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Jeff Madura

International Corporate Finance


Solution Manual

Chapter 2: International Flow of Funds


Effects of Tariffs
Assume a simple world in which the U.S. exports soft drinks and beer to France and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French beverage firms, and the French wine producers. ANSWER: The U.S. wine producers benefit from the U.S. tariffs, while the F r e n c h w i n e producers are adversely affected. The French government would likely retaliate by imposing tariffs on the U.S. beverage firms, which would adversely affect their value. The French beverage firms would benefit.

Currency Effects
When South Koreas export growth stalled, some South Korean firms suggested that South Koreas primary export problem was the weakness in the Japanese yen. How would you interpret this statement? ANSWER: One of South Koreas primary competitors in exporting is Japan, which produces and exports many of the same types of products to the same countries. When the Japanese yen is weak, some importers switch to Japanese products in place of South Korean products. For this reason, it is often suggested that South Koreas primary export problem i s weakness in the Japanese yen.

Exchange Rate Effect on Trade Balance


Would the U.S. balance of trade deficit be larger or smaller if the dollar depreciates against all currencies, versus depreciating against some currencies but appreciated against others? Explain. ANSWER: If the dollar weakens against all currencies, the U.S. balance of trade deficit will likely be smaller. Some U.S. importers would have more seriously considered purchasing their g o o d s i n t h e U . S . i f m o s t o r a l l c u r r e n c i e s s i m u l t a n e o u s l y s t r e n g t h e n e d a g a i n s t t h e d o l l a r . Conversely, if some currencies weaken against the dollar, the U.S. importers may have simply shifted their importing from one foreign country to another.

Government Restrictions
How can government restrictions affect international payments among countries? ANSWER: Governments can place tariffs or quotas on imports to restrict imports. They can also place taxes on income from foreign securities, thereby discouraging investors Brac University

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from purchasing foreign securities. If they loosen restrictions, they can encourage international payments among countries.

Inflation Effect on Trade


a. How would a relatively high home inflation rate affect the home countrys current account, other things being equal? ANSWER: A high inflation rate tends to increase imports and decrease e x p o r t s , t h e r e b y increasing the current account deficit, other things equal. b. Is a negative current account harmful to a country? Discuss. ANSWER: This question is intended to encourage opinions and does not have a perfect solution. A negative current account is thought to reflect lost jobs in a country, which is unfavorable. Yet, the foreign importing reflects strong competition from foreign producers, which may keep prices (inflation) low.

Balance of Payments
a. What is the current account generally composed of? ANSWER: The current account balance is composed of (1) the balance of trade, (2) the net amount of payments of interest to foreign investors and from foreign investment, (3) payments from international tourism, and (4) private gifts and grants. b. What is the capital account generally composed of? ANSWER: The capital account is composed of all capital investments made between countries, including both direct foreign investment and purchases of securities with maturities exceeding one year.

Advance Question:
International Investments
I n r e c e n t y e a r s , m a n y U . S . - b a s e d M N C s h a v e i n c r e a s e d t h e i r investments in foreign securities, which are not as susceptible to negative shocks in the U.S. market. Also, when MNCs believe that U.S. securities are overvalued, they can pursue non-U.S. securities that are driven by a different market. Moreover, in periods of low U.S. interest rates, U.S. corporations tend to seek investments in foreign securities. In general, the flow of funds into foreign countries tends to decline when U.S. investors anticipate a strong dollar. a. Explain how expectations of a strong dollar can affect the tendency of U.S. investors to invest abroad.

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ANSWER: A weak dollar would discourage U.S. investors from investing abroad. It can cause the investors to purchase foreign currency (when investing) at a higher exchange rate than the exchange rate at which they would sell the currency (when the investment is liquidated). b. Explain how low U.S. interest rates can affect the tendency of U.S. b a s e d M N C s t o i n v e s t abroad. ANSWER: Low U.S. interest rates can encourage U.S. -based MNCs to i n v e s t a b r o a d , a s investors seek higher returns on their investment than they can earn in the U.S. c. In general terms, what is the attraction of foreign investments to U.S. investors? ANSWER: The main attraction is potentially higher returns. The international stocks can outperform U.S. stocks, and international bonds can outperform U.S. bonds. However, there is no guarantee that the returns on international investments will be so favorable. Some investors may also pursue international investments to diversify their investment portfolio, which can possibly reduce risk.

Exchange Rate Effects on Trade


a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a weaker dollar could affect the U.S. balance of trade deficit. ANSWER: A stronger dollar makes U.S. exports more expensive to importers and may reduce imports. It makes U.S. imports cheap and may increase U.S. imports. A weaker home currency increases the prices of imports purchased by the home country and reduces the prices paid by foreign businesses for the home countrys exports. This should cause a decrease in the home co untrys demand for imports and an increase in the foreign demand for the home countrys exports, and therefore increase the current account. However, this relationship can be distorted by other factors. b. It is sometimes suggested that a floating exchan ge rate will adjust to reduce or eliminate any current account deficit. Explain why this adjustment would occur. ANSWER: A current account deficit reflects a net sale of the home currency in exchange for other currencies. This places downward pressure on that home currencys value. If the currency weakens, it will reduce the home demand for foreign goods (since goods will now be more expensive), and will increase the home export volume (since exports will appear cheaper to foreign countries). c. Why does the exchange rate not always adjust to a current account deficit? ANSWER: In some cases, the home currency will remain strong even though a current account deficit exists, since other factors (such as international capital flows) can offset the forces placed on the currency by the current account.

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Jeff Madura

Solution to Continuing Case Problem: Blades, Inc


1. How could a higher level of inflation in Thailand affect Blades (assume U.S. inflation remains constant)? ANSWER: A high level of inflation in Thailand relative to the United States could affect Blades favorably. Generally, if a countrys inflation rate increases relative to the countries with which it trades, consumers and corporations within the country will most likely purchase more goods overseas, as local goods become more expensive. Consequently, Blades sales to Thailand may increase. 2. How could competition from firms in Thailand and from U.S. firms c o n d u c t i n g b u s i n e s s i n Thailand affect Blades? ANSWER: Blades would be favorably affected relati ve to Thai roller blade manufacturers and relative to other U.S. roller blade manufacturers with operations in Thailand. Both groups of firms will likely be forced to raise their prices if they want to maintain the same profit margin should inflation in Thailand increase. This is especially true if both groups of firms source their supplies directly from Thailand, so that the prices of these supplies are subject to the higher inflation in T h a i l a n d . C o n v e r s e l y , B l a d e s c o s t o f g o o d s s o l d i n c u r r e d i n T h a i l a n d i s r e l a t i v e l y s m a l l . Consequently, costs will not be subject to the higher level of inflation in Thailand to a great extent and Blades will probably not have to raise its prices to the same extent as Thai roller blade manufacturers or U.S. manufacturers with operations in Thailand.

3. How could a decreasing level of national income in Thailand affect Blades? ANSWER: At first glance, it would appear that a decreasing level of national income in Thailand could hurt Blades financially, as Thai consumers will have less money to spend. Furthermore, this effect may be magnified because Blades manufactures a leisure product, which is probably one of the first products Thai consumers will stop buying. The arrangement Blades has with its primary Thai importer mitigates this effect somewhat, since the latter has committed himself to the purchase of a certain number of Speedos annually. Nevertheless, the importer may not offer tor e n e w t h i s a r r a n g e m e n t i n e x c e s s o f t h e o r i g i n a l t h r e e y e a r s i f t h e T h a i e c o n o m y d o e s n o t improve. 4. How could a continued depreciation of the Thai baht affect Blades? How would it affect Blades relative to U.S. exporters invoicing their roller blades in U.S. dollars? ANSWER: A continued depreciation of the Thai baht would hurt Blades, especially because the firm invoices its roller blades in baht. A continued depreciation of the baht means that the bahtdenominated revenue in Thailand will convert to fewer U.S. dollars. Blades a l s o h a s s o m e expenses in baht, but this amount is less than the revenue denominated in baht. Although Blades would be hurt by a depreciating baht because its exports are denominated in b a h t , t h e d e m a n d f o r B l a d e s p r o d u c t s m a y i n c r e a s e r e l a t i v e t o t h a t o f i t s U . S . c o m p e t i t o r s exporting to Thailand. This is because most of the U.S. firms exporting roller blades to Thailand invoice their products in U.S. dollars. If the baht depreciates, Thai importers will have to convert more baht to dollars in order to pay for the dollardenominated exports.

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5. If Blades increases its business in Thailand and experiences serious financial problems, are there a n y i n t e r n a t i o n a l a g e n c i e s t h a t t h e c o m p a n y c o u l d a p p r o a c h f o r l o a n s o r o t h e r f i n a n c i a l assistance? ANSWER: An agency extending direct loans to corporations involved in international trade is the International Financial Corporation (IFC). Besides extending loans, the IFC may also purchase stock in a corporation, thereby becoming part owner.

