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Problem Set 2 International Finance Shrikhande Fall 2006 SUGGESTED SOLUTIONS TO C !

PTE" # P"O$LE%S
1. From base price levels of 100 in 1987, West German and U.S. price levels in 1988 stood at 102 and 106, respectivel . !f t"e 1987 #$%& e'c"an(e rate )as #0.*+, )"at s"o,ld t"e e'c"an(e rate be in 1988- !n fact, t"e e'c"an(e rate in 1988 )as %& 1 . #0.*6. W"at mi("t acco,nt for t"e discrepanc /0rice levels )ere meas,red ,sin( t"e cons,mer price inde'.1

!NS&E"' !f e1981 is t"e dollar val,e of t"e German mar2 in 1988, t"en accordin( to p,rc"asin( po)er
parit e1988$.*+ . 106$102 or e1988 . #.*612. 3"e discrepanc bet)een t"e predicted rate of #.*612 and t"e act,al rate of #.*6 is insi(nificant and "ence needs no e'plainin(. 4istoricall , "o)ever, discrepancies bet)eent"e 000 rate and t"e act,al rate "ave fre5,entl occ,rred. 3"ese discrepancies co,ld be d,e to mismeas,rement of t"e relevant price indices. 6stimates based on narro)er price indices reflectin( onl traded (oods prices )o,ld probabl be closer to t"e mar2, so to spea2. 7lternativel , it co,ld be d,e to a s)itc" in investors8 preferences from dollar to non9dollar assets. :. !n earl 1996, t"e s"ort9term interest rate in France )as :.7;, and forecast Frenc" inflation )as 1.8;. 7t t"e same time, t"e s"ort9term German interest rate )as 2.6; and forecast German inflation )as 1.6;. a. <ased on t"ese fi(,res, )"at )ere t"e real interest rates in France and German -

!NS&E"' 3"e Frenc" real interest rate )as 1.0:7$1.018 9 1 . 1.87;. 3"e correspondin( real rate in
German )as 1.026$1.016 9 1 . 0.98;. b. 3o )"at )o,ld o, attrib,te an discrepanc in real rates bet)een France and German -

!NS&E"' 3"e most li2el reason for t"e discrepanc is t"e incl,sion of a "i("er inflation ris2
component in t"e Frenc" real interest rate t"an in t"e German real rate. =t"er possibilities are t"e effects of c,rrenc ris2 or transactions costs precl,din( t"is seemin( arbitra(e opport,nit . +. !n >,l , t"e one9 ear interest rate is 12; on <ritis" po,nds and 9; on U.S. dollars. a. !f t"e c,rrent e'c"an(e rate is #1.6:?,1, )"at is t"e e'pected f,t,re e'c"an(e rate in one ear-

!NS&E"' 7ccordin( to t"e international Fis"er effect, t"e spot e'c"an(e rate e'pected in one ear
e5,als 1.6: ' 1.09$1.12 . #1.*86:. b.S,ppose a c"an(e in e'pectations re(ardin( f,t,re U.S. inflation ca,ses t"e e'pected f,t,re spot rate to decline to #1.*2?1. W"at s"o,ld "appen to t"e U.S. interest rate-

!NS&E"' !f r,s is t"e ,n2no)n U.S. interest rate, and ass,min( t"at t"e <ritis" interest rate sta ed at
12; /beca,se t"ere "as been no c"an(e in e'pectations of <ritis" inflation1, t"en accordin( to t"e !F6, 1.*2$1.6: . /1@r,s1$1.12 or r,s . +.++;.

*. !f e'pected inflation is 100; and t"e real re5,ired ret,rn is *;, )"at )ill t"e nominal interest rate be accordin( to t"e Fis"er effect-

!NS&E"' 7ccordin( to t"e Fis"er effect, t"e relations"ip bet)een t"e nominal interest rate, r, t"e real
interest rate a, and t"e e'pected inflation rate, i, is 1 @ r . /1 @ a1/1 @ i1. S,bstit,tin( in t"e n,mbers in t"e problem ields 1 @ r . 1.0* ' 2 . 2.1, or r . 110;. 6. S,ppose t"at in >apan t"e interest rate is 8; and inflation is e'pected to be :;. &ean)"ile, t"e e'pected inflation rate in France is 12;, and t"e 6n(lis" interest rate is 1+;. 3o t"e nearest )"ole n,mber, )"at is t"e best estimate of t"e one9 ear for)ard e'c"an(e premi,m /disco,nt1 at )"ic" t"e po,nd )ill be sellin( relative to t"e Frenc" franc-

