Exchange rate, Money market hedge, interest arbitrage, Inflation, interest rates, Economics
Section B (Attempt TWO questions in Section B)
Question B1
HB Corp., a UK company, has subsidiaries in the U.S., Germany, Singapore and
Australia. It regularly sells goods denominated in U.S. dollars. The company will have
two transactions in the near future:
Three months (90 days): Paying 400,000 Euros for imported goods
Six months (180 days): Receiving 600,000 USDs for exports
The following exchange rates and interest rates are available for the company:
Bid Quote Ask Quote
(bank buys) (bank sells)
Spot exchange rate (Euro per £1): 1.17 1.13
Three-month forward rate (Euro per £1): 1.10 1.05
Spot exchange rate (USD per £1): 1.217 1.188
Six-month forward rate (USD per £1): 1.202 1.178
Spot exchange rate (AUD per £1): 1.762 1.735
1-year forward rate (AUD per £1): 1.765 1.738
1 year (360 days) interest rates:
Borrow Deposit
USD 7.8% 4.0%
Pound 6.7% 2.4%
Euro 6.2% 3.2%
AUD 7.8% 5.2%
a) Suggest how HB Corp. could implement a money market hedge for payables,
support your answer with detailed calculations. Would HB Corp. be better off using
forward hedge or money market hedge? Substantiate your answer with estimated
cost each type of hedge.
(10 marks)
b) The company has recently received £800,000 and is considering invest in Australia
to exploit the higher interest rate. What is the yield to the company if it conducts a
covered interest arbitrage? Would covered interest arbitrage work for the company
in this case? (Ignore transaction fees and tax effects.)
(10 marks)
c) Based on the question above, discuss how the Australian dollar’s spot and forward
rates will adjust until covered interest arbitrage is no longer feasible. Why are
arbitrage opportunities diminishing quickly after they have been discovered? To
illustrate your answer, assume that the immediate purchase and forward sale of
Australian dollar is allowed. What is the resulting equilibrium state referred to?
(8 marks)
Total 28 marks
Question B2
a) Scandina Corp., a Swedish furniture producer, plans to establish a subsidiary in
Malaysia in order to penetrate the Asian market. The company’s managers believe
that the value of Malaysian ringgit is relative weak now and will strengthen against
the Swedish Krona over time. If their expectations about ringgit’s value are correct,
how will this affect the costs and earnings of the project? Explain.
(5 marks)
b) Scandina Corp. is also considering a joint venture with a Malaysian company IDEAL
AS for two years. Scandina will invest 20 million ringgits to help to finance IDEAL’s
production. For each of the two years, 50% of the total profits will be distributed to
the Malaysian company and the other 50% will be converted to krona to be sent to
Sweden.
The estimated total profits resulting from the joint venture per year are as follows:
Total Profits (in ringgits)
Performance Probability Year 1 Year 2
Strong 80% 30 million 50 million
Poor 20% 10 million 20 million
Scandina is concerned about the country risk that the Malaysian government is
likely to increase the corporate tax rate imposed on joint venture from 10% to 20%
beginning from Year 1 and the possibility is 50%.
Scandina’s average cost of capital is 12 per cent and it automatically adds 3
percentage points to it cost of capital when deriving required rate of return on
international joint venture projects. Though this project has particular form of
country risk that is unique, Scandina plans to account for the form of risk within its
estimation of cash flows.
Required:
Determine the expected net present value of Scandina’s investment. Would you
recommend Scandina to participate the Joint Venture? Explain.
(15 marks)
c) Scandina finally decided to penetrate Malaysian market by purchasing an 80%
stake in IDEAL AS, a Malaysian company that produces furniture. How can
borrowing Malaysian ringgit locally from a Malaysian Bank reduce the exposure of
Scandina to (i) exchange rate risk and (ii) political risk caused by government
regulations? (8 marks)
Total 28 marks
Question B3
“U.S.-China economic ties have expanded substantially since China began reforming
its economy and liberalizing its trade regime in the late 1970s. Total U.S.-China
merchandise trade rose from $2 billion in 1979 (when China’s economic reforms
began) to $636 billion in 2017. China is currently the United States’ largest
merchandise trading partner, its third-largest export market, and its biggest source of
imports. In 2015, sales by U.S. foreign affiliates in China totaled $482 billion. Many
U.S. firms view participation in China’s market as critical to their global
competitiveness. U.S. imports of lower-cost goods from China greatly benefit U.S.
consumers. U.S. firms that use China as the final point of assembly for their products,
or use Chinese-made inputs for production in the United States, are able to lower
costs. China is also the largest foreign holder of U.S. Treasury securities (at $1.2 trillion
as of April 2018). China’s purchases of U.S. debt securities help keep U.S. interest
rates low… More recently, the Chinese government has diversified its investments in
order to obtain higher returns, such as by encouraging its firms (especially SOEs) to
invest overseas to become more globally competitive, as well as to help China gain
access to raw materials (such as oil), food, and technology. As a result, Chinese
annual FDI outflows have grown significantly in recent years, rising from $21 billion in
2006 to $183 billion in 2016, making China the second-largest source of annual global
FDI outflows.”1
(W. M. Morrison, 2018)
As you work for a U.S. company that exports goods to China, you are expected to
forecast the value of U.S. dollars with respect to the Chinese yuan.
Required:
Explain how each of the following conditions will affect the demand and supply of the
currencies, hence affect the value of the dollar against Chinese yuan, holding other
things equal.
a) While U.S.’s inflation remains low, Chinese inflation increased substantially.
(4 marks)
b) Chinese interest rates have increased substantially, while U.S.’s interest rates
remain low. Both countries’ investors are attracted to high interest rates.
(4 marks)
1 Wayne M. Morrison, “China-U.S. Trade Issues”, Congressional Research Service, July 2018
c) With the economic growth, the income level increased substantially in China
while U.S.’s income level has remained comparatively stable.
(4 marks)
d) The U.S. government is going to increase the tariff on goods imported from
China. As a result, Chinese government will also increase the tariff on goods
imported from the U.S.
(6 marks)
e) Based on the reported figures of trade and investments between the US and
China, combine all expected impacts mentioned from Question (a) to (d) to
develop an overall forecast of the dollar’s movement against the Chinese yuan.
(10 marks)
Total 28 marks
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