  Answers to End-of-Chapter Problems

1. Foreign exchange and commodity prices. While traveling in the following countries, you see
20-ounce plastic bottles of Coca-Cola. You know the price in the United States for a Coke is
$1.09, but the countries have the following prices:
Canada: C$1.50
Japan: ¥125
England: £0.60
Average Price across Europe: €0.90
What is the implied exchange rate for U.S. dollars and these four currencies?

Answer: Indirect Direct (1/Indirect)

C$1.50
= C$1.3761 per $1 $0.7267 per C$1.00
$1.09
¥125.00
= ¥114.6789 per $1 $0.0087 per ¥1.00
$1.09
£0.6000
= £0.5505 per $1 $1.8167 per £1.00
$1.09
€0.9000
= €0.8257 per $1.00 $1.2111 per €1.00
$1.09

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16  Brooks • Financial Management: Core Concepts

2. Foreign exchange and commodity prices. While traveling in various countries, you occasionally
resort to U.S. food. You pay the following prices for a Big Mac:
India: 210 rupee
Kuwait: 1.39 dinar
Sweden: 34.90 krona
Ukraine: 133 rubles
If the price of a Big Mac is $4.59 in the United States, what are the implied exchange rates for
these currencies?
Answer: Indirect Direct (1/Indirect)
210 Rupee
= Rupees 45.7516 per $1.00 $0.0219 per Rupees
$4.59
1.39 Dinar
= Dinar 0.3028 per $1.00 $3.3022 per Dinar
$4.59
34.90 Krona
= Krona 7.6035 per $1.00 $0.1315 per Krona
$4.59
133 Rubles
= Rubles 28.976 per $1.00 $0.0345 per Ruble
$4.59

3. Currency exchange rate. You are taking a trip to six European countries. It is a ten-day trip,
and you are taking $3,500. The current direct conversion rate is 1.2150 for euros. While in
Europe, you spend €2638.30. You convert your remaining euros back to U.S. dollars upon your
return. If the exchange rates remained the same over your trip, how much do you have left in
U.S. dollars?

Answer: Convert $ to € $3,500/(1.2150) = €2,880.6584

<€2638.30>
€242.3584 Remaining

Convert € to $ €242.3584 × (1.2150) = $294.4655

4. Currency exchange rates. On the day you arrive in England, the exchange rate for U.S. dollars
and British pounds is $1:£0.58. While you remain in England for the next two weeks, the
exchange rate falls to $1:£0.54. When you entered England, you converted $4,200 to pounds. As
you leave England, you have £135. How much did you spend in England in U.S. dollars? Did
the movement in the exchange rate help or hurt you?

Answer: Convert $ to £ $4,200 × (0.5800) = £2,436.00

Left in pounds £2,436.00 − £2,301.00 = £135.00
Dollars left after converting: £135/(0.5400) = $250
Dollars spent $4,200.00 − $250.00 = $3,950.00
Appreciation of the £: $ helped you: bought the £ low and sold the £ high
Initial value of $1.00 = £0.5800

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 Chapter 18 International Financial Management  17

Ending value of $ = £0.5800/(£0.5400) = 1.074074

You gained about 7.4 cents per dollar while in England.

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18  Brooks • Financial Management: Core Concepts

5. Cross rates. You plan to travel to Japan and China on a business trip. You will first stop in
Japan, where the current direct exchange rate is $1:¥0.0092. You will next stop in China, where
the current direct exchange rate is $1:yuan 0.1285. As you leave Japan, you have ¥980,000 and
need to convert to yuan. What is the cross rate for yuan? How many yuan do you get for your
yen? Verify by converting yen back to dollars and then dollars to yuan.

Note: Please note an error in the wording of this problem. The problem should state that the current direct
exchange rate for Japan is 0.0092 for yen (that is, $0.0092 buys one yen) and that the current direct
exchange rate for China is 0.1285 for yuan (that is, $0.1285 buys one yuan).

Answer: Direct rate: $0.0092/¥1.00 and $0.1285/yuan 1.00

Cross rate: ($0.0092/¥1.00)/($0.1285/yuan 1.00) = yuan 0.0716/¥1.00
Convert: ¥980,000 to yuan = ¥980,000 × (0.0716) = yuan 70,163.424
Verification: ¥980,000 × 0.0092 = $9,016
$9,016/(0.1285) = yuan 70,163.424

6. Cross rates. Fill in the missing cross rates and direct rates in the table below:

International Cross Rates

$ Euro Pound Peso Yen C$
Canada 1.3689 —
Japan 109.48 —
Mexico 11.3921 —
U.K. 0.5460 —
Euro 0.8222 —
U.S. —

Answer:
International Cross Rates
$ Euro Pound Peso Yen C$
Canada 1.3689 1.6649 2.5071 0.1202 0.0125 —
Japan 109.48 133.1550 200.5128 9.6103 — 79.9766
Mexico 11.3921 13.8556 20.8647 — 0.1041 8.3195
U.K. 0.5460 0.6641 — 0.0479 0.0050 0.3989
Euro 0.8222 — 1.5059 0.0722 0.0075 0.6006
U.S. — 1.2162 1.8315 0.0879 0.0091 0.7305

7. Triangular arbitrage. Great Exchanges, Inc. is a currency exchange company located at most
international airports. Today, a clerk has made a mistake on one of the currency exchanges and
has posted the following rates:

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 Chapter 18 International Financial Management  19

$ for £ £ for € € for $ £ for $ € for £ $ for €

0.5310 1.4435 1.3046 1.8832 0.9628 0.7665

Which corresponding rates do not match? If you had $1,000, how much could you make on one
pass through the currencies?

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20  Brooks • Financial Management: Core Concepts

Answer: Direct Indirect Actual Indirect

£0.5310 $1.8832 $1.8832
=
$1.00 £1.00 £1.00
€1.4435 £0.6928 £0.9628
=  Mismatch
£1.00 €1.00 €1.00
$1.3046 €0.7665 €0.7665
=
€1.00 $1.00 $1.00

Arbitrage strategy: Need to use the mismatched euros to British pounds…

1. Convert $ to €: $1,000 × 0.7665 = €766.50
2. Convert € to £: €766.50 × 0.9628 = £737.9862
3. Convert £ to $: £737.9862 × 1.8832 = $1,389.77
Profit: $389.77

8. Triangular arbitrage. Using the data from Problem 7, determine what you would lose if you
went the wrong way for the arbitrage. Explain this result.

Answer: Direct Indirect Actual Indirect

£0.5310 $1.8832 $1.8832
=
$1.00 £1.00 £1.00
€1.4435 £0.6928 £0.9628
=  Mismatch
£1.00 €1.00 €1.00
$1.3046 €0.7665 €0.7665
=
€1.00 $1.00 $1.00

Arbitrage strategy:
1. Convert $ to £: $1,000 × 0.5310 = £531.00
2. Convert £ to €: £531.00 × 1.4435 = €766.4985
3. Convert € to $: £766.4985 × 1.3046 = $999.97

You lose three cents, nothing really, because all the rates used were correct and you
did not take advantage of the mismatched pounds to euro rate nor did you use that
mismatched rate in the wrong direction.

9. Forward rates. Your company has posted you on an eighteen-month overseas assignment in
Budapest, Hungary. You will be living on the Buda side of the river, but will be spending much
of your time on the Pest side. The current indirect rate for the Hungarian forint is 187.90. If the
anticipated inflation rate in the United States is 3% and the anticipated rate in Hungary is
8.5% (annually), what exchange rate do you anticipate at the end of your assignment?

Answer: Current indirect exchange rate: 187.90 HF

Anticipated forward 18 mo: (187.90 HF) × [(1 + 0.085)/(1 + 0.03)]1.5 = 203.1494 HF

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 Chapter 18 International Financial Management  21

10. Forward rates. The Wall Street Journal lists forward rates for Japanese yen. Say that the
current listings are:
one-month forward rate (indirect) 103.17
three-month forward rate (indirect) 102.68
six-month forward rate (indirect) 101.88
First, is the anticipated inflation rate higher or lower in Japan compared with that in the
United States? Second, if the current indirect rate is 103.37, what do the six-month rate and the
current rate imply about the relative difference in the anticipated annual inflation rates?
Finally, using the current indirect rate and the six-month forward rate, determine the annual
anticipated inflation rates for Japan if the U.S. inflation rate is anticipated to be 3.45%.

Answer: Forward indirect rates:

One-month ¥103.17/$1.00
Three-month ¥102.68/$1.00
Six-month ¥101.88/$1.00
A depreciating ¥ signifies lower inflation in the next six months for Japan versus the
United States.
Inflation: 101.88 = 103.37 × [(1 + infJAPAN)/(1 + infU.S.)]0.5
[(1 + infJAPAN)/(1 + infU.S.)] = (101.88/103.37)2
[(1 + infJAPAN)/(1 + infU.S.)] = 0.97137929
(1 + infJAPAN) = (1 + infU.S.) × 0.9713729

Therefore, (1 + infJAPAN) < (1 + infU.S.) and thus infJAPAN < infU.S. And if U.S. inflation is
3.45%, then (1 + infJAPAN) = (1.0345) × 0.9713729 InfJAPAN = 0.004891876 or 0.49%

11. Real rates. Determine the real interest rates in the following countries, given their nominal
interest rates and inflation rates:
Canada: Inflation is 4.5%, and the nominal risk-free interest rate is 6.0%.
Switzerland: Inflation is 1.25%, and the nominal risk-free interest rate is 3.75%.
United States: Inflation is 3%, and the nominal risk-free interest rate is 4.50%.

Answer: Using the simple approximate approach:

Canada: 0.06 Nom RF − 0.045 INF = 0.015 or 1.5% real
Switzerland: 0.0375 Nom RF − 0.0125 INF = 0.015 or 1.5% real
U.S.: 0.045 Nom RF − 0.030 INF = 0.015 or 1.5% real

Using the Fisher Effect approach:

Canada: (1.06/1.045) − 1 = 0.01435 or 1.435% real
Switzerland: (1.0375/1.0125) − 1 = 0.024691 or 2.46% real
U.S.: (1.045/1.030) − 1 = 0.01456 or 1.456% real

12. Real rates. Determine the nominal rates for the three countries listed if they have the following
inflation rates and the real rate the world over is 1.25%:

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22  Brooks • Financial Management: Core Concepts

Canada: Inflation is 4.5%.

Switzerland: Inflation is 1.25%.
United States: Inflation is 3%.

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 Chapter 18 International Financial Management  23

Answer: Using the simple approximate approach:

Canada: 0.0125 real + 0.045 INF = 0.0575 or 5.75% nominal
Switzerland: 0.0125 real + 0.0125 INF = 0.0250 or 2.5% nominal
U.S.: 0.0125 real + 0.030 INF = 0.0425 or 4.25% nominal

Using the Fisher Effect approach:

Canada: (1.0125 × 1.045) − 1 = 0.05806 or 5.806% real
Switzerland: (1.0125 × 1.0125) − 1 = 0.025156 or 2.5156% real
U.S.: (1.0125 × 1.030) − 1 = 0.042875 or 4.2875% real

13. Transaction exposure. International Products, Inc. has ordered 10,000 leather coats from
Argentina to be delivered in six months. The contracted cost of a coat is 122 pesos. International
Products will pay for the coats upon delivery. The current indirect exchange rate is $1 for
1.2902 pesos. The anticipated inflation rate is 3% in the United States and 7% in Argentina. In
U.S. dollars, how much will the 10,000 leather coats cost International Products at delivery?

Answer: Anticipated forward 6 mo. (Ps1.2902) × [(1 + 0.07)/(1 + 0.03)](1/2) = Ps 1.3150

Cost of 10,000 coats: 10,000 × [Ps122 × ($1.00)/Ps 1.3150)] = $927,746.91

14. Transaction exposure. International Products has contracted for 5,000 winter hats from Russia.
The contract price is 1,375 rubles per hat. The current direct exchange rate is 0.03562. The
expected inflation rate for the next nine months is 5% in the United States and 2% in Russia. If
International Products will pay for the hats at delivery and scheduled delivery is nine months
away, what is the cost of the hats in U.S. dollars? Did waiting the nine months to pay increase
or decrease the payment (in U.S. dollars)? If so, by how much?

Answer: Current cost of 5,000 winter hats:

5,000 × [Ru 1,375 × $0.03562] = $244,887.50
Anticipated forward 9 mos. ($0.03562) × [(1 + 0.05)/(1 + 0.02)]3/4 = $0.0364 per Ru1
New cost of 5,000 winter hats:
5,000 × [Ru 1,375 × ($0.0364/Ru 1.00)] = $250,269.81
Exposure loss: $5,382.3095

15. Operating exposure. Copy-Cat, Inc. has signed a deal to make vintage Nissan 240-Z sports cars
for the next three years. The cars will be built in Japan and shipped to the United States for
sale. The current indirect rate is 103.50 for $ and ¥. The inflation rate for parts and labor in
Japan is anticipated to be 2.5% over the next three years, and the overall inflation rate for
Japan is anticipated to be 3.5% over the next three years. The overall inflation rate in the
United States is expected to be 4.0% over the next three years. (Rates are stated on an annual
basis.) If Copy-Cat plans to sell 500 cars a year at an initial price of $45,000 and the cost of
production is ¥4,036,500, what is the annual profit in real dollars for Copy-Cat? Assume that it
takes one year for production and that all sales revenues and production costs are at the end of
the year. Is this profit rising or falling each year? Why?

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24  Brooks • Financial Management: Core Concepts

Answer: Assume the revenue and costs are from the start of the year and will inflate over the
first year.
Anticipated forwards:
Year 1: (¥103.50/$1.00) × (1.035/1.04) = ¥103.0024/$1.00
Year 2: (¥103.50/$1.00) × (1.035/1.04) 2 = ¥102.5072/$1.00
Year 3: (¥103.50/$1.00) × (1.035/1.04)3 = ¥102.0144/$1.00

$ Profit per car

Year 1 2 3
Revenue $46,800.00 $48,672.00 $50,618.90
Cost $40,168.12 $41,371.22 $42,610.35
Profit $ 6,631.88 $ 7,300.78 $ 8,008.55

Profit end of Year 1: $6,631.88 × 500 = $3,315,940

Profit end of Year 2: $7,300.78 × 500 = $3,650,390
Profit end of Year 3: $8,008.55 × 500 = $4,004,275

Revenue:
$45,000 (1.04) = $46,800.00
$45,000 (1.04)2 = $48,672.00
$45,000 (1.04)3 = $50,618.88

Cost:
¥4,036,500 (1.025)/103.0024 = $40,168.12
¥4,036,500 (1.025)2/102.5072 = $41,371.22
¥4,036,500 (1.025)3/102.0144 = $42,610.35

$ Profits are rising as the revenue is growing at a higher inflation rate than the production
costs despite the weakening dollar against the yen.

16. Operating exposure. Just before Copy-Cat, Inc. starts the project outlined in Problem 15, the
government announces new anticipated inflation numbers. For Japan, the estimate is a higher
inflation rate of 5%. For the United States, the estimate is a lower projection of 3.0%. If the
production cost inflation rate remains at 2.5%, will these new anticipated inflation rates affect
the production of vintage 240-Zs?

Answer: Assume the revenue and costs are from the start of the year and will inflate over the
first year.

Anticipated forwards:
Year 1: (¥103.50/$1.00) × (1.05/1.03) = ¥105.5097/$1.00
Year 2: (¥103.50/$1.00) × (1.05/1.03)2 = ¥107.55844/$1.00
Year 3: (¥103.50/$1.00) × (1.05/1.03)3 = ¥109.6469544/$1.00

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 Chapter 18 International Financial Management  25

$ Profit per car

Year 1 2 3
Revenue $46,350.00 $47,740.50 $49,172.715
Cost $39,213.57 $39,428.33 $39,644.229
Profit $ 7,136.43 $ 8,312.17 $ 9,528.49

Profit end of Year 1: $7,136.43 × 500 = $3,568,215

Profit end of Year 2: $8,312.17 × 500 = $4,156,085
Profit end of Year 3: $9,528.49 × 500 = $4,764,245
Revenue:
$45,000 (1.03) = $46,350.00
$45,000 (1.03)2 = $47,740.50
$45,000 (1.03)3 = $49,172.715
Cost:
¥4,036,500 (1.025)/105.5097 = $39,213.57
¥4,036,500 (1.025) /107.5584
2 = $39,428.33
¥4,036,500 (1.025) /109.6469544 = $39,644.229
3

$ Profits are rising as the revenue is growing at a higher inflation rate than the production
costs, and the weakening yen allows for the production costs to fall even more against
the dollar.
17. Domestic NPV approach. Surfboards USA wants to expand its operations to Australia. The
current indirect exchange rate is 1.45 for U.S. and Australian dollars. The anticipated inflation
rate is 3% in the United States, but only 1.5% in Australia. The discount rate in the United
States for the expansion project is 14%. If the following Australian dollars have been forecasted
for the expansion project, should Surfboards USA expand to Australia? Use the domestic-
currency approach.
Investment: A$40,000,000
Year 1 cash flow − A$5,000,000
Year 2 cash flow − A$9,000,000
Year 3 cash flow − A$16,000,000
Year 4 cash flow − A$20,000,000
Year 5 cash flow − A$8,000,000
Year 6 cash flow − A$3,000,000

Answer: Anticipated forwards:

Year 1: (Au$1.45/$1.00) × (1.015/1.03) = Au$1.4289/$1.00
Year 2: (Au$1.45/$1.00) × (1.015/1.03)2 = Au$1.4081/$1.00
Year 3: (Au$1.45/$1.00) × (1.015/1.03) 3 = Au$1.3876/$1.00
Year 4: (Au$1.45/$1.00) × (1.015/1.03)4 = Au$1.3674/$1.00

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26  Brooks • Financial Management: Core Concepts

Year 5: (Au$1.45/$1.00) × (1.015/1.03)5 = Au$1.3474/$1.00

Year 6: (Au$1.45/$1.00) × (1.015/1.03) 6 = Au$1.3278/$1.00

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 Chapter 18 International Financial Management  27

Cash Flows:
Au$ −40,000,000/1.45
Au$ 5,000,000/1.4289
Au$ 9,000,000/1.4081
Au$ 16,000,000/1.3876
Au$ 20,000,000/1.3674
Au$ 8,000,000/1.3474
Au$ 3,000,000/1.3278
$ Value
= $ −27,586,207.0
= $3,499,235.6/(1.14)
= $6,391,707.2/(1.14)2
= $11,530,962/(1.14)3
= $14,626,712/(1.14)4
= $ 5,937,148.3/(1.14)5
= $ 2,259,333.5/(1.14)6
Present Value
$ −27,586,207.00
$ 3,069,504.90
$ 4,918,211.10
$ 7,783,070.70
$ 8,660,188.00
$ 3,083,568.80
$ 1,029,322.00

NPV = ∑(PV Column)  $957,658.50. Expand!

18. Domestic NPV approach. Farbucks is thinking of expanding to South Korea. The current
indirect rate for dollars and South Korean won is 1025. The inflation rate in South Korea is
expected to hover near 0.5% for the next five years. The U.S. inflation rate is expected to stay
around 3.0%. The discount rate for expanding is 15% for Farbucks. Given the following
projected cash flows for the expansion project and using the domestic NPV approach, should
Farbucks expand to South Korea?
Cash Flows: Year 0, initial investment costs of 82,000,000 Won per coffee shop
Year 1 cash flow Won 25,000,000
Year 2 cash flow Won 30,000,000
Year 3 cash flow Won 70,000,000
Year 4 cash flow Won 90,000,000
Year 5 cash flow Won 45,000,000

Answer: Anticipated forwards:

Year 1: (Won1025/$1.00) × (1.005/1.03) = Won 1000.1214/$1.00
Year 2: (Won1025/$1.00) × (1.005/1.03)2 = Won 975.8466/$1.00
Year 3: (Won1025/$1.00) × (1.005/1.03) 3 = Won 952.1610/$1.00
Year 4: (Won1025/$1.00) × (1.005/1.03)4 = Won 929.0503/$1.00
Year 5: (Won1025/$1.00) × (1.005/1.03)5 = Won 906.5005/$1.00

Cash Flows:
$ Value Present Value
Won −82,000,000/1025.0000 = $ −80,000 $ −80,000.00
Won 25,000,000/1000.1214 = $24,996.966/(1.15) $ 21,736.49
Won 30,000,000/975.8466 = $30,742.538/(1.15)2 $ 23,245.78
Won 70,000,000/952.1610 = $73,516.981/(1.15) 3 $ 48,338.61
Won 90,000,000/929.0503 = $96,873.122/(1.15)4 $ 55,387.52

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28  Brooks • Financial Management: Core Concepts

Won 45,000,000/906.5005 = $ 49,641.451/(1.15)5 $ 24,680.57

NPV = ∑(PV Column) $93,388.97. Expand!

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 Chapter 18 International Financial Management  29

19. Foreign currency NPV approach. Verify your answer to Problem 17 using the foreign-currency
approach.

Answer: Foreign discount rate:

{(1 + U.S. discount rate) × [(1 + inflation FC)/(1 + inflation U.S.)]} − 1
[1.14 × (1.015/1.03)] − 1 = 12.339806%
PV A$
Cash Flows: Cost – A$ −40,000,000 A$ −40,000,000
Year 1 – A$5,000,000/(1 + 12.339806%) A$ 4,450,782.1
Year 2 – A$9,000,000/(1 + 12.339806%) 2 A$ 7,131,406.2
Year 3 – A$16,000,000/(1 + 12.339806%)3 A$ 11,285,452
Year 4 – A$20,000,000/(1 + 12.339806%) 4 A$ 12,557,273
Year 5 – A$8,000,000/(1 + 12.339806%) 5 A$ 4,471,174.7
Year 6 – A$ 3,000,000/(1 + 12.339806%)6 A$ 1,492,516.8

NPV = ∑(PV Column) A$1,388,604.9/1.45 = $957,658.50. Expand!

20. Foreign currency NPV approach. Verify your answer to Problem 18 using the foreign currency
approach.

Answer: Foreign discount rate:

{(1 + U.S. discount rate) × [(1 + inflation FC)/(1 + inflation U.S.)]} − 1
[1.15 × (1.005/1.03)] − 1 = 12.208738%
PV Won
Cash Flows: Cost – Won −82,000,000 Won −82,000,000
Year 1 – Won 25,000,000/(1 + 12.208738%) Won 22,279,905
Year 2 – Won 30,000,000/(1 + 12.208738%)2 Won 23,826,920
Year 3 – Won 70,000,000/(1 + 12.208738%) 3 Won 49,547,073
Year 4 – Won 90,000,000/(1 + 12.208738%)4 Won 56,772,210
Year 5 – Won 45,000,000/(1 + 12.208738%)5 Won 25,297,589

NPV = ∑(PV Column), Won 95,723,697/1025 = $93,388.97. Expand!

  Additional Problems with Answers  (Slides 18-35–18-45)

1. Currency exchange rates. On the day you arrive in New Zealand, the exchange rate for
U.S. dollars and New Zealand dollars is $1:2.25 NZ$. While you remain in New Zealand for
the next few months, the exchange rate falls to $1:$1.75439 NZ$. When you entered New
Zealand, you converted US$10,500 to NZ$. As you leave New Zealand, you have NZ$400.
How much did you spend in New Zealand in U.S. dollars? Did the movement in the exchange
rate help or hurt you?

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30  Brooks • Financial Management: Core Concepts

Answer: Convert US$ to NZ$: $10,500 × 2.25 = NZ$23,625

Remaining NZ$ after trip is over = NZ$400; amount spent  NZ$23,625 − NZ$400
= NZ$23,225
Dollars left after converting: NZ$400/1.75439 = $228
Dollars spent: $10,500 − $228.00 = $10,272
Appreciation of the NZ$ helped you: you bought the NZ low and sold the NZ high.
Initial value of $1.00 = NZ$2.25
Ending value of $ = NZ$2.25/NZ$1.75439 = 1.2825
You gained about 28.25 cents per dollar while in New Zealand.

2. Cross rates. You plan to travel to South Korea and China on a business trip. You will first stop
in Korea, where the current direct exchange rate is $1:1243.78SK won. You will next stop in
China, where the current direct exchange rate is $1:yuan 6.83013. As you leave South Korea,
you have 825,000 won and need to convert it to yuan. What is the cross-rate for yuan, and how
many yuan do you get for your won? Verify by converting won back to dollars and then dollars
to yuan.

Answer: Direct rate: $0.000804/won 1.00 & $0.1464101/yuan 1.00

Cross rate: ($0.000804/won 1.00)/($0.1464101/yuan 1.00)
 yuan 0.00549142/won 1.00
Convert: 125,000 won to yuan = won 825,000 × (0.00549142)
 yuan 4,530.42
Verification: 825,000 won = 825,00 × 0.000804  $663.3
$663.3 × 6.83013Yuan  = yuan 4,530.42

3. Triangular arbitrage. On-Line Currency, Inc. is an online currency exchange company that will
immediately convert and credit your bank account based on its published rates. Being the
smart finance major that you are, you notice that one of the rates published below is incorrect,
and you want to take advantage of it. Let’s say that you have $20,000 of next semester’s college
funds sitting in your checking account and decide to take advantage of the error by doing a
triangular arbitrage (we do not advise doing this in reality!). Explain how you would go about
doing the arbitrage by first identifying the mismatched currency pair:

$ for £ £ for € € for $ £ for $ € for £ $ for €

0.5510 1.5235 1.3046 1.8148820 0.95683 0.7665
3

Answer: Direct Indirect Actual Indirect

£0.5510 $1.81488203 $1.81488203
=
$1.00 £1.00 £1.00

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 Chapter 18 International Financial Management  31

€1.5235 £0.65638333 £0.95683

= = Mismatch
£1.00 €1.00 €1.00
$1.3046 €0.7665 €0.7665
=
€1.00 $1.00 $1.00

©2010 Pearson Education, Inc. Publishing as Prentice Hall

32  Brooks • Financial Management: Core Concepts

Arbitrage strategy: Need to use the mismatched euros to British pounds.

