MGT 3460 Assignment #1 Questions and Solutions 1.

How is international financial management different from domestic financial management? Answer: There are three major dimensions that set apart international finance from domestic finance. They are: 1. foreign exchange and political risks, 2. market imperfections, and 3. expanded opportunity set. We are now living in a world where all the major economic functions, i.e., consumption, production, and investment, are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a situation that existed when the authors of this book were learning finance some twenty years ago. At that time, most professors customarily (and safely, to some extent) ignored international aspects of finance. This mode of operation has become untenable since then. 2. State the theory of comparative advantage. From the following table calculate the opportunity costs for each country A and B of producing goods X and Y with a unit of generalized input K. Draw the production possibility boundaries for each country. Draw the consumption (trade) possibilities boundary for each on the PPB graphs assuming that the terms of trade are 50/50 (.5). What considerations might limit the extent to which the theory of comparative advantage is realistic? According to David Ricardo, with free international trade, it is mutually beneficial for two countries to each specialize in the production of the goods that it can produce relatively most efficiently and then trade those goods. By doing so, the two countries can increase their combined production, which allows both countries to consume more of both goods. This argument remains valid even if a country can produce both goods more efficiently than the other country. International trade is not a ‘zero-sum’ game in which one country benefits at the expense of another country. Rather, international trade could be an ‘increasing-sum’ game at which all players become winners. The theory claims that economic well-being is enhanced if each country’s citizens produce what they have a comparative advantage in producing relative to the citizens of other countries, and then trade products. Country A B Units of input (000,000) K Output per unit of input X Y

100 200 50 30 20 10

5 |Slope| = .What considerations might limit the extent to which the theory of comparative advantage is realistic? Answer: Underlying the theory are the assumptions of free trade between nations and that the factors of production (land.67) 3000 PPC |Slope| = .5) PPC 2 .6 The PPC slope for Country 4000 X (Opp cost = . To the extent that these assumptions do not hold.5 The PPC slope for Country TPC Trade Possibilities Curve: |Slope| = .6) Production & Trade Possibilities Country B Y (Opp cost = 2) 2000 TPC Trade Possibilities Curve: |Slope| = . Country A can produce Y more efficiently (lower cost) and Country B can produce X more efficiently. labor.55 5000 X (Opp cost = .6 |Slope| = . with the respective opportunity costs for each good in each country. technology. CountryA Y (Opp cost = 1.55 |Slope| = . Therefore the trade possibilities curves (dashed lines) at 50/50 sharing terms of trade start at the good each country will specialize in and expand out beyond the PPC. buildings. the theory of comparative advantage will not realistically describe international trade. The figure below shows the PPC for each country. and capital) are relatively immobile and there is full employment.

S. eventually eliminating the initial BOP disequilibrium. countries may pursue economic policies (like de-monetization of gold) that are incompatible with the gold standard. Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted.. Consequently. U. (2) any BOP disequilibrium can be corrected automatically through cross-border flows of gold.K. (ii) the gold standard itself has no mechanism to enforce the rules of the game. to the U. (U. Bush stated that while tougher laws might help. On the other hand. Suppose that the U. balance of payments. As a result. a balance of payment disequilibrium will be corrected by a counter-flow of gold.K. imports more from the U. 5. This means that the price level will tend to fall in the U.) will experience a decrease (increase) in money supply. 3 . President George W. than it exports to the latter. as a result. Since we cannot fully depend on the ethical behavior on the part of business leaders.K. and. the U. What would be the effect of transactions costs on your answer? Answer: As with anything bought and sold. as opposed to enforcement. The adjustment mechanism under the gold standard is referred to as the price-specie-flow mechanism expounded by David Hume. See graph below for illustration using the supply and demand model. Enron and WorldCom. products become less competitive.K. countries cannot have high inflation. This change will improve U. and rise in the U. will flow from the U.S. gold.” Describe your view on this statement. the U. if exchange rates are different in different markets yet are ‘fixed’ by each country there is an opportunity for arbitrage— the process of buying in the low priced market and selling in the high priced market and pocketing the difference as profit. many of the corporate scandals we have seen lately might not have happened. e. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.K.3.S. Under the gold standard. the main disadvantages of the gold standard are: (I) the world economy can be subject to deflationary pressure due to restricted supply of gold. products become more competitive in the export market. Emphasizing the importance of voluntary compliance. the society should protect itself by adopting the rules/regulations and governance structure that would induce business leaders to behave in the interest of the society at large. balance of payments and at the same time hurt the U.K.g. in the aftermath of corporate scandals.S. Answer: [There can be different answers to this question] If business leaders always behave with a high ethical standard. Under the classical gold standard. which is the only means of international payments.S.S. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.S. 4. the ethics of American business depends on the conscience of America’s business leaders. “ultimately. Explain the arbitrage process when fixed exchange rates have differing prices and illustrate your answer with the supply and demand model. What are the advantages and disadvantages of the gold standard. while U.

