Chapter 4: Exchange Rate Determination

ANSWER: Various models are possible. One model would be: % Change = a0 + a1 (rU.S. rM) + u in peso Where rU.S. rM a0 a1 u = = = = real interest rate in the U.S. real interest rate in Mexico intercept regression coefficient measuring the relationship between the real interest rate differential and the percentage change in the pesos value error term

45

Based on the model above, the regression coefficient is expected to have a negative sign. A relatively high real interest rate differential would likely cause a weaker peso value, other things being equal. An appropriate model would also include other independent variables that may influence the percentage change in the pesos value. b. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have affected exchange rates, how might this be accounted for in the regression model? ANSWER: A dummy variable could be included in the model, assigned a value of one for periods when a quota existed and a value of zero when it did not exist. This answer requires some creative thinking, as it is not drawn directly from the text.

Solution to Continuing Case Problem: Blades, Inc.

1. How are percentage changes in a currencys value measured? Illustrate your answer numerically by assuming a change in the Thai bahts value from a value of $0.022 to $0.026. ANSWER: The percentage change in a currencys value is measured as follows:

% =

S St 1 St 1

where S denotes the spot rate, and St 1 denotes the spot rate as of the earlier date. A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation. In the example provided, the percentage change in the Thai baht would be:

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International Financial Management S St 1 $0.026 $0.022 = = 1818% . St 1 $0.022

% =

That is, the baht would be expected to appreciate by 18.18%. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currencys value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. 3. How might the relatively high levels of inflation and interest rates affect the bahts value? (Assume a constant level of U.S. inflation and interest rates.) ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the U.S. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for U.S. goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for U.S. investors, causing an increase in the demand for baht. Furthermore, U.S. securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailands inflation. 4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from Thailand, will affect the bahts value? Would Blades be affected by the change in value, given the primary Thai customers commitment? ANSWER: In general, depreciation in the foreign currency results when investors liquidate their investments in the foreign currency, increasing the supply of its currency for sale. Blades would probably be affected by the change in value, as the sales are denominated in baht. Thus, the depreciation in the baht would have caused a conversion of the baht revenue into fewer U.S. dollars. 5. Assume that Thailands central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currencys value. How could it accomplish this objective using interest rates? ANSWER: If Thailands central bank wishes to prevent further depreciation in the bahts value, it would attempt to increase the level of interest rates in Thailand. In turn, this would increase the demand for Thai baht by U.S. investors, as Thai securities would now seem more attractive. This would place upward pressure on the currencys value. However, the high interest rates could reduce local borrowing and spending.

Chapter 4: Exchange Rate Determination

47

6. Construct a spreadsheet illustrating the steps Blades treasurer would need to follow in order to speculate on expected movements in the bahts value over the next 30 days. Also show the speculative profit (in dollars) resulting from each scenario. Use both of Ben Holts examples to illustrate possible speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount. Furthermore, assume that the following short-term interest rates (annualized) are available to Blades: Currency Dollars Thai baht Lending Rate 8.10% 14.80% Borrowing Rate 8.20% 15.40%

ANSWER: (See spreadsheet attached.) Depreciation of the Baht from $0.022 to $0.020 1. Borrow Thai baht ($10,000,000/0.022). 2. Convert the Thai baht to dollars ($454,545,454.50 million $0.022). 3. Lend the dollars at 8.10% annualized, which represents a 0.68% return over the 30-day period [computed as 8.10% (30/360)]. After 30 days, Blades would receive ($10,000,000 (1 + .0068)). 4. Use the proceeds of the dollar loan repayment (on Day 30) to repay the baht borrowed. The annual interest on the baht borrowed is 15.40%, or 1.28% over the 30-day period [computed as 15.40% (30/360)]. The total baht amount necessary to repay the loan is therefore (454,545,454.50 (1 + .0128)). 5. Number of dollars necessary to repay baht loan ($THB460,363,636.40 $0.02). 6. Speculative profit ($10,068,000 $9,207,272.73). Appreciation of the Baht from $0.022 to $0.025 1. Borrow dollars. 2. Convert the dollars to Thai baht ($10 million/$0.022). 3. Lend the baht at 14.80% annualized, which represents a 1.23% return over the 30-day period [computed as 14.80% (30/360)]. After 30 days, Blades would receive (THB454,545,454.50 (1 + .0123)). 4. Use the proceeds of the baht loan repayment (on Day 30) to repay the dollars borrowed. The annual interest on the dollars borrowed is 8.20%, or 0.68% over the 30-day period [computed as 8.20% (30/360)]. The total dollar amount necessary to repay the loan is therefore ($10,000,000 (1 + .0068)). 5. Number of baht necessary to repay dollar loan ($10,068,000.00/$0.025). 10,000,000.00 454,545,454.50 454,545,454.50 10,000,000.00

