in all five breweries today NPV0D = D ? If NPV0D > D0, continue to invest Invest in first brewery If NPV0D < D0, don’t invest further b. At the expected end-of-year price of ½(D25/btl+D75/btl) = D50/btl, the NPV of a single brewery is: NPV(exploratory brewery) = [((D50/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10] - D200,000,000 = D100,000,000 NPV(invest in all five breweries today) = (5) NPV(exploratory brewery) = D500,000,000 c. If Grolsch management waits one year before making its investment decision, beer prices will be either D25 or D75 with certainty in this problem. Of course, it won’t know this until it invests in the first brewery. NPVPbeer=D75 = [((D75/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10]-D200,000,000 = D350,000,000 ⇒ invest in additional capacity If Pbeer=D75, investment in four additional breweries at time t=1 yields a net present 37
- 38. Kirt C. Butler, Multinational Finance, 2nd edition value at time zero of (4)( D350,000,000/1.10) = D1,272,727,273. NPVPbeer=D25 = [((D25/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10]-D200,000,000 = -D150,000,000 < $0 ⇒ don’t invest in additional capacity If Pbeer=D25, do not invest in additional capacity. (In fact, you should look into abandoning this losing venture. But that is a different problem.) NPV(invest in exploratory brewery and continue to invest if it is positive-NPV) = [Prob(P1=D75)] (NPVP1=D75) + [Prob(P1=D25)] (NPVP1=D25) = (½)[(D350,000,000) +(4)(D350,000,000/1.10)] + (½)(-D150,000,000) = +D736,363,636 > NPV(invest in all five today) = +D500,000,000 > D0 d. Option Value = Intrinsic Value + Time Value NPV(wait one year) = NPV(invest today) + Opportunity cost of investing in four additional breweries today D 736,363,636 = D500,000,000 + D 236,363,636 The NPV of investing in all five breweries today is -D236,363,636. Grolsch would not be taking advantage of 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. 10.4 a. NPV(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: NPVC1=R12,000 = [((R18,000/car-R12,000/car)(10,000cars)/0.20]/1.20]-R100 million = R150 million ⇒ invest, or NPVC1=R18,000 = [((R18,000/car-R18,000/car)(10,000cars)/0.20]/1.20]-R100 million = -R100 million ⇒ do not invest (so that NPV = R0). NPV(wait one year) = [Prob(C1=R12,000)](NPVC1=R12,000) + [Prob(C1=R18,000)](NPVC1=R18,000) = (½)(R150,000,000) + (½)(R0) = +75,000,000 > NPV(invest today) =R50,000 > R0 The time value of this real option reflects the opportunity cost of investing today: Time value = option value less intrinsic value = R75 million - R50 million = R25 million. b. NPV(invest in all 10 plants today) = 10*NPV(invest in one plant today) = R500 million NPV(invest in exploratory plant and continue to invest in 9 other plants if NPV>0) = [Prob(C1=R12,000)](NPVC1=R12,000) 38
- 39. Solutions to End-of-Chapter Questions and Problems + [Prob(C1=R18,000)](NPVC1=R18,000) = (½)[(R150 million)+(9)(R150 million/1.20)] + (½)(-R100 million) = +R587.5 million > NPV(invest in all ten today) = R500 million > R0 The opportunity cost of investing in all ten plants today is equal to the time value of this real investment option: time value = option value less intrinsic value = R587.5 million - R500 million = R87.5 million. 10.5 This provocative question goes 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 the industry. If a firm has a real investment option that only it can exercise, such as a drug that effectively combats prostate cancer and for which only it has patent approval, then the analysis in this chapter is appropriate. There will be an optimal time to invest and perhaps to exit, and it may 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 may stay invested in unprofitable situations in the hope that other less-profitable firms will exit first. Chapter 11 Corporate Governance and the International Market for Corporate Control Answers to Conceptual Questions 11.1 What does the term “corporate governance” mean? 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 which 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 large influence on top executive turnover and the market for corporate control. 11.2 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 and collaborative alliances. 39
- 40. Kirt C. Butler, Multinational Finance, 2nd edition 11.3 What is synergy? When the whole is greater than the sum of the parts in a corporate acquisition. 11.4 What is the difference between a private and a public capital market? Why is this difference important in corporate governance? Private capital markets place debt and equity through direct placements rather than through public issues. Public capital markets include public issues of debt and equity. Bank-based systems of corporate governance are usually dominated by private debt markets. Market-based systems of corporate governance are dominated by relatively anonymous public debt and equity markets. Private capital markets often lead to concentrations of debt and equity ownership and facilitate the influence of commercial banks. Public capital markets result in dispersed ownership and relatively anonymous owners. This frees management from scrutiny by a single stakeholder. 11.5 Describe several differences in the role of commercial banks in corporate governance in Germany, Japan, and the United States. Commercial governance in the United States is dominated by the public debt and equity capital markets. Commercial banks in the U.S. have been constrained by the U.S. Congress in the influence that they can exert over U.S. corporations. For example, the Glass-Steagall Act of 1933 prohibited banks from owning stock except in trust, actively voting shares held in trust for their clients, or acting as investment bankers or equity brokers. Banks in Germany are not constrained in any of these ways. While banks in Japan cannot own more than 5% of the equity of any single company, the share cross- holdings in Japan’s keiretsu place Japanese banks in a more prominent role than their counterparts in the United States. For these reasons, German banks are more influential in corporate governance than Japanese banks and Japanese banks are more influential than U.S. banks in corporate governance. 11.6 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 much more closely tied to this major stakeholder than their counterparts in the U.K. and the U.S. 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 U.K. and U.S. allow hostile suitors to appeal directly to the public markets through a tender offer. Tender offers in the U.K. and U.S. may or may not be in cooperation with current management. 11.7 How is turnover in the ranks of top executives similar in 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 40
- 41. Solutions to End-of-Chapter Questions and Problems 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 the United States. 11.8 Who are the likely winners and losers in domestic mergers and acquisitions that involve two firms incorporated in the United States? Target shareholders gain while bidding firm shareholders may or may not win. Bidding firm shareholders are more likely to win: a) when cash is offered rather than stock, b) when the firm does not have a lot of free cash flow, and c) when management has a large ownership stake in the firm. 11.9 In what ways are the winners and losers in cross-border mergers and acquisitions the same as in domestic mergers and acquisitions? In what ways do they differ? Shareholders of the bidding firm are more likely to win in a cross-border merger or acquisition. Target firm shareholders win in either case. As with domestic acquisitions, bidders are more likely to win if the bidding firm does not have a great deal of free cash flow or profitability. Empirical evidence also suggests that bidding firms are more likely to win in a cross-border acquisition if: a) the firm has intangible assets (e.g., patents) that can be exploited in new markets, b) the firm has prior international experience, c) the firm is acquiring a firm in a related business, and d) the firm is entering a market for the first time. 11.10 Why might the shareholders of bidding firms lose when the bidding firm has excess free cash flow or profitability? Jensen’s “free cash flow hypothesis” suggests that managers are more likely to waste shareholders capital on poor investments when there is a lot of free cash flow (or profitability) around. When things are tight, capital constraints are more likely to be imposed by the market and managers cannot as easily rationalize wasteful expenditures. 11.11 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 11.1 a. E b. D c. F d. A e. B f. G g. C 11.2 The pre-acquisition value of the two firms is $3 billion + $1 billion = $4 billion. Synergy is 10% of this value, or (0.1)($4 billion) = $400,000. After subtracting the (0.2)($1 billion) = $200,000 acquisition premium from the $400,000 synergy, Agile shareholders 41
- 42. Kirt C. Butler, Multinational Finance, 2nd edition are likely to see a $200,000 appreciation in the value of their shares. Stated as a percentage return in the combined firm, this is an increase of ($200,000)/($4,400,000) = 4.5% to Agile shareholders. 11.3 The BP-Amoco deal was lauded in the financial press for combining BP’s strengths in oil exploration and development with Amoco’s refining and distribution capabilities. Amoco stock jumped about 26 percent to a record high of 521/8 immediately after announcement of the deal. BP stock price rose modestly, along with other oil issues. This share price behavior is typical of a domestic acquisition in that the target firm was a clear winner while the acquiring firm neither gained nor lost. 11.4 a. 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. b. First-time entrants often have interesting opportunities but also face new risks. Returns are not significantly different from zero for firms entering the international arena through a foreign acquisition for the first time (Doukas and Travlos [1988]). c. Acquisitions into unrelated businesses in other countries tend to result in losses for the shareholders of acquiring firms (Markides and Ittner [1994]). If you want to increase your international operations, stick to what you know best - chemicals. d. Although prior international experience is valuable, you have to start somewhere. Acquisitions of companies in related businesses tend to result in gains to acquiring firms (Markides and Ittner [1994]). Experience in southern Europe will also prove useful in Portuguese-speaking Brazil and the rest of Spanish-speaking Latin America. Not all of your VP’s ideas are bad. 11.5 A real increase in the value of the domestic currency increases the purchasing power of domestic residents. Froot and Stein [1991] suggest that an informational asymmetry between inside managers and outside investors can make outside capital more expensive than inside capital, which can preferentially benefit bidders that see their currency rise in real terms. If an increase in the real value of the domestic currency forces foreign companies to access capital markets to fund acquisitions whereas domestic companies can fund acquisitions with cash, then domestic companies enjoy an advantage in the presence of this informational asymmetry. 11.6 Several deals were rumored in early 1999. Suitors for Nissan’s equity or Volvo’s assets included Ford Motor Company of the U.S., Daimler-Chrysler of Germany, and Renault of France. A search of your library database will reveal whether any of these deals actually came to fruition. 11.7 a. Recent restructurings include the 1995 merger of Mitsubishi Bank with the Bank of Tokyo, the 1998 merger of Sumitomo Trust with Long-Term Credit Bank, and the 1998 merger of Mitsui Trust with Chuo Trust. Japan recently passed a “bridge bank” law to assist troubled banks, so other mergers and acquisitions (either privately arranged or forced by the government) are sure to follow. 42
- 43. Solutions to End-of-Chapter Questions and Problems b. It ain’t business as usual for Japanese companies. Several key keiretsu members have recently refused to bail out their banking affiliates. Through 1998, Toyota had declined to bail out Sakura Bank in the Mitsui keiretsu despite its long relationship with the bank. Troubled companies are increasingly turning overseas for additional investment rather than to their keiretsu partners. In 1998, Zexel Corp. (a supplier to Isuzu Motor of diesel engines and air conditioners) obtained new equity investment and technology from the German auto parts supplier Bosch. Cross-border investments into Japan are increasingly easy to document. c. This revered convention is gradually disappearing as Japanese companies struggle for flexibility in their cost structures. PART IV The Multinational Corporation’s Financial Decisions Chapter 12 Multinational Treasury Management Answers to Conceptual Questions 12.1 What is multinational treasury management? Multinational treasury management involves five functions: 1) set overall financial goals, 2) manage the risks of international transactions, 3) arrange financing for international trade, 4) consolidate and manage the financial flows of the firm, and 5) identify, measure, and manage the firm’s risk exposures. 12.2 What function does a firm’s strategic business plan perform? The strategic business plan performs the following functions: 1) identify the firm’s core competencies and potential growth opportunities, 2) evaluate the business environment within which the firm operates, 3) formulate a comprehensive strategic plan for turning the firm’s core competencies into sustainable competitive advantages, 4) develop robust processes for implementing the strategic business plan. 12.3 Why is international trade more difficult than domestic trade? International trade is difficult largely because of information costs. Exporters must ensure timely payment from far-away customers. Importers must ensure timely delivery of quality goods or services. Also, dispute resolution is difficult across multiple jurisdictions. 12.4 Why use a freight forwarder? A freight shipper coordinates the logistics of transportation and documentation, which can be formidable on international shipments. 12.5 Describe four methods of payment on international sales. The four methods are open account, cash in advance, drafts, and letters of credit. Under an open account, the seller bills the buyer upon delivery of the goods. In cash in advance, the buyer pays prior to receiving shipment. A draft is used to pay upon delivery and is like a check or money order. A bank letter of credit guarantees payment upon presentation of the specified trade documents. 43
