Chapter 21

International Financial Management

Learning Objectives

1. Discuss how the basic principles of finance apply to international financial

transactions.

2. Differentiate among the spot rate, the forward rate, and the cross rate in the foreign

exchange markets; make foreign exchange and cross rate calculations; and be able

to hedge an asset purchase where payment is made in a foreign currency.

3. Identify the major factors that distinguish international from domestic capital

budgeting, explain how the capital budgeting process can be adjusted to account for

these factors, and compute the NPV for a typical international capital project.

4. Discuss the importance of the Euromarkets to large U.S. multinational firms, and

calculate the cost of borrowing in the Eurobond market.

5. Explain how large U.S. money center banks make and price Eurocredit loans to

their customers, and compute the cost of a Eurocredit bank loan.

I. Chapter Outline

21.1 Introduction to International Finance Management

A. Globalization of the World Economy

1

Globalization refers to the removal of barriers to free trade and the closer

integration of national economies.

Consumers in many countries buy goods that are purchased from a number of

countries, other than just their own.

The production of goods and services has also become highly globalized.

Like product markets, the financial system has also become highly integrated.

B. The Rise of Multinational Corporations

A multinational corporation is a business firm that operates in more than one

country but is headquartered or based in its home country.

Multinational corporations may purchase raw materials from one country, obtain

financing from a capital market in another country, produce finished goods with

labor and capital equipment from a third country, and sell finished goods in a

number of other countries.

Multinationals are owned by a mixture of domestic and foreign stockholders.

Transnational corporations, regardless of the location of their headquarters, are

managed from a global perspective rather than the perspective of a firm residing

in a particular country.

Exhibit 21.1 lists the top 15 multinational business firms ranked by total revenues.

C. Factors Affecting International Financial Management

2

Six factors can cause international business transactions to differ from domestic

deals.

The uncertainty of future exchange rate movements is called foreign

exchange rate risk, or just exchange rate risk.

Differences in legal systems and tax codes can also impact the way firms

operate in foreign countries.

There are two important levels of communication in international business

deals: business communication and social communication.

o Although English is the official business language, it is not the

world’s social language.

The cultures of different countries, and even different regions within the

same country, can vary considerably.

o Cultural views also shape business practices and people’s attitudes

toward business.

An economic system determines how a country mobilizes its resources to

produce goods and services needed by society, as well as how the

production is distributed.

Country risk refers to political uncertainty associated with a particular

country.

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o At the extreme, a country’s government may even expropriate—

that is, take over—a business’s assets within the country.

o These types of actions clearly can affect a firm’s cash flows and,

thus, the value of the firm.

D. Goals of International Financial Management

Stockholder wealth maximization is the accepted goal for firms in the United

States, as well as in some other countries that share a similar heritage, such as the

United Kingdom, Australia, India, and Canada.

In Continental Europe, for example, countries such as France and Germany focus

on maximizing corporate wealth.

The European manager’s goal is to earn as much wealth as possible for the

firm while considering the overall welfare of all stakeholders.

In Japan, companies form tightly knit, interlocking business groups called

keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, and the goal of the Japanese

business manager is to increase the wealth and growth of the keiretsu.

As a result, they might focus on maximizing market share rather than

stockholder wealth.

In China, which is making a transition from a command economy to a market-

based economy, there are sharp differences between state-owned companies and

emerging private-sector firms.

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The large state-owned companies have an overall goal that can best be

described as maintaining full employment in the economy while the new

private-sector firms fully embrace the Western standard of stockholder

wealth maximization.

E. Basic Principles Remain the Same

The basic principles of managerial finance remain the same whether a transaction

is domestic or international.

The time value of money is not affected by whether a business transaction

is domestic or international. Likewise, the same models are used for

valuing capital assets, bonds, stocks, and entire firms.

Exhibit 21.2 lists some of the important finance concepts and procedures and

indicates where there are differences between domestic and international

operations.

21.2 Foreign Exchange Markets

The foreign exchange market is a group of international markets connected

electronically where currencies are bought and sold in wholesale amounts.

Foreign exchange markets provide three basic economic benefits:

A mechanism to transfer purchasing power from individuals who deal in one

currency to people who deal in a different currency.

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A way for corporations to pass the risk associated with foreign exchange price

fluctuations to professional risk-takers.

A channel for importers and exporters to acquire credit for international business

transactions.

The market for foreign exchange is very large, and the daily volume was more

than $2 trillion in 2006.

London is by far the largest foreign exchange trading center, with an average

daily volume of $753 billion, while New York City is second with $461 billion,

and Tokyo is third with $199 billion.

A. Market Structure and Major Participants

Participants are linked by telephone, telegraph, and cable.

The major participants in the foreign exchange markets are multinational

commercial banks, large investment banking firms, and small currency boutiques

that specialize in foreign exchange transactions.

In addition, the central banks, which intervene in the markets primarily to smooth

out fluctuations in their exchange rates, also play a significant role.

B. Foreign Exchange Rates and the Equilibrium Exchange Rate

A foreign exchange rate is the price of one monetary unit.

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One of two parties in a transaction will be forced to deal in a foreign currency and

incur foreign exchange rate risk.

Exhibit 21.4 shows the equilibrium exchange rate, which is at the point where the

supply and demand curves intersect.

Equilibrium occurs at the price at which the quantity of the currency

demanded exactly equals the quantity supplied.

In general, whatever causes U.S. residents to buy more or fewer foreign

goods shifts the demand curve for the foreign currency.

Similarly, whatever causes foreigners to buy more or fewer U.S. goods

shifts the supply curve for the foreign currency.

C. Foreign Currency Quotations

Exhibit 21.5 shows selected exchange rate quotations from the Wall Street

Journal.

The spot rate is the cost of buying a foreign currency today, “on the spot.”

If the exchange rate is the price in dollars for a foreign currency, it is often

called the American or direct quote.

If the exchange rate is the price in foreign currency for a dollar, the quote

is called a European or an indirect quote.

Foreign exchange dealers quote two prices: bid and ask quotes.

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The bid quote represents the rate at which the dealer will buy foreign

currency.

The ask quote is the rate at which the dealer will sell foreign currency.

When one is given two quotes of foreign exchange rates involving three

currencies, it is possible to find the exchange rate between the third pair of

currencies, and this is known as the cross rate.

The forward rate is the rate at which one agrees to buy or sell a currency at some

future date.

Note that the forward rate is established at the date on which the

agreement is made and defines the exchange rate to be used when the

transaction is completed in the future.

