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LANCASTER UNIVERSITY 2012 EXAMINATIONS PART II (SECOND AND FINAL YEAR) ACCOUNTING AND FINANCE AcF 305 INTERNATIONAL FINANCIAL MANAGEMENT (2 hours + 15 minutes reading time) Answer ALL SUB-QUESTIONS OF QUESTION 1 (THE MULTIPLE CHOICE PART) AND ONE SUB-QUESTION (EITHER SUB-QUESTION A OR B) OF QUESTIONS 2 TO 8. Question 1 carries 30 marks and questions 2 to 8 each carry 10 marks. Answer Question 1 using the MCQ sheet and Questions 2 to 8 in a booklet. QUESTION 1: MULTIPLE CHOICE PART (30 marks in total): Answer all sub-questions. Required: 1) Identify the one true statement about an exchange-rate regime with fixed exchange rates relative to gold: (A) (B) (C) (D) It will lead to central banks running out of gold reserves. It is unable to maintain a low level of inflation. It will lead to continuously increasing prices of gold. It suffers from the Triffin Dilemma, i.e. the necessity of choosing between economic growth and maintaining a credible gold backing of the currency. (E) None of the above. (3 marks) 2) Identify the one false statement about bid and ask rates when you want to buy foreign currency from a bank in the spot market: (A) (B) (C) (D) (E) The bank sells at the ask rate. You buy at the ask rate. The spread depends on the liquidity. The spread depends on the maturity. The spread depends on the transaction volume. (3 marks) Please turn over 1 3) Identify the one false statement about forwards: (A) Forward markets are not organised exchanges, but over-the-counter markets. (B) The general formula for the delivery date of a forward is: day [t + 2 plus n months]. The delivery date differs from the general formula in certain circumstances. (C) A 90-day forward contract signed on Thursday, 29 March 2012, is normally settled on Friday, 29 June 2012. (D) The outright rate for a forward is its actual rate. (E) The GBP trades at a premium if the swap rates of GBP/EUR forwards are positive. (3 marks) 4) Identify the one false statement about hedging contractual exposure: (A) Perfect hedging means that the contractual exposure is hedged in the cheapest way possible. (B) Options are imperfect hedges in the sense that they do not entirely eliminate uncertainty about future cash flows. (C) For a hedge with a forward, there is reverse risk due to credit risk. (D) Hedging of pooled cash flows can introduce interest risk. (E) A duration-matched hedge is an example of a value hedge. (3 marks) 5) Identify the one true statement about FX forwards and futures. (A) (B) (C) (D) (E) Forwards do not have default risk. Forwards are less liquid than futures. Forwards are more profitable than futures. Forwards can require a margin call. None of the above. (3 marks) 6) Identify the one false statement about swaps: (A) A fixed-for-fixed currency swap allows a company to borrow in the market where it can obtain the lowest spread. (B) In a fixed-for-fixed currency swap, the bank's risks in case of default are limited because of the right-of-offset clause. (C) A fixed-for-floating interest-rate swap allows a company to swap fixed interest payments of one currency into variable interest payments of another currency. (D) In a fixed-for-floating interest-rate swap, interest rates used in the swap contract are (near) risk-free rates. (E) Coupon swap is an alternative name for an interest-rate swap. (3 marks) Please turn over 2 7) Identify the one true statement about all currency options with a strike price of GBP/NZD 0.55 when the current spot rate is GBP/NZD 0.50: (A) (B) (C) (D) (E) The option is said to be deep out of the money. The option is said to be out of the money. The option is said to be at the money. The option is said to be in the money. None of the above. (3 marks) 8) Identify the one false statement about corporate hedging of exchange risk: (A) Adding a zero-initial-value financial instrument for hedging purposes can increase the value of the firm. (B) There is an agency conflict between shareholders and managers if managers decide not to implement effective hedging strategies. (C) If a company has always been profitable, no risk of bankruptcy exists and corporate taxes are linear, hedging will not reduce expected taxes. (D) Hedging can