1. Convert $ to €: $20,000 × 0.7665 = €15,330
2. Convert € to £: €15,330 × 0.95683 = £14,668.20390
3. Convert £ to $: £14,668.20 × 1.81488203= $26,621.06
Profit: $6,621.06

4. Forward rates. The Wall Street Journal lists forward rates for euros. Say that the current
listings are:
one-month forward rate (indirect) 0.7025
three-month forward rate (indirect) 0.7145
six-month forward rate (indirect) 0.7245
First, is the anticipated inflation rate higher or lower in Europe compared with that in the
United States? Second, if the current indirect rate is 0.6994, what do the six-month rate and
the current rate imply about the relative difference in the anticipated annual inflation rates?
Finally, using the current indirect rate and the six-month forward rate, determine the annual
anticipated inflation rates for Europe if the U.S. inflation rate is anticipated to be 3.15%.

Answer: Forward indirect rates:

One-month €0.7025/$1.00
Three-month €0.7145/$1.00
Six-month €0.7245/$1.00
A depreciating € signifies higher inflation in the next six months for Europe versus the
United States.
Inflation: 0.7245 = 0.6994 × [(1 + infEUROPE)/(1 + infU.S.)]0.5
[(1 + infEUROPE)/(1 + infU.S.)] = (0.7245/.6994)2
[(1 + infEUROPE)/(1 + infU.S.)] = 1.07306375
(1 + infEUROPE) = (1 + infU.S.) × 1.07306375
Since inflation in the U.S. is 3.15%
(1 + infEUROPE) = (1.0315) × 1.07306375  1.10686526
InfEUROPE = 10.69%

5. Domestic NPV approach. Kalamazoo Marine wants to expand its operations to New Zealand.
The current indirect exchange rate is 1.75 for U.S. and New Zealand dollars. The anticipated
inflation rate is 3.8% in the United States, but only 1.75% in New Zealand. The discount rate
in the United States for the expansion project is 16%. If the following after-tax cash flows
have been forecasted for the expansion project in NZ$, should Kalamazoo Marine expand to
New Zealand?
Investment: NZ$60,000,000
Year 1 cash flow – NZ$ 7,000,000
Year 2 cash flow – NZ$10,000,000
Year 3 cash flow – NZ$25,000,000

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 Chapter 18 International Financial Management  33

Year 4 cash flow – NZ$19,000,000

Year 5 cash flow – NZ$17,000,000
Year 6 cash flow – NZ$ 5,000,000

©2010 Pearson Education, Inc. Publishing as Prentice Hall

34  Brooks • Financial Management: Core Concepts

Answer: Anticipated forwards:

Year 1: (NZ$1.75/$1.00) × (1.0175/1.038) = NZ$1.7154/$1.00
Year 2: (NZ$1.75/$1.00) × (1.0175/1.038)2 = NZ$1.6816/$1.00
Year 3: (NZ$1.75/$1.00) × (1.0175/1.038)3 = NZ$1.6483/$1.00
Year 4: (NZ$1.75/$1.00) × (1.0175/1.038) 4 = NZ$1.6158/$1.00
Year 5: (NZ$1.75/$1.00) × (1.0175/1.038)5 = NZ$1.5839/$1.00
Year 6: (NZ$1.75/$1.00) × (1.0175/1.038)6 = NZ$1.5526/$1.00

Cash Flows:
NZ$ −60,000,000/1.75
NZ$7,000,000/1.7154
NZ$10,000,000/1.6816
NZ$25,000,000/1.6483
NZ$19,000,000/1.6158
NZ$17,000,000/1.5839
NZ$5,000,000/1.5526
$ Value
= $ −34,285,714.29
= $4,080,680.89/(1.16)
= $5,946,717.41/(1.16)2
= $15,167,141.90/(1.16)3
= $11,758,881.05/(1.16)
= $10,733,000.82/(1.16)5
= $3,220,404.48/ (1.16)6
Present Value
$ −34,285,714.29
$ 3,517,828.35
$ 4,419,379.77
$ 9,716,945.85
4 $ 6,494,325.32
$ 5,110,121.39
$ 1,321,790.08

NPV = ∑(PV column)  −$3,705,323.53. Do not expand…Negative NPV!

©2010 Pearson Education, Inc. Publishing as Prentice Hall