9602 in Fin Solve

Chapter 1
Financial Goals and Corporate Governance

T Questions
Tridents globalization
1.
After reading the chapters description of Tridents globalization process, how would you explain the
distinctions between international, multinational, and global companies.
The difference in definitions for these three terms is subjective, with different writers using different
terms at different times. No single definition can be considered definitive, although as a general
matter the following probably reflect general usage.
International simply means that the company has some form of business interest in more than one
country. That international business interest may be no more than exporting and importing, or it may
include having branches or incorporated subsidiaries in other countries. International trade is usually
the first step in becoming international, but the term also encompasses foreign subsidiaries created
for the single purpose of marketing, distribution, or financing. The term international is also used to
encompass what are defined as multinational and global below.
Multinational is usually taken to mean a company that has operating subsidiaries and performs a full
set of its major operations in a number of countries; i.e., in many nations. Operations in this
context includes both manufacturing and selling, as well as other corporate functions, and a
multinational company is often presumed to operate in a greater number of countries than simply an
international company. A multinational company is presumed to operate with each foreign unit
standing on its ownalthough that term does not preclude specialization by country and/or
supplying parts from one country operation to another.
Global is a newer term which essentially means about the same as multinational; i.e., operating
around the globe. Global has tended to replace other terms because of its use in demonstrators at the
international meetings (global forums?) of the International Monetary Fund and World Bank that
took place in Seattle in 1999 and Rome in 2001. Terrorist attacks on the World Trade Center and the
Pentagon in 2001 led politicians to refer to the need to eliminate global terrorism.
Trident, the MNE

2.
At what point in the globalization process did Trident become a multinational enterprise (MNE)?
Trident became a multinational enterprise (MNE) when it began to establish foreign sales and service
subsidiaries, followed by creation of manufacturing operations abroad or by licensing foreign firms to
produce and service Tridents products. This multinational phase usually follows the international
phase, which involved the import and/or export of goods and/or services.
Moffett Fundamentals of Multinational Finance, Second Edition
Tridents advantages
3.
What are the main advantages that Trident gains by developing a multinational presence?
(a) Entry into new markets, not currently served by the firm, which in turn allow the firm to grow
and possibly to acquire economies of scale.
(b) Acquisition of raw materials, not available elsewhere.
(c) Achievement of greater efficiency, by producing in countries where one or more of the factors of
production are underpriced relative to other locations.
(d) Acquisition of knowledge and expertise centered primarily in the foreign location.
(e) Location of the firms foreign operations in countries deemed politically safe.
Tridents phases
4.
What are the main phases that Trident passed through as it evolved into a truly global firm? What are
the advantages and disadvantages of each?
(a) International trade. Two advantages are finding out if the firms products are desired in the
foreign country and learning about the foreign market. Two disadvantages are lack of control
over the final sale and service to final customer (many exports are to distributors or other types of
firms that in turn resell to the final customer) and the possibility that costs and thus final
customer sales prices will be greater than those of competitors that manufacture locally.
(b) Foreign sales and service offices. The greatest advantage is that the firm has a physical presence
in the country, allowing it great control over sales and service as well as allowing it to learn more
about the local market. The disadvantage is the final local sales prices, based on home country
plus transportation costs, may be greater than competitors that manufacture locally.
(c) Licensing a foreign firm to manufacture and sell. The advantages are that product costs are based
on local costs and that the local licensed firm has the knowledge and expertise to operate
efficiently in the foreign country. The major disadvantages are that the firm might lose control of
valuable proprietary technology and that the goals of the foreign partner might differ from those
of the home country firm. Two common problems in the latter category are whether or not the
foreign firm (that is manufacturing the product under license) is a shareholder wealth or
corporate wealth maximizer, which in turn often leads to disagreements about reinvesting earning
to achieve greater future growth versus making larger current dividends to owners and payments
to other stakeholders.
(d) Part ownership of a foreign, incorporated, subsidiary; i.e., a joint venture. The advantages and
disadvantages are similar to those for licensing: Product costs are based on local costs and that
the local joint owner presumably has the knowledge and expertise to operate efficiently in the
foreign country. The major disadvantages are that the firm might lose control of valuable
proprietary technology to its joint venture partner, and that the goals of the foreign owners might
differ from those of the home country firm.
(e) Direct ownership of a foreign, incorporated, subsidiary. If fully owned, the advantage is that the
foreign operations may be fully integrated into the global activities of the parent firm, with
products resold to other units in the global corporate family without questions as to fair transfer
prices or too great specialization. (Example: the Ford transmission factory in Spain is of little use
as a self-standing operation; it depends on its integration into Fords European operations.) The
disadvantage is that the firm may come to be identified as a foreign exploiter because
politicians find it advantageous to attack foreign owned businesses.
Chapter 1
Corporate goals: shareholder wealth maximization

5.
Explain the assumptions and objectives of the shareholder wealth maximization model.
The Anglo-American markets are characterized by a philosophy that a firms objective should be to
maximize shareholder wealth. Anglo-American is defined to mean the United States, United
Kingdom, Canada, Australia, and New Zealand. This theory assumes that the firm should strive to
maximize the return to shareholdersthose individuals owning equity shares in the firm, as measured
by the sum of capital gains and dividends, for a given level of risk. This in turn implies that
management should always attempt to minimize the risk to shareholders for a given rate of return.
Corporate goals: corporate wealth maximization

6.
Explain the assumptions and objectives of the corporate wealth maximization model.
Continental European and Japanese markets are characterized by a philosophy that all of a
corporations stakeholders should be considered, and the objective should be to maximize corporate
wealth. Thus a firm should treat shareholders on a par with other corporate stakeholders, such as
management, labor, the local community, suppliers, creditors, and even the government. The goal is
to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for
the benefit of all. This model has also been labeled the stakeholder capitalism model.
Corporate governance
7.
Define the following terms:

(a) Corporate governance Corporate governance is the control of the firm. It is a broad operation
concerned with choosing the board of directors and with setting the long run objectives of the
firm. This means managing the relationship between various stakeholders in the context of
determining and controlling the strategic direction and performance of the organization.
Corporate governance is the process of ensuring that managers make decision in line with the
stated objectives of the firm.
Management of the firm concerns implementation of the stated objectives of the firm by
professional managers employed by the firm. In theory managers are the employees of the
shareholders, and can be hired or fired as the shareholders, acting through their elected board,
may decide. Ownership of the firm is that group of individuals and institutions which own shares
of stock and which elected the board of directors.
(b) The market for corporate control The relationship among stakeholders used to determine and
control the strategic direction and performance of an organization is termed corporate
governance. The corporate governance of the organization is therefore the way in which order
and process is established to ensure that decisions are made and interests are representedfor all
stakeholdersproperly.
(c) Agency theory In countries and cultures in which the ownership of the firm has continued to
be an integral part of management, agency issues and failures have been less a problem. In
countries like the United States, in which ownership has become largely separated from
management (and widely dispersed), aligning the goals of management and ownership is much
more difficult.
(d) Stakeholder capitalism The philosophy that all of a corporations stakeholders should be
considered, and the objective should be to maximize corporate wealth. Thus a firm should treat
shareholders on a par with other corporate stakeholders, such as management, labor, the local
community, suppliers, creditors, and even the government. The goal is to earn as much as
possible in the long run, but to retain enough to increase the corporate wealth for the benefit of
all. This model has also been labeled the stakeholder capitalism model.
Operational goals
8.
What should be the primary operational goal of an MNE?

Financial goals differ from strategic goals in that the former focus on money and wealth (such as the
present value of expected future cash flows.). Strategic goals are more qualitativeoperating
objectives such as growth rates and/or share-of-market goals.
Tridents strategic goals are the setting of such objectives as degree of global scope and depth of
operations. In what countries should the firm operate? What products should be made in each
country? Should the firm integrate its international operations or have each foreign subsidiary operate
more or less on its own? Should it manufacture abroad through wholly owned subsidiaries, through
joint ventures, or through licensing other companies to make its products? Of course, successful
implementation of these several strategic goals is undertaken as a means to benefit shareholders
and/or other stakeholders.
Tridents financial goals are to maximize shareholder wealth relative to a risk constraint and in
consideration of the long-term life of the firm and the long-term wealth of shareholders. I.e., wealth
maximization does not mean short term pushing up share prices so executives can execute their
options before the company crashesa consideration that must be made in the light of the Enron
scandals.
Knowledge assets
9.
Knowledge assets are a firms intangible assets, the sources and uses of its intellectual talentits
competitive advantage. What are some of the most important knowledge assets that create
shareholder value?
The definition of corporate wealth is much broader than just financial wealth. It includes the firms
technical, market, and human resources. This means that a MNE that believes it must close a
manufacturing facility in Stuttgart, Germany, and shift its operations to Penang, Malaysia, may not
do so without considering the employment and other social impacts on the Stuttgart community. As
one study put it, [Corporate wealth] goes beyond the wealth measured by conventional financial
reports to include the firms market position as well as the knowledge and skill of its employees in
technology, manufacturing processes, marketing and administration of the enterprise.
Labor unions
10. In Germany and Scandinavia, among others, labor unions have representation on boards of directors
or supervisory boards. How might such union representation be viewed under the shareholder wealth
maximization model compared to the corporate wealth maximization model?
Labor union representation required by statute is an example of governmental direction toward the
corporate wealth maximization (CWM) model, in that such a requirement is intended to make the
board responsive to stakeholders other than owners. Under the CWM model, such a statute would be
viewed favorably, while under the SWM model such a statute would be viewed as undue interference
in the right of owners to manage the assets into which they alone have invested money.
Chapter 1
Interlocking directorates
11. In an interlocking directorate members of the board of directors of one firm also sit on the board of
directors of other firms. How would interlocking directorates be viewed by the shareholder wealth
Interlocking directorates allow firms, via intertwined management and governance, to cooperate
and/or collude. A simple answer along corporate wealth maximization (CWM) or stockholder wealth
maximization (SWM) lines is not so easy here. Many countries characterized by the CWM model,
such as Germany and Japan, allow interlocking directorates so that all stakeholders will be
represented. SWM countries, such as the United States, often prohibit interlocking directorates on the
premise they may stifle unfettered competition because decision may be based on friendships,
influence, or promises of reciprocity. Crony capitalism is a term often used to describe economic
systems where decisions are frequently based on friendships, influence, or promises of reciprocity.
Leveraged buyouts
12. A leveraged buyout is a financial strategy in which a group of investors gain voting control of a firm
and then liquidate its assets in order to repay the loans used to purchase the firms shares. How would
leveraged buyouts be viewed by the shareholder wealth maximization model compared to the
corporate wealth maximization model?
A leveraged buyout is perceived in a country that believes in corporate wealth maximization (CWM)
as generally irresponsible. The liquidation of assets, often at market prices that do not reflect the
value of the activity to workers and their communities, is not consistent with the CWM philosophy.
Those believing in shareholder wealth maximization (SWM) argue that if the selling shareholders
the initial owners of the firmare paid a price for their shares that is higher than the market as a
result of the leveraged buyout, the market forces which are so important for competition and growth
are allowed to work. Additionally the selling shareholders now have more capital to freely invest in
other ventures, in turn creating more jobs and attendant benefits.
High leverage
13. How would a high degree of leverage (debt/assets) be viewed by the shareholder wealth
High leverage increases both the risk of corporate bankruptcy and the possibility of a greater rate of
return for shareholders. The corporate wealth maximization (CWM) model looks askance at higher
leverage because any benefits will flow only to shareholders, while other stakeholders (such as labor)
will bear the brunt of the risk should the company go bankrupt because of the fixed financial costs of
disproportionately high debt. Under the shareholder wealth maximization (SWM) model, the decision
on the degree of leverage resides with the owners as represented by the board, and the tradeoff
between risk and return is presumably based on their risk-return preferences. Under modern financial
theory, the risk-return attributes of a single company are meaningful only in the context of the
contribution that company makes to a diversified portfolio.
Conglomerates
14. Conglomerates are firms that have diversified into unrelated fields. How would a policy of
conglomeration be viewed by the shareholder wealth maximization model compared to the corporate
wealth maximization model?
Conglomerates created to achieve diversification are presumably looked upon more favorably in
countries tied to the corporate wealth maximization (CWM) model because the greater size of the
conglomerate means the business entity in its entirety is larger; i.e., has greater wealth and is possibly
less vulnerable to competition or takeover by another firm. Worker jobs are safer. An offsetting
argument is that firms in CWM countries with interlocking directorates can act as if they were
conglomerates, even though structurally they are not.
Under the shareholder wealth maximization (SWM) model, conglomerates created to achieve
diversification are formed only when the owners alone believe that synergies will come about
because of the consolidation. Critics of conglomerates in SWM countries point out that shareholders
can achieve unique diversification in their own portfolios without conglomerate diversification being
forced upon them. Additionally an argument is sometimes made that management skilled in one
type of economic activity may be quite incapable in another type of activity, and that consequently
conglomerates may perform less well overall than would a portfolio composed of the no-longerexisting separate constituent companies.
Risk
15. How is risk defined in the shareholder wealth maximization model compared to the corporate wealth
maximization model?
Shareholder Wealth Maximization (SWM) firms usually consider risk as a constraint on seeking to
maximize current earnings. In an operational context for managers, risk is usually taken to be the
expected variability for earnings over a period of future years. In a more specific portfolio sense for
investors (as distinct from managers), risk in SWM countries is the added systematic risk that the
firms shares bring to a diversified portfolio. Unsystematic risk, the risk of the individual security, can
be eliminated through portfolio diversification by the investors. Thus unsystematic risk is not be a
prime concern for management unless it increases the prospect of bankruptcy. Systematic risk, the
risk of the market in general, cannot be eliminated.
Corporate Wealth Maximization (CWM) firms define risk in a much more qualitative sense. The term
patient capital is sometimes used to imply that only performance over a very long term is of
concern. In addition, the much greater array of stakeholders with divergent interests implies that some
sort of consensus must be reached before a decision is made that might negatively impact one of the
set of stakeholderseven if other sets of stakeholders gain.
Stock options
16. How would stock options granted to a firms management and employees be viewed by the
shareholder wealth maximization model compared to the corporate wealth maximization model?
Stock options are used in Shareholder Wealth Maximizing firms to align the interests of managers
with those of shareholders, in the belief that those managers will then make decisions which will
enhance the wealth of all stockholders, including those executives. Of course, those executives are
punished (financially) if the firm they manage fails to increase in market value.
Stock options to managers in Corporate Wealth Maximizing firms are unlikely, because they seek to
cause managers to act to benefit the shareholders without, necessarily, benefitting the array of other
stakeholders in the firm.
Chapter 1
Shareholder dissatisfaction
17. If shareholders are dissatisfied with their company what alternative actions can they take?
Disgruntled shareholders may:
(a) Remain quietly disgruntled. This puts no pressure on management to change its ways under both
the Shareholder Wealth Maximization (SWM) model and the Corporate Wealth Maximization
(CWM) model.
(b) Sell their shares. Under the SWM model, this action (if undertaken by a significant number of
shareholders) drives down share prices, making the firm an easier candidate for takeover and the
probable loss of jobs among the former managers. Under the CWM model, management can
more easily ignore any drop in share prices.
(c) Change management. Under the one-share, one-vote procedures of the SWM model, a concerted
group of shareholders can vote out existing board members if they fail to change management
practices. This usually takes the form of the board firing the firms president or chief operating
officer. Cumulative voting, which is a common attribute of SWM firms, facilitates the placing of
minority stockholder representation on the board. If, under the CWM model, different groups of
shareholders have voting power greater than their proportionate ownership of the company,
ousting of directors and managers is more difficult.
(d) Initiate a takeover. Under the SWM model it is possible to accumulate sufficient shares to take
control of a company. This is usually done by a firm seeking to acquire the target firm making a
tender offer for a sufficient number of shares to acquire a majority position on the board of
directors. Under the CWM model acquisition of sufficient shares to bring about a takeover is
much more difficult, in part because non-shareholder stakeholder wishes are considered in any
board action. (One can argue as to whether the long-run interests of non-shareholding
stakeholders are served by near-term avoidance of unsettling actions.) Moreover, many firms
have disproportionate voting rights because of multiple classes of stock, thus allowing entrenched
management to remain.
Dual classes of common stock
18. In many countries it is common for a firm to have two or more classes of common stock with
differential voting rights. In the United States the norm is for a firm to have one class of common
stock with one-share-one-vote. What are the advantages and disadvantages of each system?
A variety of arguments exist as to why Europeans allow this differential in voting rights. In some
countries it is believed that ordinary individual shareholders are not qualified to influence business
decisions. The average share-owning individual investor is presumed to be neither business-oriented
nor knowledgeable about the business and prospects for the firm in which shares are owned. Hence
they are not sufficiently informed to be trusted with influence of the selection of directors or other
important corporate issues. Dual classes of stock allow one class (the informed professional) to
control the company while the second class (the uninformed amateur) to provide capital and reap
ownership rewards but not have a chance to mess up the company by having power over decisions.
A second reason for dual classes of stock is that takeover bids by other companies are made more
difficult because the acquiring company would have to purchase the class of stock that has voting
power, which class is usually held or controlled by existing management. Hence the job tenure of
existing management is made more secure, even if they do not perform well and the value of shares
in the market drops.
Emerging markets corporate governance failures

