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FINANCE QUESTIONS Case Solution

Question 1

It is true to state that multinational enterprises (MNEs) are at a competitive advantage because they have lower cost of capital as compared to their domestically based counterparts. There are a number of factors behind this. First, certain countries allow companies to be more leveraged as compared to other countries like America. For instance, FGP also has its operations in America.

Therefore, the company takes advantage of these differences to enhance the returns to equity holders. Secondly, MNEs also take the advantage of the tax and interest differences among the countries to minimize their cost of debt and the cost of capital. The Beta for FGP is lower than the beta of GOG, which suggests that the cost of debt is lower for FGP and this is evident by the higher proportion of debt in the capital structure of the company.

Moreover, GOG has been financing its equity through debt issue as indicated by the total debt to equity ratio. This suggests that GOG is highly levered and thus would have higher cost of debt because its capital structure has high level of debt. Lastly, FGP has a lower cost of capital because it would have global access to availability of capital and global cost, it allows more optimality in its capital projects, and the budgets compared to its domestic counterparts. This leads to a constant WACC for a large budget.

Question 2

a).

Swap transaction is an agreement between two parties to exchange the series of future cash flows. If we take an example of a plain vanilla swap, which is simply an interest rate swap, in which one party pays the floating rate of interest and the other party pays the fixed interest rate. The party, which is willing to pay the floating rate of interests, believes that the interest rates would fall in future. If the rate actually goes down, then the party’s interest payments would also go down.

For example, we have a company XYZ that structures a swap of future interest payments and has an investor, which is willing to buy the stream of the interest payments at this variable rate and thus pay fixed amount of interest in each of the future periods. At the time of the swap, the amount to be paid would be same over the entire life of the debt. Overall, in this transaction the investor is betting that the variable interest rates would go down and it would lower their costs. On the other hand, the interest cost for Company XYZ would be same, which would allow a gain or arbitrage on the difference.

A bid-offer spread in a foreign exchange market is the amount by which the ask price exceeds the bid price for a specific asset in the market. It is the difference between the higher price, which the buyer is willing to pay, and the lowest price the seller is willing to accept for an asset in the market.

b).

1). Triangular arbitrage is a riskless profit, which occurs in an exchange market when the quoted exchange rate is not equal to the cross exchange rate of the market. It works by exploiting the inefficiency in the market where one market is undervalued and the other is overvalued. The differences in prices are only fractions of a cent and the trader must trade a large amount of capital so that the arbitrage can become profitable.

2). If we look at the observation period in the graph then we can see a rapid growth in algorithm and high frequency trading during the 2001 to 2005 and then the situation reversed after 2005. However, before 2005 this high growth trading had promoted efficiency in the spot trading foreign exchange market. Arbitrage opportunities, or market price differences, seem to occur in about one in every 20 seconds between the euro-dollar, dollar-yen and euro-yen currency pairs during the active part of the trading day during early 2000s. The data in the graph shows that high frequency trading had enhanced the market efficiency as measured by the persistence and availability of the pricing arbitrage opportunities available in the FX market.

Question 3

a). (1+ i $) = 1.075 <  (F/S) (1+ i ) = 1.10. Thus, one has to borrow dollars and invest in euros to make arbitrage profit.

 

  • Borrow $1,000 and repay $1,331 in three months.
  • Sell $1,000 spot for €1450.
  • Invest €1450 at the euro interest rate of 7.5 % for three months and receive €1,801.31 at maturity.
  • Sell €1801.31 forward for $1334.32....................................................

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