- 44. Kirt C. Butler, Multinational Finance, 2nd edition 12.6 What is a banker’s acceptance, and how is it used in international trade? 44
- 45. Solutions to End-of-Chapter Questions and Problems A banker’s acceptance is a time draft drawn on a commercial bank in which the bank promises to pay the holder of the draft a stated amount on a specified future date. Banker’s acceptances are negotiable and so may be sold by the exporter to finance working capital. 12.7 What is discounting, and how is it used in international trade? Discounting is the purchase of a promised payment at a discount from face value. 12.8 How is factoring different from forfaiting? Factoring is the sale of accounts receivable. Forfaiting is a form of factoring involving medium- to long-term receivables with maturities of six months or more. 12.9 What is countertrade? When is it most likely to be used? Countertrade involves an exchange of goods or services without the use of cash. It is commonly used in countries with inconvertible currencies, currency controls, or limited reserves of hard currency. Large exporters with significant international experience are more likely to use countertrade as a means of entry into new and developing markets. 12.10 What is multinational netting? In multinational netting, transactions that offset one another are identified within the corporation. Once offsetting transactions are identified, only the net amount of funds need be exchanged. 12.11 How can the treasury division assist in managing relations among the operating units of the multinational corporation? Treasury can serve as a “corporate bank” satisfying the financing requirements of the operating 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. Problem Solutions 12.1 a. A 6% interest rate compounded quarterly is the same as a 1.5% 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% per quarter or an effective annual rate of (1.0160)4-1= 0.0656, or 6.56% per year. 12.2 a. The 2%/month factoring fee of ($10000,000)(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. 45
- 46. Kirt C. Butler, Multinational Finance, 2nd edition 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% 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. 12.3 a. The net amount payable at maturity is $998,000 after subtracting the bank’s acceptance fee. A 5% annual rate compounded quarterly is the same as a 1¼% 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% per six months or an effective annual rate of (1.0272)2-1= 5.52% per year. 12.4 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% per year. Chapter 13 The Rationale for Hedging Currency Risk Answers to Conceptual Questions 13.1 Describe the conditions that can lead to tax schedule convexity. Tax schedule convexity can arise from any of the following: a) progressive taxation in which larger taxable income receives a higher tax rate, b) tax-loss carryforwards or carrybacks, c) Alternative Minimum Tax (AMT) rules, d) investment tax credits. 13.2 Define financial distress. Give examples of direct and indirect costs of financial distress. Financial distress refers to the additional financial troubles facing firms when the value of equity approaches zero. Direct costs are incurred during bankruptcy proceedings. Indirect costs include lower revenues or higher operating/financial costs. 13.3 What is an agency conflict? How can agency costs be reduced? Agency conflicts arise as managers act in their own interests rather than those of shareholders. Agency costs are the costs of aligning managers’ and shareholders’ objectives. Although currency risk may be diversifiable to shareholders, managers are undiversified and care about currency risk. Allowing managers to hedge exposure to currency risk may reduce agency conflicts. 46
- 47. Solutions to End-of-Chapter Questions and Problems Problem Solutions 13.1 a. Taxes 20% tax rate 40% tax rate R250,000 R200,000 R0 R1,000,000 R2,000,000 R500,000 Taxable income R1,500,000 b. Expected taxes with no hedging: (½) [(R500,000)(0.20)] + (½)[(R1,000,000)(0.20) + (R500,000)(0.40)] = (½) (R100,000) + (½) (R400,000) = R250,000. c. Expected taxes with hedging: (R1,000,000)(0.20) = R200,000 < R250,000. d. Hedging allows Widget to minimize its expected tax liability. This increase in expected future cash flows to equity results in an increase in equity value. 13.2 a. Expected taxable income is (½)($250,000) + (½)(-$250,000) = $0. E[PV(taxes)|unhedged] = (½)($125,000)-(½)($125,000)/(1.25) = $12,500. The present value of current taxes is $125,000. The present value of the tax shield received in one year is only ($125,000)/(1.25) = $100,000. E[PV(taxes)|hedged] = Tax rate times expected taxable income = (½)($0) = $0, an expected tax savings of $12,500. b. Expected taxable income is (½)($250,000) + (½)(-$250,000) = $0. E[PV(taxes)|unhedged] = (½)($125,000)-(½)($125,000)/(1.00) = $0. E[PV(taxes)|hedged] = (tax rate) times (expected taxable income) = (½)($0) = $0. The present value of the tax shield from tax loss carryforwards increases at lower discount rates. If the discount rate is zero, time doesn’t matter and future tax shields have the same magnitude as current tax payments. 47
- 48. Kirt C. Butler, Multinational Finance, 2nd edition c. Expected taxable income is (½)($250,000) + (½)(-$250,000) = $0. E[PV(taxes)|unhedged] = (½)($125,000)-(½)($125,000)/(1.25)2 = $22,500. The present value of current taxes is $125,000. The present value of the tax shield received in one year is only ($125,000)/(1.25)2 = $80,000. E[PV(taxes)|hedged] = (tax rate) times (expected taxable income) = (0.50)($0) = $0, a savings in expected tax payments of $22,500. 13.3 a. At $6,000 in taxable income, debt receives $6,000 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: VBonds + VStock = VBonds + Stock + = $10,000 $10,000 $10,000 $6,000 $16,000 Firm value c. Unhedged E[VBonds] = (½)($6,000-$2,000) + (½)($10,000) = $7,000 + E[VStock] = (½)($0) + (½)($6,000) = $3,000 E[VFirm] = (½)($6,000-$2,000) + (½)($16,000) = $10,000 Hedged E[VBonds] = $10,000 + E[VStock] = $1,000 E[VFirm] = $11,000 Firm value rises from $10,000 when unhedged to $11,000 when hedged. Hedging results in a $3,000 increase in the value of debt and a $2,000 decrease in the value of equity, for a net gain of $1,000. The $1,000 net gain is captured by 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 choose to leave its currency risk exposure unhedged. 48
- 49. Solutions to End-of-Chapter Questions and Problems 13.4 a. VBonds + VStock = VBonds + Stock + = $10,000 $10,000 $10,000 $4,000 $14,000 Firm value b. Unhedged E[VBonds] = (½)($4,000-$2,000) + (½)($10,000) = $6,000 + E[VStock] = (½)($0) + (½)($4,000) = $2,000 E[VFirm] = (½)($4,000-$2,000) + (½)($14,000) = $8,000 In this example, hedging can keep the firm solvent and avoid all of the costs of bankruptcy. Firm value is then (½)($6,000) + (½)($16,000) = $11,000 with certainty as in Problem 17.2. Payoffs are as follows: Hedged E[VBonds] = $10,000 + E[VStock] = $1,000 E[VFirm] = $11,000 Hedging avoids the $2,000 indirect cost as well as the ½ probability of a $2,000 direct cost, resulting in a stakeholder gain of $3,000. Bondholders would prefer to hedge and lock in $10,000, resulting in a gain of $4,000 over the unhedged situation. Equity locks in a value of $1,000, resulting in an expected loss of $1,000 relative to the unhedged situation. If equity is risk neutral, they will prefer to remain unhedged and face a 50 percent chance of having a $4,000 payout. Equity can gain from hedging: If equity can renegotiate the bond contract in these examples, then they can more evenly share the gain in firm value with the debt. Alternatively, equity can pre-negotiate a smaller promised payment to debt (resulting in a lower required return and hence cost of capital) by establishing and maintaining a risk-hedging program. Again, this will allow equity to share in any gain from reducing the probability and costs associated with financial distress. 13.5 a. If firm value is £9,000, equity will not exercise its option to buy the firm at a price of £10,000. In this case, equity receives nothing and debt receives £9,000. If the firm is worth £19,000, equity pays bondholders £10,000 and retains the residual £9,000. Firm value is E[VFIRM] = E[VBONDS] + E[VSTOCK] = [(½)(£9,000) + (½)(£10,000)] + [(½)(£0)+(½)(£9,000)] = £9,500 + £4,500 = £14,000. 49
- 50. Kirt C. Butler, Multinational Finance, 2nd edition Hedged, firm value is VFIRM = VBONDS + VSTOCK = £10,000 + £4,000 = £14,000. The reduction in the variability of firm value results in a reduction in call option value and a £500 shift in value from equity to debt. b. Unhedged, firm value is decomposed as: E[VFIRM] = E[VBONDS] + E[VSTOCK] = [(½) (£9,000-£1,000) + (½)(£10,000)] + [(½)(£0) + (½)(£9,000)] = £9,000 + £4,500 = £13,500. With hedging, VFIRM = VBONDS + VSTOCK = £10,000 + £4,000 = £14,000. As in the previous example, there is a reduction in the variability of firm value and an accompanying £500 transfer of wealth from equity to debt. Hedging also avoids the deadweight £1,000 bankruptcy cost and yields a higher expected payoff in the amount of (½)(£1,000) = £500. In this example, debt captures the expected gain of £500. Equity may capture some of the gain if hedging results in lower interest payments on the next round of debt. c. Unhedged, firm value is E[VFIRM] = E[VBONDS] + E[VSTOCK] = [(½)(£6,000-£1,000) + (½)(£10,000)] + [(½)(£0) + (½)(£8,000)] = £7,500 + £4,000 = £11,500. If the firm hedges, then VFIRM = VBONDS + VSTOCK = £10,000 + £2,000 = £12,000. 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. Chapter 14 Transaction Exposure to Currency Risk Answers to Conceptual Questions 14.1 What is transaction exposure to currency risk? Transaction exposure is change in the value of monetary (contractual) cash flows due to an unexpected change in exchange rates. 14.2 What is a risk profile? A risk profile graphically displays change in the value of an underlying currency exposure to change in the value of the underlying currency, such as ∆Vd/f as a function of ∆Sd/f. Risk profiles can be displayed in levels or in changes in levels. 14.3 In what ways can diversified multinational operations provide a natural hedge of transaction exposure to currency risk? Geographically diversified multinational corporations have relatively low transaction exposure to currency risk when they have cash inflows and outflows in a wide variety of currencies. Geographically diversified operations provide opportunities to reduce the multinational corporation’s currency risk exposures through multinational netting and leading and lagging of intracompany transactions. 14.4 What is multinational netting? Why is it used by multinational corporations? In multinational netting, a corporation’s exposure to currency risk is found by consolidating and then netting the exposures of individual assets and liabilities. Multinational netting reduces the transactions costs of hedging individual currency risk exposures in external financial markets. 50