10,068,000.00

460,363,636.40 9,207,272.73 860,727.27

460,136,363.60

10,068,000.00 402,720,000.00

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International Financial Management

57,416,363.60 1,435,409.09

6. Speculative profit (THB460,136,363.60 THB402,720,000.00). 7. Dollar equivalent of speculative profit (THB57,416,363.60 $0.025).

Solution to Supplemental Case: Bruin Aircraft, Inc.

Some of the more commonly cited factors are listed as follows. This exercise forces students to recognize how factors influence the value of each currency. Check (X) Here if the Factor Influences the U.S. Demand for Pounds X X X Check (X) Here if the Factor Influences the Supply of Pounds for Sale X X X

Factors that Can Affect the Value of the Pound iU.S. iU.K. INFU.S. INFU.S. Income Growth Differential New U.S. Quotas on Imports from U.K. U.S. Tariffs on Imports from U.K. New U.K. Quotas on Imports from U.S.

X Check (X) Here if the Factor Influences the U.S. Demand for Pounds Check (X) Here if the Factor Influences the Supply of Pounds for Sale X

Factors that Can Affect the Value of the Pound New U.K. Tariffs on Imports from U.S. Government Intervention to Purchase $ with Pounds Government Intervention to Purchase Pounds with $ Government Tax to be Imposed on Interest Income Earned by U.K. Investors from Future U.S. Investments Government Tax to be Imposed on Interest Income Earned by U.S. Investors from Future U.K. Investments

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International Financial Management

ANSWER: The central bank intervention placed downward pressure on the pound and other European currencies. Thus, the values of futures contracts on these currencies declined. Traders that had short positions in futures would benefit because they could now close out their short positions by purchasing the same contracts that they had sold earlier. Since the prices of futures contracts declined, they would purchase the contracts for a lower price than the price at which they initially sold the contracts. d. Some traders with buy positions may have responded immediately to the central banks intervention by selling futures contracts. Why would some speculators with buy positions leave their positions unchanged or even increase their positions by purchasing more futures contracts in response to the central banks intervention? ANSWER: Central bank intervention sometimes has only a temporary effect on exchange rates. Thus, the European currencies could strengthen after a temporary effect caused by central bank intervention. Traders have to predict whether natural market forces will ultimately overwhelm any pressure induced as a result of central bank intervention.

Chapter 5

Solution to Continuing Case Problem: Blades, Inc.

