Part A (10 marks): (4) Multiple Choice questions worth 2.5 marks each.
You speculate that the € will appreciate in the next 3 weeks. As a result, you buy a futures contract of €62,500 at $0.9/€. The bank requires you to put an initial deposit of $5,625 which 10% of the contract size. You will get a margin call when your balance is below $2,000. At what settlement price will you get a margin call from the bank?
For European options, what is the effect of an increase in the volatility?
- Decrease the value of calls and puts, all else being equal.
- Increase the value of calls and puts, all else being equal.
- Decrease the value of calls, increase the value of puts, all else being equal.
- Increase the value of calls, decrease the value of puts, all else being equal.
You are speculating on appreciation of the €. You purchase call options on €62,500 with a strike price of $1.2 = €1.00. The options position costs a total of $7,000. The current spot rate is $1.35 = €1.00. At what exchange rate will you break-even from the option position?
Depreciation of the euro relative to the U.S. dollar will cause a U.S.-based multinational firm’s euro-based reported earnings (from the consolidated income statement) to _______. If a firm desired to protect against this possibility, it could stabilize its reported earnings by _______ euros forward in the foreign exchange market.
- be reduced; purchasing
- be reduced; selling
- increase; selling
- increase; purchasing
- None of the above
Part B (90 marks): Five (5) Short Answer questions. Marks are clearly stated in each question.
Question 1 (20 marks)
Gaggle is a U.S. based firm with operations across Europe. The firm expects to pay €20mil in 90 days. As the head of the risk management department, you need to hedge against the € exposure. The European prevailing interest rate is 2% p.a., while that of the U.S. is 3% p.a.. The current spot rate of the € is $1.2. The 90-day forward price is $1.15/€. The 90-day European call option on the $ with the exercise price of €0.85 is selling at 3% premium. The 90-day European put option on the $ with the exercise price of €0.87 is selling at 2% premium.
- What is the dollar cost of using a forward hedge? Make sure you state your position in the forward contract. (4 marks)
- What is the cost if you decided to use money markets to hedge against the $XX of payable in 90 days?
- What is the cost of an option hedge at the time the payment is due assuming you exercise the option when the payment is due. (6 marks)
- Based on the answers in (a), (b), and (c), which hedging methods should your firm choose?
(4 marks) Question 2 (15 marks)
You work for a large bank which provides funding for a number of firms across Europe. Gauging the funding demand from clients, you have identified some interest-rate swap opportunities that could potentially lower their borrowing costs. The following table provides information about the funding costs for two of your clients ABC and TLP:
|ABC||12%||LIBOR + 2%|
|TLP||13.5%||LIBOR + 2.5%|
While ABC prefers to borrow in the variable-rate market, TLP’s preference is to borrow in the fixed-rate market. You propose an interest-rate swap deal to your clients. ABC is particularly unimpressed with your proposal. They argue that an interest rate swap with TLP is a disaster and only benefits TPL because ABC can borrow at both fixed and variable debt at more attractive rates than TLP.
- Explain to ABC why they might benefit from the swap. Make sure that your explanation includes the discussion about the absolute and comparative advantages and the potential
savings from the interest rate swap deal? (5 marks)
- Now show both clients that the interest rate swap will work by completing the diagram below with the following assumptions: 1) ABC will have 50% of the potential savings, and TLP will receive the rest 2) To maintain long-term relationship with both clients, the bank will not receive any commission from the current swap. Not that you can have multiple
correct answers. (10 marks)
v LIBOR (floating rate) must be used in the transaction between ABC and TLP companies i.e. either transaction (iii) or (iv).
Question 3 (15 marks)
Seeking Beta is an investment asset manager based in China. Recognizing Australia as a potential market for diversification, the fund invested RMB100 mil to buy Australian shares two years ago. The exchange rate was RMB7.00/AUD. The Australian equity market performed well since then from 5000 to 7000 points. The current exchange rate is RMB5.00/AUD. The fund exited the position to capitalise that gain. They sold the Australian shares at 7000 points.
- Determine the percentage return from this investment in Australian dollars. Show all workings. (4 marks)
- Compute the rate of return on your investment in RMB terms. Show all workings.
(6 marks) C) What are channels that contribute to your investment risk? (Hint: Think about the
variance of your investment) (5 marks)
Question 4 (15 marks)
ABC Ltd. considers to issue $100mil debts to fund a potential acquisition of DEF Ltd.. ABC decides to hire Macquarie Bank as their lead underwriter. Macquarie Bank proposes three options.
- ABC can raise the capital in the Australian domestic bond market. The coupon rate is 5% p.a.. The coupon is paid semi-annually. The bond will mature in 3 years. The underwriting fees is 0.85% of the issue size.
- Alternatively, ABC can tap into the Eurobond market. The Euro-bonds also have three years to maturity. The annual coupon payment is slightly higher at 5.25% p.a. Macquarie has a reputation in this market so the underwriting fees is lower at 0.65%.
- Finally, ABC can issue two-year Dim-Sum bonds in China with a coupon rate of 5.5% paid annually. The underwriting fee is 0.75%.
Based on All-in cost method, which bond should ABC Ltd. choose? (15 marks) Question 5 (25 marks)
Textla Ltd. (TXLA), an Australian firm, wishes to expand its electric car operations to East Asia as fierce competition has significantly affect demands across Europe. They plan to enter the East Asia markets through Malaysia. The plant expansion cost is RM 80mil which must be immediately expended. Moreover, TXLA would have to fund additional working capital of RM 5mil at the time of the expansion. Further investment in net working capital would be RM 5mil, RM 8mil, and RM 10mil in year 1, 2, and 3 respectively. TXLA will depreciate the plant at a rate of RM 4mil per year (starting in year 1) and will have to fund additional capital expenditures of RM 8mil per year to maintain and improve the plant. Although the project is assumed to have an infinite life, cash-flows are only projected up to three years and the terminal value of the project is computed based on the year 3 free cash-flow (FCF) assuming a growth rate that equals the Malaysian longrun GDP growth rate. The Earnings before Interests, Taxes, Depreciation and Amortisation (EBITDA) are projected to be $35mil, $45mil, and $55mil for year 1, year 2, and year 3, respectively.
All taxes are paid in Malaysia in the year the income is earned. Tax treaties are in effect so that TXLA will have no tax obligations to the Australian Tax Office (ATO). The following information applies to the valuation.
|Annual return on government bonds||2.00%||4.00%|
|Corporate tax rate||30.00%||40.00%|
|Equity market risk premium AUD||5.00%|
|Before tax cost of debt||6.00%|
|Debt-to-value ratio (D/V)||0.3|
|Systematic risk (beta)||1.2|
|Malaysian long-run GDP growth rate||3.00%|
- Calculate the cost of capital, in Australia, for the project. (4 marks)
- Calculate the forward exchange rates, F1(AUD/RM) through F3(AUD/RM), for the years 1, 2, and 3 based on the spot rate and the interest rates given in the question. (round to 5 decimal places) (3 marks)
- Calculate the Free of Cash Flows of the project in RM from year 1 to year 3.
- What is the terminal value as of year 3? Use a perpetuity formula, the Free Cash Flows in RM for year 3, and the Malaysian growth rate assumption given in the question. Assume the appropriate discount rate is WACC. (3 marks)
- Calculate the AUD value of FCF for the years 0, 1, 2 and 3 and the terminal value using the forward rates calculated in (b). (5 marks)
- What is the NPV of the project from TXLA’s perceptive (in AUD)? Should TXLA expand into the Asian market? (3 marks)