By contracting now to buy or sell foreign currencies at some future date,

businesses can lock in the cost of foreign exchange at the beginning of the

transaction and do not have to worry about the risk of an unfavorable

movement in the exchange rate in the future.

The difference between the forward rate and the spot rate is called the forward

premium or forward discount.

21.3 International Capital Budgeting

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When a multinational firm wants to consider overseas capital projects, the financial

manager faces the decision of which capital projects should be accepted on a

companywide basis.

The decision to accept international projects with a positive NPV increases the value of

the firm and is consistent with the fundamental goal of financial management, which is to

maximize stockholder wealth.

Although the same basic principles apply to both international and domestic capital

budgeting, firms must deal with some differences.

A. Determining Cash Flows

A number of issues complicate the determination of cash flows from overseas

capital projects.

First, most companies find it more difficult to estimate the incremental cash flows

for foreign projects.

Second, problems with cash flows can arise when foreign governments restrict the

amount of cash that can be repatriated, or returned, to the parent company.

B. Exchange Rate Risk

Financial managers have to deal with foreign exchange rate risk on international

capital investments.

To convert the project’s future cash flows into another currency, we need to come

up with projected or forecast exchange rates.

9

One of the problems with obtaining currency rate forecasts for use in analysis of

capital projects is that many projects have lives of 20 years or more.

C. Country Risk

Financial managers must also incorporate a country risk premium when

evaluating foreign business activities.

If a firm is located in a country with a relatively unstable political environment,

management will require a higher rate of return on capital projects as

compensation for the additional risk.

At the extreme, a local government could take over the plant and equipment of the

overseas operation without giving the company any compensation. This

expropriation of assets is called nationalization.

Some other ways that a foreign government can affect the risk of a foreign project

include:

Change tax laws in a way that adversely impacts the firm.

Impose laws related to labor, wages, and prices that are more restrictive

than those applicable for domestic firms.

Disallow any remittance of funds from the subsidiary to the parent firm for

either a limited period of time or the duration of the project.

Require that the subsidiary be headed by a local citizen or have a local

firm as a major equity partner.

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Impose tariffs and quotas on any imports.

Once management has gauged a capital project’s country risk, that risk must be

incorporated into the capital budgeting analysis by, for example, adjusting the

firm’s discount rate for the additional risk.

21.4 Global Money and Capital Markets

A. The Emergence of the Euromarkets

A Eurodollar is defined as a U.S. dollar deposited in a bank outside the United

States, primarily in Europe.

The banks accepting these deposits are called Eurobanks.

The Euromarkets are vast, largely unregulated money and capital markets with

major financial centers in Tokyo, Hong Kong, and Singapore.

B. The Eurocurrency Market

The Eurocurrency market is the short-term portion of the Euromarket.

A Eurocurrency is a time deposit of money held by corporations and

governments in a bank located in a country different from the country that issued

the currency.

The most widely quoted Eurocurrency interest rate is the London Interbank

Offer Rate, or LIBOR, which is the short-term interest rate that major banks in

London charge one another.

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C. The Eurocredit Market

The international banking system gathers funds from businesses and governments

in the Eurocurrency market and then allocates funds to banks that have the most

profitable lending opportunities.

These loans, which are short- to medium-term loans of a Eurocurrency to

multinational corporations and governments of medium to high credit quality, are

called Eurocredits.

Eurocredits are denominated in all major Eurocurrencies, although the dollar is

the overwhelming favorite.

D. International Bond Markets

International bonds fall into two generic categories: foreign bonds and Eurobonds.

Foreign bonds are long-term debt sold by a foreign firm to investors in another

country and denominated in that country’s currency.

Foreign bonds may have colorful nicknames: foreign bonds sold in the

United States are called Yankee bonds, and yen-denominated bonds sold in

Japanese financial markets by non-Japanese firms are called Samurai bonds.

Firms sell foreign bonds when they need to finance projects in a particular

foreign country.

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Eurobonds are long-term debt instruments sold by firms to investors in countries

other than the country in whose currency the bonds are denominated.

Multinational firms can use Eurobonds to finance international or

domestic projects.

Eurodollar and other Eurocurrency bonds have a number of characteristics

that differ from similar U.S corporate bonds.

Eurobonds are bearer bonds and do not have to be registered.

Eurobonds also pay interest annually.

While historically almost all Eurocurrency bonds were sold without credit

ratings, today, more than half of the Eurodollar bonds sold in Europe have

credit ratings.

21.5 International Banking

European governments fostered the growth of large international banks in their countries

and viewed them as engines of territorial and economic expansion.

To accommodate their customers’ needs, large U.S. banks established networks of

foreign branches and affiliates.

Exhibit 21.7 shows the 15 largest banks in the world in 2007, as ranked by Forbes in its

annual list of the 2000 Largest Public Companies in the World.

A. Risks Involved in International Bank Lending

13

The principles of loan administration and credit analysis are similar for domestic

and overseas loans.

There are differences, however, including some additional risk exposures for

overseas lending.

Credit risk is the same whether a loan is domestic or international.

However, it may be more difficult to obtain or assess credit information

abroad.

Bank loans that have foreign exchange risk will carry an additional risk

premium.

If an international loan or investment is expected to suffer some loss in

value, the loan will carry an additional risk premium.

B. Eurocredit Bank Loans

Eurocredits are short- to medium-term loans of a Eurocurrency to multinational

corporations or governments.

They can have a high degree of credit risk and may be too large for a single bank

to handle.

The lending banks often form a syndicate to spread the risk.

The loan rate (k) is equal to a base rate, such as LIBOR, which represents the

bank’s cost of funds, plus a markup.

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The general equation for Eurocredit pricing is expressed in Equation 21.3.

Eurocredits typically are floating-rate loans structured as “rollovers.”

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II. Suggested and Alternative Approaches to the Material

The chapter begins with some background information about the globalization of the world

economy, the rise of multinational corporations, and the key factors that distinguish domestic

from international business transactions. Emphasis is placed on the fact that the basic principles

of finance remain valid for international business transactions, even though some of the variables

used to calculate financial models change. Two risks are introduced that are not present in

domestic business transactions: foreign exchange risk and country risk.

The markets for foreign exchange are discussed next, and the authors explain how firms

protect themselves from fluctuations in exchange rates. The discussion moves to how

multinational firms manage their overseas capital investments and compute the NPV for these

projects.

Finally, the discussion turns to global money and capital markets. Particular attention is

paid to the Euromarket, where large multinational companies adjust their liquidity, borrow short

term from banks in the Eurocredit market, and borrow long term in the international bond

markets. Finally, bank pricing and the structure of Eurocredits are discussed.

