Seminar 8 (week 9) Read: Chapters 7, 8, 9 & 16 of Eun and Resnick Part A: Tutorial solutions will be discussed in week 9 meeting

1. Japanese MNCs, such as Toyota, Toshiba, Matsushita, etc., made extensive investments in the Southeast Asian countries like Thailand, Malaysia and Indonesia. In your opinion, what forces are driving Japanese investments in the region? Answer: Most likely, these Japanese MNCs have invested heavily in Southeast Asia in order to take advantage of under priced labor services and cheaper land and other factors of production. Refer to the life-cycle theory of FDI. 2. Explain Vernons product life-cycle theory of FDI. What are the strength and weakness of the theory? Answer: According to the product life-cycle theory, firms undertake FDI at a particular stage in the lifecycle of the products that they initially introduced. When a new product is introduced, the firm chooses to keep production at home, close to customers. But when the product become mature and foreign demands develop, the firm may be induced to start production in foreign countries, especially in low-cost countries, to serve the local markets as well as to export the product back to the home country. As can be inferred from the boxed reading on Singer in the text, the product life-cycle theory can explain historical development of FDI quite well. In recent years, however, the international system of production has become too complicated to be explained neatly by the life-cycle theory. For example, new products are often introduced simultaneously in many countries and production facilities may be located in many countries at the same time. 3. What factors would you consider in evaluating the political risk associated with making FDI in a foreign country. Answer: Factors to be considered include: (1) the host countrys political and government system; (2) track record of political parties and their relative strength; (3) the degree of integration into the world system; (4) the host countrys ethnic and religious stability; (5) regional security; and (6) key economic indicators.

4. How would you define economic exposure to exchange risk?

Answer: Economic exposure can be defined as the possibility that the firms cash flows and thus its market value may be affected by the unexpected exchange rate changes. 5. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth 2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., 1,500, but the pound will be stronger, i.e., $1.50/. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability. (a) Estimate your exposure b to the exchange risk. (b) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty. (c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging. Solution: (a) Let us compute the necessary parameter values: E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580 E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44 Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2 = .00096+.00144 = .0024. Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44) = -5.28-7.92 = -13.20 b = Cov(P,S)/Var(S) = -13.20/.0024 = -5,500. You have a negative exposure! As the pound gets stronger (weaker) against the dollar, the dollar value of your British holding goes down (up). (b) b2Var(S) = (-5500)2(.0024) =72,600($)2 (c) Buy 5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your British asset that is due to the exchange rate volatility. 6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen. (a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges.

(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used. (c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge? Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124) = $4,147,465. (b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08) = $75,600. At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will exercise its call option and buy 500,000,000 for $4,050,000 (=500,000,000x.0081). The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000. (c) When the option hedge is used, PCC will spend at most $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges. 7 How would you define transaction exposure? How is it different from economic exposure? Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firms contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and short-term.

8. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed 250 million payable in three months. Currently, the spot exchange rate is 105/$ and the three-month forward rate is 100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable. (a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation. (b) Conduct the cash flow analysis of the money market hedge. Solution: (a). Lets first compute the PV of 250 million, i.e., 250m/1.0175 = 245,700,245.70 So if the above yen amount is invested today at the Japanese interest rate for three months, the

maturity value will be exactly equal to 25 million which is the amount of payable. To buy the above yen amount today, it will cost: $2,340,002.34 = 245,700,245.70/105. The dollar cost of meeting this yen obligation is $2,340,002.34 as of today. (b) ___________________________________________________________________ Transaction CF0 CF1 ____________________________________________________________________ 1. Buy yens spot with dollars 2. Invest in Japan 3. Pay yens Net cash flow - $2,340,002.34 -$2,340,002.34 245,700,245.70 - 245,700,245.70 250,000,000 - 250,000,000

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Part B: (Self-test questions, suggested answers will be posted on Monday after tute) 1. What operational and financial measures can a MNC take in order to minimize the political risk associated with a foreign investment project? Answer: First, MNCs should explicitly incorporate political risk in the capital budgeting process and adjust the projects NPV accordingly. Second, MNCs can form joint-ventures with local partners or form a consortium with other MNCs to reduce risk. Third, MNCs can purchase insurance against political risk from OPIC, Lloyds, etc. 2. After you read the research paper on stock pricing in the iLearn (Ariff and Marisetty), is it

possible to use a market-determined measure of country risk. Please explain what the risk measure is. Yes, it is possible to measure risk as determined by the market that prices the risk of a country. This is based on the International Asset Pricing Theory (Solnik 1974). This measure is called the country beta. Country beta is the sensitivity of a countrys world share price to a given countrys share price. In that paper, 22 countries were covered, and each had a risk measure.
3. Explain the following statement: Exposure is the regression coefficient. Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firms future cash flows and the market value to random changes in exchange rates. Statistically, this

sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the regression coefficient.

4. Assume todays settlement price on a CME EUR futures contract is $1.3140/EUR. You have a
short position in one contract. Your performance bond account currently has a balance of $1,700. The next three days settlement prices are $1.3126, $1.3133, and $1.3049. Calculate the changes in the performance bond account from daily marking-to-market and the balance of the performance bond account after the third day. Solution: $1,700 + [($1.3140 - $1.3126) + ($1.3126 - $1.3133) + ($1.3133 - $1.3049)] x EUR125,000 = $2,837.50, where EUR125,000 is the contractual size of one EUR contract. 5. Do problem 4 again assuming you have a long position in the futures contract. Solution: $1,700 + [($1.3126 - $1.3140) + ($1.3133 - $1.3126) + ($1.3049 - $1.3133)] x

EUR125,000 = $562.50, where EUR125,000 is the contractual size of one EUR contract. With only $562.50 in your performance bond account, you would experience a margin call requesting that additional funds be added to your performance bond account to bring the balance back up to the initial performance bond level.