Dean's Office Official Model Question Paper

Multinational Enterprise (MNE)

An MNE is a corporate entity headquartered in one nation (home country) that owns, manages, and controls productive operations, facilities, or subsidiaries in one or more foreign nations (host countries).

Primary Motive: Market-seeking (accessing new international customer demand) or Resource-seeking (accessing cheaper labor or raw materials).

Currency Cross Rate

A cross rate is an exchange rate calculated between two foreign currencies, neither of which is the official base currency of the country in which the quote is published (often derived using the US Dollar as a common intermediary currency).

Covered Interest Rate Parity (CIRP)

$$\frac{F}{S} = \frac{1 + r_h}{1 + r_f}$$

Where $F$ is the forward exchange rate, $S$ is the spot exchange rate, $r_h$ is the home country nominal interest rate, and $r_f$ is the foreign country nominal interest rate.

Transaction vs. Operating Exposure

• Transaction Exposure: The contractual foreign exchange risk arising from existing, outstanding monetary obligations denominated in foreign currency (e.g., an unhedged import payable due in 60 days).
• Operating (Economic) Exposure: The long-term impact of unexpected exchange rate shifts on a firm’s future competitive market position, sales volume, and operating cash flows.

Currency Swap

A currency swap is a contractual agreement between two counterparty institutions to exchange principal and fixed or floating interest rate payment streams denominated in two different currencies over a specified multi-year maturity, with principal re-exchanged at maturity.

Cross Rates & Triangular Arbitrage

1. Given Data

• $\text{EUR/USD Bid} = 1.0800$, $\text{EUR/USD Ask} = 1.0810$
• $\text{USD/NPR Bid} = 132.50$, $\text{USD/NPR Ask} = 132.70$

2. (a) Synthetic EUR/NPR Cross Quote Calculation

• EUR/NPR Bid (Bank buys EUR, sells NPR):
  $$\text{EUR/NPR Bid} = \text{EUR/USD Bid} \times \text{USD/NPR Bid} = 1.0800 \times 132.50 = \mathbf{Rs.\ 143.10}$$
• EUR/NPR Ask (Bank sells EUR, buys NPR):
  $$\text{EUR/NPR Ask} = \text{EUR/USD Ask} \times \text{USD/NPR Ask} = 1.0810 \times 132.70 = \mathbf{Rs.\ 143.45}$$
• Synthetic Cross Quote: EUR/NPR = 143.10 - 143.45

3. (b) Triangular Arbitrage Evaluation

• The second bank quotes EUR/NPR = 144.00 - 144.20.
• Opportunity: EUR is priced at Rs. 143.45 (synthetic ask) through the dollar cross, but can be sold directly to the second bank at Rs. 144.00 (direct bid). Because direct bid ($144.00$) > synthetic ask ($143.45$), a triangular arbitrage profit exists.

Arbitrage Execution Steps (Starting with NPR 10,000,000):

1. Step 1: Buy USD with NPR at Ask (132.70):
   $$\text{USD Obtained} = \frac{10,000,000}{132.70} = \text{USD } 75,357.95$$
2. Step 2: Buy EUR with USD at Ask (1.0810):
   $$\text{EUR Obtained} = \frac{75,357.95}{1.0810} = \text{EUR } 69,711.33$$
3. Step 3: Sell EUR to Bank 2 for NPR at Direct Bid (144.00):
   $$\text{Final NPR Proceeds} = 69,711.33 \times 144.00 = \mathbf{\text{Rs. } 10,038,431.52}$$
4. Net Arbitrage Profit:
   $$\text{Arbitrage Profit} = 10,038,431.52 - 10,000,000 = \mathbf{Rs.\ 38,431.52}$$

• The arbitrageur pockets an immediate riskless profit of Rs. 38,432.

International Parity Conditions and Real-World Deviations

International finance links exchange rates, interest rates, and inflation rates through core economic parity theorems:

+----------------------------------------------------------------------+
|                 THE FOUR INTERNATIONAL PARITIES                      |
+-------------------+--------------------------------------------------+
| 1. Relative PPP   | % Change in Spot Rate = Inflation Differential   |
| 2. CIRP           | Forward Premium/Discount = Interest Differential |
| 3. Fisher Effect  | Nominal Interest Rate = Real Rate + Inflation    |
| 4. IFE            | % Change in Spot Rate = Nominal Rate Differential|
+-------------------+--------------------------------------------------+

1. Relative Purchasing Power Parity (RPPP)

• States that the exchange rate between two currencies will adjust to reflect changes in the price levels (inflation rates) of the two nations:
  $$\frac{S_1 - S_0}{S_0} \approx I_h - I_f$$
• The currency of the high-inflation nation depreciates relative to the low-inflation nation.

