Exam Prep Chapter 17 Adam International Investment Decisions

Chapter 17 ­– International investment decisions

MULTIPLE CHOICE

1. The spot rate for the US dollar relative to the euro is $1.47/€. The spot rate for the US dollar relative to the Canadian dollar is US$0.765/C$. What is the cross exchange rate for the Canadian dollar and euro?

To figure out the cross exchange rate, divide US$1.470/€ by $0.765/C$. The correct answer is C$1.922/€.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

2. Suppose that the one-year risk-free interest rate is 5% in Australia. The current spot rate is $0.7642/C$ and the one-year forward rate is $0.7834/C$. What must the Canadian one-year risk-free interest rate be in order for interest rate parity to hold?

The correct answer is 2.43%. You get this answer by applying the interest rate parity formula to the information given:

($0.7834/C$)/($0.7642/C$) = (1.05/1 + Canadian rate)

Solving this equation yields a one-year risk-free Canadian rate of 2.43%.

PTS: 1 DIF: E

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

3. The annualised rate of interest on three-month government bonds is 7% in Italy and 4% in the USA. The current spot rate is US$1.12/€. Using interest rate parity, what is the implied three-month forward rate between the US dollar and the euro?

Because we are looking for a three-month forward rate, divide the annualised rate of interest by 4. Then plug the information given into the interest rate parity formula:

[Forward (US$/€)/US$1.12/€] = (1.01/1.0175)

Then solve for the forward rate.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

4. Suppose that JB Campbell & Company operates in Australia and sells 10 coffee tables to a Japanese company. JB Campbell & Company delivers the tables now and will receive ¥187 500 in six months. The current spot rate is ¥122/$. If the exchange rate in six months is ¥127/$, how much will JB Campbell & Company have gained or lost from the movements in exchange rates if it does not hedge this transaction?

To calculate this, convert ¥187 500 into Australian dollars at the current spot rate and at the spot rate in six months. Today, the ¥187 500 is worth $1536.88 and in six months it is worth only $1476.38. Thus, JB Campbell & Company will lose $60.50.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

5. Gates Auto Inc. manufactures automobile engines in the USA. Gates Auto Inc. sells 200 of its 8-cylinder Hoste model engines to a company in Canada. The total price for these engines is C$60 000. Gates Auto Inc. will deliver the engines today and receive payment in three months from the Canadian company. When payment is received, Gates Auto will convert the C$60 000 into US dollars. The spot rate is US$0.7865/C$. If the spot rate in three months is US$0.7622/C$, how much will Gates Auto Inc. gain or lose due to exchange rate movements on this transaction if it does not perform any hedges?

To calculate this, convert C$60 000 into US dollars at the current spot rate and at the spot rate in three months. Today, the C$60 000 is worth US$47 190 and in three months the C$60 000 will be worth $45 731.71. Therefore, if Gates Auto Inc. remains unhedged in this transaction, it will lose $1458.29.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

6. Beech Industries is an Australian company that sells shoes to Japanese retailers. Beech Industries just signed a contract to sell 1000 pairs of shoes to Yakata, Inc. The total price for these shoes is ¥200 000. The shoes will be delivered today but Beech Industries will not receive payment for six months. The current spot rate is ¥127/$ and the six-month forward rate is ¥128/$. Marcus Duncan, the treasurer at Beech Industries, expects that in six months the spot rate will ¥131/$. Based on the information given, Beech Industries is most likely to:

Beech Industries will most likely enter into a forward contract that locks it into the rate of ¥128/$. It will do this because it expects the yen to depreciate more than the rate of the forward contract. The forward contract will allow the company to convert yen into dollars at a rate ¥128/$, but if the company remains unhedged and its expectations are realised, it will have to convert the ¥200 000 into dollars at a rate of ¥131/$. Entering in the forward contract will give the company $1562.50 in six months, but if it is unhedged and its expectations about exchange rates are realised, it will only have $1526.72.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

7. Which of the following is not a strategy that corporations can use to transfer exchange rate risk?

Multinational corporations frequently use forward contracts, interest rate swaps and currency swaps to transfer exchange rate risk to third parties. Operating and selling in only one country does not transfer exchange rate risk because if that company’s goods compete with imports, exchange rate risk is still present.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

8. Which of these is not an example of political risk that could affect a multinational corporation?

Raising taxes on a company’s activities, implementing quotas and not allowing a company to repatriate its profits back to its home country are all examples of political risk. If a government implements tax incentives, this would actually help the multinational corporation and not be a political risk.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

9. Suppose that a US company is considering an investment that will yield cash flows in Canadian dollars. The projects cash flows will be as follows: initial cost = –C$1 000 000, year 1 = C$550 000, year 2 = C$340 000 and year 3 = C$125 000. The US company plans to evaluate the project by discounting the cash flows at the Canadian cost of capital of 7% and then converting the NPV back to US dollars at the current spot rate, which is US$0.8213/C$. What is the NPV of the project in US dollars?

