Problem Set
2
International
Finance
Shrikhande
Fall 2006
SUGGESTED
SOLUTIONS TO CHAPTER 4 PROBLEMS
1. From base
price levels of 100 in 1987, West German and U.S. price levels in 1988 stood at
102 and 106, respectively. If the 1987 $/DM exchange rate was $0.54, what
should the exchange rate be in 1988? In fact, the exchange rate in 1988 was DM
1 = $0.56. What might account for the discrepancy? (Price levels were measured
using the consumer price index.)
Answer. If e1981
is the dollar value of the German mark in 1988, then according to purchasing
power parity e1988/.54 = 106/102 or e1988 = $.5612. The
discrepancy between the predicted rate of $.5612 and the actual rate of $.56 is
insignificant and hence needs no explaining. Historically, however,
discrepancies betweenthe PPP rate and the actual rate have frequently occurred.
These discrepancies could be due to mismeasurement of the relevant price
indices. Estimates based on narrower price indices reflecting only traded goods
prices would probably be closer to the mark, so to speak. Alternatively, it
could be due to a switch in investors' preferences from dollar to non‑dollar
assets.
3. In early
1996, the short-term interest rate in France was 3.7%, and forecast French
inflation was 1.8%. At the same time, the short-term German interest rate was
2.6% and forecast German inflation was 1.6%.
a. Based on
these figures, what were the real interest rates in France and Germany?
Answer. The French real
interest rate was 1.037/1.018 - 1 = 1.87%. The corresponding real rate in
Germany was 1.026/1.016 - 1 = 0.98%.
b. To what would
you attribute any discrepancy in real rates between France and Germany?
Answer. The most likely
reason for the discrepancy is the inclusion of a higher inflation risk
component in the French real interest rate than in the German real rate. Other
possibilities are the effects of currency risk or transactions costs precluding
this seeming arbitrage opportunity.
4. In July, the
one‑year interest rate is 12% on British pounds and 9% on U.S. dollars.
a. If the
current exchange rate is $1.63:,1, what is the
expected future exchange rate in one year?
Answer. According to the
international Fisher effect, the spot exchange rate expected in one year equals
1.63 x 1.09/1.12 = $1.5863.
b.Suppose a change in expectations regarding future
U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?
Answer. If rus
is the unknown U.S. interest rate, and assuming that the British interest rate
stayed at 12% (because there has been no change in expectations of British
inflation), then according to the IFE, 1.52/1.63 = (1+rus)/1.12 or rus
= 4.44%.
5. If expected
inflation is 100% and the real required return is 5%, what will the nominal
interest rate be according to the Fisher effect?
Answer. According to the
Fisher effect, the relationship between the nominal interest rate, r, the real
interest rate a, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i).
Substituting in the numbers in the problem yields 1 + r = 1.05 x 2 = 2.1, or r
= 110%.
6. Suppose that
in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile,
the expected inflation rate in France is 12%, and the English interest rate is
14%. To the nearest whole number, what is the best estimate of the one‑year
forward exchange premium (discount) at which the pound will be selling relative
to the French franc?
Answer. Based on the
numbers, Japan's real interest rate is about 5% (8% ‑ 3%). From that, we can
calculate France's nominal interest rate as about 17% (12% + 5%), assuming that
arbitrage will equate real interest rates across countries and currencies.
Since England's nominal interest rate is 14%, for interest rate parity to hold,
the pound should sell at around a 3% forward premium relative to the French
franc.
9. The inflation
rate in Great Britain is expected to be 4% per year, and the inflation rate in Switzerland
is expected to be 6% per year. If the current spot rate is £1 = SF 12.50, what is the expected spot rate in two
years?
Answer. Based on PPP, the
expected value of the pound in two years is 12.5 x (1.06/1.04)2 = SF12.99.
10. If the $:¥ spot rate is $1 = ¥218 and
interest rates in Tokyo and New York are 6% and 12%, respectively, what is the
expected $:¥ exchange rate one year hence?
Answer. According to the
international Fisher effect, the dollar spot rate in one year should equal
218(1.06/1.12) = ¥206.32.
12. Suppose that
on January 1, the cost of borrowing French francs for the year is 18%. During
the year, U.S. inflation is 5%, and French inflation is 9%. At the same time,
the exchange rate changes from FF 1 = $0.15 on January 1 to FF 1 = $0.10 on
December 31. What was the real U.S. dollar cost of borrowing francs for the
year?
