International Finance Test -
Use this information for the first five questions:
An American Hedge Fund is considering a one-year investment in an Italian government bond with a one-year maturity and a euro - denominated rate of return of t€ = 5%. The bond costs €1,000 today and will return €1,050 at the end of one year without risk. The current exchange rate is €1.00 - $1.50 U.S. dollar-denominated government bonds currently have a yield to maturity of 4%. Suppose that the European Central Bank is considering either tightening or loosening its monetary policy. It is widely believed that in year there are only two possibilities:
S1($|€) = $1.80 per € or S1($|€) = $1.40 per €
Following revaluation, the exchanging rate is expected to remain steady for at least another year.
1. Find the NPV in dollars for the American firm if they wait one year to buy the bond after the exchange rate rises to S1($|€) = $1.80 per €. Assume that t€ doesn't change.
2. Find the NPV in dollars for the American firm if they wait one year to undertake the project after the exchange rate falls to S1($|€) = $1.40 per €. Assume that t€ doesn't change.
3. The hedge fund manager notices the "win big"/"loss big" payoffs associated with starting this project today. He asks you to value this bond using risk neutral valuation.
4. Your banker quotes the euro-zone risk-free rate at t€ = 5% and the U.S. risk free rate at t$ = 4%. Find the value of the option to delay and thereby the correct value of the bond to a U.S. investor.
5. Using your results to the last question, make a recommendation vis-à-vis when to buy the bond.
6. Using the notion of hedging, make a recommendation vis-à-vis how to undertake the project today without "buying" the option.
7. An Italian firm is considering selling its line of coin-operated cappuccino machines in the U.K. The business risk will be identical to the firm's existing line of business in the euro zone, the cost of capital in the euro zone is t€ = 10%. The expected inflation rate over the next two years in the U.K. is 3% per year and 2% per year in the euro zone. The spot exchange rates are $1.80 = £1.00 and $1.15 = €1.00.
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Year 0
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Year 1
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Year 2
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-£100,000
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£25,000
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£100,000
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a) What is the £-denominated NPV of this project?
b) What is the £-denominated IRR of this project?
c) What is the €-denominated NPV of this project?
d) What is the €-denominated IRR of this project?
8. Your firm is a U.K.-based exporter of Swiss bicycles. You have sold an order with an Italian retailer for €750,000 worth of bicycles. Payment (in euro) is due in six month. Your firm want to hefge the receivable into pounds.
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Country
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U.S. $ equiv,
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Currency per U.S. $
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Tuesday
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Monday
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Tuesday
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Monday
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Britain (Pound) £62,500
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2.0000
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2.0002
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0.5000
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0.5000
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1 Month Forward
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1.9900
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1.9902
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0.5025
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0.5025
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3 Months Forward
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1.9800
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1.9802
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0.5051
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0.5050
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6 Months Forward
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2.0000
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1.9702
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0.5102
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0.5076
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12 Months Forward
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2.1000
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1.9602
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0.5102
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0.5102
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Euro €125,000
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1.4700
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1.4700
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1.05263
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1.20012
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1 Month Forward
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1.4800
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1.4800
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1.04167
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1.20616
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3 Months Forward
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1.4900
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1.4900
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1.03093
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1.21224
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6 Months Forward
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1.5000
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1.5000
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1.02041
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1.21840
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12 Months Forward
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1.5100
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1.5100
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1.01010
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1.22460
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a) Detail a strategy using futures contracting that will hedge your exchange rate risk. Have an estimate of how many contracts of what type (long or short on what currency at what price).
b) Outline a strategy using exchange rates and borrowing or lending that will hedge your exchange rate risk. Your answer does not require numbers, it requires a sentences.
c) Assume interest rates are 3% in €, 6% in $ and 4% in £, all quoted as an APR. Estimate the pound-denominated future value of the strategy that you offered in part b.
Attachment:- Assignment Files.rar