19. It has been claimed that failures in corporate governance have hampered the growth and profitability
of some prominent firms located in emerging markets. What are some typical causes of these failures
in corporate governance?
Causes include lack of transparency, poor auditing standards, cronyism, insider boards of directors
(especially among family-owned and operated firms), and weak judicial systems.
Emerging markets corporate governance improvements
20. In recent years emerging market MNEs have improved their corporate governance policies and
become more shareholder-friendly. What do you think is driving this phenomenon?
It is driven by the need to access global capital markets. The depth and breadth of capital markets is
critical to the evolution of corporate governance practices. Country markets which have had relatively
slow growth, as in the emerging markets, or have industrialized rapidly utilizing neighboring capital
markets (as is the case of Western Europe), may not form large public equity market systems.
Without significant public trading of ownership shares, high concentrations of ownership are
preserved and few disciplined processes of governance developed.
T Mini-Case: The Failure of Corporate Governance at Enron

1.
Which parts of the corporate governance system, internal and external, do you believe failed Enron
the most?
The failures at Enron were so wide and deep, it is difficult to say which failed most. If pushed, it
might be argued that the massive failures and internal culture of accounting earnings and selfenrichment at all costs led to a contagion of the external. Because many of Enrons businesses such as
power trading fell between the cracks of many regulatory systems, some failures were inevitable. In
other cases, however, such as with its auditors and the debt and equity markets, the failures were in
many cases related to the self-enrichment and profits at all costs culture from within.
2.
Describe how you think each of the individual stakeholders and components of the corporate
governance system should have either prevented the problems at Enron or acted to resolve the
problems before they reached crisis proportions.
The chief internal officersand the culture they createdare in many peoples opinions that primary
cause of many of the problems at Enron. The CEO and other senior management team members are
typically those held most visibly responsible for creating solid and sustainable value for the firm, as
well as serving as the premier examples of the companys global ethics. The second major internal
unit, the corporate Board, could also be seen as extremely deficient in their due diligence of many of
the practices of the firm. In a number of cases the Board literally knew it was breaking its own rules
and corporate code of conduct, but decided very cavalierly to ignore them.
In terms of the many external constituents to Enrons corporate governance structurethe debt
markets, the equity markets and their analysts, the auditors, the law firms, the regulators for both
Enrons industry and its investors of all kindsall could simply have done their job with less conflict
of interest. In nearly each and every case (the possible exceptions are most of the regulatory agencies
which are generally hindered by law or budget from pursuing their duties as possibly needed), these
external constituents had more to gain from Enrons business and new business than from the conduct
of their own due diligence.
Chapter 1
3.
If all publicly-traded firms in the United States are operating within the same basic corporate
governance system as Enron, why would some people believe this was an isolated incident, and not
an example of many failures to come?
In fact, it appears that much of American society did indeed believe the Enron (and Worldcom, and
HealthSouth) was an indication of things to come. This is most likely why Sarbanes-Oxley and a
number of other rather extraordinary measures were taken in the years following the Enron collapse.
Given how visible Enron was, particularly during its glory years, many experts have argued that
Enron would be followed by many other similar corporate governance failures as a variety of the
weaknesses in the current system continued to be exploited.
Ironically, there is now a growing debate as to whether the cure is worse than the illness. Many senior
executives today argue that the costs associated with Sarbanes-Oxley compliance (among other
measures) will result in many firms moving toward private ownership, and at the least, some of the
truly talented people in business moving towards the private-ownership sector to avoid many of the
personal liabilities of being an officer in a publicly traded company.
10
T Problems
Problem 1.1 Shareholder returns
What are the shareholders returns?
Assumptions
Share price, P1
Share price, P2
Dividend paid, D2
Value
$16.00
$18.00
a. If the company paid no dividend (plugging zero in for the dividend):

Return = (P2 P1 + D2)/(P1)
Assumptions
Share price, P1
Share price, P2
Dividend paid, D2
b. Total shareholder return, including dividends, is:
Return = (P2 P1 + D2)/(P1)
12.500%
Value
$16.00
$18.00
$1.00
18.750%
Chapter 1
Problem 1.2 Shareholder choices

Assumptions
Share price, P1
Share price, P2
Dividend paid, D2
b. Total shareholder return for the period is
Return = (P2 P1 + D2)/(P1)
Value
$62.00
$74.00
$2.25
22.98%
The shares expected return of 22.98% far exceeds the required return
by Mr. Fong of 12%. He should therefore make the investment.
11
12
What would the return have been on Microsoft shares if it had paid a constant dividend in the recent past?
Assumptions
1998 (January 2)
1999 (January 4)
2000 (January 3)
2001 (January 2)
2002 (January 2)
2003 (January 2)
Closing
Share
Price
$131.13
$141.00
$116.56
$43.38
$67.04
$53.72
a. Average shareholder return for the period is

Return = (P2 P1)/(P1)
b. Total shareholder return if Microsoft had paid a constant dividend:
Return = (P2 P1 + D)/(P1)
If
Dividend
Paid
Shareholder
Return
(without Div)
Shareholder
Return
(with Div)
$0.16
$0.16
$0.16
$0.16
$0.16
7.53%
17.33%
62.78%
54.54%
19.87%
7.65%
17.22%
62.65%
54.91%
19.63%
7.58%
7.39%
Problem 1.3 Microsofts dividend
Chapter 1
Problem 1.4 Dual Classes of Common Stock (A)

What are the implications for the distribution of voting rights and dividend distributions for Powlitz?
Powlitz Manufacturing
Long-term debt
Retained earnings
Paid-in common stock: 1 million A-shares
Paid-in common stock: 4 million B-shares
Total long-term capital
Local
Currency
(millions)
200
300
100
400
1,000
Votes per Share
Total Votes
10
1
1,000
400
1,400
100/1,000
10.00%
1,000/1,400
71.43%
100/(100 + 400)
20.00%
a. What proportion of the total long-term capital has been raised by A-shares?
A-shares/Total long-term capital
b. What proportion of voting rights is represented by A-shares?
A-share total votes/Total Votes
c. What proportion of the dividends should the A-shares receive?
A-shares in local currency/Total equity shares in local currency
13
14
Problem 1.5 Dual Classes of Common Stock (B)

What are the implications for the distribution of voting rights and dividend distributions for Powlitz?
Powlitz Manufacturing
Long-term debt
Retained earnings
Paid-in common stock: 1 million A-shares
Paid-in common stock: 4 million B-shares
Total long-term capital
Local Currency
(millions)
200
300
100
400
1,000
Votes per Share
Total Votes
10
1
1,000
400
1,400
a. What proportion of the total long-term capital has been raised by A-shares?
A-shares/Total long-term capital
100/1,000
10.00%
1,000/1,400
71.43%
100/(100 + 400)
20.00%
b. What proportion of voting rights is represented by A-shares?

A-share total votes/Total Votes
c. What proportion of the dividends should the A-shares receive?
A-shares in local currency/Total equity shares in local currency
Problem 1.6 Price/Earnings ratios and acquisitions
Company
P/E Ratio
Number
of Shares
Market
Value
per Share
Earnings
EPS
Total
Market
Value
20
40
10,000,000
10,000,000
$20.00
$40.00
$10,000,000
$10,000,000
$1.00
$1.00
$200,000,000
$400,000,000
Pharm-Italy
Pharm-USA
Rate of exchange: Pharm-USA shares per Pharm-Italy shares:

5,500,000
a. How many shares would Pharm-USA have outstanding after the acquisition of Pharm-Italy?
15,500,000
b. What would be the consolidated earnings of the combined Pharm-USA and Pharm-Italy?
Pharm-Italy earnings + Pharm-USA earnings
$20,000,000
c. Assuming the market continues to capitalize Pharm-USAs earnings at a P/E ratio of 40, what would be
the new market value of Pharm-USA?
$800,000,000
(Continued)
15
P/E Consolidated earnings = 40 $20,000,000
Because Pharm-Italy shares are worth$20 per share, they are only worth one-half the value per share of Pharm-USAs$40 per share.
So, on a straight exchange, 1 Pharm-USA share is worth 2 Pharm-Italy shares.
But, Pharm-USA also needs to pay a premium for gaining control of Pharm-Italy, so it pays an additional 10% over market.
So, Pharm-USA pays: 10 million divided by 2 (1 + 10% premium)
Chapter 1
10,000,000 + 5,500,000
16
d. What is the new earnings per share of Pharm-USA?

$20,000,000/15,500,000 shares
$1.29
e. What is the new market value of a share of Pharm-USA?

New market value/Total shares outstanding = $800,000,000/15,500,000
$51.61
f. How much did Pharm-USAs stock price increase?

Share price rose from$40.00 to$51.61.
Percentage increase
$11.61
29.03%
g. Assume that the market takes a negative view of the acquisition and lowers Pharm-USAs P/E ratio to 30.
What would be the new market price per share of stock? What would be its percentage loss?
New market value = Total earnings P/E = $20,000,000 30
New market price per share = total market value/shares outstanding =
Percentage loss to original Pharm-USA shareholders = ($38.71 $40.00)/($40.00)
$600,000,000
$38.71
3.23%
Problem 1.6 Price/Earnings ratios and acquisitions (Continued)
Problem 1.7 Corporate governance: Overstating earnings
Company
Pharm-Italy
Pharm-USA
P/E Ratio
Number
of Shares
Market
Value
per Share
Earnings
EPS
Total
Market
Value
20
40
10,000,000
10,000,000
$20.00
$20.00
$10,000,000
$5,000,000
$1.00
$1.00
$200,000,000
$200,000,000
To do the deal, Pharm-Italys shareholders need to be paid their market value plus a 10% premium, or
11,000,000 shares.
This 11 million shares would exceed Pharm-USAs existing shares outstanding, effectively giving Pharm-Italy control.
Therefore the acquistion would probably not take place.
At new market rates for Pharm-USA, this would require the offer of ($220 million/$20 per share)
$220,000,000
Chapter 1
If earnings were lowered to$5 million from the previously reported$10 million, could Pharm-USA still do the deal?
17
18
USA
(US$)
Brazil
(reais, R$)
Germany
(euros, E)
China
(renminbi, Rmb)
Earnings before taxes, EBT (local currency)

Less corporate income taxes
35%
Net profits of individual subsidiary
4,500.00
(1,575.00)
2,925.00
6,250.00
(1,562.50)
4,687.50
4,500.00
(1,800.00)
2,700.00
2,500.00
(750.00)
1,750.00
Avg exchange rate for the period (fc/$)

Net profits of individual subsidiary (US$)
$2,925.00
Consolidated profits (total across units)

Total diluted shares outstanding (000s)
$7,385.93
650.00
Business Performance (000s)
a. Consolidated earnings per share (EPS)
25%
3.5000
$1,339.29
40%
0.92600
$2,915.77
30%
8.5000
$205.88
$11.36
b. Proportion of total profits originating

by country
39.6%
c. Proportion of total profits originating

from outside the United States
60.4%
18.1%
39.5%
2.8%
Problem 1.8 Trident Corporations Consolidated Earnings
Problem 1.9 Tridents EPS Sensitivity to Exchange Rates

USA
Brazil
(US$)
4,500.00
35%
(1,575.00)
$2,925.00
$7,088.32
650.00
Baseline earnings per share (EPS)
1,750.00
4.5000
0.92600
8.5000
$1,041.67
$2,915.77
$205.88
Brazilian
Subsidiary
(US$)
(1,575.00)
2,925.00
$2,925.00

$7,013.32
650.00
Baseline earnings per share (EPS)
$11.36
b. If both the real and the earnings in
$10.79
German
Subsidiary
(reais, R$)
4,500.00
35%
(1,450.00)
Chinese
Subsidiary
(euros, E)
5,800.00
25%
4.0%
(renminbi, Rmb)
4,500.00
40%
(1,800.00)
2,500.00
30%
(750.00)
4,350.00
2,700.00
1,750.00
4.5000
0.92600
8.5000
$966.67
$2,915.77
$205.88
EPS has fallen 5 percent from baseline.
5.0%
Brazil fall, Tridents EPS is now:
(750.00)
Chapter 1
2,500.00
30%
2,700.00
EPS has fallen 4 percent from baseline.
$10.91
US Parent
Company
(1,800.00)
$11.36
a. If Brazilian real falls to R$4.50/$: EPS
(renminbi, Rmb)
4,500.00
40%
4,687.50
(1,562.50)
China
(euros, E)
6,250.00
25%
2,925.00
Germany
(reais, R$)
19
20
USA
(US$)

Consoldiated earnings per share (EPS)
Tax payments by country in US dollars
35%
4,500.00
(1,575.00)
2,925.00
$2,925.00
$7,385.93
650.00
$11.36
$1,575.00
a. Total global tax bill, US$
$4,053.51
b. What is Tridents effective tax rate?