2. Covered Interest Rate Parity (CIRP)

• States that the forward premium or discount on a foreign currency equals the nominal interest rate differential between the two countries, preventing covered interest arbitrage.

3. International Fisher Effect (IFE)

• Combines PPP and the Fisher Effect: currencies with higher nominal interest rates will depreciate against currencies with lower interest rates because higher nominal rates reflect higher expected inflation.

4. Why PPP Violations Occur in the Short Run

• Non-Tradable Goods: Real estate, personal services, and haircuts cannot be traded internationally to arbitrage price differences.
• Tariffs and Transport Costs: Shipping freight, import duties, and customs inspection fees create substantial price wedges.
• Sticky Prices and Financial Market Flows: Foreign exchange markets adjust in seconds to interest rate changes and capital flows, whereas product retail prices adjust slowly.

Hedging Transaction Exposure: Forward vs. Money Market Hedge

1. Given Data

• Foreign Currency Payable = $\text{USD } 500,000$ due in 180 days
• Spot Exchange Rate ($S_0$) = $\text{USD/NPR } 132.50$
• 180-day Forward Exchange Rate ($F$) = $\text{USD/NPR } 135.00$
• 180-day US Dollar Deposit Rate ($r_{\text{USD}}$) = $4\% \times \frac{180}{360} = 2.0\%$
• 180-day NPR Borrowing Rate ($r_{\text{NPR}}$) = $10\% \times \frac{180}{360} = 5.0\%$

2. Strategy 1: Forward Market Hedge

• Under a forward contract, the firm locks in the exact forward rate today:
  $$\text{Total NPR Cost} = \text{USD } 500,000 \times 135.00 = \mathbf{Rs.\ 67,500,000}$$

3. Strategy 2: Money Market Hedge (Borrow in NPR, Invest in USD)

1. Calculate USD amount to invest today at 2.0% so it matures to USD 500,000 in 180 days:
   $$\text{USD Needed Today} = \frac{500,000}{1 + 0.02} = \frac{500,000}{1.02} = \text{USD } 490,196.08$$
2. Buy USD 490,196.08 in spot market at USD/NPR 132.50:
   $$\text{NPR Required Today} = 490,196.08 \times 132.50 = \text{Rs. } 64,950,980.60$$
3. Borrow Rs. 64,950,980.60 in Nepal at 5.0% for 180 days:
   $$\text{Total NPR Repayment at 180 Days} = 64,950,980.60 \times (1 + 0.05) = \mathbf{Rs.\ 68,198,529.63}$$

4. Comparison & Decision Recommendation

• Forward Hedge Total Cost: Rs. 67,500,000
• Money Market Hedge Total Cost: Rs. 68,198,530
• Cost Difference: The Forward Market Hedge is cheaper by: $\text{Rs. } 68,198,530 - 67,500,000 = \mathbf{\text{Rs. } 698,530}$.
• Recommendation: The importer should execute the Forward Market Hedge, locking in Rs. 67.5 Million and saving approximately Rs. 698,530 compared to the money market hedge.

Foreign Exchange Exposure Management & Operational Hedging

+----------------------------------------------------------------------+
|                 TYPES OF FOREIGN EXCHANGE EXPOSURE                   |
+-------------------+--------------------------------------------------+
| 1. Transaction    | Sensitivity of contractual cash flows to FX shifts|
| 2. Translation    | Accounting balance sheet consolidation paper loss|
| 3. Economic       | Long-term impact on firm's global market value   |
+-------------------+--------------------------------------------------+

1. The Three Forms of Exposure

1. Transaction Exposure: Arises when a firm has obligations denominated in foreign currency (e.g., import payables, export receivables). Fluctuations between transaction date and settlement date cause realized cash gains/losses.
2. Translation (Accounting) Exposure: Arises when an MNE consolidates foreign subsidiary balance sheets into parent reporting currency. Changes in exchange rates create non-cash balance sheet equity reserve adjustments.
3. Economic (Operating) Exposure: Measures the change in the present value of future operating cash flows caused by competitive shifts in real exchange rates.

