University Assignment: FIN3IFM S1 2019 Homework 1 - Finance

This document provides a comprehensive solution to the FIN3IFM S1 2019 Homework 1 assignment, focusing on strategic financial management. The solution addresses ten questions, including the implications of currency appreciation and depreciation, the impact of bimetallism, and strategies for capitalizing on exchange rate deviations. It delves into the concepts of the incompatible trinity, J-curve effects, and arbitrage opportunities. Furthermore, the document details the calculation of cross rates, explains forward contract positions, and demonstrates hedging foreign exchange risk. The assignment covers various aspects of international finance, currency risk management, and financial decision-making, offering detailed explanations, calculations, and real-world examples to aid understanding.

Running head: STRATEGIC FINANCIAL MANAGEMENT.
Strategic financial management.
Name of the student:
Name of the university:
Author Note:
Table of Contents

1
Answer to question no. 1:...........................................................................................................2
Answer to question no. 2:...........................................................................................................3
Answer to question no. 3:...........................................................................................................4
Answer to question no. 4............................................................................................................5
Answer to question no. 5:...........................................................................................................6
Answer to question no. 7:...........................................................................................................7
Answer to question no. 8:...........................................................................................................8
Answer to question no. 9:...........................................................................................................9
Answer to question no. 10:.......................................................................................................10
References:...............................................................................................................................11

2
Answer to question no. 1:
Appreciation and depreciation in the foreign currency has direct impact on the
revenue and profit from the export of the company. In this question, the exporting country is
US and importing country is Mexico. The appreciation in Mexican peso means that the US
dollar is depreciating against Mexican peso. This result into increase into expected income
from export in US $ but the income in Mexican peso will remain same if the whole contract
has been invoiced in Mexican peso. The implications of such fluctuation also depends upon
the currency mentioned in invoice or on the contract of invoicing either in US $ or Mexican
peso. If the invoicing has based on US $ then there will not be any effect due to fluctuation in
Mexican peso but if the same is invoiced in Mexican peso then it will have material effect on
the profitability, cost and revenue of the contract because it will change the previous expected
figures of the contract. Thus, it will also result into a change to management policy of the
company towards export.

3
Answer to question no. 2:
When the value of currency depends upon the value of metal like gold and silver then
it is called as Bimetallism i.e. most preferable monetary system in late 1800. In this system,
value of gold and silver are tied together. Governments generally incorporates the value of
gold and silver in their currency valuation. It means that the country having more gold and
silver reserve will always have their currency in the upward direction of currency valuation.
The valuation is effected by any change in demand and supply of the precious metal. Like in
above case, the supply of gold has been increased. Due to which value of gold depressed,
resulting into overvaluation of gold under French official ratio and making Franc as a gold
currency. This depreciation caused devaluation of French in terms of gold as the value of
currency depends upon the value of the gold. Any fluctuation in the price of the gold will
change the value of underlying currency.

4
Answer to question no. 3:
The current exchange rate is $ 1.80 per pound whereas to be exchange rate is $ 1.75
per pound. It means pound is overvalued. The resultant strategy to gain advantage from such
deviation would be taking short position. Short position implies that selling the currency at a
high price and purchasing the currency when the price falls resulting into profit in short span
of time. Investor would sell the currency at $ 1.80 per pound and repurchase it when the price
falls below $ 1.75 per pound. The investor will make a profit $ 0.05 per pound due to such
overvaluation of currency.

5
Answer to question no. 4
The incompatible trinity, also known as impossible trinity and trilemma is a situation,
which states that it is impossible to have all of the followings at a time:
 A fixed foreign exchange rate
 Free flow of capital
 An independent monitory policy.
The central bank of any government can purse any two of the above activities. It is
impossible to control all these at a time because all of these activities are interrelated. For
example. Suppose a government has fixed foreign exchange rate i.e. whatever the inflation,
demand, and supply of the foreign currency prevailing, the government would accept it at a
predetermined fixed rate. Therefore, it will affect free flow of capital and inflation rate in the
country. The inflation will reflect the effect of flow of capital due to fixed foreign exchange.

