International Financial Management
Spring, 2017
Homework Questions 2: Due date–Tuesday, Mar 21, 2017
Name:
Instructions:
• Read the questions carefully, write all your steps where necessary.
• You don’t have to computer-type the solution. However, the hand-written version has
to be reader-friendly.
• Hard copies of the solutions must be dropped in the TA’s box by 6PM on the due
date. No later submission will be accepted.
• You may work in groups of four or less, and only one solution set will be turned in
by each group. The grade on the problems turned by the group will be given to each
member of the group.
1. The Economist publishes annually the “hamburger standard” by which they compare
the prices of the McDonalds Corporation Big Mac hamburger around the world. The
index estimates the exchange rates for currencies based on the assumption that the
burgers in question are the same across the world and therefore, the price should be
the same. If a Big Mac costs $2.54 in the United States and 294 yen in Japan, what
is the estimated exchange rate of yen per dollar as hypothesized by the Hamburger
index?
(a) $.0086/=
Y
(b) 124=
Y/$
(c) $.0081/=
Y
(d) 115.75=
Y/$
Answer: d)
Y
=294
= 115.7480=
Y/$
$2.54
2. If the current exchange rate is 124 Japanese yen per U.S. dollar, the price of a Big
Mac hamburger in the United States is $2.54, and the price of a Big Mac hamburger
in Japan is 294 yen, then other things equal, the Big Mac hamburger in Japan is
.
(a) correctly priced
(b) under priced
– 1–
International Financial Management
Spring, 2017
(c) over priced
(d) not enough information to determine if the price is appropriate or not
Answer: b)
Y
=294
= $2.37 < $2.54
124=
Y/$
3. When exchange rates change,
(a) U.S. firms that sell only to domestic customers will be unaffected.
(b) U.S. firms that sell only to domestic customers can be affected if they compete
against imports.
(c) U.S. firms that sell only to domestic customers will be affected, but only if they
borrow in foreign currency to finance their domestic operations.
(d) Both a) and b)
Answer: b)
4. The exposure coefficient b =
Cov(P,S)
V ar(S)
in the regression P = a + b × S + e is:
(a) A measure of how a change in the exchange rate affects the dollar value of a
firm’s assets.
(b) Has a value of zero if the value of the firm’s assets is perfectly correlated with
changes in the exchange rate
(c) a) and b)
(d) none of the above
Answer: a). Note that the exposure has a value of zero if the value of the firm’s
assets is not correlated with changes in the exchange rate at all
5. Suppose you are a British venture capitalist holding a major stake in an e-commerce
start-up in Silicon Valley. As a British resident, you are concerned with the pound
value of your U.S. equity position. Assume that if the American economy booms in
the future, your equity stake will be worth $1,000,000, and the exchange rate will be
$1.40/£. If the American economy experiences a recession, on the other hand, your
American equity stake will be worth $500,000, and the exchange rate will be $1.60/£.
You assess that the American economy will experience a boom with a 70 percent
probability and a recession with a 30 percent probability.
(a) Estimate your exposure to the exchange risk.
(b) Compute the variance of the pound value of your American equity position that
is attributable to the exchange rate uncertainty.
(c) How would you hedge this exposure? If you hedge, what is the variance of the
pound value of the hedged position?
– 2–
International Financial Management
Spring, 2017
Solution:
Prob = 0.70, P ∗ = $1, 000, 000, S = $1.40, P =£714,285.71
Prob = 0.30, P ∗ = $500, 000, S = $1.60, P = £312,500
E(S) = (0.70)/(1.40) + (0.30)/(1.60) = £0.6875
E(P ) = (0.70) ∗ (714, 285.71) + (0.30) ∗ (312, 500) = £593,750
V ar(S) = 0.001674
Cov(P, S) = 7, 533.482
(a) b = Cov(P, S)/V ar(S) = 7, 533.482/0.00167 = 4, 500, 000
(b) b2 V ar(S) = (4, 500, 000)2 ∗ (0.00167) = 33, 900, 669, 643
(c) You can hedge this exposure by selling $4,500,000 forward. V ar(e) = V ar(P ) −
b2 V ar(S) = 33, 900, 669, 643 − 33, 900, 669, 643 = 0
6. Consider the three cases of Albion Computers PLC discussed in the chapter. Now,
assume that the pound is expected to depreciate to $1.50 (instead of $1.40 from the
textbook) from the current level of $1.60 per pound. Assume all other conditions
remain the same as in each cases
(a) Compute the projected annual cash flow in dollars.
(b) Compute the projected operating gains/losses over the four-year horizon as the
discounted present value of change in cash flows, which is due to the pound
depreciation, from the benchmark case presented in Exhibit 12.4.
– 3–
International Financial Management
sales
imported input in $
FX rate ($/)
imported input in
local input
unit variable cost
unit price $
inflation
unit price
units sold
sales
variable costs
overhead
depreciation
Net profit beore tax
income tax (50%)
profit after tax
add back depreciation
operating CF in
operating CF in $
PV
Spring, 2017
50,000
512
1.6
320
330
650
1600
8%
50,000
512
1.5
342.00
330
672.00
1600
8%
50,000
512
1.5
342.00
330
672.00
1600
8%
40,000
512
1.5
342.00
356.00
698.00
1600
8%
1,000
50,000
50,000,000
32,500,000
4,000,000
1,000,000
12,500,000
6,250,000
6,250,000
1,000,000
7,250,000
1,000
50,000
50,000,000
33,600,000
4,000,000
1,000,000
11,400,000
5,700,000
5,700,000
1,000,000
6,700,000
1067.00
50,000
53,350,000
33,600,000
4,000,000
1,000,000
14,750,000
7,375,000
7,375,000
1,000,000
8,375,000
1,080
40,000
43,200,000
27,920,000
4,000,000
1,000,000
10,280,000
5,140,000
5,140,000
1,000,000
6,140,000
11,600,000
$33,117,749.01
10,050,000
$28,692,532.55
12,562,500
$35,865,665.68
9,210,000
$26,294,350.72
– 4–