FIN 463 International Finance
Professor Robert B.H. Hauswald Kogod School of Business, AU
Midterm Exam: Online Version
Please read the following general information carefully before you begin the exam:
• The midterm is an individual take-home exam: it is to be submitted in electronic format on the Blackboard course website and by email to me and the course assistant by 2h00pm (14h00) on Monday, April 13. It is your responsibility to make sure that we receive the completed exam by email before the expiration of the time window: the Outlook and
Blackboard time stamp will decide any disputes in this regard.
• Submissions consist of your type-written answers and one Excel workbook containing your analyses, both zipped together in the same file; each question or part thereof that requires major calculations is to be presented on a separate worksheet with the bottom tab indicating the precise question number (e.g., 3.a). All file names need to contain 463 Midterm and your last name, e.g., 463midterm hauswald.xxx for the *.zip, *.doc, and *.xls files. Word or text documents should consist of the print-outs of your written answers.
• This exam is an individual effort: no cooperation, discussion, joint work, etc. is permitted.
Only clarifying questions will be answered. Be reminded that, as part of the honor code,you are not to share the contents or structure of this exam with anyone else, including your classmates not here today or those attending other sections of this course.
• By taking the exam early you engage yourself not to communicate any information about its make-up, content, etc. to other students. Since the course grade distribution is fixed and you are graded on a curve, it is in your own best interest to adhere to this policy.
• Put your name and student ID number on each page of your answers. Your answers should be short and to the point, type-written and may contain pasted excerpts from your analytic spreadsheets together with careful explanations of the analysis and its underlying assumptions.
• The midterm comprises 7 questions including bonus parts and one optional bonus problem with a maximum total number of points of 600 (individual points given in the margin).
The bonus problem should only be attempted after all the other questions have been answered.
• Show your work but write to the point: explain each answer as fully and carefully as necessary.
Label all diagrams and box intermediate and final results.
• Good Luck!
1. Short questions and definitions. Briefly define the following objects or terms (at most 100 one sentence) and provide examples if necessary:
(a) Define and give an example of relative purchasing power parity.
(b) Are implied forward rates good predictors of future spot rates? Explain.
(c) Define and give an example of reciprocal arbitrage.
(d) What is uncovered interest parity used for?
(e) What is the most important difference between an FX forward and futures contract?
(f) What are American quotes? Give an example.
(g) Explain what is meant by a money market hedge.
(h) Define synthetic debt and give an example.
(i) What is the difference between FX risk and exposure?
(j) Define and give an example of translation exposure.
2. Russia’s Alternative-Currency Bonds. On March 17, 2018, the Russian Federation 100+20 issued USD 4bn in eurobonds (what are they?) with an unusual provision. The issuer
reserves the right pay bondholders principal and interest in EUR, GBP, or CHF should the Russian Federation be unable to make payment in USD for “for reasons beyond its control..”
Working for the chief investment officer (CInvO) of NoNaCaPa (No-Name Capital Partners), a prominent hedge fund, you are analyzing the bonds to determine what their risk and rewards are. Your company is USD based but not averse to taking on foreign currency risk to enhance a position’s return potential. Your starting point is the attached Financial Times article which you can also supplement by your own research. In particular, you wonder about the alternative-currency clause in the indenture (debt contract) and how it might affect the investment performance of the bonds.
(a) Research dual- or multiple-currency debt securities which are typically issued in the eurobond market.
• What are eurobonds?
• What are dual- or multiple-currency bonds? What do they consist of and how can you unbundle the bonds into their constituent parts?
(b) In comparison to multiple-curency bonds, what does the alternative-currency payment provision effectively amount to?
(c) What motivates the alternative currency payment provision and how does it affect the pricing of the bonds?
(d) What risk factors do investors face? Present the risks in tabular form distinguishing between financial from nonfinancial risks which obviously translate into financial risks at a later stage. Identify each risk’s origin and nature,who bears it, its impact on bond pricing, and whether and how investors can hedge or not against it.
(e) What investment recommendation would you give to your CInvO? Explain your advice and motivate your investment thesis, i.e., the rationale why or why not you should participate in the transaction.
(f) Bonus problem. To what precise purpuse is the Russian Federation issuing these 20 debt securities? Research the question and explain the strategy behind Russia’s recent
eurobond offerings and how it ties in to both the management of its foreign-currency reserves and the Russian national debt.
