FIN$4514!‐$Exam$II$Review!14! mathematical!(based!on!h omewo rk!problem s),!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!exch ange!rate!was!€0.72,!me aning!you!c an!purchase!0.72!Euros!for!1!US!Dollar.!To!figure!ou t!how!ma ny!dollars!you!can!get!with!one!Euro,!you!do !1/US‐to‐Euro!exchange!rate!(1/0.72!=!$1.3 8)!telling!us!1!Euro!is!wor th!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!purch ased!1000!shares!of!Kangaroo!Lager,!which!trades!on! the! Sydney!Stock!Exch ange!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!doll ar!d epreciates!to!$0.7000;!what!is!your!holding!per iod!return!i f!you!se ll!the!shares?!i. [(1000*AUD1.95*$0.7000/A UD)‐(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!in terest!rates!a. The!real)rate!of!in terest!reflects!the!rate!of!return!investors!de mand!as!compensation !for! giving!up!the!curre nt!use!of!th eir!f und s!b. The!inflati on)premium!reflects!the!way!the!general! pric e!level!is!changing!i. Norma lly!positive ;!measures! how!rapidly!the!money!standard!is!los ing!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!funct ion!of!how!much!risk!a!security !carries!d. The!real)rate)and!the!inflation)premium!are!c ollectively! refe rred!to!as!the!nominal!risk‐free!rate!which!can !be!approximated!by!the!rate!of!US!T ‐bills!4. Be!able!to!distinguish!between!t he!forward!rate!and!the!spot!rate!a. The!spot)rate!is!the!current!p rice!of!a!foreign!security!(changes!daily)!b. The!forward)rate!is!a!contrac tual!rat e!between!a!co mm ercial!b ank!and!a!client!for!t he!future!delivery!of!a! specifie d!quantity!of!foreign!curre ncy!(Usually!quoted!on!the!basis!of!1,!2,!3,!6!&!12!months)!i. Best!estimate!of!the!future!spot!rate !1. If!the!forw ard! rate!indicates!the!dollar!will!strengthen,!importers! should!delay!payment!2. If!the!forw ard! rate!indicates!the!dollar!will!wea ken,!importers!should!loc k!in!a!rate!now !5. Know!how!to! compute!the!forward!rate!premiu m!or!discount!!!a. Forward!rate!premium!or!dis count:!i. Forward rate - Spot rateSpot rate!12n!100,!n=contract!length!in!months!ii. Example!–!On!May!5,!2011,!the!B ritish!pound!had!a! spot!rate!of!$1.914 6.!The!3‐month!for ward!rate!of!th e!pound!was!$1.9041!on!that!date.!What’s! the! forward!premium!or!disco unt?!1. [($1.904 1‐$1.91 46)/($1.9146)*(12/3)*(100)!=!‐2.19%!di sc.!2. Positive!answers!are!premiums,!negative!an swers!are!discounts!6. Understan d!the!implications! of!interest!rate !par ity!!a. Interest)rate)parity!st ates!that!differences!in!nation al!interest!rates!will!be!reflected!in!the!currency!forward!market!i. Two!secur ities!of!similar!risk !and!maturity!will! show!a!difference!i n!their!interest!rate s!equal!to!t he!forward!premiu m!or!discount,!but!with!the!oppo site!sign.!Implications:!1. If!there’s!a !forward!premium,!then!the!foreign!currency!will!exhibit!a!lower!interest!rate!2. If!there’s!a !forward!discount,!then!th e!foreign!currency!will!exhibit!a!h igher!in terest!rate!7. Know!how!to! use!relative!purchasing!power!parity!to!determine!the!expe cted!change!in!the!spot!exchange!rate!!a. Rel ativ e)purch asing)power)parity )states!that!differences!in!countries’!inflation!rates !det ermine! exchange!rates)b. !S=1+IF1+ID"1!)i. !S!is!the!change!in!the!spot!exchange!rate)ii. IF!is!the!foreign!country!inflation!rate)iii. ID!is!the!domestic!country!inflat ion!rate )8. Understan d!the!m eaning!of!cross‐hedging,!and!know!how!to!calculate!the!net!return!from!cross ‐!he dging!!a. Many!i nvestors!choose!to!cross‐hedge!a!fore ign!investment !into!a!different!currency!which!is!done!by!invest ing!in!Country! A,!h edging!into !Country!B’s!currency,!and!convert ing!to!the!home!currency!i. Example!–!a!US!investor!might!in vest!in!Switzerland,!use!the!forward!ma rket!to!sell!Swiss!francs!for!Japanese!yen,!and!convert!the!yen!back!to!do llars!b. The!net)return!from!c ross‐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!Coun try!B!–!interest!rate!in!Country!A!iii. The!actual!change!in!Country!B’s !exc hange!rate !9. Be!familiar!with!the!components!of!cou ntry!risk!!!a. Country)risk!refers!to!a!country’s !ability! and!wil ling ness!to!meet!its!foreign!exchange!obligations;!two!components:!i. Pol itical)risk!is!a!measure !of!a!countr y’s!willingness!to!honor!its!foreign!obligation s,!which!is!a!function!of!the!stability!of!the!governments!and! its!l eadership,!attitudes!of!labor!unions,!the !country’s!i deologi cal!background!an d!the!country’s !past!history!w ith!foreign!investors!1. Inc luded!are!r eal)(direct))investments!which!are!inv estments!over!which!the!invest or!retains!c ontrol,!such!as!a!plant!in!a!foreign!countr y!2. Inc luded!are!portfolio)(financial) )investments!which!are!foreign!investments!v ia!the!securities!market,!such! as!buying!a!number!of!share s!of!a!fo reig n!company!3. Extreme!forms!of!country!risk!for!portfolio!investment:! !a. Government!takeover!of!a!company!b. Political!unrest!le ading!to!work!stoppages!c. Physical!damage!to!fa cilities!d. Forced!renegot iation!of!contracts!4. Modes t!forms!of!coun try!risk!for!portfolio!investme nt:!a. Establishment!of!a!requirement!that!a!minimum!percen tage!of!supervisory!positions!be!held!by!local!nationals!b. Changes!in!operat ing!rules!c. Restrictions!on!re patriati on!of!capital!5. Factors!contribution!to!political!risk!a. “Buy!Local”!attitude!–!makes!for eign!customers!buy!loc al!goods!instea d!of!goods!produced!or!obtained!elsewhere!b. Public! Attitude!i. Local!citizens!