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15.8

VIEWS: 46 PAGES: 39

  • pg 1
									Problem 6.1 - 6.5 The Latin American Big Mac Index: Historical

This textbook has used the Economist magazine's Big Mac Index for many years and many editions. Below are the Big Mac pric
exchange rates for select Latin American countries as printed in previous editions. Use the data to complete the calculation of th
PPP value of the currency versus the U.S. dollar and the calculation as to whether that currency is undervalued (-%) or overvalu
versus the U.S. dollar.


April 1997                        (1)                         (2)                      (3)
                           Big Mac                      Actual                   Big Mac
                       Price in local            exchange rate                   Prices in
Country                    currency             (April 7, 1997)                   dollars
United States (dollar)          2.42                        ----                     2.42
Argentina (peso)                2.50                       1.00                      2.50
Brazil (reais)                  2.97                       1.06                      2.80
Chile (peso)                  1,200                         417                      2.88
Mexico (peso)                 14.90                        7.90                      1.89
y editions. Below are the Big Mac prices and actual
 data to complete the calculation of the implied
rency is undervalued (-%) or overvalued (+%)



                     (4)                        (5)
                Implied           Local currency
              PPP of the       under (-) / over (+)
                  dollar                 valuation
                   1.00
                   1.03                      3.3%
                   1.23                     15.8%
                    496                     18.9%
                   6.16                    -22.1%
Problem 6.6 Argentine Peso and PPP


The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002 the Argentine
peso was floated. On January 29, 2003 it was trading at Ps3.20/$. During that one year period Argentina's inflation rate was
20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized.


Assumptions
Spot exchange rate, fixed peg, early January 2002 (Ps/$)
Spot exchange rate, January 29, 2003 (Ps/$)
US inflation for year (per annum)
Argentine inflation for year (per annum)

a. What should have been the exchange rate in January 2003 if PPP held?

                                                                          Beginning spot rate (Ps/$)
                                                                                Argentine inflation
                                                                                       US inflation
                                                                                 PPP exchange rate

b. By what percentage was the peso overvalued?

                                                                       Actual exchange rate (Ps/$)
                                                                         PPP exchange rate (Ps/$)
                                  Percentage overvaluation (positive) or undervaluation (negative)

c. What were the probable causes of undervaluation?

   The rapid decline in the value of the Argentine peso was a result of not only inflation,
   but also a severe crisis in the balance of payments (see Chapter 4).
ry 2002 the Argentine
ntina's inflation rate was
lized.


                    Value
                  1.0000
                  3.2000
                   2.20%
                  20.00%




                     1.00
                  20.00%
                   2.20%
                     1.17




                     3.20
                     1.17
                -63.307%
Problem 6.7 Akira Numata -- CIA Japan


Akira Numata, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage possibilities. He wants
covered interest arbitrage between U.S. dollars and Japanese yen. He faced the following exchange rate and interest rate quotes.


             Assumptions
             Arbitrage funds available
             Spot rate (¥/$)
             180-day forward rate (¥/$)
             180-day U.S. dollar interest rate
             180-day Japanese yen interest rate



Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change i
interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot ra



             Difference in interest rates ( i ¥ - i $)
             Forward premium on the yen
             CIA profit potential


This tells Toshi Numata that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to lock-in a cover




              $                               5,000,000                → →
                                  ↑
                                  ↑
                                 ↑
                                 ↑
                                 ↑
                             Spot (¥/$)
                              118.60
                                 ↑
                                 ↑
                                  ↑
                                     593,000,000.00                    → →
                           Japanese yen

                               START
Akira Numata generates a CIA profit by investing in the higher interest rate currency, the dollar, and simultaneously selling the
premium which does not completely negate the interest differential.
yo), is exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen equivalent, in a
 n. He faced the following exchange rate and interest rate quotes.


                                                     Value                             Yen Equivalent
                                                $5,000,000                               593,000,000
                                                   118.60
                                                   117.80
                                                   4.800%
                                                   3.400%



reater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher
ess than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.



                                                  -1.400%
                                                   1.358%
                                                  -0.042%


n the higher yielding currency, the U.S. dollar, to lock-in a covered interest arbitrage (CIA) profit.