To calculate the correct answer, discount each Canadian dollar cash flow using the appropriate discount rate of 7%. When you do this, you get a NPV of –C$86 975. Then, convert this Canadian dollar figure to US dollars using the current spot rate of $US0.8213/C$. This gives you –US$71 433.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

10. Mark Duncan owns a furniture manufacturing company in Australia. He is considering an investment in Japan, which will have the following cash flows: initial cost = –¥300 000 000, year 1 = ¥150 000 000, year 2 = ¥200 000 000, year 3 = ¥250 000 000 and year 4 = ¥100 000 000. The appropriate discount rate that should be used to discount yen-denominated cash flows is 11%. If Duncan plans on converting the NPV from yen into US dollars at the current spot rate of ¥123/US$, what is the NPV of the project?

Begin by calculating the NPV in Japanese yen using a discount rate of 11%. This will give you an NPV of ¥246 130 565. Then convert that figure into US dollars at the current spot rate, which will give you US$2 001 062.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

11. Crum Industries is a paper manufacturing company based in the USA. The CEO of the company Hannah Monstzka is considering an investment in Canada to take advantage of Canadian government subsidies. The investment will have the following cash flows: initial cost = –C$2 000 000, year 1 = C$1 250 000, year 2 = C$1 000 000 and year 3 = C$750 000. Monstzka plans on hedging the cash flows using forward contracts throughout the life of the project. The risk-free rate of interest is 5% in Canada and 4% in the USA. Currently, the spot rate is US$0.7134/C$ and the project should be discounted at a US adjusted rate of 9%. Assume Monstzka will be able to convert the Canadian dollar cash flows into US dollars at the implied forward rates when they are received. What is the NPV of the project in US dollars?

First, calculate the implied forward rates from the information given with the interest rate parity formula. The one-year forward rate is calculated by using the following formula:

(One-year forward/US$0.7134/C$) = (1.04)¹/(1.05)¹
One-year forward = US$0.7066/C$

You would use interest rate parity to calculate the two- and three-year forward rates as well, which are US$0.6999/C$ and US$0.6932/C$, respectively. Next, multiply the Canadian dollar cash flows by the appropriate forward rate and then discount them back using the appropriate discount rate of 9%. The converted US dollar cash flows that you need to discount are as follows: initial cost = US$1 426 800, year 1 = US$883 250, year 2 = US$699 900 and year 3 = US$519 900. When you discount these cash flows at 9%, you get a NPV of US$374 071.

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

12. Calculate the required return for a project undertaken in Italy. The appropriate risk-free rate is 4%, the project has a calculated beta of 1.35 relative to the Italian share market and the market risk premium for the Italian share market is 7%.

r = 0.04 + 1.35(0.07) = 0.1345

PTS: 1 DIF: E

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

13. The spot rate for Canadian and Australian dollars is $0.7213/C$. The annualised interest rate on a six-month government bond is 4% in Canada and 3% in Australia. Calculate the six-month forward rate that is needed for interest rate parity to hold.

To calculate the six-month forward rate, use the interest rate parity formula. Change the annualised risk-free rates into six-month risk-free rates to calculate the six-month forward rate. The interest rate parity formula is:

(Six-month forward rate/$0.7213/C$) = (1.015)/(1.02)

Six-month forward rate = $0.7248/C$

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

14. The annualised rate of interest on a three-month government bond is 7% in Japan and 4% in the USA. The current spot rate is US$0.0079/¥. Calculate the three-month forward rate needed for interest rate parity to hold.

To calculate the three-month forward rate, use the interest rate parity formula and change the risk-free interest rates into three-month rates. The interest rate parity formula is:

(Three-month forward rate/US$0.0079/¥) = (1.0175)/(1.01)

Three-month forward rate = US$0.00786/¥

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

15. In Italy the annualised rate on a three-month government bond is 5% and in Canada the rate is 8%. The current spot rate is €0.6542/C$. Calculate the three-month forward rate needed for interest rate parity to hold.

