The Stern School of Business

New York University

International Financial Management

Professor Ian Giddy

Sample Final Exam: Suggested Solutions

1. (c) 128.452

2. (b) An index designed to measure deviations from purchasing power parity.

a. Money market hedge: borrow dollars, buy yen, invest in 1-year Euroyen deposit.
b. Forward hedge: purchase yen for 1 year forward delivery
c. Rollover forward hedge: buy 3-month yen forward and roll over this forward contract 3 times
d. Buy yen futures
e. Synthetic forward with options: buy a 1-year call and sell a 1-year put on yen.

4. A forward contract is essentially a contract between two parties that will "lock in" a specified exchange rate for delivery at a specific point of time in the future. Options, on the other hand, give the holder the right but not the obligation to buy or sell the currency at a future point in time. The key difference between the two types of contracts is in the symmetry of the risk profile. FX options have an asymmetric risk profile in that there is unlimited upside potential and limited downside risk. On the other hand, forwards and futures are mutual obligations where gains and losses are equal and therefore have a symmetrical risk profile.

An option is a better hedging tool when hedging asymmetrical exchange risk (e.g. hedging foreign exchange risk when cash flow denominations are uncertain).

Why Sallie Mae issues currency-linked bonds: purely as an arbitrage. Investors do not work out the implied forward rate in the SLMA bond, and the agency is able to enter into a currency swap or long dated forward exchange contract with a bank, completely hedging out the exchange risk, and give it an all-in cost of funds lower than it could get with a straight bond.

Why U.S. individual investors buy them: they do not know exactly what the terms should be, and they have a view that the dollar will be strong against the yen in the next few year. They accept a lower interest rate in exchange for this position. Also because of counterparty risk, they cannot enter into a forward exchange contract to short the yen for a similar maturity. Even if the futures market is more efficient, it may not go out that far and it is much more of a day-to-day hassle.

a. ASSETS Exposed under Current/Non current translation rule Exposed under Monetary/Non monetary translation rule
Cash 23 23 23
A/R in A$ 143 143 143
Inventory 11 11
Fixed Assets 205
S.T. A$ bank debt 50 -50 -50
Taxes Payable 6 -6 -6
5 yr A$ bank debt 100 -100
1 yr A$ parent loan 120
Equity 161
Net exposure (A$) 121 10
Net exposure (US$ @ 80c per A$) $96.8 $8.0
If 10% devaluation, lose $9.7 $0.8
Current/non current rule: all "current" (i.e. short term) assets and liabilities are exposed, and translated at the current exchange rate; the rest is not exposed, and so translated at the historical exchange rate.
Monetary/ non monetary rule: all "monetary" (i.e. contractual) assets and liabilities are exposed, and translated at the current exchange rate; the rest is not exposed, and so translated at the historical exchange rate.
b. Economic exposure measures how the value of the firm, perhaps as measured by the NPV of expected cash flows, is affected by an exchange rate change. In Australia, the business is a local, differentiated one, so prices are largely unaffected by exchange rate changes. Thus Kingston is exposed to the Australian dollar, and should probably hedge that exposure.
c. From US viewpoint, this is a pure NZ$ transactions exposure: so sell NZ$ forward against US$.
2. Yes. If in A$, it becomes an A$ transactions exposure: so sell A$ forward against US$.

7. We will do this by first ignoring the up front issuance costs. To avoid currency risk on the coupon, Turkey would wish to match the 8.35% it pays on the Eurobond with an equal receipt of 8.35% from the swap (check this by drawing the diagram). Since the swap rate is 7.50%, and we want to receove 8.35%, we need to figure out how the 0.85% difference translates to a spread over LIBOR on Turkey's floating payments. From the swap quotation sheet, the US$ swap rate is 5.73%. Using the basis point conversion formula to convert the DFl basis points to $ basis points:

BPDFL 85 = BP$ 83

Therefore Turkey would pay LIBOR + .83% disregarding the up front cost.

The up front cost of 1.3% could be annuitized using the $ fixed rate of 5.73% semi-annual. The annuity formula gives 0.32% per annum. Therefore Turkey's LIBOR-based cost of funds will be:

LIBOR + 0.83% + 0.32% = LIBOR + 1.15%