Chapter 20—International Financial Management
MULTIPLE CHOICE
1. Which of the following would be considered a player in the foreign exchange (forex) market?
a.
exporters and importers
b.
investors and hedgers
c.
speculators and dealers
d.
governments
e.
all of the above
2. __________ influence currency values when they take positions to offset the risks of their existing
exposures to certain currencies.
a.
Investors
b.
Hedgers
c.
Speculator
d.
Dealers
e.
Governments
3. Why do studies suggest that the law of one price is violated for as long as three to four years?
a.
investment in time
b.
investment in money
c.
legal restrictions on trade
d.
physical impediments to transporting goods
e.
all of the above
4. One approach for evaluating the investment project dominated in a foreign currency is to calculate the
NPV in dollar terms, assuming that the firm hedges the project’s cash flows using __________.
a.
a currency board arrangement
b.
forward contracts
c.
economic exposure
d.
FDI
e.
WTO
5. On the spot market, one Canadian dollar will purchase $p1 U.S. The exchange rate for trades that will
take place d days later is $p2 U.S./Canadian $. The Canadian dollar is trading at an annualized forward
__________ of __________ percent.
a.
premium; ans
b.
premium; w2
c.
premium; w1
d.
discount; w1
e.
discount; ans
6. Today’s spot rates are U.S. $p1/Swiss franc and U.S. $p2/British pound sterling. How many pounds
must a Swiss franc be able to buy such that a triangular arbitrage will not exist?
a.
w1
b.
w2
c.
w3
d.
w4
e.
ans
7. If the price of Great North Maple Syrup is C $p in Canada, and the exchange rate between Canadian
and U.S. dollars is C $r / U.S. $, what price must Great North Maple Syrup be selling for in the U.S.
for the law of one price to hold?
a.
$ w1 U.S.
b.
$ w2 U.S.
c.
$ ans U.S.
d.
$ w3 U.S.
e.
$ w4 U.S.
8. Suppose the spot rate of exchange between Germany and the U.S. is euro r1/$, with an expected future
spot rate of euro r2/$. Expected inflation in Germany is g%, while U.S. expected inflation is us%. In
this situation, traders expect the __________ to appreciate and __________.
a.
euro; purchasing power parity holds
b.
euro; purchasing power parity is violated
c.
dollar; purchasing power parity holds
d.
dollar; purchasing power parity is violated
e.
euro; inflation in Germany to increase
9. If expected inflation in the U.S. is us%, expected inflation in France is f%, and the one-year risk-free
rate in the U.S. is ru%, what would the one-year risk-free rate have to be in France for real interest rate
parity to hold?
a.
w1%
b.
w2%
c.
w3%
d.
rf%
e.
w4%
10. Send-it-Soon (SIS) will ship goods valued at euro v to a German buyer in three months. Payment will
occur upon delivery. The current spot exchange rate is euro r/$ and the three-month forward rate is
euro r1/$. If the actual exchange rate in three months is euro r2/$, SIS would experience a __________
of __________ if it remained unhedged versus hedging in the forward market.
a.
profit; $w1
b.
profit; $w2
c.
profit; $ans
d.
loss; $w2
e.
loss; $ans
11. Uneek is a U.S. manufacturer of enormous, very specialized equipment. Months before the equipment
is delivered, Uneek must negotiate payment terms with its Swiss buyer. If the contract is denominated
in Swiss francs, then __________, but if the contract is denominated in dollars, then __________.
a.
Uneek can create a natural hedge to offset risk exposure; exchange rate risk is eliminated
b.
Uneek bears the exchange rate risk; the risk is transferred to the Swiss buyer
c.
Uneek should undertake a forward contract to eliminate risk; the Swiss buyer faces no
exposure to exchange rate risk
d.
the Swiss buyer bears the exchange rate risk; Uneek faces all exposure to changes in the
exchange rate
e.
the Swiss buyer bears the exchange rate risk; exchange rate risk is eliminated
12. Consider a U.S. firm undertaking an investment project in France. If the firm’s shareholders maintain
internationally diversified portfolios, the project’s beta should be calculated:
a.
by measuring the covariance of similar European investments with the European market
b.
by measuring the covariance of similar European investments with the U.S. market
c.
by comparing the covariance of returns on similar investments with returns on a
worldwide stock index
d.
by comparing the covariance of returns on similar investments with returns on a European
stock index
e.
by comparing the returns of similar existing French investments with the returns on a U.S.
stock index
13. The technique known as “leading and lagging” can be effective in correcting undesirable exchange rate
exposures for MNCs. In appreciation-prone countries, intra-MNC accounts receivable should be
collected __________, and intra-MNC accounts payable should be __________.
a.
as late as possible; paid as soon as possible
b.
as late as possible; delayed as long as possible
c.
as soon as possible; paid as soon as possible
d.
as soon as possible; delayed as long as possible
e.
whenever; paid whenever
14. If the inflation rate in Japan is higher than the inflation rate in the U.S., we would:
a.
