Explain why it may be necessary for a multinational company to make adjustments to its risk premium for the purposes of evaluating proposed capital projects.

1. London-based consultancy company has recently completed a sale on three-months credit in New England, USA, as a result of which it will receive $50 million in three-months time. The company treasurer is concerned that the dollar will weaken relative to sterling over the three-month period and cause a fall in the value of the receivable from the US-client. In respect of the foreign exchange exposure, the company treasurer is considering choosing between two possible hedging approaches as follows:

1.Hedge in the forward market by borrowing dollars from a US bank and investing in sterling.
2.Buy a three-month $50 million put option at a strike price equal to the three-month forward rate at a cost of 1,250,000.

The current Sterling-US Dollar (USD) exchange rates are as follow:

Bid price Ask price
Spot exchange rate 1: $1.713 1: $1.714
3-month forward rate 1: $1.724 1: $1.725

Spot interest rate:
UK: 4.00% 4.50%
US: 2.50% 3.00%

Provide calculations of the effects of each of the two above hedging approaches assuming that the spot rate prevailing in three months time is:
(i) 1: $1.60 1.65
(ii) 1: $1.80 1.85
12 marks

2. Briefly discuss the advantages and disadvantages of each of the two above hedging approaches, i.e. hedge in the forward market by borrowing dollars from a US bank and investing in sterling, or buy a three-month put option at a strike price equal to the three-month forward rate for addressing the foreign currency exposure.
10 marks

3. Explain why it may be necessary for a multinational company to make adjustments to its risk premium for the purposes of evaluating proposed capital projects.
10 marks

4. A US firm manufactures and sells womens clothing exclusively in the US. Which of the following situations would most likely cause the value of the firm to increase? Consider each situation individually. The firms major competitors are located in:
(a) Europe, and the value of the US dollar increases relative to the euro; (2 marks)
(b) Europe, and the value of the US dollar decreases relative to the euro; (2 marks)
(c) The US, and the value of the US dollar increases relative to the euro; (2 marks)
(d) The US, and the value of the US dollar decreases relative to the euro. (2 marks)
Total 8 marks

7. Suppose in a particular year the annual interest rate is 6.5% in the UK and 5.2% in the USA.
(a)If the current exchange rate is $1.61: 1, what would you expect the future exchange rate to be in one years time? (5 marks)

(b)Suppose a change in expectations regarding future U.S. inflation causes the
expected future spot rate to decline to $1.52 : 1. Calculate what you would expect to happen to the U.S. interest rate and explain your results. (5 marks)
Total 10 marks

9. Suppose that the one-year interest rate is 12% in the United Kingdom. The expected annual rate of inflation for the coming year is 10% for the United Kingdom and 4% for Switzerland. The current spot exchange rate is 3 Swiss francs to the pound. Using the precise form of the international parity relations:
(a) compute the one-year interest rate in Switzerland; (4 marks)
(b) the expected Swiss franc to pound exchange rate in one year; (4 marks)
(c) the one-year forward exchange rate. (2 marks)
Total 10 marks