Answer. During the year,
the franc devalued by (.15 - .10)/.15 = 33.33%. The nominal dollar cost of
borrowing French francs, therefore, was .18(1 - .3333) - .3333 = -21.33% (see
Chapter 12). For each dollar's worth of francs borrowed on January 1, it cost
only $0.7867 to repay the principal plus interest. With U.S. inflation of 5%
during the year, the real dollar cost of repaying the principal and interest is
$0.7867/1.05 = $0.7492. Subtracting the original $1 borrowed, we see that the
real dollar cost of repaying the franc loan is -$0.2508 or a real dollar
interest rate of -25.08%.
14. Assume the
interest rate is 16% on pounds sterling and 7% on the Euro. At the same time,
inflation is running at an annual rate of 3% in Germany and 9% in England.
a. If the Euro
is selling at a one-year forward premium of 10% against the pound, is there an
arbitrage opportunity? Explain.
Answer. According to
interest rate parity, with a Euro rate of 7% and a 10% forward premium on the Euro
against the pound, the equilibrium pound interest rate should be
1.07
x 1.10 - 1 = 17.7%
Since the pound interest rate is only 16%, there is an
arbitrage opportunity. It involves borrowing pounds at 16%, converting them
into Euro, investing them at 7%, and then selling the proceeds forward, locking
in a pound return of 17.7%.
b. What is the
real interest rate in Germany? in England?
Answer. The real interest
rate in Germany is 1.07/1.03 -1 = 3.88%. The real interest rate in England is
1.16/1.09 -1 = 6.42%.
c. Suppose that
during the year the exchange rate changes from Euro2.7/£1 to Euro2.65/£1. What are
the real costs to a German company of borrowing pounds? Contrast this cost to
its real cost of borrowing Euro.
Answer. At the end of one
year, the German company must repay ,1.16
for every pound borrowed. However, since the pound has devalued against the Euro
by 1.85% (2.65/2.70 - 1 = -1.85%), the effective cost in Euro is 1.16 x (1 -
0.0185) - 1 = 13.85%. In real terms, given the 3% rate of German inflation, the
cost of the pound loan is found as 1.1385/1.03 -1 = 10.54%.
As shown above, the real cost of borrowing Euro equals
3.88%, which is significantly lower than the real cost of borrowing pounds.
What happened is that the pound loan factored in an expected devaluation of about
9% (16% - 7%), whereas the pound only devalued by about 2%. The difference
between the expected and actual pound devaluation accounts for the
approximately 7% higher real cost of borrowing pounds.
d. What are the
real costs to a British firm of borrowing Euro? Contrast this cost to its real
cost of borrowing pounds.
Answer. During the year,
the Euro appreciated by 1.89% (2.70/2.65 - 1) against the pound. Hence, a Euro
loan at 7% will cost 9.02% in pounds (1.07 x 1.0189 - 1). In real pound terms,
given a 9% rate of inflation in England, this loan will cost the British firm
0.02% (1.0902/1.09 - 1) or essentially zero. As shown above, the real interest
on borrowing pounds is 6.42%.
15. Suppose
today's exchange rate is $0.62/Euro. The 6-month interest rates on dollars and Euro
are 6% and 3%, respectively. The 6-month forward rate is $0.6185. A foreign
exchange advisory service has predicted that the Euro will appreciate to $0.64
within six months.
a. How would you
use forward contracts to profit in the above situation?
Answer. By buying Euro
forward for six months and selling it in the spot market, you can lock in an
expected profit of $0.0215 (0.64 - 0.6185) per Euro bought forward. This is a
semiannual percentage return of 3.48% (0.0215/0.6185). Whether this profit
materializes depends on the accuracy of the advisory service's forecast.
b. How would you
use money market instruments (borrowing and lending) to profit?
Answer. By borrowing
dollars at 6% (3% semiannually), converting them to Euro in the spot market,
investing the Euro at 3% (1.5% semiannually), selling the Euro proceeds at an
expected price of $0.64/Euro, and repaying the dollar loan, you will earn an
expected semiannual return of 1.77%:
Return
per dollar borrowed = (1/0.62) x 1.015 x 0.64 - 1.03 = 1.77%
c. Which
alternatives (forward contracts or money market instruments) would you prefer?
Why?