Small Business Dilemma


Identif yin g Factors That Will Affect the Foreign Demand at t he S ports E x p o r t s Company Identify the factors that affect the current account balance between the U.S. and the U.K. Explain how each factor may possibly affect the British demand for the footballs that are produced by the Sports Exports Company. ANSWER: 1. High inflation in the U.K. could cause a shift in the demand for U.S. products instead of British products. However, at this time there is not a British producer of footballs, so that high British inflation will not cause an increase in the demand for U.S.-produced footballs. 2. High national income in the U.K. could increase the amount of spending by British consumers, and would therefore cause an increase in the demand for footballs produced by the Sports Exports Company. A lower national income in the U.K. would have the opposite effect. 3. Government restrictions could be imposed by the British government on goods (such as the footballs) exported by U.S. firms. However, footballs are not likely to be targeted by the British government as a product that should be subject to restrictions. 4. The exchange rate of the British pound will change over time. However, since the Sports Exports Company is willing to accept pounds when it sells footballs to the distributor, the distributor does not have to convert the pounds into dollars. Therefore, the British demand for footballs is not affected by changes in the value of the pound (unless this causes the Sports Exports Company to change the price it charges for the footballs someday).

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Chapter 3: International Financial Markets


Indirect Exchange Rate
If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in Euros? ANSWER: 1/1.25 = .8 Euros.

Foreign Stock Markets


Explain why firms may issue stock in foreign markets. Why might U.S. firms issue more stock in Europe since the conversion to a single currency in 1999? ANSWER: Firms may issue stock in foreign markets when they are concerned that their home market may be unable to absorb the entire issue. In addition, these firms may have foreign currency inflows in the foreign country that can be used to pay dividends on foreign-issued stock. They may also desire to enhance their global image. Since the euro can be used in several countries, firms may need a large amount of Euros if they are expanding across Europe.

Foreign Exchange
You just came back from Canada, where the Canadian dollar was worth $.70.You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 130 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged f o r 1 2 0 p e s o s (computed as 200 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 130 pesos.

Forward Contract
The Wolf pack Corporation is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract? Explain. ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk. Yet, in this case, the Wolf pack Corporation should not hedge because it would benefit from appreciation of the pound when it converts the pounds to dollars.

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Bid/ask Spread
Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10. ANSWER: [($.11 $.10)/$.11] = .091, or 9.1%.

Bid/ask Spread
Utah Banks bid price for Canadian dollars is $.7938 and its ask price is $.81.What is the bid/ask percentage spread? ANSWER: ($.81 $.7938)/$.81 = .02 or 2%

Cross Exchange Rate


Assume Polands currency (the zloty) is worth $.17 and the Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty? ANSWER: $.17/$.008 = 21.251 zloty = 21.25 yen

Interpreting Exchange Rate Quotations


Today you Notice the following exchange rate quotations: a. $1 = 3.00 Argentine Pesos and b. 1 Argentine Pesos = 0.50 Canadian dollars. You need to purchase 100,000 Canadian dollars with US dollars. How many US Dollars will you need for your purchase? Answer: Value of argentine pesos = $0.333 Value of Canadian dollar in Argentine pesos = 2 Value of CAD in $ = $0.666 So you need $ 66,666 to purchase CAD 100,000.

International Financial Markets


Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are mas sive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal -Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future. a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange. ANSWER: The Wal-Mart stores in China need other currencies to buy products from other countries, and must convert the Chinese curre ncy (Yuan) into the other currencies in the spot m a r k e t t o p u r c h a s e t h e s e p r o d u c t s . T h e y a l s o c o u l d u s e t h e s p o t m a r k e t t o c o n v e r t e x c e s s earnings denominated in Yuan into dollars, which would be remitted to the U.S. parent.

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b. Explain how Wal-Mart might utilize the international money market when it is establishing other Wal-Mart stores in Asia. ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Wal -Mart stores in various foreign markets. When some Wal-Mart stores in foreign markets need funds, they borrow from banks in the Eurocurrency market. Thus, the Eurocurrency market serves as a deposit or lending source for Wal-Mart and other MNCs on a short-term basis. c. Explain how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets. ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are established, some of the cash flows generated by those stores could be used to pay interest on the bonds.

Chapter 4: Exchange Rate Determination


Question And Applications
1. Impact of September 11. The terrorist attacks on the U.S. on September 11, 2001 were expected to weaken U.S. economic conditions, and reduce U.S. interest rates. How do you think the weaker U.S. economic conditions would affect trade flows? How would this have affected the value of the dollar (holding other factors constant)? How do you think the lower U.S. interest rates would have affected the value of the U.S. dollar (holding other factors constant)? ANSWER: The weak U.S. economy would result in a reduced demand for foreign products, which results in a decline in the demand for foreign currencies, and therefore places downward pressure on currencies relative to the dollar (upward pressure on the dollars value). The lower U.S. interest rates should reduce the capital flows to the U.S., which place downward pressure on the value of the dollar. 2. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro against the dollar? ANSWER: The Euros value could change because of the balance of trade, which reflects more U.S. demand for European goods than the European demand for U.S. goods. The capital flows between the U.S. and Europe will also affect the U.S. demand for Euros and the supply of Euros for sale (to be exchanged for dollars). 3. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital flows? ANSWER: Capital flows have a larger influence. In general, crises tend to cause investors to expect that there will be less investment in the country in the future and also cause concern that Brac University

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any existing investments will generate poor returns (because of defaults on loans or reduced valuations of stocks). Thus, as investors liquidate their investments and convert the local currency into other currencies to invest elsewhere, downward pressure is placed on the local currency. 4. Effects of Real Interest Rates. What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies? ANSWER: The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal. 5. Factors Affecting Exchange Rates. If the Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result), how will their currency values (relative to the U.S. dollar) be affected? ANSWER: A relative decline in Asian economic growth will reduce Asian demand for U.S. products, which places upward pressure on Asian currencies. However, given the change in interest rates, Asian corporations with excess cash may now invest in the U.S. or other countries, thereby increasing the demand for U.S. dollars. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. The overall impact depends on the magnitude of the forces just described. 6. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist about future interest rates could affect the value of the dollar today. Why do some forecasts by well-respected economists have no impact on todays value of the dollar? ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currencies value. These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investors original expectations, an announced forecast does not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected. 7. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held constant, increased national income could increase imports and cause the local currency to weaken. In reality, other factors are not constant. What other factor is likely to be affected by increased economic growth and could place upward pressure on the value of the local currency? ANSWER: Interest rates tend to rise in response to a stronger economy, and higher interest rates can place upward pressure on the local currency (as long as there is not offsetting pressure by higher expected inflation). 8. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c)equilibrium value of the yen? Brac University

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ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease. 9. Co movements of Exchange Rates. Explain why the value of the British pound against the dollar will not always move in tandem with the value of the euro against the dollar. ANSWER: The Euros value changes in response to the flow of funds between the U.S. and the countries using the euro or their currency. The pounds value changes in response to the flow of funds between the U.S. and the U.K. [Answer is based on intuition, is not directly from the text.] 10. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Assuming no effect on U.S. interest rates, demand for dollars should increase, supply of dollars for sale may not be affected, and the dollars value should increase. 11. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods but had little to offer other countries in terms of potential exports. In addition, Russians inflation rate was high. Explain the type of pressure that these factors placed on the Russian currency. ANSWER: The large amount of Russian imports and lack of Russian exports placed downward pressure on the Russian currency. The high inflation rate in Russia also placed downward pressure on the Russian currency. 12. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the pounds value should increase. 13. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced. a. Why do you think the trade deficit announcement sometimes has such an impact on foreign exchange trading? ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits and therefore has implications about supply and demand conditions in the foreign exchange market. For example, if the trade deficit was larger than anticipated, and is expected to continue, this implies that the U.S. demand for foreign currencies may be larger than initially anticipated. Thus, the dollar would be expected to weaken. Some speculators may take a position in foreign currencies immediately and could cause an immediate decline in the dollar. b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even when the announced deficit is very large. Offer an explanation for such a lack of response.

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ANSWER: If the market correctly anticipated the trade deficit figure, then any news contained in the announcement has already been accounted for in the market. The market should only respond to an announcement about the trade deficit if the announcement contains new information. 14. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollars value should increase. 15. Interaction of Exchange Rates. Assume that there are substantial capital flows among Canada, the U.S., and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar against the U.S. dollar? How might this decline in Canadas interest rates possibly affect the value of the Canadian dollar against the Japanese yen? ANSWER: If interest rates in Canada decline, there may be an increase in capital flows from Canada to the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S. interest rates, while U.S. investors reduce their investments in Canadas securities. This places down ward pressure on the Canadian dollars value. Japanese investors that previously invested in Canada may shift to the U.S. Thus, the reduced flow of funds from Japan would place downward pressure on the Canadian dollar against the Japanese yen. 16. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect? ANSWER: ($1.66 $1.73)/$1.73= 4.05% Expected depreciation of 4.05% percent.