- 51. Solutions to End-of-Chapter Questions and Problems 14.5 What is leading and lagging? Why is it used by multinational corporations? Leading and lagging is a way to reduce the firm’s transaction exposure by altering the timing of cash flows within the corporation. Like multinational netting, leading and lagging works best when the currency needs of the individual units within the corporation offset one another. 14.6 Define each of the following: a) currency forwards, b) currency futures, c) currency options, d) currency swaps, and e) money market hedges. Currency forwards are contracts for future delivery according to an agreed-upon delivery date, exchange rate, and amount. Exchange-traded currency futures contracts are similar to forwards except that changes in value are settled daily as the two sides of the contract are marked-to-market. A currency option contract gives the option holder the right to buy or sell an underlying currency at a specified price and on a specified date. A currency swap is a contractual agreement to exchange a principal amount of two different currencies and, after a prearranged length of time, to give back the original principal. A money market hedge replicates a currency forward contract through the spot currency and Eurocurrency markets. 14.7 What is a currency cross-hedge? Why might it be used? A currency cross-hedge uses a currency that is different from, but closely related to, the currency of the underlying exposure. It is used when the underlying exposure is in an illiquid or thinly traded currency. Problem Solutions 14.1. Paying affiliate Total Net Net Receiving affiliate U.S. Can. Mex. P.R. Receipts ReceiptsPayments United States 0 $300 $500 $600 $1400 $100 $0 Canadian $500 0 $400 $200 $1100 $0 $800 Mexican $400 $700 0 $200 $1300 $0 $0 Puerto Rican $400 $900 $400 0 $1700 $700 $0 Total payments $1300 $1900 $1300 $1000 0 $800 $800 14.2 Paying affiliate Net Net Receiving affiliate U.S. Can. Mex. P.R. Total receipts Receipts Payments United States 0 $800 $300 $400 $1500 $600 $0 Canadian $600 0 $300 $700 $1600 $0 $700 Mexican $100 $900 0 $800 $1800 $600 $0 Puerto Rican $200 $600 $600 0 $1400 $0 $500 Total payments $900 $2300 $1200 $1900 0 $1200 $1200 Here is one possible set of settling transactions. 51
- 52. Kirt C. Butler, Multinational Finance, 2nd edition U.S. Mexican affiliate affiliate $100 $600 $500 Canadian Puerto Rican affiliate affiliate 14.3 a. V $/€ Underlying long euro exposure $/€ ∆ V $/€ V0 $/€ ∆ S $/€ $/€ S S0 b. Hedges: i) a short euro forward hedge $/€ ∆ V $/€ ∆ S Short euro forward contract ii) a short euro futures contract has the same exposure as this forward position. iii) money market hedge 52
- 53. Solutions to End-of-Chapter Questions and Problems Borrow an amount such that $X is due $ in one period at an interest rate of i $ +($X)/(1+i ) Money market hedge -($X) Convert to euros at today’s spot rate $/€ $X = F1 (€ 1m) +(€ € $/€ $/€ $ 1m)/(1+ i ) s.t. (F1 /S0 )=(1+ i )/(1+ i ) € ⇒ -(€ 1m) $ $ $/€ € -($X)/(1+i ) s.t. [($X)/(1+i )]/S0 = (€1m)/(1+ i ) $/€ $ $/€ € ⇒ [F1 (€ 1m)/(1+i )]/S0 = (€ 1m)/(1+ i ) $/€ $/€ $ € ⇒ 1 /S0 ) = [(1+i )/(1+ i )] (F € Invest this amount at i +(€ 1m) € -(€ 1m)/(1+ i ) iv) short euro call option $/€ V ∆ V $/€ Net position $/€ ∆ S $/€ S Short euro call Short euro call 14.4 a. Not necessarily. From interest rate parity, F tA$/$/S0A$/$ = [(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. 53
- 54. Kirt C. Butler, Multinational Finance, 2nd edition 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 $5 million forward. Hedging an anticipated transaction makes good business sense when the anticipated transaction is highly likely to occur. If Rupert is not sure that he’ll actually incur this additional dollar exposure, he should probably wait before hedging. f. Rupert should buy the U.S. dollar forward against the Australian dollar. Futures contracts on the AS/$ 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. g. 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 3-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. h. 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. i. Rupert can swap existing Australian dollar debt for U.S. dollar debt such that his obligation in U.S. dollars is $5 million per quarter. Chapter 15 Operating Exposure to Currency Risk Answers to Conceptual Questions 15.1 What is operating exposure to currency risk and why is it important? A firm has operating exposure to currency risk when the value of its nonmonetary (real) cash flows changes with unexpected changes in currency values. 15.2 In a discounted cash flow framework, in what ways can operating risk affect the value of the multinational corporation. Operating exposure (indeed, currency exposure generally) affects value either through the cash flows or the discount rate in the valuation equation Vd = Σt E[CFtd]/ (1+id)t. 15.3 What is an integrated market? a segmented market? Why is this distinction important in multinational financial management? Purchasing power parity holds in an integrated market for goods, services, or financial assets. This means that equivalent assets trade for the same price. A market is segmented if purchasing power parity does not hold. Companies operating in segmented markets have prices that are locally determined. Companies operating in integrated markets face prices that are globally determined. 54
- 55. Solutions to End-of-Chapter Questions and Problems 15.4 How is an importer affected by a real depreciation of the domestic currency? An exporter? A diversified multinational corporation competing in globally competitive goods and financial markets? The classic exporter faces costs that are locally determined in segmented markets and revenues that are globally determined in integrated markets, resulting in a positive exposure to the foreign currency. The classic importer buys goods in integrated global markets and sell them in segmented local markets, resulting in a negative exposure to foreign currency values. A real depreciation of the domestic currency hurts the exporter and helps the importer. Multinational corporations operating in integrated global input and output markets have foreign currency exposures in both revenues and costs. The net exposure of the multinational corporation depends on the balance between its import and export activities. 15.5 What is meant by the statement “Exposure is a regression coefficient?” According to equation (15.2), exposure is measured by the slope coefficient in the regression Rtd = αd + βf std/f + etd. The regression coefficient βf captures the sensitivity of an asset (such as a share of common stock) to changes in exchange rates. 15.6 Suppose the correlation of a share of stock with a foreign currency value is +0.10. Calculate the r-square. What does it tell you? R-square is the square of the correlation coefficient, so (0.10) 2 = 0.01. One percent of the variation in share price comes from variation in the foreign currency value. 15.7 Define net monetary assets. Why is this measure important? Net monetary assets are monetary (or contractual) assets less monetary liabilities. The firm’s net transaction exposure depends on its net monetary assets. 15.8 List several financial market alternatives for hedging operating exposure to currency risk. How effective are these in hedging the nonmonetary cash flows of real assets? Why might firms hedge through the financial markets rather than through changes in operations? Financial market hedges of operating exposure include: a) foreign borrowings or lendings, b) long-dated forward foreign currency contracts, c) currency swaps, and d) roll-over hedges (a 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. 15.9 List several operating strategies for hedging operating risk. What are the advantages and disadvantages of these hedges compared to 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. 55
- 56. Kirt C. Butler, Multinational Finance, 2nd edition 15.10 What is the price elasticity of demand and 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, -(∆Q/Q)/(∆P/P). The price elasticity of demand determines whether and how much revenues will increase or decrease with a given change in price. 15.11 What five steps are involved in estimating the impact of exchange rate changes on the value of the firm’s real assets or on the value of equity? The five steps are: a) Identify the distribution of future exchange rates, b) estimate the sensitivity of revenues and operating expenses to changes in exchange rates, c) determine the desirability of hedging, given the firm’s risk management policy, d) identify the hedging alternatives and evaluate the cost/benefit performance of each alternative, given the forecasted exchange rate distributions, and e) monitor the position and revisit steps 1 through 4 as necessary. Problem Solutions 15.1 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) = +2. A 10 percent appreciation of the dollar is likely to increase the pound value of Sterling & Co.’s plant and equipment by 20 percent or $16,000, from £80,000 to £96,000. The relation between real asset value and the exchange rate is not very strong. The r-square is (0.10)2 = 0.01, so one percent of the variation in real asset value is explained by variation in the value of the dollar. d. Equity exposure is equal to the exposure of net monetary assets plus the exposure of real assets, or (-£70,000) + £16,000 = £56,000. e. Sterling’s use of long-term dollar liabilities tends to offset the positive exposure of their 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 in U.K. expatriates into the United States, and perhaps moving an existing supervisor from the U.K. to the United States as well. It will be difficult for Sterling & Co. to manage their U.S. operations as effectively as they manage their U.K. operations. Sterling should undertake this operating hedge if and only if it makes good business sense. Their dollar exposure should not be the deciding factor. 56
- 57. Solutions to End-of-Chapter Questions and Problems 15.2 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. 15.3 Low currency risk exposures for U.S. firms means that U.S. investors are more likely to be able to diversify away currency risk than investors in other countries. This also suggests that currency risk management is more important outside the United States than within the United States. Chapter 16 Translation Exposure to Currency Risk Answers to Conceptual Questions 16.1 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. 16.2 List the rules of the current/noncurrent translation method. Current accounts are translated at current exchange rates. Noncurrent accounts are translated at historical exchange rates. Most income statement items are translated at the average exchange rate over the reporting period. Depreciation is translated at historical rates. 16.3 List the rules of the monetary/nonmonetary translation method. Monetary accounts are translated at the current exchange rate. Nonmonetary accounts are translated at historical rates. Most income statement items are translated at the average exchange rate over the reporting period. Depreciation and COGS are translated at historical exchange rates. 16.4 List the rules of the current rate translation method. All assets and liabilities except equity are translated at the current exchange rate. Equity is translated at historical exchange rates. Income statement items are translated at the current exchange rate. Gains or losses caused by translation adjustments are put in a cumulative translation adjustment account in the equity section of the balance sheet. 57
- 58. Kirt C. Butler, Multinational Finance, 2nd edition 16.5 Which translation method is the most realistic from the perspective of finance theory? The current/noncurrent method is the least realistic, because it values long-term debt at historical exchange rates. The choice between the temporal method (as in FAS #8) and the current rate method (as in FAS #52) depends on whether real assets are more realistically translated at historical or current exchange rates. The temporal method translates real assets at historical rates assuming real assets are unaffected by currency risk. The current rate method (FAS #52) assumes real assets are exposed one-for-one to exchange rate risk. For most firms, the truth is somewhere between these two positions. 16.6 Did the switch from FAS #8 to FAS #52 in the United States improve the quality or informativeness of corporate earnings? How can we tell? Collins and Salatka [“Noisy Accounting Earnings Signals and Earnings Response Coefficients,” Contemporary Accounting Research 10, Spring 1994] and Bartov [“Foreign Currency Exposure of Multinational Firms,” Contemporary Accounting Research 14, Winter 1997] studied the relation of stock returns to earnings surprises and found that FAS #52 improved the informativeness or information quality of accounting earnings for U.S. multinationals with foreign operations. 16.7 According to finance theory, what determines whether an exposure to currency risk should be hedged? Finance theory states that the firm should only consider hedging risk exposures that are related to firm value. There is no value in hedging noncash transactions that do not cost or risk cash. 16.8 List three information-based reasons for hedging a translation exposure to currency risk. Information-based reasons include: (a) satisfying loan covenants, (b) meeting profit forecasts, and (c) retaining a credit rating. Each justification relies on informational asymmetries between corporate insiders and outsiders, presumably arising from costly or restricted access to information on the part of investors or information providers. 16.9 How can corporate hedging of translation exposure reduce the agency conflict between managers and other stakeholders? In what other ways can agency conflicts be reduced? If managers are evaluated based on accounting performance rather than on the value they add to the firm, then allowing them to hedge can remove this source of risk from their deliberations and help align managerial incentives with shareholder objectives. 16.10 Identify several cross-border differences in corporate hedging of translation exposure? What might account for these differences. Studies have documented higher derivatives usage as well as a greater willingness to hedge translation exposure to currency risk outside the U.S. than within the United States. It could be that non-U.S. managers are either more exposed to currency risk or more risk averse given their exposures. 58
