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Dear Tutor.
I need your help again on this.
I have just solved 4 International Investment Appraisal Questions and I am confused about the treatment of determining the forward rates using the parity formula, (Only because different solutions have been provided for the same item).
We are UK company and we want to invest in Either USA or Japan . We need either 10 million dollars or 10 million Yen.
We can borrow the funds for the investment
Inflation Rates for the whole period ( year 1 to 5)
USA 10%
UK 6%
Japan 8%Spot Rates are
Yen/£1 US$/£1
2.500 – 2.600 1.500 – 1.600Since we will be needing either 10 million dollars or 10 million Yen, mu understanding is that we will convert at the lower rates (i.e 2.500 for Yen or 1.500 for Dollars)
So Year 1 exchange rate will be for (USA) : 10% divide 6% multiply by 1.500 and for (JAPAN) It will be 8% divide by 6% multiply by 2.500. This method was correct for 2 of the questions i solved.
Then the last 2 questions, the same scenario, they used Mid Point Figures for Spot, instead of the lower rate, why the inconsistency?, it just makes students confused.
I have checked 2 other text books and they used either the lower rate or the Mid Point (A house divided against itself?)
PLEASE for the purpose of the exam next week, what should be the correct method to use?
Many Thanks
Just in addition to the above,
Another question used Mid Point Spots and said that was correct because the Cashflows were 6 monthly (i.e 6 months, 12 months, 18 months etc)
This made it more confusing, then why use Mid Point Spot rates for those that were Yearly Cashflows?
Without seeing the actual questions, it is difficult for me to be specific.
However:
1) for the initial investment you are correct to convert at those rates
2) I am guessing, but in the later years maybe there is a net cash receipt instead of a payment?
3) Most importantly, at P4 the markers do not mark to one precise final answer, they give the marks if it is clear that you know what you are trying to do. There are so many assumptions necessary (in real life as well) that there is not just one precise answer. Provided that you prove you know how to set up the cash flows, prove you know how to convert, prove you know how to use the parity formula to forecast exchange rates, prove you know how to discount etc..then you will get most, if not all, of the marks.
4) To be fair to the text books, the examiner is not always consistent either!
5) Finally (although I guess not in the questions you are referring to) I can remember at least one real exam question where you were specifically told to use the mid-market rate. Obviously in that case there is no argument.Subject to the above, I personally would use the mid-market rates for the forecasts, and I am confident that I would pass the question well (because I would set out my workings well and so it would be clear what I was trying to do). I might not get 100% on the question, but I am confident I would pass well enough and that is all the matters 🙂
You made my day! I am more confident this time sitting this exam.
Thanks a lot
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