EBT by country, US$
$4,500.00
Brazil
(real, R$)
25%
6,250.00
(1,562.50)
4,687.50
3.5000
$1,339.29
Germany
(euros, )
40%
4,500.00
(1,800.00)
2,700.00
0.92600
$2,915.77
China
(renminbi, Rmb)
30%
2,500.00
(750.00)
1,750.00
8.5000
$205.88
$446.43
$1,943.84
$88.24
$1,785.71
$4,859.61
$294.12
Consolidated EBT
$11,439.44
Total tax bill
$4,053.51
Effective tax rate
35.4%
c. What would be the impact on Tridents EPS and global effective tax rate if Germany instituted a tax cut to 28% and German subsidiary
earnings rose to 5 million euros?
After plugging in the new values, EPS is
$12.86
and the effective tax rate would be
30.2%
Problem 1.10 Tridents Earnings and Global Taxation
Chapter 2
The International Monetary System
T Questions
The gold standard and the money supply
1.
Under the gold standard all national governments promised to follow the rules of the game. This
meant defending a fixed exchange rate. What did this promise imply about a countrys money
supply?
A countrys money supply was limited to the amount of gold held by its central bank or treasury. For
example, if a country had 1,000,000 ounces of gold and its fixed rate of exchange was 100 local
currency units per ounce of gold, that country could have 100,000,000 local currency units
outstanding. Any change in its holdings of gold needed to be matched by a change in the number of
local currency units outstanding.
Causes of devaluation
2.
If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the
fixed exchange rate to be devalued?
The following macroeconomic variables could cause the fixed exchange rate to be devalued:
An interest rate that is too low compared to other competing currencies
A continuing balance of payments deficit
An inflation rate consistently higher than in other countries
Fixed versus flexible exchange rates

3.
What are the advantages and disadvantages of fixed exchange rates?
Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in
the growth of international trade and lessen risks for all businesses.
Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive
monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country
wishing to pursue policies that alleviate continuing internal economic problems, such as high
unemployment or slow economic growth.
22
Fixed exchange rate regimes necessitate that central banks maintain large quantities of
international reserves (hard currencies and gold) for use in the occasional defense of the fixed
rate. As international currency markets have grown rapidly in size and volume, increasing reserve
holdings has become a significant burden to many nations.
Fixed rates, once in place, may be maintained at rates that are inconsistent with economic
fundamentals. As the structure of a nations economy changes, and as its trade relationships and
balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to
happen gradually and efficiently, but fixed rates must be changed administrativelyusually too
late, too highly publicized, and at too large a one-time cost to the nations economic health.
The Impossible Trinity

4.
Explain what is meant by the term Impossible Trinity and what it implies.
Countries with floating rate regimes can maintain monetary independence and financial
integration but must sacrifice exchange rate stability.
Countries with tight control over capital inflows and outflows can retain their monetary
independence and stable exchange rate, but surrender being integrated with the worlds capital
markets.
Countries that maintain exchange rate stability by having fixed rates give up the ability to have
an independent monetary policy.
Currency board or dollarization

5.
Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or
dollarization (Ecuador). What is the difference between the two approaches?
In a currency board arrangement, the country issues its own currency but that currency is backed
100% by foreign exchange holdings of a hard foreign currencyusually the U.S. dollar. In
dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S.
dollar, for all domestic transactions.
Emerging market exchange rate regimes

6.
High capital mobility is forcing emerging-market nations to choose between free-floating regimes
and currency board or dollarization regimes. What are the main outcomes of each of these regimes
from the perspective of emerging market nations?
There is no doubt that for many emerging markets a currency board, dollarization, and freely-floating
exchange rate regimes are all extremes. In fact, many experts feel that the global financial
marketplace will drive more and more emerging market nations towards one of these extremes. As
illustrated by Exhibit 2.5, there is a distinct lack of middle ground left between rigidly fixed and
freely floating. In anecdotal support of this argument, a poll of the general population in Mexico in
1999 indicated that 9 out of 10 people would prefer dollarization over a floating-rate peso. Clearly,
there are many in the emerging markets of the world who have little faith in their leadership and
institutions to implement an effective exchange rate policy.
Chapter 2
23
Argentine currency board

7.
How did the Argentine currency board function from 1991 to January 2002 and why did it collapse?
Argentinas currency board exchange regime of fixing the value of its peso on a one-to-one basis with
the U.S. dollar ended for several reasons:
(a) As the U.S. dollar strengthened against other major world currencies, including the euro, during
the 1990s, Argentine export prices rose vis--vis the currencies of its major trading partners.
(b) This problem was aggravated by the devaluation of the Brazilian real in the late 1990s.
(c) These two problems, in turn, led to continued trade deficits and a loss of foreign exchange
reserves by the Argentine central bank. (4) This problem, in turn, led Argentine residents to flee
from the peso and into the dollar, further worsening Argentinas ability to maintain its one-to-one
peg.
The euro
8.
On January 4, 1999, 11 member states of the European Union initiated the European Monetary Union
(EMU) and established a single currency, the euro, which replaced the individual currencies of
participating member states. Describe three of the main ways that the euro affects the members of the
EMU.
The euro affects markets in three ways: (1) countries within the euro zone enjoy cheaper transaction
costs; (2) currency risks and costs related to exchange rate uncertainty are reduced; and (3) all
consumers and businesses both inside and outside the euro zone enjoy price transparency and
increased price-based competition.
24
Mavericks
9.
The United Kingdom, Denmark, and Sweden have chosen not to adopt the euro but rather to maintain
their individual currencies. What are the motivations of each of these three countries that are also
members of the European Union?
The United Kingdom chose not to adopt the euro because of the extensive use of the U.K. pound in
international trade and financial transactions. London is still the worlds most important financial
center. The British are also very proud of their long tradition in financial matters when Britannia
ruled the waves. They are afraid that monetary and financial matters may eventually migrate to
Frankfurt where the European Central Bank is located. The British are also worried about continued
concentration of decision making in Brussels where the main European Union institutions are located.
Denmark is also worried about losing its economic independence as a small country surrounded by
big neighbors. Denmarks currency, the krone, is mostly tied to the euro anyway, so it does not suffer
a misalignment with the primary currency unit of the surrounding economies. Sweden has strong
economic ties to Denmark, Norway, and the United Kingdom, none of which adopted the euro so far.
Sweden, like the others, are afraid of over concentration of power within European Union
institutions.
Despite popular fears and a certain amount of nationalism, all three countries have strong fores within
that would like these countries to adopt the euro. This would usually require popular referendums, so
you may see them adopt the euro in the future.
International Monetary Fund (IMF)

10. The IMF was established by the Bretton Woods Agreement (1944). What were its original
objectives?
The IMF was established to render temporary assistance to member countries trying to defend the
value of their currencies against cyclical, seasonal, or random occurrences. Additionally it was to
assist countries having structural trade problems. More recently it has attempted to help countries,
such as Russia, Brazil, Argentina, and Indonesia to resolve financial crises.
Special Drawing Rights
11. What are the Special Drawing Rights?
The Special Drawing Right (SDR) is an international reserve asset created by the IMF to supplement
existing foreign exchange reserves. It serves as a unit of account for the IMF and other international
and regional organizations, and is also the base against which some countries peg the exchange rate
for their currencies.
Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is
currently the weighted value of currencies of the five IMF members having the largest exports of
goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These
holdings are part of each countrys international monetary reserves, along with official holdings of
gold, foreign exchange, and its reserve position at the IMF. Members may settle transactions among
themselves by transferring SDRs.
Chapter 2
25
Definitions
12. Define the following currency terms:
(a) devaluation of a currency refers to a drop in foreign exchange value of a currency that is pegged
to gold or to another currency
(b) revaluation of a currency refers to an increase in foreign exchange value of a currency that is
pegged to gold or to another currency
(c) depreciation of a currency refers to a drop in the foreign exchange value of a floating currency
(d) appreciation of a currency refers to an increase in the foreign exchange value of a floating
currency
(e) soft or weak describes a currency that we expect to devalue or depreciate relative to other major
currencies
(f) hard or strong describes a currency that we expect to revalue or appreciate relative to other major
trading currencies
(g) eurodollar is a U.S. dollar-denominated interest-bearing deposit in a bank outside of the United
States
(h) euroyen is a Japanese yen-denominated interest-bearing deposit in a bank outside of Japan
Exchange rate regime classifications
13. The IMF classifies all exchange rate regimes into eight specific categories that are summarized in this
chapter. Under which exchange rate regime would you classify the following countries?
(a) France: Exchange arrangements with no separate legal tender
(b) The United States: independent floating
(c) Japan: independent floating
(d) Thailand: managed floating with no pre-announced path for the exchange rate. Prior to the Asian
Crisis of 1997 it was tied to the U.S. dollar.
The ideal currency
14. What are the attributes of the ideal currency?
If the ideal currency existed in todays world, it would possess three attributes, often referred to as
The Impossible Trinity:
(1) Exchange rate stability. The value of the currency would be fixed in relationship to other major
currencies so traders and investors could be relatively certain of the foreign exchange value of
each currency in the present and into the near future.
(2) Full financial integration. Complete freedom of monetary flows would be allowed, so traders and
investors could willingly and easily move funds from one country and currency to another in
response to perceived economic opportunities or risks.
(3) Monetary independence. Domestic monetary and interest rate policies would be set by each
individual country to pursue desired national economic policies, especially as they might relate to
limiting inflation, combating recessions, and fostering prosperity and full employment.
26
Bretton Woods failure

15. Why did the fixed exchange rate regime of 19451973 eventually fail?
The fixed exchange rate regime of 19451973 failed because of widely diverging national monetary
and fiscal policies, differential rates of inflation, and various unexpected external shocks. The U.S.
dollar was the main reserve currency held by central banks was the key to the web of exchange rate
values. The United States ran persistent and growing deficits in its balance of payments requiring a
heavy outflow of dollars to finance the deficits. Eventually the heavy overhang of dollars held by
foreigners forced the United States to devalue the dollar because the U.S. was no longer able to
guarantee conversion of dollars into its diminishing store of gold.
Chapter 2
T Problems
Problem 2.1 Frankfurt and New York
What is the exchange rate between the dollar and the euro?
Assumptions
Values
Buy a US dollar in Frankfurt for (in euros/$)

Which is equivalent, the reciprocal, in $/euro
0.9200
$1.0870
Buy a euro in NY for (in $/euros)

Which is equivalent, the reciprocal, in euros/$
$1.0870
0.9200
27
28
Problem 2.2 Peso exchange rate changes

Peso was devalued from 3.2 per dollar to 5.5 per dollar.
Any time a government sets, or resets, the value of a currency,
it is a managed or fixed exchange rate. A governmental decision
to decrease a currencys value when it is a fixed exchange rate is
termed a devaluation.
Calculation of Percentage Change in Value
Initial exchange rate (peso/$)
Devalued exchange rate (peso/$)
Percentage change in peso value
(beginning rate ending rate)/(ending rate)
Values
3.20
5.50
41.82%
Chapter 2
Problem 2.3 Good as gold

What if gold had cost $38.00 per ounce?
Assumptions
Price of an ounce of gold in US dollars ($/oz)
Price of an ounce of gold in British pounds (/oz)
What is the implied US$/ exchange rate?
(dollar price of an ounce/pound price of an ounce)
Gold Standard
Values
$20.67
4.2474
What If
$38.00
4.2474
$4.8665
$8.9466
29
30
Problem 2.4 Gold standard

What was the exchange rate between the FF and US$?
Assumptions
Price of an ounce of gold in US dollars ($/oz)
Price of an ounce of gold in French francs (FF/oz)
What is the implied French franc/US$ exchange rate?
(French franc price of an ounce/US$ price of an ounce)
. Or if expressed as US$/FF
Values
$20.67
310.00
15.00
$0.0667
Chapter 2
Problem 2.5 Spot Ratecustomer

What must your company pay?
Assumptions
Spot rate on Mexican peso (pesos/US$)
Your company buys this amount of pesos
Values
9.5200
100,000.00
What is the cost in US$?

(the peso amount divided by the spot exchange rate)
$10,504.20
Spot transactions are settled in two business days, so in this case, Wednesday.
31
32
Problem 2.6 Forward rate

Settlement for a forward contract?
Assumptions
180-day forward rate, euros/$
Maturity of forward, days
Euros bought forward
Values
0.9210
180
100,000.00
What must the company pay to settle the forward?

Payment = Amount in euros/forward rate
$108,577.63
The contract would be settled 180 days later plus 2 days for actual
settlement on March 6, 2004. Please note that 2004 is actually a
leap year.
Chapter 2
Problem 2.7 Forward discount on the dollar

What is the forward discount on the dollar?
Assumptions
Spot rate, $/euros
Forward rate, 180-days, $/euros
Days forward
Values
$1.0200
$1.0858
180
What is the forward discount on the dollar?
12.90%
Since these are direct quotes on the dollar, the calculation is:
forward discount = (F S)/(S) (360/180)
33
34
Problem 2.8 Forward premium on the euro

What is the forward premuim on the euro?
Assumptions
Spot rate, euros/$
Forward rate, 180-days, euros/$
Days forward
Values
0.9804
0.9210
180
What is the forward premium on the euro?
12.90%
Since these are direct quotes on the euro, the calculation is:
forward premium = (S F)/(F) (360/180)
Chapter 2
Problem 2.9 Saudi import

What is the dollar price after all exchanges and fees?
Assumptions
Purchase price, in euros
Spot rate of exchange, Jordanian dinar (JD)/euro
Spot rate of exchange, Jordanian dinar (JD)/US$
Spot rate of exchange, Saudi Arabian (SRI)/Jordanian dinar (JD)
Jordanian import duty on EU products
Jordanian resale fees
Spot rate of exchange, Saudi Arabian riyal (SRI)/US$
Values
375,000
0.8700
0.7080
5.2966
12.00%
22.00%
3.750
What is the dollar price after all exchanges and fees?