- 59. Solutions to End-of-Chapter Questions and Problems 16.11 Recommend some general policies for deciding whether to hedge a translation exposure to currency risk. (a) In general, only economic exposures should be hedged. (b) Financing foreign operations with foreign capital can reduce both translation and economic exposures. (c) To the extent possible, insulate managers’ performance evaluations from currency risk. (d) If hedging translation exposure is necessary to align managers with shareholders, then individual units should be charged market prices for these hedges. (e) The treasury should hedge internally whenever possible. 16.12 How did accounting standard setters react to the prominent derivatives-related failures of the 1990s? The short-term response was to require increased disclosure of derivative transactions. Most nations are also moving toward market value accounting for derivatives, often with special accounting rules for hedge transactions. 16.13 Describe the four key elements of the United States’ FAS #133 “Accounting for Derivative Instruments and Hedging Activities.” (a) Derivatives should be reported in the financial statements. (b) Market value is the most relevant measure of value. (c) Only assets and liabilities should be reported on the balance sheet. Income and expenses should be reported on the income statement. (d) Special accounting rules should be limited to qualifying hedge transactions. 16.14 What is the International Accounting Standards Committee? Over which organizations does it have jurisdiction? The IASC is an international committee charged with harmonizing accounting standards. The IASC doesn’t have jurisdiction over any national accounting bodies. It provides a forum where national standard-setting bodies can develop a set of core standards for companies raising capital or listing securities internationally, so that international investors can evaluate the risks and performance of the companies in which they invest. Many multinational corporations use the IASC’s standards to report their financial performance to international investors. 16.15 What is a hedge? Why is it difficult to distinguish a hedge from a speculative position. How does the United States’ FAS #133 qualify a hedge? 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 under FASB #133 (and the proposed standards of the U.K. and the IASC), 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. 59
- 60. Kirt C. Butler, Multinational Finance, 2nd edition Problem Solutions 16.1 Balance sheets Translated value at $0.80/€ according to: Value at Current/ Assets € value $1.00/€ noncurrent Temporal Current € Cash 50,000 $50,000 $40,000 $40,000 $40,000 € A/R 30,000 $30,000 $24,000 $24,000 $24,000 € Inventory 20,000 $20,000 $16,000 $16,000 $16,000 € P&E 900,000 $900,000 $900,000 $900,000 $720,000 € Total assets 1,000,000 $1,000,000 $980,000 $980,000 $800,000 Liabilities € A/P 125,000 $125,000 $100,000 $100,000 $100,000 € ST debt 75,000 $75,000 $60,000 $60,000 $60,000 € LT debt 750,000 $750,000 $750,000 $600,000 $600,000 € Net worth 50,000 $50,000 $70,000 $220,000 $40,000 € Total liabs 1,000,000 $1,000,000 $980,000 $980,000 $800,000 a) Net exposed assets: Current/noncurrent rate method: ($50,000+$30,000+$20,000) -($125,000+$75,000) = $100,000-$200,000 = -$100,000. Temporal method (FAS #8): ($50,000+$30,000+$20,000) - ($125,000+$75,000+$750,000) = $100,000-$950,000 = -$850,000. Current rate method (FAS #52): ($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) Current/noncurrent rate method: (-0.2)(-$100,000) = +$20,000. Temporal method (FAS #8): (-0.2)(-$850,000) = +$170,000. Current rate method (FAS #52): (-0.2)(+$50,000) = -$10,000. 16.2 Balance sheets Translated value at C$1.50/$: Value at Current/ Assets C$ value C$1.60/$ noncurrent Temporal Current C$ Cash 320,000 $200,000 $213,333 $213,333 $213,333 C$ A/R 160,000 $100,000 $106,667 $106,667 $106,667 C$ Inventory 640,000 $400,000 $426,667 $426,667 $426,667 C$ P&E 480,000 $300,000 $300,000 $300,000 $320,000 C$ Total assets 1,600,000 $1,000,000 $1,046,667 $1,046,667 $1,066,667 Liabilities C$ A/P 320,000 $200,000 $213,333 $213,333 $213,333 C$ Wages 160,000 $100,000 $106,667 $106,667 $106,667 C$ Net worth 1,120,000 $700,000 $726,667 $726,667 $746,667 C$ Total liabs 1,600,000 $1,000,000 $1,046,667 $1,046,667 $1,066,667 60
- 61. Solutions to End-of-Chapter Questions and Problems a) Net exposed assets: Current/noncurrent rate method: ($200,000+$100,000+$400,000) -($200,000+$100,000) = $700,000-$300,000 = $400,000. Temporal method (FAS #8): ($200,000+$100,000+$400,000) -($200,000+$100,000) = $700,000-$300,000 = $400,000. Current rate method (FAS #52): ($200,000+$100,000+$400,000+$300,000) -($200,000+$100,000) = $1,000,000-$300,000 = $700,000. b) The Canadian dollar has appreciated by (S1$/C$/S0$/C$)-1 = (C$1.60/$)/(C$1.50/$)-1 = 6.67 percent. Translation gains from the appreciation of the C$ are then: Current/noncurrent rate method: (+0.066667)($400,000) = +$26,667. Temporal method (FAS #8): (+0.066667)($400,000) = +$26,667. Current rate method (FAS #52): (+0.066667)($700,000) = +$46,667. 16.3 a. Capitalizing the short peso (long dollar) position on the balance sheet: Assets Liabilities and Owners’ Equity Current assets Current liabilities Cash & marketable securities $15,000 Accounts payable $30,000 Accounts receivable $10,000 Wages payable $10,000 Long $ forward $30,000 Short-term debt $50,000 Fixed assets Forwards (P300,000 at $0.1/P) $30,000 Supplies (towels, etc.) $25,000 Long-term liabilities Property and buildings $950,000 Long-term debt $500,000 Owners’ equity $410,000 Total assets $1,030,000 Liabilities & owners’ equity $1,030,000 b. Debt-to-assets Current ratio Before $550,000/$1,000,000 = 0.5500 $25,000/$90,000 = 0.27778 After $580,000/$1,030,000 = 0.5631 $55,000/$120,000 = 0.4583 Although debt and current ratios have apparently deteriorated, Silver Saddle is actually less risky after the hedge. Capitalizing both sides of the hedge on the balance sheet misrepresents the impact of the hedge on the financial leverage and liquidity of the firm. c. Silver Saddle can qualify this hedge under FASB #133 by documenting the underlying exposure and showing how the hedge is linked to this exposure. After qualifying the hedge, the balance sheet will appear as in the original problem. This hedge is important enough for Silver Saddle to provide a footnote to the balance sheet indicating the forward contract and how it relates to the underlying exposure. 61
- 62. Kirt C. Butler, Multinational Finance, 2nd edition 16.4 a. Capitalizing the long euro (short dollar) position on the balance sheet: Assets Liabilities and Owners’ Equity Current assets Current liabilities Cash & marketable securities $15,000 Accounts payable $30,000 Accounts receivable $10,000 Wages payable $10,000 Long $ forward $10,000 Short-term debt $50,000 (€10,000 at $1.00/€) Short $ forward $10,000 Fixed assets Long-term liabilities Supplies (towels, etc.) $25,000 Long-term debt $500,000 Property and buildings $950,000 Owners’ equity $410,000 Total assets $1,010,000 Liabilities & owners’ equity $1,010,000 b. Debt-to-assets Current ratio Before $550,000/$1,000,000 = 0.5500 $25,000/$90,000 = 0.27778 After $56,000/$1,010,000 = 0.55446 $35,000/$100,000 = 0.3500 The situation is similar to 16.3 b. Debt and current ratios have deteriorated, but Silver Saddle is actually less risky after the hedge. c. Silver Saddle can qualify this hedge under FASB #133. However, because this is only an anticipated transaction, the forward position has an element of speculation in it. The speculative element depends on the probability of not receiving the euro payment. If Silver Saddle is certain of receiving euros, this is a hedge. Otherwise, the forward position has an element of speculation. Chapter 17 Multinational Capital Structure and Cost of Capital Answers to Conceptual Questions 17.1 Does corporate financial policy matter in a perfect financial market? In a perfect financial market, investors can replicate any action that the firm can undertake. Hence, corporate financial policy is irrelevant in a perfect financial market. 17.2 What distinguishes an integrated from a segmented capital market? In an integrated market, real after-tax required returns on equivalent assets are the same everywhere the assets are traded. If real after-tax rates of return are different in a particular market, then that market is at least partially segmented from other markets. 17.3 What factors could lead to capital market segmentation? Violations of any of the perfect market conditions can lead to capital market segmentation. These factors include prohibitive transactions costs, differing legal and political systems, regulatory interference (e.g., barriers to financial flows or to financial innovation), differential taxes or tax regimes, informational barriers such as disclosure requirements, home asset bias, and differential investor expectations. 62
- 63. Solutions to End-of-Chapter Questions and Problems 17.4 Does the required return on a project depend on who is investing the money or on where the money is being invested? The required return on an investment project should be an asset-specific discount rate that reflects the opportunity cost of capital on the project. That is, it depends on where the money is going and not from where it came. 17.5 Does the value of a foreign project depend on the way it is financed? Yes. Additional debt brings additional tax shields from the tax deductibility of interest payments as well as additional costs of financial distress. The adjusted present value approach to project valuation attempts to separate the value of the unlevered project from the value of these financial side-effects. 17.6 When is the adjusted present value approach to project valuation most useful? When the financial side-effects are easy to separate from the project. This includes many of the special circumstances listed in the chapter on “Cross-Border Capital Budgeting” including blocked funds, subsidized financing, negative-NPV tie-in projects, expropriation risk, and government-sponsored tax holidays. 17.7 What is a targeted registered offering and why is it useful to the corporation? Targeted registered offerings are securities issues 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. 17.8 What is project financing and when is it most appropriate? 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. 17.9 What evidence is there on the international determinants of corporate capital structure? How is the international evidence similar to the domestic U.S. evidence? Rajan and Zingales (1995) find that leverage is positively related to the tangibility of firm assets (i.e. the proportion of fixed assets), the presence of growth options (i.e. the asset market-to-book ratio), and firm size. Leverage is negatively related to profitability. These relations are shared by several markets including the domestic U.S. market. Problem Solutions 17.1 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%. 17.2 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%. 63
- 64. Kirt C. Butler, Multinational Finance, 2nd edition 17.3 a. The required return on Oilily’s equity within the French market is R F+β(E[RM]-RF) = 5% + (1.4)(11%-5%) = 13.4%. Oilily’s weighted average cost of capital is i WACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.4)(7%)(1-0.33)+(0.6)(13.4%) = 9.916%. b. Required return on Oilily’s stock is R = 5%+(1.2)(12%-5%) = 13.4% for an international investor. Using international sources, Oilily’s cost of capital is i WACC = (B/VL)iB(1-TC) + (S/VL)iS = (½)(6%)(1-0.33) + (½)(13.4%) = 8.710%. c. Let’s assume that the BFr1 billion operating cash flow is before interest expense. In the French market, Oilily’s value is V 0 = CF1 / (i-g) = BFr10,000,000/(0.09916- 0.04) = BFr169,033,130. If Oilily can raise funds in the global market, Oilily’s value is V0 = CF1 / (i-g) = BFr10,000,000/(0.08710-0.04) = BFr212,314,225. Oilily can increase its value by over 25% by financing in international markets because of this market’s higher tolerance for debt and lower required returns. 17.4 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)(15%-5%) = 17%. Grand Pet’s weighted average cost of capital is: i WACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.25) (6%)(1-0.33) + (0.75)(17%) = 13.755%. b. The debt ratio is now (B/VL) = 50/(50+100) = 0.33. The required return on Grand Pet’s equity in international markets is R = R F+β(E[RW]-RF) = 5%+(0.8)(10%-5%) = 9%. Using international sources of capital, Grand Pet’s cost of capital is: i WACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.33)(5%)(1-0.33) + (0.67)(9%) = 7.117%. c. Let’s assume that the £1 billion operating cash flow is before interest expense, so that the weighted average cost of capital is the appropriate discount rate on these cash flows to debt and equity. In the U.K. market, Grand Pet’s value is V0 = CF1 / (i-g) = £1,000,000,000/(0.13755-0.03) = £9,298,000,000. If Grand Pet can raise funds in the global market, Grand Pet’s value is V0 = CF1 / (i-g) = £1,000,000,000/(0.07117-0.03) = £24,291,000,000. Grand Pet can increase its value by over 150% by raising funds internationally. 17.5 a. All-equity value is APV = VU-CF0 = (CF1 )/(1+iU)-Initial investment = (BFr112 million/1.10)-BFr100 million = BFr1,818,182. b. Borrowing BFr50 million at 6% results in an interest payment of i BB = BFr3 million. The present value of the tax shield is (T CibB)/1+iB) = (BFr990,000/1.06) ≈ BFr933,962. The APV of the investment is then BFr1,818,182 + BFr933,962 = BFr2,752,144. c. All-equity value is APV = VU-CF0 = BFr12 million/0.10-BFr100 million = BFr20,000,000. The value of the perpetual tax shield is T CB = (0.33)(BFr50 million) = BFr16,500,000. The levered firm worth BFr36,500,000. 17.6 a. All-equity value is APV = VU-CF0 = (CF1 )/(1+iU)-Initial investment = £108 million/1.08-£100 million = £0. 64