Advanced Questions:
17. Assessing the Euros potential movements. Yoou reside in the United States and are planning to make a one year investment in Germany during the next year. Since the investment is denominated in Euros, you want to forecast how the Euros value may change against the dollar over the one year period. You expect the Germany will experience an inflation rate of 1% during the next year. While all over European countries will experience an inflation rate of 8% over the next year. You expect the United States will experience an annual inflation rate of 2 % during the next year. You believe that the primary factors that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate or stay at about same level against the dollar over the next year?? Answer: The euro should depreciate because most countries in the Eurozone are presumed to have high inflation.

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18. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist: Lending Rate U.S. dollar Singapore dollar 7.0% 22.0% Borrowing Rate 7.2%24.0% Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in dollars for 60 days. Estimate the profits (or losses)that could be earned from this strategy. Should Diamond Bank pursue this strategy? ANSWER: Borrow S$10,000,000 and convert to U.S. $: S$10,000,000 $.43 =$4,300,000. Invest funds for 60 days. The rate earned in the U.S. for 60 days is: 7%(60/360) = 1.17%. Total amount accumulated in 60 days: $4,300,000 (1 + .0117) =$4,350,310. Convert U.S. $ back to S$ in 60 days: $4,350,310/$.42 = S$10,357,881. The rate to be paid on loan is: .24 (60/360) = .04. Amount owed on S$ loan is: S$10,000,000(1 + .04) = S$10,400,000. This strategy results in a loss: S$10,357,881 S$10,400,000 =S$42,119. Diamond Bank should not pursue this strategy. 19. Speculation: Diamond bank expects that the Singapore dollar will depreciate against the Us dollar from its spot rate of $.43 to $.42 in 60 days/ the following interbank lending and borrowing rates exist: Currency US$ Singapore $ Lending Rates 7.0% 22.0% Borrowing rates 7.2% 24.0%

Diamond bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in US$ for 60days. Estimate the profits or losses that could be earned from this strategy. Should diamond bank pursue this strategy???

Answer: Borrowing S$ 10million and convert to US$: S$10Million * $.43= $ 4300,000.


Invest funds for 60 days. The rate earned in the US for 60 days is; 7%(60/360)= 1.17%. Total amount accumulated in 60 days: $34300,000*1.0117= s$10357881. The rate to be paid on loan is .24*(60/360) = .04. Amount owed on S$ loan is S$10 million *1.04 = S$ 10400,000. This strategy results in a loss : (S$42119). Diamond bank should not pursue this strategy. 23. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: U.S. dollar Mexican peso Lending Rate 8.0% 8.5% Borrowing Rate 8.3% 8.7% 41 Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow.

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10th Edition

Jeff Madura

a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows: 1. Borrow MXP70 million 2.Convert the MXP70 million to dollars: MXP70, 000,000 $.15 = $10,500,000 3. Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The amount accumulated in 10 days is: $10,500,000 [1 + (8% 10/360)] = $10,500,000[1.002222] = $10,523,333 4. Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 [1 + (8.7% 10/360)] = 70,000,000 [1.002417]=MXP70,169,167 5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is: MXP70,169,167 $.14 = $9,823,683 6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of:$10,523,333 $9,823,683 = $699,650 b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations as follows: 1. Borrow$10 million 2. Convert the $10 million to pesos (MXP): $10,000,000/$.15 =MXP66,666,667 3.Lend the pesos through the interbank market at 8.5% annualized over a 30-dayperiod. The amount accumulated in 30 days is: MXP66,666,667 [1 + (8.5% 30/360)] =66,666,667 [1.007083] = MXP67,138,889. 4. Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 [1 + (8.3% 30/360)] = $10,000,000 [1.006917]= $10,069,170. 5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $.17) is: MXP67,138,889$.17 = $11,413,611. 6. The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 $10,069,170 = $1,344,441 25. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approximately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future. Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country Ks currency (the k rank) with respect to the dollar. Explain how each of the following conditions will affect the value of the k rank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the k ranks movement against the dollar. a. U.S. inflation has suddenly increased substantially, while Country Ks inflation remains low. ANSWER: Increased U.S. demand for the k rank. Decreased supply of k ranks for sale. Upward pressure in the k ranks value.

Brac University

10th Edition

Jeff Madura

b. U.S. interest rates have increased substantially, while Country Ks interest rates remain low. Investors of both countries are attracted to high interest rates. ANSWER: Decreased U.S. demand for the k rank. Increased supply of k ranks for sale. Downward pressure on the k ranks value. c. The U.S. income level increased substantially, while Country Ks income level has remained unchanged. ANSWER: Increased U.S. demand for the k rank. Upward pressure on the kranks value. d. The U.S. is expected to impose a small tariff on goods imported from Country K. ANSWER: The tariff will cause a decrease in the United States desire for Country Ks goods, and will therefore reduce the demand for k ranks for sale. Downward pressure on the k ranks value. e. Combine all expected impacts to develop an overall forecast. ANSWER: Twoof the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the U.S. and Country K. The interest rate scenario places downward pressure on the k ranks value. Since the interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate. 27. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. a. Identify the most obvious economic reason for the persistent depreciation of the peso. ANSWER: The high inflation in Mexico places continual downward pressure on the value of the peso. b. High interest rates are commonly expected to strengthen a countrys currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the pesos value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexicos securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico? ANSWER: The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate(when they convert the pesos back to dollars at the end of the

Brac University

10th Edition

Jeff Madura

investment period).Therefore, the high Mexican interest rates do not encourage U.S. investment in Mexican securities, and do not help to strengthen the value of the peso. c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico? ANSWER: The bid/ask spread is wider because the banks that provide foreign exchange services are subject to more risk when they maintain currencies such as the peso that could decline abruptly at any time. A wider bid/ask spread adversely affects the U.S. firm that does business in Mexico because it increases the transactions costs associated with conversion of dollars to pesos, or pesos to dollars.

Case Problem: Blades, Inc.


1. How are percentage changes in a currencys value measured? Illustrate your answer numerically by assuming a change in the Thai baths value from a value of $0.022 to $0.026. ANSWER: The percentage change in a currencys value is measured as follows: % S St St 1 1 where S denotes the spot rate, and St 1 denotes the spot rate as of the earlier date. A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation. In the example provided, the percentage change in the Thai baht would be: % S St St 1 1$0.026 $0.022 $0.022 . 1818% That is, the baht would be expected to appreciate by18.18%. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currencys value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. 3. How might the relatively high levels of inflation and interest rates have affected the baths value? (Assume a constant level of U.S. inflation and interest rates.) ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the U.S. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for U.S. goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for U.S. investors, causing an increase in the demand for baht. Furthermore, U.S. securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailands inflation.

Brac University

10th Edition

Jeff Madura

Speculators who are confident that the exchange rate will appreciate, with very little risk of depreciation, may be more willing to buy futures than call options, because they do not need to insure against depreciation. However, speculators who expect appreciation but want to cover against possible depreciation may be willing to buy call options so that their downside risk is limited to what they pay for the call option. 4. How do yiu think the loss of confidence in the Thai bath evidenced by the withdrawal of funs from Thailand, will affect the baths value ?? Would blades be affected by the changes in value, given the primary Thai customers commitment?? Answer: In general, depreciation in the foreign currency results when investors liquidate their investments in the foreign currency, increasing the supply of its currency or sale. Blades would probably be affected by the change in value, as the sales are denominated in bath. Thus, the depreciation in the bath would have caused a conversion of the bath revenue in to fewer US $. 5. Assume the Thailands central bank wishes to prevent a withdrawal of fund from its country in order to prevent further changes in the currencys value. How could it accomplish this objectives using interest rates?? Answer: If Thailands central bank wishes to prevent further depreciation in the baths value, it would attempt to increase the level of interest rates in Thailand. In turn , this would increase the demand for Thai by US investors as Thai securities would now seem more attractive. This would place upward pressure on the currencys value. however the high interest rates could educe local borrowing and spending.

Small Business Dilemma:


1. Given Jims Expectations, forecast whether the pound will appreciate or depreciate against the dollar over time ??? Answer: The pound should depreciate because the British inflation is expected to be higher the US inflation. This could cause a shift in trade that would place downward pressure on the pounds value. The interest rate movements of both countries are expected to be similar for both countries. Therefore, there should not be any adjustment in the capital flows between the two countries. 2. Given Jims expectations, will the sports exports company be favorable or unfavorably affected by the future changes in the value of pound?? Answer: The sports export company will be unfavorably affected, because depreciation in the British pound will cause the pound receivable to convert into fewer dollars.