Answer. The return per
dollar in the forward market is substantially higher than the return using the
money market speculation. Other things being equal, therefore, the forward
market speculation would be preferred.
Chapter 11(a) problems
5. On January
1, the U.S. dollar:Japanese yen exchange rate is $1 = ¥250. During the year,
U.S. inflation is 4% and Japanese inflation is 2%. On December 31, the exchange
rate is $1 = ¥235. What are the likely competitive effects of this exchange
rate change on Caterpillar Tractor, the American earth‑moving manufacturer,
whose toughest competitor is Japan's Komatsu?
Answer. The real value of
the yen changed from $.004000 (1/250) at the start of the year to $.004339
(1/235 x 1.04/1.02) at the end of the year, an increase of 8.47%. Caterpillar
Tractor should benefit from this increase in the real value of the yen since
Komatsu does most of its manufacturing in Japan. The inflation‑adjusted dollar
cost of Japanese‑supplied components and labor will rise in line with the
increase in the real value of the yen. Komatsu's raw materials and energy
prices should not rise in dollar terms because these resources are imported.
7. In 1990,
General Electric acquired Tungsram Ltd., a Hungarian light bulb manufacturer.
Hungary's inflation rate was 28% in 1990 and 35% in 1991, while the forint
(Hungary's currency) was devalued 5% and 15%, respectively, during those years.
Corresponding inflation for the U.S. was 6.1% in 1990 and 3.1% in 1991.
a. What has
happened to the competitiveness of GE's Hungarian operations during 1990 and
1991? Explain.
Answer. Since forint
devaluations haven't kept pace with Hungary's roaring inflation, we know that
the forint's real exchange rate has risen. Specifically, if the nominal
exchange rate (dollar value of the forint) at the start of 1990 was e0,
the forint's real value at the end of 1991 was:
0.95
x 0.85e0 x (1.28)(1.35)/[(1.061)(1.031)] = 1.276e0
This equation reflects the fact that if the nominal
exchange rate (dollar value of the forint) at the start of 1990 was e0,
then the 5% devaluation during 1990 left it at 0.95e0 by the end of
1990. A further 15% devaluation during 1991 would have left the nominal rate
equal to 0.95 x 0.85e0 by the end of 1991.
Based on this equation, we can see that the real
exchange rate increased by 27.6% during this two-year period. The sharp
appreciation in the real value of the forint reduced the cost competitiveness
of GE's Hungarian operations.
b. In early
1992, GE announced that it would cut back its capital investment in Tungsram.
What might have been the purpose of GE's publicly announced cutback?
Answer. GE was trying to
put pressure on the Hungarian government to devalue further the forint and
thereby improve the cost competitiveness of its Tungsram manufacturing
facilities. In effect, GE was telling the Hungarian government that it was in
business to make a profit and that if it couldn't make a profit in Hungary
because of the high forint and the resulting sharp jump in its costs, it was
not going to invest there in the future.
11. Assess the
likely consequences of a declining dollar on Fluor Corporation, the
international construction‑ engineering contractor based in Irvine, California.
Most of Fluor's value‑added involves project design and management; most of its
costs are for U.S. labor in design, engineering, and construction‑management
services.
Answer. Fluor will
benefit from a falling dollar since it will be more cost competitive vis‑a‑vis
foreign contractors both at home and abroad. Its costs are primarily denominated and determined in dollars. Thus, when the dollar declines, these costs
fall relative to those of its foreign competitors. Although many of the costs
incurred on foreign projects are set in the local currency, these costs are the
same for all potential competitors. Hence, in competing against foreign firms,
Fluor will find that some of its costs are the same while other of its costs,
particularly for the labor involved in design, engineering, and construction
management services, are now lower.
14. The Edmonton
Oilers (Canada) of the National Hockey League are two‑time defending Stanley
Cup champions. (The Stanley Cup playoff is hockey's equivalent of football's
Super Bowl or baseball's World Series.) As is true of all NHL teams, most of
the Oilers' players are Canadian. How are the Oilers affected by changes in the
Canadian dollar/U.S. dollar exchange rate?
Answer. The fact that the
Oilers are paid in Canadian dollars does not affect the answer to this question
very much. While the C$ is the currency of denomination,
the U.S.$ is the currency of determination.