- 65. Solutions to End-of-Chapter Questions and Problems b. APV = VU + PV(financing side effects)-Initial investment. Borrowing £25 million at 6% results in an interest payment of i BB = £1.5 million. The annual tax shield on this debt is TCibB = £500,000. The present value of this financing side effect is (TCiBB)/(1+iB) ≈ £467,000. Since the unlevered investment has a zero value, £467,000 is the APV of the one-year investment in production of doggy beer after including the interest tax shield from the debt. c. As a perpetuity, the all-equity value is still £0. The levered value is: APV = VU + (TCiBB)/iB-CF0 = VU + TCB-CF0 = £100,000,000 + £8,250,000 - £100,000,000 = £8,250,000. The value continues to arise solely from the interest tax shield. PART V Derivative Securities for Currency Risk Management Chapter 18 Currency Futures and Futures Markets Answers to Conceptual Questions 18.1 How do currency forward and futures contracts differ with respect to maturity, settlement, and the size and timing of cash flows? Currency forward contracts are traded in an interbank market, have negotiated terms (maturity, amount, and collateral), and are traded with a bid-ask spread. Nearly all forward contracts are held until maturity. Currency futures contracts are exchange- traded, standardized instruments that are traded on a fee basis rather than with a bid- ask spread. Less than 5% of futures contracts are held until maturity. 18.2 What is the primary role of the exchange clearinghouse? The Chicago Board of Trade Clearing Board’s slogan is “A party to every trade.” This is the primary role of a futures exchange. Users of futures always know the reputation and credit-worthiness of the party on the other side of the trade. 18.3 Draw and explain the payoff profile associated with a currency futures contract. Payoff profiles for an underlying exposure and for the corresponding futures hedge: Underlying exposure Futures hedge ∆V d/f ∆Vd/f ∆Sd/f ∆Sd/f Long the foreign currency Short the foreign currency 65
- 66. Kirt C. Butler, Multinational Finance, 2nd edition Underlying exposure Futures hedge ∆Vd/f ∆Vd/f ∆Sd/f ∆Sd/f Short the foreign currency Long the foreign currency 18.4 What is a delta-hedge? a cross-hedge? a delta-cross-hedge? When there is a maturity mismatch between an underlying transaction exposure and the expiration date of the nearest futures contract, the hedge that minimizes the variance in the hedged position is called a delta-hedge. When there is a currency mismatch but not a maturity mismatch, the variance-minimizing hedge is called a cross-hedge. When there is both a currency mismatch and a maturity mismatch, the variance-minimizing hedge is called a delta-cross-hedge. 18.5 What is the basis? What is basis risk? The basis is the difference in nominal interest rates, (i d-if). The relationship between futures prices and spot prices changes if interest rate levels in the two currencies rise and fall unexpectedly. The risk of unexpected change in the relationship between the futures prices and spot prices is called basis risk. 18.6 How do you measure the quality of a futures hedge? The quality of a currency hedge is measured by the r-square of a regression of the underlying spot rate change on change in the appropriate futures contract. This measures the percentage variation in one variable that is explained by variation in another variable. If there is both a currency and a maturity mismatch, then hedge quality is measured by the r-square of std/f on futtd/f , where d = the domestic currency, 2 1 f2 = the currency in which transaction exposure is denominated, and f 1 = the currency used to hedge against std/f . If there is neither a currency nor a maturity mismatch, then 2 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 18.1 The U.S. multinational corporation will need (S$3,000,000)/(S$125,000/contract) = 24 futures contracts to cover their forward exposure. The underlying position is long S$, so the MNC should sell 24 S$ futures contracts. A short futures position in S$ gains from a depreciation of the S$. If the spot rate closes at $0.5900/S$ on the expiration date, then the profit 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. 66
- 67. Solutions to End-of-Chapter Questions and Problems 18.2 a. ¥9,000,000 today 6 months b. Draw a payoff profile for this project with $/¥ on the axes. ∆V$/¥ ∆S$/¥ c. Snow White pays ¥9 million and receives (¥9,000,000)(F$/¥) in six months. d. Futures contracts are generally less expensive and more liquid than forward contracts. However, the expiration date may not match the transaction date and the standard contract size may not be evenly divisible into the amount to be hedged. 18.3 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. 18.4 a. Expected future cash flows +S$125,000 -Sh500,000 b. Buy francs in the U.S. dollar futures +Sh500,000 market -$81,250 Sell marks in the U.S. dollar futures +$81,250 market -S$125,000 67
- 68. Kirt C. Butler, Multinational Finance, 2nd edition Net payoff on futures hedge +Sh500,000 -S$125,000 These ending values exactly hedge the currency exposures of the expected cash flows. Any changes in spot rates S Sh/$ 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/Sh500,000) = S$0.2500/Sh = FS$/Sh, the underlying exposures can be matched exactly. The implied forward rate is S$0.25/Sh. Cotton Bolls would save on commissions, having to buy one futures contract rather than two. 18.5 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)(DKr10bn) = DKr10.25bn, so buy (DKr10.25bn)($0.80/ DKr)/($50,000/contract) = 164,000 contracts. b. The optimal amount in the futures position of this cross-hedge is: ⇒ (amt in futures) = (-1.04)(DKr10bn) = DKr10.4bn, or (€0.75/DKr)(DKr10.4bn) = DKr7.8bn at the €0.75/DKr exchange rate. c. The optimal amount in the futures position of this delta-cross-hedge is: ⇒ (amt in futures) = (-1.05)(DKr10bn) = DKr10.5bn. This is equal to (DKr10.5bn)($0.80/DKr)/($50,000/contract) = 168,000 contracts. d. Hedge quality can be ranked as follows: 1) delta-hedge (r 2 = 0.98), 2) cross-hedge (r2 = 0.89), and 3) delta-cross-hedge (r2 =0.86). If the merchant banker does not enjoy the same volume and liquidity as the futures exchanges, the cross-hedge through the merchant bank is likely to be the most expensive hedge. 18.6 a. Profit/loss on each of the positions is as follows: Scenario #1 St$/S$ = $0.6089/S$ i$ = 6.24% iS$ = 4.04% Futt,T$/S$ = ($0.6089/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.6107/S$ Profit on futures: +($0.6107/S$-$0.6107/S$) +$0.0000/S$ Profit on spot: -($0.6089/S$-$0.6089/S$) - $0.0000/S$ Net gain $0.0000/S$ Scenario #2 St$/S$ = $0.6089/S$ i$ = 6.24% iS$ = 4.54% Futt,T$/S$ = ($0.6089/S$) [(1.0624)/(1.0454)](51/365) ≅ $0.6102/S$ Profit on futures: +($0.6102/S$-$0.6107/S$) -$0.0004/S$ Profit on spot: -($0.6089/S$-$0.6089/S$) - $0.0000/S$ Net gain -$0.0004/S$ 68
- 69. Solutions to End-of-Chapter Questions and Problems Scenario #3 St$/S$ = $0.6089/S$ i$ = 6.74% iS$ = 4.04% Futt,T$/S$ = ($0.6089/S$) [(1.0674)/(1.0404)](51/365) ≅ $0.6111/S$ Profit on futures: -($0.6111/S$-$0.6107/S$) +$0.0004/S$ Profit on spot: +($0.6089/S$-$0.6089/S$) - $0.0000/S$ Net gain +$0.0004/S$ The profit spread is ±$0.0004/S$. This is about the same as in the example of Figure 18.5. This shows that basis risk exists even if the spot exchange rate does not change. b. 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$/S$ = ($0.6089/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.6107/S$ Profit on futures: +($0.6107/S$-$0.6107/S$) +$0.0000/S$ Profit on spot: -($0.6089/S$-$0.6089/S$) - $0.0000/S$ Net gain $0.0000/S$ Scenario #2 St$/S$ = $0.6255/S$ i$ = 6.24% iS$ = 4.04% Futt,T$/S$ = ($0.6255/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.6273/S$ Profit on futures: +($0.6273/S$-$0.6107/S$) -$0.0166/S$ Profit on spot: -($0.6255/S$-$0.6089/S$) - $0.0166/S$ Net gain $0.0000/S$ Scenario #3 St$/S$ = $0.5774/S$ i$ = 6.24% iS$ = 4.04% Futt,T$/S$ = ($0.6089/S$) [(1.0624)/(1.0404)](51/365) ≅ $0.5791/S$ Profit on futures: -($0.5791/S$-$0.6107/S$) +$0.0315/S$ Profit on spot: +($0.5774/S$-$0.6089/S$) - $0.0315/S$ Net gain $0.0000/S$ Part b shows that the futures hedge provides a perfect hedge against changes in the spot rate of exchange if the basis does not change. Chapter 19 Currency Options and Options Markets Answers to Conceptual Questions 19.1 What is the difference between a call option and a put option? A call option is an option to buy the underlying asset at a predetermined exercise price. A put option is an option to sell the underlying asset at the exercise price. 19.2 What are the differences between exchange-traded and over-the-counter currency options? Exchange-traded currency options are standardized as to currencies, maturity, exercise prices, and settlement procedures. Over-the-counter options traded by commercial and investment banks can be tailored to fit the needs of the client. 69
- 70. Kirt C. Butler, Multinational Finance, 2nd edition 19.3 In what sense is a currency call option also a currency put option? Because an option to buy one currency is simultaneously an option to sell another currency, currency options are both a call (on one currency) and a put (on the other currency). 19.4 In what sense is a currency forward contract a combination of a put and a call? A currency forward contract to buy currency f at a forward price of F Td/f at time T can be replicated by purchasing a European call option on currency f with the same expiration date and an exercise price K d/f = FTd/f and simultaneously selling a put option at the same exercise price and maturity date. Conversely, a short forward contract on currency f is a combination of a written call on f and a purchased put on f with the same expiration date and exercise price. 19.5 What are the six determinants of a currency option value? The determinants of currency option values are riskless domestic and foreign interest rates, the exercise price, the underlying spot (or futures) price, the expiration date, and the volatility of the underlying exchange rate. 19.6 What determines the intrinsic value of an option? What determines time value of an option? The intrinsic value is the value if exercised today. For a call on the spot rate S d/f, intrinsic value is equal to max(Sd/f-Kd/f,0). For a put option, intrinsic value is equal to max(Kd/f-Sd/f,0). Time value is the difference between the market value and the intrinsic value of an option and reflects the additional value of waiting until expiration before exercise. Time value primarily depends on time to expiration and volatility in the underlying exchange rate. Foreign and domestic interest rates play a lesser role for most currency options. 19.7 In what ways can you estimate currency volatility? Exchange rate volatility is a key determinant of currency option value because it is not directly observable in the marketplace. The other determinants of option value (foreign and domestic interest rates, exercise price, time to expiration, and underlying exchange rate) are usually observable. Volatility can be estimated from historical volatilities (the recent history of exchange rate movements) or implied volatilities (volatilities implied by the five observable determinants of option values and the observed market price of an option). Problem Solutions 19.1 ln [(¥110.517/$) / (¥100/$)] = ln(1.10517) = +0.10 = +10% ln [(¥90.484/$) / (¥100/$)] = ln(0.90484) = -0.10 = -10% 19.2 ln [(¥156.64/$) / (¥105/$)] = ln(1.49181) = +0.40 = +40% ln [(¥70.38/$) / (¥105/$)] = ln(0.50819) = -0.40 = -40% 70
- 71. Solutions to End-of-Chapter Questions and Problems 19.3 Exchange rate volatility and standard deviations: a. A daily standard deviation of 0.742% measured over 252 trading days implies σ√T = (0.742%)(√252) = 11.78% per year. b. +2σ: e2(0.1178) = e0.2356 = 1.2657 ⇒ (A$1.4/$)(1.2657) = A$1.7719/$ -2σ: e2(-0.1178) = e-0.2356 = 0.7901 ⇒ (A$1.4/$)(0.7901) = A$1.1061/$ c.+2σ: r = ln((A$1.7719/$)/(A$1.4/$)) = ln(1.2657) = +0.2356 ⇒ 0.1178/year -2σ: r = ln((A$1.1061/$)/(A$1.4/$)) = ln(0.7901) = -0.2356 ⇒ 0.1178/year d. S$/A$ = 1/SA$/$ = 1/(A$1.4/$) = $0.714285/A$ +2σ: e2*(0.1178) = 1.2657 ⇒ ($0.7143/A$)(1.2657) = $0.9040/A$ ⇒ A$1.1061/$ -2σ: e2*(-0.1178) = 0.7901 ⇒ ($0.7143/A$)(0.7901) = $0.5644/A$ ⇒ A$1.7719/$ 19.4 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: Spot exchange rate volatility and at-of-the-money put option value Sd/f Sd/f -2 -1 0 1 2 3 0 1 2 3 -2 -1 -3 -3 Spot exchange rate volatility and out-of-the-money put option value Sd/f Sd/f -1 -2 0 1 2 3 0 1 2 3 -2 -1 -3 -3 Spot exchange rate volatility and in-the-money put option value Sd/f -2 -1 0 1 2 3 Sd/f 0 1 2 3 -2 -1 -3 3 - 71
