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1) Eurobonds versus Domestic Bonds - International Corporate Finance The dollar cost of debt for Coval Consulting, a U.S. research firm, is 7.5%. The firm faces a tax rate of 30% on all income, no matter where it is earned. Managers in the firm need to know its yen cost of debt because they are considering launching a new bond issue in Tokyo to raise money for a new investment there. The risk-free interest rates on dollars and yen are r$ = 5% and r¥ = 1%, respectively. Coval Consulting is willing to assume that capital markets are internationally integrated and that its free cash flows are uncorrelated with the yen-dollar spot rate. What is Coval Consultingβs after-tax cost of debt in yen? Answer: We first find the after-tax cost of debt in dollars and then find the yen equivalent. after-tax cost of debt = (0.075)(1 β 0.30) = 0.0525 or 5.25% To internationalize the cost of capital we use the following formula: π¥ = π¥ = π + π¥ β (π + π$ ) β π π + π$ π + π. ππ β (π + π. ππππ) β π = π. ππ% π + π. ππ 2) Credit & Exchange Rate Risk -International Corporate Finance Suppose the interest on Russian government bonds is 7.5%, and the current exchange rate is 28 rubles per dollar. If the forward exchange rate is 28.5 rubles per dollar, and the current U.S. riskfree interest rate is 4.5%, what is the implied credit spread for Russian government bonds? Answer: The covered interest parity equation is: π=πΊβ π + ππΉ π + π$ where F = forward exchange rate, S = spot exchange rate, rR = risk-free rate in rubles and r$ = risk-free rate in dollars. Using this equation, we first find the risk-free rate in rubles rR, then subtract it from the risk-free rate in dollars to find the implied credit spread for Russian government bonds. Re-arrange the equation find the risk-free rate in rubles rR: ππΉ = π β (π + π$ ) πΊ ππΉ = ππ. π β π. πππ = π. ππ% ππ Therefore, the implied credit is: 7.5% - 6.37% = 1.13% 3) Forward Market Hedge - Risk Management You are a broker for frozen seafood products for Choyce Products. You just signed a deal with a Belgian distributor. Under the terms of the contract, in 1 year, you will deliver 4000 kg of frozen king crab for 100,000 euros. Your cost for obtaining the king crab is $110,000. All cash flows occur in exactly 1 year. a. Plot your profits in 1 year from the contract as a function of the exchange rate in 1 year for exchange rates from $0.75/β¬ to $1.50/β¬. Label this line Unhedged Profits. Answer: Unhedged profit = (100,000 euros) * (S1 $/euro) β 110,000 (see Figure 1 below) Computations: At $0.75/β¬: At $1.00/β¬: At $1.25/β¬: At $1.50/β¬: (100,000 euros) * ($0.75/β¬) β 110,000 = (100,000 euros) * ($1.00/β¬) β 110,000 = (100,000 euros) * ($1.25/β¬) β 110,000 = (100,000 euros) * ($1.50/β¬) β 110,000 = ($35,000) ($10,000) $15,000 $40,000 b. Suppose the 1-year forward exchange rate is $1.25/β¬ and that you enter into a forward contract to sell the euros you will receive at this rate. In the figure from part (a), plot your combined profits from the crab contract and the forward contract as a function of the exchange rate in one year. Label this line Forward Hedge. Answer: Forward Hedged profit = (100,000 euros) * (1.25 $/euro) β 110,000 = $15,000 (see Figure 1 below) Computations: At $0.75/β¬: At $1.00/β¬: At $1.25/β¬: At $1.50/β¬: (100,000 euros) * (1.25 $/β¬) β 110,000 = (100,000 euros) * (1.25 $/β¬) β 110,000 = (100,000 euros) * (1.25 $/β¬) β 110,000 = (100,000 euros) * (1.25 $/β¬) β 110,000 = $15,000 $15,000 $15,000 $15,000 c. Suppose that instead of using a forward contract, you consider using options. A 1-year call option to buy euros at a strike price of $1.25/β¬ is trading for $0.10/β¬. Similarly, a 1-year put option to sell euros at a strike price of $1.25/β¬ is trading for $0.10/β¬. To hedge the risk of your profits, should you buy or sell the call or the put? Answer: Since I am selling euros and buying dollars, I should buy the put to hedge the risk of my profits. d. In the figure from parts (a) and (b), plot your βall inβ profits using the option hedge (combined profits of crab contract, option contract, and option price) as a function of the exchange rate in one year. Label this line Option Hedge. (Note: You can ignore the effect of interest on the option price.) Answer: The cost of buying put options for 100,000 euros is 100,000 * $0.10 = $10,000. Because of the put, the minimum selling price for euros would then be $1.25/euro. The All-in Option hedged profit is therefore: Profit = (100,000 euros) * (max[1.25, S1] $/euro) β 110,000 β 10,000 Profit = max [$5,000, (100,000 euros) * (S1 $/euro) β 120,000] (see Figure 1 below) Computations: At $0.75/β¬: At $1.00/β¬: At $1.25/β¬: At $1.50/β¬: max [$5,000, (β¬100,000* $0.75/β¬) β 120,000] = max [$5,000, (β¬100,000* $1.00/β¬) β 120,000] = max [$5,000, (β¬100,000* $1.25/β¬) β 120,000] = max [$5,000, (β¬100,000* $1.50/β¬) β 120,000] = $5,000 $5,000 $5,000 $30,000 Figure 1 e. Suppose that by the end of the year, a trade war erupts, leading to a European embargo on U.S. food products. As a result, your deal is cancelled, and you donβt receive the euros or incur the costs of procuring the crab. However, you still have the profits (or losses) associated with your forward or options contract. In a new figure, plot the profits associated with the forward hedge and the options hedge (labeling each line). When there is a risk of cancellation, which type of hedge has the least downside risk? Explain briefly. The forward hedge results in profit if the euro depreciates and results in loss if the euro appreciates. The profit from the forward hedge is: (100,000 euros)*(1.25 β S1 $/euro) (see Figure 2 below) Computations: At $0.75/β¬: At $1.00/β¬: At $1.25/β¬: At $1.50/β¬: (100,000 euros)*(1.25 β $0.75/β¬) = (100,000 euros)*(1.25 β $1.00/β¬) = (100,000 euros)*(1.25 β $1.25/β¬) = (100,000 euros)*(1.25 β $1.50/β¬) = $50,000 $25,000 $0 ($25,000) The option hedge pays if the euro declines. It is worthless if the euro appreciates and the maximum loss is the initial cost of $10,000. The profit from the option hedge is: max [0, (100,000 euros)*(1.25 β S1 $/euro)] β 10,000 (see Figure 2 below) Computations: At $0.75/β¬: At $1.00/β¬: At $1.25/β¬: At $1.50/β¬: max [0, (100,000 euros)*(1.25 β $0.75/β¬)] β 10,000 = max [0, (100,000 euros)*(1.25 β $1.00/β¬)] β 10,000 = max [0, (100,000 euros)*(1.25 β $1.25/β¬)] β 10,000 = max [0, (100,000 euros)*(1.25 β $1.50/β¬)] β 10,000 = Figure 2 $40,000 $25,000 ($10,000) ($10,000)