Chapter 4

Exchange Rate Determination

Example 4.5 A
▪ Chicago Financial Co. expects the exchange rate of the New Zealand dollar (NZ$) to
appreciate from its present level of $0.50 to $0.52 in 30 days.
▪ Chicago Financial is able to borrow $20 million on a short-term basis from other banks.
▪ Present short-term interest rates (annualized) in the interbank market are as given in the
table

Problem 20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate
against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending
and borrowing rates exist:

CURRENCY LENDING RATE BORROWING RATE

U.S. dollar 8.0% 8.3%

Mexican peso 8.5% 8.7%

Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos
in the interbank market, depending on which currency it wants to borrow. a. How could Blue
Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate
the profits that could be generated from this strategy.
Problem 21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate
against the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending
and borrowing rates exist:
CURRENCY LENDING RATE BORROWING RATE
U.S. dollar 7.0% 7.2%
Singapore dollar 22.0% 24.0%

Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and
investing the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned
from this strategy. Should Diamond Bank pursue this strategy?
 Chapter 7
International Arbitrage
Problem 1. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario
necessary for it to be plausible.

Problem 2. Locational Arbitrage. Assume the following information:

Beal Bank Yardley Bank
Bid price of New Zealand $.401 $.398
dollar
Ask price of New Zealand $.404 $.400
dollar

Given this information, is locational arbitrage possible? If so, explain the steps involved in
locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What
market forces would occur to eliminate any further possibilities of locational arbitrage?
Problem 3. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario
necessary for it to be plausible.
Problem 4. Triangular Arbitrage. Assume the following information:
Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand NZ$3.02
dollars

Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect
triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What
market forces would occur to eliminate any further possibilities of triangular arbitrage?
Example 7.4 Currency Quotes for Triangular Arbitrage Example with Transaction Costs

Problem 5. Covered Interest Arbitrage. Explain the concept of covered interest arbitrage and
the scenario necessary for it to be plausible
Problem 6. Covered Interest Arbitrage. Assume the following information:
Quoted Price
Spot rate of Canadian dollar $.80
90-day forward rate of Canadian dollar $.79
90-day Canadian interest rate 4%
90-day U.S. interest rate 2.5%

Given this information, what would be the yield (percentage return) to a U.S. investor who used
covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would
occur to eliminate any further possibilities of covered interest arbitrage?
Example: Covered Interest Arbitrage. Process You desire to capitalize on the relatively high
interest rates found in the United Kingdom and have funds available for 90 days. The interest rate
is certain; only the future exchange rate at which you will exchange pounds back to U.S. dollars
is uncertain. You can use a forward sale of pounds to guarantee the rate at which you can exchange
pounds for dollars at some future time. Assume the following information:
▪ You have $800,000 to invest.
▪ The current spot rate of the pound is $1.60.
▪ The 90-day forward rate of the pound is $1.60.
▪ The 90-day interest rate in the United States is 2 percent.
▪ The 90-day interest rate in the United Kingdom is 4 percent.
Example: Assume that, as a result of covered interest arbitrage, the 90-day forward rate of the
pound declined to $1.5692 (which reflects a discount of about 2 percent from the pound’s spot
rate of $1.60). Consider the results from using $800,000 (as in the previous example) to engage
in covered interest arbitrage after the forward rate has adjusted
Example: Arbitrage Example When Accounting for Spreads. Suppose you are given the
following exchange rates and one-year interest rates.

You have $100,000 to invest for one year. Would you benefit from engaging in covered interest
arbitrage? Observe that the quotes for the euro spot and forward rates are exactly the same
whereas the deposit rate for euros is 0.5 percent higher than the deposit rate for dollars. It might
seem as if covered interest arbitrage is feasible in this case, but U.S. investors would be subjected
to the ask quote when buying euros (€) in the spot market versus the bid quote when selling those
euros via a one-year forward contract.
Problem 7. Covered Interest Arbitrage. Assume the following information:
Quoted Price
Spot rate of Mexican peso $.100
180-day forward rate of Mexican peso $.098
180-day Mexican interest rate 6%
180-day U.S. interest rate 5%