the reserve-currency country should run BOP deficits to supply reserves to the world economy. as in the case of France redeeming gold for large amounts of US$. (ii) smooth adjustments to BoP disequilibriums as they arise. bringing a common price (except transaction costs). What are the criteria for a ‘good’ international monetary system? Answer: A good international monetary system should provide (i) sufficient liquidity to the world economy. Under the gold-exchange system. What do you consider determines the possibility for the euro to become another global currency rivaling the U.S. but if the deficits are large and persistent.Arbitrage Market A P P Pe A Market B S S* D PB P S D* D Y* Sell in the high market QY S Y* Buy in the low market D QY Arbitrage brings markets together over space. Why did the Bretton Woods system fail? Answer: The answer to this question is related to the Triffin paradox. they can lead to a crisis of confidence in the reserve currency itself. The US was providing the world with currency using the $35/ounce gold standard. dollar? If the euro really becomes a global currency. what impact will it have on the U. 8. and (iii) safeguard against the crisis of confidence in the system—A banker of last resort. 7. dollar and the world economy? 4 . 6.S. eventually causing the downfall of the system when there is a “run” on the bank.

10. For example. 12. Official reserve assets are those financial assets that can be used as international means of payments. can run trade deficits without having to maintain substantial foreign exchange reserves. In light of the large transactions domain of the euro. due to ballooning federal budget deficits that kept the dollar strong and weak competitiveness of the U. Japan is an example of a country keeping the Yen low to promote exports and capital export. etc. Second. If Europe becomes politically more integrated. which is comparable to that of the U.S.S. Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. and (iv) reserve positions with the IMF. Explain how a country can run an overall balance of payments deficit or surplus. dollarbased agents will start to bear more exchange risk. if a country is experiencing perennial BoP deficits. What are the short-term and long-term effects of foreigners’ investment on the Canadian balance of payments? Illustrate with BoP accounts.S. Currently. If the euro is to be used as a major denomination. an overall BOP surplus can be absorbed by adding to the central bank’s reserve holdings. the euro is more likely to become a global currency. among other things. the U. Foreign exchanges are by far the most important official reserves.S. reflect an historically high real interest rate in the U. Currently. Is it desirable to have continuous current account surpluses? Answer: Continuous current account surpluses appear positive as export industries thrive however the surpluses are maintained by an artificially low FX rate and may reflect (and cause) low productivity. First. If the euro becomes a global currency. BoP data can be used to evaluate the performance of the country in international economic competition. A major uncertainty about this prospect is the lack of political integration of Europe. It is not desirable especially when it is brought about by the mercantilist (export all you can) policies. For example. can carry out international commercial and financial transactions in dollars without bearing exchange risk. For example.S. Likewise. industries. and the mandate for the European Central Bank (ECB) to guarantee the monetary stability in Europe. current account deficits of U. BoP provides detailed information about the supply and demand of the country’s currency. Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions.Answer: The degree of use of the Euro in Europe and the in the world. official reserve assets comprise: (I) gold. derives substantial benefits from the dollar’s status as the dominant global currency – for instance. an overall BOP deficit can be supported by drawing down the central bank’s reserve holdings. it may signal that the country’s industries lack competitiveness. reserve. 9. it will come at the expense of the dollar.S. the euro is likely to become another global currency over time. Foreigners have invested significantly in both direct and portfolio investments in Canada. and invoice currency in the world economy. Why is it useful to examine a country’s balance of payments data? Answer: It would be useful to examine a country’s BoP for at least two reasons. dollar.. 11. (iii) special drawing rights (SDRs). 5 . the U. (ii) foreign exchanges.

