ANSWER Q2

HighTech is a multinational U.S.A. company that performs diverse activities. It manufactures electronic tools like hand-held digital electronic veniers, digital multimeters, voltage testers etc.

To conduct this manufacturing they import certain electronic components from countries like Japan and South Korea.

The market for the manufactured tools are the U.S.A, Australia, Canada and United Kingdom (U.K). However, the majority of sales is in the U.K. Therefore, the company has already put up a subsidiary in the U.K. It resells and distribute the products to different businesses. The quarterly net profit after tax generated by the subsidiary is 500,000. The exports to Canada and Australia are to other independent distributing companies that buys the tools at wholesale prices from HighTech.

HighTech is also considering the construction of an electronic component manufacturing plant in the U.S.A. to eliminate the risks and costs associated with the current importing of electronic components from countries like Japan and South Korea.

HighTech already has sufficient manufacturing space available and only has to import manufacturing equipment of 63,000,000 Yen from Japan. The installation of the machinery will be conducted by local U.S.A. companies and will cost $1000,000.

The Chief Executive Officer (CEO) of HighTech, requests the following information to assist him with determining the extent of exchange rate risk and the availability of funds to conduct the multinational transactions:

Question 1. The CEO requires a forecast of the one year and two year exchange rates for the $/ calculated based on purchasing power parity (PPP) and with the International Fisher Effect (IFE) with the following existing available information:

Current $/ spot exchange rate	$1.3036/
Expected annual U.S. inflation	0.37%
Expected annual British inflation	0.20%
Expected U.S. one-year interest rate	0.140%
Expected British one-year interest rate	0.077%

Question 2. The CEO is afraid interest rates will increase by 0.5% in the U.K. The U.K. subsidiary has a current short term loan of 1,000,000 that expires 90 days from now, but will have to borrow the same amount again after expiry for operational expenses that will be incurred. Calculate the expected outcome of a 90 day forward rate agreement entered into in the United Kingdom to hedge against the increase in interest rates on 1,000,000. The current risk free United Kingdom rate is to be used as the agreed rate for the calculation. Also assume the settlement rate is the current risk free rate plus 0.5%. Advise the CEO whether HighTech should take a long or short position to hedge the risk of the increasing interest rates. Information from the following table can be used for your calculations:

Annual risk free interest rates:
USA	0.140%
Japan	0.025%
South Korea	0.664%
Canada	0.166%
UK	0.077%
Australia	0.112%
South Africa	4.545%

The CEO requires a forecast of the one year and two year exchange rates for the $/ calculated based on purchasing power parity (PPP) and with the International Fisher Effect (IFE).

Calculate the one year forward $/ exchange rate based on PPP in the space provided below: (2 marks)

Expected Forward Rate(one year forward) = 1.3036 * (1+ 0.0037)^1/(1+0.0020)^1

= 1.3036 * (1.0016966)

= 1.305812

Calculate the two year forward $/ exchange rate based on PPP in the space provided below: (2 marks)

Expected Forward Rate(two year forward) = 1.3036 * (1+ 0.0037)^2/(1+0.0020)^2

= 1.3036 * (1.007414/1.004004)

= 1.3036 * (1.0033964)

= 1.308027

Calculate the one year forward $/ exchange rate based on IFE in the space provided below: (2 marks)

Expected Forward Rate = Spot Rate * (1+Nominal Interest Rate of quote currency) ^ n / (1+ Nominal Interest Rate of base currency) ^ n\

Nominal Interest Rate = Real Interest Rate + Inflation: For Pound(Britain) : NIR = 0.077% + 0.20% = 0.28% For USD(USA) : NIR = 0.14% + 0.37% = 0.51%

Expected Forward Rate(one year forward) = 1.3036 * (1+0.0051)^1/(1+0.0028)^1 = 1.3036 * (1.002294) = 1.30659

Calculate the two year forward $/ exchange rate based on IFE in the space provided below: (2 marks)

Expected Forward Rate(two year forward) = 1.3036 * (1+ 0.0051)^2/(1+0.0028)^2 = 1.3036 * (1.010226)/(1.005607) = 1.3036 * (1.004592) = 1.309587

Explain the conditions under which the forward exchange rates calculated by you will be unbiased predictors of the future spot exchange rate. Use the space provided below. (2 marks)

1. Based on the PPP: The PPP follows the law of one price, which states that in markets that are competitive, the prices of goods are identical for identical goods when valued in the same currency. As such, PPP implies that the change in the exchange rate is correlated to the change in the price levels (also indicated by the inflation rate). PPP states that changes in exchange rates are proportional to changes in the ratio of the two countries' price levels.

Conditions for PPP to hold and for the forward exchange rates to be unbiased predictors of the future spot rate: PPP assumes: (1) commodities are equal, (2) all goods are tradable, (3) no shipping costs, (4) no tariffs, taxes, or trade barriers, and (5) exchange rates are only determined by relative inflation rates.

2. Based on the IFE: The International Fisher Effect (IFE) dictates that the difference between two countries' nominal interest rates is proportional to changes in their currencies' exchange rates.

Conditions for IFE to hold and for the forward exchange rates to be unbiased predictors of the future spot rate: (1) investors are risk neutral, (2) markets are informationally efficient.

Q2

Show your calculation by applying the correct formula in the space provided below: 6 marks

Question	Your answer
Do you recommend that HighTech should be the seller or buyer of the forward rate agreement? (1 mark)
Briefly explain how the forward rate agreement will assist Hightech in terms of the interest rate that it will have to pay if it borrows 1,000,000 again for 90 days after expiry of the current loan. (3 marks)