                  U.S. dollar interest rate (180 days)
                                4.800%

                                 1.0240                       → →                  $        5,120,000
                                                                                            ↓
                                                                                            ↓
                                                                                          ↓
                                                                                          ↓
                                                                                          ↓
                ---------------> 180 days ---------------->                        Forward-180 (¥/$)
                                                                                       117.80
                                                                                          ↓
                                                                                          ↓
                                                                                          603,136,000
                                 1.0170                       → →                         603,081,000
                                                                                               55,000
                               3.400%
                 Japanese yen interest rate (180 days)                                    END
interest rate currency, the dollar, and simultaneously selling the dollar proceeds forward into yen at a forward
tial.
Problem 6.8 Akira Numata -- UIA Japan


Akira Numata, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and both dollar and yen interest r
week. Akira wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of
models -- are predicting the spot rate to remain close to ¥118.00/$ for the coming 180 days. Using the same data as in the previo



             Assumptions
             Arbitrage funds available
             Spot rate (¥/$)
             180-day forward rate (¥/$)
             Expected spot rate in 180 days (¥/$)
             180-day U.S. dollar interest rate
             180-day Japanese yen interest rate



Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change i
interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot ra



             Difference in interest rates ( i ¥ - i $)
             Expected gain (loss) on the spot rate
             UIA profit potential


This tells Akira Numata that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to potentially gain




                                             $5,000,000                → →
                                  ↑
                                  ↑
                                 ↑
                                 ↑
                                 ↑
                             Spot (¥/$)
                              118.60
                                 ↑
                                 ↑
                                  ↑
                                     593,000,000.00                    → →
                           Japanese yen
                               START




a) Akira Numata generates an uncovered interest arbitrage (UIA) profit of ¥1,079,000 if his expectations about the future spot r



b) The risk Akira is taking is that the actual spot rate at the end of the period can theoretically be anything, better or worse for h
"wiggle room," as they say. A small movement will cost him a lot of money. If the spot rate ends up any stronger than about 117
(Verify by inputting ¥117.70/$ in the expected spot rate cell under assumptions.)
 t rate has been holding steady, and both dollar and yen interest rates have remained relatively fixed over the past
 trage (UIA) and thereby save the cost of forward cover. Many of Akira's research associates -- and their computer
0/$ for the coming 180 days. Using the same data as in the previous problem, analyze the UIA potential.



                                                     Value                             Yen Equivalent
                                                $5,000,000                               593,000,000
                                                   118.60
                                                   117.80
                                                   118.00
                                                   4.800%
                                                   3.400%



reater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher
ess than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.



                                                  -1.400%
                                                   1.017%
                                                  -0.383%


n the higher yielding currency, the U.S. dollar, to potentially gain on an uncovered basis (UIA).




                 U.S. dollar interest rate (180 days)
                               4.800%

                                 1.0240                       → →                          $5,120,000
                                                                                           ↓
                                                                                           ↓
                                                                                          ↓
                                                                                          ↓
                                                                                 Expected Spot Rate
                ---------------> 180 days ---------------->                       in 180 days (¥/$)
                                                                                       118.00
                                                                                          ↓
                                                                                          ↓
                                                                                          604,160,000
                                 1.0170                       → →                         603,081,000
                                                                                            1,079,000
                               3.400%
                 Japanese yen interest rate (180 days)                                      END




A) profit of ¥1,079,000 if his expectations about the future spot rate, the one in effect in 180 days, prove correct.



of the period can theoretically be anything, better or worse for his speculative position. He in fact has very little
ot of money. If the spot rate ends up any stronger than about 117.79/$ (a smaller number), he will lose money.
der assumptions.)
Problem 6.10 XTerra exports and pass through

Assume that the export price of a Nissan XTerra from Osaka, Japan is ¥3,250,000. The exchange rate is ¥115.20/$.
The forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to
answer the following questions on exchange rate pass through.