2. Operational (Internal) Hedging Strategies

• Currency Matching (Natural Hedging): Financing foreign assets with debt denominated in the same currency, matching foreign currency cash inflows with matching foreign currency debt payments.
• Leading and Lagging:
  • Leading: Accelerating payment of payables denominated in an appreciating currency.
  • Lagging: Delaying payment of payables denominated in a depreciating currency.
• Invoice Currency Selection: Invoicing exports in a strong, stable currency or invoicing in home currency (NPR) to transfer exchange risk entirely to the foreign counterparty.
• Re-invoicing Centers: Centralizing MNE intra-company trade flows through a regional corporate treasury hub to net offsetting currency exposures.

Comprehensive Solution: International FX Risk Management

(a) Forward Market Hedge (5 Marks)

$$\text{Total NPR Cost} = \text{USD } 1,000,000 \times 135.50 = \mathbf{Rs.\ 135,500,000}$$

• The importer locks in an exact, guaranteed cost of Rs. 135.50 Million.

---

(b) Money Market Hedge (5 Marks)

1. USD to deposit today at 2.0% for 180 days:
   $$\text{USD Today} = \frac{1,000,000}{1 + 0.02} = \frac{1,000,000}{1.02} = \text{USD } 980,392.16$$
2. Convert USD into NPR at Spot Rate (133.00):
   $$\text{NPR Borrowed Today} = 980,392.16 \times 133.00 = \text{Rs. } 130,392,157.28$$
3. Repay NPR loan in 180 days at 5.0% interest:
   $$\text{Total Repayment at Maturity} = 130,392,157.28 \times 1.05 = \mathbf{Rs.\ 136,911,765.14}$$

• Total cost under Money Market Hedge is Rs. 136.91 Million.

---

(c) Currency Call Option Hedge (5 Marks)

• Call Option Strike Price ($X$) = $\text{Rs. } 134.00$
• Option Premium Paid Today = $\text{Rs. } 2.50 \times 1,000,000 = \text{Rs. } 2,500,000$
• Future Value of Premium at 5.0% interest = $2,500,000 \times 1.05 = \mathbf{\text{Rs. } 2,625,000}$

1. Scenario (i): Spot Rate Rises to USD/NPR 140.00:

   • Because market price (140.00) > strike (134.00), the importer exercises the call option at 134.00:
     $$\text{Cost of Dollars} = 1,000,000 \times 134.00 = \text{Rs. } 134,000,000$$
     $$\text{Total Cost (including premium)} = 134,000,000 + 2,625,000 = \mathbf{Rs.\ 136,625,000}$$

2. Scenario (ii): Spot Rate Drops to USD/NPR 128.00:

   • Because market price (128.00) < strike (134.00), the importer lets the option expire unexercised and buys dollars in the open spot market at 128.00:
     $$\text{Cost of Dollars} = 1,000,000 \times 128.00 = \text{Rs. } 128,000,000$$
     $$\text{Total Cost (including premium)} = 128,000,000 + 2,625,000 = \mathbf{Rs.\ 130,625,000}$$

---

(d) Strategy Comparison, Break-Even & Currency Peg Evaluation (5 Marks)

1. Break-Even Spot Rate ($S^*$):
   • Option total cost = Forward cost:
     $$(1,000,000 \times S^*) + 2,625,000 = 135,500,000$$
     $$1,000,000 \times S^* = 132,875,000 \implies \mathbf{S^* = USD/NPR\ 132.88}$$
   • If the spot rate in 180 days is below USD/NPR 132.88, the Option Hedge outperforms the Forward Hedge.
2. Macroeconomic Impact of the INR Peg:
   • The Nepalese Rupee is pegged at INR 1 = NPR 1.60. Consequently, the USD/NPR rate is entirely a synthetic reflection of USD/INR market movements.
   • When India faces balance-of-payments pressures or crude oil spikes, the Indian Rupee depreciates against the US Dollar, causing automatic depreciation of the Nepalese Rupee against the US Dollar, regardless of domestic Nepalese economic fundamentals.