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III. Summary of Learning Objectives

1. Discuss how the basic principles of finance apply to international financial

transactions.

The basic principles of managerial finance remain the same whether a transaction is

domestic or international. For example, the time value of money calculations remain the

same, as do the models used to calculate asset values. What does change, however, are

some of the input variables. These variables may be affected by cultural or procedural

differences between countries, such as a country’s unique currency, or differences in tax

and accounting standards.

2. Differentiate among the spot rate, the forward rate, and the cross rate in the foreign

exchange markets; make foreign exchange and cross rate calculations; and be able

to hedge an asset purchase where payment is made in a foreign currency.

The spot rate is the exchange rate at which one currency can be converted to another

immediately, whereas the forward rate is a rate agreed on today for an exchange to take

place at a specified point in the future. Forward rates are usually different from spot rates

and are the market’s best estimate of what a future spot rate will be. The cross rate is

simply the exchange rate between two currencies. Learning by Doing Applications 21.1

through 21.3 are foreign exchange rate problems that you should be able to solve.

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3. Identify the major factors that distinguish international from domestic capital

budgeting, explain how the capital budgeting process can be adjusted to account for

these factors, and compute the NPV for a typical international capital project.

One issue that distinguishes international from domestic capital budgeting is the

difficulty in estimating the incremental cash flows from an international project. These

difficulties can stem from differences in operating, accounting, and legal practices, as

well as from the variety of ways in which a multinational firm can transfer profits and

funds from the subsidiary to the parent corporation. Furthermore, firms engaged in

international capital budgeting face two risks that domestic firms do not have to deal

with: foreign exchange rate risk and country risk. The Barcelona example in Section 21.3

and Learning by Doing Application 21.4 illustrate capital budgeting calculations.

4. Discuss the importance of the Euromarkets to large U.S. multinational firms, and

calculate the cost of borrowing in the Eurobond market.

The Eurocurrency markets are important to large multinational corporations around the

world. These corporations hold Eurocurrency time deposits as investments and finance

much of their business activity by borrowing in the Eurocredit market and selling debt in

the Eurobond market. The Euromarkets are popular with large multinational firms

because they are largely unregulated; thus, they offer more attractive borrowing and

lending rates and greater flexibility in conducting transactions. Learning by Doing

Application 21.5 illustrates the cost of issuing bonds in the domestic and Eurobond

markets.

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5. Explain how large U.S. money center banks make and price Eurocredit loans to

their customers, and compute the cost of a Eurocredit bank loan.

Eurocredit loans are made by large multinational banks. Eurocredits typically have fixed

maturities and variable, or floating, rates of interest. The loan rate is tied to a base interest

rate (BR), such as LIBOR. Thus, the rate charged on a Eurocredit is BR + X, where X is

the lending margin, which consists of risk premiums (credit, country, and currency risks)

and the lender’s profit margin. The Citibank example in Section 21.5 and Learning by

Doing Application 21.6 illustrate how loan costs are computed.

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IV. Summary of Key Equations

Equation Description Formula

21.1 Bid-Ask spread

21.2 Discount or forward premium

21.3 Eurocredit pricingk = BR + DRP + FXR + CR + GPMAR

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V. Before You Go On Questions and Answers

Section 21.1

1. What is globalization?

Globalization refers to the removal of barriers to free trade and the closer integration of

national economies. Consumers in many countries buy goods that are purchased from a

number of countries, other than just their own. The production of goods and services has

also become highly globalized. Like product markets, the financial system has also

become highly integrated.

2. What are multinational corporations?

Multinational corporations are business firms that have their operations in at least one

other country than their home country where they are headquartered. These firms are

headquartered all over the world and are owned by a mixture of domestic and foreign

stockholders.

3. Explain the difference between American and European business executives’ views on

wealth maximization.

American business executives embrace shareholder wealth maximization as their number

one goal, whereas in most parts of Europe, the main goal of business executives is to

maximize corporate wealth. This means that shareholders are treated on par with other

stakeholders, such as management, employees, creditors, or the government.

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Section 21.2

1. What is foreign exchange rate risk?

Foreign exchange risk is the risk of a change in investment’s value due to changes in

currency exchange rates. This risk usually affects firms that import/export goods as well

as investors that make international investments.

2. How is the equilibrium exchange rate determined?

The equilibrium exchange rate is the point of intersection between the currencies’ supply

and demand curves. It is the point at which the quantity of the currency demanded equals

the quantity of currency supplied.

3. What does it mean to hedge a financial transaction?

To hedge a financial transaction with foreign exchange means to reduce the potential

gains or losses caused by fluctuations in the price of foreign exchange. Many instruments

can be used to hedge this risk, such as foreign currency options.

Section 21.3

1. What difficulties do firms face in estimating cash flows from an overseas project?

Estimating cash flows from an overseas project is difficult because of the various ways a

firm is likely to get cash flows from a subsidiary—dividends, royalty or license

payments, debt repayment, management or consulting fees. It is also difficult to precisely

time the cash flows or estimate the magnitude because of restrictions and controls a

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country is likely to put on the transfer of funds from the overseas project back to the

home country.

2. Why is the repatriation of cash flows from an overseas project considered critical?

From a parent firm’s point of view, the cash flows expected from the subsidiary are the

basis for undertaking a project or rejecting it. Any delays in receiving the cash flows will

affect the NPV of the project. Parent companies often rely on the cash flows from foreign

operations to be repatriated and to fund projects in other countries.

3. When do companies have to consider country or political risk?

Any company doing business in a foreign country has to consider political or country

risks. Especially if the target country has a relatively unstable political environment,

financial managers must incorporate the potential risk into the cost of the project.

Section 21.4

1. Which currency is the preferred currency of exchange in global financial markets? Why?

The U.S. dollar is the preferred currency of exchange on the global financial markets, as it is

perceived to be the most stable currency. This is mainly due to the size and strength of the

U.S. economy, the long history of political stability, and the strength of military forces.

2. What is the difference between foreign bonds and Eurobonds?

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Both foreign bonds and Eurobonds are types of international bonds. However, foreign bonds

are long-term debt instruments sold by a foreign firm to investors in another country, and

they are denominated in that country’s currency. On the other hand, Eurobonds are long-

term debt instruments sold by a firm in one country but are denominated in the currency of

another country.

