Suppose that the current spot exchange rate is 0.98/$ and the six-month forward exchange rate is 0.9712/$. The six-month interest rate is 2.11 percent per annum in the United States and 4.92 percent per annum in France. Assume that you can borrow up to $1,000,000 or 980,000 a) Show the steps until you can create a profit via covered interest arbitrage in U.S. dollars. (20 marks) b) Repeat the above of (a) but you would create a profit in euros. (10 marks) Question 2 (40 marks) You are the U.S residents who are going to pay SF 5,000 for your family flight tickets to Switzerland in 3 months later. The 3-month forward rate is $0.63/SF. Today, the spot rate of USD to Swiss Franc (SF) is 0.60. You plan to hedge the exchange rate by entering into a 3month call option on SF. The exercise rate of the option is $0.64/SF for the premium of $0.05 per SF. The addition information you have collected is 3-month USD interest rate 6 percent per annum and SF interest rate 4 percent per annum. You expect the future spot exchange rate would be the forward rate. a) What is your cost of buying SF5,000 with SF call option used for hedging? (8 marks) b) Compared with (a), what is the dollar (USD) cost of SF payable if you hedge using a forward contract. (6 marks) c) Determine the future spot exchange rate that will equate the total cost of using forward and option market hedges. (8 marks) d) If the SF appreciates beyond the exercise price of call option, what is your total dollar cost of SF payable? (8 marks) e) Draft a graph of Cost (y-axis) against \$/SF (x-axis) on option hedge and forward hedge. (10 marks) A U.S. company namely Alpha Best Corporation's capital structure is composed of 40 percent debt and 60 percent equity. Its cost of equity capital is 12 percent and its before-tax borrowing rate is 8 percent. Given a marginal tax rate of 35 percent, calculate a) the weighted-average cost of capital; (6 marks) b) the cost of equity for an equivalent all-equity financed firm. (8 marks) c) The company is planning to invest in South Korea. The investment requires initial outlay of South Korean won KRW80,000. The annual cash flows over the five year economic life of the investment in KRW are estimated to be 300,000,400,000,500,000,600,000, and 700,000 . The parent firm's cost of capital in dollars is 9.5 percent. Inflation in the U.S. is 3 percent per annum and 7 percent in South Korea. The current spot foreign exchange rate is KRW1336.42/\$. i) Calculating the NPV in KRW using the KRW equivalent cost of capital according to the Fisher Effect and then converting to USD at the current spot rate. (6 marks) ii) Converting all cash flows from KRW to USD at Purchasing Power Parity forecasted exchange rates and then calculating the NPV at the dollar cost of capital. (6 marks) iii) What can you conclude based on the answers in (a) and (b)? (4 marks)