reduce the costs of bankruptcy and financial distress. (E) It is possible to hedge non-linear exposure with financial instruments. (3 marks) 9) Identify the one false statement about the expected exposure of the USD value of assets to a change in the USD/EUR exchange rate: (A) (B) (C) (D) (E) US government bonds have zero exposure. European government bonds have positive exposure. Shares in an American importer have positive exposure. Shares in a European importer have positive exposure. Shares in an American exporter have positive exposure. (3 marks) 10) Identify the one false statement about international NPV calculations: (A) The valuation can be done in either FC or HC if the home and host country are part of one integrated financial market. (B) Political risks include transfer risk. (C) It may not be possible to perfectly hedge against the political risk of expropriation. (D) The term 'incremental cash flows' refers to the cash flows generated at the level of the foreign subsidiary. (E) Usually you should assume that the international investment has a positive terminal value. (3 marks) (TOTAL: 30 MARKS) Please turn over 3 QUESTION 2 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) How would each of the transactions below show up in the UK Balance of Payments, i.e. what is the source of funds, what is the use of funds and in which sub-balances would the source and the use be credited or debited? Note that the sub-accounts of the balance of payments are shown in the Appendix. Required: i) A UK investment bank advises a Russian company in a merger transaction, and gets its fee paid into its London bank account. ii) GlaxoSmithKline S.A., the French subsidiary of a UK pharmaceutical firm, buys drugs from Pfizer Inc., a US pharmaceutical firm, and pays for these by transferring money into the New York bank account of Pfizer. iii) Ericsson, a Swedish firm, sells network equipment to Vodafone plc, a UK telecommunications firm, and receives a trade bill, payable in 90 days. iv) A UK investor sells shares of a Turkish firm and uses the receipts to pay for a Turkish citizen to travel to the UK and give him a Turkish massage. (10 marks) OR b) Different currencies trade under different exchange-rate regimes. Required: i) Describe what fixed against a single currency means and give one example. ii) Name two other exchange-rate regimes and give an example for each (you do not need to provide descriptions of the exchange-rate regimes). iii) How do some governments intervene in the exchange markets? (10 marks) Please turn over 4 QUESTION 3 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) The following table shows spot rates against the GBP, i.e. XXX/GBP. Note: Bid-ask spreads show only the last three decimal places. When the ask seems to be smaller than the bid, add 1,000. Country Denmark Norway Turkey Code DKK NOK TRY Midpoint 12.5994 11.5327 2.7655 Spread 816-172 256-398 623-687 Required: i) What are the bid-ask quotes for DKK/GBP and TRY/GBP? ii) What is the bid-ask quote for GBP/NOK? iii) What is the synthetic TRY/NOK rate? Is there an opportunity of arbitrage or shopping around if the TRY/NOK spot rate is 0.2398-0.2401? (10 marks) OR b) The following table shows Big Mac prices and exchange rates from the Economist, 26 May 2006. Egypt United States Switzerland Currency (HC) EGP USD CHF Local price 9.5 3.1 6.3 HC/USD 5.77 1.00 1.21 Required: i) Calculate the USD price of a Big Mac in Egypt and Switzerland using the exchange rates provided in the table above. ii) Calculate the implied purchasing power parity rates in HC/USD for Egypt and Switzerland. iii) Calculate the real exchange rates in HC/USD for Egypt and Switzerland. iv) According to the Big Mac prices, which currency is undervalued compared to USD? (10 marks) Please turn over 5 QUESTION 4 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) You are given the following data: the spot exchange rate is GBP/EUR 0.85; the p.a. simple interest rate on a three-month deposit is 6% in the UK and 4% in Europe. Note: t is today and T is the end of the investment period. Required: Compute: i) The time-T EUR value of a time-t EUR 100 investment. ii) The time-t GBP value of a time-T GBP 100 loan. iii) The EUR/GBP forward rate for a