Given this information, is covered interest arbitrage worthwhile for Mexican investors who have
pesos to invest? Explain your answer.
Problem 22. Covered Interest Arbitrage in Both Directions. The following information is
available:
• You have $500,000 to invest
• The current spot rate of the Moroccan dirham is $.110.
• The 60-day forward rate of the Moroccan dirham is $.108.
• The 60-day interest rate in the U.S. is 1 percent.
• The 60-day interest rate in Morocco is 2 percent.
a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered
interest arbitrage work for the investor in this case?
b. Would covered interest arbitrage be possible for a Moroccan investor in this case?
 Chapter 14
Multinational Capital Budgeting
Example 14-3a. Spartan, Inc., is considering establishing a subsidiary in Singapore that would
manufacture and sell tennis rackets locally. Spartan’s financial managers have asked the
manufacturing, marketing, and financial departments to provide them with relevant input so they
can apply a capital budgeting analysis to this project. In addition, some Spartan executives have
met with government officials in Singapore to discuss the proposed subsidiary. The project would
end in four years. All relevant information follows.
1. Initial investment. The project would require an initial investment of 20 million Singapore
dollars (S$), which includes funds to support working capital. Given the existing spot rate of
$0.50 per Singapore dollar, the U.S. dollar amount of the parent’s initial investment is S$20
million 3 5 $0.50 $10 million.
2. Price and consumer demand. The estimated price and demand schedules during each of the
next four years are shown here:

3. Costs. The variable costs (for materials, labor, etc.) per unit have been estimated and
consolidated as shown here:

The expense of leasing extra office space is S$1 million per year. Other annual overhead expenses
are expected to total S$1 million per year.
4. Tax laws. The Singapore government will allow Spartan’s subsidiary to depreciate the cost of
the plant and equipment at a maximum rate of S$2 million per year, which is the rate that the
subsidiary will use. The Singapore government will impose a 20 percent tax rate on income. In
addition, it will impose a 10 percent withholding tax on any funds remitted by the subsidiary to
the parent. The earnings remitted by the subsidiary in Singapore to the U.S. parent will not be
taxed by the U.S. government, and therefore represent cash inflows for the U.S. parent.
5. Remitted funds. The Spartan subsidiary plans to send all net cash flows received back to the
parent firm at the end of each year. The Singapore government promises no restrictions on the
cash flows to be remitted to the parent firm, but does impose a 10 percent withholding tax on any
funds sent to the parent, as mentioned previously.
6. Exchange rates. The spot exchange rate of the Singapore dollar is $0.50. Spartan uses the spot
rate as its forecast for all future periods.
7. Salvage value. The Singapore government will pay the parent S$12 million to assume
ownership of the subsidiary at the end of four years. Assume that there is no capital gains tax on
the sale of the subsidiary.
8. Required rate of return. Spartan, Inc., requires a 15 percent return on this project.

Problem 20. Capital Budgeting Analysis. A project in South Korea requires an initial investment
of 2 billion South Korean won. The project is expected to generate net cash flows to the subsidiary
of 3 billion and 4 billion won in the two years of operation, respectively. The project has no
salvage value. The current value of the won is 1,100 won per U.S. dollar, and the value of the
won is expected to remain constant over the next two years.
a) What is the NPV of this project if the required rate of return is 13 percent?
b) Repeat the question, except assume that the value of the won is expected to be 1,200 won
per U.S. dollar after two years. Further assume that the funds are blocked and that the
parent company will only unable to remit them back to the U.S. in two years. How does
this affect the NPV of the project?
Problem 24. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next
three years, the project will generate total operating cash flows of $3,500,000, measured in today’s
dollars using a required rate of return of 14 percent. What is the break-even salvage value of this
project?
Problem 26. Accounting for Uncertain Cash Flows Blustream, Inc., considers a project in
which it will sell the use of its technology to firms in Mexico. It already has received orders from
Mexican firms that will generate 3 million Mexican pesos (MXP) in revenue at the end of the
next year. However, it might also receive a contract to provide this technology to the Mexican
government. In this case, it will generate a total of MXP5 million at the end of the next year. It
will not know whether it will receive the government order until the end of the year.
Today’s spot rate of the peso is $0.14, and the one-year forward rate is $0.12. Blustream expects
that the spot rate of the peso will be $0.13 one year from now. Its only initial outlay with the
proposed project will be $300,000 to cover development expenses (regardless of whether the
Mexican government purchases the technology). Blustream will pursue the project only if it can
satisfy its required rate of return of 18 percent. Ignore possible tax effects. Blustream decides to
hedge the maximum amount of revenue that it will receive from the project.
a) Determine the NPV if Blustream receives the government contract.
b) If Blustream does not receive the contract, it will have hedged more than it needed to and
will offset the excess forward sales by purchasing pesos in the spot market at the time the
forward sale is executed. Determine the NPV of the project assuming that Blustream does
not receive the government contract.
 c) Now consider an alternative strategy in which Blustream hedges only the minimum peso
revenue that it will receive. In this case, any revenue due to the government contract would
not be hedged. Determine the NPV based on this alternative strategy and assume that
Blustream receives the government contract.
d) If Blustream uses the alternative strategy of hedging only the minimum peso revenue that
it will receive, determine the NPV assuming that it does not receive the government
contract.
e) If there is a 50 percent chance that Blustream will receive the government contract, would
you advise the company to hedge the maximum amount or the minimum amount of revenue
that it may receive? Explain.
f) Blustream recognizes that it is exposed to exchange rate risk whether it hedges the
minimum amount or the maximum amount of revenue it will receive. It considers a new
strategy of hedging the minimum amount it will receive with a forward contract and
hedging the additional revenue it might receive with a put option on Mexican pesos. The
one-year put option has an exercise price of $0.125 and a premium of $0.01. Determine the
NPV if Blustream uses this strategy and receives the government contract. Also, determine
the NPV if Blustream uses this strategy and does not receive the government contract.
Given that there is a 50 percent probability that Blustream will receive the government
contract, would you use this new strategy or the strategy that you selected in question (e)?
Problem 27. Capital Budgeting Analysis Wolverine Corp. currently has no existing business in
New Zealand but is considering establishing a subsidiary there. The following information has
been gathered to assess this project:
▪ The initial investment required is $50 million in New Zealand dollars (NZ$). Given the
existing spot rate of $0.50 per New Zealand dollar, the initial investment in U.S. dollars is
$25 million. In addition to the NZ$50 million initial investment for the subsidiary’s plant
and equipment, NZ$20 million is needed for working capital and will be borrowed by the
subsidiary from a New Zealand bank. The New Zealand subsidiary will pay interest only
on the loan each year, at an interest rate of 14 percent. The loan principal is to be paid in
10 years.
▪ The project will be terminated at the end of year 3, when the subsidiary will be sold.
▪ The price, demand, and variable cost of the product in New Zealand are as follows:

▪ The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year. The
exchange rate of the New Zealand dollar is expected to be $0.52 at the end of year 1, $0.54
at the end of year 2, and $0.56 at the end of year 3.
▪ The New Zealand government will impose an income tax of 30 percent on income. In
addition, it will impose a withholding tax of 10 percent on earnings remitted by the
subsidiary. The U.S. government will not impose any corporate income tax on the earnings
that the subsidiary in New Zealand remits to its U.S. parent.
▪ All cash flows received by the subsidiary will be sent to the parent at the end of each year.
The subsidiary will use its working capital to support ongoing operations.
▪ The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Because the plant and equipment are initially valued at NZ$50 million, the annual
depreciation expense is NZ$5 million.
▪ In three years, Wolverine will sell the subsidiary. The parent plans to let the acquiring firm
assume the existing New Zealand loan. The working capital will not be liquidated, but
rather will be used by the acquiring firm that buys the subsidiary. Wolverine expects to
receive NZ$52 million after subtracting capital gains taxes. Assume that this amount is not
subject to a withholding tax.
▪ Wolverine requires a 20 percent rate of return on this project.
a. Determine the net present value of this project. Should Wolverine accept this
project?
b. Assume that Wolverine is also considering an alternative financing arrangement in
which the parent would invest an additional $10 million to cover the working capital
requirements so that the subsidiary would not need the New Zealand loan. If it uses
this arrangement, the selling price of the subsidiary (after subtracting any capital
gains taxes) is expected to be NZ$18 million higher. Is this alternative financing
arrangement more feasible for the parent than the original proposal? Explain.
c. From the parent’s perspective, would the NPV of this project be more sensitive to
exchange rate movements if the subsidiary uses New Zealand financing to cover the
working capital or if the parent invests more of its own funds to cover the working
capital? Explain.
d. Assume that Wolverine used the original financing proposal and that funds are
blocked until the subsidiary is sold. The funds to be remitted are reinvested at a rate
of 6 percent (after taxes) until the end of year 3. How is the project’s NPV affected?
e. What is the break-even salvage value of this project if Wolverine uses the original
financing proposal and funds are not blocked?
f. Assume that Wolverine decides to implement the project using the original financing
proposal. Also assume that after one year, a New Zealand firm offers Wolverine a
price of $27 million after taxes for the subsidiary and that Wolverine’s original
forecasts for years 2 and 3 have not changed. Compare the present value of the
expected cash flows if Wolverine keeps the subsidiary to the selling price. Should
Wolverine divest the subsidiary? Explain.