FIN 4514 Exam II Review 14 mathematical based on homework problems 11 conceptual 1 Know how to use exchange rates to convert prices from one currency to another a Example 1 On October 31 2011 the USD to Euro exchange rate was 0 72 meaning you can purchase 0 72 Euros for 1 US Dollar To figure out how many dollars you can get with one Euro you do 1 US to Euro exchange rate 1 0 72 1 38 telling us 1 Euro is worth 1 38 USD b Example 2 The exchange rate is the same as above 0 72 for 1 You have 100 how many Euros does that convert to You have 100 how many USD does that convert to i 100 0 72 72 22 ii 100 0 72 138 48 2 Be able to compute the holding period return on a foreign investment a HPR is the total return on an asset over the period in which it was held b Example You just purchased 1000 shares of Kangaroo Lager which trades on the Sydney Stock Exchange for AUD1 45 per share The exchange rate for the Australian dollar at the time of purchase was 0 7735 The Kangaroo Lager stock rises to AUD1 95 per share and the Australian dollar depreciates to 0 7000 what is your holding period return if you sell the shares i 1000 AUD1 95 0 7000 AUD 1000 AUD1 45 0 7735 AUD 1000 AUD1 45 0 7735 AUD 1365 00 1121 58 1121 58 21 7 3 Be familiar with the three components of interest rates a The real rate of interest reflects the rate of return investors demand as compensation for giving up the current use of their funds b The inflation premium reflects the way the general price level is changing i Normally positive measures how rapidly the money standard is losing its purchasing power c The risk premium is the component of interest rates that reflects compensation for risk to risk adverse investors it s a function of how much risk a security carries d The real rate and the inflation premium are collectively referred to as the nominal risk free rate which can be approximated by the rate of US T bills 4 Be able to distinguish between the forward rate and the spot rate a The spot rate is the current price of a foreign security changes daily b The forward rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency Usually quoted on the basis of 1 2 3 6 12 months i Best estimate of the future spot rate 1 If the forward rate indicates the dollar will strengthen importers should delay payment 2 If the forward rate indicates the dollar will weaken importers 5 Know how to compute the forward rate premium or discount should lock in a rate now a Forward rate premium or discount i Forward rate Spot rate Spot rate 12 n 100 n contract length in months ii Example On May 5 2011 the British pound had a spot rate of 1 9146 The 3 month forward rate of the pound was 1 9041 on that date What s the forward premium or discount 1 1 9041 1 9146 1 9146 12 3 100 2 19 disc 2 Positive answers are premiums negative answers are 6 Understand the implications of interest rate parity discounts a Interest rate parity states that differences in national interest rates will be reflected in the currency forward market i Two securities of similar risk and maturity will show a difference in their interest rates equal to the forward premium or discount but with the opposite sign Implications 1 If there s a forward premium then the foreign currency will 2 If there s a forward discount then the foreign currency will exhibit a lower interest rate exhibit a higher interest rate 7 Know how to use relative purchasing power parity to determine the expected change in the spot exchange rate a Relative purchasing power parity states that differences in countries inflation rates determine exchange rates b S 1 1 IF 1 ID i S is the change in the spot exchange rate ii IF is the foreign country inflation rate iii ID is the domestic country inflation rate 8 Understand the meaning of cross hedging and know how to calculate the net return from cross hedging a Many investors choose to cross hedge a foreign investment into a different currency which is done by investing in Country A hedging into Country B s currency and converting to the home currency i Example a US investor might invest in Switzerland use the forward market to sell Swiss francs for Japanese yen and convert the yen back to dollars b The net return from cross hedging equals the sum of three components i The return from the investment in Country A ii The forward market premium discount 1 Forward market P D interest rate in Country B interest rate in Country A iii The actual change in Country B s exchange rate 9 Be familiar with the components of country risk a Country risk refers to a country s ability and willingness to meet its foreign exchange obligations two components i Political risk is a measure of a country s willingness to honor its foreign obligations which is a function of the stability of the governments and its leadership attitudes of labor unions the country s ideological background and the country s past history with foreign investors 1 Included are real direct investments which are investments over which the investor retains control such as a plant in a foreign country 2 Included are portfolio financial investments which are foreign investments via the securities market such as buying a number of shares of a foreign company 3 Extreme forms of country risk for portfolio investment a Government takeover of a company b Political unrest leading to work stoppages c Physical damage to facilities d Forced renegotiation of contracts 4 Modest forms of country risk for portfolio investment a Establishment of a requirement that a minimum percentage of supervisory positions be held by local nationals b Changes in operating rules c Restrictions on repatriation of capital 5 Factors contribution to political risk a Buy Local attitude makes foreign customers buy local goods instead of goods produced or obtained elsewhere b Public Attitude i Local citizens may observe a gap between its aspirations and potential standard of living c Government Attitude i Unstable governments may blame foreign investors for local problems ii May suspend ability to send funds back to home country d Macro political risk refers to government actions that affect all foreign firms in a particular industry e Micro political risk refers to politically motivated changes in the business environment directed to selected fields of business activity or to foreign enterprises with specific characters f In dealing with political risk seek a foreign investment