International Financial Managmenet N1548 Seminar 4 Questions and answers 1. If we assume that foreign exchange markets for major world currencies are "efficient" and forward exchange rates are unbiased predictors of future spot exchange rates then using the assumptions of relative purchasing power parity and the below table of inflation rates and initial spot exchange rates in United States and UK, estimate the spot exchange rate for each period. Current spot exchange rate: $1.5723/ £ every 1£= $1.5723 Year 1 2 3 4 5 6 USA 2.4% 2.8% 3.5% 3.2% 1.8% 2.2% UK inflation 3.2% 3.6% 4.2% 2.5% 2.4% 3.1% inflation Expected X1 X2 X3 X4 X5 X6 exchange rate Answer: Using RPPP theory 0*1+T 1Us S1=S 1+T 1UK =USD 1.5601/GBP 1*1+T 2US =USD 1.5481/GBP S2=S 1+T 2UK 2*1+13 1+T 3UK =USD 1.5377/GBP S3=S 3*1+T 4US S4=S =USD 1.5482/GBP 1+T 4 UK 4 * 1+15 US 1+15 UK =USD 1.5391/GBP S5=S
5*1+T 6US S6=S 1+T 6 UK =USD 1.5257 /GBP 2. If the current spot exchange rate is CNY 9.8483/GBP, the 90-day Chinese Yuan deposit rate is 6.5% per annum and the yield on 90-day UK GBP denominated deposit is 9.6% per annum From the above scenario what is the forward exchange rate in 3 months' time? i of price currency (CNY ) adjusted i of unit currency (GBP ) adjusted S* 1+(¿ maturity) F 90= [1+ ¿maturity] CNY /GBP* 1+ 0.065*90 360 F90=9.8483 [ 1+ 0.096*90 360 ? =9.7737 CNY / GBP 3. A UK based firm, has a foreign currency denominated payable to a Brazilian trading partner due in 180 days of BRL 8,000,000. As CFO and given the information in the table below you have to evaluate and distinguish between four strategies and decide which is preferable. i) What is the value if the company remains unhedged? ii) What is the value if a forward contract is used as a hedge? iii) What is the value if a Money market hedge is used? iv) What is the terminal value if an option hedge is used? v) As CFO which of these hedging techniques would you recommend and why? Assumptions: spot rate six month forward rate BRL2.7002/GBP firm's best estimate of spot rate in six months BRL2.7200/GBP Firm's WACC 7% Six Month Brazilian investing rate 8% Six Month Brazilian borrowing rate 10% Six Month UK investing rate 6% Six Month UK borrowing rate 9% call option strike price on BRL BRL2.7300/GBP BRL2.7312/GBP
call option premium 1.50% Put option strike price on BRL BRL 2.7300/GBP Put option premium 2% Answer: i) What is the most likely value in six months if position if left un-hedged? This is simply the initial sterling value of payable divided by the best estimate of spot exchange rate in six months. i.e. Unfihedged value = BRL 8,000,000 / BRL2.7200/GBP = GBP 2,941,176 ii) What is the value is a forward contract is used as a hedge? The firm could buy a forward contract thereby locking in the rate as B-Real 2.7002/£UK and as such: