Chapter 7 Zuber, Inc.
Using Covered Interest Arl)itrage Zuber, Inc., is a U.S.-based NINC that has been aggressively pursuing business in East-ern Europe since the Iron Curtain was lifted in 1989. Poland has allowed its currency's value to be market determined. The spot rate of the Polish zloty is S.40. Poland also has begun to allow investments by foreign investors, as a method of attracting funds to help build its economy. Its interest rate on one-year securities issued by the federal govern-ment is l4 percent, which is substantially higher than the 9 percent rate currently of-fered on one-year U.S. Treasury securities. A local bank has begun to create a forward market for the zloty. This hank was re-cently privatized and has been trying to make a name for itself in international business. The bank has quoted a one-year forward rate of 5.39 for the zloty. As an employee in Zuber's international money market division, you have been asked to assess the possi-bility of investing shop-term funds in Poland. You are in charge of investing S10 million over the next year. Your objective is to earn the highest return possible while maintain-ing safety (since the firm will need the funds next year). Since the exchange rate has just become market determined, there is a high proba-bility that the zloty's value will he very volatile for several years as it seeks its true equi-librium value. The expected value of the zloty in one year is S.40, but there is a high SOLdegree of uncertainty about this. The actual value in one year may be as much as 40 per-t above or below this expected value. a. Would you be willing to invest the funds in Poland without covering your posi-tion? Explain. b. Suggest how you could attempt covered interest arbitrage. What is the expected return from using covered interest arbitrage! c. What risks are involved in using covered interest arbitrage here? d. If you had to choose between investing your funds in U.S. Treasury bills at 9 per-cent or using covered interest arbitrage, what would be your choice? Defend your answer.
Chapter 8 Flame Fixtures, Inc.
Business Application of Purchasing Power Parity Flame nxtures, Inc., Is a small U.S. business In Arizona that produces and sells lamp fixtures. Its costs and revenues have been very stable over time. Its profits have been ad.
specified number of parts with the bill invoiced in Mexican pesos. By having the parts produced by Cor6n, Flame expects to save about 20 percent on production costs. Cor6n is only willing to work out a deal if it is assured that it will receive a minimum specified amount of orders every three months over the next ten years, for a minimum specified amount. Flame will be required to use its assets to serve as collateral in case it does not fulfill its obligation. The price of the parts will change over time in response to the costs of production. Flame recognizes that the cost to Conan will increase substantially over time as a result of the very high inflation rate in Mexico. Therefore, the price charged in pets likely will rise substantially every three months. However, Flame feels that, because of the concept of purchasing power parity (PPP), its dollar payments to Cor6n will be very stable. According to PPP, if Mexican inflation is much higher than U.S. inflation, the peso will weaken against the dollar by that difference. Since Flame does not have much liq-uidity, it could experience a severe cash shortage if its expenses are much higher than anticipated. The demand for Flame's product has been very stable and is expected to continue that way. Since the U.S. inflation rate is expected to be very low, Flame likely will con-tinue pricing its lamps at today's prices (in dollars). It believes that by sating 20 percent on production costs it will substantially increase its profits. It is about ready to sign a contract with Corer Company. a. Describe a scenario that could cause Flame to save even more than 20 percent on production costs. b. Describe a scenario that could cause Flame to actually incur higher production costs than if it simply had the pans produced in the United States. c. Do you think that Flame will experience stable dollar outflow payments to Cor6n over time? Explain. (Assume that the number of parts ordered is constant over time.) d. Do you think that Flame's risk changes at all as a result of its new relationship with CorOn Company? Explain.