three-month forward contract. iv) The time-t EUR value of a time-t GBP 100 spot sale. v) The time-t GBP value of the proceeds of a time-T EUR 100 loan. (10 marks) OR b) Given the following data, are there any arbitrage opportunities? If so, how would you make a risk-free profit? Required: i) ii) iii) HC/FC JPY/GBP THB/NZD USD/EUR St 292.07 22.17 1.18 Ft,T 299.28 22.43 1.18 rt,T 4.9% 3.8% 4.2% r*t,T 3.1% 2.6% 2.5% (10 marks) Please turn over 6 QUESTION 5 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) A French exporter wants to hedge an inflow of CAD 50m with futures contracts. However, no future on EUR/CAD is available. After doing some research, she finds that EUR/CAD and EUR/AUD are strongly correlated because both Canada's and Australia's economies have a strong exposure to prices of commodities. Therefore she decides to hedge the risk with a EUR/AUD future. Additionally, she considers a EUR/USD future. The regres2 sion output is, with t-statistics in parentheses and R = 0.72, as follows. S[EUR/CAD] = a + 0.59f[EUR/AUS] + 0.21f[EUR/USD]. (14.57) (7.22) Required: i) Why does it make sense to consider a EUR/USD future although the USD does not have a strong commodities exposure? ii) How will you hedge if you use both contracts, and if an AUD contract is for AUD 5m and a USD contract for USD 2m? iii) Should you use both contracts if you base your decision solely on the t-statistics? Note that a t-statistic above (below) 1.96 (1.96) indicates statistical significance. iv) If the French exporter does not exclusively focus on futures, is there a way to hedge the CAD 50m cash inflow perfectly? If yes, how? (10 marks) OR b) One year ago, a US firm swapped USD 150m with a swap rate of 4% for GBP 75m with a swap rate of 5%. Both assets had 2 years to maturity at that time. Currently, the USD swap rate is 5%, the GBP swap rate is 6% and the spot rate is USD/GBP 2.2. Required: i) ii) iii) iv) Calculate the current value of the USD leg of the swap (in USD). Calculate the current value of the GBP leg of the swap (in GBP). Calculate the value of the swap in USD. Has the US firm benefitted from the swap? Why? (10 marks) Please turn over 7 QUESTION 6 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) Both forwards and options can be used for hedging purposes. Consider a US company which wants to hedge a future JPY cash inflow. Required: i) Draw a diagram which shows the payoff at expiration from selling a USD/JPY forward. Label the axes. ii) Draw a diagram which shows the payoff at expiration from buying a USD/JPY put option. Label the axes. iii) When does the US firm benefit from buying a put but not from selling a forward? iv) What is the disadvantage of buying a put instead of selling a forward? (10 marks) OR b) Options can be used for hedging purposes. For this question, consider that you are the CFO of a German firm. Required: i) Draw a diagram which shows the payoff at expiration of a EUR/JPY call option, a loan denominated in JPY and the combined payoff. Label the axes. The option expires on the day when the loan has to be repaid. ii) What is the benefit of the hedge from i)? iii) What is the advantage of a hedge with an option compared to a hedge with a forward? (10 marks) Please turn over 8 QUESTION 7 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) A firm can be affected by different types of exposure to exchange rates. Your answers to the following questions should concentrate on the main aspects. Required: i) ii) iii) iv) What is contractual exposure? What is operating exposure? What is accounting exposure? What is the main difference between contractual and operating exposure on the one side and accounting exposure on the other? (10 marks) OR b) Forwards can be used to hedge operating exposure. Consider the Italian firm Fiat. If the EUR is strong against the USD, exporting becomes more difficult and the value of the firm decreases. Additionally, the value of the firm depends on the general state of the economy in Italy (bad or good). State of the economy Value (joint probability) if EUR/USD=0.95 Value (joint probability) if EUR/USD=0.75 Bad 5.7bn (30%) 4.8bn (25%) Good 6.7bn (10%) 6.2bn (35%) Required: i) Calculate the currency exposure. ii) What is the optimal