6 04-08-17solutions Manual

Solutions to End-of-Chapter Questions and Problems
Solutions
to
End-of-Chapter
Questions and Problems
in
Multinational
Finance
by Kirt C. Butler
1
Kirt C. Butler, Multinational Finance, 2
nd
edition
Second Edition
2
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 MNCs 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
nd
edition
Chapter 2 World Trade and the International Monetary System
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 worlds goods markets affected world trade? How has
globalization in the worlds financial markets affected world trade?
Some of the economic consequences of globalization in the worlds 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
2.5 Describe the International Monetary Funds balance-of-payments accounting system.
The IMF publishes a monthly summary of cross-border transactions that tracks each
countrys 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 IMFs 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
nd
edition
PART II International Currency and Eurocurrency Markets
Chapter 3 The Foreign Exchange and Eurocurrency Markets
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
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). Youre selling dollars, so youll get the
banks 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)/($0.67/DM) - 1 = -0.164
7
nd
edition
3.6 a. FM5,000,000 / (FM4.0200/$) = $1,243,781. Tokyos bid price for FM is their ask
price for dollars. So, FM4.0200/$ 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 P
0
$
= P
0
/S
0
/$
= (104,000,000)/(1.04/$) = $1 million. When you
buy back the yen, you must pay P
1
$
= P
1
/S
1
/$
= (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 S
Pts/$
= 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
$/
= (1/0.90)-1 = +0.111, or an 11.1% appreciation.
b. (1+s
Rbl/$
) = 11 = 1/(1+s
Rbl/
)s
$/Rbl
= (1/11)-1 = -0.909, or a 90.9% depreciation.
3.10 The 90-day dollar forward price is 33 basis points below the spot price: F
1
SFr/$
-S
0
SFr/$
=
(SFr0.7432/$-SFr0.7465/$) = -SFr0.0033/$. The percentage dollar forward discount is
(F
1
SFr/$
-S
0
SFr/$
)/S
0
SFr/$
= (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. S
1
$/
= S
0
$/
(1+ s
$/
) = ($0.0100/)(1.2586) = ($0.012586/)
b. (1+ s
/$
) = S
1
/$
/S
0
/$
= (1/S
1
$/
) / (1/S
0
$/
) = 1 / (S
1
$/
/S
0
$/
) = 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
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
V
$/BF
Dows exposure
c. The expected cash flow in dollars is E[CF
1
$
] = E[CF
1
BF
] E[S
1
$/BF
] = (BF40,000,000)
($0.025/BF) = $1,000,000. Actual dollar cash flow is CF
1
$
= CF
1
BF
S
1
$/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
F
1
$/BF
= $0.025/BF, or F
1
BF/$
= BF40/$.
+$1,000,000
BF40,000,000
The Belgian franc is being sold forward, so Dows 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.
V
$/BF
V
$/BF
Forward
exposure
3.15 (F
t
d/f
-S
0
d/f
)/S
0
d/f
= [(1/F
t
f/d
)-(1/S
0
f/d
)]/(1/S
0
f/d
) = [(S
0
f/d
/F
t
f/d
)-(S
0
f/d
/S
0
f/d
)]/(S
0
f/d
/S
0
f/d
)
= [(S
0
f/d
/F
t
f/d
) - 1] = (S
0
f/d
- F
t
f/d
) / F
t
f/d
.
9
nd
edition
Chapter 4 The International Parity Conditions
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
A
S
f/d

B
S
d/f
1 for banks A and B and
currencies d and f). Triangular arbitrage is conducted across three different cross exchange
rates (such that S
d/e
S
e/f
S
f/d
1 for currencies d, e, and f). Covered interest arbitrage takes
advantage of a disequilibrium in the interest rate parity condition [(F
t
d/ f
) / (S
0
d/ f
)] (1+i
d
) /
(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
t
d/f
]/S
0
d/f
=
[(1+i
d
) / (1+i
f
)]
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
t
d/f
] / S
0
d/f
= [(1+i
d
) /
(1+i
f
)]
t
= [(1+p
d
) / (1+p
f
)]
t
= F
t
d/f
/ S
0
d/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+i
d
) / (1+i
f
)]
t
= [(1+p
d
) / (1+p
f
)]
t
.
10
Problem Solutions
4.1 a. S
DM
= S
/$
S
$/DM
= (200/$)($0.50/DM) = 100/DM
b. S
DM
= S
/$
/S
DM/$
=(100/$)/(DM1.60/$) = 62.5/DM.
4.2 S
DM/$
S
$/
S
/DM
= 1.0326 > 1. Triangular arbitrage would yield a profit of 3.26 percent of
the starting amount. For triangular arbitrage to be profitable, transactions costs on a
round turn cannot be more than this amount.
4.3 The forward price is at a 9 basis point discount over six months, or 18 bps on an
annualized basis. The six-month percentage discount is (F
1
/$
/S
0
/$
)-1 = (0.6352/$)/
(0.6361/$)-1 = 0.9986-1 = 0.14%, or 0.28% on an annualized basis. Because F
t
/$
=
E[S
t
/$
] 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/Ps28.7356/Ps)/(28.7356/Ps) = 0.125%
Mexico City quote for yen: (Ps0.03420/Ps0.03416/)/(Ps0.03416/) = 0.117%
b. The Mexican banks 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/$)-1 = 10.526%.
4.7 a. In this problem, we know the spot and forward rates and U.S. inflation. The real and
nominal interest rates are not needed: F
1
/$
/S
0
/$
= (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[P
1
D
] = P
0
D
(1+p
D
) = D100(1.10) = D110
E[P
1
F
] = P
0
F
(1+p
F
) = F1(1.21) = F1.21
E[S
1
D/F
] = E[P
1
D
] / E[P
1
F
] = D110 / F1.21 = D90.91/F.
11
nd
edition
b. E[P
2
D
] = P
0
D
(1+p
D
)
2
= D100(1.10)
2
= D121
E[P
2
F
] = P
0
F
(1+p
F
)
2
= F1(1.21)
2
= F1.4641
E[S
2
D/F
] = E[P
2
D
]/E[P
2
F
] = D121/F1.4641
= S
0
D/F
[(1+p
D
)/(1+p
F
)]
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
F
FM/$
/S
FM/$
= (FM3.9888/$)/(FM4.0200/$) = (1+i
FM
)/(1+i
$
) = (1+i
FM
)/(1+0.0175) =>
i
FM
= 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 $10,000,000 by borrowing FM40,200,000. Your obligation on
this contract will be (FM40,200,000)(1.009603) FM40,586,040 which is exactly
offset by the proceeds from your forward contract.
4.10 a. F
t
Bt/$
/S
0
Bt/$
= (1 + i
Bt
)
t
/(1 + i
$
)
t
= (Bt 25.64/$)/(Bt 24.96/$) = (1 + i
Bt
)/(1.06125)
1.02724 = (1 + i
Bt
)/1.06125 i
Bt
= 9.02%
b. F
1
Bt/$
/S
0
Bt/$
= (Bt25.64/$)/(Bt24.96/$) = 1.027 < (1+i
Bt
)/(1+i
$
) = (1.1)/(1.06125) =
1.037. So, borrow at i
$
and lend at i
Bt
.

