Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U.S. market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):• £/$ spot exchange rate = 0.8• £/C$ spot exchange rate = 0.4• U.K. risk-free rate = 6%• U.K. expected inflation rate = 4%• Canadian risk-free rate = 9%• Canadian expected inflation rate = 7%• U.S. risk-free rate = 4%• U.S. expected inflation = 2%Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the £/C$ exchange rate. In order to apply the model, he estimates the following parameters using the £ as the base currency:• World market risk premium = 6%• Sensitivity of Slapshot to the world market = 1.2• Sensitivity of Slapshot to changes in the £/C$ exchange rate = 1.4• Holmes' expectation for the depreciation of the C$ against the £ = 2%• The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.Consider the current U.S. dollar to C$ ($/C$) spot exchange rate. Suppose that after one year, the nominal spot $/C$ exchange rate is 0.350. The most likely impact on Slapshot's valuation from the $/C$ exchange rate change is the:
Answer(s): A
Since the beginning-of-period $/C$ spot exchange rate is not given directly, we must calculate it from the £/$ and £/C$ quotes. Dividing £/C$ by £/$ gives a rate for the $/C$ exchange rate of 0.5. Next we need to determine whether there was any real change in the exchange rate during the year. Inflation in the United States is 2%, and inflation in Canada is 7% (remember that inflation is perfectly predictable). The 5% inflation differential means that to maintain parity, the C$ must depreciate by 5%. If the C$ depreciates by 5%, the new exchange rate would be 0.5(1 - 0.05) = 0.475. Since the end-of-period rate is less than what was expected given the inflation differential, the real value of the C$ has decreased. Hence, the firm should have a higher value because it is primarily an exporter, and exporters are helped by real domestic currency depreciation. (Study Session 18, LOS 66.e,m)
Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U.S. market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):• £/$ spot exchange rate = 0.8• £/C$ spot exchange rate = 0.4• U.K. risk-free rate = 6%• U.K. expected inflation rate = 4%• Canadian risk-free rate = 9%• Canadian expected inflation rate = 7%• U.S. risk-free rate = 4%• U.S. expected inflation = 2%Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the £/C$ exchange rate. In order to apply the model, he estimates the following parameters using the £ as the base currency:• World market risk premium = 6%• Sensitivity of Slapshot to the world market = 1.2• Sensitivity of Slapshot to changes in the £/C$ exchange rate = 1.4• Holmes' expectation for the depreciation of the C$ against the £ = 2%• The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.Suppose the C$ suddenly depreciates by 10% against the £. Given his estimated parameters, what is most likely to happen to the CAD value of Slapshot in response to this sudden exchange rate change?
Answer(s): B
The sensitivity of Slapshot returns to changes in the £/C$ exchange rate is 1.4. The sensitivity is a function of the CAD reaction; specifically, the sensitivity of the currency return is equal to y(CAD) + 1 (recall that y is the sensitivity measure). Since y = 1.4, y(CAD) must be 0.4. This means that the CAD value of Slapshot changes by 40% of the amount of the currency change. Hence, if the C$ suddenly depreciates by 10%, the CAD value of the firm falls by 4%. (Study Session 18, LOS 66.1)
Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U.S. market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):• £/$ spot exchange rate = 0.8• £/C$ spot exchange rate = 0.4• U.K. risk-free rate = 6%• U.K. expected inflation rate = 4%• Canadian risk-free rate = 9%• Canadian expected inflation rate = 7%• U.S. risk-free rate = 4%• U.S. expected inflation = 2%Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the £/C$ exchange rate. In order to apply the model, he estimates the following parameters using the £ as the base currency:• World market risk premium = 6%• Sensitivity of Slapshot to the world market = 1.2• Sensitivity of Slapshot to changes in the £/C$ exchange rate = 1.4• Holmes' expectation for the depreciation of the C$ against the £ = 2%• The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.If Holmes uses the IC APM, the required rate of return on Slapshot is closest to:
The ICAPM (with only one foreign currency) is AH parameters are provided in the problem statement except the foreign currency risk premium (SRP). The SRP is calculated as expected foreign currency appreciation minus the rate differential (domestic-foreign). The problem indicates that Holmes expects the C$ to depreciate by 2% or, equivalently, to appreciate by -2%. Interest rates are 6% in the U.K. and 9% in Canada. Therefore, the SRP is 1% [= -2% appreciation minus -3% interest rate differential, or SRP = -2% - (-3%) =+1%). Plugging into the model, we get:(Study Session 18, LOS 66.i,j)
