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FIRE 416 Midterm 1

Review Outline
1. Explain the importance of international business activit to lar!e
corporations. "hat are the tpes of opportunities sou!ht b
aspirin! multinational companies# "hat are the ris$s faced b
these companies which are speci%c to the international nature of
their business activities# They seek shareholder wealth maximization,
investment opportunities, enhancing revenues (through global branding,
market fexibility, advantages of scale and scope) and reducing operating
costs (through low-cost raw materials, low-cost labor, fexibility in global
site selection, fexibility in sourcing and production, economies of scale
and scope, and economies of vertical integration) !isks develop out of
di"erences in legal, accounting, and tax systems, di"erences in personnel
management, di"erences in marketing, di"erence in distribution,
di"erence in #nancial markets, and di"erence in corporate governance
!isks include political (risk that the business environment in a host
country will unexpectedly change due to political events), #nancial (risk of
unexpected change in the #nancial or economic environment of a host
country), and currency$foreign exchange risk (risk of unexpected changes
in currency values a"ect the value of the #rm)
&. 'iven the followin! Euro to ( Exchan!e rate of 1.46) what is the
information contained in this *uote# If the +urchasin! +ower
+arit ,heor is correct) what is true about the relationship
between the -. dollar and the Euro at this exchan!e rate# %t
means that for every & euro, you would receive '&() *+, This means
that the -uro is currently stronger than the *+, .ccording to the
/urchasing /ower /arity Theory, these two values should be able to
purchase identical amounts of products 0 ie, a product that costs '&() in
the *nited +tates should only cost & -uro in -urope
/. 0 -. multinational compan is re*uired to report its %nancial
results in -. dollars. 1ow does this create currenc exchan!e
ris$ for the compan# "hat is the term which most accuratel
describes this particular ris$# 1urrency rates fuctuate 0 while it may
be best to convert other currency to *+,, it also may minimize the value
of the #rm This is translation risk 2hile the currency is not actually
converted, it is presented in a singular currency for the purpose of
#nancial statements ,ue to the exchange rate, there is a distortion in the
#rm3s value
4. Identif and describe the was in which a -. compan can
participate in international commerce. They can participate in
international commerce by purchasing and selling goods between foreign
countries This can either be achieved through import$export, or by
operating the business within the borders of another country
2. ,he price of a currenc forward contract is determined b the
relationship between interest rates of the two countries in
*uestion and the time period covered b the contract. Is this
statement exactl true) partl true or false. Explain our
response. This is false The price of a currency forward depends on the
exchange rate 0 the producer locks in a selling price for a future date (ie,
in six months) The producer bears no risk if the value of the foreign
currency depreciates, but is unable to bene#t if the currency appreciates
6. 3ompan 043 commits to sell (15 million of its product 6produced
in the -. with raw materials from the -.7 to a 8apanese customer
delivered within 65 das from toda with pament to be received
95 das from toda in en. "hat are the ris$s faced b 043#
"hat are the events in the currenc mar$ets which would erode
the pro%tabilit of this sale# 1ow can 043 protect itself from the
adverse conse*uences of currenc mar$et :uctuations# The value
of the 4en might depreciate against the *+ dollar within the 56 day
payment period .lso, (eventually) converting the 4en into *+, will likely
yield at least some transaction costs, which will cut into the &6 million (if
they were paid in &6mil *+,, there would be no transaction costs) %n
order to hedge this, .71 could engage in a currency swap with the
8apanese customer in order to take advantage of their higher interest
rates in their respective countries
;. <istin!uish between forward contracts) futures) options) caps)
collars and swaps as currenc ris$ mana!ement tools. . forward
contract allows two parties to buy or sell an asset at a speci#ed price on a
future date 9utures contracts are like forwards, except that they are
exchanged in a market and a deposit called the initial margin is deposited
and the price is settled daily to mitigate risk :ptions are contracts which
give the owner the right (not obligation) to buy or sell an asset at a
speci#ed price at a speci#ed date, when the seller has an obligation to
ful#ll .n option to buy is a call; an option to sell is a put . cap is the
highest rate that investors can receive on a foating-rate type bond .
collar is implemented after a stock has long experienced either substantial
gains or substantial losses (ie, can3t lose more than '<$per, can3t gain
more than '<$per) +waps are the exchange of one security for another
security in order to take advantage of better interest rates
=. "hat are the advanta!es of futures contracts as compared to
currenc forward a!reements# 9utures contracts are exchange-traded,
standardized, and margined, which provides signi#cantly less risk to the
purchaser
9. 3itiban$ -. plans to lend (155 million -. to a 3anadian customer.
,he borrower will repa the loan in 3anadian dollars. <escribe in
some detail how the ris$s of this loan di>er from those of lendin!