See more imports from Japan to the U.S.
b.
Expect the U.S. dollar to appreciate in value relative to the Japanese yen.
c.
Expect the inflation rate in the U.S. to increase to stay in line with other countries.
d.
Be able to assume the Japanese government uses a floating exchange rate system.
e.
Be able to say the Japanese yen was trading at a forward premium to the U.S. dollar.
15. With regard to foreign currencies, some nations use a currency board arrangement.
a.
Under this arrangement, the national currency continues to circulate, but every unit of the
currency is fully backed by government holdings of another currency.
b.
Under this arrangement, a currency board of one nation chooses to use another nation’s
currency as their country’s own.
c.
Under this arrangement, a currency board meets to determine the fixed exchange rate
which will peg their currency’s value to another currency.
d.
Under this arrangement, a currency board meets to manage a country’s foreign exchange
rate risk for its balance of payments.
e.
Under this arrangement, a board is developed composed of individuals from different
countries to help a developing nation manage its currency.
16. Translation exposure is one of the types of exchange rate risk. Which statement best describes
translation exposure?
a.
The effect of foreign exchange rate fluctuations on specific transactions.
b.
The effect of foreign exchange rate fluctuations on a firm’s value.
c.
The effect of an ineffective hedge when translating one currency into another.
d.
The effect of foreign exchange rate fluctuations on individual accounts in the financial
statements.
e.
The effect of foreign exchange rate fluctuations when trading one currency for another in
the spot market.
17. The risk that arises from the fact that MNCs have to report foreign revenues and costs in their
domestic financial statements is called
a.
transactions risk
b.
economic risk
c.
translation risk
d.
political risk
18. Suppose that the nominal risk-free rate of return in the U.S is ru% and inflation is expected to be at
iu%. In Australia the nominal interest rate is ra%. What is the expected rate of inflation in Australia if
the Fisher Effect holds?
a.
w1%
b.
w2%
c.
w3%
d.
ans%
19. Your cousin notes that he can borrow money in the US at a rate of 8% and invest it in Brazilian banks
and get a return of 17%. What is the most likely reason for the difference in these rates?
a.
Brazil is more politically unstable than the US
b.
Brazil has a higher inflation rate than the US
c.
Brazil has a history of seizing bank assets
d.
Brazil and the US are currently at war
20. What is an advantage of using a forward contract to hedge against exchange rate risk?
a.
Forwards are marked to market
b.
Forwards are exposed to counterparty risk
c.
Eliminates risk but preserves the potential to profit from favorable exchange rate changes
d.
Forwards can be customized to the firm’s needs
21. Suppose that expected inflation in the United States equals zero and expected
Inflation in Brazil is r1 percent. If the 1-year, risk-free rate in the United States is
r2 percent, what would the 1-year, risk-free rate have to be in Italy to maintain interest rate parity?
a.
ans%
b.
w1%
c.
w2%
d.
w3%
22. You decide to take advantage of the higher government bond rates found in Brazil.
The brazilin bonds return about r1% for a one-year bond, US bonds are returning about r2% on a one
year bond, and you intend to buy a real/dollar futures contract to eliminate the translation risk one year
from today. Assume that your home country is the US and that the political risks of the US and Brazil
is the same. What rate of return should you expect to get in one year, in US dollars?
a.
It depends on the cost of the futures contract
b.
About r3%
c.
About r1%
d.
About r2%
23. Why may there be deviations from Purchasing Power Parity?
a.
Ease of currency translation
b.
NAFTA
c.
Transportation costs
d.
Deviations from Purchasing Power Parity do not exist
MATCHING
Match the term with the correct description:
a.
Forward Premium
b.
Purchasing power parity
c.
Triangular arbitrage
d.
Forward-Spot parity
1. Situation where currency pricing allows traders to earn a risk-free profit by simultaneously trading
multiple currencies in different markets
2. Situation where the first currency buys more of another on the forward market than it does on the spot
market
3. Situation where if the law of one price holds at all times, then differences in expected inflation
between two countries are associated with expected changes in currency value
4. Situation where the forward rate should be an unbiased predictor of where the spot rate is headed
Match the tools with their impact on risk exposure:
a.
forward contracts
b.
future contracts
c.
options contracts
d.
interest rate swaps
e.
currency swaps
5. exchange traded and marked to market each day
6. permit firms to change the interest rate structure of their assets
7. eliminate risk but also eliminate opportunity to profit and has no intermediate cash flows
8. uniquely hedge risk of adverse exchange rate movement but preserve potential to profit
9. allow firms to change the currency structure of their assets
Match the terms with their best description:
a.
