Monetary Economics

Question 1
If a country chooses to have a pure float exchange rate regime, which goal(s) is a country most able to achieve under the concept of the ʺImpossible Trinityʺ?

A) Monetary independence and full financial integration.
B) Monetary independence and inflation target.
C) Exchange-rate stability and an independent monetary policy.
D) A country cannot attain any of the exchange rate goals with a pure float exchange rate regime.

Question 2
Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.60 per pound, how would you take advantage of this situation? Hint: assume that you have $350 available for investment.

A) Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce. Convert the gold to £200 at £20 per ounce. Exchange the £200 for dollars at the current rate of $1.80 per pound to get $360.
B) Start with $350. Exchange the dollars for pounds at the current rate of $1.60 per pound. Buy gold with pounds at £20 per ounce. Convert the gold to dollars at $35 per ounce.
C) A and B both work
D) None of the above.

Question 3
Which of the follow options strategies (all options share the same strike price) are consistent in their belief about the future contract of the underlying asset price?

A) Selling calls and selling puts
B) Buying calls and buying puts
C) Buying calls and selling puts
D) None of the above

Question 4
Depreciation of the euro relative to the U.S. dollar will cause a U.S.-based multinational firm’s reported earnings (from the consolidated income statement) to . If a firm desired to protect against this possi¬bility, it could stabilize its reported earnings by euros forward in the foreign exchange market.
A) be reduced; purchasing
B) be reduced; selling
C) increase; selling
D) increase; purchasing
E) None of the above

Part B (90 marks): Five (5) Short Answer questions. Marks are clearly stated in each question.
Answer all Five (5) questions in the answer booklet provided.

Question 1 (20 marks)
Assume the spot rate of the ₤ is $1.7000. The British interest rate is 10%, and the U.S. interest rate is 11% over the 360 day (1 year) period. The British inflation rate is 4% and the U.S. inflation rate is 3.5% over the 360-day (1 year) period. The 180-day forward price is $1.7200/₤. The 180-day European call option on the $ with the exercise price of ₤0.5800 is selling at 3% premium, while the 180-day European put option on the $ with the exercise price of ₤0.5900 is selling at 2% premium. Your U.S. based firm has an account payable of ₤200,000 due in 180 days.
A) What should be the 180-day forward rate based on Interest Rate Parity (IRP)?
What is the dollar cost of using a forward hedge? Make sure you state your position in the forward contract. (4 marks)
B) Assume the firm has no excess cash. Use the above to calculate the dollar cost of using a money market hedge to hedge ₤200,000 of payable due in 180 days?
(6 marks)
C) Calculate the cost of an option hedge at the time the payment is due assuming you exercise the option when the payment is due. (6 marks)
D) Based on the answers in (a), (b), and (c), which hedging methods should your firm choose? (4 marks)

Question 2 (15 marks)
Alphabetical Company (ALP) prefers variable- to fixed-rate debt. On the other hand, Microsotical Company (MIC) prefers fixed- to variable-rate debt. Assume the following information for both Companies:
Fixed-Rate Bond Variable-Rate Bond
ALP 12% LIBOR + 2%
MIC 13.5% LIBOR + 2.5%
As a rising star analyst in the ALP, you approach the Chief Financial Officer (CFO) and propose an interest swap deal that your firm can enter into with MIC. However, your CFO argues that an interest rate swap will probably not be advantageous to the company because it can issue both fixed and variable debt at more attractive rates than MIC.
A) Explain to your CFO why he is wrong. Make sure that your explanation includes the discussion about the absolute and comparative advantages and the potential savings from the interest rate swap deal? (5 marks)
B) Now show your CFO the interest rate swap deal by completing the diagram below (Write your answers in the answer booklet provided) with the following assumptions: (10 marks)
 ALP will have 50% of the potential savings, and MIC will receive the rest. There is no swap bank.
 LIBOR (floating rate) must be used in the transaction between ALP and MIC companies i.e. either transaction (iii) or (iv).

Question 3 (15 marks)
Suppose you are a China-based investor who just sold Australian Commonwealth Bank (CBA) shares that you had bought six months ago. You had invested Yuan446,000 to buy CBA shares for $60 per share. The exchange rate was Yuan4.50/$. You sold the stock for $65 per share and converted the dollar proceeds into Yuan at the exchange rate of 5.50Yuan/$.

