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Princeton University Press—International Finance:Theory Into PracticebyPiet SercuSOLUTIONS TO EXERCISESmagnanimously prepared byThi Ngoc Tuan Bui, Leuven SB&EMarian Kane, KBC BankFang Liu, Cheung Kong Business SchoolThi Tuon Van Nguyen, Leuven SB&E15:01 on 8 March 2009

15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

ForewordWriting the textook itself was an enormous task, over and above my regular work asa teacher, researcher, supervisor and administrator. Fortunately, as far as exerciseswere concerned I could fall back to a large extent on the predecessor book, SercuUppal’s International Financial Markets and the Firm. For many of these, there wereeven typed-up solutions extant, even though I must admit that much of the teacher’smanual of that book was mysteriously lost. The bulk of the original work, fifteenyears ago, had been done by Marian Kane, who was accordingly listed as the 1995Manual’s author. For the revision, I could enlist the help of Thi Ngoc Tuan Bui, FangLiu, and Thi Tuong Van Nguyen; even R. V. Badrinath provided some questions. Ithank them all very warmly.It seems likely that this set of solutions will turn out to be less than per fect. If you disagree with an answer shown here, please feel free to mail me [email protected], thus earning yourself many karma points and,who knows, perhaps even a reincarnation as a professor in Leuven.Blanden, March 8, 2009i

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Contents in Brief1 Why does the Existence of Borders Matter for Finance?12 International Finance: Institutional Background33 Spot Markets for Foreign Currency114 Understanding Forward Exchange Rates for Currency195 Using Forwards for International Financial Management276 The Market for Currency Futures357 Markets for Currency Swaps438 Currency Options (1): Concepts and Uses499 Currency Options (2): Hedging and Valuation6310 Do We Know What Makes Forex Markets Tick?7111 Do Forex Markets Themselves See What’s Coming?7312 (When) Should a Firm Hedge its Exchange Risk?7513 Measuring Exposure to Exchange Rates8114 Value-at-Risk: Quantifying Overall net Market Risks9315 Managing Credit Risk in International Trade9916 International Fixed-Income Markets10517 Segmentation/Integration of Stock Markets11118 Why—or when—Should we Cross-list our Shares?11319 Setting the Cost of International Capital11520 International Taxation of Foreign Investments12321 Putting it all Together: International Capital Budgeting13722 Negotiating a Joint-Venture Contract: the NPV Perspective145iii

iv15:01 on 8 March 2009CONTENTS IN BRIEFP. Sercu, K.U.Leuven SB&E

Chapter 1Why does the Existence of BordersMatter for Finance?[No exercises]1

2CHAPTER 1. WHY DOES THE EXISTENCE OF BORDERS MATTER FOR FINANCE?15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

Chapter 2International Finance:Institutional BackgroundQuiz QuestionsTrue-False Questions1. If a country has a BOP deficit, the total of all BOP subaccounts is negative.2. The current account is a record of all trade in goods and services, while thecapital account is a record of direct and portfolio investment and unilateraltransfers.3. When the us private sector purchases more goods or makes more investmentsabroad than foreigners purchase or invest in the us during a year, the FederalReserve (the us central bank) must make up for the shortfall.4. All errors and omissions in the BOP are a result of black market transactions.5. When a corporation purchases a company abroad, and the value of the firmappreciates over time, the NII and the capital account of the BOP is updated toreflect this change.6. The BOP theory of exchange rate determination says that most changes in theexchange rate are due to the arrival of new information about the future.7. Under a fixed exchange rate regime, if a country’s private sector sells abroadmore than it purchases, the central bank must sell foreign exchange.8. BOP theory is flawed is because it assumes that investors only invest in riskfree domestic and foreign assets.3