6
Answer to question no. 5:
The concept of J-curve explains that whenever the currency of country depreciates
then the cost of import tends to be more costly and the export becomes less expensive. This
result into current account deficit of that country. However, this situation would last long. As
the export will increase at its pace then the value of the currency will automatically
appreciates against the foreign currencies. Decrease in import and increase in export will
push upward movement in value of the currency. The deficit in current account due to
depreciation in the home currency is of short term nature and will rise accordingly and will
reach at that point that will be higher than the previous benchmark resulting into J-curve.

7
Answer to question no. 7:
As mentioned in the question, Total funds available= $ 1,000,000
Dollar-euro exchange rate is $ 1.50/ € and dollar-pound exchange rate is $ 2.00/€.
Therefore, the exchange rate of Euro-pound should be $ 2.00/$ 1.50 i.e. € 1.33/ £ but the
bank quotes the cross rate as € 1.25/ £. It means there is an arbitrage opportunity exists.
The whole arbitrage process can be explained below:
Step 1: convert $ 1,000,000 spot at $ 1.50/€ getting € 666,667.
Step 2: Convert € 666,667 spot at € 1.25/ £ getting £ 533,333.
Step 3: Convert £ 533,333 spot at $ 2.00/£ getting $ 1,066,667.
So, Arbitrage profit = $ 1,000,000 - $ 1,066,667 = $ 66,667

8
Answer to question no. 8:
The rates that have been offered to calculate cross rate is as follows:
SFr/$ = 1.5958/70,
A$/$ = 1.7249/58.
So, the cross rate of A$/ SFr = (1.5958*1.7258)/ (1.5970*1.7249)
= 2.7540/2.7546

9
Answer to question no. 9:
In a forward contract, when a party agrees to buy an asset at a given price at a future
date then it is called as a long position and when a party agrees to sell an asset at a given
price at future date then it is called as a short position.
The payoff matrix of both positions have been given below:

10
Answer to question no. 10:
i. The firm has a liability of £1,000,000 payable in three months from now. The firm is
exposed towards exchange fluctuation risk. Therefore, it can hedge such risk by
entering into a forward contract at a spot price of $1.2492/£. The company should go
long in forward market at an exercise price of $1.2492/£.
ii. Analysis showing hedging of foreign exchange risk through Forward contract:
At a spot price of $1.2342/£ at T= 3 and forward price = $1.2492/£.
So, Loss due to Forward contract = $ (1.2492-1.2342) * 1,000,000 = $15,000
At a spot price of $1.2547/£ at T= 3 and forward price = $1.2492/£.
So, profit due to Forward contract = $ (1.2547-1.2492) * 1,000,000 = $5,500

11
References:
Denga, S. and Jain, A., 2017. Forex risk management for multinationals: internal and external hedging
techniques. In София (Vol. 280, pp. 51-61).
Klaassen, F. and Mavromatis, K., 2016. Interest rate rules, exchange market pressure, and successful
exchange rate management.
Malliaris, A.G. and Ziemba, W.T., 2016. Futures Markets: An Overview. In The World Scientific
Handbook Of Futures Markets (pp. 3-22).
Meissner, C.M., 2015. The limits of bimetallism (No. w20852). National Bureau of Economic
Research.
Shaik, S., Baba, S.K. and Shaik, H., 2019. Forex Exchange Management and Challenges in Current
Global Economic Environment. Currency Risk Management: Selected Research Papers, 3, p.77.
Sudacevschi, M., 2017. Foreign currency risk hedging. Challenges of The Knowledge Society,
pp.742-746.
Wilson, T., 2017. Battles for the Standard: Bimetallism and the Spread of the Gold Standard in the
Nineteenth Century. Routledge.