Purchase price, converted to Jordanian dinar (JD)
Additional fees due on importation
Total cost, Jordanian dinar (JD)
326,250.00
39,150.00
365,400.00
Resale fee in Jordan

Resale price to Saudi Arabian, in JD
80,388.00
445,788.00
Price paid in Iraqi dinar, converting JD to SRI
2,361,165.25
US dollar equivalent of final price paid
$629,644.07
35
36
Problem 2.10 Chinese yuan (renminbi) revaluation

What if the Chinese yuan were revalued?
Any time a government sets, or resets, the value of a currency,
it is a managed or fixed exchange rate. A governmental decision
to decrease a currencys value when it is a fixed exchange rate is
termed a devaluation.
Calculation of Percentage Change in Value
Values
Initial exchange rate (Rmb/$)

Percentage devaluation against the US dollar
Revalued exchange rate (Rmb/$)
8.27
20.00%
6.89
Chapter 3
The Balance of Payments
T Questions
Balance of payments defined
1.
The measurement of all international economic transactions between the residents of a country and
foreign residents is called the balance of payments (BOP). What institution provides the primary
source of similar statistics for balance of payments and economic performance worldwide?
The primary source of similar statistics for balance of payments and economic performance
worldwide is the International Monetary Fund, Balance of Payments Statistics.
Importance of BOP
2.
Business managers and investors need BOP data to anticipate changes in host country economic
policies that might be driven by BOP events. From the perspective of business managers and
investors list three specific signals that a countrys BOP data can provide.
The BOP is an important indicator of pressure on a countrys foreign exchange rate, and thus on
the potential for a firm trading with or investing in that country to experience foreign exchange
gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange
controls.
Changes in a countrys BOP may signal the imposition or removal of controls over payment of
dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or
investors.
The BOP helps to forecast a countrys market potential, especially in the short run. A country
experiencing a serious trade deficit is not likely to expand imports as it would if running a
surplus. It may, however, welcome investments that increase its exports.
Economic activity
3.
What are the two main types of economic activity measured by a countrys BOP?
(a) Current transactions having cash flows completed within one year, such as for the import or
export of goods and services.
(b) Capital and financial transactions, in which investors acquire ownership of a foreign asset, such
as a company, or a portfolio investment, such as bonds or shares of common stock.
38
Balance
4.
Why does the BOP always balance?

The algebraic sum of all flows accounted for in the current account and the capital and financial
accounts should, in theory, equal changes in a countrys monetary reserves. Because data for the
balance of payments is collected on a single entry basis and some data is missed, the equalization
usually does not occur. The imbalance is plugged by an entry called errors and omissions which
makes the accounts balance.
BOP accounting
5.
If the BOP were viewed as an accounting statement, would it be a balance sheet of the countrys
wealth, an income statement of the countrys earnings, or a funds flow statement of money into and
out of the country?
A countrys balance of payments is similar to a corporations funds statement in that the balance of
payments records events that cause the receipt (earnings) and disbursement (expenditures) of foreign
exchange.
Current account
6.
What are the main component accounts of the current account? Give one debit and one credit
example for each component account for the United States.
The main components and possible examples are:
Trade in goods:
Debit: U.S. firm purchases German machine tools.
Credit: Singapore Air Lines buys a Boeing jet.
Trade in services:
Debit: An American takes a cruise on a Dutch cruise line.
Credit: The Brazilian tourist agency places an ad in The New York Times.
Income payments and receipts:
Debit: The U.S. subsidiary of a Taiwan computer manufacturer pays dividends to its parent.
Credit: A British company pays the salary of its executive stationed in New York.
Unilateral current transactions.
Debit: The U.S.-based International Rescue Committee pays for an American working on the
Afghan border.
Credit: A Spanish company pays tuition for an employee to study for an MBA in the United
States.
Real versus financial assets

7.
What is the difference between a real asset and a financial asset?

Real assets are goods (merchandise) and useful services. Financial assets are financial claims, such as
shares of stock or bonds.
Chapter 3
39
Direct versus portfolio investments

8.
What is the difference between a direct foreign investment and a portfolio foreign investment? Give
an example of each. Which type of investment is a multinational industrial company more likely to
make?
A direct investment is made with the intent that the investor will have a degree of control over the
asset acquired. Typical examples are the building of a factory in a foreign country by the subsidiary
of a multinational enterprise or the acquisition of more than 10% of the voting shares of a foreign
corporation. A portfolio investment is the purchase of less than 10% of the voting shares of a foreign
corporation or the purchase of debt instruments. Multinational enterprises are more likely to engage
in direct foreign investment than in portfolio investment.
Capital and financial accounts

9.
What are the main components of the financial accounts? Give one debit and one credit example for
each component account for the United States.
The main components and possible examples are:
Direct investment.
Debit: Ford Motor Company builds a factory in Australia.
Credit: Ford Motor Company sells its factory in Britain to British investors.
Portfolio investment.
Debit: An American buys shares of stock of a European food chain on the Frankfurt Stock
Exchange.
Credit: The government of Korea buys United States treasury bills to hold as part of its foreign
exchange reserves.
Other investment.
Debit: A U.S. firm deposits $1 million in a bank balance in London.
Credit: A U.S. firm generates an account receivable for exports to Canada.
Classifying transactions
10. Classify the following as a transaction reported in a sub-component of the current account or the
capital and financial accounts of the two countries involved:
(a) A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current account, credit to
Chilean goods part of current account.
(b) A U.S. resident purchases a euro-denominated bond from a German company. Debit to U.S.
portfolio part of financial account; credit to German portfolio of financial account.
(c) Singaporean parents pay for their daughter to study at a U.S. university. Credit to U.S. current
transfers in current account; debit to Singapore current transfers in current account.
(d) A U.S. university gives a tuition grant to a foreign student from Singapore. If the student is
already in the United States, no entry will appear in the balance of payments because payment is
between U.S. residents. (A student already in the U.S. becomes a resident for balance of
payments purposes.)
40
(e) A British Company imports Spanish oranges, paying with eurodollars on deposit in London. A
debit to the goods part of Britains current account; a credit to the goods part of Spains current
account.
(f) The Spanish orchard deposits half the proceeds of its sale in a New York bank. A debit to the
income receipts/payments part of Spains current account; a credit to the income
receipts/payments part of the U.S. current account.
(g) The Spanish orchard deposits half the proceeds in a eurodollar account in London. No recording
in the U.S. balance of payments, as the transaction was between foreigners using dollars already
deposited abroad. A debit to the income receipts/payments of the British current account; a credit
to the income receipts/payments of the Spanish current account.
(h) A London-based insurance company buys U.S. corporate bonds for its investment portfolio. A
debit to the portfolio investment section of the British financial accounts; a credit to the portfolio
investment section of the U.S. balance of payments.
(i) An American multinational enterprise buys insurance from a London insurance broker. A debit to
the services part of the U.S. current account; a credit to the services part of the British current
account.
(j) A London insurance firm pays for losses incurred in the United States because of an international
terrorist attack. A debit to the services part of the British current account; a credit to the services
part of the U.S. current account.
(k) Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can fly the return
segment of a flight segment back to Hong Kong. Hong Kong keeps its balance of payments
separate from those of the Peoples Republic of China. Hence a debit to the goods part of Hong
Kongs current account; a credit to the goods part of the U.S. current account.
(l) A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges.
A debit to the portfolio investment section of the U.S. financial account; a credit to the portfolio
investment section of the Japanese and British financial accounts.
(m) The U.S. army buys food for its troops in South Asia from venders in Thailand. A debit to the
goods part of the U.S. current account; a credit to the goods part of the Thai current account.
(n) A Yale graduate gets a job with the International Committee of the Red Cross working in Bosnia
and is paid in Swiss francs. A debit to the income part of the Swiss current account; a credit to
the income part of the Bosnia current account. This assumes the Yale graduate spends her
earnings within Bosnia; should she deposit the sum in the United States then the credit would be
to the income part of the U.S. current account.
(o) The Russian government hires a Dutch salvage firm to raise a sunken submarine. A debit to the
service part of Russias current account; a credit to the service part of the Netherlandss current
account.
(p) A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and
flies back to Colombia with that cash. This would not get captured in the goods part of the U.S.
or the Columbian current accounts. Assuming the cash was laundered appropriately, from the
point of view of the smugglers, bank accounts in the U.S. or somewhere else (probably not
Colombia, possibly Switzerland) would be credited. This imbalance would end up in the errors
and omissions part of the U.S. balance of payments.
Chapter 3
41
(q) The U.S. government pays the salary of a foreign service officer working in the U.S. embassy in
Beirut. Diplomats serving in a foreign country are regarded as residents of their home country, so
this payment would not be recorded in any balance of payments accounts. If or when the
diplomat spent the money in Beirut, at that time a debit should be incurred in the goods or
services part of the U.S. current account and a contrary entry in the Lebanon balance of
payments. It is doubtful that the goods or services transaction would get reported or recorded,
although on a net basis changes in bank balances would reflect half of the transaction.
(r) A Norwegian shipping firm pays U.S. dollars to the Egyptian government for passage of a ship
through the Suez canal. If the Norwegian firm paid with dollar balances held in the U.S. and the
Suez Canal Authority of Egypt redeposited the proceeds in the U.S. no entry would appear in the
U.S. balance of payments. Norway would debit a purchase of services, and Egypt would credit a
sale of services.
(s) A German automobile firm pays the salary of its business executive working for a subsidiary in
Detroit. Germany would record a debit in the income payments/receipts in its current account; the
U.S. would record a credit in the income payments/receipts in its current account.
(t) An American tourist pays for a hotel in Paris with his American Express card. A debit would be
recorded in the services part of the U.S. current account; a credit would be recorded in the
services part of the French current account.
(u) A French tourist from the provinces pays for a hotel in Paris with his American Express card. A
French resident most likely has a French-issued credit card, issued by the French subsidiary of
American Express. In this instance, no entry would appear in either countrys balance of
payments. If, later, the French subsidiary of American express paid a dividend back to the U.S.,
that would be recorded in the income part of the current accounts.
(v) A U.S. professor goes abroad for a year and lives on a Fulbright grant. The current transfers
section of the U.S. current account would be debited for the salary paid to a foreign resident.
(Even though an American, the professor is a foreign resident during the time he lives abroad.)
The current transfers section of the host countrys current account would be credited.
The Balance
11. What are the main summary statements of the balance of payments accounts and what do they
measure?
(a) The balance on goods (also called the balance of trade) measures the balance on imports and
exports of merchandise.
(b) The balance on current account expands the balance on goods to include receipts and expenses
for services, income flows, and unilateral transfers.
(c) The basic balance measures all of the international transactions (current, capital, and financial)
that come about because of market forces. I.e., the balance resulting from all decisions made for
private motives. (This includes international operating expenses of the government.)
(d) The overall balance (also called the official settlements balance) is the total change in a
countrys foreign exchange reserves caused by the basic balance plus any governmental action to
influence foreign exchange reserves.
42
Drugs and terrorists

12. Where in the balance of payments accounts do the flows of laundered money by drug dealers and
international terrorist organizations flow?
Quite obviously the merchandise involved in the import or export of marijuana, heroin, cocaine, or
other drugs is not reported to customs officials and so does not appear in the goods section of the
current account. For similar reasons, the cash payments used to finance terrorists are not reported in
the current transfers section of the current account.
The opposite side to any of these transactions is changes in bank balances held by foreigners or
foreign bank balances held by home country residents. These are usually reported, but only in the
aggregate. That is, the total changes in holdings are reported by banks, but the parties to the millions
and millions of individual transactions that lead to the total change are not reported. The imbalance
shows up in the errors and omissions part of the balance of payments.
Capital mobilityUnited States
13. The US dollar has maintained or increased its value over the past 20 years despite running a gradually
increasing current account deficit. Why has this phenomenon occurred?
The U.S. dollar has maintained or increased its value over the past 20 years despite running a
gradually increasing current account deficit because the current account deficit has been more than
offset by an inflow of dollars on capital and financial accounts.
Capital mobilityBrazil
14. Brazil has experienced periodic depreciation of its currency over the past 20 years despite
occasionally running a current account surplus. Why has this phenomenon occurred?
Brazil has experienced periodic depreciation of its currency because of speculative flights of capital
out of Brazil in response to political and/or economic shocks, including periods of hyper-inflation.
BOP Transactions
15. Identify the correct BOP account for each of the following transactions.
(a) A German based pension fund buys U.S. government 30 year bonds for its investment
portfolio.
Financial account: portfolio investment liabilities
(b) Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to
Copenhagen.
Current account: Goods: Exports FOB
(c) Hong Kong students pay tuition to the University of California, Berkeley.
Current account: Services: credit
(d) The U.S. Air Force buys food in South Korea to supply its air crews.
Current account: Goods: Imports FOB
(e) A Japanese auto company pays the salaries of its executives working for its U.S.
subsidiaries.
Current account: Services: credit
Chapter 3
43
(f) A U.S. tourist pays for a restaurant meal in Bangkok.

Current account: Services: debit
(g) A Colombian citizen smuggles cocaine into the United States, receives cash, and smuggles
the dollars back into Colombia.
Net errors and omissions
(h) A U.K. corporation purchases a euro-denominated bond from an Italian MNE.
Does not enter the U.S. balance of payments
T Mini-Case: Turkeys Kriz (A): Deteriorating Balance of Payments

1.
Where in the Current Account would the imported telecommunications equipment be listed? Would
this correspond to the increase in magnitude and timing of the Financial Account?
The telecom equipment would appear in the Current Account as an import of goods. Net other
investment would include financing by the vendors that sold TelSim the equipment. This and other
imports of capital equipment probably accounted for most of the increase in net other investment and
thus the large negative balance in the Financial Account in the year 2000.
2.
Why do you think that net direct investment declined from $571 million in 1998 to $112 million in
2000?
The decline was probably caused by a lack of confidence in Turkeys political stability and long-term
growth prospects. Turkeys war on its own inflation during the period 1999 to early 2000 must have
included high interest rates and other macroeconomic policies to slow down the rate of growth. A
slower rate of growth, if maintained in the long run, would reduce expected returns and direct
investment inflows.
3.
Why do you think that TelSim defaulted on its payments for equipment imports from Nokia and
Motorola?
TelSim needed to invest heavily in capital equipment in order to create a modern high speed, high
capacity network. Unfortunately, a considerable time gap typically exists between the time a network
is created and it s capacity is utilized by revenue-paying customers. Thus long-term financing rather
than short-term trade financing is needed. The timing gap experienced by TelSim was also
experienced by many other telecommunications companies worldwide, including the highlypublicized case of Global Crossing, which also went bankrupt.
Expectations for the telecom industry and its ability to monetize its customer base, the ability to
generate significant revenues from installed networks, proved overly optimistic. A worldwide
overcapacity of telecommunications networks led to cutthroat price competition, adding to the
shortfall in revenues experience worldwide. The overcapacity continued for several years, however,
as firms attempted to survive by covering variable costs but not fixed capital costs of providing
services.
Finally, there has been a continuing debate over the intentions and ethics of the Uzan family itself
the controlling interest group of TelSim. The press has run a number of stories raising the question as
to whether the Uzan family had ever truly intended to repay the massive infrastructure financing
provided by Motorola and Nokia. At the time of this writing, however, there is no proof that this was
the case.
T Problems
44
Balance on goods
Services: credit
Services: debit
Balance on services
Income: credit
Income: debit
Balance on income
Current transfers: credit
Current transfers: debit
Balance on current transfers
Questions
3.1 What is Australias balance on goods?
(goods exports goods imports)
3.2 What is Australias balance on services?
(services credit services debit)
3.3 What is Australias balance on goods and services?
(balance on goods + balance on services)
3.4 What is Australias current account balance?
(the sum of the four balances listed above,
goods, services, income, and current transfers)
1998
55,884
61,215
5,331
1999
56,096
65,857
9,761
2000
64,052
68,865
4,813
2001
63,676
61,890
1,786
2002
65,099
70,530
5,431
2003
70,577
85,946
15,369
16,181
17,272
1,091
17,399
18,330
931
18,677
18,388
289
16,689
16,948
259
17,906
18,107
201
21,205
21,638
433
6,532
17,842
11,310
7,394
18,968
11,574
8,984
19,516
10,532
8,063
18,332
10,269
8,194
19,884
11,690
9,457
24,245
14,788
2,651
2,933
282
3,003
3,032
29
2,622
2,669
47
2,242
2,221
21
2,310
2,373
63
2,767
2,851
84
1998
5,331
1999
9,761
2000
4,813
2001
1,786
2002
5,431
2003
15,369
1,091
931
289
259
201
433
6,422
10,692
4,524
1,527
5,632
15,802
18,014
22,295
15,103
8,721
17,385
30,674
Problems 3.13.4 Australias current account

