Study Materials:
Lecture Note 4: Network Models
Jake Nguyen runs a nervous hand through his once finely combed hair. He loosens his once perfectly knotted silk tie. And he rubs his sweaty hands across his once immaculately pressed trousers. Today has certainly not been a good day.
Over the past few months, Jake had heard whispers circulating from Wall Street—whispers from the lips of investment bankers and stockbrokers famous for their outspokenness. They had whispered about a coming Japanese economic collapse— whispered because they had believed that publicly vocalizing their fears would hasten the collapse.
And, today, their very fears have come true. Jake and his colleagues gather around a small television dedicated exclusively to the Bloomberg channel. Jake stares in disbelief as he listens to the horrors taking place in the Japanese market. And the Japanese market is taking the financial markets in all other East Asian countries with it on its tailspin. He goes numb. As manager of Asian foreign investment for Grant Hill Associates, a small West Coast investment boutique specializing in currency trading, Jake bears personal responsibility for any negative impacts of the collapse. And Grant Hill Associates will experience negative impacts. Jake had not heeded the whispered warnings of a Japanese collapse. Instead, he had greatly increased the stake Grant Hill Associates held in the Japanese market. Because the Japanese market had performed better than expected over the past year, Jake had increased investments in Japan from $2.5 million to $15 million only one month ago. At that time, one dollar was worth 80 yen.
No longer. Jake realizes that today’s devaluation of the yen means that one dollar is worth 125 yen. He will be able to liquidate these investments without any loss in yen, but now the dollar loss when converting back into U.S. currency would be huge. He takes a deep breath, closes his eyes, and mentally prepares himself for serious damage control.
Jake’s meditation is interrupted by a booming voice calling for him from a large, corner office. Grant Hill, the president of Grant Hill Associates, yells, “Nguyen, get the hell in here!” Jake jumps and looks reluctantly toward the corner office hiding the furious Grant Hill. He smooths his hair, tightens his tie, and walks briskly into the office.
Grant Hill meets Jake’s eyes upon his entrance and continues yelling, “I don’t want one word out of you, Nguyen! No excuses; just fix this debacle! Get all of our money out of Japan! My gut tells me this is only the beginning! Get the money into safe U.S. bonds! NOW! And don’t forget to get our cash positions out of Indonesia and Malaysia ASAP with it!”
Jake has enough common sense to say nothing. He nods hishead, turns on his heels, and practically runs out of the office.
Safely back at his desk, Jake begins formulating a plan tomove the investments out of Japan, Indonesia, and Malaysia. Hisexperiences investing in foreign markets have taught him thatwhen playing with millions of dollars, how he gets money out ofa foreign market is almost as important as when he gets moneyout of the market. The banking partners of Grant Hill Associatescharge different transaction fees for converting one currency intoanother one and wiring large sums of money around the globe.
And now, to make matters worse, the governments in EastAsia have imposed very tight limits on the amount of money anindividual or a company can exchange from the domestic currencyinto a particular foreign currency and withdraw it fromthe country. The goal of this dramatic measure is to reduce theoutflow of foreign investments out of those countries to preventa complete collapse of the economies in the region. Because ofGrant Hill Associates’ cash holdings of 10.5 billion Indonesianrupiahs and 28 million Malaysian ringgits, along with the holdingsin yen, it is not clear how these holdings should be convertedback into dollars.
Jake wants to find the most cost-effective method to convertthese holdings into dollars. On his company’s website, healways can find on-the-minute exchange rates for most currenciesin the world (see Table 1 ).
The table states that, for example, 1 Japanese yen equals0.008 U.S. dollars. By making a few phone calls, he discoversthe transaction costs his company must pay for large currencytransactions during these critical times (see Table 2 ).
Jake notes that exchanging one currency for another oneresults in the same transaction cost as a reverse conversion.Finally, Jake finds out the maximum amounts of domestic currencieshis company is allowed to convert into other currenciesin Japan, Indonesia, and Malaysia (see Table 3 ).
- Formulate Jake’s problem as a minimum-cost flow problem,and draw the network for his problem. Identify the supplyand demand nodes for the network.
- Which currency transactions must Jake perform to convertthe investments from yens, rupiahs, and ringgitsinto U.S. dollars to ensure that Grant Hill Associates hasthe maximum dollar amount after all transactions haveoccurred? How much money does Jake have to invest inU.S. bonds?
- The World Trade Organization forbids transaction limitsbecause they promote protectionism. If no transaction limitsexist, what method should Jake use to convert the Asianholdings from the respective currencies into dollars?
- In response to the World Trade Organization’s mandateforbidding transaction limits, the Indonesian governmentintroduces a new tax to protect its currency that leads to a500 percent increase in transaction costs for transactions ofrupiahs. Given these new transaction costs but no transactionlimits, what currency transactions should Jake perform toconvert the Asian holdings from the respective currenciesinto dollars?
- Jake realizes that his analysis is incomplete because he hasnot included all aspects that might influence his plannedcurrency exchanges. Describe other factors that Jake shouldexamine before he makes his final decision.