+
Bt24,960,000
$1,000,000
Convert to baht at the spot exchange rate

+Bt27,456,000
Bt24,960,000
Invest at the 10% baht interest rate

$1,061,250
+$1,000,000
Borrow at the 6.125% dollar interest rate

Bt27,456,000
+
$1,070,827
Cover baht forward
This leaves a net gain at time 1 of $1,070,827 - $1,061,250 = $9,577, which is worth
$9,577/1.06125 = $9,024 in present value.
12
4.11 F
1
AA/$
/S
0
AA/$
= (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; F
1
$/S$
/S
0
$/S$
= ($0.51/S$)/($0.50/S$) =
1.02, or 2% per year. This is less than is warranted by the difference in interest rates
(1+i
$
)/(1+i
S$
) = (1.06)/(1.04) = 1.019231, so F
1
$/S$
/S
0
$/S$
> (1+i
$
)/(1+i
S$
). 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.
-$1,060,000
+$1,000,000
Convert to S$2,000,000 = ($1,000,000)/($0.50/S$) at S
0
$/S$
= $0.50/S$.
+S$2,000,000
-$1,000,000
Invest S$2,000,000 at the Singapore interest rate of i
S$
= 4.0%.
+S$2,080,000
-S$2,000,000
Cover this S$ forward obligation by selling S$ in the forward market.
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+$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 S
0
$/
= $1.25/.
+$112,047
-89,638
Invest in dollars at the U.S. dollar rate of i
$
= 9.82%.
-$112,047
+$123,050
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. F
1
$/
/S
0
$/
= ($1.20/)/($1.25/) = 0.96 <
14
=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 [V
2
/V
0
]-1 = [(1+i
1
)(1+i
2
)]-1. Mean geometric return is i
avg
=
[(1+i
1
)(1+i
2
)]
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 i
avg
= [(1+1)(1-0.5)]
1/2
-1 = 0.
With continuously compounded returns, periodic rates are given by
1
= ln(1+i
1
) =
ln(2) = +0.69315 and
2
= ln(1+i
2
) = ln(0.5) = -0.69315. The (arithmetic) average
return using continuously compounded rates is (
1
+
2
)/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 p
D
= ln(1+p
D
) = ln(1.10) = 9.531% and p
F
= ln(1+p
F
) = ln(1.21) =
19.062% in continuously compounded returns. Expected price levels and spot rates are:
E[P
1
D
] = P
0
D
e
(0.09531)
= (D100)(1.10) = D110
E[P
2
D
] = P
0
D
e
(2)(0.09531)
= (D100)(1.21) = D121
E[P
1
F
] = P
0
F
e
(0.19062)
= (F1)(1.21) = F1.21
E[P
2
F
] = P
0
F
e
(2)(0.19062)
= (F1)(1.4641) = F1.4641
E[S
1
D/F
] = E[P
1
D
] / E[P
1
F
] = D110 / F1.21 = D90.91/F
E[S
2
D/F
] = E[P
2
D
] / E[P
2
F
] = D121 / F1.4641 = D82.64/F
Chapter 5 The Nature of Foreign Exchange Risk
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 firms real (noncontractual) or operating
assets is called operating exposure.
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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
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
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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[P
1
F
] = P
0
F
(1+p
F
) = 1.21
E[P
1
D
] = P
0
D
(1+p
D
) = 1.10
E[S
1
D/F
] = (S
0
D/F
)(1+p
D
)/(1+p
F
) = (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[X
1
D/F
] = (E[S
1
D/F
]/S
0
D/F
)((1+p
F
)/(1+p
D
)) = ((D90.91/F)/(D100/F))(1.21/1.10) = 1.00,
or 100%.
c. E[P
2
F
]) = P
0
F
(1+p
F
)
2
= F1.4641
E[P
2
D
]) = P
0
D
(1+p
D
)
2
= D121
E[P
2
F
]) = P
0
F
(1+p
F
)
2
= F1.4641
E[P
2
D
]) = P
0
D
(1+p
D
)
2
= D121
E[S
2
D/F
]

= S
0
D/F
((1+p
D
)/(1+p
F
))
2
=

(D100/F)(1.10/1.21)
2
D82.64/F
The real exchange rate is not expected to change: E[X
2
D/F
] = (E[S
2
D/F
]/E[S
0
D/F
])
[(1+p
F
)/(1+p
D
)]
2
= ((D82.64/F)(D100/F)) / (1.21/1.10)
2
= 1.00, or 100%.
5.2 a. s
/DM
= (S
0
/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[S
0
/DM
] = (S
-1
/DM
) [(1+p
)/(1+p
DM
)] = (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) = (S
0
/DM
-E[S
0
/DM
])/E[S
0
/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
= ((S
0
/DM
)/(S
-1
/DM
)) ((1+p
DM
)/(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 x
DM/
= ((S
0
DM/
) / (S
-1
DM/
)) ((1+p
) / (1+p
DM
)) - 1
= ((S
0
/DM
)
-1
/ (S
-1
/DM
)
-1
) ((1+p
) / (1+p
DM
)) - 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/$
= (S
1
Fl/$
/S
0
Fl/$
)-1 = (
Fl
1.55/$)/(
Fl
1.60/$)-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
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 (R
new
)/(R
old
)-1 = ((1.32Q)(0.90P) / (Q)(P))-1 = +18.8%.
5.4
t
2
= (0.0034) + (0.40)(0.05)
2
+ (0.20)(0.10)
2
= 0.0064
t
= 0.08, or 8%.
PART III The Multinational Corporations Investment Decisions
Chapter 6 Multinational Corporate Strategy
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 MNCs 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.
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According to product cycle theory, the firms 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 MNCs 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 firms 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
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, lets 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 Motorolas 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
Chinas 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
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
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7.2 Discuss each cell in Figure 7.4. What should (or shouldnt) 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: NPV
d
>0 but NPV
f
<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: NPV
d
<0 but NPV
f
>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 NPV
d
> NPV
f
> 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
(NPV
d
> NPV
f
) but also exposes the firm to currency risk. If 0 < NPV
d
< NPV
f
, then the
parent can capture a higher expected return (NPV
f
> NPV
d
) 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+i
Ren
) = (1.15)/( 1.11745) (1+p
$
)/(1+p
Ren
) = (1.06)/(1.03) 1.0291.
Discounting renminbi cash flows at the renminbi discount rate yields
NPV
Ren