(15 million in the -.. "hat are the was that a -. ban$ can
mana!e the ris$s of lendin! in 3anada. They will be exposed to a
variety of currency exchange risks, including risks associated with
currency conversion and also with fuctuations in the value of the
1anadian dollar versus the .merican dollar They could manage the risk
through a currency swap
15. Identif and explain at least four factors which a>ect currenc
exchan!e rates. %nfation, di"erentials in interest rates, political
stability, and current-account de#cits =ower infation strengthens that
country3s currency against other currencies 2ith interest rates, higher
rates attract foreign capital which in turn raises the exchange rate
/olitical and economic stability attract foreign investors 0 turmoil causes
investors to lose faith in that country3s currency and seek investments
elsewhere %f a country borrows a large amount of money from other
countries, this will tend to decrease the exchange rate, until products are
cheap enough to attract investor interest
11. <iscuss at least two ris$ factors for companies in international
commerce beond currenc exchan!e rate ris$. /olitical and
#nancial risks exist /olitical risks deal with the business environment in
the host country, while #nancial risks deal with the economic environment
in the host country
1&. International business activities are inherentl more attractive
to lar!e companies in mature mar$ets than to small hi!h !rowth
-. companies. ,rue or false. "h or wh not. 9alse 2hile large
companies in mature markets are looking for cheaper labor and materials,
small high-growth companies are looking to &) untap new markets (which
isn3t really possible in a >mature? market) and <) raise capital, which may
be easier in foreign countries
1/. 4e able to discuss the method of determinin! the ?fair value@
for forward) futures and options contracts. The fair value is, more or
less, the future value of an amount This would be the principal (or in this
case, spot) plus interest
14. 4e able to explain the importance of EAcient Mar$et
1pothesis) 0rbitra!e +ricin! ,heor) +urchasin! +ower +arit
and Interest Rate +arit in currenc mar$ets. -@cient Aarket
Bypothesis states that it is impossible to >beat the market?, as stocks
always move and represent all relevant information (ie, it is impossible to
buy an undervalued stock or sell an over-valued stock 0 the only way to
make money is to partake in riskier investments) .rbitrage /ricing
Theory is a model that that predicts the #nancial return of an asset
linearly /urchasing /ower /arity estimates the amount of adCustment
needed on an exchange rate in order for each currency to have eDual
purchasing power %nterest !ate /arity means that the interest rate
di"erential between two countries is eDual to the di"erence in the spot
and forward values for a security (ie, that in the end, the values will be
eDual)
12. 4e able to distin!uish between option) forwards B futures as
hed!in! tools in the currenc mar$ets. %n all three instances, buyers
are hedging by predicting that values will rise in the future , but by getting
prices locked in, they will be able to pro#t
16. 4e able to explain the di>erences between O,3 and Exchan!e
,raded mar$ets. -xchange traded markets are much more regulated
and standardized than :T1 traded markets, making them less risky
1;. 4e able to write a brief overview of !lobal currenc mar$et
structure. .ll currencies are able to be converted into other currencies,
allowing business to take place between any two countries (theoretically)
This also provides opportunities for investors
1=. 4e able to discuss a ran!e of arbitra!e issues as the relate to
currenc mar$ets. This occurs when a stock is priced below its value
These opportunities are short lived, as the market will correct itself as
soon as the stock is Cumped upon 7ecause of this, it reDuires real-time
pricing Duotes and the ability to act extremely Duickly
19. 4e able to explain the di>erences between !ross and net
currenc ris$ exposures for a multinational corporation. Eet
exposure is the percentage di"erence between long and short term
exposure Fross exposure is long plus short term exposure
&5. 4e able to describe the basic characteristics of currenc
hed!in! toolsC forwards) futures) swaps) options and more
complex options 6caps) :oors) collars7) as well as ?natural
hed!es@ on a corporationDs balance sheet. They are recorded as
either an asset or a liability, depending what side you are on, for forwards,
futures, swaps, and options
&1. <iscuss the importance of exchan!e rate forecastin! for
hed!in! currenc exposure.
&&. 4e able to describe the basic characteristics of currenc
hed!in! toolsC forwards) futures) swaps) options and more
complex options 6caps) :oors) collars7) as well as ?natural
hed!es@ on a corporationDs balance sheet.
&/. <iscuss the importance of exchan!e rate forecastin! for
hed!in! currenc exposure. 9orecasting exchange rates gives the
involved parties an idea of where the interest rate will land when deals
close, allowing them to take the proper precautions when it comes to risk
mitigation
&4. 3urrenc exposures are !enerall more diAcult to identif and
measure than to hed!e. React to this statement. Is it true or
false and wh. 4es (though it does not specify in regards to what),
because the currency market can be sporadic 2hile >best guesses? are
certainly worthwhile, it is impossible to determine future information
&2. <iscuss the e>ect of exchan!e rate hed!in! on corporate
value. 4e sure to use appropriate al!ebraic expressions and
assumptions to support our assertions. %t increases value because
there is less risk to the company
&6. .how that ou understand the concepts of ?!ross exchan!e
rate exposure@ and ?net exchan!e rate exposure@ and are able to
discuss the merits of centraliEed and decentraliEed mana!ement
of exchan!e ris$.
1onversion parity price G par value$number of stocks
9orward price G spot price H&Ii(t)J
9K G /KL(&Ir)Mn
Triangular arbitrage 0 exchange rates don3t match up -*!$*+,, -*!$F7/,
*+,$F7/