Chapter 20
Short-Term Financing
1. MNCs may be able to lock in a lower cost from financing in a low interest rate foreign currency if
they:
A) have future cash inflows in that foreign currency.
B) have future cash outflows in that foreign currency.
C) have offsetting future cash inflows and outflows in that foreign currency.
D) have no other cash flows in that foreign currency.
ANSWER: A
2. Assume that the Swiss franc has an annual interest rate of 8% and is expected to depreciate by 6%
against the dollar. From a U.S. perspective, the effective financing rate from borrowing francs is:
A) 8%.
B) 14.48%.
C) 2%.
D) 1.52%.
ANSWER: D
SOLUTION: (1 + 8%)[1 + (-6%)] - 1 = 1.52%.
3. Assume that the U.S. interest rate is 11% while the interest rate on euro is 7%. If euros are
borrowed by a U.S. firm, they would have to _________ against the dollar by __________ in
order to have the same effective financing rate from borrowing dollars.
A) depreciate; about 3.74%
B) appreciate; about 3.74%
C) appreciate; about 4.53%
D) depreciate; about 4.53%
ANSWER: B
SOLUTION: (1.11/1.07) – 1 = 3.74%. Euros have to appreciate since borrowing in euros is
currently cheaper.
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4. When a U.S. firm borrows a foreign currency and has no offsetting position in this currency, it
will incur an effective financing rate that is always above the __________ if the currency
__________.
A) foreign currency’s interest rate; appreciates
B) foreign currency’s interest rate; depreciates
C) domestic interest rate; depreciates
D) domestic interest rate; appreciates
ANSWER: A
5. A firm without any exposure to foreign exchange rates would likely increase this exposure the
most by:
A) borrowing domestically.
B) borrowing a portfolio of foreign currencies that are not highly correlated.
C) borrowing a portfolio of foreign currencies that are highly correlated.
D) borrowing two foreign currencies that are negatively correlated.
ANSWER: C
6. If a firm repeatedly borrows a foreign currency portfolio, the variability of the portfolio’s effective
financing rate will be highest if the correlations between currencies in the portfolio are
__________ and the individual variability of each currency is _________.
A) high; low
B) high; high
C) low; low
D) low; high
ANSWER: B
7. Assume the annual British interest rate is above the annual U.S. interest rate. Also assume the
pound’s forward rate of $1.75 equals the pound’s spot rate. Given this information, interest rate
parity __________ exist, and the U.S. firm __________ lock in a lower financing cost by
borrowing pounds for one year.
A) does; could
B) does; could not
C) does not; could not
D) does not; could
ANSWER: C
8. A risk-averse firm would prefer to borrow __________ when the expected financing costs are
similar in a foreign country as in the local country.
A) locally
B) in the foreign country
C) either A or B
D) part of the funds locally, and part from the foreign country
ANSWER: A
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9. A firm forecasts the euro’s value as follows for the next year:
Possible
Percentage Change Probability
-2% 10%
3% 50%
6% 40%
The annual interest rate on euro is 7%. The expected value of the effective financing rate from a
U.S. firm’s perspective is about:
A) 8.436%.
B) 10.959%.
C) 11.112%.
D) 11.541%.
ANSWER: B
SOLUTION:
Computation of
Effective Financing Rate Probability Expected Value
(1.07)(.98) – 1 = 4.86% 10% .486%
(1.07)(1.03) – 1 =10.21% 50% 5.105%
(1.07)(1.06) –1 =13.42% 40% 5.368%
10.959%
10. The effective financing rate:
A) adjusts the nominal interest rate for inflation over the period of concern.
B) adjusts the nominal interest rate for the change in the spot exchange rate over the period of
concern.
C) adjusts the nominal rate for a change in foreign interest rates over the period of concern.
D) adjusts the nominal rate for the forward discount (or premium) over the period of concern.
ANSWER: B
11. If interest rate parity exists and transactions costs are zero, foreign financing with a simultaneous
forward purchase of the currency borrowed will result in an effective financing rate that is:
A) less than the domestic interest rate.