That is, the Canadian dollar salaries paid to the Oilers' players are just
equal to what the players' salaries would be in U.S. dollars converted into
Canadian dollars. Thus, the Edmonton Oilers are hurt by appreciation of the
U.S.$ vis‑a‑vis the C$ and benefitted by U.S. dollar depreciation. Consider
what would happen, for example, if the U.S.$ appreciates against the C$. If the
Oilers' C$ salaries are not raised, they will find they are being paid less
than players on U.S. hockey teams. The Oilers will be forced to raise the
Canadian dollar equivalent of its players' salaries to keep them on a par with
their U.S. rivals. Otherwise, the Edmonton Oilers will either lose players to
U.S. teams or have a hostile team. Player nationality is irrelevant. Canadian
teams compete in a world market for talent and must pay the market price.
15. South Korean
companies such as Goldstar, Samsung, and Daewoo have captured more than 10% of
the U.S. color TV market with their small, low‑priced TV sets. They are also
becoming more significant exporters of videocassette recorders and small
microwave ovens. What currency risk do these firms face?
Answer. These firms have
benefitted greatly from the appreciation of the Japanese yen against the U.S.
dollar because the won has not risen by nearly the same extent against the
dollar. They have used their cost advantage vis‑Ã ‑vis Japanese competitors to
boost sales of low‑end consumer electronics products by cutting prices below
the level at which the Japanese could make money. Yen depreciation or won
appreciation would reduce their cost advantage. Similarly, they face currency
risk because competitors in other nations, such as Taiwan or Thailand, might
devalue their currencies against the won.
18. Black &
Decker Manufacturing Co. of Towson, Maryland, has roughly 45% of its assets and
40% of its sales overseas. How does a soaring dollar affect its profitability,
both at home and abroad?
Answer. Black &
Decker has a rough balance between foreign sales and costs. Thus, as the dollar
appreciates, both its sales revenue and its costs decline approximately in line
with each other. This means that its profits will decline roughly in line with
the rise of the dollar. (If both revenues and costs fall, say, 10%, then profit
must also fall by 10%.) Dollar depreciation leads to corresponding increases in
dollar revenues and costs. The bottom line is that B&D's profits fall as
the dollar rises and rise as the dollar
falls. If B&D didn't produce overseas, but instead exported from its
U.S. plants, then currency changes would lead to much greater swings in its
profits. Note that B&D's domestic profitability is also affected by
currency changes since it faces competition in the U.S. from foreign companies
such as Japan's Makita.
19. The
shipbuilding industry is facing a worldwide capacity surplus. Although Japan
currently controls about 50% of the world market, it is facing severe
competition from the South Koreans. Japanese shipyards are extraordinarily
productive, but at current price levels were just about breaking even with an
exchange rate of ¥240 = $1. What are the likely effects on Japanese
shipbuilders of a yen appreciation to ¥180 = $1? The
South Korean won has maintained its dollar value.
Answer. The statement
that "Japanese shipyards are extraordinarily productive" tells you
that there is not much room for cost cutting by Japanese shipyards. Hence,
Japanese shipyards will be devastated by a rise in the yen, as they were. As
the yen appreciates against the won, South Korean shipyards gained a
substantial cost advantage vis‑a‑via the Japanese. According to a story in the Wall Street Journal, "Japanese
industry officials say ship buyers now automatically bypass Japanese makers,
turning instead to Hyundai Corp. and other South Korean shipbuilders, which
enjoy comparative reprieve on the currency front."
The only degree of freedom to adjust Japanese
shipbuilder costs took place on the wage side. Japanese firms typically pay a
substantial fraction of workers' wages in the form of a semi‑annual bonus that
is tied to corporate profits. Thus, during hard times, labor costs fall
automatically. However, this decrease in labor costs was not nearly enough and
many Japanese shipyards went bankrupt. A spokesman for the Japan Ship Exporters
Association said that they couldn't lower prices further. "They're already
at the bottom. We can do nothing but watch competitors take away orders."
Japanese shipyards have responded by designing
innovative ships for which demand is price inelastic. They are no longer
competitive in the commodity ship business.
Chapter 11(b) problems
3. Gizmo, U.S.A.
is investigating medium‑term financing of $10 million in order to build an
addition to its factory in Toledo, Ohio. Gizmo's bank has suggested the
following alternatives:
Type of loan
|
Rate
|
3-year U.S. dollar loan
3-year Euro loan
3-year Swiss franc loan
|
14
8
4
|
a. What
information does Gizmo require to decide among the three alternatives?
