BPP 65 - Lirio (Mar/June 16)

The question specifically explains that credit is given for corporation tax already paid, and so there is the extra 5% corporation tax (25% less 20%). The withholding tax is not corporation tax and so they do not get credit for this :-)

Thank you!

Hi Mr John, I also have a query regarding this question. I am using Kaplan, it is question 23. When calculating the expected future price 0.8650, they noted in the answer that it could be done using spot rate or forward rate. Can you demonstrate for us that way to calculate expected future price? Thank you!

0.8650 is the 'lock-in rate' and you can calculate it either by taking the current futures price and subtracting the unexpired basis (0.8656 - (1/4 x (1/1.1585 - 0.8656)) = 0.8650, or alternatively by taking the current spot rate and adding the expired basis: 1/1.1585 + (3/4 x (1/1.1585 - 0.8656)) = 0.8650 I explain the workings (and the logic) in my free lectures on foreign exchange risk management.

Thank you John! It helps me alot

One more thing Mr John, Why do they purchase the June call option to protect against a weakening EUR? In my opinion, they will receive EUR in the future-> they should sell EUR ( hence buy USD). They want to receive as much USD as possible-> USD strengthening (or EUR weakening) is favorable so I wonder why they purchase June call option to protect against a weakening EUR which is favorable to them? Please help me. Thank you!

If the EUR is weaker, then it will buy fewer USD.

For the option contract, the rate used to calculate the premium is $1.1618 which is on the right side(bank buy $1.1618 per Euro1 which means Co sell $1.1618 to bank to get Euro 1). Why is this so? The premium is in euro and to convert to $, should we not use $1.1585(bank sell $1.1585 per Euro1 which means Co buy $1.1585 to bank with Euro 1)?

Also, the answer for the option contract did not include the gain earned from exercising the call option (Difference between 1.1559 & 0.85 Spot rate vs Call option rate). Is it wrong to calculate the gain and include it in the cash inflow?

The premium is payable in Euros and therefore they need to buy Euros, which means they need to sell $'s. The rate for selling $'s is 1.1618 (if they sold at 1.1585 they would end up getting more Euros and this cannot be the case because it is the banks who gain from the spread, not the customer). And no, it would not be wrong to convert the transaction at whatever spot turns out to be and then calculate the gain if the option is exercised. The problem here though is that we do not know what the spot rate will be on the date the option is exercised - we cannot assume that it will be the same as the forward rate because it almost certainly will not be.

My tutor uses the assumption that the spot future rate = the forward rate

Well your tutor should not assume that (unless obviously the question tells you to which is unlikely), because forward rates are certainly not a prediction of future spot rates. As I explain in my free lectures, forward rate are determined (in both exams and in real-life) purely by money market interest rates, whereas future spot rates are affected by all sorts of economic factors. If you did assume that the spot rate was equal to the forward rate then (provided you stated your assumption) you would get most of the marks, but not all of them :-)

For Part a, the answer states: "according to PPP the ‘law of one price’ holds because any weakness in one currency will be compensated by the rate of inflation in the currency’s country (or group of countries in the case of the euro). If PPP holds, then companies may not be affected by exchange rate fluctuations, as lower currency value can be compensated by the ability to raise prices due to higher inflation levels. This depends on markets being efficient." How does the weakness in one currency be compensated by the rate of the inflation? The difference in inflation rate multiply the spot rate today in the PPP formula will derive the future spot rate which will be impacted by the difference in inflation rate of the 2 countries. If the base country has a higher inflation rate, the future spot rate will be lower than the spot rate today vice versa. However, the exchange rate will still fluctuate. I didnt quite understand how the company will not be affected. Also what does "prices" in the 2nd paragraph refer to?

If inflation in the base country is higher, then the currency in the other country will depreciate. So if prices of goods bought from the other country increase then because the currency in that country will have depreciated the two effects should (in theory) cancel out. I explain how PPP works (with examples) in my free lectures on forecasting future spot rates. Have you watched the lectures?