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Calculate the mean and volatility of the yearly percentage changes (%) of the BRL/USD exchange rate for the period 2005-2016. What risk does GM face if it chooses not to hedge its sales?
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QUESTION 1.

Using the data available to you, you are encouraged to use Excel. Include all your Excel tables/calculations in the Appendix and write your answer to question 1 inside the assignment explaining every step.

You are the Financial Manager of General Motors in the US. GM has recently started exporting automobile parts to a Brazilian company, Agrale. The exports are currently invoiced in the currency of the importer.

a) Calculate the mean and volatility of the yearly percentage changes (%) of the BRL/USD exchange rate for the period 2005-2016. What risk does GM face if it chooses not to hedge its sales?

b) GM ships an order to Agrale invoiced at 100 billion Brazilian Real on December 31, 2016. GM expects payment in a year’s time. Based on your predictions from the analysis above at 95% confidence level, what do you expect the range for the future spot rate to be in a year’s time, and how would this impact the value of the receivables?

c) Suppose you conduct a currency carry trade by borrowing US$1 million at the start of each year and investing in the South Korean Won for one year. Using the one-year interest rates for US and Brazil between 2005 – 2016 provided, compute the total dollar profits/losses from this carry trade for each individual year over the sample period. In your report show and explain the formula used and each step of the calculation.

d) It is often argued that forward exchange rates should be unbiased predictors of future spot exchange rates if the foreign exchange market is efficient. Is this true or false? Why?

Notes: To calculate the yearly percentage change use the formula: st = (St - St-1)/St-1 in % format. You do not need to apply any further transformation to the percentage changes or interest rates.

QUESTION 2.

a) As a foreign exchange trader for JPMorgan Chase, you have just called a trader at UBS to get quotes for the British pound. Your UBS counterpart has given you the

following quotes for the spot, 30-day, 60-day, and 90-day forward rates: “We trade sterling at $1.7745-50, 47/44, 88/81, 125/115.” What cash flows would you make and receive if you do a forward foreign exchange swap in which you swap into £5,000,000 at the 30-day rate and out of £5,000,000 at the 90-day rate? What must be the relationship between dollar interest rates and pound sterling interest rates? Justify your answer clearly.

b) Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two alternative investments of EUR10,000,000. Either she will invest in euro deposits or she will invest in Swiss francs (CHF) for 180 days. In the latter case, she knows that she must worry about transaction foreign exchange risk, so she has decided to fully hedge her investment. Suppose she has the following data:

Swiss franc deposits:

8.0% p.a.

Euro deposits:

10.0% p.a.

Spot exchange rate:

EUR1.1960/CHF

180-day forward exchange rate:

EUR1.2024/CHF

Which of these deposits provides the higher euro return in 180 days? If these were actual market prices, what would you expect to happen in the future to these rates?

c) Explain the reasons why interest parity may not hold, in general, between two countries.

QUESTION 3.

You are the sales manager for Motorola and export cellular phones from the United States to other countries. You have just signed a deal to ship phones to a British distributor. The deal is denominated in pounds, and you will receive £700,000 when the phones arrive in London in 180 days. Assume that you can borrow and lend at 7% p.a. in U.S. dollars and at 10% p.a. in British Pounds. Both interest rate quotes are for a 360-day year. The spot exchange rate is $1.4945/£, and the 180-day forward exchange rate is $1.4802/£.

a) Describe the nature and extent of your transaction foreign exchange risk.

b) Describe how you might hedge the transaction foreign exchange risk using a forward and money market hedge (how are they constructed?).

c) Calculate and explain which of the alternatives in part b) is superior and why? Show and explain all calculations at every step.

d) Assume that the dollar interest rate and the exchange rates are correct. Determine what annualized sterling interest rate would make your firm indifferent between the two alternative hedges.

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