B) greater than the domestic interest rate.
C) equal to the domestic interest rate.
D) greater than the domestic interest rate if the forward rate exhibits a premium and less than the
domestic interest rate if the forward rate exhibits a discount.
ANSWER: C
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12. If interest rate parity exists, transactions costs are zero, and the forward rate is an accurate
predictor of the future spot rate, then the effective financing rate on a foreign currency:
A) would be equal to the U.S. interest rate.
B) would be less than the U.S. interest rate.
C) would be more than the U.S. financing rate.
D) would be less than the U.S. interest rate if the forward rate exhibited a discount and more than
the U.S. interest rate of the forward rate exhibited a premium.
ANSWER: A
13. Assume that interest rate parity exists, and there are zero transactions costs. If the forward rate
consistently underestimates the future spot rate, then:
A) on average, the foreign effective financing rate is greater than the domestic interest rate.
B) on average, the foreign effective financing rate is less than the domestic rate.
C) the foreign effective financing rate exceeds the U.S. interest rate when its forward rate
exhibits a discount and is less than the U.S. interest rate when its forward rate exhibits a
premium.
D) the foreign effective financing rate is less than the U.S. interest rate when its forward rate
exhibits a discount and exceeds the U.S. interest rate when its forward rate exhibits a
discount.
ANSWER: A
14. Assume the U.S. one-year interest rate is 8%, and the British one-year interest rate is 6%. The
one-year forward rate of the pound is $1.97. The spot rate of the pound at the beginning of the
year is $1.95. By the end of the year, the pound’s spot rate is $2.05. Based on the information,
what is the effective financing rate for a U.S. firm that takes out a one -year, uncovered British
loan?
A) about 12.4%.
B) about 7.1%.
C) about 13.5%.
D) about 10.3%.
E) about 11.3%.
ANSWER: E
SOLUTION:
% change in pound = $2.05 - $1.95 = about 5.1%
$1.95
Effective financing rate = (1 + 6%)(1 + 5.1%) - 1 = 11.4%
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15. The variance in financing costs over time is _______ for foreign financing than domestic
financing. The variance when financing with foreign currencies is lower when those currencies
exhibit _______ correlations, assuming the firm has no other business in those currencies.
A) lower; low
B) lower; high
C) higher; high
D) higher; low
ANSWER: D
16. Euronotes are underwritten by:
A) European central banks.
B) commercial banks.
C) the International Monetary Fund.
D) the Federal Reserve System.
ANSWER: B
17. Assume the U.S. interest rate is 7.5%, the New Zealand interest rate is 6.5%, the spot rate of the
NZ$ is $.52, and the one-year forward rate of the NZ$ is $.50. At the end of the year, the spot
rate is $.48. Based on this information, what is the effective financing rate for a U.S. firm that
takes out a one-year, uncovered NZ$ loan?
A) about -1.7%.
B) about 0.0%.
C) about 14.7%.
D) about 15.4%.
E) about 8.3%.
ANSWER: A
SOLUTION:
% change in NZ$ = $.48 - $.52 = about -7.7%
$.52
Effective financing rate = (1 + 6.5%)[1 + (-7.7%)] –1 = about -1.7%
18. A negative effective financing rate for a U.S. firm implies that the firm:
A) will incur a loss on the project financed with the funds.
B) paid more interest on the funds than what it would have paid if it had borrowed dollars.
C) will be unable to repay the loan.
D) none of the above
ANSWER: D
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19. A U.S. firm plans to borrow Swiss francs today for a one-year period. The Swiss interest rate is
9%. It uses today’s spot rate as a forecast for the franc’s spot rate in one year. The U.S. one-year
interest rate is 10%. The expected effective financing rate on Swiss francs is:
A) equal to the U.S. interest rate.
B) less than the U.S. interest rate, but more than the Swiss interest rate.
C) equal to the Swiss interest rate.
D) less than the Swiss interest rate.
E) more than the U.S. interest rate.