= -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[S
t
$/Ren
]/E[S
0
$/Ren
] = [(1+E[p
$
])/(1+E[p
Ren
])]
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[S
1
$/Ren
] = ($0.5526)[(1.06)/(1.03)]
1
= $0.5687/Ren
E[S
2
$/Ren
] = ($0.5526)[(1.06)/(1.03)]
2
= $0.5853/Ren
E[S
3
$/Ren
] = ($0.5526)[(1.06)/(1.03)]
3
= $0.6023/Ren
Based on these spot exchange rates, expected dollar cash flows are:
22
E[CF
0
$
] = (Ren600)($0.5526/Ren) = $331.56
E[CF
1
$
] = (Ren200)($0.5687/Ren) = $113.74
E[CF
2
$
] = (Ren500)($0.5853/Ren) = $292.63
E[CF
3
$
] = (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
NWC -50000 60500 grows at 10% inflation rate
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
NPV at i
Euro
= 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,
Expected dollar CFs -2000000 2608000 4697800
NPV at i
$
= 20% $3,435,694
7.3 a. i
W
= (1+p
W
)(1+r
W
) - 1 = (1.50)(1.10)-1 = 65%
i
L
= (1+p
L
)(1+r
L
) - 1 = (1.00)(1.10)-1 = 10%
b. E[S
1
W/L
] = (S
0
W/L
) [(1+p
W
) / (1+p
L
)]
t
= (W100/L) [(1.50) / (1.00)] = W150/L
E[S
2
W/L
] = (S
0
W/L
) [(1+p
W
) / (1+p
L
)]
t
= (W100/L) [(1.50) / (1.00)]
2
= W225/L
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nd
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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 (P
0
W
=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 CF
W
267,500 376,250 CF = NI + Depreciation
Total NCF
W
-400,000 267,500 701,250
NPV
W
at 65% W19,697
NPV
L
= NPV
W
/ S
0
W/L
= L197
d. E[CF
t
L
] = E[CF
t
W
] / E[S
t
W/L
] E[CF
0
L
] = (-W400,000) / (W100/L) = -L4,000
E[CF
1
L
] = (W267,500) / (W150/L) = L1,783
E[CF
2
L
] = (W701,250) / (W225/L) = L3,117
NPV
L
= -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
i
Bt
= 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
NPV
0
Bt
= Bt5,413,548
b. (1+i
Bt
)=(1+r
Bt
)(1+p
Bt
) r
Bt
= (1.20/1.10)-1=0.0909091 r

= 9.09091%
i
= (1.0909091)(1.05) - 1 = 0.1454545, or 14.54545%

c. E(S
1
Bt/
) = (Bt0.25/)(1.20/1.1454545) = Bt.2619048/
E(S
2
Bt/
) = (Bt0.25/)(1.20/1.1454545)
2
= Bt.2743764/
E(S
3
Bt/
) = (Bt0.25/)(1.20/1.1454545)
3
= Bt.2874420/
E(S
4
Bt/
) = (Bt0.25/)(1.20/1.1454545)
4
= Bt.3011297/
E(S
5
Bt/
) = (Bt0.25/)(1.20/1.1454545)
5
= Bt.3154692/
24
d. Recipe #1: NPV
= Bt5,413,548/(Bt0.25/) = 21,654,192
Recipe #2: NPV
0
= 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.
NPV
Ren
= [
t
E[CF
t
Ren
] / (1+i
Ren
)
t
]
= [-Ren600+Ren200/(1.1175)+Ren500/(1.1175)
2
+Ren300/(1.1175)
3
]
= Ren194.39
NPV
$
= (S
0
$/Ren
) (NPV
Ren
) = ($0.5526/Ren)(Ren194.39) = $107.42
Discount in dollars.
NPV
$
=
t
{E[S
t
$/Ren
]E[CF
t
Ren
] / (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 parents 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.
NPV
Ren
= [
t
E[CF
t
Ren
] / (1+i
Ren
)
t
]
= [-Ren600 + Ren200/(1.1175) + Ren500/(1.1175)
2
+Ren300/(1.1175)
3
]
= Ren194.39
NPV
$
= (S
0
$/Ren
) (NPV
Ren
) = ($0.5526/Ren)(Ren194.39) = $107.42
Discount in $:
NPV
$
=
t
{E[S
t
$/Ren
]E[CF
t
Ren
] / (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
nd
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26
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
NPV
ren
= -
Ren
600m+
Ren
200m/(1.11745)
2
+
Ren
500m/(1.11745)
3
+
Ren
300m/(1.11745)
4

=
Ren
110.90 million, or
NPV
$
= (
Ren
110.90)($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 (
Ren
600m)(0.0506-0.0403)(1-0.4) =
Ren
3.708 million. The present value
of a three-year annuity of
Ren
3.708 million discounted at 3.036% is
Ren
10.48 million.
7.8 NPV
Ren
=
Ren
194.39 million without the side effect. The airport project reduces this value
by
Ren
100 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,
NPV
ren
= -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.
V
project with side effect
= V
project without side effect
+ V
side 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 Hooks treasure chest is riskless.
27
nd
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Chapter 8 Taxes and Multinational Corporate Strategy
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
Problem Solutions
8.1 Indias currency is the rupee (Rp). Thailands currency is the bhat (Bt). From equation
(8.1), interest rates in India are i
Rp
= (i
Bt
)(1-t
Bt
)/(1-t
Rp
) = (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
Parents 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
nd
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30
b. If produced in the U.S., Quacks 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
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 countrys
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 countrys
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 countrys 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
nd
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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
corporations 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
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 Russias 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 companys 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
i

= 0.3 has greater total risk than the domestic
asset with a standard deviation of
i
= 0.2.
b. The foreign asset also has greater systematic risk:
i
=
iW
(
i
/
W
) = (0.3)
(0.3/0.1) = 0.9 >
i
=
iW
(
i
/
W
) = (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
nd
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Chapter 10 Real Options and Cross-Border Investment
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
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 firms 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 Grolschs invest in Dubiety, the decision tree looks like:
Invest today
Invest in one year
Invest at P
beer
=
D
75
Invest at P
beer
=
D
25
NPV
0
D
= ?
NPV
0
D
|P
beer
=
D
75 = ?
NPV
0
D
|P
beer
=
D
25 = ?
b. Equation (9.2) from the text must be modified to include fixed costs:
INVEST TODAY: NPV
0
=
( ) P - V Q- F
i
0 I
NPV(invest today)
= [((
D
50/btl-
D
10/btl)(1,000,000 btls) -
D
10,000,000)/0.10] -