Steps
Initial spot exchange rate (¥/$)
Initial price of a Nissan Xterra (¥)
Expected US dollar inflation rate for the coming year
Expected Japanese yen inflation rate for the coming year
Desired rate of pass through by Nissan

a. What was the export price for the XTerra at the beginning of the year?
   Year-beginning price of an XTerra (¥)
   Spot exchange rate (¥/$)
   Year-beginning price of a XTerra ($)

b. What is the expected spot rate at the end of the year assuming PPP?
   Initial spot rate (¥/$)
   Expected US$ inflation
   Expected Japanese yen inflation
       Expected spot rate at end of year assuming PPP (¥/$)

c. Assuming complete pass through, what will the price be in US$ in one year?
   Price of XTerra at beginning of year (¥)
   Japanese yen inflation over the year
   Price of XTerra at end of year (¥)
      Expected spot rate one year from now assuming PPP (¥/$)
   Price of XTerra at end of year in ($)

d. Assuming partial pass through, what will the price be in US$ in one year?
   Price of XTerra at end of year (¥)
   Amount of expected exchange rate change, in percent (from PPP)
      Proportion of exchange rate change passed through by Nissan
         Proportional percentage change
   Effective exchange rate used by Nissan to price in US$ for end of year
   Price of XTerra at end of year ($)
xchange rate is ¥115.20/$.
 Japan. Use this data to



                      Value
                    115.20
                 3,250,000
                    2.200%
                    0.000%
                  75.000%



                3,250,000
                   115.20
              $ 28,211.81



                    115.20
                     2.20%
                     0.00%
                    112.72



                3,250,000
                   0.000%
                3,250,000
                   112.72
              $ 28,832.47



                3,250,000
                   2.200%
                 75.000%
                   1.650%
                  113.330
              $ 28,677.30
Problem 7.6 Russian Ruble


The Russian ruble ( R) traded at R6.25/$ on August 7, 1998. By September 10, 1998, its value had fallen
to R20.00/$. What was the percentage change in its value?


Assumptions                                                               Rate                  Values
Spot rate, August 7, 1998 (Rub/$)                                          S1                    6.25
Spot rate, September 10, 1998 (Rub/$)                                      S2                   20.00

Calculation of percentage change:
Percentage change in the peso versus the dollar                                               -68.75%

Percent change = ( S1 - S2 ) ÷ ( S2 )
Problem 8.1 Peregrine Funds -- Jakarta


Samuel Samosir trades currencies for Peregrine Funds in Jakarta. He focuses nearly all of his time and attention on the U.S. dollar/Singap
cross-rate. The current spot rate is $0.6000/S$. After considerable study, he has concluded that the Singapore dollar will appreciate versu
in the coming 90 days, probably to about $0.7000/S$. He has the following optons on the Singapore dollar to choose from:

Option choices on the Singapore dollar:
Strike price (US$/Singapore dollar)
Premium (US$/Singapore dollar)

Assumptions
Current spot rate (US$/Singapore dollar)
Days to maturity
Expected spot rate in 90 days (US$/Singapore dollar)

a) Should Samuel buy a put on Singapore dollars or a call on Singapore dollars?


Since Samuel expects the Singapore dollar to appreciate versus the US dollar, he should buy a call on Singapore dollars. This gives him t
Singapore dollars at a future date at $0.65 each, and then immediately resell them in the open market at $0.70 each for a profit. (If his exp
future spot rate proves correct.)

b) What is Samuel's breakeven price on the option purchased in part a)?



Note this does not include any interest cost on the premium.



c) What is Samuel's gross profit and net profit (including premium) if the ending spot rate is $0.70/S$?




                                                                                                                Spot rate
                                                                                                        Less strike price
                                                                                                          Less premium
                                                                                                                   Profit

d) What is Samuel's gross profit and net profit (including premium) if the ending spot rate is $0.80/S$?