Euro
b.
EU
c.
GATT
d.
WTO
e.
FDI
10. dealing with a wave of new applicants
11. extends free trading rules to broad areas of economic activity
12. transfer assets from home country to host country
13. police world trading practices
14. continent-wide medium of exchange
SHORT ANSWER
1. What does it mean when a country has a floating exchange rate?
2. What happens when a country adopts a currency board arrangement?
3. How does a strong (rise in value) U.S. dollar affect U.S. exports and imports?
4. What does theory suggest about the parity conditions in international finance?
5.
If a VCR sells in the U.S. for $d and in Japan for y yen, does the law of one price hold when
the exchange rate between dollars and yen is s yen/$?
What does the price of the VCR have to be in yen if the exchange rate goes to s2 yen/$ and the
law of one price holds?
6. The Switzerland interest rate on a one-year bond is r1% while a similar bond in the U.S. is r2%. If the
forward Swiss franc is selling at a r3% discount per year is there an opportunity for you to do a
covered interest arbitrage?
7. What is the expected inflation rate in the U.S. and Japan if the real rate of interest in the U.S. is rru%
and in Japan rrj%, while the nominal interest rate in the U.S. is nru% and in Japan nrj%?
8. The U.S. expected inflation rate equals eiru% and the expected inflation rate in Canada is eirc%.
What is the 1-year, risk-free rate in Canada if the 1-year, risk-free rate in the U.S. is rua% and
there is real interest rate parity?
How does your answer change if the U.S. inflation rate increases to ir%?
Yes, the law of one price holds because s yen/$ is the exchange rate.
d s2 = y2 yen
The price must go to y2 yen.
9. The Swiss decide to manufacture watches in the U.S. and build a plant in Minneapolis, Minnesota. The
Swiss decide to evaluate their beta using a similar foreign company’s beta of b1, a market premium of
r1%, and the Swiss risk-free rate of r%. If the Swiss find that there is a world market portfolio risk
premium of r2% and a beta of b2, what should be the project’s required rate of return, RP using the
CAPM?
10. A U.S. firm is considering an investment in a country using the euro. The projected cash flows are
shown below, denominated in euro currency.
Initial Cost
Year 1
Year 2
Year 3
–ic million
+y1 million
+y2 million
+y3 million
Using the NPV analysis and a spot rate for the euro of $sr/euro, should the U.S. firm make the
investment if their cost of capital is r%?
11. You are searching for a case of your favorite wine on the Internet. You find that you can purchase n
bottles of the wine locally for $d. Alternatively, you can purchase a case directly from a distributor in
France for e euros. The current spot rate of exchange is r euros/$.
Explain why you should buy the wine in France. (Ignore all market frictions such as costs of
transportation, insurance, spoilage, or insurance.)
How much would you be willing to pay for shipping, if you are in no hurry to receive the
wine?
The Euro cost of the wine bought locally is $d r euros / $ = a Euros. Given this is more than
12. Explain the primary differences between parity relations involving financial versus real goods. Provide
an example of some of the special costs involved in shipping real goods across national borders (such
as cows or strawberries).
13. Discuss the law of one price as it relates to arbitrage with financial goods. Are there any fundamental
differences between arbitrage with real and financial goods?
14. Suppose the annual riskless rate in the U.S. is r1 percent. The annual riskless rate in pounds (the
Sterling rate) is r2 percent. Suppose the spot rate of exchange is srpounds / $.
What should the one-year forward rate be between pounds and dollars?
Assuming all interest rates remain unchanged over the next five years, what would this imply
about a hypothetical five-year forward rate of exchange between pounds and dollars?
15. Your firm, Cheesis Fin Inc, is a British manufacturer of fine Stilton cheese. You believe you can sell
your product effectively in France. You have recently agreed to sell a large container of cheese for s
euros in six months time. The spot rate of exchange between euros and pounds, is sr euros / pound.
The forward rate for a transaction in six months is sr1 euros/pound.
Explain how you might establish a forward contract to mitigate your transaction exposure in
this instance. What will be your expected future cash flow in pounds?
If you expect the future spot rate in six months to be sr2 euros/pound, will this influence your
decision?
