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FURTHER TEST BANK QUESTIONS © Pearson Education Limited 2004 FURTHER QUESTIONS TO TEST BANK NUMBER ONE A. The six-month interest rate or the Canadian $ is 9% when the six-month interest rate for the US $ is 6.75%. At the same time the spot Canadian $ quotation in New York is US $0.9100 and the six-month forward rate is US $0.9025. (a) Is interest rate parity holding? Why? (b) If not, how could advantage be taken of the situation? (c) If a large number of operators decide to do the arbitrage suggested under (b), what will the effect be upon spot and forward quotations and upon interest rates for the two currencies? B. Imagine that you are a trader working for a New York bank. The spot exchange rate against the Canadian $ is US $0.9968 and the one-month and oneyear forward rates are respectively US $0.9985 and US $1.0166. Twelve-month interest rates in the USA and Canada may be taken as 6.45% and 4.46% respectively. (a) What is the forward premium as an annual percentage? (b) Which currency is at a premium? Why? You become party to some inside information which suggests that US interest rates will rise by 1 per cent per annum during the next month. The bank has a rule that in the foreign exchange markets ‘buy equals sell’. This means that for any currency the total of long positions must equal the total of short positions – but this aggregation disregards maturity. (c) Indicate the mechanics of two operations by which you may trade in expectation of profit for the bank should the inside information turn out to be well-founded. © Pearson Education Limited 2004 C. On 27 March 2004 the following applied: £/krone spot value 3.79–3.80 £ three-month interest 1311/16–139/16 Krone three-month interest 61/16–515/16 £/krone three-month forward 71/8–7pm (The ensuing three months consists of 90 days) The treasurer of a £-based company decided to hedge a krone receivable due in three months time. What are two alternative methods, and what are the effective interest rates for each? Why are they not the same? D. A UK company has a requirement for krone for 3 months. A proposition is put that the currency should be borrowed direct due to the low interest rate. At 27 March 2004: £/krone spot 3.2075–3.2175 £/krone three-month forward 2.75–2.25 cents pm £ three-month interest 1311/16–139/16 krone three-month interest 57/8–53/4 Should the proposition be carried? E. Given the exchange rate and interest rate information below, what quote would you expect for buying and selling forward Doppels: (a) for one month forward? (b) for two months forward? (c) if the quotes obtained were different from these what factors would determine the corporate response to the existence of such differentials © Pearson Education Limited 2004 Exchange Rate £/Doppel spot £1 3.331/4 3.341/4 Eurocurrency Interest Rates one month three months Sterling 101/4–101/8 10–915/16 Doppel 41/2–45/8 41/2–45/8 F. You are a Foreign Exchange Dealer in a large UK-based company, in which the treasury is a profit centre. Your dealing limit is £10m. You are given the following quotes: £/$ $/Doppel Spot 12 month Forward £1 $1.5802/12 515/505 $1 DP2.0065/75 359/354 £/Doppel 1763/1728 You are also aware of the following 12-month euro interest rates: £ 131/16–1215/16 $ 93/8–91/4 Doppel (a) 75/16–73/16 If your only objective is to generate a profit, what would you do and why? (b) Does this course of action involve any drawbacks for the company? © Pearson Education Limited 2004 FURTHER QUESTIONS TO TEST BANK NUMBER TWO G. You are Treasurer of a large UK plc in a segment of the consumer durable industry which is dominated by three companies: yourselves, a Swiss and a German company. Your Board of Directors has recently entered discussions with the other two companies concerning the establishment of a joint venture manufacturing company to exploit a market opportunity. The joint venture company will have its assets and its domicile in Switzerland. Maximum use will be made of debt. The likely structure of ownership is shown below, together with estimates of sales by currency and costs by currency. Currency of Currency of Ownership % Sales % Costs % UK 40 10 20 Switzerland 15 5 40 West Germany 35 20 15 US 5 35 10 Japan 5 30 15 Country You have been asked to produce a paper which outlines alternative currency structures appropriate for financing the joint venture, and makes a recommendation. (a) What are the factors to be considered? (b) What would your recommendation be, giving your reasons? (Association of Corporate Treasurers: Part II, September 1987, Paper in Currency Management) H. Domestic Group plc has until now been a group entirely located in the UK, in terms of its sourcing, manufacturing and trading. I has bought all its supplies, © Pearson Education Limited 2004 incurred all its cost, and faced all its competition from within the UK, from UK based competitors. Following a period of acquisition-led growth, Domestic Group now has two companies operating in international