                                                                                                                Spot rate
                                                                                                        Less strike price
                                                                                                          Less premium
                                                                                                                   Profit
on on the U.S. dollar/Singapore dollar ($/S$)
 dollar will appreciate versus the U.S. dollar
 choose from:

                  Call on S$         Put on S$
                   $0.6500            $0.6500
                  $0.00046           $0.00003

                     Values
                    $0.6000
                         90
                    $0.7000




ore dollars. This gives him the right to BUY
 each for a profit. (If his expectation of the




                                        Per S$
                 Strike price        $0.65000
               Plus premium          $0.00046
                  Breakeven          $0.65046




                Gross profit         Net profit
                   (US$/S$)           (US$/S$)
                  $0.70000           $0.70000
                 ($0.65000)         ($0.65000)
                                    ($0.00046)
                   $0.05000          $0.04954




                Gross profit         Net profit
                   (US$/S$)           (US$/S$)
                  $0.80000           $0.80000
                 ($0.65000)         ($0.65000)
                                    ($0.00046)
                   $0.15000          $0.14954
Problem 8.2 Paulo's Puts

Paulo writes a put option on Japanese yen with a strike price of $0.008000/¥ (¥125.00/$) at a premium of 0.0080¢ per yen and with an e
option is for ¥12,500,000. What is Paulo's profit or loss at maturity if the ending spot rates are ¥110/$, ¥115/$, ¥120/$, ¥125/$, ¥130/$, ¥



                                                      a)                   b)                   c)                   d)
Assumptions                                       Values               Values               Values               Values
Notional principal (¥)                       12,500,000           12,500,000           12,500,000           12,500,000
Maturity (days)                                     180                  180                  180                  180
Strike price (US$/¥)                          $0.008000            $0.008000            $0.008000            $0.008000
Premium (US$/¥)                               $0.000080            $0.000080            $0.000080            $0.000080

Ending spot rate (¥/US$)                          110.00               115.00               120.00              125.00
                            in US$/¥          $0.009091            $0.008696            $0.008333           $0.008000

Gross profit on option                        $0.000000            $0.000000            $0.000000            $0.000000
Less premium                                 ($0.000080)          ($0.000080)          ($0.000080)          ($0.000080)
Net profit (US$/¥)                           ($0.000080)          ($0.000080)          ($0.000080)          ($0.000080)

Net profit, total                             ($1,000.00)          ($1,000.00)         ($1,000.00)          ($1,000.00)
080¢ per yen and with an expiration date six month from now. The
, ¥120/$, ¥125/$, ¥130/$, ¥135/$, and ¥140/$.



                         e)                  f)                 g)
                     Values              Values             Values
                12,500,000          12,500,000         12,500,000
                       180                 180                180
                 $0.008000           $0.008000          $0.008000
                 $0.000080           $0.000080          $0.000080

                     130.00             135.00              140.00
                 $0.007692          $0.007407           $0.007143

                 $0.000308          $0.000593           $0.000857
                ($0.000080)        ($0.000080)         ($0.000080)
                 $0.000228          $0.000513           $0.000777

                 $2,846.15           $6,407.41          $9,714.29
Problem 8.5 Madera Capital


Katya Berezovsky works is a currency speculator for madera Capital of Los Angeles. Her latest speculative
position is to profit from her expectation that the U.S. dollar will rise significantly against the Japanese yen.
The current spot rate is ¥120.00/$. She must choose between the following 90-day options on the Japanese yen:

Assumptions                                                                     Values
Current spot rate (Japanese yen/US$)                                           120.00
  in US$/yen                                                                  $0.00833
Maturity of option (days)                                                          90
Expected ending spot rate in 90 days (yen/$)                                   140.00
  in US$/yen                                                                  $0.00714

                                                                          Call on yen               Put on yen
Strike price (yen/US$)                                                         125.00                   125.00
   in US$/yen                                                                $0.00800                 $0.00800
Premium (US$/yen)                                                            $0.00046                 $0.00003

a) Should she buy a call on yen or a put on yen?
   Katya should buy a put on yen to profit from the rise of the dollar (the fall of the yen).

b) What is Katy'as break even price on her option of choice in part a)?
   Katya buys a put on yen. Pays premium today.
   In 90 days, exercises the put, receiving US$.
                                                                                                        in yen/$
                                              Strike price                    $0.00800                   125.00
                                            Less premium                     -$0.00003
                                               Breakeven                      $0.00797                   125.47

c) What is Katya's gross profit and net profit if the end spot rate is 140 yen/$?