Answer: _________________________________________________________________ Transactions Credit Debit _______________________________________________________________ American purchase of Cdn bonds √ American payment using Toronto account √ Cdn. Account Credit Debit _______________________________________________________________ Capital Direct investment in a Canada √ Portfolio Investment in Canada √ Current Investment Income paid to foreigners √ _______________________________________________________________ 13. A Canadian consumes a meal at a restaurant in Paris and pays with her VISA card. payments of investment income (negative) on long term investment will occur every year in the current account.Answer: Direct and portfolio investment by foreigners in Canada are positives in the BoP capital account in the year they are received (short term effect). √ _________________________________________________________________ 6 . citizen having a meal in Paris Paying the meal with Visa Gift to parents in Bombay Receipts of the cheque by parents (goodwill) √ √ √ √ Export of programming service √ British payment out its account in Canada. c. A computer programmer is hired by a British company for consulting. An Indian immigrant living in Calgary sends a cheque drawn on his Royal Bank account as a gift to his parents living in Bombay. An American insurance company purchases Cdn bonds and pays out of its bank account kept in Toronto. b. However. d. Using a table indicate how each of the following transactions will be classified and recorded in the debit and credit of the Canadian balance of payments: a.

8 Interest payments -11.9 Profit remittances -1.765.3 Exports (merchandise) 160.4 Balance 7 0 .0 External debt guarantees 1.612.994.947.235.377.058.0 Foreign investment (total) 12.1 Credits to non-residents 190. Hint: search the IMF or other websites for the data. CAPITAL ACCOUNT BALANCE 20.148.619.5 Non-financial private sector 779.0 Imports (merchandise) -168.5 Investment income 405.6 Banco de México 3/ 0.9 Financial services (net) -12.1 Excursionists (net) -1.6 Other services and transfers (net) 9.8 Assets 11.2 Loans and deposits -3.1 E. Answer: The data was found at the Mexican Ministry of Finance and Debt site: http://www. VALUE AND EXCHANGE ADJUSTMENTS -14.1.3 In foreign banks 10.8 Other 637.883.133. CHANGES IN NET INTERNATIONAL RESERVES 7.255. and interpret the data. ERRORS AND OMISSIONS 770.0 Commercial banks 498.104.220.678.html Total Year 2002* A.5 Liabilities 8.3 Mexican direct investment -969.495.824.682.6 Development banks -545. CURRENT ACCOUNT BALANCE -14. Construct the balance of payment table for Mexico for the year of 2002 which is comparable in format to Exhibit 3.7 Non-financial public sector -1.773.gob.shcp.14.9 Transportation and insurance (net) -5.2 B.3 D.3 C.0 Tourism (net)

Foreign Exchange Market $Cdn S S* P e D QS QD Q* 8 FE . as illustrated in the following graph. The FE market will reach equilibrium and the dollar will depreciate. If a country balance of payments is running a deficit in a flexible exchange rate environment explain using supply and demand the effect on the exchange rate. Answer: As illustrated in the graph below. This will cause imports to fall and exports to rise bringing the BoP into balance. What should the monetary authorities do if the wish to maintain the current exchange rate. the quantity demanded of foreign exchange is greater than the quantity supplied QD > QS as there is a Balance of Payments deficit.15. Foreign Exchange Market $Cdn S Pe P D QS Q* QD FE If the Bank of Canada wishes to maintain the current exchange rate it could increase the supply of foreign currencies by selling some of its reserves.

