Question 12

a) The depreciation of the Ghana Cedi against the major trading currencies is a source of worry to many businesses who import raw materials as inputs for production. It is also a major challenge in the petroleum sector as it is one of the inputs in the price build-up.

You have been recently appointed as a consultant on Financial Risk management and your tasks include advising government and private sector on how to manage foreign exchange rate risk.

You are required to give your first public lecture on how the private sector should position itself to reduce the effect of foreign exchange rate risk and also what options are available to government to insulate the economy against exchange rate risk. Your presentation should cover;

i) The sources of exchange rate risk in the private sector

ii) Business practices that can be adopted to mitigate exchange rate risk

iii) Financial instruments available on the international market that can be used by government to hedge exchange rate risk. (10 marks)

b) The exchange rate between the Ghana cedi (GHS) and the United States Dollar (USD) on Friday 21st July 2017 is 1 USD to 4.4450. The 6months interest rate for GHS is 12.9% whilst that of USD is 1.78%.

i) How should the 6months forward rate between USD and GHS be quoted to avoid arbitrage? (5marks)

ii) A company expects to pay USD 1m in 6months time for goods it is importing from China and is looking to hedge its exchange rate risk. Is it prudent for the company to buy USD 6months forward? Advise the company. (5 marks)

iii) In just one sentence, define each of the following expressions

a. Currency call option

b. Triangular arbitrage

c. The futures market

d. The forward market

e. Cross rate

iv) State the Theory of Comparative Advantage and show how it explains firms motivation to expand internationally.

v) Differentiate between licensing and franchising as two methods of international business. Give one example each of licensing and franchise cases that you find in Ghana.

vi) Give the three main dealers in the foreign exchange market briefly describing their activities in the market.

vii) Describe the two ways by which futures contracts may be liquidated.

viii) A Ghanaian multinational company has total assets valued at GHS200 million with debt amounting to GHS40 million. The cost of debt before tax of this multinational is 10% whilst its cost of financing with equity is 16%. If the MNC has corporate tax rate of 34%, find the firms weighted average cost of capital.

ix) The current cedi euro spot rate is GHS5.5555/. Assume inflation rate in the euro zone is 4% and that of Ghana is 12% and that they are expected to persist in the foreseeable future. If a Ghanaian businesswoman who imports goods from the eurozone is expected to import goods to the tune of two million euros (2,000,000) in the coming year

(i) What budget estimate in cedis should be made towards the payment of the imports from France in the euro zone. Assume PPP holds.

(ii) What budget estimate in cedis should be made towards the payment of imports in the second year for imports amounting to three million euros (3,000,000). Again assume that PPP holds.

x) Ford America has exported cars to Switzerland to the tune of ten million Swiss francs (CHF10,000,000). This amount is expected to be received in 90 days by Ford America. Ford America believes the 90-day forward rate is an accurate forecast of the future spot rate. The 90-day forward rate of the Swiss franc is $0.98. A put option is available with a strike price of $0.99 and a premium of $0.03. As a financial manager of Ford America, analyse how much Ford America is expected to receive as net sales from this export in US dollars.

xi) The table below shows the currencies of selected four countries, Russia, Kenya, United Arab Emirates and South Africa buying a unit of the UK pound, the US dollar, and the European Union euro. Figures are closing rates taken on a particular day in 2018. Using the concept of cross rates, fill in the spaces marked X using the available information.

Country Currency STG $ US Euro

Russia Rouble X 61.4472 72.1301

Kenya Shilling 135.4700 X X

United Arab Emirates Dirham 4.9198 3.6732 4.3118

South Africa Rand X 12.3976 X

xii) A Ghanaian firm has two sources to borrow to finance its operations. The local course of borrowing at 25 percent per annum or dollar denominated source at 6 percent. The consultant also indicates that the expected possible appreciation or depreciation of the dollar in relation to the cedi is given in the table below. Advise which of the financing sources the Ghanaian firm should borrow from.

Possible rate of change in the US dollar the next one year (ef) Probability of occurrence

-5% 10%

-4% 15%

8% 20%

12% 25%

15% 30%

100%

xiii) Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.

(2 marks)

Bank A Bank B

Bid price of Ghana Cedi $0.2222 $0.2251

Ask Price of Ghana Cedi $0.2247 $0.2255

Given the above information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1 million to use. (3 marks)

xiv) You often take speculative positions in options on euros. One month ago, the spot rate of the euro was $1.49, and the 1-month forward rate was $1.50. At that time, you sold call options on euros at the money. The premium on that option was $.02. Today is when the option will be exercised if it is feasible to do so.

a) Determine your profit or loss per unit on your option position if the spot rate of the euro is $1.55 today. (3marks)

b) Repeat question a, but assume that the spot rate of the euro today is $1.48. (2marks)

xv) a) Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of currencies in countries with high inflation? (2marks)

b) Todays spot rate of the Ghana Cedi is $0.22. Assume that purchasing power parity holds. The U.S. inflation rate over this year is expected to be 5 percent, while Ghana inflation over this year is expected to be 9.8 percent. E5 Company Ltd is a Ghanaian company and it plans to import from United States and will need 20 million US dollars in 1 year. Determine the expected amount of cedis to be paid by the E5 Company Ltd for the US dollars in 1 year. (Please take Ghana as the home country). (3marks)

xvi) a) Explain the international Fisher effect (IFE) theory. Explain why the IFE may not hold. (1 mark)

b) Assume that the Australian dollars spot rate is $.90 and that the Australian and U.S. one-year interest rates are initially 6 percent. Then assume that the Australian one-year interest rate increases by 5 percentage points, while the U.S. one-year interest rate remains unchanged.

Using this information and the international Fisher effect (IFE) theory, forecast the spot rate for one year ahead. (2marks)

c) According to the IFE, what is the underlying factor that would cause such a change in interest rate in (b) above? If U.S. investors believe in the IFE, will they attempt to capitalize on the higher Australian interest rates? Explain. (2 marks)

xvii) a) Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its net cash flows in each currency when assessing its transaction exposure? (2 marks)

b) Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash flows are as follows for the next year. Danish krone inflows equal DK50, 000,000 while outflows equal DK40, 000,000. British pound inflows equal 2,000,000 while outflows equal 5,000,000. The spot rate of the krone is $.15, while the spot rate of the pound is $1.50. Estimate your companys transactions exposure. It is forecasted that USD will depreciate over the next 1 year against the major currencies around the world, what do you think will be the impact of the companys currency position on its value? Explain your answer. (3 marks)

xviii) a) Explain the concept of interest rate parity. Provide the rationale for its possible existence. (2 marks)

b) Assume that the existing U.S. one-year interest rate is 10 percent and the Canadian one-year interest rate is 11 percent. Also assume that interest rate parity exists.

Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return?

(3 marks)

xix) a) The exchange rate between the Ghana cedi (GHS) and the United States Dollar (USD) on Friday 18th May 2018 is 1 USD to 4.5175. The 6-month interest rate for GHS is 13.90% whilst that of USD is 3%. How should the 6-month rate between USD and GHS be quoted to avoid arbitrage? (2 marks)

b) A company expects to pay USD 1m in 6months time for goods it is importing from China and is looking to hedge its exchange rate risk. Is it prudent for the company to buy USD 6months forward? Explain your answer. (1 mark)

c) The Treasurer of this company has heard that a new bank that has opened in Ghana offers Risk management products that can help him hedge its foreign exchange rate risk. He however lacks understanding and has contacted you for advice. Explain three derivative products he can use to hedge its foreign exchange rate risk. (2marks)