Brac University

10th Edition

Jeff Madura

Chapter 5: Currency Derivatives


1. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike s net profit on the call option? ANSWER: Premium received per unit $0.01, Amount per unit received from selling C$ 0.76, Amount per unit paid when purchasing C$ 0.82, Net profit per unit ($0.05). Net Profit = 50,000 units ($.05) = $.01 = $.76 = $.82 = $.05 = $2,500. 2. Hedging with Currency Derivatives. A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal, and approval (or disapproval) will not occur for three months. How can the team hedge its position? What is there to lose by waiting three months to see if the exhibition game is approved before hedging? ANSWER: The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire. If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-month period, put options with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling futures contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved. 3. Speculating with Put Currency Options. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was $1.59. Assume there are 31,250 units in a British pound option. What was Alice s net profit on the option? ANSWER: Profit per unit on exercising the option $0.21, Premium paid per unit$0.04, Net profit per unit$0.17. Net profit for one option = 31,250 units $.17 = $.21 = $.04 = $.17 =$5,312.50. 4. Speculation with Currency Put Option. Bulldog, Inc has sold Australian Dollar put option at a premium of $0.01 per unit, and exercise price of $.76 per unit. It has forecasted the Australian dollars lowest level over the period of concern as shown in the following table. Determine the net profit or loss per unit to Buildog Inc, if each level occurs and the put options are exercised at that time

Brac University

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Jeff Madura

Net profit or loss to Bulldog inc, if value occurs $.72 $.73 $.74 $.75 $.76

ANSWER:
Possible value of Australian Dollar Net profit or loss to Bulldog Inc, if value occurs -$ .03 -$0.02 -$0.01 00 $0.01

$.72 $.73 $.74 $.75 $.76

5. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume there are 31,250 units in a British pound option. What was Randy s net profit on this option? ANSWER: Profit per unit on exercising the option $0.01, Premium paid per unit $0.02, Net profit per unit $0.01. Net profit per option = 31,250 units ($.01) = $.01 = $.02 = $.01 = $312.50.

6. Speculating with currency call option: Bama Corp has British pound call options for speculative purposes. The option premium was $0.06 per unit and the exercise price was $1.58. Bama will purchase the pounds on the day the options the options are exercised ( if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit or loss to Barma corp, if the listed spot rate exists at the time the purchaser of the call options considers exercising them.

Brac University

10th Edition Answer: Spot Rate $ 1.53 1.55 1.57 1.60 1.62 1.64 1.68 Net profit / loss per unit 1.58 1.58 + 0.06 = 0.11 1.58 1.55 + 0.06 = 0.09 1.58 1.57 + 0.06 = 0.07 1.58 1.60 + 0.06 = 0.04 1.58 1.62 + 0.06 = 0.02 1.58 1.64 + 0.06 = 0.00 1.58 1.68 + 0.06 = -0.04

Jeff Madura

8. Speculating with Currency Put Options: Auburn Co has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of $0.02 per unit; with an exercise price of $0.86 per unit. Auburn Co will purchase the Canadian dollar just before it exercises the options (If it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, fill in the net profit or loss per unit to Auburn Co based on the listed possible spot rates of the Canadian dollar on the expiration date. Answer: Spot Rate $ 0.76 0.79 0.84 0.87 0.89 0.91 Net loss of gain per unit 0.86 0.76 0.02 = 0.08 0.86 0.79 0.02 = 0.05 0.86 0.84 0.02 = 0.00 0.86 0.87 0.02 = -0.03 0.86 0.89 0.02 = -0.05 0.86 0.91 0.02 = -0.07

Solution to Continuing Case Problem: Blades, Inc.


1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $0.00756 or the call option with the exercise price of $0.00792? Describe the tradeoff. ANSWER: The table shows how the option choices have changed for Blades. If it wants to ensure paying no more than 5 percent above the spot rate, the option with the exercise price of $0.00756 should be considered, although the premium on that option now has increased to be worth 2 percent of the exercise price (more expensive). The option premium is higher than what the firm normally prefers to pay. The firm could pay a lower premium by purchasing the alternative option with an exercise price of $0.00792, but that exercise price is 10 percent above the existing spot rate. This alternative option does not achieve the firm s desire to ensure paying no more than 5 percent above the existing spot rate. So if the firm is to continue to use options, it must accept either paying a higher premium than it would prefer, or a higher exercise price that limits the Brac University

10th Edition

Jeff Madura

Chapter 6: Government Influence on Exchange Rates


1. Indirect Intervention. Why would the Feds indirect intervention have a stronger impact on some currencies than others? Why would a central banks indirect intervention have a stronger impact than its direct intervention? Answer: Intervention may have a more pronounced impact when the market f o r a g i v e n currency is less active, such that the intervention can jolt the supply and demand conditions more. A central banks indirect intervention can affect the factors that influence exchange rates and t h e r e f o r e a f f e c t t h e n a t u r a l e q u i l i b r i u m e x c h a n g e r a t e . C o n v e r s e l y, d i r e c t i n t e r v e n t i o n i s a superficial method of affecting the demand and supply conditions for a currency, and could be over whelmed by market forces. 2. Indirect Intervention. During the Asian crisis, some Asian central banks raised their in terest rates to prevent their currencies from weakening. Yet, the currencies weakened anyway. Offer your opinion as to why the central banks efforts at indirect intervention did not work. ANSWER: The higher interest rates did not attract sufficient funds to offset the outflow of funds, as investors had no confidence that the currencies would stabilize and were unwilling to invest in Asia. 3. Feedback Effects. Explain the potential feedback effects of a currencys changing value on inflation. Answer: A weak home currency can cause inflation since it tends to reduce f o r e i g n competition within any given industry. Higher inflation can weaken the currency further since it encourages consumers to purchase goods abroad (where prices are not inflated).A strong home currency can reduce inflation since it reduces the prices of foreign goods and forces home producers to offer competitive prices. Low inflation, in turn, places upward pressure on the home currency. 4. Freely Floating Exchange Rates. S h o u l d t h e g o v e r n m e n t s o f A s i a n c o u n t r i e s a l l o w t h e i r currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages? Answer: A freely floating currency may allow the exchange rate to adjust to market conditions, which can stabilize flows of funds between countries. If there is a larger amount of funds going out versus coming in, the exchange rate will weaken due to the forces and the flows may change because the currency has become cheaper; this discourages further outflows. Yet, a disadvantage is that speculators may take positions that force a freely floating currency to deviate far from what is perceived to be a desirable exchange rate.

Brac University

10th Edition 5. Currency Effects on Economy.

Jeff Madura

W h a t i s t h e i m p a c t o f a w e a k h o m e c u r r e n c y o n t h e h o m e economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? Answer: A weak home currency tends to increase a countrys exports and decrease its imports, thereby lowering its unemployment. However, it also can cause higher inflation since there is a reduction in foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local producers can more easily increase prices without concern about pricing themselves out of the market. A s t r o n g h o m e c u r r e n c y c a n k e e p i n f l a t i o n i n t h e h o m e c o u n t r y l o w , s i n c e i t e n c o u r a g e s consumers to buy abroad. Local producers must maintain low prices to remain competitive. A l s o , f o r e i g n s u p p l i e s c a n b e o b t a i n e d c h e a p l y . T h i s a l s o h e l p s t o m a i n t a i n l o w inflation. However, a strong home currency can increase unemployment in the home country. This is due to the increase in imports and decrease in exports often associated with a strong home c u r r e n c y ( i m p o r t s b e c o m e c h e a p e r t o t h a t c o u n t r y b u t t h e c o u n t r y s e x p o r t s b e c o m e m o r e expensive to foreign customers). 6. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its key interest rates. The values of several other Latin American currencies are expected to change substantially against the Chilean peso in response to the news. a. Explain why other Latin American currencies could be affected by a cut in Chiles interest rates. Answer: Exchange rates are partially driven by relative interest rates of the countries of concern. When Chile's interest rates decline, there is a smaller flow of funds to be exchanged into Chilean pesos because the Chile interest rate is not as attractive to investors. There may be a shift of investment into the other Latin American countries where interest rates have not declined. However, if these Latin American countries are expected to reduce their rates as well, they will not attract more capital and may even attract less capital flows in the future, which could reduce their values. b. H o w w o u l d t h e c e n t r a l b a n k s o f o t h e r L a t i n A m e r i c a n c o u n t r i e s l i k e l y a d j u s t t h e i r i n t e r e s t rates? How would the currencies of these countries respond to the central bank interventions? Answer: The central banks would likely attempt to lower interest rates, which causes the currency to weaken. A weaker currency and lower interest rates can stimulate the economy. c. How would a U.S. firm that exports products to Latin American countries be affect ed by the central bank interventions? (Assume the exports are denominated in the corresponding Latin American currency for each country.) Answer: The exporter is adversely affected if the Chilean peso and other currencies depreciate. It is favorably affected by the appreciation of any Latin American currencies.

Brac University

10th Edition 7. Intervention Effects.