forward hedge? iii) Calculate the value of the hedged firm in each currency state if the forward rate is EUR/USD 0.83. (10 marks) Please turn over 9 QUESTION 8 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) Consider the following information regarding the returns of Google and Ford. Expected return Google Ford 0.14 0.09 Covariances Google Ford 0.85 0.31 0.31 0.56 Required: You hold a portfolio of Google and Ford in which Google has a weight of 60%. i) Calculate the expected return. ii) Calculate the variance. iii) Draw a diagram which shows the efficient portfolios and the tangency portfolio of a single-country CAPM. Label the axes. You do not need to make any calculations for this question. iv) Explain the two key differences between the standard CAPM and the international CAPM. (10 marks) OR b) There are three steps which should be followed in international NPV calculations. Your answers to the following questions should concentrate on the main aspects. Required: i) ii) iii) iv) What should be done in the branch stage? What should be done in the unbundling stage? What should be done in the external financing stage? Why is it useful to have a separate branch stage? (10 marks) Please turn over 10 Appendix: Sub-Accounts of the Balance of Payments END OF PAPER 11 LANCASTER UNIVERSITY 2013 EXAMINATIONS PART II (SECOND AND FINAL YEAR) ACCOUNTING AND FINANCE AcF 305 INTERNATIONAL FINANCIAL MANAGEMENT (2 hours + 15 minutes reading time) Answer ALL SUB-QUESTIONS OF QUESTION 1 (THE MULTIPLE CHOICE PART) AND ONE SUB-QUESTION (EITHER SUB-QUESTION A OR B) OF QUESTIONS 2 TO 8. Question 1 carries 30 marks and questions 2 to 8 each carry 10 marks. Answer Question 1 using the MCQ sheet and Questions 2 to 8 in an answer booklet. QUESTION 1: MULTIPLE CHOICE PART (30 marks in total): ANSWER ALL SUB-QUESTIONS. Required: 1) Identify the one false statement about the UK balance of payments (BOP): (A) The sale of computers of a UK company to a Swedish company is recorded in the merchandise account of the current account. (B) The source side of a deal tells us where the money in an international transaction was obtained. (C) The balance of payments has two categories: the current account and the capital and financial account. (D) The following transaction will not be recorded in the UK BOP: AstraZeneca AG, the German subsidiary of a UK pharmaceutical firm, buys drugs from Merck Inc., a US pharmaceutical firm. (E) Securities bought internationally are a use of funds. (3 marks) 1 Please turn over 2) Identify the one false statement about purchasing power parity (PPP): (A) Absolute PPP may not hold when the consumption bundles of different countries are not the same. (B) Absolute PPP may not hold when the prices for individual goods are sticky. (C) Absolute PPP holds when commodity price parity holds for every individual good. (D) Absolute PPP holds if the real exchange rate equals 1. (E) Absolute PPP holds if relative PPP holds. (3 marks) 3) Assume that you have bought forward EUR (=FC) 2,000 at a forward rate of GBP/EUR 0.80, with delivery date in six months. In addition, you will need to repay a loan of NZD (=FC) 5,000 in six months. What will be the combined future payoff of your two cash flows in GBP (=HC)? (Note: FC is foreign currency and HC is home currency.) (A) (B) (C) (D) (E) 5,000*(future spot rate(EUR/GBP) - 0.80) - 2,000*(future spot rate(GBP/NZD). 5,000*(future spot rate(GBP/EUR) - 0.80) + 2,000*(future spot rate(NZD/GBP). 2,000*(future spot rate(GBP/EUR) - 0.80) + 5,000*(future spot rate(GBP/NZD). 2,000*(future spot rate(GBP/EUR) - 0.80) - 5,000*(future spot rate(GBP/NZD). 