D
200,000,000
=
D
100,000,000 invest today?
c. Equation (9.3) from the text must be modified to include fixed costs:
WAIT ONE YEAR: NPV
0
=
( ) P- V Q- F
i
(1 i)
0 I
]
]
]
+
NPV|P
beer
=
D
75
= [(((
D
75/btl-
D
10/btl)(1,000,000 btls)-
D
10,000,000)/0.10)/(1.10)]-
D
200,000,000
=
D
300,000,000 invest
NPV|P
beer
=
D
25
= [(((
D
25/btl-
D
10/btl)(1,000,000 btls)-
D
10,000,000)/0.10) / (1.10)]-
D
200,000,000
35
nd
edition
= -
D
154,545,455 < $0 dont invest
NPV(wait one year)
= [Prob(P
1
=
D
75)](NPV|P
1
=
D
75)+[Prob(P
1
=
D
25)](NPV|P
1
=
D
25)
= () (
D
300,000,000) + ()(
D
0)
= +
D
150,000,000 > NPV(invest today) >
D
0
d. Option Value = Intrinsic Value + Time Value
NPV(wait one year) = NPV(invest today) + Opportunity cost of investing today
D
150,000,000 =
D
100,000,000 +
D
50,000,000
e. Wait one period before deciding to invest.
10.2 a.
Abandon today
Abandon in one year
Abandon at P
beer
=
D
35
Abandon at P
beer
=
D
15
NPV
0
D
= ?
NPV
0
D
|P
beer
=
D
35 = ?
NPV
0
D
|P
beer
=
D
15 = ?
b. The problem states that the current price of beer is
D
15 in perpetuity. The statement
in perpetuity clearly cannot hold because prices in one year are stated to be
either
D
15 or
D
35 with equal probability. Lets assume that the price is currently
D
15 per bottle and will either remain at
D
15 or will rise to
D
35 by time 1. For
simplicity, lets also assume end-of-year beer prices and cash flows so that we
dont have to worry about the path of beer prices during the year. In this setting,
the current price of
D
15/bottle is irrelevant to the abandonment decision. The
expected future price of
D
25 does matter. (If beer prices throughout the first year
either remain at
D
15 or rise at a constant rate to
D
35, then the expected price during
the first year is not
D
25 but rather [D15+(D15+D35)] =
D
20.)
Note that if the project is abandoned today at a cost of
D
10,000,000, 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 (
D
15/btl+
D
35/btl) =
D
25/btl, the NPV of the
abandon today alternative is:
NPV(abandon today)
= -[((
D
25/btl-
D
20/btl)(1,000,000 btls)-
D
10,000,000)/0.10]-D10,000,000
=
D
40,000,000 >
D
0 abandon today?
c. If Grolsch management waits one year before making its abandonment decision, beer
prices will be either
D
15 or
D
35 with certainty.
NPV|P
1
=
D
35
= -[(((
D
35/btl-
D
20/btl)(1,000,000 btls) -
D
10,000,000) /0.10)/(1.10)]-
D
10,000,000
= -
D
55,454,545 dont abandon if price rises to
D
35
36
NPV|P
1
=
D
15
= -[(((
D
15/btl-
D
20/btl)(1,000,000 btls) -
D
10,000,000) /0.10)/(1.10)]-
D
10,000,000
=
D
126,363,636 abandon if price falls to
D
15
NPV(wait one year)=[Prob(P
1
=
D
35)](NPV|P
1
=
D
35)+[Prob(P
1
=
D
15)](NPV|P
1
=
D
15)
= () (
D
126,363,636) + ()($0)
= +
D
63,181,818 > NPV(abandon today) >
D
0
NPV(wait one year) =NPV(abandon today)+Opportunity cost of abandoning today
+
D
63,181,818 = +
D
40,000,000 +
D
23,181,818
e. Wait one year before making the abandonment decision.
10.3 Lets 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
Invest in first brewery
NPV
0
D
=
D
?
If NPV
0
D
>
D
0, continue to invest
If NPV
0
D
<
D
0, dont invest further
b. At the expected end-of-year price of (
D
25/btl+
D
75/btl) =
D
50/btl, the NPV of a
single brewery is:
NPV(exploratory brewery)
= [((
D
50/btl-
D
10/btl)(1,000,000 btls)-
D
10,000,000)/0.10] -

D
200,000,000
=
D
100,000,000
NPV(invest in all five breweries today) = (5) NPV(exploratory brewery)
=
D
500,000,000
c. If Grolsch management waits one year before making its investment decision, beer
prices will be either
D
25 or
D
75 with certainty in this problem. Of course, it wont
know this until it invests in the first brewery.
NPV|P
beer
=
D
75
= [((
D
75/btl-
D
10/btl)(1,000,000 btls)-
D
10,000,000)/0.10]-
D
200,000,000
=
D
350,000,000 invest in additional capacity
If P
beer
=
D
75, investment in four additional breweries at time t=1 yields a net present
value at time zero of (4)(
D
350,000,000/1.10) =
D
1,272,727,273.
37
nd
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NPV|P
beer
=
D
25
= [((
D
25/btl-
D
10/btl)(1,000,000 btls)-
D
10,000,000)/0.10]-
D
200,000,000
= -
D
150,000,000 < $0 dont invest in additional capacity
If P
beer
=
D
25, 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(P
1
=
D
75)] (NPV|P
1
=
D
75) + [Prob(P
1
=
D
25)] (NPV|P
1
=
D
25)
= ()[(
D
350,000,000) +(4)(
D
350,000,000/1.10)] + ()(-
D
150,000,000)
= +
D
736,363,636 > NPV(invest in all five today) = +
D
500,000,000 >
D
0
NPV(wait one year) = NPV(invest today) + Opportunity cost of investing in
four additional breweries today
D
736,363,636 =
D
500,000,000 +
D
236,363,636
The NPV of investing in all five breweries today is -
D
236,363,636. 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:
NPV|C
1
=R12,000
= [((R18,000/car-R12,000/car)(10,000cars)/0.20]/1.20]-R100 million
= R150 million invest,
or NPV|C
1
=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(C
1
=R12,000)](NPV|C
1
=R12,000)
+ [Prob(C
1
=R18,000)](NPV|C
1
=R18,000)
= ()(R150,000,000) + ()(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(C
1
=R12,000)](NPV|C
1
=R12,000)
+ [Prob(C
1
=R18,000)](NPV|C
1
=R18,000)
= ()[(R150 million)+(9)(R150 million/1.20)] + ()(-R100 million)
38
= +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
Grolschs 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
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 firms 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.
11.3 What is synergy?
39
nd
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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 Japans 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
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
40
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?
Jensens 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
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) =
41
nd
edition
4.5% to Agile shareholders.
11.3 The BP-Amoco deal was lauded in the financial press for combining BPs strengths in
oil exploration and development with Amocos refining and distribution capabilities.
Amoco stock jumped about 26 percent to a record high of 52
1/8
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 VPs 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 Nissans equity or Volvos
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.
b. It aint business as usual for Japanese companies. Several key keiretsu members
have recently refused to bail out their banking affiliates. Through 1998, Toyota
42
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 Corporations Financial Decisions
Chapter 12 Multinational Treasury Management
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 firms risk exposures.
12.2 What function does a firms strategic business plan perform?
The strategic business plan performs the following functions: 1) identify the firms
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 firms 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.
12.6 What is a bankers acceptance, and how is it used in international trade?
43
nd
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A bankers 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.
Bankers 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.
44
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 banks
acceptance fee. A 5% annual rate compounded quarterly is the same as a 1%
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
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.
45
nd
edition
Problem Solutions
13.1a.
Taxes

