1.A friend of yours has recently started a new business. She is importing wine from all across the world to sell in the US. Your friend calls you one day and asks for advice. She entered into a contract with a large Australian winery that will deliver a selection of different red wines to her in six months. The contract specifies that she will have to pay the winery in Australian Dollar (AUD) in six months. The current spot rate for the Australian dollar is0.9600AUD/USD. Your friend plans to buy AUD today (she mentioned that she has enough funds available) and invest the AUD for six months. She argues that the interest rates in Australia are higher than in the US. Her business partner suggests investing in USD and buying AUD six months forward to eliminate any exchange rate risk.

a.Generally speaking and assuming that markets are arbitrage-free and frictionless, should your friend listen to her business partner (i.e., invest in USD first and then convert into AUD at the forward rate) or implement her own strategy?

b.Assume now your friend tells you that she has access to the following interest rates (Recall that interest rates for less than a year are quoted p.a. in multiples of the effective interest rate):

6-month USD borrowing rate:11.00 %p.a.

6-month USD investing rate:3.00%p.a.

6-month AUD investing rate:6.00%p.a.

6-month AUD borrowing rate:not available to your friend

Your friend has decided that she definitely would like to eliminate the exchange rate risk she faces. She also tells you that her bank offers her the following forward rate:

F(t, t+6 months, AUD/USD) = 0.9750

Do you have any advice for your friend? What should she do?

You might want to draw the time / currency diagram we have used in class. Make sure you compare the alternatives that are relevant for the case of your friend who has the needed USD funds today.

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c.The next day your friend calls again and tells you that she discovered that she does not have enough USD available today. However, she expects to have enough USD in six months. What changes in your analysis? Does your advice (from point b.) change? Please explain!

2.The Real Exchange Rate

Suppose you own a small US business that sells books to India. You read an analyst report about the INR/USD exchange rate (INR: Indian Rupee). The report suggests that 10 years ago the real exchange rate between the USD and the INR was about 1. The cumulative inflation (over the past 10 years) in the US has been 42%, while India experienced about 78% cumulative inflation (over the past 10 years). The graph below shows the nominal INR/USD exchange rate over the past 10 years.

a)Today, is the USD overvalued, undervalued or neither with respect to the Indian Rupee? Explain.

b)What do you expect will happen to the nominal exchange rate in the long run and why? Will your export business be affected? Explain.

3.International Finance Questions

A colleague of yours heard that you just took an International Finance class. She has a few questions for you that she hopes you can address with a few sentences. You can make additional assumptions as needed, as long as you state them clearly.

a) "We import a lot of material from Mexico and sell quite a bit of our products to Canada. I have heard about forward contracts and options as tools to manage FX exposure, but I have never really thought about what it is we could or should do. To be specific assume that in an average month we import goods worth of USD 2 M from Mexico and sell goods worth of USD 1 M to Canada. Based on your understanding, how could we address the uncertainty associated with the USD value of the MXN and the CAD? Which instruments should we use? What do we buy and sell? For how long out? What factors should we keep in mind when considering these points? Finally, based on your understanding of our business should we be managing our FX exposures? Why or why not?"

b)"One of our larger competitors in Australia recently issued a corporate bond in JPY (without hedging this JPY exposure), even though, they hardly have any business in Japan. Their CFO said it was positive NPV financing choice. Can you explain why they might have done this? What are the risks? Should we as a US company do this as well?"

c)"We recently discussed building our own factory in Mexico. There was brought agreement in the executive team that the expected cash flows for such a project would be lower than for a similar project in the US, given the additional red tape and occasional interruptions due to strikes etc. But there was little agreement about the appropriate cost of capital or discount rate to be used to discount those cash flows. Some felt that the discount rate should be higher than in the U.S. given the higher volatility of such Mexican cash flows, others disagreed and argued we should use the same discount rate as for a similar project in the U.S. Who is right? How should I think about this?"