markets. Both are based in the UK, operating entirely domestically, except for the following: the first sells specialist scientific equipment, largely to West Germany; while the second buys commodity-type materials, largely from West Germany. Given that the euro values of trade are roughly similar, what are the exposure risks, and how should they be managed? I. You are Treasurer of a group with subsidiaries in several countries. The closing rate method is used for translating non-sterling balance sheets and profit and loss accounts into sterling or consolidation purposes. Throughout the last year, one subsidiary’s local currency has strengthened significantly versus sterling, against the long term trend. The currency concerned is, however, expected to revert to its previous trend. The group is a net borrower in a variety of currencies. The subsidiary has positive net assets and is at present holding cash. (a) What impact will the strengthening local currency have on the group’s consolidated accounts? (b) What are the advantages and disadvantages of the alternative methods of hedging this translation exposure? (Association of Corporate Treasurers: Part II, September 1990, Paper in Currency Management) © Pearson Education Limited 2004 FURTHER QUESTIONS TO TEST BANK NUMBER THREE J. Your company has recently decided to cease manufacture of a particular product and instead buy in from either a Far Eastern manufacturer or a Middle Eastern trader. As your markets are exclusively domestic, this represents your company’s first contact with the foreign exchange market. Your Managing Director asks how to buy foreign currency and how and where to pay for it. He appears to be of the view that the best course of action is to delegate this area to the company’s sole clearing bank. Assuming the currencies concerned are freely tradable, how would you advise him? (Association of Corporate Treasurers: Part II, September 1985, Paper in Currency Management) K. A UK company has excess cash for a period of 3 months. A proposition is put that it should be invested in the Batavian drac (a fully convertible currency) due to the high interest rate. When the decision is to be made the rates are as follows: £1 2,5071/2–2,5081/2 £/drac spot £/drac 3-month forward 9–13 dis £ 3-month interest 121/2–123/8% Euro-drac 3-month interest 141/4–133/4% What would you do and why? L. Your company is a large consumer of dollar denominated commodity products. As a matter of policy the dollars are always bought on the spot market. You know that your next purchase will be in three or four months’ time. However, the exact time will be determined by the way spot prices move, or are expected to move. © Pearson Education Limited 2004 How would you manage the currency risk inherent in this situation? (Association of Corporate Treasurers: Part II, September 1985, Paper in Currency Management) M. “Swap transactions are the sure route to cheaper long-term finance for the corporate treasurer”. Explain your reasons for agreeing or disagreeing with this statement. (Association of Corporate Treasurers: Part II, September 1986, Paper in Funding Management) N. As Treasurer of a major company you are approached by the Finance Director of one of your UK-based subsidiaries which is in the business of supplying a service to customers worldwide. The subsidiary is about to submit a quote for a major contract to be awarded in three months’ time. The customer is a Saudi company and the major competitors are based in Germany and the US. The subsidiary is anxious to secure the business, but needs to ensure some, if minimal, level of profit. Make recommendations outlining the currency considerations in pricing and risk evaluation and the methods of mitigating the risk. (Association of Corporate Treasurers: Part II, September 1986, Paper in Currency Management) O. Over the past three years, the value of the £ in $ terms has ranged between 1.65 and 1.05. How would you evaluate a decision to invest in capacity to enable one of your UK subsidiaries to manufacture a product destined solely for the US market? © Pearson Education Limited 2004 What factors will have determined whether UK suppliers to the US market have been able to survive this volatility? (Association of Corporate Treasurers: Part II, September 1986, Paper in Currency Management) P. You have been appointed as European Treasurer for Global Materials Group plc. One of Global’s main products is an industrial product which is made from naturally occurring minerals in the UK. After extraction by the UK subsidiary the semi-processed material is shipped on to the German subsidiary where it is further processed and refined. It is then transported to a specialist distribution subsidiary in Denmark. The three subsidiaries have no other business, although very small amounts of semi-finished product are sold to third parties. There is a world market for the product, which is normally sold in US$. Each of the subsidiaries in the UK and Germany invoice their fellow subsidiaries in their home