                                                                          Gross profit                Net profit
                                                                           (US$/yen)                  (US$/yen)
                                              Strike price                   $0.00800                  $0.00800
                                            Less spot rate                  -$0.00714                 -$0.00714
                                            Less premium                                              -$0.00003
                                                    Profit                    $0.00086                 $0.00083
Problem 8.8 Call Profits

Assume a call option on euros is written with a strike price of $1.2500/€ at a premium of 3.80¢ per euro ($0.0380/€) and with an expirati
option is for €100,000. Calculate your profit or loss should you exercise before maturity at a time when the euro is traded spot at .....

Note: the option premium is 3.8 cents per euro, not 38 cents per euro.

                                                      a)                   b)                  c)                  d)
Assumptions                                       Values               Values              Values              Values
Notional principal (euros)                  € 100,000.00         € 100,000.00        € 100,000.00        € 100,000.00
Maturity (days)                                      90                   90                  90                  90
Strike price (US$/euro)                         $1.2500              $1.2500             $1.2500             $1.2500
Premium (US$/euro)                              $0.0380              $0.0380             $0.0380             $0.0380
Ending spot rate (US$/euro)                     $1.1000              $1.1500             $1.2000             $1.2500

Gross profit on option                          $0.0000              $0.0000             $0.0000              $0.0000
Less premium                                   ($0.0380)            ($0.0380)           ($0.0380)            ($0.0380)
Net profit (US$/euro)                          ($0.0380)            ($0.0380)           ($0.0380)            ($0.0380)

Net profit, total                            ($3,800.00)          ($3,800.00)         ($3,800.00)          ($3,800.00)
380/€) and with an expiration date three months from now. The
ro is traded spot at .....




                         e)                   f)                g)
                     Values              Values             Values
               € 100,000.00        € 100,000.00       € 100,000.00
                        90                  90                 90
                   $1.2500             $1.2500            $1.2500
                   $0.0380             $0.0380            $0.0380
                   $1.3000             $1.3500            $1.4000

                   $0.0500             $0.1000             $0.1500
                  ($0.0380)           ($0.0380)           ($0.0380)
                   $0.0120             $0.0620             $0.1120

                 $1,200.00           $6,200.00         $11,200.00
Problem 8.10 Downing Street


Sydney Reeks is a currency trader for Downing Street, a private investment house in London. Downing Street’s clients are a collection of
wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors
expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars.

    Sydney is convinced that the British pound will slide significantly -- possibly to $1.3200/£ -- in the coming 30 to 60 days. The current
spot rate is $1.4260/£. Andy wishes to buy a put on pounds which will yield the 25% return expected by his investors. Which of the
following put options would you recommend he purchase. Prove your choice is the preferable combination of strike price, maturity, and u
front premium expense.

Assumptions                                                                   Values
Current spot rate (US$/£)                                                   $1.4260
Expected endings spot rate in 30 to 60 days (US$/£)                         $1.3200
Potential investment principal per person (£)                            £250,000.00

Put options on pounds                                                         Put #1                      Put #2
Strike price (US$/£)                                                            $1.36                       $1.34
Maturity (days)                                                                    30                          30
Premium (US$/£)                                                             $0.00081                    $0.00021

Put options on pounds                                                         Put #4                      Put #5
Strike price (US$/£)                                                            $1.36                       $1.34
Maturity (days)                                                                    60                          60
Premium (US$/£)                                                             $0.00333                    $0.00150

Issues for Sydney to consider:

1. Because his expectation is for "30 to 60 days" he should confine his choices to the 60 day options to be sure and capture
   the timing of the exchange rate change. (We have no explicit idea of why he believes this specific timing.)

2. The choice of which strike price is an interesting debate.
     * The lower the strike price (1.34 or 1.32), the cheaper the option price.
     * The reason they are cheaper is that, statistically speaking, they are increasingly less likely to end up in the money.
     * The choice, given that all the options are relatively "cheap," is to pick the strike price which will yield the required return.
     * The $1.32 strike price is too far 'down,' given that Sydney only expects the pound to fall to about $1.32.