1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $0.00756 or the call option with the exercise price of $0.00792? Describe the tradeoff. ANSWER: The table shows how the option choices have changed for Blades. If it wants to ensure paying no more than 5 percent above the spot rate, the option with the exercise price of $0.00756 should be considered, although the premium on that option now has increased to be worth 2 percent of the exercise price (more expensive). The option premium is higher than what the firm normally prefers to pay. The firm could pay a lower premium by purchasing the alternative option with an exercise price of $0.00792, but that exercise price is 10 percent above the existing spot rate. This alternative option does not achieve the firms desire to ensure paying no more than 5 percent above the existing spot rate. So if the firm is to continue to use options, it must accept either paying a higher premium than it would prefer, or a higher exercise price that limits the effectiveness of the hedge. If it decides to use an option, the tradeoff is paying a premium of $1,417.50 to limit the payables amount to $99,000 or paying a premium of $1,890 to limit the payables amount to $94,500. The preferred option depends on the firms assessment about the yen, but many analysts would select the higher premium (an extra $472.50) to pay for the lower limit on payables. 2. Should Blades allow its yen position to be unhedged? Describe the tradeoff. ANSWER: Blades could also remain unhedged, but given its previous desire to hedge because of the volatile movements even before the event, it would have an even stronger desire to hedge once the event caused more uncertainty about the yens future value. Since futures prices were not affected by the uncertainty-increasing event, Blades should seriously consider futures contracts as an alternative to options. Thus, the firm could purchase a futures contract and lock in its future payment at the same futures price as before the event. 3. Assume there are speculators who attempt to capitalize on their expectation of the yens movement over the two months between the order and delivery dates by either buying or selling yen futures now and buying or selling yen at the future spot rate. Given this information, what is

Chapter 5: Currency Derivatives

73

the expectation on the order date of the yen spot rate by the delivery date? (Your answer should consist of one number.) ANSWER: If there are speculators who attempt to capitalize on their expectation of the yens future movement, then the expectation of the future spot rate would be equal to the futures rate. For example, suppose speculators expect the yen to appreciate. They would buy yen futures now. If the yen appreciates, they will buy the yen at the futures rate in two months and sell them at the spot rate prevailing at that time. Thus, if the market expectation is that the yen will appreciate, all speculators will engage in similar actions, which would place upward pressure on the futures rate and downward pressure on the expected future spot rate. This process continues until the futures rate is equal to the expected future spot rate. Therefore, the expected spot rate at the delivery date is equal to the futures rate, $0.006912. 4. Assume that the firm shares the market consensus of the future yen spot rate. Given this expectation and given that the firm makes a decision (i.e., option, futures contract, remain unhedged) purely on a cost basis, what would be its optimal choice? ANSWER: (See spreadsheet attached.) The optimal choice, given the expected future spot rate in question 3 and given that the decision is made solely on a cost basis, is to purchase one futures contract, which would result in an actual cost on the delivery date of $86,400. Although remaining unhedged also has an expected cost of $86,400, actual costs incurred on the delivery date to purchase yen may deviate substantially from this value, depending on the movements of the yen between the order date and the delivery date. Consequently, the firm will probably prefer using a futures contract over remaining unhedged. 5. Will the choice you made as to the optimal hedging strategy in question 4 definitely turn out to be the lowest-cost alternative in terms of actual costs incurred? Why or why not? ANSWER: No, as mentioned in the case, the yen is very volatile and, therefore, the actual costs incurred may turn out to be lower had the firm employed either an option to hedge the yen payable or remained unhedged. By employing a futures contract to hedge, which locks the firm into the price it will pay to buy the yen at the delivery date, the firm forgoes any cost advantage that may result from a substantial depreciation of the yen by the delivery date. In that case, remaining unhedged and employing options afford the firm with the flexibility to buy yen at the spot rate; this flexibility is not available with a futures contract. Alternative 1Remain Unhedged Expected Spot Rate Amount of Yen Payables Cost in Two Months ($.006912 12,500,000 units) Alternative 2Purchase One Futures Contract Futures Price per Unit Units in Contract Cost in Two Months ($.006912 12,500,000) $ 0.006912 12,500,000 $ 86,400.00 $ 0.006912 12,500,000 $ 86,400.00

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Alternative 3Purchase Two Options Options Information Exercise Price Premium per Unit Units in Contract Calculations Column A Total Premium (Premium per Unit Units) Two Options, Exercise Price of $.00756 Two Options, Exercise Price of $.00792 One Option of Each Exercise Price $1,890.00 $1,417.50 $1,653.75 Column B

International Financial Management

Option 1 $0.0075600 $0.0001512 6,250,000 Column C Amount Paid for Yen (Exercise Price Units) $86,400.00 $86,400.00 $86,400.00

Option 2 $0.0079200 $0.0001134 6,250,000 Column D Total Paid (Column A + Column C) $88,290.00 $87,817.50 $88,053.75