Section 21.5

1. Why is credit risk higher in international markets?

In international markets, the credit risk of borrowers is higher, as it is more difficult to

obtain credit information abroad. It is mainly the issue of familiarity with foreign

economic conditions and business practices. Thus, the cost of gathering all this necessary

information is higher, which is then being passed onto the customer in terms of higher

premium.

2. List the inputs that are used in calculating a Eurocredit price.

The loan pricing for Eurocredits is similar to the loan pricing that U.S. money center

banks use for their largest domestic customers. The loan rate (k) is equal to a base rate,

such as LIBOR, which represents the bank’s cost of funds, plus a markup, which is the

bank’s lending margin:

k = Base rate + X

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where X is the lending margin. The lending margin depends on the borrower’s credit risk;

international risk factors, such as foreign exchange risk and country risk; and the bank’s

gross profit margin. Equation 21.3 represents the Eurocredit pricing.

k = BR + DRP + FXR + CR + GPMAR

where

k = individual firm’s loan rate

BR = Eurocurrency base rate, such as LIBOR

DRP = default risk premium

FXR = foreign exchange or currency risk premium

CR = country risk premium

GPMAR = bank’s gross profit margin

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VI. Self-Study Problems

21.1 If a Volkswagen Passat costs $26,350 in Baltimore and €21,675 in Frankfurt, what is the

exchange rate between the U.S. dollar and the euro?

Solution:

Cost of the car in Baltimore = $26,350

Cost of the car in Frankfurt = €21,675

Dollar to euro exchange rate = $26,350 / €21,675

= $1.2157/€

21.2 Calculate the following exchange rates given the following information.

Given Compute

a. ¥111.3500/$ $/¥

b. $1.8694/£ £/$

c. $0.7613/C$ C$/$

Solution:

a. 1 / ¥111.3500/$ = $0.008981/¥

b. 1 / $1.8694/£ = £0.5349/$

c. 1 / $0.7613/C$ = C$1.3135/$

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21.3 Digital, Inc., an electronic games manufacturer, is planning to purchase flash memory

from one of two sources. Kyoto, Inc., quotes a price of ¥8,900 per gigabyte. The current

exchange rate is ¥110.36/$. Another Japanese manufacture offers to supply the same

flash memory at a price of €77.46 per gigabyte. The spot rate available is ¥121.57/€.

Which is the cheaper source of flash memory for Digital?

Solution:

Cost from Vendor 1:

Flash memory price quote = ¥8,900 per gigabyte

Spot rate for U.S. dollar = ¥110.36/$

Cost to Digital in dollars = ¥8,900 / ¥110.36/$

= $80.65 per gigabyte

Cost from Vendor 2:

Flash memory price quote = €77.46 per gigabyte

Spot rate for U.S. dollar = ¥121.57/€

To compute the dollar cost, we need to compute the cross rate between the euro and the

dollar.

Cost to Digital in dollars = €77.46 x $1.1016/€

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= $85.33 per gigabyte

The first vendor has the cheaper quote for Digital.

21.4 Columbia Corp. has just made a sale to a British customer. The sale was for a total value

of £135,000 and is to be paid 60 days from now. Columbia is concerned that the British

pound will depreciate against the U.S. dollar, and management plans to hedge. The

company’s bank informs management that the spot rate is $1.8133/£ and the 60-day

forward rate is $1.7864/£. If Columbia sells its pounds receivable at the forward rate,

what is the dollar value of its receivables? If it did not enter into a forward contract and

the spot rate 60 days later was $1.7635/£, how much did the company lose by not

hedging?

Solution:

Amount received by Columbia by selling at the forward rate:

= £135,000 x $1.7864/£ = $241,164

Amount received by Columbia by selling at the spot rate 60 days later:

= £135,000 x $1.7635/£ = $238,072.50

Loss incurred by not hedging = $241,164 - $238,072.50 = $3,091.50

21.5 American Bancorp is planning to make a $3.5 million loan to a French firm. Currently,

LIBOR is at 4.5 percent. American considers a default risk premium of 1.15 percent, a

foreign exchange risk premium of 0.35 percent, and a country risk premium of 0.13

percent. What is the loan rate charged by American Bancorp?

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Solution:

k = BR + DRP + FXR + CR

= 4.5% + 1.15% + 0.35% + 0.13%

= 6.13%

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VII. Critical Thinking Questions

21.1 Shell Corporation, an oil company, has headquarters in both the Netherlands and the

United Kingdom. What type of firm is it?

This company is both a multinational corporation and a transnational company. Since it

produces, refines, and sells oil in a variety of different locations around the world, it is an

MNC. Since it is owned by investors in more than one country and is managed from a

global perspective, it is a transnational firm.

21.2 International economic integration and technological changes in the last couple of

decades have dramatically increased globalization across many industries. Explain how a

biotech firm or a medical firm (for example, a hospital) takes advantage of these changes.

Technological changes have come in a variety of forms—computers, telecommunication,

data digitalization, and such. A biotech firm may be able to conduct research and

development on new drugs in India, clinical trials in other countries before submitting it

for FDA approval. A hospital in the United States may be able to cost efficiently

digitalize medical records by transmitting the records overseas. Hospitals and doctors can

use these digital records to consult physicians halfway across the world to get a more

precise diagnosis.

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21.3 In the United States, managers are asked to focus on maximizing shareholder wealth. Is

this consistent with the goals of firms in Germany and Japan?

In countries such as France and Germany, stockholders are treated no differently than any

other stakeholder of the firm. Thus, they are on a par with employees, suppliers,

creditors, customers, and the government. The firm’s management focus is on

maximizing the wealth of the firm such that everyone benefits, not just the shareholders.

In Japan, a group of businesses have ownerships in each other. This is known as keiretsu.

Japanese managers focus on growing the market share of their firm such that the wealth

of their keiretsu, and not the wealth of the shareholders, is maximized. Maximizing

shareholder wealth is consistent with these other goals. Management taking this approach

will, in the long run, help all the stakeholders of the firms, including the community in

which they operate, to benefit.

21.4 A Canadian cooperative of wheat farmers sold wheat to a grain company in Russia.

Under what circumstances will the Canadian farmers be exposed to foreign exchange

risk? When will the Russian importer be facing foreign exchange risk?

If the payment to the Canadian exporter is in any currency other than the Canadian dollar,

the Canadian exporter faces foreign exchange risk. If the Russian importer is forced to

pay the Canadian exporter in Canadian dollars, then the entire foreign exchange risk is

borne by the Russian importer.