2.000*(future spot rate(EUR/GBP) - 0.80) + 5,000*(future spot rate(NZD/GBP). (3 marks) 4) Identify the one false statement about the mechanisms used by banks that partially solve the problem of default risk under a forward contract: (A) (B) (C) (D) (E) Margin requirements. Restricted use. Short lives. Right to offset. Credit agreements. (3 marks) 5) Identify the one false statement about hedging with futures: (A) The expiration dates of the futures contract rarely match those for the currency inflows/outflows that the contract is meant to hedge. (B) The choice of underlying assets in the futures market is limited, and the currency one wishes to hedge may not have a futures contract. (C) Hedging with futures involves higher transaction costs than hedging with forwards. (D) A currency-mismatch can be hedged via a cross-hedge. (E) A maturity-mismatch can be hedged via a delta hedge. (3 marks) 2 Please turn over 6) Identify the one true statement about swaps: (A) In practice, swap rates are much higher than risk-free rates in order to compensate banks for default risk. (B) A fixed-for-floating swap is insensitive to changes in the interest rate. (C) A fixed-for-fixed currency swap is insensitive to changes in the foreign interest rate. (D) A fixed-for-fixed currency swap is insensitive to changes in the respective exchange rate. (E) Swaps allow a company to borrow in the market where it can obtain the lowest spread. (3 marks) 7) Identify the one false statement about a currency option with a strike price of EUR/EGP 8.00: (A) The underlying is the exchange rate between the euro and the Egyptian pound. (B) A put on the EUR/EGP exchange rate can be used to hedge a future cash outflow in EGP. (C) You will lose money at expiration if the option is a call, you are short the call and the EUR/EGP spot rate is 8.50. (D) The option is said to be in the money if it is a call and the EUR/EGP spot rate is 8.50. (E) Combining a short put and a long call replicates the payoff of a forward purchase. (3 marks) 8) Identify the one false statement about accounting exposure: (A) Accounting exposure arises because the outcome of translating the accounting numbers of foreign subsidiaries from FC to HC depends on the exchange rate at the date of consolidation, which is uncertain. (B) Accounting exposure is not an economic exposure. (C) Accounting exposure cannot be hedged. (D) Examples of accounting translation methods are: currentoncurrent method, monetaryonmonetary method and temporal method. (E) The HC value of total assets of a foreign subsidiary is higher under the current-rate or closingrate method than under all other methods if the FC had appreciated. (3 marks) 9) Identify the one true statement about the expected exposure of the GBP value of assets to a change in the GBP/USD exchange rate: (A) (B) (C) (D) (E) US government bonds have zero exposure. UK government bonds have negative exposure. Shares in an American importer have negative exposure. Shares in a British importer have negative exposure. Shares in a British exporter have negative exposure. (3 marks) 3 Please turn over 10) Identify the one false statement about international NPV calculations: (A) A three-step process can be used for valuing international projects: branch stage, unbundling stage and external financing stage. (B) In the branch stage, the foreign subsidiary is treated as a legally separate company. (C) In the unbundling stage, the costs and benefits of intragroup financial arrangements are analysed. (D) In the external financing stage, it has to be decided whether the parent or the subsidiary should borrow. (E) Political risks include transfer risk and the risk of expropriation. (3 marks) (Total 30 Marks) 4 Please turn over QUESTION 2 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) The following questions are about money and banking. Required: i) ii) iii) iv) How was trade conducted before the development of paper (fiat) money? Was there any role for exchange rates before the development of paper money? Explain. In the current monetary system, how do central banks influence the money supply? Why are monetary policies of central banks important for exchange rates? Hint: Consider the covered interest parity formula. (10 marks) OR b) Over time, different currencies traded under different exchange-rate regimes. Required: i) How did the exchange-rate regime work which involved gold? ii) Describe one exchange-rate regime which is currently used and give an example of a currency other than the US dollar traded under this regime. iii) Under which different exchange rate-regimes had the US dollar traded since 1900? iv) State one reason why the US dollar is the most important currency in the world today? (10 marks) 5 Please turn over QUESTION 3 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) Assume that a Big Mac costs AUD 