3. Contractual Exposure: Aeroflot and the Russian Ruble. In 2007, Aeroflot Russian 80 Airlines (short: Aeroflot), the flag carrier and largest airline of the Russian Federation
(Moscow Stock Exchange: AFLT), placed a large order with Boeing Company formerly of Seattle, WA but now headquartered in Chicago, Ill. The carrier operates domestic and international passenger and cargo services, mainly from its hub at Sheremetyevo International Airport outside Moscow. Aeroflot is one of the oldest airlines in the world, tracing its history back to 1923. During the Soviet era, Aeroflot was the Soviet national airline and the largest airline in the world. Following the dissolution of the USSR, the carrier has been transformed from a state-run enterprise into a semi-privatised company which ranked 19th most profitable airline in the world in 2007. Aeroflot is still considered the de facto national airline of Russia.
One of the most pressing needs of Aeroflot is replacing its aging fleet of often Soviet aircraft.
To that effect, it had bought or leased Airbus aircraft but decided to diversify its fleet in the mid 2000s. After long and tortuous negotiations, Aeroflot finalized an important order for 18 Boeing 787-8 and four Boeing 787-9 in 2007. At that time, the order was valued at $3.6 billion at list prices although steep discounts and outright contract renegotiations including configuration and price are common for newly developed aircraft such as the 787 Dreamliner. Also, as the development work proceeds aircraft manufacturers keep their customers appraised of the progress and changes in technical specifications which often necessitate further negotiations. Aeroflot paid 10% of the total amount at the time of order to secure the purchase rights with the balance being due upon delivery.
It is now early 2014 and Boeing has been delivering the new aircraft for three years, primarily to Asian carriers including the launch customer, All Nippon Airlines. Aeroflot soon has to make several major financial decisions about the order because the delivery of its first planes is about to start in a year’s time (summer 2015) with payments coming due at that moment for each delivered aircraft which will continue till 2019 with the bulk of deliveries scheduled for 2017-2018. After several changes and discounts, he renegotiated contract is worth about $3.2 billion. Current financial markets data is as follows (RUB: Russian Ruble):
Spot rate RUB 32.00/USD
12M forward rate RUB 35.00/USD
12M RUB money market rate 18.00% p.a.
12M USD money market rate 2.00% p.a.
Aeroflot’s FX forecasting model suggests that the following spot rates can be expected in 12 months’ time:
highest expected rate RUB 35.00/USD
most likely rate RUB 31.50/USD
lowest expected rate RUB 29.00/USD
At the moment (early 2014), the airline does not have any significant cash reserves but given Russia’s booming oil economy and rapidly increasing tourist trade it expects to receive sufficient revenues for the purchase by the time of delivery. The only clouds on the horizon are the rapidly deteriorating situation in Eastern Ukraine and volatility in the crude oil market.
Energy is of vital importance to the Russian government and economy because it accounts for about 60% of exports and 30% of Russian GDP.
(a) What are the realistically available alternatives for Aeroflot to make payment?
(b) Which is the best strategy to minimize Aeroflot’s expected expense for making the final payment?
(c) Suppose that Aeroflot decided to keep the order in 2014 but left the exposure unhedged.
It is now early 2015, the oil price has fallen from over $100 to about $51 per barrel,Russia faces economic sanctions following its annexation of Crimea, and the Russian economy is in deep recession. As a result, the RUB is in free fall against the USD currently trading around RUB 69/USD.
• What are the consequences of the rapidly depreciating RUB for Aeroflot in light of the Boeing order?
• What options does Aeroflot have to meet its obligations or at least cushion part of the FX loss?
• With hindsight, what would the optimal hedging strategy have been?
(d) What would you recommend to Aeroflot regarding the order given that there is no end in sight to recession and the weak ruble?
4. Champagne PPP. Brazil recently experienced a lot of currency fluctuation which is due in 80 large part to the deteriorating economic conditions and the political upheaval brought about by a long running corruption scandal which culminated in the impeachment of President Dilma Rousseff. Given the recent economic and political instability it is important to gain a better understanding of the fundamental forces of exchange rate determination. In particular,you wonder whether the Brazilian real (BRL) is over- or undervalued by fundamental factors.
