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Part 1 Question 1: Oryx

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Part 1

Question 1:

Oryx. Ltd. is a US company that is considering moving its manufacturing facility to Mexico. The Mexican subsidiary manufactures toys for kids which will be sold to Mexican households in big cities. The cost to purchase and equip the facility is 20,000,000 Mexican pesos. The company’s production, administrative and sales department have supplied the estimates of earnings and annual changes in net working capital, interest rates in Mexico and the US, the current peso/dollar exchange rate as follows:

year	0	1	2	3
US interest rate		1.50%	1.50%	1.50%
Mexico’s interest rate		7.25%	7.25%	7.25%
Pesos per dollar	18
Initial investment	-20,000,000
EBIT		100,000	140,000	948,000
Change in net working capital		250,000	40,000	40,000
Capital expenditure		0	0	0
Unit: Mexican Peso

Perform an NPV analysis to determine whether this is a good investment, under the following assumptions:

1. The peso/dollar exchange rate is currently 18pesos/$, and the peso is expected to appreciate/depreciate at a rate justified by the expected basic interest rate differential between Mexico and the United States.
2. Depreciation of the fixed assets worth 20,000,000 peso initially invested in year 0 will be taken on a straight-line basis over 20 years.
3. The Mexico corporate income tax rate is 30%, and there is a 10% withholding tax on dividends payments.
4. The dollar-denominated discount rate for the project is 15%.
5. All the Mexican subsidiary’s free cash flows will be paid to the US parent as dividends.
6. All earnings repatriated to the US are subject to the US Tax Cuts and Jobs Act 2017.
7. After year 3, the dollar free-cash flows for the US parent will grow at a constant rate of 1% per year forever. 

 

(100 marks)

 

 

 

 

Question 2

Use the paper entitled “EQUITY HOME BIAS: A REVIEW ESSAY” by Kavous Ardalan (2019) to answer the following questions:

1. What is equity home bias and why are proponents of international portfolio diversification puzzled by the home bias phenomenon?

(20 marks) 

2. Provide a critique on the impact of barriers to foreign investments and information asymmetry on equity home bias.

(40 marks)

3. Equity home bias still exists despite the financial globalization. What is the explanation for home bias put forward by psychologists and experimental economists?

 (40 marks)

(Total: 100 marks)

The overall limit for question 2 is 1,100 words

 

 

 

Part 2

Question 3

Abdullah has just secured a graduate trainee job as a currency trader, assisting the senior FX trader in a major bank. One of the corporate clients, Al-Khor Ltd, transacts business with partners across several international jurisdictions. The global nature of its business exposes Al-Khor Ltd to significant foreign exchange risks because whereas some countries maintain fixed exchange rate regimes, others operate a floating exchange system. Al-Khor Ltd wants to determine how the different exchange rate regimes might impact its operations and foreign exchange transactions.

Al-Khor Ltd has contacted its bank for advice on a foreign exchange transaction involving three currencies. As a trainee of the bank, Abdullah is tasked to review and advise the client on the transaction, using the following quotes for Canadian dollars (CAD), U.S. dollars (USD), and Mexican pesos (MXN):

 

Currency Quotes for USD, CAD and MXN
USD/CAD MXN/CAD MXN/USD	0.7047 6.4390 8.7535

 

However, Abdullah being a trainee, has limited information about the impact of arbitrage on foreign exchange transactions and has asked his supervisor the following question:

“Does arbitrage destabilize foreign exchange markets?”

 

Answer the following questions:

1. Using relevant references, discuss the differences between floating exchange rate and fixed exchange rate regimes.                                                                     (60 marks)

The limit for question 3, part a is 700 words

 

2. Discuss whether or not arbitrage destabilizes foreign exchange markets.

           (20 marks)

3. Determine the arbitrage profit of investing $1,000,000.                            (20 marks)

 

(Total: 100 marks)

Question 4

The data in the table below establishes the interrelationships between the international parity conditions.

 

Spot Rate, Interest Rates, Price Level, Inflation Rates for Canada and UK
Current Spot Rate C$/£ Canada Interest Rate (% p.a.) Canada Price Level (2019) UK Price Level (2019) Expected Canada Inflation 2020 (% p.a.) Expected UK Inflation 2020 (% p.a.)	1.58 1.25% 18,200 11,250 2% 2.5%

 

Answer the following questions.

1. Using relevant academic references to support your arguments, compare and contrast interest rate parity, purchasing power parity (PPP), and the international Fisher effect (IFE).                                                                                                  (40 marks)
2. Does PPP eliminate concerns about long-term exchange rate risk?

       (20 marks)

3. Compute the UK interest rate, the current forward rate 12 months C$/£ and expected spot rate 12 months C$/£. How does unexpected changes in UK forecast inflation and UK interest rates affect the current forward rate and the expected spot rate?

         (20 marks)

4. Calculate the C$/£ exchange rate predicted by Purchasing Power Parity, and the associated real exchange rate.  What conclusions might you draw?

          (10 marks)

5. What amount of appreciation or depreciation of the pound would be required to return the actual exchange rate to its PPP value?                                        (10 marks)

 

The limit for Question 4, part a, is 500 words

 

(Total: 100 marks)z`