Tristar, Inc. (a US corporation) has sold some heavy machinery to an Italian company for 2,000,000 euros, with the payment to be received in 6 months. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, Tristar is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
- The spot exchange rate is $1.0512/€
- The six month forward rate is $1.0625/€
- Tristar's cost of capital is 12% per annum.
- The euro 6-month borrowing rate is 3.5% (or 1.75% for 6 months)
- The euro 6-month lending rate is 1.5% (or 0.75% for 6 months)
- The US dollar 6-month borrowing rate is 4.5% (or 2.25% for 6 months)
- The US dollar 6-month lending rate is 2.5% (or 1.25% for 6 months)
- The premium on 6 month put options on the euro with strike rate $1.0500 is 1.5%.
You are required to compute the net receipts in dollars of each hedging alternative. The phrase "net receipts in dollars" refers to the (actual or deemed) net cash inflow in dollars in 6 months time. As you know, in general, adding cash flows occurring at different points in time is inappropriate unless the cash flows have been appropriately present-valued or future-valued.
a) Suppose that Tristar chooses to hedge its transaction exposure using a forward contract. Will Tristar sell or buy euros forward? What will be the net receipts in dollars?
b) Suppose Tristar chooses a money market hedge. What are the transactions that the firm will need to undertake to implement this hedge, and what will be the net receipts in dollars using this hedge?
c) Suppose Tristar decides to hedge using a put option.
(i) Suppose that the spot rate in 6 months is $1.15 per euro. Will the option be exercised? What will be the net receipts in dollars?
(ii) Suppose that spot rate in 6 months is $1.00 per euro. Will the option be exercised? What will be the net receipts in dollars?
d) Suppose that Tristar strongly expects the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation
e) Suppose that Tristar strongly expects the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation
f) By how much does the euro need to appreciate to make the put option a better alternative than the forward contract? Covered Interest Arbitrage: Martha Brown is an FX trader for a bank in New York. She is faced with the following market rates relating to the US dollar and the British pound:
Spot exchange rate: 1.4079 $/£
1 year dollar interest rate = 1.5%
1 year pound interest rate = 2.0%
1 year forward exchange rate: = 1.4021 $/£
Assume that she may borrow up to $10,000,000 (or its equivalent in British pounds) to engage in this arbitrage. Show all calculations as you respond to the questions below.
a) Check whether Interest Rate Parity holds, and confirm that there is a Covered Interest Arbitrage opportunity. You can use either the exact equation or the rule of thumb.
b) Spell out the actions Martha would take to profit from this situation.
Which currency would she borrow and what amount?
Which currency would she lend (invest) and what amount?
What is the forward transaction she would engage in? State clearly the currency she would sell forward, the currency she would buy forward, and the respective amounts.
Calculate her arbitrage profits, either in US dollars or in British pounds.
Note: Please respond to the questions above. It is not enough to merely draw a graph without verbal explanations.
3. Berkeley Quantum Fund, a U.S.-based investment partnership, borrows 1 billion yen from Matsushita bank.. The entire principal is to be repaid at the end of the year, and interest is 4% per annum, to be paid in yen. The spot exchange rate is 120 ¥/$, but the yen is expected to appreciate against the dollar at 3% per annum. Compute the cash flows of the loan both in yen and in dollars, and calculate the effective cost (i.e., the effective interest rate) of the loan in dollars (based on the expected change in the exchange rate).
4. Sequoia Properties, a California based corporation, expects to receive cash dividends from a Spanish joint venture over the next four years. Suppose that today is January 1st, 2015. The first dividend, to be paid on December 31, 2015, is expected to be €500,000. The dividend is then expected to grow 10.0% each year over the following three years. The current exchange rate (that is, as of January 1st, 2015) is $1.0762/€. Sequoia's weighted average cost of capital for domestic investments is 12%. For foreign investments, Sequoia's practice is to add an additional risk premium of 3%.
Suppose that the expected annual inflation is 2% in the US and 0.5% in the eurozone. Assume that the euro-dollar exchange rate movement will be in accordance with relative purchasing power parity.
Compute the present value in dollars of the expected stream of euro dividends.
5. Explain the difference between Relative Purchasing Power Parity and Uncovered Interest Rate Parity (also known as the International Fisher Effect).
6. Suppose that you want to estimate the cost of equity of Petrobras, the Brazilian oil company. In using the CAPM, what is the appropriate market portfolio for estimating the stock's beta and the market risk premium? Should you use an index of the Brazilian stock market or some global index? Explain your answer.
7. a) Given the following pair wise exchange rates: £1 = $1.7522 and €1 = $1.2651
Calculate the cross-rate of euros per pound.
b) Suppose a few years ago, the exchange rate was $1.35/€ and today the exchange rate is $ 1.05/€:
Calculate the percentage change in the value of the US dollar.