acf305-exam-2012-13 LANCASTER UNIVERSITY 2013 EXAMINATIONS PART II (SECOND AND FINAL YEAR) ACCOUNTING AND FINANCE

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: current/noncurrent method, monetary/nonmonetary 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: 2.32?2.34
- 6-month forward rate: 2.365?2.394
- 6-month NZD interest rate (simple, p.a.): 5.15?5.35%
- 6-month GBP interest rate (simple, p.a.): 2.65?2.85%
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 + 0.46?f [EUR/USD] ? 0.02?f [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)