You are a junior investment banker at a major Wall Street player specializing in Latin America just about to acquire your own portfolio of clients in late 2016. On a recent trip to pitch business to an important client in Sao Paolo, Brazil, you notice that a bottle of Veuve Cliquot champagne costs BRL 150 at a Sao Paolo airport gourmet store. When leaving the US, you had seen the same bottle for USD 45 at JF Kennedy Airport in New York, NY. An idea slowly takes shape how you could come up with an estimate of fundamental USD-BRL FX rates.
(a) Define the Law of One Price and Purchasing Power Parity.
(b) What spot exchange rate would establish the Law of One Price in terms of champagne?
What is this FX rate called?
(c) If the current spot FX rate is BRL 3.5709/USD (December 01, 2016) what is the real exchange rate? Is the BRL overvalued or undervalued?
(d) Inflation is expected to run between 4.5% in Brazil (official target rate of the Central Bank for 2017) and 5% (OECD forecast for 2018). In the US, the OECD expects it to run at about 2.2% in the next year. What is a good estimate of the future BRL/USD spot rate?
5. Operating Exposure Management at Western Mining.1
It is critical for business 80+20
executives to clearly understand the dynamic interaction of currency exposure and exposure management for their company’s long-term welfare. In the 1980s, Australia’s Western Mining Company (WMC) assessed its foreign exchange exposure and decided to hedge these exposures given the rapid globalization of its business. WMC was an Australian based mineral producer with business interests in nineteen countries. It was taken over in 2005 by BHP Biliton, an Anglo-Australian competitor, to create one of the largest mining groups in the world. But in 2000, WMC is the world’s third largest nickel producer, owns 40 percent of the world’s largest alumina producer (Alcoa World Alumina and Chemicals), and is a major producer of copper, uranium, gold, fertilizer, and talc. WMC builds its business on large, low cost, and long life assets, which are globally competitive.
Most commodities produced by Australian mining companies, including WMC, are exported and priced in US dollars. Thus, these companies would suffer significantly and their Australian dollar (AUD) revenue would drop if the Australian dollar appreciated sharply against the US dollar. Given such an exposure, the conventional wisdom held that borrowing in US dollars would provide a ”natural” hedge against their dollar revenue stream. When forward markets began to develop in the mid-1970s, Australian mining companies often hedged up to 100 percent of forecasted revenues with a combination of debt servicing and forward contracts–often for periods up to ten years. In the early and mid-1980s, the Australian dollar declined sharply against the US dollar, and the “natural” hedge proved not to be a hedge at all, but rather an uncovered short position in the US dollar. As expected, the decline in the Australian dollar increased the cost of serving US dollar debt. And those companies that had also sold forward their expected dollar revenue stream also suffered further foreign exchange losses as these contracts matured. The positive effect of the stronger US dollar on dollar-denominated revenues was offset by a prolonged slump in mineral commodity prices.
Although WMC too experienced some currency losses, it fared better than many of its competitors for two reasons. First, it had relied more on the equity markets to finance capital expenditures. Second, it had not participated in new major projects in the early 1980s. In 1984, however, the company contemplated investment in new copper, uranium, and gold mine, with capital costs expected to be about $750 million. Under arrangements with a joint venture partner, the company planned to finance its share of the mine solely with debt, thereby increasing its total debt by a magnitude of two or three times.
1Adapted from “Western Mining’s economic exposure management,” Multinational Business Review Fall 2001.
When confronted with the need to decide the currency denomination of the debt, WMC concluded that taking a short position in US dollars, whether by borrowing or selling forwards,would not stabilize the volatility of its home country operating profits. Consequently, WMC decided to borrow in a basket of currencies that included Australian dollars, US dollars, Japanese yen, British pounds, and European euros. The company also decided to discontinue its practice of selling forward US dollar revenues, except when actual sales had been made.
(a) Evaluate the advantages and disadvantages of various exchange-hedging instruments and techniques. Also, distinguish financial from non-financial risk management approaches.
You may present your result in tabular form separating instruments from techniques.
(b) What are the different types of foreign exchange risk WMC faces in its operations? How do they affect the company? Which exposures do they hedged, which ones did they decide not to hedge anymore?
(c) Explain why borrowing in US dollars and forward sales of US dollar revenues by Australian mining companies in the 1980s had backfired. What about the 1990? You might want to research the evolution of the USD/AUD exchange rate.
(d) WMC decided to borrow in a basket of currencies rather than exclusively in US dollars or Australian dollars. What are they trying to accomplish? What are the advantages
and disadvantages of this course off action?