Assumptions (millions of US dollars)
Goods: exports
Goods: imports
Problems 3.53.9 Uruguays current account

2000
2001
2002
Goods: exports
Goods: imports
Balance on goods
2,829.3
3,601.4
772.1
2,290.6
3,187.2
896.6
2,383.8
3,311.1
927.3
2,139.4
2,914.7
775.3
1,933.1
1,872.9
60.2
Services: credit
Services: debit
Balance on services
1,319.1
883.6
435.5
1,261.6
802.3
459.3
1,275.7
881.8
393.9
1,122.5
801.4
321.1
774.7
652.2
122.5
Income: credit
Income: debit
Balance on income
608.0
805.9
197.9
735.5
879.3
143.8
781.5
841.8
60.3
832.0
895.2
63.2
455.9
446.3
9.6

75.0
16.0
59.0
78.4
4.9
73.5
48.0
20.5
27.5
48.0
18.3
29.7
83.7
14.3
69.4
Questions
1998
1999
2000
2001
2002
772.1
896.6
927.3
775.3
60.2
435.5
459.3
393.9
321.1
122.5
3.7 What is Uruguays balance on goods and services?
336.6
437.3
533.4
454.2
182.7
3.8 What is the balance on goods, services and income?
534.5
581.1
593.7
517.4
192.3
3.9 What is Uruguays current account balance?
475.5
507.6
566.2
487.7
261.7
3.5 What is Uruguays balance on goods?

3.6 What is Uruguays balance on services?
1999
Chapter 3
1998
45
46
1998
1999
2000
2001
499.1
0.0
540.9
18.7
60.4
284.7
0.0
251.2
12.4
45.9
211.7
0.0
212.8
24.5
23.4
308.5
0.0
399.1
89.3
179.8
1998
1999
2000
2001
540.9
inflow
251.2
inflow
212.8
inflow
399.1
inflow
499.1
284.7
211.7
308.5
3.12 What is Myanmars total for groups A through C?
41.8
33.5
1.1
90.6
3.13 What is Myanmars total for groups A through D?
60.5
45.9
23.4
179.9
A.
B.
C.
D.
E.
Current account balance

Capital account balance
Financial account balance
Net errors and omissions
Reserves and related items
Questions
3.10 Is Myanmar experiencing a net capital inflow or outflow?
3.11 What is Myanmars total for groups A and B?
Problems 3.103.13 Myanmars balance of payments
Problems 3.143.20 Argentinas balance of payments

2000
2001
2002
26,434
29,531
3,097
23,309
24,103
794
26,341
23,889
2,452
26,543
19,158
7,385
25,709
8,473
17,236
Services: credit
Services: debit
Balance on services
4,704
9,136
4,432
4,554
8,660
4,106
4,765
9,039
4,274
4,398
8,298
3,900
2,966
4,577
1,611
Income: credit
Income: debit
Balance on income
6,125
13,531
7,406
6,095
13,558
7,463
7,489
14,959
7,470
5,370
13,117
7,747
3,176
9,645
6,469
720
314
406
704
307
397
724
369
355
681
399
282
570
167
403
14,529
11,966
8,937
3,980
9,559
73
86
106
101
39
2,325
7,291
4,966
1,730
23,988
22,258
901
10,418
9,517
161
2,166
2,005
627
785
1,412
1,906
10,693
5,183
2,005
4,780
1,065
1,252
1,331
784
1,797
9,574
7,596
477
6,596
18,738
389
4,090
515
2,013
63
1,176
4,155
21,405
1,422
15,269
4,432
11,432
4,106
11,172
4,274
11,389
3,900
11,365
1,611
7,677
income debit
18,936
7,577
7,188
income debit
14,408
3,322
2,807
income debit
7,718
3,565
3,628
income debit
13,368
24,632
28,787
income credit
23,445
31,083
32,505
A. Current Account
Goods: exports
Goods: imports
Balance on goods

Current Account Balance (Group A)
B. Capital Account (Group B)
C. Financial Account
Direct investment abroad
Direct investment in Argentina
Direct investment in Argentina, net
Portfolio investment assets, net
Portfolio investment liabilities, net
Balance on other investment assets and liabilities, net
D. Net Errors and Omissions
E. Reserves and Related Items
Questions
3.14 What is Argentinas balance on services?
3.15 What is Argentinas current account balance?
3.16 What seems to have been the primary driver in
Argentinas current account balance?
3.17 What is Argentinas financial account balance?
3.18 What is Argentinas total for groups A through C?
3.19 What is Argentinas total for groups A through D?
3.20 Unless the financial account could grow a very large
surplus, a crisis will ensue.
1999
Chapter 3
1998
47
Chapter 4
International Parity Conditions
T Questions
Purchasing power parity
1.
What is the Law of One Price? According to this law, what should happen to the currency of a
country experiencing hyper-inflation?
The law of one prices states that producers prices for goods or services of identical quality should be
the same in different markets; i.e., different countries (assuming no restrictions on the sale and
allowing for transportation costs). If a country has higher inflation than other countries, its currency
should devalue or depreciate so that the real price remains the same as in all countries. Application of
this law results in the theory of Purchasing Power Parity (PPP).
Undervalued and overvalued

2.
What is an undervalued currency? What is an overvalued currency?

In its semantic sense, undervalued means current value (current price) is lower than true intrinsic
worth, and overvalued means current value (current price) is above true intrinsic worth. Application
of these concepts to currencies implies that one has some basis, such as purchasing power parity, to
determine true intrinsic worth.
(a) An undervalued currency is a currency for which the current exchange rate (e.g., current value),
stated as the foreign currency price for the base currency is lower than it should be. Assume the
current exchange rate for the Slovak koruna is K50.0/$ at a time when the korunas intrinsic
worth is K40.0/$. Using reciprocals (1 K50.0/$ = $0.0200/K; 1 K40/$ = $0.0250/K), the
koruna is currently priced in dollars at 2.0 per koruna at a time when its intrinsic worth is 2.5
per koruna. Hence at its present price it is undervalued, meaning the value placed on the koruna
by the market (2.0) is below its true worth (2.5).
(b) An overvalued currency is a currency for which the current exchange rate (e.g., current value),
stated as the foreign currency price for the base currency is higher than it should be. Assume the
current exchange rate for the Sri Lankan rupee is R100/$ at a time when the rupees intrinsic
worth is R125/$. Using reciprocals (1 R100/$ = $0.0100/R; 1 R125/$ = $0.0800/R), the rupee
is currently priced in dollars at 1.0 per rupee at a time that its intrinsic worth is only 0.8 per
koruna. Hence at its present price it is overvalued, meaning the value placed on the rupee by the
market (1.0) is greater than its true worth (0.9).
Most exchange rates are stated as the number of foreign currency units needed to buy one U.S. dollar.
For these currencies, then, an exchange rate where the stated rate is greater than the intrinsic worth of
the currency is undervalued; and vice versa. One will note that in Exhibit 4.1 in the text, those
currencies given a minus sign in column (5) are undervaluedsee heading of column (5). I.e. their
actual exchange rate (column 2, expressed as currency units per dollar) is greater than their inherent
worth, the implied PPP vis vise the dollar (column 4).
Chapter 4
49
Hamburger standard
3.
Using the data in Exhibit 4.1, separate the countries in which the actual exchange rate on April 17,
2004, was overvalued; i.e., above the hamburger parity rate, from those in which the actual exchange
rate was undervalued; i.e., below the implied parity rate. What do you conclude?
In Exhibit 4.1, currencies with a minus sign in the third column entry per country are undervalued. It
is in fact easier to simply identify which currencies are overvalued against the dollar, because there
are so few!
Overvalued countries/currencies
Britain
Iceland
Denmark
Jordan
Euro area
Kuwait
Sweden
Norway
Switzerland
Data in the current table suggest that most of the worlds currencies were undervalued against the
dollar at that time, making hamburgers cheaper in the rest of the world than they were in Britain,
Denmark, Switzerland, the Euro area, Sweden, Iceland, Jordan, Kuwait, and Norway. If the
hamburger standard is a correct measure of overall purchasing power parity, goods in general are less
expensive in all countries except these specific countries.
Relativity
4.
What is the difference between the absolute theory of purchasing power parity and the relative
version of that theory?
The absolute version of the theory of purchasing power parity states that exchange rates should
reflect the difference in price indices for traded goods and services between two countries. The
relative version of the theory uses changes in such price indices between two time periods to predict
changes in the exchange rate (rather than the absolute exchange rate) relative to some past base
period.
PPP and BOP

5.
What is the connection between changes in purchasing power parity and changes in a countrys
balance of payments?
If a countrys inflation rate exceeds that of its main trading partners and its exchange rate does not
change, its exports of goods and services become evermore expensive while imports become
evermore cheaper at home. These conditions lead to a deficit in the current account of the balance of
payments.
Validating PPP
6.
What two general conclusions can be made about the actual working of purchasing power parity?
As a general matter research has shown (a) that PPP works well over the very long run but poorly
over the short run, and (b) the theory holds better for countries with relatively high rates of inflation
and underdeveloped capital markets.
50
Exchange rate indices

7.
What is a nominal effective exchange rate index and how does it differ from a real effective exchange
rate index?
An exchange rate index is an index that measures the value of a given countrys exchange rate against
all other exchange rates in order to determine if that currency is overvalued or undervalued.
(a) The nominal effective exchange rate index is based on a weighted average of actual exchange
rates over a period of time. It is unrelated to PPP and simply measures changes in the exchange
rate (i.e., currency value) relative to some arbitrary base period. It is used in calculating the real
effective exchange rate index.
(b) The real effective exchange rate index adjusts the nominal effective exchange rate index to
reflect differences in inflation. The adjustment is achieved by multiplying the nominal index by
the ratio of domestic costs to foreign costs. The real index measures deviation from purchasing
power parity, and consequently pressures on a countrys current account and foreign exchange
rate.
Interest rates
8.
What is the difference between nominal interest rates and real interest rates?
Nominal interest rates are simply the stated contractual rate of interest within a country. Real interest
rates are the nominal interest rate less the rate of inflation. (If one earns 8% interest on a debt
instrument, but inflation eats away 3 percentage points of those earnings, the real interest rate is
only 5%. The purchasing power of debt holders rose only 5% during the year.)
International Fisher effect

9.
What did Irving Fisher postulate about the relationship between nominal interest rates and foreign
exchange rates?
Irving Fisher stated that the spot exchange rate should change in an equal amount but opposite in
direction to the difference in nominal interest rates. Stated differently, the real return in different
countries should be the same, so that if one country has a higher nominal interest rate, the gain from
investing in that currency will be lost by a deterioration of its exchange rate.
The relationship between the percentage change in the spot exchange rate over time and the
differential between comparable interest rates in different national capital markets is known as the
international Fisher effect. Fisher-open, as it is often termed, states that the spot exchange rate
should change in an equal amount but in the opposite direction to the difference in interest rates
between two countries. More formally:
S1 S2
100 = i$ i ,
S2
$
where i and i are the respective national interest rates, and S is the spot exchange rate using indirect
quotes (an indirect quote on the dollar is, for example, /$) at the beginning of the period (S1) and the
end of the period (S2). This is the approximation form commonly used in industry. The precise
formulation is:
S1 S2 i$ i
=
.
S2
1 + i
Chapter 4
51
Fisher effect
10. What did Irving Fisher state to be the relationship between nominal and real interest rates?
Irving Fisher stated that nominal interest rates in each country should equal the required rate of return
plus compensation for inflation. Using i for the nominal rate, r for the real rate, and for the rate of
inflation, the Fisher effect may be stated two ways:
i = r + ,
or
r=i
The Fisher effect also states that real interest rates in various countries should be the same.
T Mini-Case: The Introduction of the Porsche 911 Carrera

4S Cabriolet
1.
Clearly, at some point sooner or later, Porsche must raise the US dollar price of this model and all
product models (particularly if the euro continues to strengthen and maintains this strength compared
to the dollar). But when would that be?
This pricing dilemmawhen to pass through to final price cost pressuresis experienced in all
industries all of the time. In the case of Porsche, the firm has publicly argued that it can afford to
maintain its pricing by way of the subsidization coming from its successful option hedging program
over the past few years. The second factor which aids in the postponement of price changes is that
exchange rates, unlike many other input prices, do not just go one direction (up). Many believe that
the dollar/euro exchange rate will return to a more traditional trading range (and Porsche appears to
be one of them by way of its public announcements) which would eliminate the need. But, if these
subsidies and market movements do not occur in the near termsay by early to mid 2005the retail
price of the Porsche in target markets like the US would have to be raised to simply cover the costs of
production, independent of degree of profitability as seen in margins.
2.
What would it take to convince Porsches management that now is the time to pass-through more of
the exchange rate change in the price?
Ironically, much of the news in late 2004 and early 2005 in which senior government and treasury
officials in the United States publicly stated that exchange rates are best set by markets (meaning
there will be no concerted effort by the Bush administration to push the dollar up against the euro),
adds to a market opinion that $1.30 or better is where the euro may stay for some time to come. If this
rate of exchange is sustained, and several other major European-based automakers like Volkswagen
and Mercedes start pushing dollar prices up, Porsche may indeed decide the time is now.
52
T Problems
Problem 4.1 Passing through
Steps
Initial spot exchange rate (/US$)
Initial price of a Honda in, in yen
Expected US dollar inflation rate for the coming year
Expected Japanese yen inflation rate for the coming year
Desired rate of pass through by Honda
a. What was the dollar price for a Honda at the beginning of the year?
Year-beginning price of a Honda (in yen)
Spot exchange rate (/US$)
Year-beginning price of a Honda (in US$)
b. What is the expected spot rate one year from now assuming PPP?
Initial spot rate (/US$)
Expected US$ inflation
Expected Japanese yen inflation
Expected spot rate one year from now assuming PPP (/US$)
c. Assuming complete pass through, what will the price be in US$ in one year?
Price of Honda at beginning of year (in yen)
Japanese yen inflation over the year
Price of Honda at end of year (in yen)
Expected spot rate one year from now assuming PPP (/US$)
Price of Honda at end of year (in US$)
d. Assuming partial pass through, what will the price be in US$ in one year?
Price of Honda at end of year (in yen)
Amount of expected exchange rate change, in percent
Proportion of exchange rate change passed through by Honda
Proportional percentage change
Effective exchange rate used by Honda to price in US$ for end of year
Price of Honda at end of year (in US$)
Value
125.00
4,000,000
3.000%
1.000%
60.000%
4,000,000
125.00
$32,000.00
125.00
3.00%
1.00%
122.57
4,000,000
1.000%
4,040,000
122.57
$32,960.00
4,040,000
1.980%
60.000%
1.188%
123.532
$32,704
Chapter 4
Problem 4.2 Chilean pesos

Assumptions
Spot exchange rate, one year ago, pesos per US$
Change in value of peso over the year
US inflation over year
Chilean inflation over year
Value
500.00
25.00%
0.00%
22.00%
a. What is the actual exchange rate today?