3440/$1. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars.S. Show how you can make a triangular arbitrage profit by trading at these prices.000= $5.) Assume you have $5.0242/$1.3436-CD1. 18. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity? Answer: Triangular arbitrage is the process of trading out of the U. you notice that Dresdner Bank is quoting €1. in many instances for hedging purposes. the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. a triangular arbitrage profit is possible. To illustrate. Most.0242. What is implied about the trader’s beliefs by his prices? Answer: The trader must think the Canadian dollar is going to appreciate against the U.6750. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency.00 and offering to sell from inventory at the slightly lower than market price of CD1. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate. Certain banks specialize in making a direct market between non-dollar currencies. (Ignore bid-ask spreads for this problem.S. with a current €/SF quote of .0242/$1. What happens if you initially sell dollars for Swiss francs? What €/SF price will eliminate triangular arbitrage? Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5. 9 .00 and Credit Suisse is offering SF1.000. dollar into a second currency. You learn that UBS is making a direct market between the Swiss franc and the euro.000 with which to conduct the arbitrage. but not all.00.00. dollars.00. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward. 17. A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40. which is in turn traded for U. The bank will lend the dollars for three months until they are needed to deliver against the dollars it has sold forward.5030/$1. If their direct quotes are not consistent with the cross exchange rates.S.16.000 to Dresdner Bank at €1.3435/$1.3441.000. 19.S. Assume you are a trader with Deutsche Bank. dollars by standing willing to buy $ at only CD1. This trade would yield €5. Nevertheless. then trading it for a third currency. suppose a bank customer wants to buy dollars three months forward against British pound sterling. when the rest of the market is trading at CD1. pricing at a narrower bid-ask spread than the cross-rate spread. How can the bank eliminate the currency exposure it has created for itself by accommodating a client’s forward transaction? Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade.000 x 1. currency transactions go through the dollar.000. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U. From the quote screen on your computer terminal.121. The British pounds received will be used to liquidate the sterling loan.

the trade would yield SF7.667 = €5.0242.00.6750.625= SF7.52/£ in three months. 10 . or a loss of $47.000 x ($1. That is.952. This is an equilibrium rate at which a triangular arbitrage profit will not exist. i. you are pretty confident that the spot exchange rate will be $1.515.00 instead of the higher no-arbitrage rate of €0.000.000 = £1. instead of euros. yielding SF7.52/£ in three months.683.£ in three months.000 x .50). Assume that you would like to buy or sell £1.6750/SF1.121.5030 = . Answer: If you believe the spot exchange rate will be $1.683 = SF7.46/£.6750/SF1.000/.e. Based on your analysis of the exchange rate.50/£.000.50).00. The S(€/SF) cross exchange rate should be 1. The euros would be resold to Dresdner Bank for $4.232.0242/1. Swiss francs are purchased for only €0. yielding a triangular arbitrage profit of $47.50/£. 20.6750. (The student can determine this for himself. your loss from the long position will be: -$40. resulting in too few euros. you should buy £1.072.6750/SF1.515.000 = $5. If the Deutsche Bank trader initially sold $5. If the spot exchange rate actually turns out to be $1.000.6814.5030.000 x 1.000 = £1.55/£ and the three-month forward rate is $1.000.000 for Swiss francs.667/1. it is necessary to conduct the triangular arbitrage in the correct order. an arbitrage loss results because Swiss francs are sold for euros at too low a rate. when dollars are first sold for Swiss francs. Your expected profit will be: $20.000 forward for $1.000. Thus.6814/SF1. The Swiss francs would in turn be traded for euros to UBS for €5.The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of €0.000 x ($1.46 -$1.586. each Swiss franc is sold for €0.00 instead of the no-arbitrage rate of €0. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation? What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.768 = €5.6814/SF1.52 -$1..000.) A profit results from the triangular arbitrage when dollars are first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate. Similarly. The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for $5. The current spot exchange rate is $1.586.

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