currency, and raise all debt in their own currencies. At present, Global Materials plc is aware that there are currency risks involved, but are unsure as to where they arise, what issues are raised, and how the risks should be managed. Using the following information, how would you advise them on the currency risks? Currency Analysis (£ million equivalent) GBP EUR DKK USD Total UK Costs 63 2 0 1 66 subsidiary Sales 85 2 1 2 90 West German Costs 60 55 2 3 120 subsidiary Sales 2 173 2 3 180 Danish Costs 4 176 15 0 195 subsidiary Sales 8 10 2 180 200 © Pearson Education Limited 2004 All in £ million equivalent UK Germany 24 60 5 3 85 176 117 198 40 Stock Debtors – Creditors 27 27 40 Total Debt 54 117 40 Total Equity 90 108 40 Profit before Interest & Tax Raw Material cost Fixed Assets Q. Denmark The following is a summary of the published accounts (and notes thereto) of Sample plc. Sample plc is UK based and produces a range of food and household products with approximately 50 percent of its business overseas. Notes: Sample plc: Consolidated Balance Sheet 31 March 1988 £mn Fixed Assets: Tangible and intangible: 716 Investments: 105 (Including: Company securities held as long term trade investments valued at £2.80mn) Current Assets: Investments: (Comprising short term deposits) Other (Stock, Debtors, Cash) 81.2 966 Creditors due within one year: Loans Bank loans and overdrafts Bills of exchange payable Other (trade creditors, accruals) (20) (209.6) (40) (546) Total assets less current liabilities: 1052.6 Creditors due after more than one year: (1) Loans 112 Bank Loans 136.6 Shareholders’ funds 804 1052.6 © Pearson Education Limited 2004 Notes: (1) Loans are composed as follows: 61/2% unsecured loan stock 1987/92 Other medium term loans Commercial notes, issued in the USA and Holland with maturities between 30 and 90 days but classified as due after more than one year because it is the company’s intention to refinance them on a continuing basis. Medium term committed backup facilities have been arranged with US and UK banks in support of these notes £mn 30 20 62 112 (a) (b) (c) What types of interest rate risk arise in this company? Identify the information which you would request from Sample plc in order to provide a thorough analysis of its interest rate risk Advise Sample plc’s Board on the main methods of managing interest rate risk, commenting on the advantages and limitations of the methods. (Association of Corporate Treasurers: Part II, September 1988, Paper in Liquidity Management) © Pearson Education Limited 2004 FURTHER QUESTIONS TO TEST BANK NUMBER FIVE R. Hi-Tech Tractors is a manufacturer of agricultural tractors and earth moving equipment. It has experienced a period during which it has lost market share, with consequent decline of profitability, due to problems with its product line. During this time its indebtedness has increased and it is approaching what Hi-Tech has assessed to be the limit of its debt capacity. One cause of its increasing indebtedness has been the cost of a new product development programme which is now complete. Traditionally Hi-Tech has found the majority of its sales in the home market and has little experience of exporting. However, the company expects substantial overseas sales from its new product line both in developed and less developed countries and is mounting a sales drive accordingly based upon credit terms of 90 days in developed countries and up to two years in less developed countries. Hi-Tech is investigating methods of export finance for its expected overseas sales. What methods of export finance would you recommend to Hi-Tech and why? (Association of Corporate Treasurers: Part II, September 1988, Paper in Liquidity Management) S. What factors would you take into account in establishing your company’s borrowing capacity if you were finance director of a major plc: (a) in the advertising industry (b) in a production line manufacturing business (c) in a mixed construction, housing, property group (Association of Corporate Treasurers: Part II, September 1989, Paper in Corporate Finance) © Pearson Education Limited 2004 T. (i) (a) Explain what is meant by the yield curve and sketch the principal shapes it may take. (b) Explain what are the implications for interest rates of: a flat yield curve for three months which rises gradually thereafter a yield curve over six months which rises by 1/16% for each month a sterling yield curve for seven days with 13% for overnight rates and 10% thereafter (ii) Your company has £1 million to deposit for three months and receives the following quotes: (a) a bank deposit of 15% pa (with interest paid at the end) (b) a trade bill with a rate quoted of 151/16% (c) a certificate of deposit with a rate quoted of 14 15/16% Which provides the best post-tax return? Briefly discuss other issues which the Treasurer should consider in assessing these potential investments. (Association of Corporate Treasurers: Part II, September 1990, Paper in Liquidity Management) © Pearson Education Limited 2004