Exercise? (Is Spot Rate > Exercise Price?) No No O1-No; O2-No

6. Now assume that you have determined that the historical standard deviation of the yen is about $0.0005. Based on your assessment, you believe it is highly unlikely that the future spot rate will be more than two standard deviations above the expected spot rate by the delivery date. Also assume that the futures price remains at its current level of $0.006912. Based on this expectation of the future spot rate, what is the optimal hedge for the firm? ANSWER: (See spreadsheet attached.) Although the spreadsheet is required, the answer to this question is intuitive. If the futures rate remains at its current level while the expected spot rate at the delivery date increases, remaining unhedged will become more expensive than hedging with a futures contract (recall that the two alternatives have the same expected cost). However, as the spreadsheet shows, the option with the exercise price of $0.00756 would now be exercised. Nevertheless, since both options have an exercise price greater than the futures rate of $0.006912, and since the expected future spot rate is greater than the futures rate, the futures contract is again the best alternative for the firm. Calculation of Highest Forecasted Spot Rate Expected Spot Standard Deviation Spot Rate if Yen Increases 2 Standard Deviations ($.006912 + [2 0.0005]) Alternative 1Remain Unhedged Expected Spot Rate Amount of Yen Payables Cost in Two Months ($.007912 12,500,000) Alternative 2Purchase One Futures Contract Futures Price per Unit Units in Contract Cost in Two Months ($.006912 12,500,000) $0.006912 0.000500 $0.007912 $ 0.007912 12,500,000 $ 98,900.00 $ 0.006912 12,500,000 $ 86,400.00

Chapter 5: Currency Derivatives

Alternative 3Purchase Two Options Options Information Exercise Price Premium per Unit Units in Contract Calculations Column A Total Premium (Premium per Unit Units) Two Options, Exercise Price of $.00756 Two Options, Exercise Price of $.00792 One Option of Each Exercise Price $1,890.00 $1,417.50 $1,653.75 Column B Exercise? (Is Spot Rate > Exercise Price?) Yes No O1-Yes; O2-No Option 1 $0.0075600 $0.0001512 6,250,000 Column C Amount Paid for Yen (Exercise Price Units) $94,500.00 $98,900.00 $96,700.00

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Option 2 $0.0079200 $0.0001134 6,250,000 Column D Total Paid (Column A + Column C) $96,390.00 $100,317.50 $98,353.75

Solution to Supplemental Case: Capital Crystal, Inc.

This case is designed to give students more insight on the advantages and disadvantages of currency futures and options. More comprehensive questions on this subject are offered in Chapter 11. a. To hedge with futures, the cost of the imports will be $795 million ($1.59 500 million). To hedge with call options, the cost per unit (including the premium paid) is $1.61, so that the cost of the imports if the option is exercised is $805 million. Since the pounds spot rate is expected to be above the call options exercise price, the call option would likely be exercised. In this case, hedging with futures will cost $10 million less than hedging with call options. b. Since the future spot rate is likely to exceed the futures price, hedging with futures would likely be less costly than not hedging. Even if it was more costly, it might be wise to hedge in keeping with the conservative management style of Capital Crystal, Inc. This part of the case illustrates that currency call options may not always be the best choice, even though they offer more flexibility than currency futures. Based on the new information, the cost of importing when using futures is still $795 million. When using the call option, if the forecast of the pounds future spot rate is correct, the option would not be exercised. Thus, the amount paid per unit would be the future spot rate of $1.57 plus the $.01 premium paid per unit for the option. Therefore, the cost of imports would be $790 million, or $5 million less than when using the futures hedge. Assuming the forecast is correct, the cost of importing when not hedging is $785 million ($1.57 500 million), which is less than the cost of either hedge. However, given the conservative management style of Capital Crystal, Inc., a hedge may still be appropriate. If the pounds value is just $.02 higher than forecasted in three months, Capital will have to pay $5 million more than if it had hedged with a call option. This issue normally generates much discussion. The key question is whether a manager should take the risk of not hedging. While this strategy is expected to save the