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22/08/2022
1) Eurobonds versus Domestic Bonds – International Corporate Finance
The dollar cost of debt for Coval Consulting, a U.S. research firm, is 7.5%. The firm faces a tax rate of 30% on all income, no matter where it is earned. Managers in the firm need to know its yen cost of debt because they are considering launching a new bond issue in Tokyo to raise money for a new investment there.
The risk-free interest rates on dollars and yen are r$ = 5% and r¥ = 1%, respectively. Coval Consulting is willing to assume that capital markets are internationally integrated and that its free cash flows are uncorrelated with the yen-dollar spot rate.
What is Coval Consulting’s after-tax cost of debt in yen?
2) Credit & Exchange Rate Risk -International Corporate Finance
Suppose the interest on Russian government bonds is 7.5%, and the current exchange rate is 28 rubles per dollar. If the forward exchange rate is 28.5 rubles per dollar, and the current U.S. risk-free interest rate is 4.5%, what is the implied credit spread for Russian government bonds?
3) Forward Market Hedge – Risk Management
You are a broker for frozen seafood products for Choyce Products. You just signed a deal with a Belgian distributor. Under the terms of the contract, in 1 year, you will deliver 4000 kg of frozen king crab for 100,000 euros. Your cost for obtaining the king crab is $110,000. All cash flows occur in exactly 1 year.
a. Plot your profits in 1 year from the contract as a function of the exchange rate in 1 year for exchange rates from $0.75/€ to $1.50/€. Label this line Unhedged Profits.
b. Suppose the 1-year forward exchange rate is $1.25/€ and that you enter into a forward contract to sell the euros you will receive at this rate. In the figure from part (a), plot your combined profits from the crab contract and the forward contract as a function of the exchange rate in one year. Label this line Forward Hedge.
c. Suppose that instead of using a forward contract, you consider using options. A 1-year call option to buy euros at a strike price of $1.25/€ is trading for $0.10/€. Similarly, a 1-year put option to sell euros at a strike price of $1.25/€ is trading for $0.10/€. To hedge the risk of your profits, should you buy or sell the call or the put?
d. In the figure from parts (a) and (b), plot your “all in” profits using the option hedge (combined profits of crab contract, option contract, and option price) as a function of the exchange rate in one year. Label this line Option Hedge. (Note: You can ignore the effect of interest on the option price.)
e. Suppose that by the end of the year, a trade war erupts, leading to a European embargo on U.S. food products. As a result, your deal is cancelled, and you don’t receive the euros or incur the costs of procuring the crab. However, you still have the profits (or losses) associated with your forward or options contract. In a new figure, plot the profits associated with the forward hedge and the options hedge (labeling each line). When there is a risk of cancellation, which type of hedge has the least downside risk? Explain briefly.
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