Jeff Madura

Assume there is concern that the United States may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might U.S. exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms? Answer: The Federal Reserve would normally consider a loose money policy to stimulate the economy. However, to the extent that the policy puts upward pressure on economic growth and inflation, it could weaken the dollar. A weak dollar is expected to favorably affect U.S. exporting firms and adversely affect U.S. importing firms. If the U.S. interest rates rise in response to the possible increase in economic growth and inflation i n t h e U . S . , t h i s c o u l d o f f s e t t h e d o w n w a r d p r e s s u r e o n t h e U . S . d o l l a r . I n t h i s c a s e , U . S . exporting and importing firms would not be affected as much. 8. Sterilized Intervention. Explain the difference between sterilized and non sterilized intervention. Answer: Sterilized intervention is conducted to ensure no change in the money supply while non sterilized intervention is conducted without concern about maintaining the same money supply. 9. Indirect Intervention. How can a central bank use indirect intervention to change the value of a currency? Answer: To increase the value of its home currency, a central bank could attempt to increase interest rates, thereby attracting a foreign demand for the home currency to buy high yield securities. To decrease the value of its home currency, a central bank could attempt to lower interest rates in order to reduce demand for the home currency by foreign investors. 10. Direct Intervention in Europe. If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth? Answer: The ECB could sell euros in the foreign exchange market, which may cause the euro to depreciate against other currencies, and therefore cause an increase in the demand for European imports. 11. Direct Intervention. How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency. Answer: Central banks can use their currency reserves to buy up a specific currency in the foreign exchange market in order to place upward pressure on that currency. Central banks can also attempt to force currency depreciation by flooding the market with that specific currency(selling that currency in the foreign exchange market in exchange for other currencies).Abrupt movements in a currencys value may cause more volatile business cycles, and may cause more concern in financial markets (and therefore more volatility in these markets). Central Brac University

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Jeff Madura

bank intervention used to smooth exchange rate movements may stabilize the economy and financial markets. 12. Intervention Effects on Bond Prices. U.S. bond prices are normally inversely related to U.S. inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected? ANSWER: Expectations of a weak dollar can cause expectations of higher inflation, because a weak dollar places upward pressure on U.S. prices for reasons mentioned in the chapter. Higher inflation tends to place upward pressure on interest rates. Because there is an inverse relationship between interest rates and bond prices, bond prices would be expected to decline. Such an expectation causes bond portfolio manage rs to liquidate some of their bond holdings, thereby causing bond prices to decline immediately. 13. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the dollar. Can it apply central bank intervention to achieve this objective? Explain. Answer: It can not apply intervention on its own because the European Central Bank (ECB) controls the money supply of euros. Belgium is subject to the intervention decisions of the ECB. 14. Effects on Currencies Tied to the Dollar. The Hong Kong dollars value is tied to the U.S.dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States. Answer: a . Hong Kong exports to Japan should increase because the yen will have appreciated against the H o n g K o n g d o l l a r . T h e r e f o r e , H o n g K o n g g o o d s w i l l b e l e s s e x p e n s i v e t o J a p a n e s e importers. b. Hong Kong exports to the U.S. should increase because Japanese g o o d s b e c o m e m o r e expensive to U.S. importers as a result of yen appreciation. Therefore, some U.S. importers may find that even though the exchange rate between the U.S. dollar and Hong Kong dollar is u n c h a n g e d , t h e H o n g K o n g p r i c e s a r e n o w l o w e r t h a n J a p a n e s e p r i c e s ( f r o m a U . S . perspective). This answer assumes that Japanese exporters did not reduce their prices to compensate U.S. importers for the weaker dollar. If Japanese exporters do reduce their prices to fully offset the effect of the stronger yen, there would be less of a shift to Hong Kong goods. 15. Exchange Rate Systems. Compare and contrast the fixed, freely floating, and managed float exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system? Answer: Under a fixed exchange rate system, the governments attempted to maintain exchange rates within 1% of the initially set value (slightly widening the bands in 1971). Under a freely floating system, government intervention would be non-existent. Under a managed float system, governments will allow exchange rates move according to market forces; however, they will intervene when they believe it is necessary. A freely floating system may help correct balanceof-trade deficits since the currency will adjust according to market forces. Also, countries are more Brac University

10th Edition

Jeff Madura

insulated from problems of foreign countries u n d e r a f r e e l y f l o a t i n g e x c h a n g e r a t e s ys t e m . H o w e v e r , a d i s a d v a n t a g e o f f r e e l y f l o a t i n g exchange rates is that firms have to manage their exposure to exchange rate risk. Also, floating rates still can often have a significant adverse impact on a countrys unemployment or inflation. 16. Pegged Currency and International Trade. Assume that Canada decides to peg its currency ( the Canadian dollar) To the US dollar and that the exchange rate will remain fixed. Assume that Canada commonly obtains its imports from the Us and Mexico. The US commonly obtains its imports from Canada and Mexico. Mexico commonly obtains its imports from US and Canada. The traded products are always invoiced in the exporting countrys currency. Assume that the Mexican peso appreciates substantially against the US dollar during the nest year. a. What is the likely effect (if Any) of the pesos exchange rate movement on the volume of Canadas export to Mexico? Explain Answer: The Peso appreciates against Canadian dollar, so Canadian exports to Mexico should increase. b. What is the likely effect (if any) of the pesos exchange rate movement on the volume of Canadas export to the United States? Explain Answer: The US should demand more from Canada ( Shift away from Mexico), so Canadian export should increase.

Brac University

10th Edition

Jeff Madura

Chapter 7: Interest Rate Parity and International Arbitrage


1. Covered Interest Arbitrage in Both Directions.
The following information is available: You have $500,000 to invest. The current spot rate of the Moroccan dirham is $.110. The 60-day forward rate of the Moroccan dirham is $.108. The 60-day interest rate in the U.S. is 1 percent. The 60-day interest rate in Morocco is 2 percent. a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest arbitrage work for the investor in this case? b. Would covered interest arbitrage be possible for a Moroccan investor in this case? ANSWER: a. Covered interest arbitrage would involve the following steps: 1. Convert dollars to Moroccan dirham: $500,000/$.11 = MD 4,545,454.55. 2. Deposit the dirham in a Moroccan bank for 60 days. You will have MD 4,545,454.55 (1.02) = MD 4,636,363.64 in 60 days. 3. In 60 days, convert the dirham back to dollars at the forward rate and receive MD4,636,363.64 $.108 = $500,727.27 The yield to the U.S. investor is$500,727.27/$500,000 1 = .15%. Covered interest arbitrage did not work for the investor in this case. The lower Moroccan forward rate more than offsets the higher interest rate in Morocco. b. Yes, covered interest arbitrage would be possible for a Moroccan investor. The investor would convert dirham to dollars, invest the dollars at a 1 percent interest rate in the U.S., and sell the dollars forward 60 days. Even though the Moroccan investor would earn an interest rate that is 1 percent lower in the U.S., the forward rate discount of the dirham more than offsets that differential. 2. Covered Interest Arbitrage in Both Directions. Assume that the existing U.S. one-year interest rate is 10 percent and the Canadian one-year interest rate is 11 percent. Also assume that interest rate parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return? ANSWER: The Canadian dollar's forward rate should exhibit a discount because its interest rate exceeds the U.S. interest rate. U.S. investors would earn a return of 10 percent using covered interest

Brac University

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Jeff Madura

arbitrage, the same as what they would earn in the U.S. Canadian investors would earn a return of 11 percent using covered interest arbitrage, the same as they would earn in Canada. 3. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent. a. According to IRP, what should the forward rate premium or discount of the euro be? b. If the Euros spot rate is $1.10, what should the one-year forward rate of the euro be? ANSWER: a. P = (1.04) / (1.06) 1 = -.0189 or 1.89%. b. F = $1.10(1 .0189) = $1.079. 4. Inflation Effects on the Forward Rate. Why do you think currencies of countries with high inflation rates tend to have forward discounts? ANSWER: These currencies have high interest rates, which cause forward rates to have discounts as a result of interest rate parity. 5. Covered Interest Arbitrage. The South African rand has a one-year forward premium of 2 percent. One-year interest rates in the U.S. are 3 percentage points higher than in South Africa. Based on this information, is covered interest arbitrage possible for a U.S. investor if interest rate parity holds? ANSWER: No, covered interest arbitrage is not possible for a U.S. investor. Although the investor can lock in the higher exchange rate in one year, interest rates are 3 percent lower in South Africa. 6. Interest Rate Parity. Explain the concept of interest rate parity. Provide the rationale for its possible existence. ANSWER: Interest rate parity states that the forward rate premium (or discount) of a currency should reflect the differential in interest rates between the two countries. If interest rate parity didn't exist, covered interest arbitrage could occur (in the absence of transactions costs, and foreign risk), which should cause market forces to move back toward conditions which reflect interest rate parity. The exact formula is provided in the chapter. 7. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is currently 8 percent and Germanys annual interest rate is currently 9 percent. The Euros one-year forward rate currently exhibits a discount of 2 percent. a. Does interest rate parity exist? ANSWER: No, because the discount is larger than the interest rate differential.