Answer. It is useful to
divide this problem into two issues: what is the expected cost and what is the
risk of each alternative. Defining the terms "cost" and
"risk" requires careful thought.
If we assume that (1) the international money markets
are efficient and (2) the international Fisher effect holds (these are separate
issues) then the expected cost of each loan is the same. If the market is
anticipating that for the next three years the Euro and the Swiss franc will
appreciate 6% and 10% annually, respectively, then the expected U.S. dollar
cost of each loan is the same. If we are unwilling to make assumptions (1) and
(2), then we need to use independent forecasts of the Euro and Swiss franc
exchange rates to calculate the loan whose expected
U.S. dollar cost is the lowest.
Even if the expected cost of each loan is the same,
the risk associated with each loan may be different for Gizmo. This risk will
depend on the currency denomination of assets that Gizmo holds as well as on
the markets in which Gizmo buys its inputs and sells it outputs. For example,
if Gizmo sells many products in Germany, then it probably has accounts receivable
denominated in Euro. It can use these receivables to pay off a DM loan and
avoid the risks that are associated with an uncertain $/Euro rate. If Gizmo
desires a particular risk level, then it may rationally prefer a particular
currency denomination for the loan. It may also be that forward markets are
more developed in one currency or that unanticipated exchange rate changes are
smaller in one currency, and therefore, the risks associated with that currency
are smaller even if the expected costs are the same.
b. Suppose the
factory will be built in Geneva, Switzerland, rather than Toledo. How does this
affect your answer in part a?
Answer. If the factory in
Geneva sells in Switzerland, then Gizmo has an asset which is essentially
denominated in Swiss francs. This may establish a natural hedge against a Swiss
franc loan and reduce the risk of this particular alternative. If the expected
cost of each loan alternative if the same, and if the firm seeks to reduce
total risk, then this information would suggest a Swiss franc loan.
But if the Swiss factory is exporting to the U.S., or
is selling in the Swiss market and facing import competition, then some dollar
financing or financing in the currency of the country in which its main
competitors are located might be appropriate. If the objective is to minimize
currency risk, the relative amount of financing to do in each currency will
also depend on the sources of Gizmo's inputs, particularly the extent to which
it uses Swiss labor. The more labor‑intensive the production process, the less
useful Swiss franc financing will be in reducing Gizmo's exposure (since by
using Swiss labor it already has Swiss franc outflows).
5. In September
1992, Dow Chemical reacted to the currency chaos in Europe by switching to Euro
pricing for all its products in Europe. The purpose, said a Dow executive, was
to shift currency risk from Dow to its European customers. Moreover, said the
Dow executive, the policy was fairer: By setting the same DM price throughout
Europe, Dow's new policy would nullify any advantage that a Dow customer in one
company might have over competitors in another country based on currency
swings.
a. What is Dow
really trying to accomplish with its new pricing policy?
Answer. Dow was really
trying to raise its prices in those European counties whose currencies devalued
so as to preserve its dollar margins, which were eroding from the devaluations.
b. What is the
likelihood that this new policy will reduce Dow's currency risk?
Answer. Not very likely.
Unless all its leading competitors go along with Euro pricing (its U.S. and
foreign competitors said that they wouldn't follow Dow but would continue doing
business in local currencies), Dow will have to cut its Euro price every time
the Euro appreciates or else lose market share. In other words, Dow can't use Euro
pricing to avoid margin erosion when European currencies devalue against the
dollar unless it is willing to sacrifice market share.
c. How are Dow's
customers likely to respond to this new policy?
Answer. They will simply
demand lower Euro prices if their currencies devalue. If Dow doesn't cut its Euro
prices, many of them will buy from those of Dow's competitors who are willing
to cut their dollar or Euro prices.
8. Cost Plus
Imports is a West Coast chain specializing in low‑cost imported goods,
principally from Japan. It has to put out its semiannual catalogue with prices
that are good for six months. Advise Cost Plus Imports on how it can protect
itself against currency risk.
Answer. A company such as
Cost Plus will typically negotiate purchase contracts with the suppliers of its
catalogue merchandise in advance. Cost Plus could hedge these purchases using
forward contracts. A problem, though, is that if the foreign currencies devalue
during the life of the catalogue, prices of substitute products for the items
in the catalogue will likely come down somewhat. In this case, some customers
who might have bought from Cost Plus will decide to buy the cheaper
substitutes, costing Cost Plus sales. This is very likely here given the nature
of Cost-Plus products: low‑cost goods presumably bought by a price‑sensitive
clientele.
