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Mini Case: 17 - 18
e. What is a convertible currency? What problems arise when a multinational
company operates in a country whose currency is not convertible?
Answer: A currency is convertible when it is traded on the world currency exchanges and
f. What is the difference between spot rates and forward rates? When is the
forward rate at a premium to the spot rate? At a discount?
Answer: Spot rates are the rates paid to buy currency for immediate delivery (actually, two
days after the date of the trade). Forward rates are the rates paid to buy currency for
a U. S. importer buys German appliances for sale in the U. S. The terms are net 90,
so the importer must pay in Euros in 90 days. The dollar could weaken against the
Euro over the period, and hence force the importer to use more dollars to buy the
merchandise. To guard against this possibility, the importer could buy Euros for
delivery in 90 days, thus locking in the current forward rate.
g. What is interest rate parity? Currently, you can exchange 1 euro for 1.2700
dollars in the 180-day forward market, and the risk-free rate on 180-day
securities is 6 percent in the United States and 4 percent in France. Does interest
rate parity hold? If not, which securities offer the highest expected return?
h. What is purchasing power parity? If a package of jerky costs $2.00 a liter in the
United States and purchasing power parity holds, what should be the price of
Spot rate = Ph/Pf
$1.2500 = $2.00/Pf
Pf = $2.00/$1.2500 = 1.60 euros.
i. What impact does relative inflation have on interest rates and exchange rates?
amount by which its inflation rate exceeds (or is less than) our own. Thus, the dollar
has generally weakened against the yen over time, so it would take more and more
dollars to pay back interest denominated in yen.
Mini Case: 17 - 21
j. Briefly discuss the international capital markets.
Answer: Individuals buy securities issued by foreign governments and firms, and U. S. Firms
issue securities abroad. These transactions take place in the international capital
markets. Here is a brief description of the major international capital markets:
1. A eurodollar is a U. S. dollar deposited in a bank outside the United States. The
major difference between a “regular” dollar and a eurodollar is its location. This
Interest rates on eurodollars are tied to the London Interbank Offer Rate
(LIBOR), which is the rate of interest offered by the largest and strongest London
banks on eurodollar deposits. LIBOR rates are generally 0.5 to 1.0 percentage
points higher than the rate on comparable deposits offered by domestic banks in
the U. S. The eurodollar market deals mostly with short maturities, generally less
of the country in which they are issued.
Eurobonds are bonds sold in some country other than the one in whose
currency the bond is denominated. For example, when Mercedes-Benz (a
German company) sell bonds denominated in German marks in Switzerland, these
bonds are eurobonds. In general, countries do not apply as stringent requirements
Mini Case: 17 - 22
k. To what extent do average capital structures vary across different countries?
Answer: There is some evidence that average capital structures vary among the large industrial
differences, capital structures are more similar across different countries than a
refurbish the plant. The expected net cash flows from the plant for the next two
years, in millions, are: CF1 = ¥500 and CF2 = ¥800. A similar project in the U.S.
would have a risk adjusted cost of capital of 10 percent. What is the project’s
NPV?
The first step is to estimate the future expected exchange rates using the multi-
year interest rate parity equation:
t
h
r1
Maturity (in years)
rh
rf
Spot rate
($/¥)
Expected
forward rate
($/¥)
1
2.0%
0.05%
0.009091
0.009268
2
2.8%
0.26%
0.009091
0.009557
Year
0
1
2
Cash flows in yen
-¥1,000
¥500
¥800
Expected exchange rates
0.009091
0.009268
0.009557
Cash flows in dollars
-$9.09
$4.63
$7.65
Project cost of capital =
10%
NPV =
$1.44
m. What is the impact of multinational operations on each of the following financial
management topics?
1. Cash management.
m. 2. Credit management.
important for international business, because much of the commerce on which lesser-
developed countries depend could not occur if the seller did not grant credit. Many
companies buy export credit risk insurance when granting credit to foreign customers.
m. 3. Inventory management.