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21.5 Stardust, Inc., is an exporter of plumbing fixtures. About 30 percent of their sales are to

Canada. Their sales department just found out that the Canadian dollar is at a premium

against the U.S. dollar based on the 90-day forward rate, while the 180-day forward rate

indicates that the Canadian dollar is at a forward discount. What is the impact on the

company’s sales to Canada?

The fact that the Canadian dollar is at a forward premium indicates that the Canadian

dollar will be able to buy more U.S. dollars. In the short run, this can lead to increased

sales for Stardust since Canadians will be able to buy more with their money. Six months

from now, this Canadian dollar is at a forward discount. Imports from the United States

will be more expensive for Canadians, and this could lead to Stardust seeing a decrease in

their exports to Canada at that time.

21.6 Mello Wires, a California winery, grows its grapes locally, uses local labor, and sells its

wines only in the United States. Can this firm be exposed to foreign exchange risk?

Even though Mello is merely a domestic company, it does have foreign exchange risk.

Suppose the U.S. dollar appreciates against the euro. This will make imported wine from

the euro zone more affordable to Americans and increase import competition to Mello.

21.7 A U.S. firm owns a subsidiary in Belgium. What kind of foreign exchange risk does the

U.S. firm face?

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Since it owns assets and has liabilities in Belgium denominated in euros, the firm faces

foreign exchange risk. Converting the euro-denominated assets and liabilities to U.S.

dollars for reporting purposes will make the dollar value of the Belgian subsidiary’s

assets and liabilities fluctuate.

21.8 Raycor Corp is a U.S. electronic manufacturer with a production plant in Turkey. This

morning, the Turkish government introduced a new law prohibiting remitting of any

funds from the country for another two years. What type of risk does Raycor face?

Raycor is facing a form of country or political risk. Country risk can be of many forms,

including changes in tax or labor laws, currency or trade controls, remittance controls, or

even expropriation of the firm’s assets.

21.9 Suppose GE issued bearer bonds in France denominated in British pounds. What type of

bond is it?

This is an example of a Eurobond. GE, a foreign issuer in France is issuing a bearer bond

in a currency (British pounds) to investors in a country whose currency is different from

that of the bond issue.

21.10 Give examples of U.S. banks facing different risks in international lending.

33

The first risk that a bank will face in any market is credit risk—the risk that the interest

and/or principal will not be paid. Suppose Citicorp made a loan to a firm in Honduras.

Unlike lending in the domestic market, the bank is likely to be less familiar with the new

market, economic conditions, and business practices. That makes it more difficult to

judge the credit worthiness of a loan customer. The second risk to consider is currency

risk. The loan is made in the Honduran currency, and repayment of principal and interest

payments are also going to be in it. So, Citicorp needs to protect itself against currency

risk. The third risk is potentially the worst. This is political or country risk, which

relates the ability of Citicorp making a profitable loan and being able to remit the funds

back to the United States due to the political climate in Honduras. The more unstable a

government is, the higher the country risk that Citicorp will face.

34

VIII. Questions and Problems

BASIC

21.1 Spot rate: Ryan spots a pair of leather shoes at Harrods in London priced at £113.60. If

the exchange rate that day was $1.8422/£, what is Ryan’s cost in U.S. dollars?

Solution:

Cost of shoes in London = £113.60

Spot rate = $1.8422/£

Dollar cost of shoes = £113.60 × $1.8422/£ = $209.27

21.2 Spot rate: Crescent Corporation’s recent sale to a Mexican firm produced revenues of

13,144,800 Mexican pesos (MPs). If the firm sold the pesos to its bank and was credited

with $1,795,579.69, what was the spot rate at which the pesos were converted?

Solution:

Revenue from sale to Mexican firm = MP 13,144,800

Dollar revenue received from sale = $1,795,579.69

Spot rate at which the foreign currency revenue was converted:

This is the same as MP7.3206/$

21.3 Spot rate: Given the following direct quotes, calculate the equivalent indirect quotes.

35

a. $0.0844/Mexican pesos

b. £0.6113/€

c. Rs 31.64/ C$

Solution:

a.

b. 1 / £0.6113/€ = €1.6359/£

c. 1 / Rs 31.64/ C$ = C$ 0.0316/Rs.

21.4 Spot rate: Convert the following indirect quotes to the appropriate American quote.

a. £0.6917/$

b. Rs. 43.37/$

c. SF 1.2133/$

Solution:

a. 1 / £0.6917/$ = $1.4457/£

b. 1 / Rs. 43.37/$ = $0.02305 / Rs

c. 1 / SF 1.2133/$ = $0.8242 / SF

21.5 Spot rate: Suppose a BMW 745i car is priced at $57,750 in New York and € 48,387 in

Berlin. In which place is the car more expensive if the spot rate is $1.1935/€?

Solution:

36

Cost of car in New York = $57,750

Cost of car in Berlin = € 48,387

Spot rate = $1.1935/€?

Dollar cost in Berlin = € 48,387 × $1.1935/€? = $57,750

The cost of the car is the same in both cities based on the spot rate!

21.6 Forward rate: Explain the relationship between each pair of currencies.

Spot Rate Forward Rate

a. $1.8316/ £ $1.7874/£

b. ¥110.45/$ ¥108.33/$

c. C$ 1.3111/$ C$ 1.2933/$

Solution:

a. Since the forward rate indicates that fewer dollars will be required to buy a pound

in the future, we say that the dollar is at a forward premium against the British

pound.

b. The yen is at a forward premium against the dollar as the forward quote indicates

that the dollar can be purchased with fewer yen.

c. The U.S. dollar is at a forward discount against the Canadian dollar as a dollar is

expected to purchase fewer Canadian dollars in the future.

37

21.7 Forward rate: If the spot rate was $0.7413/C$ and the 90-day forward rate was

$0.7507/C$, how much more (in U.S. dollars) would you receive by selling C$ 1,000,000

at the forward rate than at the spot rate?

Solution:

If C$1,000,000 was sold at the spot rate, dollar revenue received:

C$1,000,000 × $0.7413/C$ = $741,300

If C$1,000,000 was sold at the 90 day forward rate, dollar revenue received:

C$1,000,000 × $0.7507/C$ = $750,700

Additional revenue received by selling forward = $750,700 − $741,300 = $9,400

21.8 Forward rate: Crane, Inc., sold equipment to an Irish firm and will receive €1,319,405

in 30 days. If the company entered a forward contract to sell at the 30-day forward rate of

$1.1912/€, what is the dollar revenue received?

