Risk

Question 1

A US importer of Japanese-built cars can best protect itself against foreign exchange risk by

Answer 1

buying yen futures

Question 2

TRUE / FALSE If you sold a wheat futures contract for $3.75 per bushel and the contract ended at $3.60, you would net a profit of $0.15 per bushel

Answer 2

TRUE

Question 3

TRUE / FALSE Suppose that the spot rate and the 90-day forward rate on the pound sterling are $1.35 and $1.30, respectively. Your company, wishing to avoid foreign exchange risk on a sterling payment to a British supplier (to be paid in 3 months), buys 500,000 pound sterling forward 90 days. If the spot rate in fact remains the same 90 days from now as it was today, the firm would with hindsight have been better off not hedging.

Answer 3

FALSE [the co locked in a stonger dollar: it costs them only 1.30 per pound, versus 1.35 had they not hedged]

Question 4

An all-equity company is in the process of doing some product testing, which if successful, means that the firm will be worth $100 million in one year. If the testing is unsuccessful, firm value will be only $50 million in one year. Outside investors currently view the outcomes as equally likely, but you, the CEO, have inside knowledge telling you that success is virtually certain! You would like to signal your beliefs in the hope that the stock price would increase right away (so you can cash in your stock options, which expire in a month). Will issuing debt of $25 million (and buy back equity) make your claims credible? How about leverage of $60 million?

Answer 4

With debt of less than $50 million, the company will have no risk of financial distress regardless of the outcome. Thus there is no distress cost to leverage even if the CEO’s inside information is false. Leverage of only $25mm would not be a credible signal. However, leverage at least $50, or more than the firm value under the unfavorable scenario would allow the CEO to signal his/her confidence, because (s)he would not agree to this amount of debt unless (s)he had favorable inside information.

Question 5

In 2004, Microsoft paid a special dividend of $3 a share, returning $32 billion in cash to its shareholders. If instead Microsoft had not done that, but had retained the cash permanently, what would have been the present value of the additional taxes paid on a per share basis? Microsoft pays 35% corporate taxes.

Answer 5

The extra taxes would have been ($32 billion)R.35 where R is the yield on the cash invested. The PV of these payments, discounted at R, is ($32 billion)R.35/R= $32 billion.35=$11.2 billion, or $3.35=$1.05 per share

Question 6

Today, the one-year forward rate for the Japanese Yen is ¥95 per US dollar. You think that the forward market misprices the yen-US dollar exchange rate. You believe that due to the new policies championed by the new Japanese prime minister, confidence in the Yen will rise, and you foresee a much stronger Yen in a year’s time than what is reflected in today’s forward rate. In order to speculate on your opinion, do you buy or sell, and what will do you expect the exchange rate/value to be?

Answer 6

buy 1,000,000 yen forward at today’s forward rate; if you are right and in a year the spot exchange rate turns out to be 85 ¥ per USD, you will have made a profit