Beginning spot rate (pesos/US$)
Percentage change in the peso
Actual exchange rate today (pesos/US$)
500.00
25.00%
666.67
Check: (Beginning-Ending)/(Ending)
25.00%
b. What should be the exchange rate today based on PPP?

Beginning spot rate (pesos/US$)
Chilean inflation
US inflation
PPP exchange rate
500.00
22.00%
0.00%
610.00
c. By what percentage is the peso overvalued or undervalued?

Actual exchange rate today (pesos/US$)
PPP exchange rate (pesos/US$)
Percentage overvaluation (positive) or undervaluation (negative)
666.67
610.00
8.500%
53
54
Problem 4.3 International Interest Rates

Assumptions
One year interest rate in the United States (dollars, US$)
One year interest rate in the United Kingdom (pounds, )
Current spot rate (US$/)
Expected spot rate according to International Fisher effect (US$/)
Value
1.500%
4.800%
1.8500
1.7917
Chapter 4
Problem 4.4 Trident borrows euros

Assumptions
Trident is borrowing the following principal, in euros ()
Tridents cost of borrowing euros ()
Interest savings over borrowing rate in the US
Current spot exchange rate (US$/)
Expected US inflation rate for the coming year
Expected euro inflation rate for the coming year
Value

5.000%
3.000%
$1.3200
3.000%
2.000%
Euro borrowing:
Trident borrows the following euros
At the following interest rate
Repaying principal and interest of the following in one year

5.000%

Proceeds of euro loan in US dollars
$5,280,000
Expected spot rate in one year:

Current spot rate (US$/euro)
US inflation rate
euro inflation rate
Expected spot rate assuming PPP (US$/)
Repaying the euro loan in US dollars will cost:
Required repayment in euros
At the following expected spot rate ($/)
Will require this amount of US dollars
Cost of the loan in dollar terms is = (Repayment/Proceeds) 1
This is the real cost of borrowing in euros as Trident would expect.
$1.3200
3.000%
2.000%
1.3329

$1.3329
$5,598,353
6.0294%
55
56
Problem 4.5 Covering

How does the risk of an uncovered interest arbitrage investment differ from the risk of
a covered interest arbitrage investment?
By being uncovered, the investor still bears foreign exchange rate risk. The investments
Returnsin the originating currency of the investmentare not protected against exchange
rate changes if uncovered. UIA is therefore significantly risky compared to CIA.
Chapter 4
Problem 4.6 Mary SmythCIA

Assumptions
Spot exchange rate (Swiss francs per US dollar)
3-month forward ratae (Swiss francs per US dollar)
3-month US dollar interest rate (per annum)
3-month Swiss franc interest rate (per annum)
Principal to be invested
Value
SFr. 1.1520
SFr. 1.1472
4.500%
3.200%
$1,000,000.00
Invest the Dollars in the US:

Principal
Interest for the 3-month period
Gross return
Net return in US dollars
$1,000,000.00
1.125%
$1,011,250.00
$11,250.00
Convert Dollars to Swiss francs and Cover:

Principal
Converted to Swiss francs at the current spot rate (SFr./$) of
Yielding this principal of Swiss francs
Invested at Swiss franc interest rate for the 3-month period
Yielding this amount of Swiss francs at the end of one year
Which are simultaneously sold forward at the forward rate of
Gross return in US dollars, fully covered, at the end of one year
Mary Smyth is better off investing in the Swiss franc deposits.
$1,000,000.00
SFr. 1.1520
SFr. 1,152,000
0.800%
SFr. 1,161,216
1.1472
$1,012,217.57
$12,217.57
57
58
Assumptions
Value
SFr. 1.1520
SFr. 1.1472
4.500%
3.200%
$1,000,000.00

Principal
Gross return
$1,000,000.00
1.125%
$1,011,250.00
$11,250.00

Principal
Converted to Swiss francs at the current spot rate (SFr./$) of
The outcome of Uncovered Interest Arbitrage depends on the
ending spot rate (SF/$):
Compared to investing in the US dollar markets,
Mary Smyth, by investing uncovered in Swiss francs, earns:
$1,000,000.00
SFr. 1.1520
SFr. 1,152,000.00
0.800%
SFr. 1,161,216.00
$1,000,000.00
SFr. 1.1520
SFr. 1,152,000.00
0.800%
SFr. 1,161,216.00
$1,000,000.00
SFr. 1.1520
SFr. 1,152,000.00
0.800%
SFr. 1,161,216.00
SFr. 1.1000
$1,055,650.91
$55,650.91
SFr. 1.1500
$1,009,753.04
$9,753.04
SFr. 1.2000
$967,680.00
($32,320.00)
$44,400.91
($1,496.96)
($43,570.00)
Problem 4.7 Mary SmythUIA
Chapter 4
Problem 4.8 Mary Smythone month later

Assumptions
Value
SFr. 1.1800
SFr. 1.1680
4.800%
3.000%
$1,000,000.00

Principal
Gross return
$1,000,000.00
1.200%
$1,012,000.00
$12,000.00

Principal
Converted to Swiss francs at the current spot rate (SF/$) of
Mary Smyth is better off investing in the Swiss franc deposits.
$1,000,000.00
SFr. 1.1800
SFr. 1,180,000.00
0.750%
SFr. 1,188,850.00
SFr. 1.1680
$1,017,851.03
$17,851.03
59
60
Assumptions
Charge for suite plus meals (in ringgit)
Spot exchange rate (ringgit per US$)
US$ cost today for a 30 day stay
Malaysian ringgit inflation rate expected to be
U.S. dollar inflation rate expected to be
Value
760.00
3.8000
$6,000.00
4.000%
1.000%
a. How many dollars might you expecte to need one year hence for your 30-day vacation?
Spot exchange rate (ringgit per US$)
Malaysian ringgit inflation rate expected to be
U.S. dollar inflation rate expected to be
Expected spot rate one year from now based on PPP (ringgit per US$)
3.8000
4.000%
1.000%
3.9129
Hotel charges expected to be paid one year from now for a 30-day stay
23,712.00
US dollars needed on the basis of these two expectations:
$6,060.00
b. By what percent has the dollar cost gone up? Why?

New dollar cost
Original dollar cost
Percent change in US$ cost
The dollar cost has risen by the US dollar inflation rate. This is a result of your
estimation of the future suite costs and exchange rate changing in relation to inflation.
$6,060.00
$6,000.00
1.000%
Problem 4.9 Langkawi Island Resort
Chapter 4
Problem 4.10 Covered interest against the krone

Assumptions
Spot exchange rate (NKr/$)
3-month forward rate (NKr/$)
US 3-month Treasury bill rate
Norwegian 3-month Treasury bill rate
Notional investment
Value
6.2280
6.2640
4.400%
4.800%
$500,000.00

Principal
Gross return
$500,000.00
1.100%
$505,500.00
$5,500.00
Covered Interest Arbitrage in Norwegian Kroner:

Principal
Converted to Norwegian kroner at the spot rate (NKr/$) of
Yielding this principal in Norwegian kroner
Invested at Norwegian Treasury bill rate for the 3-month period
Yielding this amount of Norwegian kroner at the end of 3 months
Opportunity cost of investing in Norway over the US:
$500,000.00
6.2280
3,114,000.00
1.200%
3,151,368.00
6.2640
$503,091.95
$3,091.95
($2,408.05)
61
62
Assumptions
Spot exchange rate (US$/euro)
One-year Treasury bill rate
Expected inflation rate
Frankfurt
1.2200
2.100%
?
New York
1.2200
1.500%
2.000%
102.100%
?
99.510%
101.500%
102.000%
99.510%
0.490%
a. What do the financial markets suggest for inflation in Europe next year?
According to the Fisher Effect, real interest rates should be the same in both Europe and the United States.
Since the nominal rate = [(1 + real) (1 + expected inflation)] 1:
1 + real rate = (1 + nominal)/(1 + expected inflation)
1 + nominal rate
1 + expected inflation
So 1 + real =
and therefore the real rate in the US is:
The expected rate of inflation in Frankfurt is then:
2.603%
b. Estimate todays one-year forward exchange rate between the dollar and the euro.
Spot exchange rate (US$/euro)
US dollar one-year Treasury bill rate
European euro one-year Treasury bill rate
1.2200
1.500%
2.100%
One year forward rate (US$/euro)
1.2128
Problem 4.11 Frankfurt and New York
Problem 4.12 The Beer Standard
Country
Beer
South Africa
Botswana
Ghana
Kenya
Malawi
Mauritius
Namibia
Zambia
Zimbabwe
Castle
Castle
Star
Tusker
Carlsberg
Phoenix
Windhoek
Castle
Castle
Local
Currency
Beer Prices
Local
Currency
In
Rand
Implied
PPP Rate
Spot
Rate
3/15/99
Under or
Overvalued
to Rand (%)
Rand
Pula
Cedi
Shilling
Kwacha
Rupee
N$
Kwacha
Z$
2.30
2.20
1,200.00
41.25
18.50
15.00
2.50
1,200.00
9.00
2.94
3.17
4.02
2.66
3.72
2.50
3.52
1.46
0.96
521.74
17.93
8.04
6.52
1.09
521.74
3.91
0.75
379.10
10.27
6.96
4.03
1.00
340.68
6.15
27.9%
37.6%
74.6%
15.6%
61.8%
8.7%
53.1%
36.4%
Chapter 4
Notes:
1. Beer price in South African rand = Price in local currency/spot rate on 3/15/99.
2. Implied PPP exchange rate = Price in local currency/2.30.
3. Under or overvalued to rand = Implied PPP rate/spot rate on 3/15/99.
63
Chapter 5
Foreign Exchange Rate Determination
T Questions
Term forecasting
1.
What are the major differences between short-term and long-term forecasts for a fixed versus floating
exchange rate?
Long-run forecasts may be motivated by a multinational firms desire to initiate a foreign investment
in Japan, or perhaps to raise long-term funds denominated in Japanese yen. Or a portfolio manager
may be considering diversifying for the long term in Japanese securities. The longer the time horizon
of the forecast, the more inaccurate but also the less critical the forecast is likely to be. The forecaster
will typically use annual data to display long-run trends in such economic fundamentals as Japanese
inflation, growth, and the BOP.
Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend
for perhaps a period of three months. In this case the long-run economic fundamentals may not be as
important as technical factors in the marketplace, government intervention, news, and passing whims
of traders and investors. Accuracy of the forecast is critical since most of the exchange rate changes
are relatively small even though the day-to-day volatility may be high.
Chapter 5
65
Forecasting services normally undertake fundamental economic analysis for long-term forecasts, and
some base their short-term forecasts on the same basic model. Others base their short-term forecasts
on technical analysis similar to that conducted in security analysis. They attempt to correlate exchange
rate changes with various other variables, regardless of whether there is any economic rationale for the
correlation. The chances of these forecasts being consistently useful or profitable depends on whether
one believes the foreign exchange market is efficient. The more efficient the market is, the more likely
it is that exchange rates are random walks, with past price behavior providing no clues to the future.
The less efficient the foreign exchange market is, the better the chance that forecasters may get lucky
and find a key relationship that holds, at least for the short run. If the relationship is really consistent,
however, others will soon discover it and the market will become efficient again with respect to that
piece of information. Exhibit 5.9 summarizes the various forecasting periods, regimes, and the
authors opinions on the preferred methodologies.
Exchange rate dynamics
2.
What is meant by the term overshooting? What causes it and how is it corrected?
Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 5.10 in the
text, is S0. The U.S. Federal Reserve announces an expansionary monetary policy which cuts
U.S. dollar interest rates. If euro-denominated interest rates remain unchanged, the new spot rate
expected by the exchange markets on the basis of interest differentials is S1. This immediate change
in the exchange rate is typical of how the markets react to news, distinct economic and political
events which are observable. The immediate change in the value of the dollar/euro is therefore based
on interest differentials.
As time passes, however, the price impacts of the monetary policy change start working their way
through the economy. As price changes occur over the medium to long-term, purchasing power parity
forces drive the market dynamics, and the spot rate moves from S1 towards S2. Although both S1 and
S2 were rates determined by the market, they reflected the dominance of different theoretical
principles. As a result, the initial lower value of the dollar of S1 is often explained as an overshooting
of the longer-term equilibrium value of S2.
66
Fundamental equilibrium
3.
What is meant by the term fundamental equilibrium path for a currency value? What is noise?
It appears from decades of theoretical and empirical studies that exchange rates do adhere to the
fundamental principles and theories outlined in the chapter (namely purchasing power parity and
interest rate parity). Fundamentals do apply in the long term. There is, therefore, something of a
fundamental equilibrium path for a currencys value.
It also seems that in the short term, a variety of random events, institutional frictions, and technical
factors may cause currency values to deviate significantly from their long-term fundamental path.
This is sometimes referred to as noise. Clearly, therefore, we might expect deviations from the longterm path not only to occur, but to occur with some regularity and relative longevity.
Asset market approach to forecasting