20% tax rate 40% tax rate
R0 R2,000,000 R1,000,000
R500,000 R1,500,000 Taxable income
R200,000
R250,000
b. Expected taxes with no hedging:
() [(R500,000)(0.20)] + ()[(R1,000,000)(0.20) + (R500,000)(0.40)]
= () (R100,000) + () (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.
13.2a. Expected taxable income is ()($250,000) + ()(-$250,000) =

$0.
E[PV(taxes)|unhedged] = ()($125,000)-()($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 = ()($0) = $0, an
expected tax savings of $12,500.
b. Expected taxable income is ()($250,000) + ()(-$250,000) = $0.
E[PV(taxes)|unhedged] = ()($125,000)-()($125,000)/(1.00) = $0.
E[PV(taxes)|hedged] = (tax rate) times (expected taxable income) = ()($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 doesnt matter and future tax shields
have the same magnitude as current tax payments.
46
c. Expected taxable income is ()($250,000) + ()(-$250,000) = $0.
E[PV(taxes)|unhedged] = ()($125,000)-()($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.
13.3a. 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:
V
Bonds
+ V
Stock
= V
Bonds + Stock
+ =
$10,000 $10,000 $10,000
$6,000 $16,000
Firm value
c. Unhedged E[V
Bonds
] = ()($6,000-$2,000) + ()($10,000) = $7,000
+ E[V
Stock
] = ()($0) + ()($6,000) = $3,000
E[V
Firm
] = ()($6,000-$2,000) + ()($16,000) = $10,000
Hedged E[V
Bonds
] = $10,000
+ E[V
Stock
] = $1,000
E[V
Firm
] = $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
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 equitys 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.
47
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13.4a.
V
Bonds
+ V
Stock
= V
Bonds + Stock
+ =
$10,000 $10,000 $10,000
$4,000 $14,000
Firm value
b. Unhedged E[V
Bonds
] = ()($4,000-$2,000) + ()($10,000) = $6,000
+ E[V
Stock
] = ()($0) + ()($4,000) = $2,000
E[V
Firm
] = ()($4,000-$2,000) + ()($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 ()($6,000) + ()($16,000) = $11,000 with certainty
as in Problem 17.2. Payoffs are as follows:
Hedged E[V
Bonds
] = $10,000
+ E[V
Stock
] = $1,000
E[V
Firm
] = $11,000
Hedging avoids the $2,000 indirect cost as well as the 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.
13.5a. 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[V
FIRM
] = E[V
BONDS
] + E[V
STOCK
] = [()(9,000) + ()(10,000)] +
[()(0)+()(9,000)] = 9,500 + 4,500 = 14,000.
48
Hedged, firm value is V
FIRM
= V
BONDS
+ V
STOCK
= 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[V
FIRM
] = E[V
BONDS
] + E[V
STOCK
] = [()
(9,000-1,000) + ()(10,000)] + [()(0) + ()(9,000)] = 9,000 + 4,500 =
13,500. With hedging, V
FIRM
= V
BONDS
+ V
STOCK
= 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 ()(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[V
FIRM
] = E[V
BONDS
] + E[V
STOCK
] = [()(6,000-1,000) +
()(10,000)] + [()(0) + ()(8,000)] = 7,500 + 4,000 = 11,500. If the firm
hedges, then V
FIRM
= V
BONDS
+ V
STOCK
= 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
[()(9,000-6,000) + ()(19,000-18,000)] = 1,500+500 = 2,000.
Chapter 14 Transaction Exposure to Currency Risk
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 V
d/f
as a
function of S
d/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 corporations 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 corporations 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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14.5 What is leading and lagging? Why is it used by multinational corporations?
Leading and lagging is a way to reduce the firms 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.
50
U.S.
affiliate
Canadian
affiliate
Mexican
affiliate
Puerto Rican
affiliate
$500
$100
$600
14.3
V
0
$/
a. Underlying long euro exposure
V
$/
S
$/
S
0
$/
S
$/
V
$/
b. Hedges:
i) a short euro forward hedge
Short euro forward contract
S
$/
V
$/
ii) a short euro futures contract has the same exposure as this forward position.
iii) money market hedge
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Borrow an amount such that $X is due
in one period at an interest rate of i
$
Convert to euros at todays spot rate
Invest this amount at i
+($X)/(1+i
$
)
-($X)/(1+i
$
) s.t. [($X)/(1+i
$
)]/S
0
$/
= (1m)/(1+ i
[F
1
$/
(1m)/(1+i
$
)]/S
0
$/
= (1m)/(1+ i
(F
1
$/
/S
0
$/
) = [(1+i
$
)/(1+ i
)]
-(1m)/(1+ i
)
-($X)
+(1m)/(1+ i
) s.t. (F
1
$/
/S
0
$/
)=(1+ i
$
)/(1+ i
)
+(1m)
$X = F
1
$/
(1m)
-(1m)
Money market hedge
iv) short euro call option
Short euro call
V
$/
S
$/
V
$/
S
$/
Net position
Short euro call
14.4 a. Not necessarily. From interest rate parity, F
t
A$/$
/S
0
A$/$
= [(1+i
A$
)/(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.
52
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 $5 million forward. Hedging an anticipated transaction makes
good business sense when the anticipated transaction is highly likely to occur. If
Rupert is not sure that hell actually incur this additional dollar exposure, he should
probably wait before hedging.
f. Rupert should buy the U.S. dollar forward against the Australian dollar. Futures
contracts on the AS/$ 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
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 V
d
=
t
E[CF
t
d
]/
(1+i
d
)
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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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 R
t
d
=
d
+
f
s
t
d/f
+ e
t
d
. The regression coefficient
f
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
firms 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 firms 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.
54
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 firms 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 firms 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
$
=
R,s
(
R
/
s
) = (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. Sterlings 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.
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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
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.
56
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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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 doesnt 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 IASCs 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.
58
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
Cash
C$
320,000 $200,000 $213,333 $213,333 $213,333
A/R
C$
160,000 $100,000 $106,667 $106,667 $106,667
Inventory
C$
640,000 $400,000 $426,667 $426,667 $426,667
P&E
C$
480,000 $300,000 $300,000 $300,000 $320,000
Total assets
C$
1,600,000 $1,000,000 $1,046,667 $1,046,667 $1,066,667
Liabilities
A/P
C$
320,000 $200,000 $213,333 $213,333 $213,333
Wages
C$
160,000 $100,000 $106,667 $106,667 $106,667
Net worth
C$
1,120,000 $700,000 $726,667 $726,667 $746,667
Total liabs
C$
1,600,000 $1,000,000 $1,046,667 $1,046,667 $1,066,667
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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 (S
1
$/C$
/S
0
$/C$
)-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.
60
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
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.
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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 corporations 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 firms 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 = R
F
+ (E[R
W
] - R
F
) = 5% + (1.2)(12%-5%) = 13.4%.
b. R = R
F
+ (E[R
M
] - R
F
) = 5% + (1.4)(11%-5%) = 13.4%.
17.2 a. R = R
F
+ (E[R
W
] - R
F
) = 5% + (0.8)(10%-5%) = 9%.
b. R = R
F
+ (E[R
M
] - R
F
) = 5% + (1.2)(10%-5%) = 11%.
62
17.3 a. The required return on Oililys equity within the French market is R
F
+ (E[R
M
]-
R
F
) = 5% + (1.4)(11%-5%) = 13.4%. Oililys weighted average cost of capital is
i
WACC
= (B/V
L
)i
B
(1-T
C
)+(S/V
L
)i
S
= (0.4)(7%)(1-0.33)+(0.6)(13.4%) = 9.916%.
b. Required return on Oililys stock is R = 5%+(1.2)(12%-5%) = 13.4% for an
international investor. Using international sources, Oililys cost of capital is i
WACC
= (B/V
L
)i
B
(1-T
C
) + (S/V
L
)i
S
= ()(6%)(1-0.33) + ()(13.4%) = 8.710%.
c. Lets assume that the BFr1 billion operating cash flow is before interest expense.
In the French market, Oililys value is V
0
= CF
1
/ (i-g) = BFr10,000,000/(0.09916-
0.04) = BFr169,033,130. If Oilily can raise funds in the global market, Oililys
value is V
0
= CF
1
/ (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 markets higher tolerance for debt and lower required returns.
17.4 a. Grand Pets debt ratio is (B/V
L
) = 33/(33+100) = 0.25. The required return on
Grand Pets equity is R = R
F
+ (E[R
M
]-R
F
) = 5%+(1.2)(15%-5%) = 17%. Grand
Pets weighted average cost of capital is: i
WACC
= (B/V
L
)i
B
(1-T
C
)+(S/V
L
)i
S
= (0.25)
(6%)(1-0.33) + (0.75)(17%) = 13.755%.
b. The debt ratio is now (B/V
L
) = 50/(50+100) = 0.33. The required return on Grand
Pets equity in international markets is R = R
F
+ (E[R
W
]-R
F
) = 5%+(0.8)(10%-
5%) = 9%. Using international sources of capital, Grand Pets cost of capital is:
i
WACC
= (B/V
L
)i
B
(1-T
C
)+(S/V
L
)i
S
= (0.33)(5%)(1-0.33) + (0.67)(9%) = 7.117%.
c. Lets 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 Pets value is
V
0
= CF
1
/ (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 Pets value is
V
0
= CF
1
/ (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 = V
U
-CF
0
= (CF
1
)/(1+i
U
)-Initial investment
= (BFr112 million/1.10)-BFr100 million = BFr1,818,182.
b. Borrowing BFr50 million at 6% results in an interest payment of i
B
B = BFr3
million. The present value of the tax shield is (T
C
i
b
B)/1+i
B
) = (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 = V
U
-CF
0
= BFr12 million/0.10-BFr100 million =
BFr20,000,000. The value of the perpetual tax shield is T
C
B = (0.33)(BFr50
million) = BFr16,500,000. The levered firm worth BFr36,500,000.
17.6 a. All-equity value is
APV = V
U
-CF
0
= (CF
1
)/(1+i
U
)-Initial investment
= 108 million/1.08-100 million = 0.
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b. APV = V
U
+ PV(financing side effects)-Initial investment.
Borrowing 25 million at 6% results in an interest payment of i
B
B = 1.5 million.
The annual tax shield on this debt is T
C
i
b
B = 500,000. The present value of this
financing side effect is (T
C
i
B
B)/(1+i
B
) 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 = V
U
+ (T
C
i
B
B)/i
B
-CF
0
= V
U
+ T
C
B-CF
0

= 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
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 Boards 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:
S
d/f
V
d/f
Underlying exposure
Long the foreign currency
S
d/f
V
d/f
Futures hedge
Short the foreign currency
64
S
d/f
V
d/f
Underlying exposure
Short the foreign currency
S
d/f
V
d/f
Futures hedge
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
-i
f
). 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 s
t
d/f
2
on fut
t
d/f
1
, where d = the domestic currency,
f
2
= the currency in which transaction exposure is denominated, and f
1
= the currency
used to hedge against s
t
d/f
2
. If there is neither a currency nor a maturity mismatch, then
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.
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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
market
+Sh500,000
-$81,250
Sell marks in the U.S. dollar futures
market
+$81,250
-S$125,000
66
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 S
S$/$
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$0.2500/Sh =
F
S$/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:
N
Fut
*
= (amt in futures)/(amt exposed) = -
(amt in futures) = (- )(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
(r
2
= 0.89), and 3) delta-cross-hedge (r
2
=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 S
t
$/S$
= $0.6089/S$ i
$
= 6.24% i
S$
= 4.04%
Fut
t,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 S
t
$/S$
= $0.6089/S$ i
$
= 6.24% i
S$
= 4.54%
Fut
t,T
$/S$
= ($0.6089/S$) [(1.0624)/(1.0454)]
(51/365)
$0.6102/S$
Profit on futures: +($0.6102/S$-$0.6107/S$) -$0.0004/S$
Net gain -$0.0004/S$
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Scenario #3 S
t
$/S$
= $0.6089/S$ i
$
= 6.74% i
S$
= 4.04%
Fut
t,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 S
t
$/S$
= $0.6089/S$ i
$
= 6.24% i
S$
= 4.04%
Fut
t,T
$/S$
= ($0.6089/S$) [(1.0624)/(1.0404)]
(51/365)
$0.6107/S$
Profit on futures: +($0.6107/S$-$0.6107/S$) +$0.0000/S$
Net gain $0.0000/S$
Scenario #2 S
t
$/S$
= $0.6255/S$ i
$
= 6.24% i
S$
= 4.04%
Fut
t,T
$/S$
= ($0.6255/S$) [(1.0624)/(1.0404)]
(51/365)
$0.6273/S$
Profit on futures: +($0.6273/S$-$0.6107/S$) -$0.0166/S$
Net gain $0.0000/S$
Scenario #3 S
t
$/S$
= $0.5774/S$ i
$
= 6.24% i
S$
= 4.04%
Fut
t,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
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.
68
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
T
d/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
= F
T
d/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(S
d/f
-K
d/f
,0). For a put option, intrinsic value is equal to
max(K
d/f
-S
d/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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19.3 Exchange rate volatility and standard deviations:
a. A daily standard deviation of 0.742% measured over 252 trading days implies
T = (0.742%)(252) = 11.78% per year.
b. +2 : e
2(0.1178)
= e
0.2356
= 1.2657 (A$1.4/$)(1.2657) = A$1.7719/$
-2 : e
2(-0.1178)
= e
-0.2356
= 0.7901 (A$1.4/$)(0.7901) = A$1.1061/$
c.+2 : r = ln((A$1.7719/$)/(A$1.4/$)) = ln(1.2657) = +0.2356 0.1178/year
-2 : r = ln((A$1.1061/$)/(A$1.4/$)) = ln(0.7901) = -0.2356 0.1178/year
d. S
$/A$
= 1/S
A$/$

= 1/(A$1.4/$) = $0.714285/A$
+2 : e
2*(0.1178)
= 1.2657 ($0.7143/A$)(1.2657) = $0.9040/A$ A$1.1061/$
-2 : e
2*(-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:

- 3 -2 -1 0 1 2 3

- 3 -2 -1 0 1 2 3
S
d/f
S
d/f

-3 -2 -1 0 1 2 3

- 3 -2 -1 0 1 2 3
S
d/f
S
d/f

-3 -2 -1 0 1 2 3

-3 -2 -1 0 1 2 3
S
d/f
S
d/f
70
Spot exchange rate volatility and
at-of-the-money put option value
out-of-the-money put option value
in-the-money put option value
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:

Call
T
$/A$
F
T
$/A$
S
T
$/A$
S
T
$/A$
+
Put
T
$/A$
S
T
$/A$
=
19.6 The payoff profile of a purchased straddle at expiration is shown below.
V
T
/$
S
T
/$
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
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b. A short krone put is equivalent to a short pound call. Here are their payoff profiles.