3.4 in Australia and USD 3.2 in the United States. You are also given the following official exchange rates: USD/EUR 1.20 and AUD/EUR 1.32. Required: i) ii) iii) iv) Calculate the USD price of a Big Mac in Australia using the information provided above. Calculate the implied purchasing power parity (PPP) rate in USD/AUD. Calculate the real exchange rate in AUD/USD. According to the Big Mac prices, is the AUD overvalued or undervalued compared to the USD? Explain. (10 marks) OR b) Assume that you observe the following data regarding the NZD/GBP exchange rate: - Spot rate: 2.322.34 - 6-month forward rate: 2.3652.394 - 6-month NZD interest rate (simple, p.a.): 5.155.35% - 6-month GBP interest rate (simple, p.a.): 2.652.85% Required: i) Which of the two values shown as spot rate is the bid rate, and which one is the ask rate? Explain. ii) Calculate the synthetic 6-month forward rate (both the bid and ask rate). iii) Is there any opportunity for arbitrage or shopping around using the synthetic forward rate? Explain. (10 marks) 6 Please turn over QUESTION 4 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) You are given the following data: the spot exchange rate is INR/GBP 58; the p.a. simple interest rate on a nine-month deposit is 9% in India and 3% in the UK. Note: t is today and T is the end of the investment period. Required: Compute: i) The INR/GBP forward rate for a nine-month forward contract. ii) The INR/GBP swap rate for a nine-month period. iii) The time-T INR value of a time-t INR 10,000 investment. iv) The time-t GBP value of a time-t INR 5,000 spot sale. v) The time-t INR value of the proceeds of a time-T GBP 500 loan. (10 marks) OR b) The following questions are about spot exchange quotes in the wholesale market, where different banks provide different bid and ask quotes for various exchange rates. Required: i) What does the law of one price for spot exchange quotes state? ii) What does arbitrage mean? Give an example of an arbitrage opportunity in the spot exchange market. iii) What does shopping around mean? Give an example of an opportunity for shopping around in the spot exchange market. iv) Why is arbitrage and shopping around important in the spot exchange market? (10 marks) 7 Please turn over QUESTION 5 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) You work for a Spanish firm and are asked to hedge an outflow of MXN (Mexican peso) 400m with futures contracts. However, no future on EUR/MXN is available. After doing some research, you find that EUR/MXN and EUR/USD are correlated because Mexico and the United States share a border and therefore there is a high volume of trade between the two countries. Therefore you decide to hedge the risk with EUR/USD futures contracts. Additionally, you consider a EUR/AUD future. In order to determine your hedging positions, you estimate a multiple regression model. The regression output is, with 2 t-statistics in parentheses and R = 0.67, as follows. S [EUR/MXN] = a + 0.46f [EUR/USD] 0.02f [EUR/AUD] . (9.32) (0.05) Required: i) If a USD contract is for USD 10m and an AUD contract for AUD 5m, how will you hedge if you use both contracts? ii) Should you use both contracts? Explain. iii) Now assume that the Spanish firm hedges the outflow of MXN perfectly using forwards. Draw a diagram which shows the payoff of the outflow of MXN and the forward position which hedges the exposure. Label the axes. (10 marks) OR b) You borrow Canadian dollar (CAD) 10m at 5% for one year, and you swap the loan into South African rand (ZAR) at a spot rate of CAD/ZAR 0.20 and the one-year swap rates of 4% (CAD) and 8% (ZAR). Required: i) What are the payments on the loan, on the swap, and on the combination of them? Show your results in a table. ii) Is there a gain of using the swap if you could have borrowed ZAR at 9%? Explain. iii) State two benefits of swaps. (10 marks) 8 Please turn over QUESTION 6 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) Assume that the exchange rate between the British pound (GBP) and the Chinese yuan (CNY) is CNY/GBP 10. Also assume that the per annum interest rate in China is 6%, and the per annum interest rate in Great Britain is 4%. A bank offers to sell you options on the British pound with a