CHAPTER 2. INTERNATIONAL FINANCE: INSTITUTIONAL BACKGROUND4A. 1. false; 2. false; 3. true (if “investment” includes extending short-term credit);4. false; 5. false; 6. false (except for information on r and r*); 7. false (the centralbank must buy if the KA 0 and CA 0); 8. trueMultiple-Choice QuestionsFor the following three questions, assume that Antarctica is the home country,and its currency is the Antarctica dollar (AAD), and Greenland is the foreign countryand its currency is the crown (GRK). Choose the correct answer.1. All else being equal, an increase in income in Greenland leads to:(a) an increase in consumption in Antarctica, and therefore an increase inimports, resulting in an appreciation of the AAD.(b) a decrease in consumption in Antarctica, and therefore an increase inexports, resulting in a depreciation of the AAD.(c) an increase in consumption in Greenland, and therefore an increase inimports, resulting in an appreciation of the AAD.(d) an increase in consumption in Greenland, and therefore an increase inimports, resulting in a depreciation of the AAD.A1. (c).2. All else being equal, a decrease in the interest rate r in Greenland leads to:(a) decreased demand for assets in Greenland, and therefore a depreciationof the GRK.(b) decreased demand for assets in Greenland, and therefore a depreciationof the AAD.(c) an increase in consumption in Greenland, and therefore an increase inimports, resulting in an appreciation of the GRK.(d) an increase in consumption in Antarctica, and therefore an increase inexports, resulting in a depreciation of the AAD.A2. (a).3. All else being equal, a decrease in prices in Greenland leads to:(a) an increase in exports to Antarctica, and therefore an appreciation of theAAD.(b) an increase in exports to Antarctica, and therefore a depreciation of theAAD.(c) an increase in consumption in Greenland, and therefore an increase inimports, resulting in an appreciation of the AAD.(d) a decrease in consumption in Greenland, and therefore a decrease inimports, resulting in a depreciation of the AAD.15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

5A3. (b).Additional Quiz Questions1. The German subsidiary of a Canadian firm (that is, the subsidiary is ownedby the Canadian firm) is sold to a German firm. The Canadian firm invests thefunds obtained from the sale in Frankfurt. How is the transaction recorded inthe Canadian BOP?A1. Source: outward direct investment (decrease of foreign direct invest ment); use: outward portfolio investment.2. The BOP of Timbuktu showed the following entries for 1988: a capital accountsurplus of 50, a deficit in the services account of 15, and a trade deficit of45. The change in the official reserves was zero. What was the balance ofunilateral transfers for Timbuktu?A2.ΔRFX 0 usd50 CACA usd50 usd45 usd15 TransfersT usd10.3. If the central bank sets an exchange rate that undervalues the foreign currency—and the flows of goods and capital adjust simultaneously—what will be theimpact on the following:(a) RFX (increase/decrease)(b) BOP (surplus/deficit).A3.(a) The undervalued foreign currency encourages imports and discouragesexports to the home country, thus the CA is less than zero. Investment(including foreign direct investment in the export sector) is not attractive,therefore, the KA is likely to be less than 0. The BOP always balances,but CA and KA are likely to be negative, as we saw.(b) Whatever definition of the BOP you use, there is likely to be a deficit (netoutflow).4. If the current account balance has a surplus of usd 2 billion and the officialsettlements balance (RFX) has a deficit of usd 5 billion, what is the balance ofthe capital account?A4. Current account capital account ΔRFX . Thus, the capital accountbalance equals -7 billion.15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

CHAPTER 2. INTERNATIONAL FINANCE: INSTITUTIONAL BACKGROUND65. A British importer purchases goods from a French company and obtains atrade credit for the full value of the shipment (equal to GBP 100 ). How shouldthis transaction be recorded in the BOP of the UK?A5. Use: Imports -100; Source: Trade Credit 100 (short-term inward invest ment).6. Tumbikti, a country on the Atlantis continent, has a government deficit of 40billion while private investment exceeds private savings by 10 billion. Whatis Tumbikti’s current account balance if its exchange rate is fixed?A6.Taxes Gexp SavG usd40billion.SavP I SavP usd10billion.CA SavP SavG usd10billion usd40billion usd50billion.Applications1. Antarctica uses a system of fixed exchange rates, its current account deficit isusd 6 billion, and its capital account balance is usd 4 billion.Based on this information, answer the following questions.(a) What is the change in the official foreign exchange reserves of Antarctica?(b) What is the gap between the income of Antarctica and its expenditureon domestic output?(c) If there is only one other country in the world, Greenland, can youestimate the current account balance of Greenland?A1.CA usd6billionKA usd4billion(a) ΔRFX CA KA -usd 6 billion usd 4 billion -usd 2 billion(b) The gap between the Antarctica’s income and its expenditures on do mestic output (A) is its net exports, that is, its current account. Thus,-usd 6 billion.(c) usd 6 billion.15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