Put
T
/DKr
S
T
DKr/
.11834/DKr DKr8.45/
.11834/DKr
S
T
/DKr
Call
T
DKr/
DKr8.48/
DKr.03/
c. These are payoff profiles for a short krone put and a the equivalent short pound call.

Put
T
/DKr
S
T
DKr/
DKr8.45/
.11633/DKr
S
T
/DKr
Call
T
DKr/
DKr8.5964/
+.1464/DKr
+.00204/DKr
.11834/DKr
.11633/DKr
Appendix 19-A Currency Option Valuation
19A.1
Option determinants are as follows: i
= i
$
= 0.05, T = year = 0.5, S
/$
= $80, K
/$
=
$100, and = 0.10. Assume these are continuously compounded rates. (If not, the
transformation from holding period to continuously compounded returns is i = ln(1+i).)
d
1
= [ln(S
d/f
/K
d/f
) + (i
d
-i
f
+
2
/2)T] / ( T)
= [ln((80/$)/(100/$)) + (0.05-0.05+(0.10)
2
/2)(0.5)] / (0.10)(0.5)
1/2
= -3.1204
d
2
= d
1
- T = -3.1204 - (0.10)(0.5)
1/2
= -3.1911
Call
d/f
=
- T
f
e
i
[S
d/f
N(d
1
)] -
- T
d
e
i
[K
d/f
N(d
2
)]
= e
(-0.05*.5)
[(80/$)(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.
72
19A.2
Option determinants: Same as above, except = 0.20.
d
1
= [ln(S
d/f
/K
d/f
) + (i
d
-i
f
+
2
/2)T] / ( T)
= [ln((80/$)/(100/$)) + (0.05-0.05+(0.20)
2
/2)(0.5)] / (0.20)(0.5)
1/2
= -1.5071
d
2
= d
1
- T = -1.5071 - (0.20)(0.5)
1/2
= -1.6486
Call
d/f
=
- T
f
e
i
[S
d/f
N(d
1
)] -
- T
d
e
i
[K
d/f
N(d
2
)]
= 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 $/ exchange rate is about 0.000877 from the currency
option pricing model. Taking the square root to find the standard deviation implied in
the option price, we get 0.0296 or 2.96% per year. As verification, here are the
calculations:
d
1
= [ln(S
d/f
/K
d/f
) + (i
d
-i
f
+
2
/2)T] / ( T)
= [ln(($.008345/)/($.0084/))+(0.04-0.04+(0.0296)
2
/2)(2.5/12)]/(0.0296)(2.5/12)
1/2

= -0.1169
d
2
= d
1
- T = -0.1169 - (0.0296)(2.5/12)
1/2
= -0.1637
Call
d/f
=
- T
f
e
i
[S
d/f
N(d
1
)] -
- T
d
e
i
[K
d/f
N(d
2
)]
= 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: F
t
d/f
/ S
0
d/f
= [(1+i
d
)/(1+i
f
)]
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 Londoners
perspective. The current spot rate is S
0
/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.
d
1
= [ln(S
d/f
/K
d/f
) + (i
d
-i
f
+
2
/2)T] / ( T)
= [ln((0.11830/DKr)/(0.11765/DKr))+(0.0174-0.0130+(0.05)
2
/2)(1)]/(0.05)(1)
1/2
= +0.2244
d
2
= d
1
- T = +0.2244 - (0.05)(1)
1/2
= +0.1744
Call
d/f
=
- T
d
e
i
[F
t
d/f
N(d
1
) - K
d/f
N(d
2
)]
= 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.
-0.002
0.000
0.002
0.004
0.006
0.008
0.010
0.012
0.014
0.016
0.018
0.0900 0.0950 0.1000 0.1050 0.1100 0.1150 0.1200 0.1250
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 45
o
line is the intrinsic value of the option. European put option
values can be below intrinsic value because they cannot be exercised until expiration.
74
-0.020
0.000
0.020
0.040
0.060
0.080
0.100
0.120
0.0000 0.0200 0.0400 0.0600 0.0800 0.1000 0.1200 0.1400 0.1600
19A.5 Lets 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
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?
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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%.
76
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%
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.
LPs 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, JIs 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 BDs fixed-rate outflows
and inflows (7.45%-6.13% = 132 bps) to a money market yield, BDs 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
banks 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.
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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 GEs fixed-rate outflows and inflows (8.34%-7.44% =
90 bps) to a money market yield, GEs 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, SPs 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, FMCs 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 PMs fixed-rate outflows and inflows (9.83%-
8.22% = 161 bps) to a money market yield, PMs 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 Worlds Capital Markets
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?
78
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?
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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 Matsushitas 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 7%
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:
yield =
Coupon rat e +
100% - Price
Years to m aturity
100%
Price
|
.
`
,
|
.
`
,
= (7.25% + [(100%-100%)/2])(100%/100%) = 7.25%.

21.5 Matsushitas 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.
80
Chapter 22 International Portfolio Diversification
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?
Sharpes measure captures the ex post return/risk performance of an asset by dividing
return in excess of the riskfree rate by the assets standard deviation of return. In other
words, it measures the assets 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.
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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[R
P
] = ()(0.166)+()(0.158) = 0.1620, or 16.2%
Var(R
P
) = ()
2
(0.290)
2
+()
2
(0.295)
2
+ 2()()(0.567)(0.290)(0.295) = 0.067
P
= (0.0670)
1/2
= 0.2589, or 25.89%
SI = (R
P
- R
F
)/
P
= (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[R
P
] = ()(0.177)+()(0.158) = 16.75%
Var(R
P
) = ()
2
(0.357)
2
+()
2
(0.295)
2
+ 2()()(0.330)(0.357)(0.295) = 0.071
P
= (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[R
P
] = ()(0.136)+()(0.133) = 13.45%
Var(R
P
) = ()
2
(0.161)
2
+()
2
(0.101)
2
+ 2()()(0.360)(0.161)(0.101) = 0.012
P
= (0. 012)
1/2
= 0.1094, or 10.94%
either stocks (0.422) or bonds (0.644) alone.
22.4 E[R
P
] = (1/3)(0.177)+(1/3)(0.176)+(1/3)(0.143) = 16.53%
Var(R
P
) = (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
P
= (0. 0449)
1/2
= 0.2119, or 21.19%
the Japanese (0.305), U.S. (0.457), or U.K. (0.361) indices alone.
22.5
U.S.G
= +1:

pt
= (X
U.S.
U.S.
+ X
G
G
) = (0.5)(0.1) + (0.5)(0.2) = 0.15
U.S.G
= -1:

pt
= (X
U.S.
U.S.
- X
G
G
) = (0.5)(0.1) - (0.5)(0.2) = -0.05
U.S.G
= 0:
pt
= (X
U.S.
2
U.S.
2
+ X
G
2
G
2
)
= [(0.5)
2
(0.1)
2
+ (0.5)
2
(0.2)
2
]