!NS&E"' <ased on t"e n,mbers, >apan8s real interest rate is abo,t *; /8; 9 :;1. From t"at, )e can
calc,late France8s nominal interest rate as abo,t 17; /12; @ *;1, ass,min( t"at arbitra(e )ill e5,ate real interest rates across co,ntries and c,rrencies. Since 6n(land8s nominal interest rate is 1+;, for interest rate parit to "old, t"e po,nd s"o,ld sell at aro,nd a :; for)ard premi,m relative to t"e Frenc" franc. 9. 3"e inflation rate in Great <ritain is e'pected to be +; per ear, and t"e inflation rate in S)itAerland is e'pected to be 6; per ear. !f t"e c,rrent spot rate is 1 . SF 12.*0, )"at is t"e e'pected spot rate in t)o ears-

!NS&E"' <ased on 000, t"e e'pected val,e of t"e po,nd in t)o ears is 12.* ' /1.06$1.0+12 . SF12.99.
10.!f t"e #? spot rate is #1 . 218 and interest rates in 3o2 o and Be) Cor2 are 6; and 12;, respectivel , )"at is t"e e'pected #? e'c"an(e rate one ear "ence-

!NS&E"' 7ccordin( to t"e international Fis"er effect, t"e dollar spot rate in one ear s"o,ld e5,al
218/1.06$1.121 . 206.:2. 12.S,ppose t"at on >an,ar 1, t"e cost of borro)in( Frenc" francs for t"e ear is 18;. %,rin( t"e ear, U.S. inflation is *;, and Frenc" inflation is 9;. 7t t"e same time, t"e e'c"an(e rate c"an(es from FF 1 . #0.1* on >an,ar 1 to FF 1 . #0.10 on %ecember :1. W"at )as t"e real U.S. dollar cost of borro)in( francs for t"e ear-

!NS&E"' %,rin( t"e ear, t"e franc deval,ed b /.1* 9 .101$.1* . ::.::;. 3"e nominal dollar cost of
borro)in( Frenc" francs, t"erefore, )as .18/1 9 .::::1 9 .:::: . 921.::; /see D"apter 121. For eac" dollar8s )ort" of francs borro)ed on >an,ar 1, it cost onl #0.7867 to repa t"e principal pl,s interest. Wit" U.S. inflation of *; d,rin( t"e ear, t"e real dollar cost of repa in( t"e principal and interest is #0.7867$1.0* . #0.7+92. S,btractin( t"e ori(inal #1 borro)ed, )e see t"at t"e real dollar cost of repa in( t"e franc loan is 9#0.2*08 or a real dollar interest rate of 92*.08;. 1+.7ss,me t"e interest rate is 16; on po,nds sterlin( and 7; on t"e 6,ro. 7t t"e same time, inflation is r,nnin( at an ann,al rate of :; in German and 9; in 6n(land. a. !f t"e 6,ro is sellin( at a one9 ear for)ard premi,m of 10; a(ainst t"e po,nd, is t"ere an arbitra(e opport,nit - 6'plain.

!NS&E"' 7ccordin( to interest rate parit , )it" a 6,ro rate of 7; and a 10; for)ard premi,m on t"e
6,ro a(ainst t"e po,nd, t"e e5,ilibri,m po,nd interest rate s"o,ld be 1.07 ' 1.10 9 1 . 17.7;

Since t"e po,nd interest rate is onl 16;, t"ere is an arbitra(e opport,nit . !t involves borro)in( po,nds at 16;, convertin( t"em into 6,ro, investin( t"em at 7;, and t"en sellin( t"e proceeds for)ard, loc2in( in a po,nd ret,rn of 17.7;. b. W"at is t"e real interest rate in German - in 6n(land-

!NS&E"' 3"e real interest rate in German is 1.07$1.0: 91 . :.88;. 3"e real interest rate in 6n(land is
1.16$1.09 91 . 6.+2;. c. S,ppose t"at d,rin( t"e ear t"e e'c"an(e rate c"an(es from 6,ro2.7$ 1 to 6,ro2.6*$1. W"at are t"e real costs to a German compan of borro)in( po,nds- Dontrast t"is cost to its real cost of borro)in( 6,ro.

!NS&E"' 7t t"e end of one ear, t"e German compan m,st repa ,1.16 for ever po,nd borro)ed.
4o)ever, since t"e po,nd "as deval,ed a(ainst t"e 6,ro b 1.8*; /2.6*$2.70 9 1 . 91.8*;1, t"e effective cost in 6,ro is 1.16 ' /1 9 0.018*1 9 1 . 1:.8*;. !n real terms, (iven t"e :; rate of German inflation, t"e cost of t"e po,nd loan is fo,nd as 1.1:8*$1.0: 91 . 10.*+;. 7s s"o)n above, t"e real cost of borro)in( 6,ro e5,als :.88;, )"ic" is si(nificantl lo)er t"an t"e real cost of borro)in( po,nds. W"at "appened is t"at t"e po,nd loan factored in an e'pected deval,ation of abo,t 9; /16; 9 7;1, )"ereas t"e po,nd onl deval,ed b abo,t 2;. 3"e difference bet)een t"e e'pected and act,al po,nd deval,ation acco,nts for t"e appro'imatel 7; "i("er real cost of borro)in( po,nds. d. W"at are t"e real costs to a <ritis" firm of borro)in( 6,ro- Dontrast t"is cost to its real cost of borro)in( po,nds.