To calculate this answer, use the interest rate parity formula and adjust the six-month risk-free rates to three-month risk-free rates. Use the following formula to calculate the three-month forward rate:

(Three-month forward rate/€0.6542/C$) = (1.0125)/(1.02)

Three-month forward rate = €0.6494/C$

PTS: 1 DIF: E

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

16. In a floating exchange rate environment, the price of a currency is determined by:

In a floating exchange rate environment, currencies are allowed to fluctuate. Therefore, the price of a particular currency is determined by the supply and demand for that currency.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

17. Yesterday, the exchange rate between Canadian and US dollars was US$0.7347/C$. Today the rate is US$0.7432/C$. From yesterday to today, the Canadian dollar __________ and the US dollar __________ relative to one another.

The cost of the Canadian dollar increased from yesterday to today, meaning it cost more US dollars to buy a Canadian dollar today than it did yesterday. Therefore, the Canadian appreciated against the US dollar and the US dollar depreciated against the Canadian dollar.

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

18. The quote for a euro in terms of US dollars is US$1.1232/€. How many euros equals one US dollar?

To figure out how many euros equal US$1, take the reciprocal of the quote given: 1/(US$1.1232/€).

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

19. The exchange rate between the US dollar and the Japanese yen is US$0.008072/¥. If the exchange rate changes to US$0.0080069/¥, then you could say:

The Japanese yen is depreciating relative to the US dollar, and the US dollar is appreciating against the Japanese yen. This question may be tricky because the quotes are not in the same terms. To get the quotes in the same terms, take the reciprocal of one of them and then compare them to each other. After you calculate the reciprocal, compare the quotes to see which currency rose in value and which currency depreciated.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

20. The spot rate for US dollars and euros is US$1.232/€. The 90-day forward rate for the two currencies is US$1.254/€. The US dollar:

The US dollar trades at a 90-day forward discount of 1.79%. Because it trades at a forward discount, the US dollar is expected to depreciate relative to the euro.

PTS: 1 DIF: E

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

21. The exchange rate quote for the US dollar and the euro is US$1.2324/€, and the exchange rate quote for the US dollar and the Canadian dollar is US$0.7258/C$. What is the cross exchange rate between euros and Canadian dollars?

To calculate the cross exchange rate between the euro and the Canadian dollar, divide one quote by the other:

(US$1.2324/€)/(US$0.7258/€)

The US dollar signs cancel out, leaving C$1.6979/€ as the cross exchange rate.

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

22. A system in which a country’s currency is pegged to the value of another currency, such as the US dollar, is called a:

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

23. The current foreign exchange rate is also called the:

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

24. The European Union adopted a continent-wide medium of exchange, the euro, as its common currency. How many of the member countries of the EU are using the euro as their current currency?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

25. You checked the €/$ exchange rate a week ago and found that one dollar cost €0.8235. When you checked the €/$ exchange rate again yesterday, one dollar was trading at €0.8017. By how much did the value of the euro appreciate or depreciate?

The euro depreciated; it is now cheaper to buy one dollar.

(0.8017 – 0.8235)/0.8235 = –0.0264

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

26. You checked the €/$ exchange rate a week ago and found that one dollar cost €0.8235. When you checked the €/$ exchange rate again yesterday, one dollar was trading at €0.8017. By how much did the value of the dollar appreciate or depreciate?

The dollar appreciated; it is now cheaper to buy one euro.

1/0.8235 = 1.2143

1/0.8017 = 1.2473

(1.2473 – 1.2143)/1.2143 = 0.02717

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

27. You checked the €/$ exchange rate today and found that one dollar cost €0.8235. When you checked the one-year €/$ forward exchange rate, one dollar was trading at €0.8017. What is the forward premium or discount for the dollar?

(0.8017 – 0.8235)/0.8235 = –0.0264

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

28. You checked the €/$ exchange rate today and found that one dollar cost €0.8235. When you checked the one-year €/$ forward exchange rate, one dollar was trading at €0.8017. What is the forward premium or discount for the euro?

1/0.8235 = 1.2143

1/0.8017 = 1.2473

(1.2473 – 1.2143)/1.2143 = 0.02717

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

29. You checked the €/$ exchange rate today and found that one dollar cost €0.8235. When you checked the three-month (90-day) €/$ forward exchange rate, one dollar was trading at €0.8017. What is the annualised forward premium or discount for the dollar?

(0.8235 – 0.8017)/0.8235 × 360/90 = –0.1058

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

30. You checked the €/$ exchange rate today and found that one dollar cost €0.8235. When you checked the three-month (90-day) €/$ forward exchange rate, one dollar was trading at €0.8017. What is the annualised forward premium or discount for the euro?