The existence of quantity risk in addition to price
risk suggests that Cost Plus should hedge less than 100% of its projected sales.
As an alternative, Cost Plus could buy call options to cover its foreign
purchases. If the foreign currencies drop below the call option price, the firm
won't exercise its options; if they rise above the call price, Cost Plus will
exercise them.
11. Lyle
Shipping, a British company, has chartered out ships at fixed‑U.S.‑dollar
freight rates. How can Lyle use financing to hedge against its exposure? How
will your recommendation affect Lyle's translation exposure? Lyle uses the
current rate method to translate foreign currency assets and liabilities.
However, the charters are off‑balance‑sheet items.
Answer. Since Lyle has
chartered out its ships in dollars, it has fixed dollar revenues. By financing
its ship purchases with dollars, Lyle can offset these contractual dollar
inflows with contractual dollar outflows.
Accountants will note that Lyle bears significant
translation exposure. As the dollar rises against the pound, Lyle will show
losses on its dollar debt and vice versa when the dollar falls. But gains or
losses on the debts will be canceled out over time by changes in its operating
cash flows. In 1984, when the dollar rose, its chairman pointed out that
"Although foreign exchange losses have now been provided for in full on
all loans and leases as if they had been repayable at 30 June 1984, it must be
borne in mind that these are secured against ships chartered out at fixed
freight rates, the U.S. dollar income from which will be sufficient to service
both the interest and capital on the underlying loans. This future income will
offset the exchange losses now provided for."
13. In 1985,
Japan Airlines (JAL) bought $3 billion of foreign exchange contracts at ¥180/$1 over 11 years to hedge its purchases of U.S.
aircraft. By 1994, with the yen at about ¥100/$1, JAL
had incurred more than $1 billion in cumulative foreign exchange losses on that
deal.
a. What was the
economic rationale behind JAL's hedges?
Answer. Most likely, JAL
had signed contracts to take delivery of planes in the future and was using
forward contracts to protect itself against a rise in the value of the dollar
that would increase the yen cost of buying the planes. Alternatively, the
forward contracts could have been used to hedge purchases of U.S. planes
financed by borrowing dollars.
b. Did JAL's
forward contracts constitute an economic hedge? That is, is it likely that
JAL's losses on its forward contracts were offset by currency gains on its
operations?
Answer. The answer to
this question depends on whether JAL's yen operating profits are negatively
correlated with the yen's value. If a stronger yen means lower yen operating
profits, then these forward contracts would constitute an economic hedge. Some
factors to consider in deciding whether this is likely to be the case are as
follows. First, a good part of JAL's costs are for Japanese flight crews, whose
pay is denominated and determined in yen. To the extent that fares are
determined in dollars (in part because JAL is competing with U.S. airlines,
JAL's yen profits will vary inversely with the yen's value). At the same time,
a stronger yen will induce more Japanese to travel to the U.S. but fewer
Americans to visit Japan, increasing outbound volume but reducing inbound
volume. Where the balance lies is an empirical question. It turns out that JAL
has been hurt by yen appreciation and is now looking to cut costs, primarily by
reducing its Japanese work force through job buyouts and hiring foreigners. It
has also focused more on serving leisure travelers since the yen's strength has
led unprecedented numbers of Japanese tourists to travel abroad.
16. In 1990, a
Japanese investor paid $100 million for an office building in downtown Los
Angeles. At the time, the exchange rate was ¥145/$1. When
the investor went to sell the building five years later, in early 1995, the
exchange rate was ¥85/$1 and the building's value had collapsed to $50
million.
a. What exchange
risk did the Japanese investor face at the time of his purchase?
Answer. The risk is that
the value of the dollar would fall against the yen and that the dollar revenues
would not keep up with the decline in the value of the dollar.
b. How could
the investor have hedged his risk?
Answer. The investor
could have financed his purchase of the building by borrowing dollars, so that
the very same event that led to a decline in the yen value of his
asset--namely, a dollar decline-- would simultaneously reduce the yen cost of
the liability used to finance that asset. He could also have taken out a
long-dated forward contract to hedge the yen value of his building. Nothing
would have protected the investor from the decline in the building's dollar
price.