Question 1 (2 marks)

Explain how a firm can use currency diversification to reduce transaction exposure.

ANSWER: If a firm has net inflows in a variety of currencies that are not highly correlated with each other, ex

Question 2 (4 marks)

Fx differential : [(INR1.3320/INR1.3095) 1]x100% = +1.7182% per 180 days

SGD1 is at a 180 day forward premium against INR.
Interest differential : {[(1+(0.075x180/360))/(1+(0.03x180/360))] 1}x100% = +2.2167% per 180 days.
Hence, fx differential < interest differential & so no, IRP does not exist
Profitable strategy : borrow the strong (SGD) , invest in the weak (INR).

Day 0 : 1. borrow SGD 20m at 3%p.a. for 180 days

2. convert SGD20m to INR26,190,000 spot at INR1.3095 = SGD1
3. invest INR26,190,000 at 7.5%p.a. for 180 days
4. sell INR fwd at INR1.3320 = SGD 1

Day 180 : 1. Repay SGD loan totalling SGD $20,300,000

2. realise INR investment giving INR27,172,125
3. sell INR proceeds fwd at INR1.3320 = SGD1 giving SGD $20, 399, 493. 24
4. 180 day profit = SGD20, 399, 493.24 SGD20,300,000 = SGD $99, 493.24
elated with each other, exposure is not as great as if the equivalent amount of funds were denominated in a single currency. This is bec
a single currency. This is because not all currencies will depreciate against the firm's home currency simultaneously by the same degre
aneously by the same degree. There may be a partial offsetting effect due to a diversified set of inflow currencies.
Question 3 Answers:

Firm GBP USD

Ohio 8.40% 7.00%
Asco 9.00% 8.00%
Difference 0.60% 1.00%
Total saving= 1%-0.6% 0.400%

(a) As Firm Ohio has comparative advantage in USD market and Firm B has comparative advantage in GBP market. Net spre
(b) If they split the saving, then the saving for each firm will be 20 b.p. the interest payment for Firm Ohio: 8.4% -0.2%= 8.2
(c) (1) Firm Ohio borrows USD at 7% and lends to Firm Asco at 7.2%. Firm B borrow GBP at 9% and lends to Firm Ohio at 8.4

Firm Asco (wants USD) Swap rate workout Assume Ohio pays 8.2% to Asco on GBP loan;
Pays GBP 9% to the bank Effective interes rate of Ohio = 8.2% = 7%-X%
Receives GBP 8.2% from firm Ohio Solve this equation for X and get X=7%
Pays USD 7% to Ohio Therefore, the swap rate should be
Net interest costs: 7%+9%-8.2%= 7.8% aggregate Ohio pays 8.2% to Asco on GBP loan; Asco pa

Firm Ohio (wants GBP)

Pays USD 7% to the bank
Receives USD 7% from Asco
Pays GBP 8.2% to Asco
Net payment = GBP 8.2%+7%-7%= 8.2% aggregate

(c) (2) Firm Ohio borrows USD at 7% and lends to Firm Asco at 7%. Firm B borrow GBP at 9% and lends to Firm Ohio at 8.2%

Firm Asco (wants USD)

Pays GBP 9% to the bank
Receives GBP 8.4% from firm Ohio
Pays USD 7.2% to Ohio.
Net interest costs: 7.2%+9%-8.4%= 7.8% aggregate

Firm Ohio (wants GBP)

Pays USD 7% to the bank
Receives USD 7% from Asco
Pays GBP 8.4% to Asco
Net interest costs = GBP 8.4%+7%-7.20%= 8.2% aggregate

Firm Ohio Firm Asco Saving (in bp) Effective borrowing costs from swap
GBP 8.40% 9.00% 20 8.20%
USD 7.00% 8.00% 20 7.80%
e in GBP market. Net spread across USD and GBP markets = 1%-0.6% = 0.4% or 40b.p.
m Ohio: 8.4% -0.2%= 8.2% Interest payment for Firm Asco: 8% - 0.2% = 7.8%
d lends to Firm Ohio at 8.4% (this is just one example of possible swap rates and there can be many other possible swap rates as long as