4.
Explain how the asset market approach can be used to forecast future spot exchange rates. How does
the asset market approach differ from the BOP approach to forecasting?
The asset market approach assumes that whether foreigners are willing to hold claims in monetary
form depends on an extensive set of investment considerations or drivers. These drivers include the
following:
(1) Relative real interest rates are a major consideration for investors in foreign bonds and short term
money market instruments.
(2) Prospects for economic growth and profitability are an important determinant of cross-border
equity investment in both securities and foreign direct investment.
(3) Capital market liquidity is particularly important to foreign institutional investors. Cross-border
investors are not only interested in the ease of buying assets, but also in the ease of selling those
assets quickly for fair market value if desired.
(4) A countrys economic and social infrastructure is an important indicator of that countrys ability
to survive unexpected external shocks and to prosper in a rapidly changing world economic
environment.
(5) Political safety is exceptionally important to both foreign portfolio and direct investors. The
outlook for political safety is usually reflected in political risk premiums for a countrys
securities and for purposes of evaluating foreign direct investment in that country.
(6) The credibility of corporate governance practices is important to cross-border portfolio investors.
A firms poor corporate governance practices can reduce foreign investors influence and cause
subsequent loss of the firms focus on shareholder wealth objectives.
(7) Contagion is defined as the spread of a crisis in one country to its neighboring countries and
other countries that have similar characteristicsat least in the eyes of cross-border investors.
Contagion can cause an innocent country to experience capital flight with a resulting
depreciation of its currency.
(8) Speculation can both cause a foreign exchange crisis or make an existing crisis worse. We will
observe this effect through the three illustrative cases that follow shortly.
Chapter 5
67
Technical analysis
5.
Explain how technical analysis can be used to forecast future spot exchange rates. How does
technical analysis differ from the BOP and asset market approaches to forecasting?
Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine
past trends that are expected to continue into the future. The single most important element of
technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate
movements, similar to equity price movements, can be subdivided into three periods: (1) day-to-day
movement, which is seemingly random; (2) short-term movements extending from several days to
trends lasting several months; (3) long-term movements, which are characterized by up and down
long-term trends. Long-term technical analysis has gained new popularity as a result of recent
research into the possibility that long-term waves in currency movements exist under floating
exchange rates.
Forecasting services
6.
Many treasurers subscribe to rather expensive on-line foreign exchange forecasting services even if
these services have a dubious record of consistently correct forecasts. What might motivate a
treasurer to continue to use a forecasting service?
A treasurer might continue to use a forecasting service because it exists. If the treasurer does not
use it, and guesses wrong on an exchange rate, the treasurer could be criticized for not using available
expert advice.
Cross-rate consistency in forecasting

7.
Explain the meaning of cross-rate consistency as used by MNEs. How do MNEs use a check of
cross-rate consistency in practice?
International financial managers must often forecast their home currency exchange rates for the set of
countries in which the firm operates, not only to decide whether to hedge or to make an investment,
but also as an integral part of preparing multi-country operating budgets in the home countrys
currency. These are the operating budgets against which the performance of foreign subsidiary
managers will be judged. Checking the reasonableness of the cross rates implicit in individual
forecasts acts as a reality check to the original forecasts.
Infrastructure weakness
8.
Infrastructure weakness was one of the causes of the emerging market crisis in Thailand in 1997.
Define infrastructure weakness and explain how it could affect a countrys exchange rate.
Infrastructure weakness refers to situations where public services (roads, railroads, electric power,
impartial judicial system, minimum corruption by politicians, adequate police and fire services,
reasonable health care systems, etc.) are dysfunctional. Lack of quality services increases the
difficulty and risk of operating a business in that country, which in turn means domestic investment
funds will tend to escape from the country and foreign investment funds will not enter. The flight of
domestic currencies and the lack of foreign demand for the domestic currency force the exchange rate
down (floating regime) or force the government to devalue (fixed exchange rate regime.)
68
Infrastructure strength
9.
Explain why infrastructure strengths have helped to offset the large BOP deficits on current account
in the United States.
The strength of the U.S.infrastructure encourages foreign capital to invest in the safety of the
United States. Foreign investors like the U.S. legal system, protection of intellectual property rights,
freedom from ethnic strife, and other aspects of the U.S. infrastructure conducive to business
development.
Speculation
10. The emerging market crises of 19972002 were worsened because of rampant speculation. Do
speculators cause such crisis or do they simply respond to market signals of weakness? How can a
government manage foreign exchange speculation?
Hot money is a term used to describe funds held in one currency (country) that will move very
quickly to another currency as soon as it is deemed weak. Such a quick flow will create severe shortterm pressures on the exchange rate., forcing depreciation or a devaluation. This run on the currency
may cause others to also try to exchange their local currency holdings for foreign money, aggravating
the already apparent weakness.
If a currency is fundamentally weak, a speculator such as George Soros may lead a flight from that
currency. He will succeed if he is correct in his assessment of the fundamentals, but if he is in error
he will lose on the speculation. In the Malaysian situation, Soros correctly assessed the situation, and
by moving first was probably instrumental in setting in motion underlying factors that would have
influenced exchange rates in any casepossibly at a later date. In other words, Soros did not cause
the currency crisis in a fundamental sense, but he may well have caused (and advanced) the timing of
what would have occurred eventually in any case.
Foreign direct investment
11. Swings in foreign direct investment flows into and out of emerging markets contribute to exchange
rate volatility. Describe one concrete historical example of this phenomenon during the last 10 years.
Cross-border investment flows are of two types: direct and portfolio. Investment flows into a country
mean that foreigners are buying the local currency, which factor will drive up the value of that local
currency. Such flows also give local entities, either private individuals and corporations or the central
bank, foreign exchange balances that can be used to import goods and services or held as foreign
exchange reserves. Together the investment inflows and their usage influence the countrys
exchange rate.
In the case of Thailand, investment flows went into the country before the 1997 crisis because Thai
interest rates and expected returns on direct investments were high, because the outside world
believed the Thai government would continue to support its currency, and because the outside world
did not pay attention to the infrastructure weaknesses in Thailand. When Thailand devalued its baht,
the outside world suddenly became aware of structural weaknesses and new investment inflows
stopped at once. This precipitated the devaluation of the baht and the beginning of devaluation in
neighboring countries.
Chapter 5
69
Thailands crisis of 1997

12. What were the main causes of Thailands crisis of 1997? What lessons were learned and what steps
were eventually taken to normalize Thailands economy?
The basic cause was a period of large imports of goods (deficit on current account) financed by
inflows of foreign capital (surplus on financial account), including local borrowing in cheaper
overseas markets. Maintenance of exchange rates of the various southeast Asian currencies had been
expected. The crisis was exacerbated by what came to be called crony capitalism where many
dealings were driven by friendships and relationships to governing officials rather than by market
factors.
Once the crisis was apparent, financial managers of MNEs should rationally stop expansion of local
facilities and try to repatriate cash balances in local currencies, if possible. This would cause the
financial component of the balance of payments to worsen for the countries involved. For companies
manufacturing for local consumption, a drop in local demand, possibly caused by an increase in costs
if imported components were needed, would lead to cut backs in production and resultant
unemployment, making the crisis-caused depression even worse.
Russias crisis of 1998
13. What were the main causes of Russias crisis of 1998? What lessons were learned and what steps
were taken to normalize Russias economy?
This crisis was caused by a deterioration over the prior half decade or so of the Russian economy.
During these years private and governmental Russian entities had borrowed large amounts of money
abroad, most of which was denominated in U.S. dollars. To service this foreign currency debt Russia
had to earn dollars from exports; however dollars earned, as well as dollars obtained by borrowing,
flowed out almost at once in the form of capital flight. Furthermore, most dollar earnings came from
the export of commodities, and commodity prices were falling worldwide, in part because of the
Asian crisis.
Deteriorating conditions in Russia, combined with corruption and incompetence by governmental
officials and continued capital flight meant that MNE financial managers should minimize the
amount of cash held in any Russian subsidiary. In effect they should join the capital flight, although
the form might be that of avoiding inflows of capital rather than flight of capital already in Russia.
Plans for additional investments should be delayed until the Russian economy stabilized. Of course,
such rational behavior on the part of managers of individual private entities worsens to some degree
what is already happening.
Argentina crisis of 20012002
14. What were the main causes of Argentinas crisis of 20012002? What lessons were learned and what
steps were taken to normalize Argentinas economy?
By 2001 crisis conditions had revealed three very important underlying problems with Argentinas
economy: (1) the Argentine peso was overvalued; (2) the currency board regime had eliminated
monetary policy alternatives for macroeconomic policy; and (3) the Argentine government budget
deficitand deficit spendingwas out of control.
The peso had indeed been stabilized. But inflation had not been eliminated, and the other factors
which are important in the global markets evaluation of a currencys valueeconomic growth,
corporate profitability, etc.had not necessarily always been positive. The inability of the pesos
value to change with market forces led many to believe increasingly that it was overvalued, and that
the overvaluation gap was rising as time passed.
70
Argentinas large neighbor to the north, Brazil, had also suffered many of the economic ills of
hyperinflation and international indebtedness in the 1980s and early 1990s. Brazils response, the
Real Plan, was introduced in July 1994. The real plan worked, for a while, but eventually collapsed
in January 1999 as a result of the rising gap between the reals official value and the markets
assessment of its true value.
Brazil was by far Argentinas largest trading partner. With the fall of the Brazilian real, however,
Brazilian consumers could no longer afford Argentine exports. It simply took too many real to
purchase a peso. In fact, Argentine exports became some of the most expensive in all of South
America as other countries saw their currencies slide marginally against the dollar over the decade.
But not the Argentine peso.
T Mini-Case: Turkeys Kriz (B) Uncovered Interest Arbitrage

1.
Was the Turkish liras collapse the result of a balance of payments crisis, an inflation crisis, a
political crisis, or an economic crisis?
Although we are tempted to say all of the above, the more rigorous response is a political landscape
which led to many of the common economic ills of a struggling emerging market. The inflationary
pressures, continual volatility in current and financial balance of payment accounts, and struggling
process of privatizationall reflect an economy in both political and structural transition. Although
the struggles with BOP accounts and inflation had been recurring, the Turkish liras fixed rate could
probably have survived if it had not been for the dollar-debt obligations acquired by the Turkish
banks. The activities of the banks served to not only undermine some of the economic reforms
underway, they threatened the stability of the banking system itselfthe pillar of any market
economys ability to grow and develop.
2.
Describe precisely how the Turkish banks were performing uncovered interest arbitrage. Do you feel
this was an inappropriate investment policy?
Turkish banks simply took advantageat least for as long as it lastedof a very easy arbitrage
opportunity. As illustrated in the following diagram, the Turkish banks borrowed Eurodollars at
relatively attractive rates, 8.000% per annum. They then exchanged the dollars for Turkish lira at the
currently fixed or managed exchange rate, TL500,000/$. The Turkish lira proceeds were then
invested in Turkish government bonds yielding the higher inflation-based rates of 20.00% per annum.
At the end of the period, the Turkish lira were then converted back to U.S. dollars at the fixed
exchange rate of TL500,000/$, yielding an uncovered interest rate arbitrage profit of $120,000.
Chapter 5
71
Note that the profits from the arbitrage activity as described here are in U.S. dollars. This was also a
characteristic of the Turkish bank positionsultimately positioning their profitability in the foreign
hard currency, the U.S. dollar. The arbitrage activity could continue as long as the exchange rate at
the end of the period did not change radically against the banksa severe devaluation of the lira.
This was what, in the end, occurred.
3.
How could the Turkish banks be contributing to financial crisis if they were purchasing Turkish
government bonds and helping finance and support their own government?
While it sounds helpful that the Turkish banks were promoting an active and growing market for
Turkish government debt, and in the process allowing the government to finance its expenditures at a
lower cost than without their activity, the source of their funds was the problem. By acquiring large
quantities of dollar-denominated debt, for a country already running a current account deficit, this
would inevitably lead to a currency crisis as the ability of the Turkish economy to generate sufficient
hard-currency earnings (U.S. dollars in this case) in order to service this debt would fall short.
4.
Which do you think is more critical to a country such as Turkey, fighting inflation or fighting a large
trade and current account deficit?
The consensus among most international economists and various international organizations is that
inflation is the first and foremost problem that must be controlled in order to establish a solid
foundation for economic growth, industrial development, full employment, and managed trade.
Current account deficits are not of themselves necessarily evil or destructive, but actually often a
characteristic of a fully employed rapidly expanding economy.
72
5.
The quote from Corporate Finance magazine, although noting the outside possibility of a
devaluation, was largely positive regarding Turkeys future in January 2001. What would you have
thought?
It seems that throughout history, after every currency crisis, there is the wailing voice crying out
why didnt you see this coming? This quotation is rather useful in pointing out that in many
(most?) currency crises there were at least murmurs in the marketplace prior to the crisis. The
quotation points out that there have been some positive actionsthe IMF capital injectionsbut that
there are continuing problems with inflation. The latter was expected to drive the value of the lira
down in the near future.
Chapter 5
T Problems
Problem 5.1 Brazilian real
What was the percentage change in its value?
Assumptions
Spot rate, Monday January 11, 1999, R$/$
Spot rate, Friday January 15, 1999, R$/$
Calculation percentage appreciation or depreciation
Percentage change in the real versus the dollar
Because the real fell in value:
Values
1.21
1.43
15.38%
Depreciation
73
74
Problem 5.2 Turkish lira

What was the exchange rate and percent devaluations?
Assumptions
Spot rate, February 20, 2001 (TL/$)
Turkish government announces a devaluation of:
Spot rate, February 24, 2001 (TL/$)
Values
68,000
20.00%
100,000
a. What was the exchange rate after devaluation?

Spot rate after devaluation
Check calculation: percentage change in values
85,000
20.0%
b. What was percentage change after falling to TL100,000/$?