(e) Bonus problem. Define economic exposure. How would you go about hedging WMC’s 20 economic exposure? What do you think of WMC’s decision not to hedge its economic exposure?
6. Exchange-Rate Regimes. Scandinavian countries have followed very different paths in 80+20 response to the introduction of the Euro (EUR). Finland decided to join the common currency,Sweden adopted a free floating regime for the Krona (SEK), and Denmark pegged its currency, the Danish Krone (DKK),2 to the Euro whereas Norway and Iceland, who are only associated with the EU, retain full independence in monetary and economic affairs.
As a result, the fortunes of the Danish Krone and Swedish Krona have sharply diverged in recent times. The Financial Times explains:
“The humble Swedish krona is offering a neat reminder that relationships in financial markets are not static. The currency is hardly one of the world’s most heavily traded, accounting for only about 2 per cent of global flows. But it has played a number of roles. In a period around 2011, the krona’s direction was largely determined by global sentiment in a positive direction:
when markets were broadly upbeat, Sweden’s small, open economy meant that the currency climbed. Mindful of that relatively recent past, some observers are, therefore, surprised to note that the currency has been clobbered of late, despite a pick-up in global stocks.
Notably, the krona fell 2 per cent in January against the neighbouring euro — its main counterpart — while the S&P 500 regained its mojo after the year-end slump and jumped almost 8 per cent. Carl Hammer, head of macro strategy at Swedish bank SEB in Stockholm,See also the attached materials from the Danmarks Nationalbank, the Danish central bank.
argues that this should be no surprise. “Everyone is getting it wrong as usual,” he said.
In fact, the krona has reasserted a strong negative relationship with global sentiment. Bad news for broader markets is good news for the krona, and vice versa, he said, much as it is for the yen and other “haven” currencies. The Swedish currency is clearly abnormally weak;typically the euro trades above SKr10 only in times of dire market crisis. The rate has now been above that point for a year. It has fallen further this week, cementing its position as the world’s worst-performing leading currency this year, after the latest Swedish inflation figures proved far milder than expected. The central bank has taken note, scrapping its threat to intervene in the market and weaken the currency after three years.
The explanation is simple: Swedish interest rates are stuck in the freezer. They rose in December but are still a quarter of a point below zero. That, said Mr Hammer, was a gift
to hedge funds and computer-driven trading strategies that hunt for currencies linked to low rates and sell them in favour of higher-yielding assets elsewhere when market conditions are benign. Local Swedish investors are also avid consumers of overseas assets when they are feeling flush. When they suffer jolts of nerves, those overseas investments come home, boosting the krona. This is unlikely to change unless the central bank brings interest rates out of the cold and back above zero. Until then, it is not too hard to imagine policymakers’ concern switching to the risk of a disruptive decline in the currency.” (Katie Martin, “Tail Risk,” FT February 20, 2019)
(a) Define pegged and floating exchange-rate regimes, respectively. What regime do the DKK and SEK respectively follow?
(b) What are the advantages and disadvantages of fixed and floating exchange rates, respectively, for importers, exporters, monetary policy (central banks), and consumers?
Present your conclusions in tabular form. Who wins and who loses from a weak SEK and strong DKK, respectively?
(c) Focusing on the DKK and SEK, explain the currencies diverging fortunes against the
European EUR. What makes the DKK so stable and by what means is this stability
achieved? Why has the SEK been so weak lately?
(d) What trade does the above FT article suggest? Explain its mechanics and compute an example. How might it have contributed to the weakness of the SEK?
(e) Bonus problem. The FT article claims what type of association between markets and 20 the SEK? How would you go about verifying the claim? Find the requisite data and validate or invalidate the casual observation above.
7. Economic Exposure Management at BMW.
3 BMW Group, owner of the BMW, Mini 80+20
and Rolls-Royce brands, has been based in Munich since its founding in 1916. But by 2011,only 17 per cent of the cars it sold were bought in Germany. In recent years, China has become BMW’s fastest-growing market, accounting for 14 per cent of BMW’s global sales volume in 2011. India, Russia and eastern Europe have also become key markets.
3Adapted from “How BMW dealt with exchange rate risk,” Financial Times October 29, 2012.
