Problem 3. (30 points) Suppose that McDonald’s overseas sales revenue in Europe

Question

Problem 3.

(30 points) Suppose that McDonald’s overseas sales revenue in Europe totaled €10.00 billions in 2014 and is predicted to grow to €11.50 billions in 2015. The spot exchange rate was $1.45 per € in 2014 and is predicted to be $1.75 per € by the end of 2015. Show your calculations to answer each of the following questions.

1) From 2014 to 2015, what is the predicted growth rate of McDonald’s European revenues in terms of euros? (5 pts)

2) From 2014 to 2015, what is the predicted growth rate of McDonald’s European revenues in terms of dollars? (5 pts)

3) From 2014 to 2015, is the euro predicted to appreciate to depreciate against the dollar? What would be the rate of appreciation or depreciation? (5 pts)

4) Briefly explain why McDonald’s European euro-denominated and dollar-denominated revenues present seemingly different outlooks. (5 pts)

5) Suppose that the forward exchange rate is currently at $1.60 per €. Suppose that McDonald’s management is risk averse and is pretty much unsure about the end-of-year $/€ exchange rate, although it is predicted at $1.75 per € by the end of 2015. Explain how McDonald can hedge the exchange risk by engaging in a forward-exchange contract based on the currently quoted forward exchange rate. If so, what would be the predicted growth rate of McDonald’s European dollardenominated revenue? (10pts)

Problem 4.

(50 Points) The 12-month interest rate on dollar-denominated assets (like bank deposits) is 2.00%. The 12-month interest rate on euro-denominated assets is 1.80%. The current spot exchange rate is $1.50 per €. The current forward exchange rate is $1.58 per €. You have an initial dollar fund of $100,000. Suppose that you have decided today to invest your dollar fund in euro-denominated assets while also using the forward exchange market to hedge the exchange risk.

1) Explain what you should do today on the foreign exchange markets. (10 pts)

2) Explain what you should do 12 months from now on the foreign exchange markets. (10 pts)

3) Compute your investment gain in euros. What is the euro rate of return on your euro deposits? (10 pts)

4) Compute your investment gain in dollars. What is the dollar rate of return on your euro deposits? (10 pts)

5) Is your investment decision consistent with the covered interest parity based on the full formula? Show your calculations to support your answer. (5 pts)

6) Is your investment decision consistent with the covered interest parity based on the approximating formula? Show your calculations to support your answer. (5 pts)

Explanation / Answer

Problem - 3

(1)

Growth rate in terms of euro = (11.50 - 10) / 10 = 15%

(2)

Revenue in 2014 ($) = Euro 10 billion x $1.45 per Euro = $14.5 billion

Revenue in 2015 ($) = Euro 11.5 billion x $1.75 per Euro = $20.125 billion

Growth rate in terms of $ = (20.125 - 14.5) / 14.5 = 38.79%

(3)

In 2014, 1 Euro = $1.45

In 2015, 1 Euro = $1.75

So, Euro has appreciated with respect to dollar.

Appreciation in % = (1.75 - 1.45) / 1.45 = 20.69%

(4)

Euro-denominated revenue growth is projected at 15%, while dollar-denominated revenue growth is projected at 38.79%. This is a joint effect of two factors: Growth in euro-denominated revenue of 15%, plus the exchange rate appreciation of 20.69%:

Dollar-denominated revenue growth = [1.15 x 1.2069) - 1] x 100% = [1.3879 - 1] x 100% = 38.79%

NOTE: Out of total 10 questions, first 4 are answered.

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