ANSWER: C
20. Assume that interest rates of most industrialized countries are similar to the U.S. interest rate. In
the last few months, the currencies of all industrialized countries weakened substantially against
the U.S. dollar. If non-U.S. firms based in these countries financed with U.S. dollars during this
period (even when they had no receivables in dollars), their effective financing rate would have
been:
A) negative.
B) zero.
C) positive, but lower than the interest rate of their respective countries.
D) higher than the interest rate of their respective countries.
ANSWER: D
21. ___________ typically have maturities of less than one year.
A) Eurobonds
B) Euro-commercial paper
C) Euronotes
D) ADRs
ANSWER: B
22. MNCs can use short-term foreign financing to reduce their exposure to exchange rate fluctuations.
For example, if an American-based MNC has ____________ in Algerian dinars, it could borrow
___________, resulting in an offsetting effect.
A) payables; dinars
B) receivables; dinars
C) payables; dollars
D) receivables; dollars
ANSWER: B
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23. Assume Jelly Corporation, a U.S.-based MNC, obtains a one-year loan of 1,500,000 Malaysian
ringgit (MYR) at a nominal interest rate of 7%. At the time the loan is extended, the spot rate of
the ringgit is $.25. If the spot rate of the ringgit in one year is $.28, the dollar amount initially
obtained from the loan is $__________, and $___________ are needed to repay the loan.
A) 375,000; 449,400
B) 449,400; 375,000
C) 6,000,000; 5,357,143
D) 5,357,143; 6,000,000
ANSWER: A
SOLUTION: MYR1,500,000 x $.25 = $375,000
(MYR1,500,000 x 1.07) x $.28 = $449,400
24. Morton Company obtains a one-year loan of 2,000,000 Sudanese dinar (SDD) at an interest rate
of 6%. At the time the loan is extended, the spot rate of the dinar is $.005. If the spot rate of the
dinar at maturity of the loan is $.0035, what is the effective financing rate of borrowing dinar?
A) 37.8%.
B) 51.43%.
C) -25.8%.
D) -6%.
E) none of the above
ANSWER: C
SOLUTION: Depreciation of dinar: $.0035/$.005 – 1 = -30%
Effective financing rate: (1.06) x [1 + (-30%)] – 1 = -25.80%.
25. ____________ are free of default risk.
A) Euronotes
B) Eurobonds
C) Euro-commercial paper
D) None of the above
ANSWER: D
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26. Assume a U.S.-based MNC is borrowing Romanian leu (ROL) at an interest rate of 8% for one
year. Also assume that the spot rate of the leu is $.00012 and the one-year forward rate of the leu
is $.00010. The expected spot rate of the leu one-year from now is $.00011. What is the effective
financing rate for the MNC assuming it borrows leu on a covered basis?
A) 10%.
B) -10%.
C) -1%.
D) 1%.
E) none of the above
ANSWER: B
SOLUTION: Forward disount: .00010/.00012 – 1 = -16.67%
Effective financing rate: (1.08) x [1 + (-16.67%)] –1 = -10.00%.
27. Assume a U.S.-based MNC is borrowing Romanian leu (ROL) at an interest rate of 8% for one
year. Also assume that the spot rate of the leu is $.00012 and the one-year forward rate of the leu
is $.00010. The expected spot rate of the leu one-year from now is $.00011. What is the effective
financing rate for the MNC assuming it borrows leu on an uncovered basis?
A) about 10%.
B) about -10%.
C) about -1%.
D) about –2%.
E) none of the above
ANSWER: D
SOLUTION: Depreciation of leu: .00010/.00011 – 1 = -9.09%
Effective financing rate: (1.08) x [1 + (-9.09%)] – 1 = -1.82%.
28. Assume that interest rate parity holds between the U.S. and Cyprus. The U.S. one-year interest
rate is 7% and the Cyprus one-year interest rate is 6%. What is the approximate effective
financing rate of a one-year loan denominated in Cyprus pounds assuming that the MNC covered
its exposure by purchasing pounds one year forward?
A) 6%.
B) 7%.
C) 1%.
D) cannot answer without more information
ANSWER: B
SOLUTION: When interest rate parity holds, the foreign financing cost (when covering with a
forward hedge) is approximately equal to the domestic financing cost.
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29. Maston Corporation has forecasted the value of the Russian ruble as follows for the next year:
Percentage Change Probability of Occurrence
-5% 20%
-3% 50%
1% 30%
If the Russian interest rate is 30%, the expected cost of financing a one-year loan in rubles is:
A) 27.14%.
B) 32.86%.
C) 26.10%.
D) none of the above
ANSWER: A
SOLUTION:
Computation of
Effective Financing Rate Probability Expected Value
(1.30)(.95) - 1 =23.50% 20% 4.70%
(1.30)(.97) - 1 = 26.10% 50% 13.05%
(1.30)(1.01) - 1 = 31.30% 30% 9.39%
27.14%
The following information refers to questions 30 and 31.
To benefit from the low correlation between the Canadian dollar (C$) and the Japanese yen (¥),
Martha Corporation decides to borrow 50% of funds needed in Canadian dollars and the remainder in
yen. The domestic financing rate for a one-year loan is 7%. The Canadian one-year interest rate is 6%
and the Japanese one-year interest rate is 10%. Martha has determined the following possible
percentage changes in the two individual currencies as follows:
Currency Percentage Change Probability
Canadian dollar 2.0% 30%
Canadian dollar 4.0% 70%
Japanese yen -3.0% 60%
Japanese yen 1.0% 40%
30. What is the expected effective financing rate of the portfolio Martha is contemplating (assume the
two currencies move independently from one another)?
A) 9.03%.
B) 7.00%.
C) 10.00%.
D) 7.59%.
E) none of the above
ANSWER: A
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SOLUTION:
Step 1. Determine effective financing rate for each currency under each possible scenario.
Percentage
Currency Change Probability Effective Rate
Canadian dollar 2.0% 30% (1.06)(1.02) - 1 = 8.12%
Canadian dollar 4.0% 70% (1.06)(1.04) - 1 = 10.24%
Japanese yen -3.0% 60% (1.10)( .97) - 1 = 6.70%
Japanese yen 1.0% 40% (1.10)(1.01) - 1 = 11.10%
Step 2. Determine joint probabilities and effective financing rate of portfolio for each scenario.
Canadian Japanese Joint Portfolio
Dollar Yen Probability Effective Rate
8.12% 6.70% (.3)(.6) = .18 (.5)(8.12%) + (.5)(6.70%) = 7.41%
8.12% 11.10% (.3)(.4) = .12 (.5)(8.12%) + (.5)(11.10%) = 9.61%
10.24% 6.70% (.7)(.6) = .42 (.5)(10.24%) + (.5)(6.70%) = 8.47%
10.24% 11.10% (.7)(.4) = .28 (.5)(10.24%) + (.5)(11.10%) = 10.67%
1.00
Step 3. Determine effective financing rate of portfolio.
(.18)(7.41%) + (.12)(9.61%) + (.42)(8.47%) + (.28)(10.67%) = 9.03%
31. What is the probability that the financing rate of the two-currency portfolio is less than the
domestic financing rate?
A) 12%.
B) 30%.
C) 100%.
D) 0%.
E) none of the above
ANSWER: D
SOLUTION: Since the domestic financing rate is 7%, the table above shows that there is no
possibility that foreign financing with the portfolio of currencies is cheaper than domestic
financing.
Chapter 20: Short-Term Financing 593
The following information refers to questions 32 and 33.
Cameron Corporation would like to simultaneously borrow Japanese yen (¥) and Sudanese dinar
(SDD) for a six-month period. Cameron would like to determine the expected financing rate and the
variance of a portfolio consisting of 30% yen and 70% dinar. Cameron has gathered the following
information:
Mean effective financing rate of Japanese yen for six months 4%
Mean effective financing rate of Sudanese dinar for six months 1%
Standard deviation of Japanese yen’s effective financing rate .10
Standard deviation of Sudanese dinar’s effective financing rate .20
Correlation coefficient of effective financing rates of these
two currencies .23
32. What is the expected financing rate of the portfolio contemplated by Cameron Corporation?
A) 3.10%.