The rapid globalization of its operations posed several new financial challenges. Despite rising sales revenues, BMW was conscious that its profits were often severely eroded by changes in exchange rates. The company’s own calculations in its annual reports suggest that the negative effect of exchange rates totalled C=2.4bn between 2005 and 2009. BMW did not want to pass on its exchange rate costs to consumers through price increases. Its rival Porsche had done so at the end of the 1980s in the US and sales had plunged.
To address the issues, BMW took a two-pronged approach to managing its foreign exchange exposure. One strategy was to use a “natural hedge” – meaning it would develop ways to spend money in the same currency as where sales were taking place, meaning revenues would also be in the local currency. However, not all exposure could be offset in this way, so BMW decided it would also use formal financial hedges. To achieve this, BMW set up regional treasury centres in the US, the UK and Singapore.
BMW implemented its new FX risk management strategy in several ways. Regarding the natural hedge strategy it again followed a two-pronged implementation strategy. The first involved establishing factories in the markets where it sold its products. The second involved making more purchases denominated in the currencies of its main markets. BMW now has production facilities for cars and components in 13 countries. In 2000, its overseas production volume accounted for 20 per cent of the total. By 2011, it had risen to 44 per cent. In the 1990s, BMW had become one of the first premium carmakers from overseas to set up a plant in the US – in Spartanburg, South Carolina. In 2008, BMW announced it was investing $750m to expand its Spartanburg plant. This would create 5,000 jobs in the US while cutting 8,100 jobs in Germany. This also had the effect of shortening the supply chain between Germany and the US market. The company boosted its purchasing in US dollars generally, especially in the North American Free Trade Agreement region. Its office in Mexico City made $615m of purchases of Mexican auto parts in 2009, expected to rise significantly in following years.
Since BMW’s fastest growing markets are in Asia it also had to rethink its Asian strategy in light of risk management needs. A joint venture with Brilliance China Automotive was set up in Shenyang, China, where half the BMW cars for sale in the country are now manufactured.
The carmaker also set up a local office to help its group purchasing department to select competitive suppliers in China. By the end of 2009, Rmb 6bn worth of purchases were from local suppliers. Again, this had the effect of shortening supply chains and improving customer service. At the end of 2010, BMW announced it would invest 1.8bn rupees in its production plant in Chennai, India, and increase production capacity in India from 6,000 to 10,000 units.
It also announced plans to increase production in Kaliningrad, Russia.
Meanwhile, the overseas regional treasury centres were instructed to review the exchange rate exposure in their regions on a weekly basis and report it to a group treasurer, part of the group finance operation, in Munich. The group treasurer team then consolidates risk figures globally and recommends actions to mitigate foreign exchange risk.
Using operating strategy to address FX risk brought other benefits. By moving production to foreign markets the company not only reduces its foreign exchange exposure but also benefits from being close to its customers. In addition, sourcing parts overseas, and therefore closer to its foreign markets, also helps to diversify supply chain risks.
(a) What is the nature of BMW’s FX exposure? What fundamental financial principle should BMW use to neutralize the impact of FX rate movements on their results?
(b) How did BMW decide to tackle the problem? Do you see any problems with BMW’s approach and implementation?
(c) What differences if any exist in BMW’s approach to FX exposure management in North America and Asia?
(d) Why did BMW decide to consolidate FX risk management globally in its Munich group treasury? What principle are they implementing and what are its advantages for the group?
(e) BMW and Western Mining pursued to very different strategies to address FX exposure. 20 What are their respective FX risk management strategies? Why did each company choose their respective strategy?
8. Optional Bonus Problem Arbitrage in Montr´eal. As an arbitrageur with Banque de 80 Montr´eal in Montreal, Province Qu´ebec, Canada you see the following CAD/USD information on your customized trading system as inputs for algorithmic execution:
Spot rate CAD 1.1520/USD
6M forward rate CAD 1.1635/USD
6M CAD money market rate 10.00% p.a.
6M USD money market rate 7.50% p.a.
Having only recently started in your position fresh out of school your position limit is CAD 10m or its USD equivalent. Transaction costs for trading in these markets total around USD 1,700 and would be paid at the end of the 6 months. Being based in Canada any arbitrage profit should accrue in CAD. Assuming that you can trade, borrow and invest at the above quoted rates.
(a) What principle links the four prices? What is the relevant mathematical formulation?
(b) Identify any arbitrage opportunities and explain how they might have come about.
(c) How would you build up an arbitrage position? Describe your strategy and its mechanics.
(d) Calculate your profit resulting from the preceding arbitrage strategy.
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