1/0.8235 = 1.2143

1/0.8017 = 1.2473

(1.2473 – 1.2143)/1.2143 × 360/90 = 0.1087%

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

31. If the €/$ exchange rate is $1.3215/€ and the $/£ exchange rate is $1.7894/£, what is the €/£ exchange rate?

1.7894/1.3215 = 1.3541

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

Use the following information to answer questions 32 to 39.

Smith Enterprises is considering opening a new manufacturing plant in France. The cost of the new plant will be €25 million, and the plant is expected to generate after-tax cash flows of €10 million at the end of each year for the next four years. After that the plant will be worthless. The current €/US$ exchange rate is €0.8166/US$. The expected rate of inflation for the USA is 2.5% per year. The risk-free rate is 4% in the US and 6% in France.

32. Refer to Smith Enterprises International Investment. What is the expected rate of inflation in France?

1.06/1.04 = 1 + i/1.025

i = 0.0447

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

33. Refer to Smith Enterprises International Investment. What is the cost of the manufacturing plant in US dollars?

25 000 000(1/0.8166) = 30 615 000

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

34. Refer to Smith Enterprises International Investment. If the required return of the project is 15% in euros, what should be the required return in dollar terms?

1 + r = (1.15)(1.04/1.06)

r = 0.1283

PTS: 1 DIF: H

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

35. Refer to Smith Enterprises International Investment. What is the two-year US$/€ forward exchange rate?

F/0.8166 = (1.04)²/(1.06)²

F = 0.7861

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

36. Refer to Smith Enterprises International Investment. What is the three-year US$/€ forward exchange rate?

F/0.8166 = 1.04³/1.06³

F = 0.7719

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

37. Refer to Smith Enterprises International Investment. When evaluating the euro-denominated cash-flows, what is the NPV of the investment in US dollars? Assume a required return of 15%.

NPV = €3.5498 million

€3.5498 million(1/0.8166) = $4.3470 million

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

38. Refer to Smith Enterprises International Investment. If the required rate of return is 15%, what is the NPV of the investment in euro terms?

PV of four-year annuity at 10 million = 28.5498 million – Investment Cost of 25 million = 3.5498 million

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

39. Refer to Smith Enterprises International Investment. What is the expected dollar value of the after-tax cash flow received at the end of year 2?

Two-year F = F/0.8166 = 1.04²/1.06²

F = 0.7861

CF₂ = €10(1/0.7861) = US$12.72 million

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

40. If you are an Australia-based company making sales in Europe, you would benefit from:

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

41. In which kind of system does a country peg its currency to another currency?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

42. In a fixed exchange rate system, if the demand for a currency increases, then the government of that country must:

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

43. If you want to know the exchange rate to convert Australian dollars to euros today, then you would need to look at:

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

44. When one currency buys less of another currency in the forward market than it does in the spot market, we say that it is trading at:

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

45. If the spot rate for the ¥/$ is ¥110.00 and the forward rate is ¥111.00, then the yen trades at:

[(110 – 111)/110] = 0.0090909 discount

This is because the spot rate is greater than the forward rate.

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

46. If the spot rate for the ¥/$ is ¥110.00 and the one-month forward rate is ¥111.00, then the yen trades at an annual:

[(110 – 111)/110]× (12/1) = 0.1090909 discount

This is because the spot rate is greater than the forward rate.

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

47. If the Canadian dollar is worth $1.62 and the Swiss franc is worth $1.35, then how many Canadian dollars does it take to purchase a Swiss franc?

($1.35/SF1)/($1.62/C$1) = C$0.8334/SF

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

48. If the Canadian dollar is worth $1.50 and the Swiss franc is worth $1.30, then how many Swiss francs does it take to purchase a Canadian dollar?

($1.500/$C1)/($1.30/SF1) = SF1.1538/C$

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

49. Which of the following accounts for the largest portion of trading volume in the foreign exchange markets?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

50. The spot rate for Martian spotlets (MRS) is 4 per US dollar, and the risk-free rate of return is 10% for the Martian economy and 2% for the US economy. Based on this information, what should the one-year forward rate be for MRS/$US? (Round to the fourth decimal place.)

Forward rate = Spot rate × [(1+ Foreign risk-free rate)/(1+ Domestic risk-free rate)]

Forward rate = 4 × (1.1/1.02) = 4.3137255

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

51. The spot rate for Jupiter ringlets (JPR) is US$3 per ringlet, and the risk-free rate of return is 1% for Jupiter’s economy and 2% for the US economy. Based on this information, what should the one-year forward rate be for JPR/US$? (Round to the fourth decimal place.)