time-to-maturity of one year and a strike price of CNY/GBP 9 for GBP 1. Required: i) Draw a diagram which shows the payoff at expiration from buying the above CNY/GBP call option. Label the axes. ii) There are arbitrage conditions imposing limits on the prices of options. What is the intuition underlying the arbitrage condition between the value of a call option and the value of a long forward contract? iii) Does the bank's offer violate this arbitrage condition? Should you therefore accept the offer or should you reject it? iv) If you accept the offer, is there an arbitrage opportunity? How would you exercise it? (10 marks) OR b) Consider that an Italian firm has the following contract: - It has to sell USD in one year at a rate of EUR/USD 0.80 if the USD trades below 0.80. - It has to sell USD in one year at a rate of EUR/USD 0.90 if the USD trades above 0.90. - It has to sell USD in one year at the spot rate if the EUR/USD is between 0.80 and 0.90. Required: i) Show the payoff of the contract graphically. ii) Show that the contract can be viewed as a combination of European-style options. iii) What is the benefit of this contract as a hedging instrument? (10 marks) 9 Please turn over QUESTION 7 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) Corporate hedging can create shareholder value in the presence of market imperfections, such as taxes, financial distress costs or agency costs. Required: i) How can corporate hedging create shareholder value in the presence of taxes? ii) How can corporate hedging create shareholder value in the presence of financial distress costs? iii) What are agency costs? How can corporate hedging create shareholder value in the presence of agency costs? (10 marks) OR b) Forwards can be used to hedge operating exposure. Consider the US firm Ford. If the USD is weak against the JPY, exporting becomes easier and the value of the firm increases. Additionally, the value of the firm in USD depends on the general state of the economy in the United States (bad or good). Ford's management estimates different firm values in USD depending on the level of the USD/JPY exchange rate and states of the US economy, as shown in the table below. It estimates that it is equally likely that the USD will be strong or weak against the JPY. It also estimates that it is equally likely that the US economy will be in a bad or good state. State of the economy Value if USD/JPY=80 Value if USD/JPY=100 Bad 36bn 29bn Good 46bn 39bn Required: i) A weak USD against the JPY makes it easier for Ford to export to Japan. What is another benefit of a weak USD against the JPY for Ford? ii) Calculate the currency exposure. iii) What is the optimal forward hedge? iv) Are the estimates of the firm value by Ford's management reasonable? Explain. (10 marks) 10 Please turn over QUESTION 8 (10 marks in total): ANSWER EITHER SUB-QUESTION A) OR SUB-QUESTION B). a) You consider investing in shares of BMW AG, a German carmaker. As part of your research on the company, you determine BMW's cost of capital using the international CAPM (InCAPM). You use the FTSE World as world market portfolio and include the US and UK exchange rates in your analysis. You obtain the following regression result: E (~BMW r0 ) = 1.20 E (~ r0 ) + 0.51 E (~US + r0,US r0 ) 0.22 E (~UK + r0,UK r0 ) r rw s s ( 4.38) ( 0.86) (2.13) Required: i) Interpret the output of the regression analysis. ii) Describe the difference between the CAPM and the InCAPM. (10 marks) OR b) Assume that you are the CFO of a large French company. The company is interested in evaluating a business opportunity in Russia. You recall that domestic business opportunities can be evaluated using a standard NPV rule. Required: i) What is the additional complexity in case of evaluating a business opportunity in a foreign country such as Russia? ii) What are the two approaches in which foreign business opportunities can be evaluated using NPV analysis? iii) Why is the mathematical result that E[x*y] is not equal to E[x]*E[y] (with x and y being two arbitrary random variables) important for international capital budgeting? iv) Which of the two approaches would you decide to use for evaluating a business opportunity in Russia? Explain. (10 marks) END OF PAPER 11