Hello,

I am taking the test next week and the professor told that it's going to be something like this.

Can anyone explain how to solve this..?

1 An Italian firm is considering selling its line of coin-operated cappuccino machines in the U.K. The business risk will be identical to the firm's existing line of business in the euro zone, the cost of capital in the euro zone is i = 10%. The expected inflation rate over the next two years in the U.K. is 3% per year and 2% per year in the euro zone. The spot exchange rates are $1.80 = 1.00 and $1.15 = 1.00 The pound sterling denominated cash flows are as follows: Year 0 Year 1 Year 2 -100,000 25,000 100,000 a) What is the -denominated NPV of this project? (5 points) b) What is the -denominated IRR of this project? (5 points) c) What is the -denominated NPV of this project? (5 points) d) What is the -denominated IRR of this project? (5 points) 1 2 Your firm is a U.K.-based exporter of Swiss bicycles. You have sold an order with an Italian retailer for 750,000 worth of bicycles. Payment (in euro) is due in six months. Your firm wants to hedge the receivable into pounds. U.S. $ equiv. Currency per U.S. $ Country Tuesday Monday Tuesday Monday Britain (Pound) 62,500 2.0000 2.0002 0.5000 0.5000 1 Month Forward 1.9900 1.9902 0.5025 0.5025 3 Months Forward 1.9800 1.9802 0.5051 0.5050 6 Months Forward 2.0000 1.9702 0.5102 0.5076 12 Months Forward 2.1000 1.9602 0.5102 0.5102 Euro 125,000 1.4700 1.4700 1.05263 1.20012 1 Month Forward 1.4800 1.4800 1.04167 1.20616 3 Months Forward 1.4900 1.4900 1.03093 1.21224 6 Months Forward 1.5000 1.5000 1.02041 1.21840 12 Months Forward 1.5100 1.5100 1.01010 1.22460 a) Detail a strategy using futures contracts that will hedge your exchange rate risk. Have an estimate of how many contracts of what type (long or short on what currency at what price). (10 points) Write your answer here. b) Outline a strategy using spot exchange rates and borrowing or lending that that will hedge your exchange rate risk. Your answer does not require numbers, it requires a sentence. (5 points) Write your answer here. c) Assume interest rates are 3% in , 6% in $ and 4% in , all quoted as an APR. Estimate the pounddenominated future value of the strategy that you offered in part b). (5 points) Write your answer here. 2