                                                                              Put #4                      Put #5
                                                                            Net profit                  Net profit
                                             Strike price                   $1.36000                    $1.34000
                                  Less expected spot rate                   (1.32000)                   (1.32000)
                                          Less premium                      (0.00333)                   (0.00150)
                                                   Profit                   $0.03667                    $0.01850

      If Sydney invested an individual's principal purely
 in this specific option, they would purchase an
  option of the following notional principal ( £):    £75,075,075.08   £166,666,666.67

Expected profit, in total (profit rate x notional):    $2,753,003.00     $3,083,333.33
          Initial investment at current spot rate        $356,500.00       $356,500.00
                  Return on Investment (ROI)                   772%              865%
  Risk: They could lose it all (full premium)
 Street’s clients are a collection of
ment of currencies. The investors
based in U.S. dollars.

coming 30 to 60 days. The current
y his investors. Which of the
tion of strike price, maturity, and up-




                              Put #3
                                $1.32
                                   30
                            $0.00004

                              Put #6
                                $1.32
                                   60
                            $0.00060




o be sure and capture




nd up in the money.
ill yield the required return.



                              Put #6
                            Net profit
                            $1.32000
                            (1.32000)
                            (0.00060)
                           ($0.00060)
£416,666,666.67

   -$250,000.00
    $356,500.00
          -70%
Problem 15.2 Botany Bay Corporation

Botany Bay Corporation of Australia seeks to borrow US$30,000,000 in the Eurodollar market. Funding is needed for two years.
Investigation leads to three possibilities. Compare the alternatives and make a recommendation.

#1. Botany Bay could borrow the US$30,000,000 for two years at a fixed 5% rate of interest
#2. Botany Bay could borrow the US$30,000,000 at LIBOR + 1.5%. LIBOR is currently 3.5%, and the rate would be reset every six
months
#3. Botany Bay could borrow the US$30,000,000 for one year only at 4.5%. At the end of the first year Adelaide Corporation would
have to negotiate for a new one-year loan.

Assumptions                                               Values
Principal borrowing need                      $      30,000,000
Maturity needed, in years                                   2.00
Fixed rate, 2 years                                      5.000%
Floating rate, six-month LIBOR + spread
   Current six-month LIBOR                              3.500%
   Spread                                               1.500%
Fixed rate, 1 year, then re-fund                        4.500%

                                                  First 6-months     Second 6-months             Third 6-months
#1: Fixed rate, 2 years
Interest cost per year                                               $      1,500,000
   Certainty over access to capital                Certain                Certain                  Certain
   Certainty over cost of capital                  Certain                Certain                  Certain

#2: Floating rate, six-month LIBOR + spread
Interest cost per year                    $            750,000       $        750,000        $         750,000
   Certainty over access to capital                Certain                Certain                  Certain
   Certainty over cost of capital                  Certain               Uncertain                Uncertain

#3: Fixed rate, 1 year, then re-fund
Interest cost per year                                               $      1,350,000               ???
   Certainty over access to capital                Certain                Certain                 Uncertain
   Certainty over cost of capital                  Certain                Certain                 Uncertain

Only alternative #1 has a certain access and cost of capital for the full 2 year period.
Alternative #2 has certain access to capital for both years, but the interest costs in the final 3 of 4 periods is uncertain.
Alternatvie #3, possessing a lower interest cost in year 1, has no guaranteed access to capital in the second year.
Depending on the company's business needs and tolerance for interest rate risk, it could choose between #1 and #2.
is needed for two years.




rate would be reset every six

Adelaide Corporation would




               Fourth 6-months

              $      1,500,000
                   Certain
                   Certain



              $        750,000
                   Certain
                  Uncertain



                    ???
                  Uncertain
                  Uncertain



 of 4 periods is uncertain.
 in the second year.
ose between #1 and #2.
Problem 15.6 Cañon Chemicals

Amanda Suvari, the treasurer of Cañon Chemicals believes interest rates are going to rise, so she wants to swap her future floating
rate interest payments for fixed rates. At present she is paying LIBOR + 2% per annum on $5,000,000 of debt for the next two
years, with payments due semiannually. LIBOR is currently 4.00% per annum. Ms. Suvari has just made an interest payment
today, so the next payment is due six months from today.

