SECTION A Questions and Solutions
Answer one question from this section. Answer all questions in a separate answer book.
(a) Assume you are a UK-based buyer of New Zealand frozen lamb meat. You have just concluded a deal to buy NZD 5,000,000 worth of lamb meat from New Zealand and you will have to pay in one year’s time. You strictly prefer hedging against fluctuations in the foreign exchange market of NZD against GBP. The GBP interest rate is 2.5% per annum. The NZD interest rate is 5% per annum.
Information on the spot and forward exchange rates quoted against the U.S. Dollar (USD) on 20/03/2014 (retrieved on 21/03/2014 from The Financial Times web page http://markets.ft.com/research/Markets/Currencies) is summarised in the following table:
Currency Spot Rate 12-Month Forward
New Zealand Dollar
Great Britain Pound
1.1713 NZD/USD 1.2114 NZD/USD
1.6510 USD/GBP 1.6456 USD/GBP
- i. Calculate the spot and one-year forward cross rates of GBP against NZD. Is the New Zealand Dollar selling at a premium or at a discount versus the Great Britain Pound?
- ii. Describe two financial instruments to hedge against exchange rate risk. What is the pound cost of New Zealand lamb for each instrument?
iii. Which of the two hedging mechanisms is preferred? Why?
- iv. What happens if the UK buyer decides not to hedge? Why?
(b) Explain whether and, if so, how covered interest arbitrage opportunities can be exploited. Use the information provided in part (a). Assume that the arbitrageur can borrow up to NZD 5,000,000 or an equivalent amount in GBP.
(a) Suppose an investor is considering setting up a new e-business that consists of selling smartphone applications. Expected cash flows from her new business are for the amount of GBP 20,000 per annum over the period of 10 years, and the yield to maturity is 5%.
- i. As a financial manager, you are expected to tell to the investor how much she could invest in her business to break even. Please provide your valuable customer with a qualified advice.
- ii. Would the present value of the business be higher or lower relative the value calculated in part i if the yield to maturity increases to 10%? Explain your answer.
iii. Assume that in one year’s time, the investor encounters liquidity issues and thus is forced to sell her business. The price that she is offered is GBP 150,000. Calculate the rate of return from year 1 to year 2
(b) Calculate the market value of a perpetuity that pays a coupon of GBP 100. Assume the yield to maturity is 4%. Can the nominal price of a perpetuity be negative? Why?
(c) Explain the role of deflation for project evaluation. Why real rather than nominal cost of borrowing matters for project evaluation?
(d) If the interest rate is 4%, how much would you be willing to pay for a security that pays you GBP 1,000 next year, GBP 2,000 in two years, GBP 3,000 in three years and GBP 4,000 in four years from now? If the market price of a security is GBP 8,000, would you buy or sell it? Why?