=
0.11
U.S.G
= 0.3:

pt
= (X
U.S.
2
U.S.
2
+ X
G
2
G
2
+ 2X
U.S.
X
G
U.S.
U.S.G
)

= [0.5
2
0.1
2
+ 0.5
2
0.2
2
+ 2(0.5)(0.5)(0.1)(0.2)(0.3)]

= 0.1245
22.6 E[R
p
] = X
A
E[R
A
] + X
B
E[R
B
] + X
C
E[R
C
] = 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
82
assets ex ante.
22.8 s
d/f
= (S
t
d/f
/S
t-1
d/f
)-1= (0.7182/$)/(0.7064/$)-1 = 1.0168-1 = 1.68%
R
d
= R
f
+ S
d/f
+ R
f
S
d/f
= 0.1600 + 0.0168 + (0.1600)(0.0168) = 17.95%
22.9 (1+R
$
) = (1+R
Peso
)(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(R
Peso
) = 0.248 and Var(s
$/Peso
) = 0.327. Then Var(R
$
) =
Var(R
Peso
) + Var(s
$/Peso
) + Var(R
Peso
s
$/Peso
) + 2Cov(R
Peso
,s
$/Peso
) = 0.248 + 0.327 + 0 + 0 =
0.575.
Chapter 23 International Asset Pricing
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 assets 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?
83
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An integrated capital market is one in which the law of one price holds. Some sort of
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 Rolls Critique of the CAPM? Does it apply to the IAPM? Does it apply to
APT?
Rolls 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 R
j
=
j
+
1j
F
1
+ ... +
Kj
F
K
+ e
j
. The
good news is that APT is not a tautology like the CAPM and hence is not subject to
Rolls 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.
84
23.14 What is momentum? Can it lead to profitable investment opportunities for
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. Jorions 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. R
S
= R
F
+
S
(R
M
- R
F
) = 8% + [16.5% - 8%] (1.5) = 20.75%.
b. R
S
= R
F
+
S
(R
M
- R
F
) = 4% + [16.5% - 8%] (1.2) = 14.2%.
23.2 a.
DC
=
DC,Germany
(
DC
/
Germany
) = (0.44)(0.105/0.046) 1.00 relative to the
MSCI German stock market index.
b. R
DC
= R
F
+
DC
(E[R
M
]-R
F
) = 0.05 + (1.00)(0.06) 0.110, or 11.0%
c.
Germany,World
=
Germany,World
(
Germany
/
World
) = (0.494) (0.0526/0.0413) = 0.63
relative to the world market index.
23.3 a. According to BPs 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 BPs trading basket in the denominator of the spot rate.
b. E(R) = +
Prod
F
Prod
+
Oil
F
Oil
+
Spot
F
spot

= 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
85
nd
edition
exchange quote. (Conversely, the negative sign on this last factor means that
Paribas is likely to rise with an appreciation of the euro in the numerator of the
spot rate quote.)
b. E(R) = +
Prod
F
Prod
+
Oil
F
Oil
+
Term
F
Term
+
Risk
F
Risk
+
Spot

F
spot
= 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) = + F
M
+
Z
F
Z
+
D
F
D
= 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 Titmans
[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 Rouwenhorsts [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
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
86
ADRs or American shares, globally diversified mutual funds or funds specializing in
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 worlds 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
87
nd
edition
worlds major national debt and equity markets. Keep in mind that past performance is
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 Gattis 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
Daimler Benz (1,6%) 1.000 shs 704
DM
704.000
DM
11,264
SF
0,842/DM
SF
592.768
SF
9.484
SF
602.252 11,8
Mazda Motors (0%) 50.000 shs 372

18.600.000

0
SF
0,01152/
SF
214.272
SF
0
SF
214.272 4,2
General Motors (2,4%) 2.000 shs 58
$
116.500
$
2,796
SF
1,204/$
SF
140.266
SF
3.366
SF
143.632 2,8
Bonds
French Govt ECU 6% 2004 1.000.000 90.20
ECU
902.000
ECU
60.000
SF
1,560/ECU
SF
1.407.120
SF
93.600
SF
1.500.720 29,4
German Govt 6.875% 2005 1.000.000 101.05
DM
1.010.500
DM
68.750
SF
0,842/DM
SF
850.841
SF
57.888
SF
908.729 17,8
U.S. Govt 6.5% 2005 1.000.000 102.42
$
1.024.200
$
65.000
SF
1,204/$
SF
1.233.137
SF
78.260
SF
1.311.397 25,7
Cash
Swiss Francs (1,4%)
SF
409.115
SF
409.115
SF
5.728
SF
409.115
SF
5.728
SF
414.842 8,1
Total
SF
4.847.518
SF
248.326
SF
5.095.844 100
Beginning cash balance
SF
409.115
Deduct divs & accrued int (SF) (
SF
248.326)
Add to cash balance (SF) +
SF
248.326
Ending cash (SF)
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. NAV
Won
= (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
88
the near future, then the U.S. price is likely to fall back to NAV and this is not a
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 youll have a large number of observations. However, these statistics wont
be very timely in the sense that theyll 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.
89
nd
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Solutions to End-of-Chapter Questions and Problems

)-1 = (1.09375)(1.02)-1 = 11.56%.

= 11.56% pound sterling interest rate.

), so you should buy pounds at the

= (1.0909091)(1.05) - 1 = 0.1454545, or 14.54545%

50,000 $50,000 $40,000 $40,000 $40,000

30,000 $30,000 $24,000 $24,000 $24,000

20,000 $20,000 $16,000 $16,000 $16,000

900,000 $900,000 $900,000 $900,000 $720,000

1,000,000 $1,000,000 $980,000 $980,000 $800,000

125,000 $125,000 $100,000 $100,000 $100,000

75,000 $75,000 $60,000 $60,000 $60,000

750,000 $750,000 $750,000 $600,000 $600,000

50,000 $50,000 $70,000 $220,000 $40,000

1,000,000 $1,000,000 $980,000 $980,000 $800,000

= (7.25% + [(100%-100%)/2])(100%/100%) = 7.25%.

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