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Baton Rouge Inc., located in Germany is involved in the

production

of motor bikes and currently exports these products to India.

The company must import

certain raw materials needed in the manufacturing process

and has entered into fixed

contractual arrangements with some of its suppliers. Its main

suppliers are from India and

the Philippines and both the Indian rupee and the

Philippines peso are highly correlated.

The company has net inflows denominated in rupees and

net outflows in pesos and its

transaction exposure would be decreased if both

currencies were highly correlated.

Recently both currencies have experienced high

correlation and the company is hoping to

benefit from this new development.

Baton Rouge has decided to establish a subsidiary in India

and plans to finance this

expansion with a combination of 60% debt and 40% equity.

The average yield on the

company's bonds is 8%, Treasury security rates are 2% and

the company's stock has a beta of 1.3. The return on the DAX Index is expected to be

11% and the German

corporate tax rate is 40%.

The company would like to explore the possibility of

covered interest arbitrage. The

quoted a 180-day forward rate of 0.0225 for each rupee

the current spot rate is

0.0227. The 180-day interest rates in Germany are 2% and

3.75% in India.

a. Explain whether the company would be exposed to

foreign exchange exposure (transaction,

economic

and translation).

(6 marks)

b. Do you believe the increased correlations between

both currencies will affect the company's

transaction exposure? Why?

(2

marks)

c. Using the CAPM, estimate the average weighted

average cost of capital (WACC) of the

company.

(5 marks)

d. Determine if the forward rate is correct according to

interest rate parity. (4 marks)

e. If covered interest arbitrage is possible, determine the

percentage return and profit that could be made with

100,000.

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