B) 1.90%.
C) 17.00%.
D) 13.00%.
E) none of the above
ANSWER: B
SOLUTION: (.3)(4%) + (.7)(1%) = 1.90%.
33. What is the expected standard deviation of the portfolio contemplated by Cameron?
A) 2.24%.
B) 14.98%.
C) 2.89%.
D) 17.00%.
E) none of the above
ANSWER: B
SOLUTION: (.3) 2 (.1) 2 (.7) 2 (.2) 2 2(.3)(.7)(.1)(.2)(.23) 14.98%
34. If interest rate parity exists, financing with a foreign currency may still be feasible, but it would
have to be conducted on an uncovered basis (i.e., without use of a forward hedge).
A) true.
B) false.
ANSWER: A
35. Firms that believe the forward rate is an unbiased predictor of the future spot rate will prefer
borrowing the foreign currency.
A) true.
B) false.
ANSWER: B
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36. Euronotes are unsecured debt securities whose interest rate is based on the London Interbank
Offer Rate (LIBOR) with typical maturities of one, three, and six months.
A) true.
B) false.
ANSWER: A
37. One reason an MNC may consider foreign financing is that the proceeds could be used to offset a
foreign net payables position.
A) true.
B) false.
ANSWER: B
38. A negative effective financing rate implies that the U.S. firm actually paid fewer dollars in total
loan repayment than the number of dollars borrowed.
A) true.
B) false.
ANSWER: A
39. If all currencies in a financing portfolio are not correlated with each other, financing with such a
portfolio would not be very different from financing with a single foreign currency.
A) true.
B) false.
ANSWER: B
40. The interest rate of euronotes is based on the T-bill rate.
A) true.
B) false.
ANSWER: B
41. Countries with a _______ rate of inflation tend to have a ______ interest rate.
A) high; low
B) low; high
C) high; high
D) A and B are correct
ANSWER: C
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42. Kushter Inc. would like to finance in euros. European interest rates are currently 4%, and the euro
is expected to depreciate by 2% over the next year. What is Kushter’s effective financing rate next
year?
A) 1.92%
B) 2.00%
C) 6.08%
D) none of the above
ANSWER: A
SOLUTION: (1.04)(.98) – 1 = 1.92%
43. A negative effective financing rate indicates that an MNC:
A) paid only a small amount in interested over and above the amount borrowed.
B) has been negatively affected by a large appreciation of the foreign currency.
C) actually paid fewer dollars to repay the loan than it borrowed.
D) would have been better off borrowing in the U.S.
ANSWER: C
44. If interest rate parity exists, the attempt to finance with a foreign currency while covering the
position to avoid exchang rate risk will result in an effective financing rate that is _________ the
domestic interest rate.
A) lower than
B) greater than
C) similar to
D) none of the above
ANSWER: C
45. If interest rate parity exists, and the forward rate is an accurate estimator of the future spot rate,
the foreign financing rate will be ____________ the home financing rate.
A) lower than
B) greater than
C) similar to
D) none of the above
ANSWER: C
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46. Assume the U.S. financing rate is 10 percent and that the financing rate in Germany is 9 percent.
An MNC would be indifferent between financing in dollars and financing in euros next year if the
euro is expected to ___________.
A) appreciate by 0.92%.
B) depreciate by 0.92%.
C) appreciate by 1.00%.
D) depreciate by 1.00%.
ANSWER: A
SOLUTION: 1.10/1.09 – 1 = 0.92%
47. Foreign financing costs in a single foreign currency ____________ financing costs in dollars, and
the variance of foreign financing costs over time is ___________ than the variance of financing in
dollars.
A) are higher than; higher than
B) can be lower or higher than; higher than
C) can be lower or higher than; lower than
D) are lower than; higher than
ANSWER: B
48. The degree of volatility of financing with a currency portfolio depends on only the standard
deviations of effective financing rates of the individual currencies within the portfolio.
A) true.
B) false.
ANSWER: B