Solution:

Expected euro revenue = €1,319,405

30-day forward rate = $1.1912/€

Dollar revenue received = €1,319,405 × $1.1912/€ = $1,571,675.24

21.9 Forward rate: Brilliant Equipment purchased machinery from a Japanese firm and will

have to pay ¥313.25 million in 45 days. The bank quotes a forward rate of ¥109.46/$ to

buy the required yen. What is the cost to Brilliant in U.S. dollars?

38

Solution:

Cost of machinery = ¥313.25 million

Forward rate = ¥109.46/$

Cost of equipment in dollars = ¥313,250,000 / ¥109.46/$ = $2,861,776

21.10 Forward rate: Triumph Autos has contracted with an Indian software firm for design

software. The payment of 22,779,750 rupees (Rs.) is due in 30 days. How much will the

cost be in dollars if the 30-day forward rate is Rs.43.39/$.

Solution:

Cost of software = Rs.22,779,750

Forward rate= Rs.43.39/$

Cost of software in dollars = Rs.22,779,750 / Rs.43.39/$= $525,000

21.11 Bid-ask spread: Nova Scotia Bank offers quotes on the Canadian dollar as given below.

What is the bid-ask spread based on these quotes?

Bid Ask

C$ 0.7273/$ C$ 0.7278/$

Solution:

39

21.12 Bid-ask spread: A local community bank has requested foreign exchange quotes for the

Swiss franc from Citibank. Citibank quotes a bid rate of $0.7634/SF and an ask rate of

$0.7637/SF. What is the bid-ask spread?

Solution:

21.13 Bid-ask spread: A foreign exchange dealer is willing to buy the Danish krone (DKr) at

$0.1556/DKr and will sell it at a rate of $0.1563/DKr. What is the bid-ask spread on the

Danish krone?

Solution:

21.14 Cross rate: Given the following quotes, calculate the €/£ cross rate.

Bank of America $1.763/£

Chase $1.1914/€

40

Solution:

To find the €/£ cross rate, divide the Bank of America quote by the Chase quote.

Cross rate = $1.763/£ / $1.1914/€ = €1.4798/£

21.15 Cross rate: Barclays Bank of London has offered the following exchange rate quotes:

¥195.64/£ and Korean won 10.8374/¥. What is the cross rate between the Korean won

and the British pound?

Solution:

To find the won/£ cross rate, divide the Korean won quote by the yen quote.

Cross rate = won 10.8374/¥ × ¥ 195.64/£ = won 2,120.23/£

21.16 Cross rate: Bremer Corporation observes that the Swiss franc (SF) is being quoted at

€0.6164/SF, while the Swedish krona (SK) is quoted at €0.0981/SK. What is the SK/SF

cross rate?

Solution:

To find the SK/SF cross rate, divide the Swiss franc quote by the Swedish krona quote.

Cross rate = €0.6164/SF / €0.0981/SK = SK6.2834/SF

21.17 Foreign exchange risk: How is transaction exposure different from operating exposure?

Solution:

41

Transaction exposure is related to foreign exchange risk faced by firms that are expecting

revenues in foreign currency or have expenses in foreign currency that relate to

transactions they have already entered into. As the exchange rate changes, the home

currency value of these revenues or expenses change, leading to transaction exposure. If

exchange rate changes are more permanent in nature and modifies the way a firm does its

business, then we say that a firm is facing operating exposure.

21.18 International debt: What are Yankee bonds?

Solution:

When corporate bonds are issued by a foreign firm in the United States and denominated

in U.S. dollars, they are considered to be foreign bonds referred to as “Yankee” bonds.

Similarly, foreign issues of yen-denominated bonds in Japan are called Samurai bonds,

and British pound-denominated bonds in the United Kingdom are called “Bulldog”

bonds.

INTERMEDIATE

21.19 Forward premium: The spot rate on the London market was £0.5514/$, while the 90-

day forward rate was £0.5589/$. What is the annualized forward premium or discount on

the period?

Solution:

42

The British pound is at a forward discount against the U.S. dollar as it takes more pounds

to buy a dollar at the forward rate.

21.20 Forward premium: Bank of America quoted the 180-day forward rate on the Swiss

franc at $0.7902. The spot rate was quoted at $0.7766/SF. What is the forward premium

or discount on the Swiss franc?

Solution:

The Swiss franc is at a 3.5 percent forward premium against the dollar.

21.21 Forward premium: The foreign exchange department at Tokyo’s Daiwa Bank quoted

the spot rate on the euro at €0.007269/¥. The 90-day forward rate is quoted at a premium

of 5.42 percent on the euro. What is the 90-day forward rate?

Solution:

Spot rate = €0.007269/¥

90-day forward premium on the euro = 5.42%

43

The 90-day forward rate is 0.007368¥/€.

21.22 Forward premium: State Bank of India has offered a spot rate quote on Indian rupees

(Rs) of Rs43.54/$. The Indian rupee is quoted at a 30-day forward premium of 8.79

percent against the dollar. What is the 30-day forward quote?

Solution:

Spot rate = Rs43.54/$

30-day forward premium on the dollar = 8.79%

The 30-day forward rate is Rs43.86/$.

44

21.23 Bid-ask spread: The foreign exchange department of Bank of India has a bid quote on

Indian rupees (Rs) of Rs43.21/$. If the bank typically tries to make a bid-ask spread of

0.5 percent on these foreign exchange transactions, what will the ask rate have to be?

Solution:

The ask rate will have to be Rs.43.43/$ to provide a 0.5 percent bid-ask spread.

21.24 Bid-ask spread: Banco Santiago wants to make a bid-ask spread of 0.65 percent on its

foreign exchange transactions. If the ask rate on the Mexican peso (MP) is MP10.3092/$,

what does the bid rate have to be?

Solution:

The ask rate will have to be MP10.2422/$ to provide a 0.65 percent bid-ask spread.

45

21.25 Cross rate: Alcor Pharma just received revenues of $3,165,300 in Australian dollars

(A$). The only exchange rates management has are A$2.7011/£ and $1.7538/£. What is

the U.S. dollar value of the company’s revenues?

Solution:

Revenues received by Alcor Pharma = A$3,165,300

To determine the A$ /$ cross rate, you divide the A$ to £ quote by the $/£ quote.

Cross rate = A$2.7011/£ / $1.7538/£ = A$1.5401/$

U.S. dollar value of their revenue = A$3,165,300 / A$1.5401/$

= $2,055,201

21.26 Cross rate: Flint Corp. recently purchased auto parts worth 17.5 million Mexican pesos

(MP). Management needs to find out the U.S. dollar cost of the payables. It has access to

two quotes for Canadian dollars (C$): C$1.3174/$ and C$0.1271/MP. What will it cost

Flint to purchase 17.5 million Mexican pesos?