.2% to Asco on GBP loan; Asco pays X% to Ohio on USD loan

e of Ohio = 8.2% = 7%-X%+8.2%
for X and get X=7%
rate should be
sco on GBP loan; Asco pays 7% to Ohio on USD loan

ends to Firm Ohio at 8.2% (this is just one example of possible swap rates and there can be many other possible swap rates as long as U
ossible swap rates as long as USD rate is not higher than 8% and GBP rate is not higher than 9%)

ssible swap rates as long as USD rate is not higher than 8% and GBP rate is not higher than 9%)
Question 4 Answers:

1) Forward hedge
Purchase S$2,000,000 one year forward:
S$2,000,000 $.66 = $1.32M

2) Money market hedge

1 Need to invest S$1, 904.761.91 (S$2,000,000/1.05 = S 1, 904.761.91)
2 Need to borrow $1,238,095.24 (S$1, 904.761.91 $.65 = $1,238,095.24)
3 Will need $1.343M to repay the loan in one year ($1,238,095.24 1.085 = $1,343,333.33)

3) Call option hedge (Exercise price = $.66; premium = $.03)

Amount paid
per Unit Total amount
Possible Premium Exercise (including Paid for
Spot Rate per Unit Option? the premium)S$2,000,000 Probability
$0.61 $0.03 No $0.64 $1,280,000 20%
0.63 0.03 No 0.66 1,320,000 50%
0.67 0.03 Yes 0.69 1,380,000 30%

Expected hedged value= $1,330,000

The forward hedge is preferable than option hedge at 30% chance and has equivalent value as option hedge 50% ch

4) Unhedged Strategy

Total
Possible Amount Paid
Spot Rate for S$2,000, Probability
$0.61 $1,220,000 20%
0.63 1,260,000 50%
0.67 1,340,000 30%

Expected unhedged value= $1,276,000

The unhedged strategy is preferable to forward hedge because the expected unhedged value is better than hedged

Therefore, the unhedged strategy is the best compared to other 3 alternative strategies
$1,343,333.33)

t value as option hedge 50% chance.

ed value is better than hedged value of forward hedge, so it will outperform the forward hedge.
Question 5 Answers:

30% 55%

Scenario 2:
Scenario 1: No Remittance Must be Scenario 3: Rand Scenario 4: Both types of
Country risk Invested for 1 year Remittance tax country risk

Rand remitted by subsidiary Rand 8,000,000 8,000,000 8,000,000 8,000,000

Withholding tax Rand NA NA 500,000 500,000
Interest rate Rand NA 0.05 NA 0.05
Rand after interest earned Rand NA 400,000 NA 375,000
Rand remitted after taxes Rand 8,000,000 8,400,000 7,500,000 7,875,000
Exchange rate of Rand USD per Rand 0.09 0.09 0.09 0.09
Cash flow to parent USD 728,000 764,400 682,500 716,625
PV USD 582,400 489,216 546,000 458,640
Initial investment in USD USD 546,000 546,000 546,000 546,000
NPV USD 36,400 -56,784 0 -87,360

NPV
NPV Probability Probability Probability
Scenario 1 36,400.00 0.315 11,466.00
Scenario 2 -56,784.00 0.135 -7,665.84
Scenario 3 0.00 0.385 0.00
Scenario 4 -87,360.00 16.50% -14,414.40
1
Total NPV -10,614.24
discount rate 25%

Negative NPV. Should NOT take the project

Question answer calculations

1d
2d
3c
4a
5e
6e
7b forward hedge 1M USD= 1.06M AUD Money market hedge
borrow USD USD 990099.00990099
Sell USD and AUD 1019801.980198
Deposit AUD
FV of depositAUD 1,070,792

Money market hedge is better than forward hedge

8a
9d $109, 200 The real cost of hedging payables =
The AU dollars paid when hedging = (100,000*1.086) = $1 $108600 $109,200 = $600.
10 b Stock return = (80-83+2)/83 -0.01205 SFr rate chan 0.09 USD return =
11 e
12 d Rf * (1+C) + C= 0.05592 Euro bond is cheaper
13 c Exchange rate change= -0.2 AUD return= 0.08
14 e
15 b
16 b
17 c
18 c
19 b

20 c ((0.79-0.75)-0.02)= 0.02
09,200 = $600.
0.0768674699