Robert Williams is a junior analyst at Anderson Brothers, a large Wall Street brokerage firm. He reports to Will McDonald, the chief economist for Anderson Brothers. McDonald provides economic research, forecasts, and interpretation of economic data to all of Anderson's investment departments, as well as the firm's clients. McDonald has asked Williams to analyze economic trends in the country of Bundovia. The currency of Bundovia is the Bunco (BU).Williams first analyzes the effect of rising nominal Bundovian interest rates relative to U.S interest rates on the supply and demand for BU. He determines that the increase in Bundovian nominal interest rates would increase the demand for BU and, because the BU supply curve is upward sloping, the BU will appreciate and the equilibrium quantity of BU will increase proportionately.Bundovia has announced plans to impose either a tariff or a quota on semiconductor imports from the United States. McDonald also asks Williams to analyze the potential effect on Bundovian Semiconductors, the dominant semiconductor manufacturer located in Bundovia. Currently, Bundovian Semiconductors is not competitive in the global semiconductor market because its higher production costs make it unable to generate profits at the current world market price. Williams concludes that the imposition of either a tariff or quotas would benefit Bundovian Semiconductors. The company would become competitive with foreign producers in its domestic semiconductor market because imports would be reduced and domestic production would rise.Exhibit 1 shows the trend in the average BU/USD exchange rate over the past three years.Williams asks the bank for a GBP/SFr cross rate.From the same bank, Williams receives the following forward rate quotes in the USD/GBP market:• 30-day forward rate: USD/GBP = USD/GBP = 2.0045 - 55• 60-day forward rate: USD/GBP = USD/GBP = 2.0075 – 85Williams has uncovered a potential arbitrage opportunity in the foreign exchange markets. The current spot rate is $2.00 per BU. The Bundovian risk-free interest rate is 3%, and the one-year forward rate is $2.10 per BU. The U.S. risk-free rate is 5%.Is Williams's analysis of the effect of rising nominal Bundovian interest rates on the value and equilibrium quantity of the BU correct?
Answer(s): C
Rising nominal Bundovian interest rates will increase the demand for BU and decrease the supply of BU. The increase in demand, all else equal, will cause the BU to appreciate and increase the equilibrium quantity. The decrease in supply, all else equal, will also cause the BU to appreciate but decrease the equilibrium quantity demanded. The net effect of these two changes is to cause the BU to appreciate. However, the separate effects on quantity demanded will offset, and the equilibrium quantity will not be significantly affected. (Study Session 4, LOS 17.c and I9.d)
Robert Williams is a junior analyst at Anderson Brothers, a large Wall Street brokerage firm. He reports to Will McDonald, the chief economist for Anderson Brothers. McDonald provides economic research, forecasts, and interpretation of economic data to all of Anderson's investment departments, as well as the firm's clients. McDonald has asked Williams to analyze economic trends in the country of Bundovia. The currency of Bundovia is the Bunco (BU).Williams first analyzes the effect of rising nominal Bundovian interest rates relative to U.S interest rates on the supply and demand for BU. He determines that the increase in Bundovian nominal interest rates would increase the demand for BU and, because the BU supply curve is upward sloping, the BU will appreciate and the equilibrium quantity of BU will increase proportionately.Bundovia has announced plans to impose either a tariff or a quota on semiconductor imports from the United States. McDonald also asks Williams to analyze the potential effect on Bundovian Semiconductors, the dominant semiconductor manufacturer located in Bundovia. Currently, Bundovian Semiconductors is not competitive in the global semiconductor market because its higher production costs make it unable to generate profits at the current world market price.Williams concludes that the imposition of either a tariff or quotas would benefit Bundovian Semiconductors. The company would become competitive with foreign producers in its domestic semiconductor market because imports would be reduced and domestic production would rise.Exhibit 1 shows the trend in the average BU/USD exchange rate over the past three years.Williams asks the bank for a GBP/SFr cross rate.From the same bank, Williams receives the following forward rate quotes in the USD/GBP market:• 30-day forward rate: USD/GBP = USD/GBP = 2.0045 - 55• 60-day forward rate: USD/GBP = USD/GBP = 2.0075 - 85Williams has uncovered a potential arbitrage opportunity in the foreign exchange markets. The current spot rate is $2.00 per BU. The Bundovian risk-free interest rate is 3%, and the one-year forward rate is $2.10 per BU. The U.S. risk-free rate is 5%.Is Williams correct in his conclusions that Bundovian Semiconductors would benefit from the imposition of a tariff or quota?
Williams is correct in his assessment of the effects of a tariff and a quota. Both would benefit Bundovian Semiconductors. The company would be more competitive in the domestic market because imports would fall and domestic production would rise. (Study Session 4, LOS I6.b)
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