Solution:

Foreign currency payables = MP 17.5 million

To find the MP/$ quote, divide the C$/MP quote by the C$/$ quote.

Cross rate = C$0.1271/MP / C$1.3174/$ = $0.0964779/MP

Dollar cost of payables = MP17,500,000 × $0.0964779/MP

= $1,688,363

46

21.27 Hedging: Tricolor Industries has purchased equipment from a Brazilian firm for a total

cost of 272,500 Brazilian reals. The firm has to pay in 30 days. Citicorp has given the

firm a 30-day forward quote of $0.4723/real. Assume that on the day the payment is due,

the spot rate is at $0.4917/real. How much would Tricolor save by hedging with a

forward contract?

Solution:

Foreign currency payables = BR 272,500

Spot rate on payment date = $0.4917/BR

Dollar cost of payables = BR272,500 × $0.4917/BR = $133,988.25

30-day forward rate = $0.4723/BR

Cost if hedged at forward rate = BR272,500 × $0.4723/BR = $128,701.75

Cost savings = $133,988.25 − $128,701.75 = $5,286.50

ADVANCED

21.28 Cosmos Sporting Goods, Inc., has imported leather soccer cleats from a Thai firm for a

total cost of 3,125,750 bahts. Cosmos plans to purchase the Thai bahts at the time the

payment is due in 90 days. Today, the Thai baht has a 90-day forward quote of

$0.0215/baht. Now suppose that three months later, Cosmos purchases the bahts at the

prevailing spot rate of $0.0241/baht. How much did Cosmos lose by not hedging?

Solution:

47

Foreign currency payables = 3,125,750 bahts

Spot rate on payment date = $0.0241/baht

Dollar cost of payables = 3,125,750 bahts × $0.0241/baht = $75,330.58

90-day forward rate = $0.0215/baht

Cost if hedged at forward rate = 3,125,750 bahts × $0.0215/baht = $67,203.63

Cost savings lost = $75,330.58 − $67,203.63 = $8,126.95

21.29 Covington Industries sold equipment to a Mexican firm. Payment of 11,315,000 pesos

will be due in 30 days. Covington has the option of selling the pesos at a 30-day forward

rate of $0.09139/peso. If it waits 30 days to sell the pesos, the expected spot rate is

$0.0907/peso. In dollars, how much better off is Covington by selling the pesos in the

forward market?

Solution:

Foreign currency receivables = MP 11,315,000

Spot rate on payment date = $0.0907/peso

Dollar revenues from receivables = MP 11,315,000 x $0.0907/peso= $1,026,270.50

30-day forward rate = $0.09139/peso

Revenues if hedged at forward rate = MP 11,315,000 × $0.09139/peso= $1,034,077.85

Additional revenues received = $1,034,077.85 − $1,026,270.50 = $7,807.35

48

21.30 Barrington Fertilizers, Inc., exports its specialized lawn care products to Canada. It has

just made a sale worth C$1,150,000, with the payment due in 90 days. Its banker has

given it a forward quote of $0.8477/C$. By using the forward rate, the firm gains an

additional $8,433.25 over what it would have gotten if it had sold the Canadian dollars in

the spot market 90 days later. What was the spot rate at the time the payment was

received?

Solution:

Foreign currency receivables = C$1,150,000

90-day forward rate = $0.8477/C$

Revenues if hedged at forward rate = C$1,150,000 × $0.8477/C$= $974,855

Additional dollar revenues received = $8,433.25

Revenues at spot rate = $974,855 − $8,433.25 = $966,421.75

Spot rate on payment date = $966,421.75 / C$1,150,000 = $0.8404/C$

21.31 Moon Rhee Auto Supply, a Korean supplier of parts to Kia Motors, is looking at setting

up a plant in Alabama, where Kia Motors has an auto assembly plant for its SUVs. The

cost of this plant will be $13.5 million. The current spot rate is 946.53 Korean won per

U.S. dollar. The firm is expected to use this plant for the next five years and is expecting

to generate the following cash flows. The firm uses a discount rate of 9 percent for

projects in the United States.

Years 1 2 3 4 5

49

Cash flows (millions of

U. S. dollars)2.3 4.2 3.6 5.8 7.6

Expected exchange rate

(Korean won/$)932.031 923.632 956.155 952.221 943.670

What is the NPV of this project? Should Moon Rhee Auto Supply take on this project?

Solution:

Moon Rhee Auto Supply knows what the expected cash flows in U. S. dollars and the

expected exchange rates are, the expected cash flows to the parent firm in Korean won

can be calculated by dividing the dollar cash flows by the appropriate exchange rate.

Year 1 2 3 4 ___________5__

Cash flows ($) 2.3 4.2 3.6 5.8 7.6

Given in the following table are the cash flows that the Korean firm expects to receive

from its American subsidiary in U.S. dollars.

Year

Cash Flows (in

millions of U.S. $)

Exchange Rate

(won/$)

Cash Flows (in

millions of won)

0 (13.5) 946.530 (12,778.16)

1 2.3 932.031 2,143.67

2 4.2 923.632 2,879.15

3 3.6 956.155 3,442.16

4 5.8 952.221 5,522.88

50

5 7.6 943.670 7,171.89

The firm has determined that the appropriate discount rate is 9 percent for capital

budgeting projects in the United States. By discounting the cash flow at the risk-adjusted

discount rate of 9 percent, we can compute the NPV for this project.

NPV = −12,778.16 + 2,143.67/(1.09)1 + 3,879.25/(1.09)2 + 3,442.16/(1.09)3 +

5,522.88/(1.09)4 + 7,171.89/(1.09)5

= −12,778.16 + 1,966.67 + 3.265.09 + 2,657.98 + 3,912.55 + 4,661.24

= 3,685.360 million won

Since NPV is positive, the project should be accepted.

21.32 Boeing Corp. has two different debt issues, both maturing four years from now. The

domestic bond issue pays semiannual coupons and has a coupon rate of 4.80 percent. The

current price on the bond is $962.75. The Eurobond issue is priced at $964.33 and pays

an annual coupon of 4.95 percent. What is the yield to maturity for each bond?

Solution:

For the Eurodollar bond with annual compounding, the coupon payment is $49.50 per

year, and the yield calculation is:

Using our financial calculator, the annual yield of the Eurodollar bond issue is 5.9789

percent.