- 72. Kirt C. Butler, Multinational Finance, 2nd edition 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. 19.5 Buy a A$ call and sell a A$ put, each with an exercise price of F 1$/A$ = $0.75/A$ and the same expiration date as the forward contract. Payoffs at expiration look like this: ∆CallT$/A$ −∆PutT$/A$ ∆FT$/A$ ∆ST$/A$ + ∆ST$/A$ = ∆ST$/A$ 19.6 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. 19.7 a. A put option to sell krone for pound sterling is simultaneously a call option to buy pounds for krone. Because pounds sterling is in the denominator of these quotes, it is most convenient to think of this krone put option as a call option on pound sterling. Option values at expiration as a function of the krone value of the pound are then: Spot rate at expiration (DKr/£) 8.00 8.40 8.42 8.44 8.46 8.48 Pound call value at expiration (DKr/£) 0.00 0.00 0.00 0.00 0.01 0.03 An exercise price of DKr8.45/£ is equivalent to £0.11834/DKr. The corresponding krone put option values at this exercise price are: Spot rate at expiration (£/DKr) .12500 .11905 .11876 .11848 .11820 .11792 Pound call value at expiration (£/DKr) 0.00 0.00 0.00 0.00 0.14 0.42 72
- 73. Solutions to End-of-Chapter Questions and Problems b. A short krone put is equivalent to a short pound call. Here are their payoff profiles. −∆PutT£/DKr −∆Call TDKr/£ £.11834/DKr DKr8.45/£ DKr8.48/£ ∆ST£/DKr ≡ ∆STDKr/£ − DKr.03/£ −£.11834/DKr c. These are payoff profiles for a short krone put and a the equivalent short pound call. −∆PutT£/DKr −∆Call TDKr/£ +£.1464/DKr +£.00204/DKr ∆ST£/DKr ≡ ∆STDKr/£ DKr8.45/£ DKr8.5964/£ £.11834/DKr −£.11633/DKr £.11633/DKr Appendix 19-A Currency Option Valuation 19A.1 Option determinants are as follows: i¥ = i$ = 0.05, T = ½ year = 0.5, S ¥/$ = $80, K¥/$ = $100, and σ = 0.10. Assume these are continuously compounded rates. (If not, the transformation from holding period to continuously compounded returns is i = ln(1+i).) d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T) = [ln((¥80/$)/(¥100/$)) + (0.05-0.05+(0.10)2/2)(0.5)] / (0.10)(0.5)1/2 = -3.1204 d2 = d1 - σ√T = -3.1204 - (0.10)(0.5)1/2 = -3.1911 f d Calld/f = e- i T [Sd/f N(d1)] - e- i T [Kd/f N(d2)] = e(-0.05*.5)[(¥80/$)(0.0009)]-e(-0.05*.5)[(¥100/$)(0.0007)] = ¥0.0013/$. This deep-out-of-the-money dollar call has almost no chance of being exercised. 73
- 74. Kirt C. Butler, Multinational Finance, 2nd edition 19A.2 Option determinants: Same as above, except σ = 0.20. d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T) = [ln((¥80/$)/(¥100/$)) + (0.05-0.05+(0.20)2/2)(0.5)] / (0.20)(0.5)1/2 = -1.5071 d2 = d1 - σ√T = -1.5071 - (0.20)(0.5)1/2 = -1.6486 f d Calld/f = e- i T [Sd/f N(d1)] - e- i T [Kd/f N(d2)] = e(-0.05*.5)[(¥80/$)(0.0659)]-e(-0.05*.5)[(¥100/$)(0.0496)] = ¥0.3015/$. If the true volatility is 20% per year and this option is priced as if the volatility is 10% per year, then the option will be undervalued by (¥0.3015/$-¥0.0013/$) = ¥0.3002/$. 19A.3 The implied variance of the $/¥ exchange rate is about 0.000877 from the currency option pricing model. Taking the square root to find the standard deviation implied in the option price, we get 0.0296 or 2.96% per year. As verification, here are the calculations: d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T) = [ln(($.008345/¥)/($.0084/¥))+(0.04-0.04+(0.0296)2/2)(2.5/12)]/(0.0296)(2.5/12)1/2 = -0.1169 d2 = d1 - σ√T = -0.1169 - (0.0296)(2.5/12)1/2 = -0.1637 f d Calld/f = e- i T [Sd/f N(d1)] - e- i T [Kd/f N(d2)] = e(-0.04*2.5/12)[($.008345/¥)(0.5465)]-e(-0.04*2.5/12)[($.0084/¥)(0.4535)] = $.000118/¥. This is an unusually low volatility. Annual dollar/yen volatilities are typically between 8% and 16%. 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. 19A.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 £/DKr and quotes option prices in direct £/DKr terms from a Londoner’s perspective. The current spot rate is S0£/DKr = 1/(DKr8.4528/£) = £0.11830/DKr and the exercise price is K£/DKr = 1/(DKr8.5/£) = £0.11765/DKr. 1-month 3-month 6-month 1-year Forward rate (DKr/£) 8.4404 8.4157 8.3787 8.3053 Forward rate (£/DKr) .11848 .11883 .11935 .12040 Call option value (£/DKr) .00180 .00294 .00412 .00583 Put option value (£/DKr) .00100 .00178 .00247 .00326 74
- 75. Solutions to End-of-Chapter Questions and Problems 75
- 76. Kirt C. Butler, Multinational Finance, 2nd edition b. Here is a sample calculation for the three-month (= one period) call and put values. d1 = [ln(Sd/f/Kd/f) + (id-if+σ2/2)T] / (σ√T) = [ln((£0.11830/DKr)/(£0.11765/DKr))+(0.0174-0.0130+(0.05)2/2)(1)]/(0.05)(1)1/2 = +0.2244 d2 = d1 - σ√T = +0.2244 - (0.05)(1)1/2 = +0.1744 d Calld/f = e- i T [Ftd/f N(d1) - Kd/f N(d2)] = e(-0.0174*1)[(£0.11883)(0.5888)-(£0.11765)(0.5692)] = £0.00294/DKr. c. Here are the call option payoff profiles for the four options prior to expiration. The one-year option is plotted as the highest line in the graph.. The one-month option is the lowest (curved) line in the graph. The darkened forty-five degree line is the intrinsic value of the option. 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 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. 76
- 77. Solutions to End-of-Chapter Questions and Problems 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 19A.5 Let’s restate these exercise prices as pound per krone rates before proceeding. Exercise prices Exercise prices (DKr/£) 8.2000 8.4000 8.6000 8.8000 Exercise prices (£/DKr) .12195 .11905 .11628 .11364 Call option value .00114 .00222 .00377 .00568 Put option value .00421 .00244 .00127 .00058 Chapter 20 Currency Swaps and Swaps Markets Answers to Conceptual Questions 20.1 What is a parallel loan arrangement. What are its advantages and disadvantages? In a parallel loan, one company borrows in its home currency and then trades this debt for the foreign currency debt of a foreign counterparty. This a) legally circumvents any restrictions on cross-border capital flows, b) allows each company to borrow in its home country where it enjoys a relative borrowing advantage, and c) can be used to reduce the currency risk exposure of foreign subsidiaries, and d) it may facilitate access to new capital markets. Disadvantages include: a) default risk, b) the balance sheet impact of offsetting assets and liabilities, and c) search costs in finding a counterparty. 20.2 How can a currency swap remedy the problems of parallel loans? Currency swaps bundle a parallel loan into a single contract that a) greatly reduces default risk, b) eliminates the need to capitalize the offsetting asset and liability on the balance sheet, and c) reduces search costs through high volume and active market makers (dealers). 20.3 How are swaps related to forward contracts? 77
- 78. Kirt C. Butler, Multinational Finance, 2nd edition A swap is a portfolio of simultaneous forward contracts each with a different maturity date. 20.4 What is a currency coupon swap? A currency coupon swap is a fixed-for-floating rate non-amortizing currency swap. Currency coupon swaps are primarily traded through international commercial banks. 20.5 What is a coupon swap? A coupon swap is a fixed-for-floating rate non-amortizing interest rate swap. These swaps are also traded primarily through international commercial banks. 20.6 What is the difference between a bond equivalent yield and a money market yield? U.S. Treasury securities are quoted as a bond equivalent yield (BEY) that assumes a 365-day year and semiannual interest payments. Floating rate Eurocurrencies such as those pegged to LIBOR are quoted as a money market yield (MMY) based on a 360- day year and semiannual coupons. The relation between the two is MMY = BEY(360/365). Problem Solutions 20.1 a. Borrowing directly in the foreign currency results in the following cash flows: Sunflower borrow Lira: +100% -8% -8% -108% lire Rosa borrow $: +100% -9% -9% -109% dollars b. A parallel loan results in the following cash flows: Sunflower borrow Lira: +100% -8% -8% -108% Lira borrow $: +100% -5% -5% -105% $ lend $: -100% +9% +9% +109% $ Rosa borrow $: +100% -9% -9% -109% $ borrow Lira: +100% -7% -7% -107% Lira lend Lira: -100% +8% +8% +108% Lira c. Sunflower borrows at 8% in lira but earns (9%-5%) = 4% over cost on the dollar loan to Rosa for a net borrowing cost of (8%-4%) = 4% in lira. This is a 4% savings over borrowing directly in the lira market at 8%. 78
- 79. Solutions to End-of-Chapter Questions and Problems d. Rosa borrows at 9% in dollars but earns (8%-7%) = 1% over cost on the lira loan to Sunflower for a net borrowing cost of (9%-1%) = 8% in dollars. This is a 1% savings over the cost of borrowing directly in the dollar market at 9%. 20.2 Little Prince could form a coupon swap (an interest rate swap) of its existing fixed rate debt into floating rate debt. Consider the coupon swap indication pricing table from the text: Bank Pays Bank Receives Current Maturity Fixed Rate Fixed Rate TN Rate 2 years 2 yr TN sa + 19bps 2 yr TN sa + 40bps 7.05% 3 years 3 yr TN sa + 24bps 3 yr TN sa + 47bps 7.42% 4 years 4 yr TN sa + 28bps 4 yr TN sa + 53bps 7.85% 5 years 5 yr TN sa + 33bps 5 yr TN sa + 60bps 7.92% This schedule assumes non-amortizing debt and semiannual rates (sa). All quotes are against 6-month LIBOR flat. TN = Treasury Note rate. LP would pay LIBOR flat on the floating rate side. LP would receive the 2-year T-note rate of 7.24% (7.05% + 19 basis points) on the fixed rate side. Because LP is currently paying 8.25% on its fixed rate debt, its interest shortfall would be (8.25%-7.24%) = 1.01%. This is equal to 1.01%(360/365) = 0.996% 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. 20.3 a. JI pays fixed rate pound interest payments at a bond equivalent yield of 6.18%+5 bps = 6.23% to the swap bank. JI receives floating rate yen interest at the 6-month LIBOR rate from the swap bank. After converting the 105 bps premium above LIBOR to a bond equivalent yield, JI’s cost of fixed rate pound funds is 6.23% +1.05%(365/360) ≈ 7.295%. b. BD receives fixed rate pound interest payments from the swap bank at 6.18%- 0.05% = 6.13%. BD pays floating rate yen interest at 6-month (yen) LIBOR flat to the swap bank. After converting the difference between BD’s fixed-rate outflows and inflows (7.45%-6.13% = 132 bps) to a money market yield, BD’s cost of floating rate yen funds is LIBOR + (132 bps)(360/365) = LIBOR+130.2 bps in money market yield. c. The swap bank pays the LIBOR yen rate to JI and receives the LIBOR yen rate from BD for no net gain or loss in floating rate yen. The swap bank receives fixed rate pounds at 6.23% from JI and pays fixed rate pounds at 6.13% to BD. The swap bank’s net gain is the (6.23%-6.13%) = 10 bp spread in bond equivalent yield on the notional principal. 20.4 a. Zloty obligations can be locked in by borrowing zlotys. This can be done directly or by borrowing in another currency and then swapping into zlotys. For example, GE could swap an amount of existing dollar debt for zloty debt such that the zloty obligation is Zl 20 million in each of the next five years. 79
- 80. Kirt C. Butler, Multinational Finance, 2nd edition b. GE receives fixed-rate dollar interest payments from the swap bank at 7.94%- 0.50% = 7.44%. GE pays floating rate yen interest at 6-month ($) LIBOR flat to the swap bank. After converting GE’s fixed-rate outflows and inflows (8.34%-7.44% = 90 bps) to a money market yield, GE’s cost of floating rate zloty funds is LIBOR + (90 bps)(360/365) = LIBOR+88.8 bps in money market yield. c. SP pays fixed-rate dollar interest at a bond equivalent yield of 7.94%+50bps = 8.44% to the swap bank. SP receives floating rate interest at the 6-month zloty LIBOR rate from the swap bank. After converting the 265 bp premium above LIBOR to a bond equivalent yield, SP’s cost of fixed rate dollar funds is 8.44% +2.65%(365/360) ≈ 11.13%. d. The swap bank pays the LIBOR dollar rate to SP and receives the LIBOR zloty rate from GE for no net gain or loss in floating rate dollars. The swap bank receives fixed rate zlotys at 8.44% from SP and pays fixed rate zlotys at 7.44% to GE for a net gain of 10 bps in bond equivalent yield. 20.5 a. FMC pays fixed-rate zloty interest at a bond equivalent yield of 7.98%+0.78% = 8.76% to the swap bank. FMC receives floating rate zloty interest at the 6-month LIBOR rate. After converting the 45 bps premium above LIBOR to a bond equivalent yield, FMC’s cost of fixed rate zloty debt is 8.76%+0.45%(365/360) ≈ 9.22%. b. PM receives fixed rate zloty interest from the swap bank at 7.98%+0.24% = 8.22%. PM pays floating rate zloty interest at 6-month LIBOR flat to the swap bank. 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 FMC and receives the LIBOR from PM for no net gain or loss in floating-rate zlotys. The swap bank receives 8.76% (sa) from FMC 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. PART VI International Capital Markets and Portfolio Investment Chapter 21 A Tour of the World’s Capital Markets Answers to Conceptual Questions 21.1 What is the difference between a money market and a capital market? Financial markets are comprised of money markets and capital markets. Money markets are markets for assets of short (less than one year) maturity. Capital markets are markets for assets of greater than one-year maturity. 21.2 Define liquidity. Liquidity: the ease with which you can exchange an asset for another asset of equal value. 21.3 What is the difference between an intermediated and a nonintermediated financial market? 80