   Ms. Suvari finds that she can swap her current floating rate payments for fixed payments of 7.00% per annum.
(Cañon’s weighted average cost of capital is 12%, which Ms. Suvari calculates to be 6% per six month period,
compounded semiannually).

a. If LIBOR rises at the rate of 50 basis points per six month period, starting tomorrow, how much does Ms. Suvari
save or cost her company by making this swap?

b. If LIBOR falls at the rate of 25 basis points per six month period, starting tomorrow, how much does Ms. Suvari
save or cost her company by making this swap?

Assumptions                                                Values
Notional principal                                $    5,000,000
LIBOR, per annum                                          4.000%
Spread paid over LIBOR, per annum                         2.000%
Swap rate, to pay fixed, per annum                        7.000%

                                                           First                Second                 Third
Interest & Swap Payments                                6-months              6-months              6-months

a. LIBOR increases 50 basis pts/6 months                  0.500%
   Expected LIBOR                                         4.500%                5.000%               5.500%

Current loan agreement:
   Expected LIBOR (for 6 months)                         -2.250%               -2.500%               -2.750%
   Spread (for 6 months)                                 -1.000%               -1.000%               -1.000%
   Expected interest payment                             -3.250%               -3.500%               -3.750%

Swap Agreement:
   Pay fixed (for 6-months)                              -3.500%               -3.500%               -3.500%
   Receive floating (LIBOR for 6 months)                  2.250%                2.500%                2.750%

Net interest (loan + swap)                               -4.500%               -4.500%               -4.500%

Swap savings?
   Net interest after swap                        $     (225,000)       $     (225,000)      $      (225,000)
   Loan agreement interest                              (162,500)             (175,000)             (187,500)
      Swap savings (swap cost)                    $      (62,500)       $      (50,000)      $       (37,500)
b. LIBOR decreases 25 basis pts/6 months                -0.250%
   Expected LIBOR                                        3.750%               3.500%         3.250%

Current loan agreement:
   Expected LIBOR (for 6 months)                        -1.875%              -1.750%        -1.625%
   Spread (for 6 months)                                -1.000%              -1.000%        -1.000%
   Expected interest payment                            -2.875%              -2.750%        -2.625%

Swap Agreement:
   Pay fixed (for 6-months)                             -3.500%              -3.500%        -3.500%
   Receive floating (LIBOR for 6 months)                 1.875%               1.750%         1.625%

Net interest (loan + swap)                              -4.500%              -4.500%        -4.500%

Swap savings?
   Net interest after swap                       $     (225,000)      $     (225,000)   $   (225,000)
   Loan agreement interest                             (143,750)            (137,500)       (131,250)
      Swap savings (swap cost)                   $      (81,250)      $      (87,500)   $    (93,750)

In both cases Canon is suffering higher total interest costs as a result of the swap.
 nts to swap her future floating
 00 of debt for the next two
made an interest payment



nts of 7.00% per annum.
er six month period,


ow much does Ms. Suvari


ow much does Ms. Suvari




                        Fourth
                      6-months



                        6.000%



                       -3.000%
                       -1.000%
                       -4.000%



                       -3.500%
                        3.000%

                       -4.500%



               $      (225,000)
                      (200,000)
               $       (25,000)
     3.000%



    -1.500%
    -1.000%
    -2.500%



    -3.500%
     1.500%

    -4.500%



$   (225,000)
    (125,000)
$   (100,000)
Problem 15.7 Xavier and Zulu

Xavier Manufacturing and Zulu Products both seek funding at the lowest possible cost. Xavier would
prefer the flexibility of floating rate borrowing, while Zulu wants the security of fixed rate borrowing.
Xavier is the more credit-worthy company. They face the following rate structure. Xavier, with the better
credit rating, has lower borrowing costs in both types of borrowing.