Percentage change from initial value
Percentage change from devalued value
32.0%
15.0%
Chapter 5
Problem 5.3 Mexican peso

What was the percentage devaluation?
Assumptions
Spot rate, December 20, 1994 (Ps/$)
Spot rate, December 21, 1994 (Ps/$)
Calculation percentage of devaluation:
Percentage change in the peso versus the dollar
Values
3.30
5.50
40.00%
75
76
Problem 5.4 Russian ruble

Assumptions
Spot rate, August 7, 1998 (Rub/$)
Spot rate, September 10, 1998 (Rub/$)
Calculation of percentage change:
Percentage change in the ruble versus the dollar
Values
6.25
20.00
68.75%
Chapter 5
Problem 5.5 Thai baht

Assumptions
Opening spot rate, July 2, 1997 (Bt/$)
Closing spot rate, July 2, 1997 (Bt/$)
Percentage change in the baht versus the dollar
Values
25.00
29.00
13.79%
77
78
Problem 5.6 Ecuadoran sucre

What was the percentage change in its value?
Assumptions
Initial spot rate, 1999 (Sucre/$)
Ending spot rate, 1999 (Sucre/$)
Percentage change in the sucre versus the dollar
Values
5,000
25,000
80.00%
Problem 5.7 Forecating the Argentine peso

What will be the pesos future value in the coming weeks?
Date
February 1st (Ps/$)
February 28th (Ps/$)
Percent change
Eye-balled
Values
2.00
2.20
9.09%
2.20
9.09%
2.42
The period immediately following the pesos devaluation was highly volatile and a period of transition. Most forecasters would view the February period
as a period in which the new exchange rate is beginning to stabilize in its trading.
March 1, 2002 (Ps/$)

Percent change
March 30, 2002 (Ps/$)
Chapter 5
If peso continued to fall at same rate for 1 month:
79
80
Country
Australia
Japan
United States
Country
Australia
Japan
United States
Country
Australia
Japan
United States
Country
Australia
Japan
United States
Gross Domestic Product

Industrial
Retail
Unemployment
Forecast
Forecast
Production
Sales
Rate
Recent Qtr
2003
2004e
2005e
Recent Qtr
Recent Qtr
Recent Qtr
0.9%
2.8%
3.8%
3.1%
0.9%
7.7%
5.5%
6.1%
2.3%
4.1%
2.1%
8.7%
-0.5%
4.7%
4.4%
3.2%
4.7%
3.6%
6.3%
8.5%
5.6%
Consumer Prices
Producer Prices
Wages & Earnings
Forecast
Year Ago
2003
2004e
Latest
Year Ago
Latest
Year Ago
3.4%
2.7%
2.3%
1.1%
3.0%
5.1%
4.4%
0.1%
0.3%
0.1%
1.1%
1.1%
0.7%
1.8%
2.1%
2.3%
2.3%
4.9%
2.4%
2.2%
3.0%
Money
Interest Rates (percent per annum)
Supply
3-month money market
2-year
10-year Govt Bonds
Corporate
Growth
Latest
Year Ago
Govt Bonds
Latest
Year Ago
Bonds
11.0%
5.48%
4.62%
5.18%
5.90%
4.73%
6.66%
2.0%
0.02%
0.01%
0.20%
1.87%
0.63%
1.93%
5.5%
1.40%
0.88%
2.74%
4.70%
3.35%
6.11%
Trade Balance
Current Account
Trade-Weighted Exchange
Currency
Last 12 mos
Last 12 mos
Actual 2003
Forecast 04
Rate (1990 = 100)
per Pound
(billion $)
(billion $)
(% of GDP)
(% of GDP)
June 23
Year Ago
June 23
16.8
$33.0
6.2%
5.2%
81.6
83.5
2.65
121.4
$157.2
3.0%
3.3%
136.1
128.5
198
568.9
$537.3
5.0%
5.1%
97.5
101.9
1.82
Problems 5.85.10 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States
8. Current spot rates. What are the current spot exchange rates for the following cross rates?
a. Japanese yen/US dollar exchange rate
= (yen/pound spot)/(US$/pound spot)
108.79
b. Japanese yen/Australian dollar exchange rate
= (yen/pound spot)/(A$/pound spot)
74.72
c. Australian dollar/US dollar exchange rate

= (A$/pound spot)/(US$/pound spot)
9. Purchasing power parity forecasts. Assuming purchasing power parity, and that the forecast of consumer price
increases for the coming year are correct, forecast the:
= Spot (Y/US$) (1 + Y-inflation)/(1 + US$-inflation)
b. Japanese yen/Australian dollar in 1
= Spot (Y/A$) (1 + Y-inflation)/(1 + A$-inflation)
a. Japanese yen/US dollar in 1 year
= Spot (Y/US$) (1 + i-2year-Yen)/(1 + i-2year-US$)
b. Japanese yen/Australian dollar in 1 year = Spot (Y/A$) (1 + i-2year-Yen)/(1 + i-2year-A$)

c. Australian dollar/US dollar in 1 year
= Spot (A$/US$) (1 + i-2year-A$)/(1 + i-2year-US$)
72.96
1.4560
106.10
71.18
1.4906
c. Australian dollar/US dollar in 1 year

= Spot (A$/US$) (1 + A$-inflation)/(1 + US$ inflation)
10. International Fisher forecasts. Asssuming International Fisher applies to the coming year, forecast the
following future spot exchange rates using the 2-year government bond interest rates:
106.24
Chapter 5
a. Japanese yen/US dollar in 1 year
1.4560
81
82
Country
Australia
Japan
United States
Recent Qtr
0.9%
6.1%
4.4%
Country
Australia
Japan
United States
Year Ago
3.4%
0.1%
2.1%
Money
Supply
Growth
11.0%
2.0%
5.5%
Trade Balance
Country
Australia
Japan
United States
Country
Australia
Japan
United States
Last 12 mos
(billion $)
16.8
121.4
568.9

Forecast
2003
2004e
2.8%
3.8%
2.3%
4.1%
3.2%
4.7%
Consumer Prices
Forecast
2003
2004e
2.7%
2.3%
0.3%
0.1%
2.3%
2.3%
Latest
Year Ago
5.48%
4.62%
0.02%
0.01%
1.40%
0.88%
Curent Account
Last 12
mos
Actual 2003
(billion $)
(% of GDP)
$33.0
6.2%
$157.2
3.0%
$537.3
5.0%
Industrial
Forecast
Production
2005e
Recent Qtr
3.1%
0.9%
2.1%
8.7%
3.6%
6.3%
Producer Prices
Retail
Unemployment
Sales
Rate
Recent Qtr
Recent Qtr
7.7%
5.5%
0.5%
4.7%
8.5%
5.6%
Wages & Earnings
Latest
Year Ago
Latest
1.1%
3.0%
5.1%
1.1%
1.1%
0.7%
4.9%
2.4%
2.2%
2-year
10-year Govt Bonds
Govt Bonds
Latest
Year Ago
5.18%
5.90%
4.73%
0.20%
1.87%
0.63%
2.74%
4.70%
3.35%
Corporate
Bonds
6.66%
1.93%
6.11%
Currency
Rate (1990 = 100)

June 23
Year Ago
81.6
83.5
136.1
128.5
97.5
101.9
per Pound
June 23
2.65
198
1.82
Forecast 04
(% of GDP)
5.2%
3.3%
5.1%
Year Ago
4.4%
1.8%
3.0%
Problem 5.115.13 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States
11. Implied real interest rates. If the nominal interest rate is the 2-year government bond rate, and the consumer
price forecast is expected inflation, calculate the following real interest rates:
a. Australian dollar real rate forecast for 2003:
= (1 + nominal)/(1 + 2yr consumer price change forecast) 1
2.82%
b. Japanese yen real rate forecast for 2003:
0.30%
c. US dollar real rate forecast for 2003:
0.43%
Note that none of the real interest rates calculated is larger than 1.8%. In the case of Japan, the real interest rate calculated
is only as large as it is because of the forecast deflation in the price level (negative change in consumer prices). In the case
of the United States, the real rate calculated is actually negative as a result of unusually low nominal interest rates while
consumer prices are still seen to be rising over 2% per annum.
12. Forecasting with real interest rates. Using the real interest rates calculated in problem 11, forecast the
b. Japanese yen/Australian dollar exchange rate in 1 year
= Spot (Y/A$) (1 + Y-real)/(1 + A$-real)
108.65
72.89
1.4906
= Spot (Y/A$) (1 + i-3mo-Yen 90/360)/(1 + i-3mo-A$ 90/360)

= Spot (A$/US$) (1 + i-3mo-A$ 90/360)/(1 + i-3mo-US$ 90/360)
73.71
1.4708
b. Japanese yen/Australian dollar 90-day forward rate

c. Australian dollar/US dollar 90-day forward rate
108.42
c. Australian dollar/US dollar exchange rate in 1 year

= Spot (A$/US$) (1 + A$-real)/(1 + US$-real)
13. Forward rates as forecasts. Calculate the 90-day forward rate on the following currency pairs using the
current spot rate and the latest 3-month money market interest rates:
a. Japanese yen/US dollar 90-day forward rate
= Spot (Y/US$) (1 + i-3mo-Yen 90/360)/(1 + i-3mo-US$ 90/360)
Chapter 5
following future spot exchange rates using real interest rate differentials:
a. Japanese yen/US dollar exchange rate in 1 year
= Spot (Y/US$) (1 + Y-real)/(1 + US$-real)
83
84
Country
Australia
Japan
United States
Country
Australia
Japan
United States
Country
Australia
Japan
United States
Country
Australia
Japan
United States

Industrial
Retail
Unemployment
Forecast
Forecast
Production
Sales
Rate
Recent Qtr
2003
2004e
2005e
Recent Qtr
Recent Qtr
Recent Qtr
0.9%
2.8%
3.8%
3.1%
0.9%
7.7%
5.5%
6.1%
2.3%
4.1%
2.1%
8.7%
0.5%
4.7%
4.4%
3.2%
4.7%
3.6%
6.3%
8.5%
5.6%
Consumer Prices
Producer Prices
Wages & Earnings
Forecast
Year Ago
2003
2004e
Latest
Year Ago
Latest
Year Ago
3.4%
2.7%
2.3%
1.1%
3.0%
5.1%
4.4%
0.1%
0.3%
0.1%
1.1%
1.1%
0.7%
1.8%
2.1%
2.3%
2.3%
4.9%
2.4%
2.2%
3.0%
Money
Supply
2-year
10-year Govt Bonds
Corporate
Growth
Latest
Year Ago
Govt Bonds
Latest
Year Ago
Bonds
11.0%
5.48%
4.62%
5.18%
5.90%
4.73%
6.66%
2.0%
0.02%
0.01%
0.20%
1.87%
0.63%
1.93%
5.5%
1.40%
0.88%
2.74%
4.70%
3.35%
6.11%
Trade Balance
Current Account
Currency
Last 12 mos
Last 12 mos
Actual 2003
Forecast 04
Rate (1990 = 100)
per Pound
(billion $)
(billion $)
(% of GDP)
(% of GDP)
June 23
Year Ago
June 23
6.2%
16.8
$33.0
5.2%
81.6
83.5
2.65
121.4
$157.2
3.0%
3.3%
136.1
128.5
198
568.9
$537.3
5.0%
5.1%
97.5
101.9
1.82
Problems 5.145.15 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States
14. Real economic activity and misery. Calculate the countrys Misery Index (unemployment + inflation) and then
use it like interest differentials to forecast the future spot exchange rate, one year into the future.
Australias Misery Index
Forecast spot = Spot ( 1 + Misery-1)/( 1 + Misery-2)
7.80%
Japans Misery Index
4.60%
United Statess Misery Index
7.90%
Starting
Spot Rate
108.79
74.72

1.4560
15. Balance of payments approach. Using the trade and current account information, forecast the direction of the
spot exchange rates for the coming year.
Japan is running a trade & current account surplus

Australia is running a trade & current account deficit
Australian dollar should weaken against the yen.
Australia is running a trade & current account deficit

US is running a trade & current account deficit
Indeterminate.
1.45
Japan is running a trade & current account surplus

US is running a trade & current account deficit
Dollar should weaken against the Japanese yen.
72.50
Chapter 5
Forecast
Spot Rate
105.46
85
86
2004 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Time period shown in diagrams: 1/Jan/19997/Sep/2004
16. Current accounts and spot rates. Are the current account forecasts from the previous question consistent
with the exchange rate trends shown above?
The Japanese yen appreciated in value against the US dollar over most of 2002 and 2003, stabilizing in 2004. This is consistent with the trade and current account balances
being run by the two countries.
The Australian dollar consistently strengthened against the US dollar over 20022003 period. The US dollar recovered some of its lost value in 2004. Although Australia and
the United States have similar inflation rate fundamentals, the Australian economy has grown at a more rapid rate in recent years.
17. Exchange rate trends and bounds. Use the graphs to determine trends, mean values, and upper and lower
bounds to spot exchange rate movements.
Upper
Lower
Trend
Mean
Bound
Bound
Yen/US$
US$ down
110115
135.00
102.50
A$/US$
US$ down
1.501.60
2.00
1.3
Problem 5.165.17 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States

9602 in Fin Solve

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Chapter 1

Financial Goals and Corporate Governance

Trident, the MNE

Moffett Fundamentals of Multinational Finance, Second Edition

Financial Goals and Corporate Governance

Corporate goals: shareholder wealth maximization

Corporate goals: corporate wealth maximization

Define the following terms:

Moffett Fundamentals of Multinational Finance, Second Edition

What should be the primary operational goal of an MNE?

Financial Goals and Corporate Governance

Moffett Fundamentals of Multinational Finance, Second Edition

Financial Goals and Corporate Governance

Moffett Fundamentals of Multinational Finance, Second Edition

Emerging markets corporate governance failures

T Mini-Case: The Failure of Corporate Governance at Enron

Financial Goals and Corporate Governance

Moffett Fundamentals of Multinational Finance, Second Edition

a. If the company paid no dividend (plugging zero in for the dividend):

Financial Goals and Corporate Governance

Problem 1.2 Shareholder choices

a. Average shareholder return for the period is

Moffett Fundamentals of Multinational Finance, Second Edition

Problem 1.3 Microsofts dividend

Financial Goals and Corporate Governance

Problem 1.4 Dual Classes of Common Stock (A)

Votes per Share

Moffett Fundamentals of Multinational Finance, Second Edition

Problem 1.5 Dual Classes of Common Stock (B)

Votes per Share

b. What proportion of voting rights is represented by A-shares?

Problem 1.6 Price/Earnings ratios and acquisitions

Rate of exchange: Pharm-USA shares per Pharm-Italy shares:

P/E Consolidated earnings = 40 $20,000,000

Financial Goals and Corporate Governance

d. What is the new earnings per share of Pharm-USA?

e. What is the new market value of a share of Pharm-USA?

f. How much did Pharm-USAs stock price increase?

Moffett Fundamentals of Multinational Finance, Second Edition

Problem 1.6 Price/Earnings ratios and acquisitions (Continued)

Problem 1.7 Corporate governance: Overstating earnings

Financial Goals and Corporate Governance

Earnings before taxes, EBT (local currency)

Avg exchange rate for the period (fc/$)

Consolidated profits (total across units)

Business Performance (000s)

a. Consolidated earnings per share (EPS)

b. Proportion of total profits originating

c. Proportion of total profits originating

Moffett Fundamentals of Multinational Finance, Second Edition

Problem 1.8 Trident Corporations Consolidated Earnings

Problem 1.9 Tridents EPS Sensitivity to Exchange Rates

Net profits of individual subsidiary

Consolidated profits (total across units)

Total diluted shares outstanding (000s)

Baseline earnings per share (EPS)

Net profits of individual subsidiary (US$)

Consolidated profits (total across units)

Baseline earnings per share (EPS)

b. If both the real and the earnings in

EPS has fallen 5 percent from baseline.

Financial Goals and Corporate Governance

Earnings before taxes, EBT (local currency)

Brazil fall, Tridents EPS is now: