FIN 535 Week 10 Homework

14. Letters of Credit. Ocean Traders of North America is a firm based in Mobile, Alabama, that
specializes in seafood exports and commonly uses letters of credit (L/Cs) to ensure payment. It recently
experienced a problem, however. Ocean Traders had an irrevocable L/C issued by a Russian bank to
ensure that it would receive payment upon shipment of 16,000 tons of fish to a Russian firm. This bank
backed out of its obligation, however, stating that it was not authorized to guarantee commercial
transactions.

a. Explain how an irrevocable L/C would normally facilitate the business transaction between the
Russian importer and Ocean Traders of North America (the U.S. exporter).
The letter of credit was issued by a Russian bank to guarantee payment for the goods to be exported by
the U.S. exporter.
b. Explain how the cancellation of the L/C could create a trade crisis between the U.S. and Russian
firms.
If exporting firms cannot rely on letters of credit, they must resort to trusting the counterparty in the
trade agreement. This will reduce trade, because exporters frequently do not know much about the
counterparty.
c. Why do you think situations like this (the cancellation of the L/C) are rare in industrialized
countries?
Governments or regulators have a vested interest in ensuring that banks follow through on letters of
credit. Otherwise, there would be a reluctance to conduct trade in any country that does not back its
guarantees.
d. Can you think of any alternative strategy that the U.S. exporter could have used to protect itself
better when dealing with a Russian importer?
The U.S. exporter could have attempted to obtain a letter of credit from a U.S. bank, with the
responsibility placed on the U.S. bank to guarantee payment. In this case, the U.S. bank would have
been put in a position to demand payment from the Russian importer or the importers Russian bank.

Small Business Dilemma

Ensuring Payment for Products Exported by the Sports Exports Company

1. How could Jim use a letter of credit to ensure that he will be paid for the products he
exports?

A letter of credit could be issued by a bank on behalf of the distributor promising to pay the Sports
Exports Company upon presentation of shipping documents. In this way, the letter of credit substitutes
its credit standing for that of the distributor.

2. Jim has discussed the possibility of expanding his export business through a second sporting
goods distributor in the United Kingdom; this second distributor would cover a different
territory than the first distributor. This second distributor is only willing to engage in a
consignment arrangement when selling footballs to retail stores. Explain the risk to Jim
beyond the typical types of risk he incurs when dealing with the first distributor. Should Jim
pursue this type of business?

With a consignment arrangement, the Sports Exports Company would retain title to the merchandise.
Thus, it would not receive payment until after the second distributor sold the footballs. Also, even if the
second distributor does sell the footballs but fails to pay for them, the Sports Exports Company has
limited recourse. Jim should probably avoid the consignment arrangement because of the risk involved.



15. Probability Distribution of Financing Costs. Missoula, Inc., decides to borrow Japanese yen for
one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following
probability distribution for the yens degree of fluctuation against the dollar:

Possible Degree of
Fluctuation of Percentage
Yen Against the Dollar Probability
4% 20%
1% 30%
0% 10%
3% 40%

Given this information, what is the expected value of the effective financing rate of the Japanese
yen from the U.S. corporations perspective?



Japanese
Interest Rate

Possible %
Change in
Yen Value
Effective
Financing Rate
Based on
That Change



Probability


Computation of
Expected Value
8%
4%

3.68%
20%
.736%
8%
1%

6.92%
30%
2.076%
8%
0%

8.00%
10%
.800%
8%
3%

11.24%
40%
4.496%

8.108%

Expected value = 8.108%

16. Analysis of Short-term Financing. Jacksonville Corp. is a U.S.-based firm that needs $600,000.
It has no business in Japan but is considering one-year financing with Japanese yen, because the
annual interest rate would be 5 percent versus 9 percent in the United States. Assume that interest rate
parity exists.
a. Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen one
year forward to avoid exchange rate risk? Explain.
If Jacksonville borrows yen and simultaneously purchases yen one year forward, it will pay a forward
premium that will offset the interest rate differential (given that interest rate parity exists). Based on
interest rate parity, the forward premium is about 3.8%. The effective financing rate would be:
(1 + 5%)(1 + 3.8%) 1 = about 9%

b. Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the
future spot rate. Determine the expected effective financing rate. Should Jacksonville finance with
Japanese yen? Explain.

If it does not cover the exposure but uses the forward rate as a forecast, the expected percentage
change in the Japanese yens value is about 3.8 percent. Thus, the expected effective financing rate is
9%. Jacksonville should therefore finance with dollars rather than Japanese yen, since the expected cost
of financing with dollars is not higher.

c. Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will
appreciate by either 5 percent, 3 percent, or 2 percent, and with equal probability of each
occurrence. Use this information to determine the probability distribution of the effective financing
rate. Should Jacksonville finance with Japanese yen? Explain.

Possible % Effective Financing
Change in Spot Rate of JY if that
Rate of JY Percentage Change Occurs Probability
5% (1.05)(1.05) 1 = 10.25% 33.3%
3% (1.05)(1.03) 1 = 8.15 33.3%
2% (1.05)(1.02) 1 = 7.10 33.3%

Given the probability, there is about a 67 percent chance that financing with Japanese yen will
be less costly than financing with dollars. The choice of financing with yen or dollars in this case is
dependent on Jacksonvilles degree of risk aversion.

17. Financing With a Portfolio. Pepperdine, Inc., considers obtaining 40 percent of its one-year
financing in Canadian dollars and 60 percent in Japanese yen. The forecasts of appreciation in the
Canadian dollar and Japanese yen for the next year are as follows:

Probability
Possible Percentage of that Percentage
Change in the Spot Change in the
Currency Rate Over the Loan Life Spot Rate Occurring
Canadian dollar 4% 70%
Canadian dollar 7 30
Japanese yen 6 50
Japanese yen 9 50

The interest rate on the Canadian dollar is 9 percent, and the interest rate on the Japanese yen
is 7 percent. Develop the possible effective financing rates of the overall portfolio and the probability of
each possibility based on the use of joint probabilities.

Effective
Financing
Interest Possible Rate Based on
Currency Rate % Change that Change Probability
Canadian dollar 9% 4% 13.36% 70%
Canadian dollar 9 7 16.63 30
Japanese yen 7 6 13.42 50
Japanese yen 7 9 16.63 50

Possible Joint
Effective
Financing Rate Joint Effective Financing
C$ JY Probability Rate of Portfolio
13.36% 13.42% (70%)(50%) = 35% .4(13.36%) + .6(13.42%) = 13.396%
13.36 16.63 (70%)(50%) = 35% .4(13.36%) + .6(16.63%) = 15.322%
16.63 13.42 (30%)(50%) = 15% .4(16.63%) + .6(13.42%) = 14.704%
16.63 16.63 (30%)(50%) = 15% .4(16.63%) + .6(16.63%) = 16.630%

Thus, there is a 35% probability that the portfolios effective financing rate will be 13.396%, and
so on.

18. Investing in a Portfolio. Pittsburgh Co. plans to invest its excess cash in Mexican pesos for one
year. The one-year Mexican interest rate is 19%. The probability of the pesos percentage change in
value during the next year is shown below:

Possible Rate of Change
in the Mexican Peso Over Probability of
the Life of the Investment Occurrence
15% 20%
4% 50%
0% 30%

What is the expected value of the effective yield based on this information? Given that the U.S.
interest rate for one year is 7%, what is the probability that a one-year investment in pesos will generate
a lower effective yield than could be generated if Pittsburgh Co. simply invested domestically?

Effective Yield if this
Possible Rate of Rate of Change in the
Change in Peso Probability Peso Does Occur
15% 20% (1.19) [1 + (15%)] 1 = 1.15%
4% 50% (1.19) [1 + (4%)] 1 = 14.24%
0% 30% (1.19) [1 + (0%)] 1 = 19.00%


E(r) = 20% (1.15%) + 50% (14.24%) + 30% (19.00%)
= 0.23% + 7.12% + 5.70%
= 13.05%

There is a 20% probability that the pesos effective yield will be less than the domestic yield.


Small Business Dilemma

Cash Management at the Sports Exports Company

1. If Jim invests the excess cash in U.S. Treasury bills, would this reduce the firms exposure to
exchange rate risk?
No. At the present time, the Sports Exports Company receives more pounds than it uses. If it converts
the pounds into dollars to buy U.S. Treasury bills, it remains highly exposed to the exchange rate risk
(because it is not offsetting the pound inflows with pound outflows).

2. Jim decided to use the excess cash to pay off the British loan. However, a friend advised him to
invest the cash in British Treasury bills, stating that the loan provides an offset to the pound
receivables, so you would be better off investing in British Treasury bills than paying off the
loan. Is Jims friend correct? What should Jim do?
Jims friend is incorrect. By investing in British Treasury bills, Jim would not be any less exposed to the
future value of the British pound than if he pays off part of the British loan. Furthermore he would be
earning the British Treasury bill rate on the cash, while paying 3 percentage points higher on the British
loan. He would be better off paying off part of the loan.