A) Determine the percentage return from this investment in Australian dollars. Show all workings. (4 marks)

B) Compute the rate of return on your investment in Yuan terms. Show all workings.

    (6 marks)

C) What are channels that contribute to your investment risk? (Hint: Think about the variance of your investment) (5 marks)

Question 4 (15 marks)
Yankee, a US firm, needs to raise USD1 billion or equivalent to acquire Broncon, an Australian firm. Therefore, Yankee firm is trying to decide between the following three types of bond issues.
Types of Bonds Coupon Rate (p.a.) No of Coupon Payments in a Year Initial Fees (at t=0) One-off Debt Maturity Exchange Rate (per USD) [Hint] Possible Internal Rate of Return (IRR)
U.S. bond 6% 2 0.85% 3 3.1577% 4.158%
Euro-Eurobond 6.5% 1 0.65% 3 Euro 0.9 6.7465% 7.2216%
Dim-Sum Bond 5.5% 1 0.80% 2 Rmb 6.00 5.9360% 6.9360%

Assuming all else is equal, which is the least expensive bond issue solely based on All-in cost for Yankee firm? Please show your full workings. [Hint: Compare the annualized yield to maturity (YTM) for each bond issue. Use the possible internal rate of return given above to speed up your calculation.] (15 marks)

Question 5 (25 marks)
XYZ Corporation, an Australian based carmaker, is considering an expansion into Asia after its expansion into the US last summer was highly successful. Currently, XYZ does export cars to Asia, but the increased demand raises the question of an expansion in Asia. XYZ is trying to decide whether to establish a car manufacturing plant and office in Japan where cars would be built and then sold across Asia.
All relevant data is given in the tables below. The cost of the expansion is Yen 80,000,000, which must be immediately expended. Three-year EBITDA are 35,000,000 45,000,000 and 55,000,000 respectively. Moreover, XYZ would have to fund additional working capital of Yen 5,000,000 at the time of the expansion. Further investment in net working capital would be Yen 5,000,000, Yen 8,000,000, and Yen 10,000,000 in year 1, 2, and 3 respectively. If it builds the plant, XYZ will depreciate it at a rate of Yen 4,000,000 per year (starting in year 1) and will have to fund additional capital expenditures of Yen 8,000,000 per year to maintain and improve the plant. Although the project is assumed to have an infinite life, cash-flows are only projected up to three years and the terminal value of the project is computed based on the year 3 free cash-flow (FCF) assuming a growth rate that equals the Japanese long-run GDP growth rate.
All taxes are paid in Japan in the year the income is earned. Tax treaties are in effect so that XYZ will have no tax obligations to the Australian Tax Office (ATO). The following information applies to the valuation.

Japan Australia
Price Inflation 2.00% 3.00%
Annual return on government bonds 3.00% 4.00%
Corporate tax rate 40.00% 30.00%
Equity market risk premium AUD 6.00%
Spot rate-S(AUD/Yen) 0.01
Before tax cost of debt 5.00%
Debt-to-value ratio (D/V) 0.5
Systematic risk (beta) 1.2
Japanese long-run GDP growth rate 3%
WACC 12.80%

A) Calculate the cost of capital, in Australia, for the project. (4 marks)
B) Calculate the forward exchange rates, F1(AUD/Yen) through F3(AUD/Yen), for the years 1, 2, and 3 based on the spot rate and the interest rates given in the question. (round to 5 decimal places) (3 marks)
C) Calculate the Free of Cash Flows of the project in Yen from year 1 to year 3.
(7 marks)
D) What is the terminal value as of year 3? Use a perpetuity formula, the Free Cash Flows in Yen for year 3, and the Japanese growth rate assumption given in the question. Assume the appropriate discount rate is WACC. (3 marks)
E) Calculate the AUD value of FCF for the years 0, 1, 2 and 3 and the terminal value using the forward rates calculated in (b). (5marks)
F) What is the NPV of the project from XYZ’s perceptive (in AUD)? Should XYZ expand into the Asian market? (3 marks)

Sample Solution