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b. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage? ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of investing in Germany. c. Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through covered interest arbitrage? ANSWER: Yes, because even though it would earn 1 percent less interest over the year by investing in U.S. dollars, it would be able to sell dollars for 2 percent more than it paid for them (it would be buying euros forward at a discount of 2 percent). 8. Effects of September 11. The terrorist attack on the U.S. on September 11, 2001 caused expectations of a weaker U.S. economy. Explain how such expectations could have affected U.S. interest rates, and therefore have affected the forward rate premium (or discount) on various foreign currencies. ANSWER: The expectations of a weaker U.S. economy resulted in a decline of short-term interest rates(in fact, the Fed expedited the movement by increasing liquidity in the banking system).The U.S. interest rate was reduced while foreign interest rates were not. Therefore, the forward premium on foreign currencies increased. 9. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is11 percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase the currency of that country from you one year from now at a discount of 13 percent. Would covered interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest arbitrage in this situation? (Ignore tax effects.) 10. Covered Interest Arbitrage. Assume the following information: Spot rate of Mexican peso=$0.100. 180-dayforward rate of Mexican peso = $.098 180-day Mexican interest rate = 6% 180-day U.S. interest rate = 5% Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos to invest? Explain your answer. ANSWER: To answer this question, begin with an assumed amount of pesos and determine the yield to Mexican investors who attempt covered interest arbitrage. UsingMXP1,000,000 as the initial investment: MXP1,000,000 $.100 = $100,000 (1.05) =$105,000/$.098 = MXP1,071,429 Mexican investors would generate a yield of about7.1% ([MXP1,071,429 MXP1,000,000]/MXP1,000,000), which exceeds their domestic yield. Thus, it is worthwhile for them.

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10th Edition 11. Covered Interest Arbitrage in Both Directions.

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The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible. ANSWER: To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed initial investment, such as $1,000,000. $1,000,000/$.50 = NZ$2,000,000 (1.06) = NZ$2,120,000 $.54 =$1,144,800 Yield = ($1,144,800 $1,000,000)/$1,000,000 = 14.48% Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S. interest rate of 10 percent. To determine the yield from covered interest arbitrage by New Zealand investors, start with an assumed initial investment, such as NZ$1,000,000:NZ$1,000,000 $.50 = $500,000 (1.10) = $550,000/$.54 = NZ$1,018,519 Yield =(NZ$1,018,519 NZ$1,000,000)/NZ$1,000,000 = 1.85% Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of 1.85% is less than the 6% that they could receive from investing their funds in New Zealand. 12. Covered Interest Arbitrage. Assume the following information: Spot rate of Canadian dollar $.80 90-day forward rate of Canadian dollar $.79 90-day Canadian interest rate 4% 90-day U.S. interest rate 2.5% Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage? ANSWER: $1,000,000/$.80 = C$1,250,000 (1.04) =C$1,300,000 $.79 = $1,027,000 International Corporate Finance Yield = ($1,027,000$1,000,000)/$1,000,000 = 2.7%, which exceeds the yield in the U.S. over the 90-dayperiod. The Canadian dollar's spot rate should rise, and its forward rate should fall; in addition, the Canadian interest rate may fall and the U.S. interest rate may rise. 13. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher last month than it is today. What does this imply about interest rate differentials between the United States and Europe today compared to those last month? ANSWER: The interest rate differential is smaller now than it was last month. 14. Covered Interest Arbitrage. Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible.

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ANSWER: Covered interest arbitrage involves the short-term investment in a foreign currency that is covered by a forward contract to sell that currency when the investment matures. Covered interest arbitrage is plausible when the forward premium does not reflect the interest rate differential between two countries specified by the interest rate parity formula. If transactions costs or other considerations are involved, the excess profit from covered interest arbitrage must more than off set these other considerations for covered interest arbitrage to be plausible. 15. Interest Rate Parity. If the relationship that is specified by interest rate parity does not exist at any period but does exist on average, then covered interest arbitrage should not be considered by U.S. firms. Do you agree or disagree with this statement? Explain. ANSWER: Disagree. If at any point in time, Interest rate parity does not exist, covered interest arbitrage could earn excess returns(unless transactions costs, tax differences, etc., offset the excess returns). 16. Triangular Arbitrage. Assume the following information: Quoted Price Value of Canadian dollar in U.S. dollars $.90 Value of New Zealand dollar in U.S. dollars $.30 Value of Canadian dollar in New Zealand NZ$3.02 Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage? ANSWER: Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand dollars. Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what it should be. One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this strategy would generate $1,006,667 thereby representing a profit of $6,667. [$1,000,000/$.90 = C$1,111,111 3.02 = NZ$3,355,556$.30 = $1,006,667] The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the Canadian dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the U.S. dollar would fall. 17. Changes in Forward Premiums. Assume that the Japanese yens forward rate currently exhibits a premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must this premium change to maintain interest rate parity? Why might we expect the premium to change? ANSWER: The premium will decrease in order to maintain IRP, because the difference between the interest rates is reduced. We would expect the premium to change because as U.S. interest rates Brac University

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decrease, U.S. investors could benefit from covered interest arbitrage if the forward premium stays the same. The return earned by U.S. investors who use covered interest arbitrage would not 100 International Corporate Finance be any higher than before, but the return would now exceed the interest rate earned in the U.S. Thus, there is downward pressure on the forward premium. 18. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it tobe plausible. ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two currencies differs from what it should be. The appropriate cross rate can be determined given the values of the two currencies with respect to some other currency. 19. Interest Rate Parity. Consider investors who invest in either U.S. or British one-year Treasury bills. Assume zero transaction costs and no taxes. a. If interest rate parity exists, then the return for U.S. investors who use covered interest arbitrage will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this statement true or false? If false, correct the statement. ANSWER: True b. If interest rate parity exists, then the return for British investors who use covered interest arbitrage will be the same as the return for British investors who invest in British Treasury bills. Is this statement true or false? If false, correct the statement. ANSWER: True 20. Locational Arbitrage. Assume the following information: Beal Bank Bid price of New Zealand dollar Ask price of New Zealand dollar $.401 $.404 Yardley Bank $.398 $.400

Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of locational arbitrage? ANSWER: Yes! One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401. With $1 million available,2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby generating a profit of $2,500. The large demand for New Zealand dollars at Yardley Bank will force this bank's ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Brac University

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Beal Bank will force its bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial. 21. Interest Rate Parity. Why would U.S. investors consider covered interest arbitrage in France when the interest rate on Euros in France is lower than the U.S. interest rate? ANSWER: If the forward premium on Euros more than offsets the lower interest rate, investors could use covered interest arbitrage by investing in Euros and achieve higher returns than in the U.S. 14. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, Locational arbitrage is possible; as it occurs, the spot rates among locations should become realigned.

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Chapter 8: Relationships among Exchange Rates, Inflation, and Interest Rates


1. PPP. Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of currencies in countries with high inflation? ANSWER: PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar. 2. Rationale of PPP. Explain the rationale of the PPP theory. ANSWER: When inflation is high in a particular country, foreign demand for goods in that country will decrease. In addition, that countrys demand for foreign goods should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that foreign countrys goods are no more attractive than the home countrys goods. Inflation differentials are offset by exchange rate changes. 3. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds. ANSWER: One method is to choose two countries and compare the inflation differential to the exchange rate change for several different periods. Then, determine whether the exchange rate changes were similar to what would have been expected under PPP theory. A second method is to choose a variety of countries and compare the inflation differential of each foreign country relative to the home country for a given period. Then, determine whether th exchange rate changes of each foreign currency were what would have been expected based on the inflation differentials under PPP theory. A limitation in testing PPP is that the results will vary with the base period chosen. The base period should reflect an equilibrium position, but it is difficult to determine when such a period exists. 4. Testing PPP. Inflation differentials between the U.S. and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP? ANSWER: The information suggests that there are other factors besides inflation differentials that influence exchange rate movements. Thus, the exchange rate movements will not necessarily conform to inflation differentials, and therefore PPP will not necessarily hold.

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10th Edition 5. Limitations of PPP. Explain why PPP does not hold.

