Question 1: Letters of Credit. Ocean traders of North America is a firm based in Mobile, Alabama, that specializes in seafood exports and commonly uses letters of credit (L/Cs) to ensure payment. It recently experienced a problem, however. Ocean Traders has an irrevocable L/C issued by a Russian bank to ensure that it would receive payment upon shipment of 16,00 tons of fish to a Russian firm. This bank backed out of its obligation, however, stating that it was not authorized to guarantee commercial transactions.
a) Explain how an irrevocable L/C would normally facilitate the business transaction between the Russian importer and Ocean Traders of North America (the U.S. exporter).
b) Explain how the cancellation of the L/C could create a trade crisis between the U.S. and Russian firms.
c) Why do you think situations like this (cancellation of the L/C) are rare in industrialized countries?
d) Can you think of any alternative strategy that the U.S. exporter could have used to protect itself better when dealing with a Russian importer?
Question 2: Break-Even Financing. Akron Co. needs dollars. Assume that the local one-year loan rate is 15 percent, while a one-year lone rate on Euros is 7 percent. By how much must a Euro appreciate to cause the loan in Euros to be more costly than a U.S. dollar loan?
Question 3: Effective Yield. Fort Collins Inc., has $1 million in cash available for 30 days. It can earn 1 percent on a 30 day investment in the United States. Alternatively, if it converts the dollars to Mexican pesos, it can earn 1 ½ percent on a Mexican deposit. The spot rate 30 days from now is expected to be $.10. should Fort Collins invest its cash in the United States or in Mexico? Substantiate your answer.
Question 4: Investing in a Portfolio. Pittsburgh Co. plans to invest its excess cash in Mexican pesos for one year. The one-year Mexican interest rate is 19 percent. The probability of the peso’s percentage change in value during the next year is as shown below;
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Possible rate of change in the Mexican peso over the life of the investment
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Probability of occurrence
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-15%
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20%
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-4
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50
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0
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30
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What is the expected value of the effective yield based on this information? Given that the U.S. interest rate for one year is 7 percent, what is the probability that a one-year investment in pesos will generate a lower effective yield than could be generated if Pittsburgh Co. simply invested domestically?