- 81. Solutions to End-of-Chapter Questions and Problems In an intermediated debt market, a financial institution such as a commercial bank channels funds from savers to borrowers. In a nonintermediated debt market, borrowers appeal directly to savers through the securities markets without using an intermediary. 21.4 What is the difference between an internal and an external market? Debt placed in an internal market is denominated in the currency of a host country and placed within that country. Debt placed in an external market is placed outside the borders of the country issuing the currency. 21.5 What are the characteristics of a domestic bond? an international bond? a foreign bond? a Eurobond? a global bond? Domestic bonds are issued and traded within the internal market of a single country and are denominated in the currency of that country. International bonds are traded outside the country of the issuer. The two kinds of international bonds are foreign bonds and Eurobonds. Foreign bonds are issued in a domestic market by a foreign borrower, denominated in domestic currency, marketed to domestic residents, and regulated by the domestic authorities. Eurobonds are denominated in one or more currencies but are traded in external markets outside the borders of the countries issuing those currencies. 21.6 What are the benefits and drawbacks of offering securities in bearer form relative to registered form? Bearer bonds have the advantage of retaining the anonymity of the owner. However, owners of bearer bonds must ensure that they do not lose the bonds or the bond coupons since the bearer is assumed to be the legal owner of the bond. 21.7 What is an equity-linked Eurobond? An equity-linked Eurobond is a Eurobond with an equity option attached. Equity options attached to Eurobonds include warrants and convertibility options. 21.8 What is the difference between a public stock exchange, a bankers’ stock exchange, and a private stock exchange. Public bourses are dominated by national governments. Public bourses are found in France and in countries influenced by Napoleonic rule. Bankers’ bourses are dominated by banks and are found in Germany and related countries. Private exchanges are privately owned and operated, although they are often regulated by national governments. The United Kingdom and the United States have private stock exchanges. 21.9 What is the difference between a continuous quotation system and a periodic call auction? In a continuous quotation system, buy and sell orders are matched as they arrive with market-makers assuring liquidity in individual shares. In a periodic call auction, shares are bought and sold only at pre-specified times. Continuous quotation systems are more appropriate for actively traded shares. Periodic call auction systems are frequently used for thinly traded shares. 21.10What is the difference between a spot and a forward stock market? 81
- 82. Kirt C. Butler, Multinational Finance, 2nd edition Spot (or cash basis) stock markets settle trades immediately (typically within a few days). Forward (or futures) stock markets settle trades on a specified future date. Problem Solutions 21.1 No interest accrues on the 31st of the month with the 30/360 convention. 21.2 With the actual/365 convention, 31 days out of 182.5 days would have accrued by July 31st. This is (31/182.5) = 16.986% of the semiannual interest payment. 21.3 Three days of interest accrue on the 28th of February during years that are not leap years. During leap years, one day of interest accrues on the 28th of February and two days of interest accrue on the 29th of February. 21.4 Matsushita’s global bonds selling at par: a. According to the U.S. bond equivalent yield convention, the promised yield of a bond selling at par is equal to the coupon yield. For the Matsushita bond, this is 7¼% compounded semiannually. b. According to the effective annual yield quotation commonly used in Europe, the promised yield is the solution to (1.03625)2-1 = 7.3814%. c. According to the Japanese bond quotation convention, the yield is computed according to: 100% - Price 100% yield = Coupon rate + Years to maturity Price = (7.25% + [(100%-100%)/2])(100%/100%) = 7.25%. 21.5 Matsushita’s global bonds selling at 101% of par: a. The promised yield on a semiannual basis is the solution to: 101 = (3.625)/(1+r) + (3.625)/(1+r)2 + (3.625)/(1+r)3 + (103.625)/(1+r)4 for an effective semiannual yield of r = 3.354%. The U.S. bond equivalent yield convention would quote this as 6.708% compounded semiannually. b. According to the effective annual yield quotation, the promised yield is (1.03354)2−1 = 6.8205%. c. According to the Japanese bond quotation convention, the yield is (7.25% + [(100%-101%)/2])(100%/101%) = 6.75495%. 21.6 Countries with large stock markets tend to have large government bond markets. After deleting the countries that appear only in the list of stock markets, the correlation between stock and bond market capitalizations in Table 21.1 is 0.87. The correlation between their ranks is 0.83. Italy has a large government bond market relative to its stock market. Switzerland has a large stock market capitalization relative to its government bond market. 21.7 Electronic databases that can be used to search for information on recent alliances include ABI/Inform and the Dow Jones News Retrieval Service. 82
- 83. Solutions to End-of-Chapter Questions and Problems Chapter 22 International Portfolio Diversification Answers to Conceptual Questions 22.1 How is portfolio risk measured? What determines portfolio risk? Portfolio risk is measured by the standard deviation (or variance) of return. Portfolio risk depends on the variances and covariances of the assets in the portfolio. 22.2 What happens to portfolio risk as the number of assets in the portfolio increases? As the number of assets held in a portfolio increases, the variance of return on the portfolio becomes more dependent on the covariances between the individual securities and less dependent on the variances of the individual securities. 22.3 What happens to the relevant risk measure for an individual asset when it is held in a large portfolio rather than in isolation? The risk of an individual asset in a large portfolio depends on its return covariance with other assets in the portfolio and not on its return variance. This is called systematic risk. 22.4 In words, what does the Sharpe Index measure? Sharpe’s measure captures the ex post return/risk performance of an asset by dividing return in excess of the riskfree rate by the asset’s standard deviation of return. In other words, it measures the asset’s “bang for the buck.” 22.5 Name two synonyms for “systematic risk.” Systematic risk is the same as nondiversifiable risk or market risk. 22.6 Name three synonyms for “unsystematic risk.” Diversifiable, asset-specific (company- or country-specific), or unique risk. 22.7 Is international diversification effective in reducing portfolio risk? Why? International portfolio diversification can reduce portfolio risk in two ways: 1) national stock markets are only loosely linked, and 2) the correlation between exchange rates and national market returns is very low, so domestic-currency returns on foreign investments are further isolated from returns elsewhere in the domestic market. 22.8 What is a perfect market? The perfect market assumptions include frictionless markets, rational investors, equal access to market prices, and equal access to costless information. 22.9 Are real world 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), unequal access to market prices or information, and investor irrationality. 83
- 84. Kirt C. Butler, Multinational Finance, 2nd edition 22.10 Describe some of the barriers to international portfolio diversification. Barriers to international portfolio diversification include a) market frictions such as government controls, taxes, and transactions costs, b) unequal access to market prices in foreign markets, and c) unequal access to information on foreign assets. Investor irrationality also can be a barrier to international portfolio diversification. Problem Solutions 22.1 E[RP] = (½)(0.166)+(½)(0.158) = 0.1620, or 16.2% Var(RP) = (½)2(0.290)2+(½)2(0.295)2 + 2(½)(½)(0.567)(0.290)(0.295) = 0.067 ⇒ σP = (0.0670)1/2 = 0.2589, or 25.89% SI = (RP - RF)/σP = (0.1620-0.068)/(0.2589) = 0.363, which is superior in return/risk performance to either the French (0.338) or Germany (0.305) markets alone. 22.2 E[RP] = (½)(0.177)+(½)(0.158) = 16.75% Var(RP) = (½)2(0.357)2+(½)2(0.295)2 + 2(½)(½)(0.330)(0.357)(0.295) = 0.071 ⇒ σP = (0.071)1/2 = 0.2664, or 26.64% SI = (0.1671-0.068)/(0.2664) = 0.373, which is superior in return/risk performance to either the German (0.305) or Japanese (0.305) markets alone. 22.3 E[RP] = (½)(0.136)+(½)(0.133) = 13.45% Var(RP) = (½)2(0.161)2+(½)2(0.101)2 + 2(½)(½)(0.360)(0.161)(0.101) = 0.012 ⇒ σP = (0. 012)1/2 = 0.1094, or 10.94% SI = (0.1345-0.0681)/(0.1094) = 0.608, which is superior in return/risk performance to either stocks (0.422) or bonds (0.644) alone. 22.4 E[RP] = (1/3)(0.177)+(1/3)(0.176)+(1/3)(0.143) = 16.53% Var(RP) = (1/3)2(0.357)2+(1/3)2(0.299)2+(1/3)2(0.164)2+2(1/3)2(0.317)(0.357)(0.299) + 2(1/3)2(0.325)(0.357)(0.164) + 2(1/3)2(0.557)(0.299)(0.164) = 0.0449 ⇒ σP = (0. 0449)1/2 = 0.2119, or 21.19% SI = (0.1653-0.068)/(0.2119) = 0.459, which is superior in return/risk performance to the Japanese (0.305), U.S. (0.457), or U.K. (0.361) indices alone. 22.5 ρU.S.G = +1: σpt = (XU.S.σU.S. + XGσG) = (0.5)(0.1) + (0.5)(0.2) = 0.15 ρU.S.G = -1: σpt = (XU.S.σU.S. - XGσG) = (0.5)(0.1) - (0.5)(0.2) = -0.05 ρU.S.G = 0: σpt = (XU.S.2σU.S.2 + XG2σG2)½ = [(0.5)2(0.1)2 + (0.5)2(0.2)2] ½ = 0.11 ρU.S.G = 0.3: σpt = (XU.S.2σU.S.2 + XG2σG2 + 2XU.S.XGσU.S.σGρU.S.G) ½ = [0.520.12 + 0.520.22 + 2(0.5)(0.5)(0.1)(0.2)(0.3)] ½ = 0.1245 22.6 E[Rp] = XAE[RA] + XBE[RB] + XCE[RC] = 0.2(0.08) + 0.3(0.1) + 0.5(0.13) = 11.1% 22.7 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. In an informationally efficient market, it is not possible to predict these high-performing assets ex ante. 84
- 85. Solutions to End-of-Chapter Questions and Problems 22.8 sd/f = (Std/f/St-1d/f)-1= (€0.7182/$)/(€0.7064/$)-1 = 1.0168-1 = 1.68% Rd = Rf + ∆Sd/f + Rf∆Sd/f = 0.1600 + 0.0168 + (0.1600)(0.0168) = 17.95% 22.9 (1+R$) = (1+RPeso)(1+s$/Peso ) ⇒ R$ = (1.12 )[($.0440/Peso)/($.0425/Peso)]-1 = (1.12)(1.0353)-1 = 15.95%. 22.10 Note that variance is in units of %2 and not % as stated in the problem. Suppose that the correct values are Var(RPeso) = 0.248 and Var(s$/Peso) = 0.327. Then Var(R$) = Var(RPeso) + Var(s$/Peso) + Var(RPesos$/Peso) + 2Cov(RPeso,s$/Peso) = 0.248 + 0.327 + 0 + 0 = 0.575. Chapter 23 International Asset Pricing Answers to Conceptual Questions 23.1 What is the capital market line? Why is it important? The capital market line describes the most efficient combination of risky and riskless assets. 23.2 What is the security market line? Why is it important? The security market line describes a linear relation between systematic risk and required return. 23.3 What is beta? Why is it important? Beta measures an asset’s sensitivity to changes in the market portfolio. 23.4 Does political risk affect required returns? If political risk is country-specific, then it is diversifiable and does not affect required return. If political risk is related to returns on the relevant (domestic or international) market portfolio, then it does affect required returns. 23.5 What assumptions must be added to the traditional CAPM in order to derive the international version of the CAPM? Two additional assumptions are necessary: a) investors in each country have the same consumption basket so that inflation is measured against the same benchmark in every country, and b) purchasing power parity holds so that both real prices and real interest rates are the same in every country and for every individual. 23.6 What is the hedge portfolio in the international version of the CAPM? The hedge portfolio is a combination of domestic T-bills and a hedge against the currency risk of the world market portfolio. (While the text does not go into detail, one way to construct the currency hedge is through forward currency contracts.) 23.7 What is the difference between an integrated and a segmented capital market? An integrated capital market is one in which the law of one price holds. Some sort of 85
