Finance 351 – Fall 2015 Homework No. 2

Finance 351 – Fall 2015                            Homework No. 2
Prof. Phil Uhlmann                            Due:  Friday, October 16, 2015

Homework may be done in pairs – please hand in a typed hard copy of your work.

Solutions to the homework will be posted on Friday afternoon, October 16.  A review session for the homework will be offered on Sunday morning, October 18 from 11:00 a.m. to 12:15 p.m. in our usual classroom – AAC 262.  The midterm exam is on Tuesday, October 20 during your regular class time.  Please note that we will not have class on Friday, October 23 and Tuesday, October 27 due to an international travel commitment.  The October 27 class will be made up later in the term, probably before the second midterm exam.  Please ask if you have questions.

1.    Turkey and the Turkish Kriz of 2001
Please read the two short cases on Blackboard and use your notes from class.
•    What was the Turkish Kriz all about?
•    Use the UBC Pacific Exchange Rate data to graph the performance of the Turkish Lira since January 1, 2000
•    What is the forward outlook/ prices for the Turkish Lira – use Bloomberg to obtain forward currency prices.  Which of the three factors that drive forward exchange rates do you think is at work here?
•    Look at the 10-year yield-to-maturity bond rates for the United States and Turkey.  On Friday morning, October 9 the Turkish 10-year yield to maturity was 10.01%.  See if you can calculate the Turkish country risk premium over U.S. bonds of an equivalent term.  Has the spread moved much in recent years?

2.    Exchange rates:
Hilditch & Key make proper English shirts for ladies and men in a factory just north of Edinburgh, Scotland.  Assume that a gentleman decides to buy two striped shirts – with white collars and cuffs, and two conservative ties at a cost of £240, including shipping.
Rates:  $US 1.52 = £1.00  $CDN 1.2917 = $US 1.00 ( you will need to know your rates for the midterm )
•    What is the U.S. dollar equivalent cost of the shirts and ties?
•    If the buyer paid with a Canadian dollar credit card, what was the final price of the shirts and ties in Canadian dollars?
Use the appropriate exchange rates on page one of this exam to help you answer the questions.
3.    Big Mac Index:
Purchasing Power Parity – If a Big Mac hamburger costs 75 rubles (RUB) in Russia and $USD 4.33 in the United States, is the Russian currency properly valued, overvalued, or undervalued when the market rate is RUB 32.77 = $USD 1.00.
a.    Given the exchange rate in the problem, what should a Big Mac cost in Russia.  To what degree (meaning in percentage terms) is the Russian ruble over or undervalued?
b.    What is the current exchange rate between the U.S. dollar and Rouble?

4.     Trade Finance – ( 25 marks on midterm):
Caterpillar, an Illinois based corporation is in the process of selling $5.00 million of mining equipment to South Africa.  The equipment is to ship by the end of March 2015.  Caterpillar has approached Citibank in New York and the Export-Import Bank of the United States (“EXIM”).  Exim is the U.S. ECA, a direct draw agency funded by the U.S. Treasury.  The South African buyer is African Rainbow Minerals (“ARM”) (http://www.arm.co.za/).  ARM deals with Standard Bank, the top trade finance bank in South Africa.  (https://www.gfmag.com/awards-rankings/best-banks-and-financial-rankings/worlds-best-trade-finance-banks-2014)
•    As the chief international risk officer at Citibank, you have been requested to provide a general framework for how this transaction might be structured, knowing that Caterpillar has previously sold equipment to South Africa, Exim is open for business in South Africa and that diplomatic relations between South Africa and the U.S. are acceptable.
•    Briefly outline the most important risk issues that the Citibank faces with this transaction and how these risks can be mitigated, including discussion of documentation.
•    Citibank’s CEO has told you he views South Africa as a risky country given the “neighborhood effect.”   It’s clear that he read the June 13, 2014 article in the FT when South Africa was downgraded by Standard & Poor’s – which read in part:

Standard & Poor’s, the rating agency, downgraded South Africa’s credit rating on Friday in the latest blow to the country’s ailing economy.  S&P cited an unprecedented strike in the mining sector, weak growth and a wide current account deficit for the decision as it lowered the long-term foreign currency rating one notch to BBB-. It put Africa’s most developed nation on a stable outlook.  The downgrade – the second by S&P in less than two years – is the latest bad news to hit an economy that has been hammered this year by a five-month strike in the platinum sector, the longest and costliest in the mining industry’s long history.  In the first three months of the year, economic growth contracted 0.6 per cent on a quarter-on-quarter basis, its worst performance since a 2009 recession, as mining output shrank nearly 25 per cent.  The move by S&P follows a decision by Fitch to revise its outlook for South Africa from stable to negative, while maintaining its BBB rating. The volatile rand fell by around 1 per cent to the US dollar following Fitch’s review.
Source:  http://www.ft.com/intl/cms/s/0/14c7a586-f2cf-11e3-a3f8-00144feabdc0.html#axzz3T43cmggi – accessed February 28, 2015
•    You must ensure that Citibank’s risk is minimized.  In providing a prudent risk structure, use a diagram to help support your recommendation.
Questions:
1.    What are the major documents you need for a Trade Finance transaction – 5 marks
2.    How should the risks of this transaction be mitigated to protect Citibank’s participation – 5 marks
3.    Draw a general diagram of the transaction on the next page – 5 marks
4.    Assess the economic and political risks of South Africa as best you can; what is the current exchange rate between the USD and South African Rand (“ZAR”) – why might the rate move up or down?  Who can help you on the ground in South Africa if the deal gets into trouble?  – 5 marks
5.    How long should the South Africans be given to pay for this transaction?  How should Citibank determine the pricing on this transaction, where do they start?  Do you like the deal? – 5 marks

5.    Covered and Uncovered Interest Arbitrage Questions
Please do the following questions from the textbook:
•    Chapter 6 – Problem No. 1 – Interest rate parity theorem
•    Chapter 6 – Problem No. 6 – Brazil
•    Chapter 6 – Problem No. 12 – Yen carry trade with Icelandic krona

6.    Lufthansa’s Exchange Rate Risk in 1986 – Transaction risk
Please read the short Lufthansa case on Blackboard, case is also in text on page 451
In 1985, Lufthansa entered into a contract to purchase 20 Boeing 737 aircraft for $USD 500 million. Delivery of the planes was to take place in early 1986, against a single payment for the full amount due.  Between 1982 and 1985, the U.S. dollar had appreciated against the Deutsche Mark and Lufthansa’s Chairman was concerned that this appreciation would continue. Assume that Lufthansa’s Chief Economist advised the Chairman in early 1985 that the U.S. dollar would fall in value against the Deutsche Mark.
Please answer the following questions:
•    Use the UBC Pacific Exchange data to graph the German Mark to U.S. Dollar Exchange rate from January 1, 1984 to December 31, 1988.
•    How are the following exchange rates relevant to the assigned case, as discussed in class – 2.30, 3.20 and 4.30; which is good/bad for Lufthansa?  Is this Transaction or Operational risk? – 5 marks
•    What did Lufthansa’s Chairman, Mr. Ruhnan do; did he make the correct decision; why or why not?  Explain fully – assume that option contracts were not available to Lufthansa in 1985/1986. – 5 marks