72. The data below is taken from the BOP of Switzerland. Based on this data,decide whether the following statement is true or false and explain youranswer.“From 1979 to 1982, foreigners have been net issuers of SF-denominated bonds inthe Swiss capital markets.”Portfolio investment(in billions of dollars)1979198019811982-11.8-11.8-11.9-32.2A2. We can conclude that, on balance, capital flowed out of Switzerland, but: This need not be because of Swiss purchases of securities. Possibly,Swiss banks granted loans to foreigners, or Swiss residents paid backbank loans that they had made abroad in the past. If the transactions do reflect Swiss purchases of securities, the securitiesneed not be bonds. For example, Swiss residents may have boughtstocks originally held by foreignersincluding stocks that were issued, inthe past, by Swiss companies. If the transactions relate to bonds, these need not be bonds newly issuedby foreigners. The bonds bought by Swiss residents could also be oldbondsincluding bonds originally issued abroad by Swiss companies.3. A company in Philadelphia purchases machinery from a Canadian companyfor usd 150 and receives one-year trade credit. The machinery is transported toPhiladelphia by a Canadian trucking company that charges the US companyusd 10. The US company insures the shipment with a US insurance companyand pays a premium of usd 3. After delivering the machinery to Philadelphia,the Canadian truck continues its trip to Houston, where it picks up micro computers sold by a Texan company to a Mexican company. This shipment,which is worth usd 170, is insured by a US insurance company for a premiumof usd 4. No trade credit is given to the Mexican company. Compute the BOPfor the US and assume that Canadian and Mexican companies maintain dollardeposits in New York.A3.By transaction:SourcesTrade credit (short-term inflow)Increase usd owned by Canadian*Exports (goods to Mexico)exports (services to Canadian trucker)150101704324UsesImports (goods from Canada)Imports (services from Canada)decrease usd owned by Mexicans*15010174324*: transactions on the short-term capital account. The Canadian trucker invests her revenue in a usddeposit (a “source”, from the US point of view), while the Mexican firm reduces its usd deposits (that is,the US reduces its debt to Mexicansa “use”, from the US point of view).15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

CHAPTER 2. INTERNATIONAL FINANCE: INSTITUTIONAL BACKGROUND8By BOP account:Balance of tradeInvisibles balanceCurrent accountSources1704174Uses15010160Net inflow20-614Short-term capital transactionsCapital account160160174174-14-14Balance of payments32432404. Suppose that you are an analyst for the Central Bank of Zanzibar. Decide howthe BOP accounts are affected by the following.(a) A budget deficit financed by foreign borrowing(b) An import quota for foreign cars(c) A purchase of a new embassy in Luxembourg(d) A grain embargoA4.(a) Sale of securities to foreigners: inward PI (source). The interest paidwill be an outflow (use) on the service balance, and the amortization anoutflow (use) on PI.(b) Trade balance: decrease in imports.(c) Transfers: outward unilateral transfer.(d) Trade balance: decrease in imports.5. The following data are taken from the balance of payments of Freedonia(currency fdk):Capital account1995199619971998Portfolio investment(in billions of dollars) 2.9-6.9-5.4-8.7Is the following statement consistent with the data shown above? “After1995, foreigners have issued fdk-denominated bonds in the Freedonian capital marketin order to take advantage of the favorable interest rate differential with respect to theUS capital market.”A5. Yes. If the German residents increase the amount of foreign assets theyown, the transaction is recorded as a use (outflow) in the German BOP: thereis an outflow of DEM.15:01 on 8 March 2009P. Sercu, K.U.Leuven SB&E

96. The following passage is from an article that appeared in a newspaper: “Lastyear, the US demand for capital to fund the federal deficit and to finance privateinvestment in buildings and equipment exceeded net domestic savings by about usd100 billion.” What can we infer about the magnitude of the US current accountdeficit?A6. It is at least usd-100 billion.7. The following passage is from an article that appeared in an old newspaper.Which account of the German BOP is the article talking about?“FRANKFURT, West Germany—West Germany’s balance of payments, which mea sures all flows of funds into and out of the country, was in surplus by the currentequivalent of usd 210.3 million in Februar