- 86. Kirt C. Butler, Multinational Finance, 2nd edition market imperfection is necessary for their to be segmented capital markets. 23.8 What is home asset bias? Home asset bias is the tendency of domestic investors to invest in domestic securities. 23.9 What is Roll’s Critique of the CAPM? Does it apply to the IAPM? Does it apply to APT? Roll’s Critique concerns the testability of the CAPM. Roll observed that if security performance is measured relative to an ex post efficient index then the algebra of the CAPM assures that the relation between systematic risk and mean return holds by construction. On the other hand, if security performance is measured relative to an ex post inefficient index then beta is unlikely to be related to expected return. 23.10 What is the APT? In what ways is it both better or worse than the IAPM? The arbitrage pricing model assumes that individual security returns are related to K factors according to the linear relationship Rj = µj + β1jF1 + ... + βKjFK + ej. The good news is that APT is not a tautology like the CAPM and hence is not subject to Roll’s Critique. The bad news is that APT says nothing about what systematic risk factors are priced. (The CAPM is constructed such that the only relevant systematic risk factor is the return on the market portfolio.) 23.11 What five APT factors did Chen, Roll, and Ross identify in their study of the U.S. stock market? The 5 factors are: 1) industrial production, 2) expected inflation, 3) unexpected inflation, 4) risk premia (measured by the spread between corporate and government bond yields), and 5) the term structure of interest rates (long-term government - T-bill yield). 23.12 Are individual stock returns more closely related to national or industry factors? What implication does this have for portfolio diversification? According to the Beckers, Connor, and Curds [1996] study presented in the text (as well as other recent studies), individual stock returns are most closely related to domestic stock market indices. Industry factors play a less prominent role. This suggests that diversification across countries is more effective in reducing portfolio risk than industry diversification. 23.13 What is the value premium? What is the size effect? Do international stocks exhibit these characteristics? Are these factors evidence of market inefficiency? The value premium refers to the tendency of value (high equity book-to-market) stocks to outperform growth (low equity book-to-market) stocks. The size effect refers to the tendency of small stocks to outperform large stocks. Fama and French [1998] found that these factors are present in a study of 13 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. 23.14 What is momentum? Can it lead to profitable investment opportunities for 86
- 87. Solutions to End-of-Chapter Questions and Problems 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. 23.15 Are individual stocks exposed to currency risk? Does currency risk affect required returns? Individual stocks (especially firms with international operations) are often exposed to currency risk. Jorion’s study (presented in the text) suggests that currency risk is not priced in the U.S. stock market. However, the academic literature has not reached a consensus on this point. The Dumas and Solnik article “The World Price of Foreign Exchange Risk” mentioned in the footnote (Journal of Finance 50, No. 2, June 1995, pages 445-479) comes to a different conclusion. In any case, managers will continue to care about currency risk because they cannot diversify their wealth in the same way that outside shareholders can. Problem Solutions 23.1 a. RS = RF + βS (RM - RF) = 8% + [16.5% - 8%] (1.5) = 20.75%. b. RS = RF + βS (RM - RF) = 4% + [16.5% - 8%] (1.2) = 14.2%. 23.2 a. ßDC = ρDC,Germany (σDC/σGermany) = (0.44)(0.105/0.046) ≈ 1.00 relative to the MSCI German stock market index. b. RDC = RF + βDC (E[RM]-RF) = 0.05 + (1.00)(0.06) ≈ 0.110, or 11.0% c. ßGermany,World = ρGermany,World (σGermany/σWorld) = (0.494) (0.0526/0.0413) = 0.63 relative to the world market index. 23.3 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) = µ + βProdFProd+βOilFOil+βSpotFspot = 14%+(1.5)(2%)+(-0.80)(10%)+ (0.01)(-5%) = 14% + 3% - 8% - 0.05% = 8.95%. c. With an expectation of 8.95% and an actual return of only 4%, BP underperformed its expectation by 4.95% during the period. 23.4 a. According to Paribas’ factor sensitivities, Paribas 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 Paribas’ trading basket in the denominator of the foreign exchange quote. (Conversely, the negative sign on this last factor means that 87
- 88. Kirt C. Butler, Multinational Finance, 2nd edition Paribas is likely to rise with an appreciation of the euro in the numerator of the spot rate quote.) b. E(R) = µ + 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% and an actual return of only 22%, Paribas underperformed its expectation by 4.3% during the period. 23.5 a. E(R) = µ + βFM + βZFZ + βDFD = 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% and an actual return of 12%, Amazon.com outperformed its expectation by 3.15% during the period. 23.6 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. 23.7 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 U.S., winners lost some of their accumulated gain during the subsequent year. Momentum strategies hold promise for international markets. c. At the time of this writing, momentum effects had not been investigated in Latin American markets. Momentum appears to have a strong international component in the Rouwenhorst study, so there is a strong possibility that they will be found in Latin American stock markets as well. Chapter 24 Managing an International Investment Portfolio Answers to Conceptual Questions 24.1 List the various ways in which you might invest in foreign securities. International portfolio diversification can be obtained through several paths including: a) investment in MNCs, b) direct investment in individual foreign securities (through direct purchase in the foreign market, direct purchase in the domestic market through ADRs or American shares, globally diversified mutual funds or funds specializing in 88
- 89. Solutions to End-of-Chapter Questions and Problems international securities such as closed-end country funds), hedge funds, equity-linked Eurobonds (convertibles or warrants), or index futures, options or swaps. 24.2 Do MNCs provide international portfolio diversification benefits? If so, do they provide the same diversification benefits as direct ownership of companies located in the countries in which the MNC does business? Owning shares in an internationally diversified multinational corporation provides some indirect diversification benefits. Unfortunately, MNC share prices move more with the home market than with foreign markets, so MNCs do not provide the same diversification benefits as direct investment in foreign shares. 24.3 What is the difference between a passive and an active investment philosophy? Passive strategies do not try to shift assets in anticipation of market shifts. Rather, they follow a ‘buy-and-hold’ philosophy that identifies the types of assets that are to be held and then take advantage of diversification to achieve optimal performance. Active strategies try to shift between asset classes or between individual securities in an effort to anticipate changes in market values. 24.4 What makes cross-border financial statement analysis difficult? Barriers include differences in language, accounting measurement conventions (such as accounting for cash, goodwill, discretionary reserves, pension liabilities, and inflation), and financial disclosure requirements. 24.5 What is the difference between a legalistic and a nonlegalistic approach to accounting? In what countries are each of these systems found? Legalistic accounting systems (for example, on the European Continent) state “thou shalt do this” whereas nonlegalistic accounting systems (found in the common law systems of the U.S. and the U.K.) state “thou shalt not do that.” The legalistic systems proscribe definitions of accounting income and identify how to handle difficulties in accounting measurement. The nonlegalistic systems set limits on acceptable accounting practice. 24.6 What alternatives does a multinational corporation have when investors in a foreign country demand accounting and financial information? The MNC can do nothing, prepare convenience translations, restate selected items using the accounting principles of the foreign country, or prepare an entire second set of financial statements restated in the accounting principles of the foreign country. 24.7 You are planning for retirement and must decide on the inputs to use in your asset allocation decision. Knowing the benefits of international portfolio diversification, you want to include foreign stocks and bonds in your final portfolio. What statistics should you collect on the world’s major national debt and equity markets? Can you trust that the future will be like the past? As a start, you should collect data on mean returns, variances, and covariances in the world’s major national debt and equity markets. Keep in mind that past performance is 89
- 90. Kirt C. Butler, Multinational Finance, 2nd edition no guarantee of future investment success. Expected returns, variances and covariances of international debt and equity returns are variable, especially over the short run. 24.8 Which benefits more from currency hedging - a portfolio of international stocks or a portfolio of international bonds? Nearly all of the variation in bond returns within a country come from changes in interest rates in that country. Stocks have a much larger random component. Without the additional security-specific variability of stocks, the percentage of currency risk in the return variance of an international bond portfolio is much higher than in an international stock portfolio. Currency risk hedging is much more effective in reducing the variability of foreign bond investments than of foreign stock investments. Problem Solutions 24.1 At the end of the year, Frau Gatti’s accounts will look like this: Gnomes of Zurich Bank - Account of Frau Gatti 31 Dec., 199x Number of Local Capital Div or Spot Capital Div or Market Sub- Security shares or price amount accr int rate amount accr int value totals (& div yield or interest rate) par value (local) (local) (SF/f) (SF) (SF) (SF) % Equities DM DM SF SF SF SF Daimler Benz (1,6%) 1.000 shs 704 704.000 11,264 0,842/DM 592.768 9.484 602.252 11,8 ¥ ¥ SF SF SF SF Mazda Motors (0%) 50.000 shs 372 18.600.000 0 0,01152/¥ 214.272 0 214.272 4,2 $ $ SF SF SF SF General Motors (2,4%) 2.000 shs 58¼ 116.500 2,796 1,204/$ 140.266 3.366 143.632 2,8 Bonds ECU ECU SF SF SF SF French Govt ECU 6% 2004 1.000.000 90.20 902.000 60.000 1,560/ECU 1.407.120 93.600 1.500.720 29,4 DM DM SF SF SF SF German Govt 6.875% 2005 1.000.000 101.05 1.010.500 68.750 0,842/DM 850.841 57.888 908.729 17,8 $ $ SF SF SF SF U.S. Govt 6.5% 2005 1.000.000 102.42 1.024.200 65.000 1,204/$ 1.233.137 78.260 1.311.397 25,7 Cash SF SF SF SF SF SF Swiss Francs (1,4%) 409.115 409.115 5.728 409.115 5.728 414.842 8,1 SF SF SF Total 4.847.518 248.326 5.095.844 100 SF Beginning cash balance 409.115 Deduct divs & accrued int (SF) (SF248.326) SF Add to cash balance (SF) + 248.326 SF Ending cash (SF) 657.440 In many European countries, the meaning of decimal points and commas is reversed. For example, “one thousand” is written “1.000” instead of “1,000” and “one and a quarter” is written “1,25” rather than “1.25.” This makes the accounts appear odd to an American observer. 24.2 a. NAVWon = (W8,000/share)(1,000,000 shares) + (W4,000/share)(1,000,000 shares) + (W8,000/share)(500,000 shares) = W16 billion b. (W16 billion) / (W800/$) = $20 million c. The fund is worth ($22/share)(1,000,000 shares) = $2 million in the U.S. and is selling at a ($22,000,000)/($20,000,000)-1 = 10 percent premium to NAV. As to whether this is a good investment, the answer is “it depends.” If this fund is to be open-ended or if investment restrictions into South Korea are likely to be relaxed in the near future, then the U.S. price is likely to fall back to NAV and this is not a 90
- 91. Solutions to End-of-Chapter Questions and Problems good investment. On the other hand, the premium may be justified if restrictions on foreign investment into South Korea are expected to be retained or even tightened. Perhaps an investment into other Southeast Asian companies that are not subject to these investment restrictions could provide similar diversification benefits without the high cost of the Korea Foods fund. 24.3 First of all, your return statistics will have a great deal of statistical precision in the sense that you’ll have a large number of observations. However, these statistics won’t be very timely in the sense that they’ll be estimated over periods (war, rapid economic expansion, depression, oil crisis, etc.) that might not match the current period. Market returns vary with the business cycle, and return statistics (correlations in particular) markedly fluctuate over time. Second, past performance is no guarantee of future results. Even if your return statistics are accurate, your performance over the coming year will have a large element of chance and will almost surely diverge from the past. 24.4 a. The major argument for regulation of hedge funds is that they are exerting an increasing influence over financial markets and hence should be regulated to avoid a situation in which they precipitate or acerbate a market collapse. The major argument against regulation is that they are private investment partnerships and hence should not be subject to public disclosure requirements. b. The arguments for and against public disclosure are the same as those for and against increased regulation. The Securities and Exchange Commission was established to protect investors from fraud and misrepresentation in public securities issues. The legal rules could be loosened to include hedge funds in the definition of a public issue. Ultimately, a line must be drawn to distinguish private from public investment funds. 91
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- 93. Kirt C. Butler, Multinational Finance, 2nd edition 92