QUESTION ONE Assume the following information is available for the United States
ID: 2728205 • Letter: Q
Question
QUESTION ONE
Assume the following information is available for the United States and Europe:
U.S
Europe
Nominal Interest Rate
4%
6%
Expected Infation
2%
5%
Spot Rate
$1.13
1 year Forward Rate
$1.10
Does Interest Rate Parity (IRP) hold? Show clearly with relevant calculations. [5 MARKS]
According to Purchasing Power Parity (PPP), what is the expected spot rate of the euro in one year? [5 MARKS]
According to the International Fisher Effect (IFE), what is the expected spot rate of the euro in one year? [5 MARKS]
Reconcile your answers to parts (A) and (C). [5 MARKS]
[TOTAL: 20 MARKS]
QUESTION TWO
Amco is a U.S. company that conducts major importing and exporting business in Japan, whereby all transactions are invoiced in dollars. It obtained debt in the United States at an interest rate of 10 percent per year. The long-term risk-free rate in the United States is 8 percent. The stock market return in the United States is expected to be 14 percent annually. Amco’s beta is 1.2. Its target capital structure is 30 percent debt and 70 percent equity. Amco is subject to a 25 percent corporate tax rate.
Estimate the cost of capital to Amco. [12 MARKS]
Amco has no subsidiaries in foreign countries but plans to replace some of its dollar-denominated debt with Japanese yen–denominated debt since Japanese interest rates are low. It will obtain yen- denominated debt at an interest rate of 5 percent. It cannot effectively hedge the exchange rate risk resulting from this debt because of parity conditions that make the price of derivatives contracts reect the interest rate differential. How could Amco reduce its exposure to the exchange rate risk resulting from the yen-denominated debt without moving its operations? [8 MARKS]
[TOTAL: 20 MARKS]
QUESTION THREE
The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United States is 2 percent. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.
What is the forward rate premium? [4 MARKS]
What is the one-year forward rate of the peso? [4 MARKS]
Based on the international Fisher effect, what is the expected change in the spot rate over the next year? [4 MARKS]
If the spot rate changes as expected according to the IFE, what will be the spot rate in one year? [4 MARKS]
Compare your answers to (b) and (d) and explain the relationship.
[4 MARKS]
[TOTAL: 20 MARKS]
U.S
Europe
Nominal Interest Rate
4%
6%
Expected Infation
2%
5%
Spot Rate
$1.13
1 year Forward Rate
$1.10
Explanation / Answer
Answer:
p=[(1+in)/(1+if)]-1
=[(1.04)/(1.06)]-1
=-1.89%
Therefore, the forward rate of the euro should be $1.13 × (1 – 1.89%) = $1.109. IRP does not hold in this case.
Answer:
ef=[(1.02)/(1.05)]-1
=-2.86%
According to PPP, the expected spot rate of the euro in one year is $1.13 × (1 – 2.86%) = $1.098.
Answer: ef=[(1.04)/(1.06)]-1
=-1.89%
According to the IFE, the expected spot rate of the euro in one year is $1.13 × (1 – 2.86%) = $1.098.
Answer:
Parts a and c combined say that the forward rate premium or discount is exactly equal to the expected
percentage appreciation or depreciation of the euro.
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