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Describe the risk exposure(s) in the following financial transactions. Identify which transactions are influenced by interest rates or interest income. (CAUTION: Some can be influenced by both!)

Risk Types: Interest rate risk, Credit risk, Technology risk, Foreign exchange rate risk, Country or sovereign risk

Financial Transactions

Risk Type

Describe and justify risk type

Interest Rate or Interest Income?

A bank finances a $10 million, six-year fixed-rate commercial loan by selling one-year certificate of deposit.

An insurance company invests its policy premiums in a long-term municipal bond portfolio.

A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a British entrepreneur.

A Japanese bank acquires an Austrian bank to facilitate clearing operations.

A bond dealer uses his own equity to buy Mexican debt on the less developed country (LDC) bond market.

A securities firm sells a package of mortgage loans as mortgage-backed securities.

Describe the features of the method you would choose to measure the interest risks identified.

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Jean Keeling
Jean KeelingLv2
28 Sep 2019

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Related questions

Describe the risk exposure(s) in the following financial transactions. Identify which transactions are influenced by interest rates or interest income. (CAUTION: Some can be influenced by both!)

Risk Types: Interest rate risk, Credit risk, Technology risk, Foreign exchange rate risk, Country or sovereign risk

Financial Transactions

Risk Type

Describe and justify risk type

Interest Rate or Interest Income?

A bank finances a $10 million, six-year fixed-rate commercial loan by selling one-year certificate of deposit.

An insurance company invests its policy premiums in a long-term municipal bond portfolio.

A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a British entrepreneur.

A Japanese bank acquires an Austrian bank to facilitate clearing operations.

A bond dealer uses his own equity to buy Mexican debt on the less developed country (LDC) bond market.

A securities firm sells a package of mortgage loans as mortgage-backed securities.

Describe the features of the method you would choose to measure the interest risks identified.

Describe the risk exposure(s) in the following financial transactions. Identify which transactions are influenced by interest rates or interest income. (CAUTION: Some can be influenced by both!)

Risk Types: Interest rate risk, Credit risk, Technology risk, Foreign exchange rate risk, Country or sovereign risk

Financial Transactions

Risk Type

Describe and justify risk type

Interest Rate or Interest Income?

A bank finances a $10 million, six-year fixed-rate commercial loan by selling one-year certificate of deposit.

An insurance company invests its policy premiums in a long-term municipal bond portfolio.

A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a British entrepreneur.

A Japanese bank acquires an Austrian bank to facilitate clearing operations.

A bond dealer uses his own equity to buy Mexican debt on the less developed country (LDC) bond market.

A securities firm sells a package of mortgage loans as mortgage-backed securities.

Describe the features of the method you would choose to measure the interest risks identified.

I. MULTIPLE CHOICE / SHORT ANSWER QUESTIONS

1. You work for a bank that is considering a direct investment into Thailand to serve the Thai market. Your firm is listed on a US exchange, with an estimated stock beta of 0.75. ABC is a Thai bank with a similar capital structure to your firm’s, and is also listed on a US exchange, with an estimated stock beta of 2.0. The US risk-free rate is 2%, and the expected market return is 6%.

Using the CAPM model, calculate the most appropriate cost of equity capital for your firm to use in analyzing its direct investment opportunity.

2. You are analyzing Thailand, and you observe the following bond yields: (i) 5% yield on an 10-yearinternational bond issue denominated in USD; (ii) 2.5% yield on a US Treasury bond; and (iii) 8% yield on a domestic 10-year Thai government bond denominated in Thai baht.

a. The sovereign spread is 550 basis points (bp), and the country risk premium is also 550bp.

b. The sovereign spread is 250 basis points (bp), and the country risk premium is also 550bp.

c. The sovereign spread is 250 basis points (bp), and the country risk premium cannot be calculated from the information given.

d. The sovereign spread is 550 basis points (bp), and the country risk premium cannot be calculated fromthe information given.

e. None of the above.

3. Please briefly define the term “political risk”, and give one example of political risk.

4. Please briefly define the term “country risk”, and briefly describe two methods of incorporating country risk into an international capital budgeting analysis.

II. LONGER PROBLEMS

Note. Please show your work and clearly label your answers.

Question 8 will require you to use Excel. It might be easiest to provide brief answers in the space provided below, and attach a copy of the Excel spreadsheet with the more detailed calculations.