   Xavier wants floating rate debt, so it could borrow at LIBOR+1%. However it could borrow
fixed at 8% and swap for floating rate debt. Zulu wants fixed rate, so it could borrow fixed at
12%. However it could borrow floating at LIBOR+2% and swap for fixed rate debt. What should


Assumptions                                                              Xavier                      Zulu
Credit rating                                                             AAA                       BBB
Prefers to borrow                                                      Floating                    Fixed
Fixed-rate cost of borrowing                                            8.000%                   12.000%
Floating-rate cost of borrowing:
   LIBOR (value is unimportant)                                         5.000%                     5.000%
   Spread                                                               1.000%                     2.000%
   Total floating-rate                                                  6.000%                     7.000%

Comparative Advantage in Borrowing                                       Values
Xavier's absolute advantage:
  in fixed rate borrowering                                             4.000%
  in floating-rate borrowing                                            1.000%
Comparative advantage in fixed rate                                     3.000%

One Possibility                                                           Xavier                      Zulu
Xavier borrows fixed                                                    -8.000%                         ---
Zulu borrows floating                                                         ---                 -7.000%
Xavier pays Zulu floating (LIBOR)                                       -5.000%                    5.000%
Zulu pays Xavier fixed                                                   8.500%                   -8.500%
   Net interest after swap                                              -4.500%                  -10.500%

Savings (own borrowing versus net swap):
 If Xavier borrowed floating                                            6.000%
 If Xavier borrows fixed & swaps with Zulu                              4.500%
                                                                        1.500%

 If Zulu borrowes fixed                                                                          12.000%
 If Zulu borrows floating & swaps with Xavier                                                    10.500%
                                                                                                  1.500%

The 3.0% comparative advantage enjoyed by Xavier represents the opportunity set for
improvement for both parties. This could be a 1.5% savings for each (as in the example shown)
or any other combination which distributes the 3.0% between the two parties.
The 3.0% comparative advantage enjoyed by Xavier represents the opportunity set for
improvement for both parties. This could be a 1.5% savings for each (as in the example shown)
or any other combination which distributes the 3.0% between the two parties.
Problem 15.8 Trident's Cross Currency Swap: Sfr for US$

Trident Corporation entered into a three-year cross currency interest rate swap in the chapter to receive U.S. dollars and pay Swiss francs
however, decided to unwind the swap after one year – thereby having two years left on the settlement costs of unwinding the swap after o
Repeat the calculations for unwinding, but assume that the following rates now apply:



Assumptions                                                   Values        Swap Rates                           3- year bid
Notional principal                                $       10,000,000        US dollar                                 5.56%
Spot exchange rate, SFr./$                                    1.5000        Swiss franc -- SFr.                       1.93%
Spot exchange rate, $/euro                                    1.1200

a) Interest & Swap Payments                                   Year 0                     Year 1                      Year 2

Receive fixed rate dollars at this rate:                                                 5.56%                       5.56%
On a notional principal of:                       $       10,000,000
Trident will receive cash flows:                                        →          $   556,000    →          $     556,000
                                                            ↑
Exchange rate, time of swap (SFr./$)                     1.5000
                                                            ↓
Trident will pay cash flows:                                            →         SFr. 301,500 →             SFr. 301,500
On a notional principal of:                           SFr. 15,000,000
Pay fixed rate Swiss francs at this rate:                                                2.01%                       2.01%



b) Unwinding the swap after one-year                                                     Year 1                      Year 2

Remaining dollar cash inflows                                                                           $          556,000
PV factor at now current fixed $ interest                     5.20%                                                 0.9506
PV of remaining dollar cash inflows                                                                     $          528,517
  Cumulative PV of dollar cash infllows           $       10,066,750

Remaining Swiss franc cash outflows                                                                          SFr. 301,500
PV factor at now current fixed SF interest                    2.20%                                               0.9785
PV of remaining SF cash outflows                                                                             SFr. 295,010
  Cumulative PV of SF cash outflows                 SFr. 14,944,827
New current spot rate, SFr./$                               1.5560
  Cumulative PF of SF cash outflows in $          $      9,604,645

Settlement:
   Cash inflow                                    $       10,066,750
   Cash outflow                                           (9,604,645)
   Net cash settlement of unwinding               $          462,105        This is a cash receipt by Trident from the swap dealer.
dollars and pay Swiss francs. Trident,
f unwinding the swap after one year.




                                 3-year ask
                                     5.59%
                                     2.01%



                                     Year 3

                                     5.56%

               →          $    10,556,000




               →           SFr. 15,301,500

                                     2.01%



                                     Year 3

                    $          10,556,000
                                   0.9036
                    $           9,538,232



                           SFr. 15,301,500
                                   0.9574
                           SFr. 14,649,818




nt from the swap dealer.

								
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