51

For the domestic bond issue the semiannual coupon payments are $24 ($48/2), and the

semiannual bond yield calculation is:

Making the calculation, the bond issue’s semiannual yield is 2.9291 percent. As

discussed in Chapter 8, to compare interest rates with different compounding periods, we

need to compute the effective annual yield (EAY).

Applying the equation EAY:

EAY = (1 + quoted rate/m)m – 1

= (1 + 0.029291)2 – 1

= 1.05944 – 1

= 5.94%

An investor in Boeing’s Eurobond will earn 5.98 percent, while the domestic bond would

provide a yield of 5.94 percent. Thus, the Eurobond is the better investment.

21.33 Caterpillar, Inc., is exploring the issue of either a domestic corporate bond or a Eurobond

denominated in dollars. Either issue would have a three-year maturity. The domestic

bond would carry a coupon of 4.1 percent and would sell in the market for $1,034.25.

The Eurobond issue would have a coupon of 4 percent and sell at $1,029.76. Which bond

issue will have the lowest cost to the firm?

Solution:

52

For the domestic bond issue the semiannual coupon payments are $20.50 ($41/2), and

the semiannual bond yield calculation is:

Making the calculation, we see that the bond issue’s semiannual yield is 1.4499 percent.

As discussed in Chapter 8, to compare interest rates with different compounding periods,

we need to compute the effective annual yield (EAY).

Applying the equation EAY:

EAY = 1 + quoted rate/m)m – 1

= (1 + 0.014499)2 – 1

= 1.02921 – 1

= 2.92%

For the Eurodollar bond with annual compounding, the coupon payment is $40 per year,

and the yield calculation is:

Using our financial calculator, the annual yield of the Eurodollar bond issue yield is

2.9489 percent.

From Caterpillar’s perspective, the domestic bond issue is the cheaper alternative.

21.34 IBM’s German unit is looking to borrow €7.5 million from Deutsche Bank. Deutsche

Bank quotes a rate of three-month LIBOR plus 0.25 percent for the 90-day loan.

Currently, the three-month LIBOR is 3.875 percent. What is IBM’s interest cost on the

53

loan in euros? If the exchange rate on the payoff date is €0.8164/$, what is the dollar cost

of the loan?

Solution:

Amount IBM plans to borrow = €7.5 million

Term of loan = 90 days

Interest cost = LIBOR + 0.25% = 3.875% + 0.25% = 4.125%

Interest cost in euros = €7,500,000 x 0.04125 × (90/360) = €77,343.75

Spot rate on payoff date = €0.8164/$

Dollar interest cost = €77,343.75 / €0.8164/$ = $94,737.57

21.35 Toyota is interested in borrowing $5 million for 90 days. Bank of America has quoted a

rate of 1.125 percent under the prime rate of 6.25 percent. Daiwa Bank is offering Toyota

a rate of 0.75 percent over the three-month LIBOR of 4.2 percent. Which is the better

deal for Toyota, and what is the lower interest cost in dollars?

Solution:

Bank of America Loan

Amount Toyota plans to borrow = $5 million

Term of loan = 90 days

Interest cost = Prime rate − 1.125% = 6.25% − 1.125% = 5.125%

Interest cost in = $5,000,000 × 0.05125 × (90/360) = $64,062.50

Daiwa Bank Loan

54

Amount Toyota plans to borrow = $5 million

Term of loan = 90 days

Interest cost = LIBOR + 0.75% = 4.2% + 0.75% = 4.95%

Interest cost in = $5,000,000 × 0.0495 × (90/360) = $61,875

The Daiwa Bank offers Toyota the lower cost loan with a lower interest cost of $61,875

versus $64,062.50.

55

Sample Test Problems

21.1 Creighton Industries purchased €1, 234,970 worth of electrical supplies from a German

store three months ago. The payment in euros is due today, and the firm has been quoted

a spot rate of $1.2163/€ by its bank. What is the dollar cost of Creighton’s purchase?

Solution:

Foreign currency payables = €1,234,970

Spot rate = $1.2163/€

Dollar cost of payables = €1,234,970 × $1.2163/€

= $1,502,094

It will cost Creighton $1,502,094 for the purchase of electrical supplies.

21.2 Traynor Corp. made a sale worth 27.3 million yen (¥) today to a Japanese firm. The spot

rate on the Japanese yen today is ¥109.37/$. How much is the sale worth in dollars if the

revenue is to be received today? The firm expects to receive payment after 30 days. The

one-month forward rate is quoted as ¥110.45/$. How much will the firm receive in one

month if the payment is converted at the forward rate?

Solution:

Foreign currency receivables = ¥27,300,000

Spot rate today = ¥109.37/$

Dollar revenues at today’s spot rate = ¥27,300,000 / ¥109.37/$ = $249,611.41

56

30-day forward rate= ¥110.45/$

Revenues if hedged at forward rate = ¥27,300,000 / ¥110.45/$= $247,170.67

21.3 If the spot rate on the Canadian dollar is C$1.3357/€ and the 90-day forward rate is

C$1.3614/€, what is the forward premium or discount on the Canadian dollar against the

euro?

Solution:

Spot rate = C$1.3357/€

90-day forward rate = C$1.3614/€

Since the euro costs more in C$ at the 90-day forward rate, the Canadian dollar is at a 90

day forward discount of 7.7 percent against the euro.

21.4 Deutsche Bank has offered the following exchange rate quotes on Indian rupees (Rs):

Rs.91.64/£ and $1.8734/£. What is the cross rate between the Indian rupees and the U.S.

dollar?

Solution:

To find the Rs./$ cross rate, divide the Rs/£ quote by the $/£ quote.

Cross rate = Rs.91.64/£ / $1.8734/£ = Rs.48.9164/$

57

21.5 Tantrix Industries sold equipment to a Mexican firm. Payment of 27,556,000 pesos will

be due in 30 days. Tantrix has the option of selling the pesos at a 30-day forward rate of

$0.08914/peso. If the company waits 30 days to sell the pesos, the expected spot rate is

$0.08857/peso. In dollars, how much better off will Tantrix be if the pesos are sold in the

forward market?

Solution:

Foreign currency receivables = MP 27,556,000

Expected spot rate on payment date = $0.08857/MP

Dollar revenues from receivables = MP 27,556,000 × $0.08857/MP = $2,440,634.92

30-day forward rate = $0.08914/MP

Revenues if hedged at forward rate = MP 27,556,000 × $0.08914/MP = $2,456,341.84

Additional revenues received = $2,456,341.84− $2,440,634.92= $15,706.52

The additional dollar revenue by selling pesos at the forward rate is $15,706.92.

58