US$/JPR spot rate = 3 ===> JPR/US$ spot rate = 0.33333333

Forward rate = Spot rate × [(1+ Foreign risk-free rate)/(1+ Domestic risk-free rate)]

Forward rate = 33 333 × (1.01/1.02) = 0.3300654

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

52. The spot rate for Martian Spotlets (MRS) is 4 per US dollar, and the one-year risk-free rate of return is 30% for the Martian economy. If the one-year forward rate for MRS/$US is 5, then what should be the risk-free rate for the US economy?

Forward rate = Spot rate × [(1+ Foreign risk-free rate)/(1+ Domestic risk-free rate)]

5 = 4 × [1.3/(1 + d)]

d = 0.04

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

53. The one-year risk-free rate of return is 10% in Hobbiton and 20% in Gondor. If the expected rate of inflation in Hobbiton is 5%, what should be the expected rate of inflation in Gondor? (Round to the second decimal place.)

(1 + Inflation_Gondor)/(1 + Inflation_Hobbiton) = (1 + Rate_Gondor)/(1 + Rate_Hobbiton)

(1 + Inflation_Gondor)/1.05= 1.2/1.1

Inflation_Gondor = 0.1454545

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

54. You are a French wine producer who has a contract to sell $10 000 000 worth of wine in the USA for US dollars six months in the future. If you would like to hedge this position, what could you do to hedge the currency risk involved in transaction?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

55. A US dollar-based corporation has a project in the United Kingdom that will cost £1 000 000. The project will provide free cash flow of £500 000 for the next three years. If the pound-denominated discount rate for this project is 12% and the spot rate is 0.5600£/US$, then what is the dollar-denominated NPV for the project? (Round to the nearest 10.)

Pound NPV = –1 000 000 + 500 000PVIFA(3,12%) = 200 915.63

200 915.63/0.5600 = US$358 777.92

PTS: 1 DIF: H

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

56. You are trying to determine the appropriate risk-adjusted rate in US dollars for a project in the United Kingdom. The correct risk-adjusted discount rate in pounds is 15% and the risk-free rate in pounds is 9%. If the risk-free rate in dollars is 5%, then what is the correct risk-adjusted discount rate in dollars? (Round to the nearest tenth of a percentage.)

(1.15/1.09) × 1.05 = 1+ Risk-adjusted US$ rate 

Risk-adjusted US$ rate = 0.107982

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

57. You are trying to determine the appropriate risk-adjusted rate, in Venus sun-dollars for a project on Venus. You know that the correct risk-adjusted discount rate in US dollars is 15% and the risk-free rate in dollars is 8%. If the risk-free rate in sun-dollars is 5%, then what is the correct risk-adjusted discount rate in dollars? (Round to the nearest tenth of a percentage.)

(1.15/1.08) = (1 + Risk adjusted sun-dollar rate)/ 1.05

Risk-adjusted sun-dollar rate = 0.1180556

PTS: 1 DIF: M

REF: 17.1 Exchange Rate Fundamentals NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

58. Which of the following is the practice of trading an asset for the purpose of reducing or eliminating the risk associated with some other asset?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

59. Which of the following describes taking a position in a currency to increase risk?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

60. Which of the following statements is true?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

61. Which type of institution is in a unique position to bear exchange rate risk by creating a natural hedge?

REF: 17.1 Exchange Rate Fundamentals NAT: Reflective thinking

LOC: acquire knowledge of financial markets and interest rates

62. Assume that current currencies are in equilibrium and the €/US$ exchange rate is 0.721. The US expects inflation to be 4% over the next year while in Europe there is an expectation of 2.3%. What must the €/US$ exchange rate be in one year?

PTS: 1 DIF: M

REF: 17.2 Long-term Investment Decisions NAT: Analytic skills

LOC: acquire knowledge of financial markets and interest rates

SHORT ANSWER

1. What is a triangular arbitrage?

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals

2. Define hedging.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals

3. What is interest rate parity?

PTS: 1 DIF: E

REF: 17.2 Long-term Investment Decisions

4. Distinguish between spot and forward exchange rates.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals

5. What is a managed floating rate system?

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals

6. Briefly describe what is meant by a currency board arrangement.

PTS: 1 DIF: E

REF: 17.1 Exchange Rate Fundamentals