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ANSWER: PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in perfect tandem with. In addition, there may not be substitutes for traded goods. Therefore, even when a countrys inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available. 6. Implications of IFE. Explain the international Fisher effect (IFE). What is the rationale for the existence of the IFE? What are the implications of the IFE for firms with excess cash that consistently invest in foreign Treasury bills? Explain why the IFE may not hold. ANSWER: The IFE suggests that a currencys value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currencys value if it occurs. The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold. 7. Implications of IFE. Assume U.S. interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if they believe in the IFE? ANSWER: The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased U.S. securities would on average receive a similar yield as what they receive in their own country, and U.S. investors that purchased foreign securities would on average receive a yield similar to U.S. rates. 8. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher effect (IFE). ANSWER: Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium (or discount). PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over

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time. IFE is based on nominal interest rate differentials, which are influenced by expected inflation. Thus, the IFE is closely related to PPP. 9. Real Interest Rate. One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean? ANSWER: The real return is the nominal return minus the inflation rate. If all investors require the same real return, then the differentials in nominal interest rates should be solely due to differentials in anticipated inflation among countries. 10. Interpreting Inflationary Expectations. If investors in the US & Canada require the same real interest rate and the nominal rate of interest is 2% higher in Canada, what does this imply about expectations of US inflation and Canadian inflation? What do these inflationary expectations suggest about future exchange rates ? Answer: 11. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inflation than the United States, while two other European countries that use the euro as their currency experience lower inflation than the United States. According to PPP, how will the Euros value against the dollar be affected? ANSWER: The high European inflation overall would reduce the U.S. demand for European products, increase the European demand for U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro's value would adjust in response to the weighted inflation rates of the European countries that are represented by the euro relative to the inflation in the U.S. If the European inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro. 12. Source of Weak Currencies. Currencies of some Latin American countries, such as Brazil and Venezuela, frequently weaken against most other currencies. What concept in this chapter explains this occurrence? Why dont all U.S.-based MNCs use forward contracts to hedge their future remittances of funds from Latin American countries to the U.S. even if they expect depreciation of the currencies against the dollar? ANSWER: Latin American countries typically have very high inflation, as much as 200 percent or more. PPP theory would suggest that currencies of these countries will depreciate against the U.S. dollar (another major currencies) in order to retain purchasing power across countries. The high inflation discourages demand for Latin American imports and places downward pressure in their Latin American currencies. Depreciation of the currencies offsets the increased prices on Latin American goods from the perspective of importers in other countries. Interest rate parity forces the forward rates to contain a large discount due to the high interest rates in Latin America, which reflects a disadvantage of hedging these currencies. The decision to hedge makes more sense if the Brac University

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expected degree of depreciation exceeds the degree of the forward discount. Also, keep in mind that some remittances cannot be perfectly hedged anyway because the amount of future remittances is uncertain. 13. PPP. Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yens value? Why does this expected relationship not always occur? ANSWER: Japans low inflation should place upward pressure on the yens value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yens value. 14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. ANSWER: If investors from the U.S. and Mexico required the same real (inflation-adjusted) return, then any difference in nominal interest rates is due to differences in expected inflation. Thus, the inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate. According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact formula, since the concept is stressed here more than precision.) 15. IFE. Shouldnt the IFE discourage investors from attempting to capitalize on higher foreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas? ANSWER: According to the IFE, higher foreign interest rates should not attract investors because these rates imply high expected inflation rates, which in turn imply potential depreciation of these currencies. Yet, some investors still invest in foreign countries where nominal interest rates are high. This may suggest that some investors believe that (1) the anticipated inflation rate embedded in a high nominal interest rate is overestimated, or (2) the potentially high inflation will not cause substantial depreciation of the foreign currency (which could occur if adequate substitute products were not available elsewhere), or (3) there are other factors that can offset the possible impact of inflation on the foreign currencys value. 16. Changes in Inflation. Assume that the inflation rate in Brazil is expected to increase substantially. How will this affect Brazils nominal interest rates and the value of its currency (called the real)? If the IFE holds, how

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will the nominal return to U.S. investors who invest in Brazil be affected by the higher inflation in Brazil? Explain. ANSWER: Brazils nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. If the IFE holds, the return to U.S. investors who invest in Brazil would not be affected. Even though they now earn a higher nominal interest rate, the expected decline in the Brazilian real offsets the additional interest to be earned. 17. Comparing PPP and IFE. How is it possible for PPP to hold if the IFE does not ? Answer: 18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent? ANSWER: According to PPP, the exchange rate of the pound will depreciate by 4.7 percent. Therefore, the spot rate would adjust to $1.73 [1 + (.047)] = $1.65. 19. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7percent in Singapore. What will the spot rate be in one year according to the IFE? (You may use the approximate formula to answer this question.) ANSWER: $.70 (1 + .04) =$.728 20. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is available:
USA U.S. Real rate of interest required by investors Nominal interest rate Spot rate One-year forward rate 2% 11% Mexico 2% 15% $.20 $.19

a. Use the forward rate to forecast the percentage change in the Mexican peso over the next year. ANSWER: ($.19 $.20)/$.20 = .05, or 5%

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b. Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year. ANSWER: 11% 15% = 4%; the negative sign represents depreciation of the peso. c. Use the spot rate to forecast the percentage change in the Mexican peso over the next year. ANSWER: zero percent change 21. Inflation and Interest Rate Effects. The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. a. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble. ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian goods would be low. Thus, the rubles value should depreciate against the dollar, and against other currencies. b. Does the effect of Russian inflation on the decline in the rubles value support the PPP theory? How might the relationship be distorted by political conditions in Russia? ANSWER: The general relationship suggested by PPP is supported, but the rubles value will not normally move exactly as specified by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the ruble may not decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the government may not allow the ruble to float freely to its proper equilibrium level. c. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the perspective of Russian consumers (after considering exchange rates)? Explain. ANSWER: Russian prices might be higher than U.S. prices, even after considering exchange rates, because the ruble might not depreciate enough to fully offset the Russian inflation. The exchange rate cannot fully adjust if there are barriers on trade or currency convertibility. d. Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S. importers? That is, how will U.S. importers of Russian goods be affected by the conditions? ANSWER: U.S. importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the rubles value. This may cause a reduction in the U.S. demand for Russian goods. 22. IFE Application to Asian Crisis. Before the Asian crisis, many investors attempted to capitalize on the high interest rates prevailing in the Southeast Asian countries although the level of interest rates primarily reflected expectations of Brac University

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inflation. Explain why investors behaved in this manner. Why does the IFE suggest that the Southeast Asian countries would not have attracted foreign investment before the Asian crisis despite the high interest rates prevailing in those countries? ANSWER: The investors' behavior suggests that they did not expect the international Fisher effect (IFE) to hold. Since central banks of some Asian countries were maintaining their currencies within narrow bands, they were effectively preventing the exchange rate from depreciating in a manner that would offset the interest rate differential. Consequently, superior profits from investing in the foreign countries were possible. If investors believed in the IFE, the Asian countries would not attract a high level of foreign investment because of exchange rate expectations. Specifically, the high nominal interest rate should reflect ahigh level of expected inflation. According to purchasing power parity (PPP), the higher interest rate should result in a weaker currency because of the implied market expectations of high inflation. 23. IFE Applied to the Euro. Given the recent conversion of several European currencies to the euro, explain what would cause the Euros value to change against the dollar according to the IFE. ANSWER: If interest rates change in these European countries whose home currency is the euro, the expected inflation rate in those countries change, so that the inflation differential between those countries and the U.S. changes. Thus, there may be an impact on the value of the euro, because a change in the inflation differential affects trade flows and therefore affects the exchange rate. 24. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3percent. Beth converts $100,000 to Euros and invests them in Germany. One year later, she converts the Euros back to dollars. The current spot rate of the euro is $1.10. a. According to the IFE, what should the spot rate of the euro in one year be? b. If the spot rate of the euro in one year is $1.00, what is Beths percentage return from her strategy? c. If the spot rate of the euro in one year is $1.08, what is Beths percentage return from her strategy? d. What must the spot rate of the euro be in one year for Beths strategy to be successful? ANSWER: a. ef (1 i h ) (1 i f ) (1 . 03 ) (1 .05 ) 1 1 1 . 90 % If the IFE holds, the euro should depreciate by 1.90 percent in one year. This translates to a spot rate of $1.10 (11.90%) = $1.079. b. 1. Convert dollars to Euros: $100,000/$1.10 = 90,909.09 2. Investors for one year and receive 90,909.09 1.05 = 95,454.55 3. Convert Euros back to dollars and receive 95,454.55 $1.00 = $95,454.55. The percentage return is$95,454.55/$100,000 1 = 4.55%. c. 1. Convert dollars to Euros: $100,000/$1.10 =90,909.09 2. Invest Euros for one year and receive 90,909.09 1.05 = 95,454.55 3.Convert Euros back to dollars and receive 95,454.55 $1.08 =

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$103,090.91. The percentage return is $103,090.91/$100,000 1 = 3.09%. d. Beths strategy would be successful if the spot rate of the euro in one year is greater than $1.079. 25. Integrating IRP and IFE. Assume the following information is available for the U.S. and Europe: U.S. Nominal interest rate Expected inflation Spot rate One-year forward rate 4% 2% Europe 6% 5% $1.13 $1.10

a. b. c. d.

Does IRP hold? According to PPP, what is the expected spot rate of the euro in one year? According to the IFE, what is the expected spot rate of the euro in one year? Reconcile your answers to parts (a). and(c).

