AFM_Study_Text_2024-25_ISDC..-5

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Chapter 3

Note:
F0 = forward rate
S0 = spot rate
S1 = expected future spot rate
ib = interest rate for base currency
ic = interest rate for counter currency
hb = inflation rate for base currency
hc = inflation rate for counter currency

Illustration of parity calculations

The current exchange rate is given as ($... to £1) 1.7025 – 1.7075.


Expected inflation rates are:
Year USA UK
1 5% 2%
2 3% 4%
3 4% 4%

Use the relationships above to work out the expected spot rate for
the next three years.

KAPLAN PUBLISHING 93
International operations and international investment appraisal

Solution
Using the PPPT formula:
(1 + hc )
S1 = S0 ×
(1 + hb )
(1 + USA inflation)
S1 = S0 ×
(1 + UK inflation)
and the midpoint of the quoted spread as the exchange rate today:
1.7075 + 1.7025
൬ ൰ = 1.7050
2
The calculations for the next three years are:
1.05
Year 1 1.7050 × ቀ ቁ = 1.7551
1.02
1.03
Year 2 1.7551 × ቀ ቁ = 1.7382
1.04
1.04
Year 3 1.7382 × ቀ ቁ = 1.7382
1.04

Note that the exchange rate at the end of one year becomes the basis
of the next year’s calculation.

Test your understanding 1

The spot exchange rate is €1.5325 to £1.


Expected inflation rates are:
Year Europe UK
1 3% 1%
2 1% 4%
3 2% 3%

Required:
Use the relationships above to work out the expected spot rate for
the next three years.

94 KAPLAN PUBLISHING
Chapter 3

Cross rate calculation

Cross rates

You may not be given the exchange rate you need for a particular
currency, but instead be given the relationship it has with a different
currency. You will then need to calculate a cross rate.
For example, if you have a rate in $/£ and a rate in €/£, you can derive
a cross rate for $/€ by dividing the $/£ rate by the €/£ rate.
Cross rates example

A UK company has a Greek subsidiary which is to purchase materials


costing $100,000. The NPV of the overseas cash flows is being
calculated in euros, but you have not been provided with the euro/dollar
exchange rate. Instead you have the following information:
$/£1 1.90
€/£1 1.45

Required:
Calculate the value of the purchase in euros.
Solution
The solution could be calculated in two stages:
1 Convert the purchase into £:
$100,000/1.90 = £52,632
2 Convert the £ value into euros
£52,632 × 1.45 = €76,316
However an easier alternative, particularly if there are a number of
transactions to convert, is to calculate a cross rate:
The $/€ rate will be 1.90/1.45 = 1.3103
The value of the transaction is therefore:
$100,000/1.3103 = €76,318

Changing inflation rates

When finding exchange rates it might first be necessary to calculate the inflation
rates expected in a foreign country.

KAPLAN PUBLISHING 95
International operations and international investment appraisal

Illustration 2
Inflation is currently 80% in Brazil, although the government hopes to
reduce it each year by 25% of the previous year's rate.
What will the inflation rate be in Brazil over the next four years?
Solution
Year 1 80% × 0.75 = 60%
Year 2 60% × 0.75 = 45%
Year 3 45% × 0.75 = 34%
Year 4 34% × 0.75 = 26%
OR 80% × (0.75)4 = 25.3% (more accurate)
You should also comment in your answer that it is unlikely the
government will achieve this reduction each year.

Test your understanding 2


The current rate of inflation in Costovia is 65%. Government action is
helping to reduce this rate each year by 10% of the previous rate. The
Costovian peso/ US dollar exchange rate is currently 144 pesos to 1
US dollar, and the inflation rate in the US over the next three years is
expected to be 4%, 3.5% and 3% respectively.

Required:
Calculate the exchange rate for the Costovian peso against the US
dollar for the next three years.

5 The impact of taxation, intercompany cash flows and remittance


restrictions
Taxation

The level of taxation on a project’s profits will depend on the relationship


between the tax rates in the home and foreign country.
There are three possible tax scenarios for an exam question.
The home country may have a tax rate that is:
 lower than
 the same as
 higher than the foreign country.
The question will always assume a double-tax treaty => project always taxed at
the higher rate.

96 KAPLAN PUBLISHING

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