Problem 5. Over the next year, the expected inflation rate in Australia is 2%, and the real interest rate inAustralia is also 2%. You expect the Australian dollar to appreciate by 3% relative to the Japanese yen.

a. If relative purchasing power parity holds, what is the expected inflation rate in Japan?

b. If the domestic Fisher effect holds, what is the nominal interest rate in Australia? If the internationalFisher effect holds, what is the nominal interest rate in Japan?

c. You redo your forecasts. You still expect inflation in Australia to be 2% and the real interest rate to be 2%.However, you expect inflation in Japan to be 10%.

i. Assuming that the international Fisher effect holds, what is the nominal interest rate in Japan?

ii. Assuming that relative PPP holds, what is the expected percent appreciation or depreciation of the Australian dollar against the Japanese yen over the next year? Is this consistent with the prediction of uncovered interest rate parity?

Problem 6. Your firm is thinking of buying an office building in Bangkok, and selling it in one year.You plan to finance this using a two-year loan from a Chinese bank, in Chinese yuan. The interest rate on the loan is 7% per year. You believe that it is appropriate to use the interest rate on this loan as the discount rate for the project. There are no taxes involved in this transaction.

You assemble some cash flow and exchange rate projections as follows:

Year 0 Year 2
Purchase / sale of office building (THB) 30 million 40 million

Expected Thai baht exchange rate 30 THB per EUR 33 THB per EUR

Expected Chinese yuan exchange rate 4 CNY per EUR 3.8 CNY per EUR

Your boss asks you to calculate the net present value (NPV) of this transaction. In order to present the analysis to the head office in Paris, the NPV needs to be calculated in EUR terms.

a. Please calculate the net present value of the transaction above in EUR terms. Should you proceed with this project?

Problem 7. You get an internship at a French firm called Totally Inefficient Corporation, or TIC. TIC is trying to determine its optimal capital structure. It can issue debt or equity in Thailand, denominated in Thai baht(THB). It can also issue debt or equity in London, denominated in pounds (GBP).

TIC is considering two options: (1) 30% equity and 70% debt; and (2) 70% debt and 30% equity. You don't expect the choice of the higher debt share to affect the costs of debt and equity listed below.

The firm’s marginal tax rate is zero. You believe the International Fisher Effect is the best way to compare rates of return in different currencies.You observe the following variables:

London (GBP)

Risk-free rate 2%

Credit spread for TIC’s bond 4 percentage points

Expected stock market return 4%

TIC’s market beta 1.75

UK expected annual inflation rate 1%

Thailand (THB)

Risk-free rate 7%

Credit spread for TIC’s bond 5 percentage points

Expected stock market return 9%

TIC’s market beta 1.0

Thai expected annual inflation rate 5%

a. Please compare the financing options available to TIC. Where should TIC issue debt? Where should TICissue equity? Which capital structure should TIC choose?

b. Suppose that a severe recession hits Thailand, the central bank cuts interest rates, and the Thai risk-free rate falls to 3%. Nothing else changes. Now, where should TIC issue debt? Where should TIC issue equity?Which capital structure should TIC choose?

Problem 8. Your company is considering a direct investment project to produce computers in Thailand, for sale in the US market. This will be partially financed by US dollar debt, and partially financed by issuing stock in Thailand.

Your boss instructs you to conduct an NPV analysis by estimating cash flows in USD terms, and discounting at an appropriate rate. He states that the stock issuance in Thailand should be used to determine the marginal cost of equity for the firm.

After some thought, you come up with the following assumptions:

a. The project will cost USD200mn in Year 0, and have a terminal value of USD50mn in Year 10.

b. The project will begin production in Year 1. It will produce 30,000 computers yearly in Years 1-10, at an initial price of USD2,000 per computer in Year 1. The price will increase at the US inflation rate of2% per year.

c. Costs are expected to be 30,000 Thai baht (THB) per computer in Year 1, and will increase at the Thai inflation rate of 7% per year.

d. The spot exchange rate in Year 1 is expected to be 30 THB per USD. The exchange rate will be determined by relative purchasing power parity after that.

e. The firm’s benchmark USD bond was issued at a yield of 6%. It currently trades at a yield of 7%.

f. The firm’s capital structure is 40% equity, 60% debt.

g. You believe that the CAPM is the correct way to estimate the cost of equity capital, using a local market index as a benchmark. The Thai risk-free rate is 8%, the expected return on the Thai market is12%, and the beta you expect on your stock is 1.5.

h. You believe that the International Fisher Effect is a useful method for comparing the cost of capital across countries.

5.1. What is the cost of equity capital in THB terms? What is the cost of equity capital in USD terms? What is the weighted average cost of capital for the firm?

5.2 Given the assumptions above, should the firm proceed with this project? What is the project’s NPV?

5.3 Suppose the expected Thai inflation rate increased to 12% per year, but all of the other assumptions remained unchanged. What is the project’s NPV? Should the firm proceed with this project or not?

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