ANSWER: a. 111 p (1 ih ) 1 (1 i f ) (1.04) 1 (1.06) 1.89%Therefore, the forward rate of the euro should be $1.13 (1 1.89%) = $1.109. IRP does not hold in this case. b. ef (1 I h ) 1 (1 I f ) (1.02) 1 (1.05) 2.86% According to PPP, the expected spot rate of the euro in one year is $1.13 (1 2.86%) = $1.098. c. ef (1 ih ) 1 (1 if ) (1.04) 1 (1.06) 1.89% According to the IFE, the expected spot rate of the euro in one year is $1.13 (1 2.86%) = $1.098. Parts a and c combined say that the forward rate premium or discount is exactly equal to the expected percentage appreciation or depreciation of the euro. 26. IRP. The one-year risk-free interest rate in Mexico is 10%.The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. a. What is the forward rate premium? b. What is the one-year forward rate of the peso? c. Based on the international Fisher effect, what is the expected change in the spot rate over the next year? d. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year? Brac University

10th Edition e. Compare your answers to (b) and (d) and explain the relationship. ANSWER: a. According to interest rate parity, the forward premium is (1 .02) 1 (1 .10) .07273 b. The forward rate is $.14 (1.07273) = $.1298.

Jeff Madura

c. According to the IFE, the expected change in the peso is: (1 .02) 1(1 .10) .07273 or 7.273% d. $.14 (1 .07273) = $.1298 e. The answers are the same. When IRP holds, the forward rate premium and the expected percentage change in the spot rate are derived in the same manner. Thus, the forward premium serves as the forecasted percentage change in the spot rate according to IFE. 27. Impact of Barriers on PPP and IFE. Would PPP be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungarys currency were allowed to float without any government intervention? Would the IFE be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungarys currency were allowed to float without any government intervention? Explain. ANSWER: Changes in international trade result from inflation differences and affects the exchange rate (by affecting the demand for the currency and the supply of the currency for sale).The effect on the exchange rate is more likely to occur if (a) free trade is allowed and (b)the currencys exchange rate is allowed to fluctuate without any government intervention. The underlying force of IFE is the differential in expected inflation between two countries, which can affect trade and capital flows. The effects on the exchange rate are more likely to occur if (a) free trade is allowed, and (b) the currencys exchange rate is allowed to fluctuate without government intervention. 28. Interactive Effects of PPP. Assume that the inflation rates of the countries that use the euro are very low, while other European countries that have their own currencies experience high inflation. Explain how and why the Euros value could be expected to change against these currencies according to the PPP theory. ANSWER: According to the PPP theory, the Euros value would increase against the value of the other European currencies, because the trade patterns would shift in response to the inflation differential. There would be an increase in demand for the euro by these other European countries that experienced higher inflation because they will increase their importing of products from those European countries whose home currency is the euro. 29. Applying IRP and IFE. Assume that Mexico has a one-year interest rate that is higher than the U.S. one-year interest rate. Assume that you believe in the international Fisher effect (IFE), and interest rate parity. Assume zero transactions costs.

Brac University

10th Edition

Jeff Madura

Ed is based in the U.S. and he attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of one year. Ed did not cover his position in the forward market. Maria is based in Mexico and she attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars one year forward, investing the dollars in a risk-free asset for a year, and then converting the dollars back to pesos at the end of one year. Do you think the rate of return on Eds investment will be higher than, lower than, or the same as the rate of return on Marias investment? Explain. ANSWER: Marias rate of return will be higher. Since interest rate parity exists, she will earn whatever the local risk-free interest rate is in Mexico. Eds expected rate of return is whatever the risk-free rate is in the U.S. (based on the IFE). 30. Arbitrage and PPP. Assume that locational arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound is $1.80. The spot rate of the Swiss franc is .3 pounds. You expect that the one-year inflation rate is 7 percent in the U.K., 5 percent in Switzerland, and 1 percent in the U.S. The one year interest rate is 6% in the U.K., 2% in Switzerland, and 4% in the U.S. What is your expected spot rate of the Swiss franc in one year with respect to the U.S. dollar? Show your work. ANSWER: SF spot rate in $ = 1.80 .3 = $.54. Expected %change in SF in one year = (1.01)/(1.05) 1 = 3.8% Expected spot rate of SF in one year = $.54 (1 .038) = $51.94 26. Comparing PPP and IFE. How is it possible for PPP to hold if the IFE does not? ANSWER: For the IFE to hold, the following conditions are necessary: (1) Investors across countries require the same real returns, (2) The expected inflation rate embedded in the nominal interest rate occurs, (3) the exchange rate adjusts to the inflation rate differential according to PPP. If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a foreign countrys securities. Thus, IFE would be refuted. 31. IRP versus IFE. You believe that interest rate parity and the international Fisher effect hold. Assume the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables of 1million New Zealand dollars that you will receive in one year. You could hedge the receivables with the oneyear forward contract. Or you could decide to not hedge. Is your expected U.S. dollar amount of the receivables in one year from hedging higher, lower, or the same as your expected U.S. dollar amount of the receivables without hedging? Explain. ANSWER: The expected amount is the same, because the forward rate reflects the interest rate differential, and the expected spot rate (if you do not hedge) according to IFE reflects the interest rate differential. Brac University

10th Edition 32. IRP, PPP, and Speculating in Currency Derivatives.

Jeff Madura

The U.S. three-month interest rate (unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. Interest rate parity exists. The expected inflation over this period is 5% in the U.S. and 2% in Canada. A call option with a three-month expiration date on Canadian dollars is available for a premium of $.02 and a strike price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing power parity. a. Determine the dollar amount of your profit or loss from buying a call option contract specifying C$100,000. ANSWER: The expected change in the Canadian dollars spot rate is: (1.05)/(1.02) 1 = 2.94%.Therefore, the expected spot rate in 3 months is $.65 (1.0294) = $.66911. The net profit per unit on a call option is $.66911 $.64 $.02 = $.00911. For the contract, the net profit is $.00911 100,000 = $911. b. Determine the dollar amount of your profit or loss from buying a futures contract specifying C$100,000. ANSWER: According to IRP, the futures rate premium should be (1.01)/(1.04) 1 = 2.88% Therefore, the futures rate should be $.65 (1 .0288) = $.6313. Recall that the expected spot rate in 3 months is$.65 (1.0294) = $.66911. The expected net profit per unit from buying a futures contract is $.66911 $.6313 = $.03781. For the contract, the net profit is $.03781 100,000 =$4,341.

Integrative Problem:
As an employee of the foreign exchange dept for a large company, you have been given the following info. Beginning of the year Spot rate of = $1.596. Spot rate of A$ = $.70. Cross exchange rate = A$2.28. 1 year forward rate of A$ = $.71. 1 year forward rate of = $1.58004. 1 year US interest rate = 8.00%. 1 year British interest rate = 9.09%. 1 year Australian interest rate = 7.00%. 1. Determine whether triangular arbitrage is feasible and if so how should b conducted to make a profit?

Brac University

10th Edition

Jeff Madura

Answer: triangular arbitrage is not feasible because the cross exchange rate between and A$ is properly specified. Proper cross exchange rate = $1.596/ $.7 = A$2.28. 2. Using the information in question 1; determine whether covered interest arbitrage is feasible and if so how it would be conducted to make a profit? Answer: covered interest arbitrage is only feasible when interest rate parity does not exist. To test whether interest rate parity exist, determine the forward premium that should exist for the pound and for the Australian dollar. Currency Forward premium that should exist P = ( 1 + ih) / ( 1+ if) 1 Pound = (1.08) / (1.0909) 1 = - 0.01 Actual Forward premium P = (F S) / S = $ ( 1.28004 1.596) / 1.596 = -0.01

Australian Dollar A$

P = ( 1.08) / ( 1.07) 1 = 0.0093

P = 0.71 0.70 / 0.70 = 0.1428

IRP exist for British pound. However, IRP doesnt exist for the A$. the actual forward premium is higher than it should be. US investors could benefit from the discrepancy by using covered interest arbitrage. The forward premium they would receive when selling A$ at the end of the year more than offsets the interest rate differential. While the US investors receive 1% less interest on the Australian investment, they receive 1.428% more when selling A$ than they initially pay for A$. 3. Based on the information question 1 for the beginning of the year, use IFE theory to forecast the annual % change in the British pounds value over the year? Answer: The IFE suggest that given 2 currencies, the currency with a higher interest rate reflects higher expected inflation, which will place downward pressure on the value of that currency. The currency adjustment will offset the differential in interest rate. ef = (1 + ih) / (1+ if) 1 = (1 + .08) / (1 + .0909) 1 = -0.01 or -1% Thus, the pound was expected to depreciate by 1% over the year, based on IFE. 4. Assume that at the beginning of the year, the pounds value is in equilibrium. Assume that over the year the British inflation rate in 6% while the US inflation rate is 4%. Assume that any change in the pounds value due to the inflation differential has covered by the end of the year. Using this information and the information provided in Q1, determine how the pounds value changed over the year.

Brac University

10th Edition Answer: If PPP held, the pound would have changed to ep = (1 + Ih ) / ( 1 + If ) 1 = 1.04 / 1.06 1 = -0.189 or -1.89%

Jeff Madura

5. Assume that the pounds depreciation over the year was attributed directly to central bank intervention. Explain the type of direct intervention that would place downward pressure on the value of the pound. Answer: If central banks used to purchase the dollar in the forex, they would downward pressure on the pounds value.

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