!NS&E"' %,rin( t"e ear, t"e 6,ro appreciated b 1.89; /2.70$2.6* 9 11 a(ainst t"e po,nd. 4ence, a
6,ro loan at 7; )ill cost 9.02; in po,nds /1.07 ' 1.0189 9 11. !n real po,nd terms, (iven a 9; rate of inflation in 6n(land, t"is loan )ill cost t"e <ritis" firm 0.02; /1.0902$1.09 9 11 or essentiall Aero. 7s s"o)n above, t"e real interest on borro)in( po,nds is 6.+2;. 1*.S,ppose toda 8s e'c"an(e rate is #0.62$6,ro. 3"e 69mont" interest rates on dollars and 6,ro are 6; and :;, respectivel . 3"e 69mont" for)ard rate is #0.618*. 7 forei(n e'c"an(e advisor service "as predicted t"at t"e 6,ro )ill appreciate to #0.6+ )it"in si' mont"s. a. 4o) )o,ld o, ,se for)ard contracts to profit in t"e above sit,ation-

!NS&E"' < b, in( 6,ro for)ard for si' mont"s and sellin( it in t"e spot mar2et, o, can loc2 in an
e'pected profit of #0.021* /0.6+ 9 0.618*1 per 6,ro bo,("t for)ard. 3"is is a semiann,al percenta(e ret,rn of :.+8; /0.021*$0.618*1. W"et"er t"is profit materialiAes depends on t"e acc,rac of t"e advisor service8s forecast. b. 4o) )o,ld o, ,se mone mar2et instr,ments /borro)in( and lendin(1 to profit-

!NS&E"' < borro)in( dollars at 6; /:; semiann,all 1, convertin( t"em to 6,ro in t"e spot mar2et,
investin( t"e 6,ro at :; /1.*; semiann,all 1, sellin( t"e 6,ro proceeds at an e'pected price of #0.6+$6,ro, and repa in( t"e dollar loan, o, )ill earn an e'pected semiann,al ret,rn of 1.77;? Eet,rn per dollar borro)ed . /1$0.621 ' 1.01* ' 0.6+ 9 1.0: . 1.77; c. W"ic" alternatives /for)ard contracts or mone mar2et instr,ments1 )o,ld o, prefer- W" -

!NS&E"' 3"e ret,rn per dollar in t"e for)ard mar2et is s,bstantiall "i("er t"an t"e ret,rn ,sin( t"e
mone mar2et spec,lation. =t"er t"in(s bein( e5,al, t"erefore, t"e for)ard mar2et spec,lation )o,ld be preferred.

Cha(ter ))*a+ (roblem,


*. =n >an,ar 1, t"e U.S. dollar?>apanese en e'c"an(e rate is #1 . F2*0. %,rin( t"e ear, U.S. inflation is +; and >apanese inflation is 2;. =n %ecember :1, t"e e'c"an(e rate is #1 . F2:*. W"at are t"e li2el competitive effects of t"is e'c"an(e rate c"an(e on Daterpillar 3ractor, t"e 7merican eart"9movin( man,fact,rer, )"ose to,("est competitor is >apan8s Gomats,-

!NS&E"' 3"e real val,e of t"e en c"an(ed from #.00+000 /1$2*01 at t"e start of t"e ear to #.00+::9
/1$2:* ' 1.0+$1.021 at t"e end of t"e ear, an increase of 8.+7;. Daterpillar 3ractor s"o,ld benefit from t"is increase in t"e real val,e of t"e en since Gomats, does most of its man,fact,rin( in >apan. 3"e inflation9adH,sted dollar cost of >apanese9s,pplied components and labor )ill rise in line )it" t"e increase in t"e real val,e of t"e en. Gomats,8s ra) materials and ener( prices s"o,ld not rise in dollar terms beca,se t"ese reso,rces are imported. 7. !n 1990, General 6lectric ac5,ired 3,n(sram Itd., a 4,n(arian li("t b,lb man,fact,rer. 4,n(ar 8s inflation rate )as 28; in 1990 and :*; in 1991, )"ile t"e forint /4,n(ar 8s c,rrenc 1 )as deval,ed *; and 1*;, respectivel , d,rin( t"ose ears. Dorrespondin( inflation for t"e U.S. )as 6.1; in 1990 and :.1; in 1991. W"at "as "appened to t"e competitiveness of G68s 4,n(arian operations d,rin( 1990 and 19916'plain.

a.

!NS&E"' Since forint deval,ations "aven8t 2ept pace )it" 4,n(ar 8s roarin( inflation, )e 2no) t"at t"e
forint8s real e'c"an(e rate "as risen. Specificall , if t"e nominal e'c"an(e rate /dollar val,e of t"e forint1 at t"e start of 1990 )as e0, t"e forint8s real val,e at t"e end of 1991 )as? 0.9* ' 0.8*e0 ' /1.281/1.:*1$J/1.0611/1.0:11K . 1.276e0 3"is e5,ation reflects t"e fact t"at if t"e nominal e'c"an(e rate /dollar val,e of t"e forint1 at t"e start of 1990 )as e0, t"en t"e *; deval,ation d,rin( 1990 left it at 0.9*e 0 b t"e end of 1990. 7 f,rt"er 1*; deval,ation d,rin( 1991 )o,ld "ave left t"e nominal rate e5,al to 0.9* ' 0.8*e0 b t"e end of 1991. <ased on t"is e5,ation, )e can see t"at t"e real e'c"an(e rate increased b 27.6; d,rin( t"is t)o9 ear period. 3"e s"arp appreciation in t"e real val,e of t"e forint red,ced t"e cost competitiveness of G68s 4,n(arian operations. b. !n earl 1992, G6 anno,nced t"at it )o,ld c,t bac2 its capital investment in 3,n(sram. W"at mi("t "ave been t"e p,rpose of G68s p,blicl anno,nced c,tbac2-

!NS&E"' G6 )as tr in( to p,t press,re on t"e 4,n(arian (overnment to deval,e f,rt"er t"e forint and
t"ereb improve t"e cost competitiveness of its 3,n(sram man,fact,rin( facilities. !n effect, G6 )as tellin( t"e 4,n(arian (overnment t"at it )as in b,siness to ma2e a profit and t"at if it co,ldn8t ma2e a

profit in 4,n(ar beca,se of t"e "i(" forint and t"e res,ltin( s"arp H,mp in its costs, it )as not (oin( to invest t"ere in t"e f,t,re. 11. 7ssess t"e li2el conse5,ences of a declinin( dollar on Fl,or Dorporation, t"e international constr,ction9 en(ineerin( contractor based in !rvine, Dalifornia. &ost of Fl,or8s val,e9added involves proHect desi(n and mana(ementL most of its costs are for U.S. labor in desi(n, en(ineerin(, and constr,ction9mana(ement services.

!NS&E"' Fl,or )ill benefit from a fallin( dollar since it )ill be more cost competitive vis9a9vis forei(n
contractors bot" at "ome and abroad. !ts costs are primaril denominated and determined in dollars. 3",s, )"en t"e dollar declines, t"ese costs fall relative to t"ose of its forei(n competitors. 7lt"o,(" man of t"e costs inc,rred on forei(n proHects are set in t"e local c,rrenc , t"ese costs are t"e same for all potential competitors. 4ence, in competin( a(ainst forei(n firms, Fl,or )ill find t"at some of its costs are t"e same )"ile ot"er of its costs, partic,larl for t"e labor involved in desi(n, en(ineerin(, and constr,ction mana(ement services, are no) lo)er. 1+. 3"e 6dmonton =ilers /Danada1 of t"e Bational 4oc2e Iea(,e are t)o9time defendin( Stanle D,p c"ampions. /3"e Stanle D,p pla off is "oc2e 8s e5,ivalent of football8s S,per <o)l or baseball8s World Series.1 7s is tr,e of all B4I teams, most of t"e =ilers8 pla ers are Danadian. 4o) are t"e =ilers affected b c"an(es in t"e Danadian dollar$U.S. dollar e'c"an(e rate-

!NS&E"' 3"e fact t"at t"e =ilers are paid in Danadian dollars does not affect t"e ans)er to t"is 5,estion
ver m,c". W"ile t"e D# is t"e c,rrenc of denomination, t"e U.S.# is t"e c,rrenc of determination. 3"at is, t"e Danadian dollar salaries paid to t"e =ilers8 pla ers are H,st e5,al to )"at t"e pla ers8 salaries )o,ld be in U.S. dollars converted into Danadian dollars. 3",s, t"e 6dmonton =ilers are ",rt b appreciation of t"e U.S.# vis9a9vis t"e D# and benefitted b U.S. dollar depreciation. Donsider )"at )o,ld "appen, for e'ample, if t"e U.S.# appreciates a(ainst t"e D#. !f t"e =ilers8 D# salaries are not raised, t"e )ill find t"e are bein( paid less t"an pla ers on U.S. "oc2e teams. 3"e =ilers )ill be forced to raise t"e Danadian dollar e5,ivalent of its pla ers8 salaries to 2eep t"em on a par )it" t"eir U.S. rivals. =t"er)ise, t"e 6dmonton =ilers )ill eit"er lose pla ers to U.S. teams or "ave a "ostile team. 0la er nationalit is irrelevant. Danadian teams compete in a )orld mar2et for talent and m,st pa t"e mar2et price. 1*. So,t" Gorean companies s,c" as Goldstar, Sams,n(, and %ae)oo "ave capt,red more t"an 10; of t"e U.S. color 3M mar2et )it" t"eir small, lo)9priced 3M sets. 3"e are also becomin( more si(nificant e'porters of videocassette recorders and small micro)ave ovens. W"at c,rrenc ris2 do t"ese firms face-

!NS&E"' 3"ese firms "ave benefitted (reatl from t"e appreciation of t"e >apanese en a(ainst t"e U.S.
dollar beca,se t"e )on "as not risen b nearl t"e same e'tent a(ainst t"e dollar. 3"e "ave ,sed t"eir cost advanta(e vis9N9vis >apanese competitors to boost sales of lo)9end cons,mer electronics prod,cts b c,ttin( prices belo) t"e level at )"ic" t"e >apanese co,ld ma2e mone . Cen depreciation or )on appreciation )o,ld red,ce t"eir cost advanta(e. Similarl , t"e face c,rrenc ris2 beca,se competitors in ot"er nations, s,c" as 3ai)an or 3"ailand, mi("t deval,e t"eir c,rrencies a(ainst t"e )on. 18. <lac2 O %ec2er &an,fact,rin( Do. of 3o)son, &ar land, "as ro,("l +*; of its assets and +0; of its sales overseas. 4o) does a soarin( dollar affect its profitabilit , bot" at "ome and abroad-

!NS&E"' <lac2 O %ec2er "as a ro,(" balance bet)een forei(n sales and costs. 3",s, as t"e dollar
appreciates, bot" its sales reven,e and its costs decline appro'imatel in line )it" eac" ot"er. 3"is means t"at its profits )ill decline ro,("l in line )it" t"e rise of t"e dollar. /!f bot" reven,es and costs fall, sa , 10;, t"en profit m,st also fall b 10;.1 %ollar depreciation leads to correspondin( increases in dollar reven,es and costs. 3"e bottom line is t"at <O%8s profits fall as t"e dollar rises and rise as t"e dollar falls.

!f <O% didn8t prod,ce overseas, b,t instead e'ported from its U.S. plants, t"en c,rrenc c"an(es )o,ld lead to m,c" (reater s)in(s in its profits. Bote t"at <O%8s domestic profitabilit is also affected b c,rrenc c"an(es since it faces competition in t"e U.S. from forei(n companies s,c" as >apan8s &a2ita. 19. 3"e s"ipb,ildin( ind,str is facin( a )orld)ide capacit s,rpl,s. 7lt"o,(" >apan c,rrentl controls abo,t *0; of t"e )orld mar2et, it is facin( severe competition from t"e So,t" Goreans. >apanese s"ip ards are e'traordinaril prod,ctive, b,t at c,rrent price levels )ere H,st abo,t brea2in( even )it" an e'c"an(e rate of 2+0 . #1. W"at are t"e li2el effects on >apanese s"ipb,ilders of a en appreciation to 180 . #1- 3"e So,t" Gorean )on "as maintained its dollar val,e.

!NS&E"' 3"e statement t"at P>apanese s"ip ards are e'traordinaril prod,ctiveP tells o, t"at t"ere is
not m,c" room for cost c,ttin( b >apanese s"ip ards. 4ence, >apanese s"ip ards )ill be devastated b a rise in t"e en, as t"e )ere. 7s t"e en appreciates a(ainst t"e )on, So,t" Gorean s"ip ards (ained a s,bstantial cost advanta(e vis9a9via t"e >apanese. 7ccordin( to a stor in t"e Wall Street Journal, P>apanese ind,str officials sa s"ip b, ers no) a,tomaticall b pass >apanese ma2ers, t,rnin( instead to 4 ,ndai Dorp. and ot"er So,t" Gorean s"ipb,ilders, )"ic" enHo comparative reprieve on t"e c,rrenc front.P 3"e onl de(ree of freedom to adH,st >apanese s"ipb,ilder costs too2 place on t"e )a(e side. >apanese firms t picall pa a s,bstantial fraction of )or2ers8 )a(es in t"e form of a semi9ann,al bon,s t"at is tied to corporate profits. 3",s, d,rin( "ard times, labor costs fall a,tomaticall . 4o)ever, t"is decrease in labor costs )as not nearl eno,(" and man >apanese s"ip ards )ent ban2r,pt. 7 spo2esman for t"e >apan S"ip 6'porters 7ssociation said t"at t"e co,ldn8t lo)er prices f,rt"er. P3"e 8re alread at t"e bottom. We can do not"in( b,t )atc" competitors ta2e a)a orders.P >apanese s"ip ards "ave responded b desi(nin( innovative s"ips for )"ic" demand is price inelastic. 3"e are no lon(er competitive in t"e commodit s"ip b,siness.

Cha(ter ))*b+ (roblem,


:. GiAmo, U.S.7. is investi(atin( medi,m9term financin( of #10 million in order to b,ild an addition to its factor in 3oledo, ="io. GiAmo8s ban2 "as s,((ested t"e follo)in( alternatives? 3 pe of loan :9 ear U.S. dollar loan :9 ear 6,ro loan :9 ear S)iss franc loan Eate 1+ 8 +

a. W"at information does GiAmo re5,ire to decide amon( t"e t"ree alternatives-

!NS&E"' !t is ,sef,l to divide t"is problem into t)o iss,es? )"at is t"e e'pected cost and )"at is t"e ris2
of eac" alternative. %efinin( t"e terms PcostP and Pris2P re5,ires caref,l t"o,("t. !f )e ass,me t"at /11 t"e international mone mar2ets are efficient and /21 t"e international Fis"er effect "olds /t"ese are separate iss,es1 t"en t"e e'pected cost of eac" loan is t"e same. !f t"e mar2et is anticipatin( t"at for t"e ne't t"ree ears t"e 6,ro and t"e S)iss franc )ill appreciate 6; and 10; ann,all , respectivel , t"en t"e e'pected U.S. dollar cost of eac" loan is t"e same. !f )e are ,n)illin( to ma2e ass,mptions /11 and /21, t"en )e need to ,se independent forecasts of t"e 6,ro and S)iss franc e'c"an(e rates to calc,late t"e loan )"ose expected U.S. dollar cost is t"e lo)est.

6ven if t"e e'pected cost of eac" loan is t"e same, t"e ris2 associated )it" eac" loan ma be different for GiAmo. 3"is ris2 )ill depend on t"e c,rrenc denomination of assets t"at GiAmo "olds as )ell as on t"e mar2ets in )"ic" GiAmo b, s its inp,ts and sells it o,tp,ts. For e'ample, if GiAmo sells man prod,cts in German , t"en it probabl "as acco,nts receivable denominated in 6,ro. !t can ,se t"ese receivables to pa off a %& loan and avoid t"e ris2s t"at are associated )it" an ,ncertain #$6,ro rate. !f GiAmo desires a partic,lar ris2 level, t"en it ma rationall prefer a partic,lar c,rrenc denomination for t"e loan. !t ma also be t"at for)ard mar2ets are more developed in one c,rrenc or t"at ,nanticipated e'c"an(e rate c"an(es are smaller in one c,rrenc , and t"erefore, t"e ris2s associated )it" t"at c,rrenc are smaller even if t"e e'pected costs are t"e same. b. S,ppose t"e factor )ill be b,ilt in Geneva, S)itAerland, rat"er t"an 3oledo. 4o) does t"is affect o,r ans)er in part a-

!NS&E"' !f t"e factor in Geneva sells in S)itAerland, t"en GiAmo "as an asset )"ic" is essentiall
denominated in S)iss francs. 3"is ma establis" a nat,ral "ed(e a(ainst a S)iss franc loan and red,ce t"e ris2 of t"is partic,lar alternative. !f t"e e'pected cost of eac" loan alternative if t"e same, and if t"e firm see2s to red,ce total ris2, t"en t"is information )o,ld s,((est a S)iss franc loan. <,t if t"e S)iss factor is e'portin( to t"e U.S., or is sellin( in t"e S)iss mar2et and facin( import competition, t"en some dollar financin( or financin( in t"e c,rrenc of t"e co,ntr in )"ic" its main competitors are located mi("t be appropriate. !f t"e obHective is to minimiAe c,rrenc ris2, t"e relative amo,nt of financin( to do in eac" c,rrenc )ill also depend on t"e so,rces of GiAmo8s inp,ts, partic,larl t"e e'tent to )"ic" it ,ses S)iss labor. 3"e more labor9intensive t"e prod,ction process, t"e less ,sef,l S)iss franc financin( )ill be in red,cin( GiAmo8s e'pos,re /since b ,sin( S)iss labor it alread "as S)iss franc o,tflo)s1. *. !n September 1992, %o) D"emical reacted to t"e c,rrenc c"aos in 6,rope b s)itc"in( to 6,ro pricin( for all its prod,cts in 6,rope. 3"e p,rpose, said a %o) e'ec,tive, )as to s"ift c,rrenc ris2 from %o) to its 6,ropean c,stomers. &oreover, said t"e %o) e'ec,tive, t"e polic )as fairer? < settin( t"e same %& price t"ro,("o,t 6,rope, %o)8s ne) polic )o,ld n,llif an advanta(e t"at a %o) c,stomer in one compan mi("t "ave over competitors in anot"er co,ntr based on c,rrenc s)in(s. a. W"at is %o) reall tr in( to accomplis" )it" its ne) pricin( polic -

!NS&E"' %o) )as reall tr in( to raise its prices in t"ose 6,ropean co,nties )"ose c,rrencies
deval,ed so as to preserve its dollar mar(ins, )"ic" )ere erodin( from t"e deval,ations. b. W"at is t"e li2eli"ood t"at t"is ne) polic )ill red,ce %o)8s c,rrenc ris2-

!NS&E"' Bot ver li2el . Unless all its leadin( competitors (o alon( )it" 6,ro pricin( /its U.S. and
forei(n competitors said t"at t"e )o,ldn8t follo) %o) b,t )o,ld contin,e doin( b,siness in local c,rrencies1, %o) )ill "ave to c,t its 6,ro price ever time t"e 6,ro appreciates or else lose mar2et s"are. !n ot"er )ords, %o) can8t ,se 6,ro pricin( to avoid mar(in erosion )"en 6,ropean c,rrencies deval,e a(ainst t"e dollar ,nless it is )illin( to sacrifice mar2et s"are. c. 4o) are %o)8s c,stomers li2el to respond to t"is ne) polic -

!NS&E"' 3"e )ill simpl demand lo)er 6,ro prices if t"eir c,rrencies deval,e. !f %o) doesn8t c,t its
6,ro prices, man of t"em )ill b, from t"ose of %o)8s competitors )"o are )illin( to c,t t"eir dollar or 6,ro prices.

8. Dost 0l,s !mports is a West Doast c"ain specialiAin( in lo)9cost imported (oods, principall from >apan. !t "as to p,t o,t its semiann,al catalo(,e )it" prices t"at are (ood for si' mont"s. 7dvise Dost 0l,s !mports on "o) it can protect itself a(ainst c,rrenc ris2.

!NS&E"' 7 compan s,c" as Dost 0l,s )ill t picall ne(otiate p,rc"ase contracts )it" t"e s,ppliers of
its catalo(,e merc"andise in advance. Dost 0l,s co,ld "ed(e t"ese p,rc"ases ,sin( for)ard contracts. 7 problem, t"o,(", is t"at if t"e forei(n c,rrencies deval,e d,rin( t"e life of t"e catalo(,e, prices of s,bstit,te prod,cts for t"e items in t"e catalo(,e )ill li2el come do)n some)"at. !n t"is case, some c,stomers )"o mi("t "ave bo,("t from Dost 0l,s )ill decide to b, t"e c"eaper s,bstit,tes, costin( Dost 0l,s sales. 3"is is ver li2el "ere (iven t"e nat,re of Dost90l,s prod,cts? lo)9cost (oods pres,mabl bo,("t b a price9sensitive clientele. 3"e e'istence of 5,antit ris2 in addition to price ris2 s,((ests t"at Dost 0l,s s"o,ld "ed(e less t"an 100; of its proHected sales. 7s an alternative, Dost 0l,s co,ld b, call options to cover its forei(n p,rc"ases. !f t"e forei(n c,rrencies drop belo) t"e call option price, t"e firm )on8t e'ercise its optionsL if t"e rise above t"e call price, Dost 0l,s )ill e'ercise t"em. 11. I le S"ippin(, a <ritis" compan , "as c"artered o,t s"ips at fi'ed9U.S.9dollar frei("t rates. 4o) can I le ,se financin( to "ed(e a(ainst its e'pos,re- 4o) )ill o,r recommendation affect I le8s translation e'pos,re- I le ,ses t"e c,rrent rate met"od to translate forei(n c,rrenc assets and liabilities. 4o)ever, t"e c"arters are off9balance9s"eet items.

!NS&E"' Since I le "as c"artered o,t its s"ips in dollars, it "as fi'ed dollar reven,es. < financin( its
s"ip p,rc"ases )it" dollars, I le can offset t"ese contract,al dollar inflo)s )it" contract,al dollar o,tflo)s. 7cco,ntants )ill note t"at I le bears si(nificant translation e'pos,re. 7s t"e dollar rises a(ainst t"e po,nd, I le )ill s"o) losses on its dollar debt and vice versa )"en t"e dollar falls. <,t (ains or losses on t"e debts )ill be canceled o,t over time b c"an(es in its operatin( cas" flo)s. !n 198+, )"en t"e dollar rose, its c"airman pointed o,t t"at P7lt"o,(" forei(n e'c"an(e losses "ave no) been provided for in f,ll on all loans and leases as if t"e "ad been repa able at :0 >,ne 198+, it m,st be borne in mind t"at t"ese are sec,red a(ainst s"ips c"artered o,t at fi'ed frei("t rates, t"e U.S. dollar income from )"ic" )ill be s,fficient to service bot" t"e interest and capital on t"e ,nderl in( loans. 3"is f,t,re income )ill offset t"e e'c"an(e losses no) provided for.P 1:. !n 198*, >apan 7irlines />7I1 bo,("t #: billion of forei(n e'c"an(e contracts at 180$#1 over 11 ears to "ed(e its p,rc"ases of U.S. aircraft. < 199+, )it" t"e en at abo,t 100$#1, >7I "ad inc,rred more t"an #1 billion in c,m,lative forei(n e'c"an(e losses on t"at deal. a. W"at )as t"e economic rationale be"ind >7I8s "ed(es-

!NS&E"' &ost li2el , >7I "ad si(ned contracts to ta2e deliver of planes in t"e f,t,re and )as ,sin(
for)ard contracts to protect itself a(ainst a rise in t"e val,e of t"e dollar t"at )o,ld increase t"e en cost of b, in( t"e planes. 7lternativel , t"e for)ard contracts co,ld "ave been ,sed to "ed(e p,rc"ases of U.S. planes financed b borro)in( dollars. b. %id >7I8s for)ard contracts constit,te an economic "ed(e- 3"at is, is it li2el t"at >7I8s losses on its for)ard contracts )ere offset b c,rrenc (ains on its operations-

!NS&E"' 3"e ans)er to t"is 5,estion depends on )"et"er >7I8s en operatin( profits are ne(ativel
correlated )it" t"e en8s val,e. !f a stron(er en means lo)er en operatin( profits, t"en t"ese for)ard contracts )o,ld constit,te an economic "ed(e. Some factors to consider in decidin( )"et"er t"is is li2el to be t"e case are as follo)s. First, a (ood part of >7I8s costs are for >apanese fli("t cre)s, )"ose pa is

denominated and determined in en. 3o t"e e'tent t"at fares are determined in dollars /in part beca,se >7I is competin( )it" U.S. airlines, >7I8s en profits )ill var inversel )it" t"e en8s val,e1. 7t t"e same time, a stron(er en )ill ind,ce more >apanese to travel to t"e U.S. b,t fe)er 7mericans to visit >apan, increasin( o,tbo,nd vol,me b,t red,cin( inbo,nd vol,me. W"ere t"e balance lies is an empirical 5,estion. !t t,rns o,t t"at >7I "as been ",rt b en appreciation and is no) loo2in( to c,t costs, primaril b red,cin( its >apanese )or2 force t"ro,(" Hob b, o,ts and "irin( forei(ners. !t "as also foc,sed more on servin( leis,re travelers since t"e en8s stren(t" "as led ,nprecedented n,mbers of >apanese to,rists to travel abroad. 16. !n 1990, a >apanese investor paid #100 million for an office b,ildin( in do)nto)n Ios 7n(eles. 7t t"e time, t"e e'c"an(e rate )as 1+*$#1. W"en t"e investor )ent to sell t"e b,ildin( five ears later, in earl 199*, t"e e'c"an(e rate )as 8*$#1 and t"e b,ildin(8s val,e "ad collapsed to #*0 million. a. W"at e'c"an(e ris2 did t"e >apanese investor face at t"e time of "is p,rc"ase-

!NS&E"' 3"e ris2 is t"at t"e val,e of t"e dollar )o,ld fall a(ainst t"e en and t"at t"e dollar reven,es
)o,ld not 2eep ,p )it" t"e decline in t"e val,e of t"e dollar. b. 4o) co,ld t"e investor "ave "ed(ed "is ris2-

!NS&E"' 3"e investor co,ld "ave financed "is p,rc"ase of t"e b,ildin( b borro)in( dollars, so t"at
t"e ver same event t"at led to a decline in t"e en val,e of "is asset99namel , a dollar decline99 )o,ld sim,ltaneo,sl red,ce t"e en cost of t"e liabilit ,sed to finance t"at asset. 4e co,ld also "ave ta2en o,t a lon(9dated for)ard contract to "ed(e t"e en val,e of "is b,ildin(. Bot"in( )o,ld "ave protected t"e investor from t"e decline in t"e b,ildin(8s dollar price.