Suppose you decide to undertake the forward transaction, what happens if in four months you
learn that your cheese has spoiled and you cannot deliver on your promised side of the
transaction?
pounds. This exceeds our answer to part a. by b2 pounds. We may decide not to hedge this
risk, if we wish to speculate on the direction of the currency in the spot market. We also may
decide it is not a large enough risk to bother with a hedging strategy.
delivery of the euros as promised, or by undertaking an offsetting transaction when we learn of
our production difficulties.
16. Consider a firm with the potential to invest in a small but heavily restricted foreign market. Over the
years, this firm has developed a good relationship with the host country government and understands
the quirks of its infrastructure. From the shareholders’ perspective, how should the firm view a
diversifying investment in this country? (You may assume that this country offers some unique risk
and reward characteristics given its restricted status.)
17. Are all of the parity relations (interest rate, PPP, forward-spot, real interest rate) equally likely to hold,
or is there one or more that is more reliable? Why?
18. Smith Enterprises is considering opening a new manufacturing plant in France. The cost of the new
plant will be €c million and the plant is expected to generate after tax cash flows of €pe million at the
end of each year for the next t years. After that the plant will be worthless. The current €/$ exchange
rate is €cer/$. The expected rate of inflation for the U.S is r1% per year. The risk free rate in the U.S. is
r2% and the risk free rate in France is r3%.
a) What is the expected $ value of the after tax cash flow received at the end of year ta?
b) What is the expected rate of inflation in France?
ESSAY
1. Foreign direct investment allows multiple methods of entry into a foreign market. Compare a new
plant versus a joint venture as alternative modes of entry in a new market with substantial political
risk. Can you suggest any financing strategies that might also assist in mitigating political risk?
2. The formation of the European Monetary Union has many implications for the study and practice of
international finance. In particular, discuss some of the benefits that the introduction of a common
currency might have for a small shoe manufacturer in Italy.
3. There are several risks associated with operating a multinational corporation. Given the risks
associated with an MNC, why would a firm choose to operate as an MNC?
4. A pound of premium chocolate in Germany costs €g while in the U.S. the pound of premium chocolate
costs $us. The current spot rate for the exchange of dollars for euros is €csr / $.
Discuss the law of one price and use the information above to examine the law of one price
demonstrating how an arbitrageur could exploit the situation.
Why might this situation be difficult to profitably exploit?
5. Your New York bank quotes the following exchange rates. The exchange rate for euros to dollars is
U.S.$ue / €. The exchange rate for Canadian dollars to U.S. dollars is U.S.$uc / C$.
What is the euro/Canadian dollar exchange rate?
Assume you find in Germany an exchange rate of €ucg / C$. Demonstrate triangular arbitrage
assuming you have U.S.$c.
The cross rate is (U.S. $uc / C$) / (U.S. $ue / €) = €a / C$.
Canadian dollars buy more euros in Germany than they should given the cross rate. To make a
profit, a trader would execute the following steps.
Convert U.S. dollars to Canadian dollars in New York: U.S. $c (C$ / U.S.$uc) = C$b1.
Simultaneously, the trader converts C$b1 in Germany giving the trader: C$b1 (€ucg /
U.S.$b3.
The trader ends up with an additional U.S.$b.
6. Suppose that the 6-month, risk-free (annual) rate in the United States is r1% and in Japan is r2%. The
spot exchange rate is ¥er1 / $, and the 180-day forward rate is ¥er2 / $.
Demonstrate whether interest rate parity holds.
Demonstrate how an arbitrage profit could be made assuming you will use $c0 million.
If the above situation did exist, what will happen in the marketplace?
You must determine whether risk-free investments offer the same return after converting
currencies. To examine this we can use the interest rate parity concept:
a1 < a2
Because the right-hand side of the equation is “too large” relative to parity, the interest rate in
Japan is “too high” or the rate in the U.S. is “too low” and interest rate parity does not hold.
converted back to dollars yielding €g ($ / €csr) = $usa per pound. The trader would thus
have an arbitrage profit of $d per pound.
potential profit.
7. A U.S. firm is considering an investment in Canada that will generate cash flows in Canadian dollars.
The risk-free rate of interest in Canada is r1% while in the U.S. it is r2%. The cost of capital for this
project expressed as a Canadian rate is r3%. The current spot rate is U.S.$csr / C$. Evaluate this
project by calculating the NPV in dollar terms assuming the firm hedges the project’s cash flows using
forward contracts, given the project’s cash flows in Canadian dollars were estimated as follows:
Initial Cost
Year 1
Year 2
–C$ic
+C$y1
+C$y2
8. Describe political risk on a macro and micro level and provide examples of each.
9. What are the factors and their sources that cause exchange rates to change over time?