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Assignment No. 7

(Chapter 8)

Prepared for: Mrs. Syeda Mahrufa Bashar Assistant Professor Course Instructor: International Finance

Prepared by: Mashrur Rahman Khan Adib Iqbal Shah Shihab Sadman Al-Imran Bin Khodadad Nazika Nazmin Choudhury BBA 18th ZR-11 ZR-12 ZR-27 ZR-46 RH-57

Question 1

What is the relationship between the exchange rates and relative inflation levels of the two countries? How will this relationship affect Blades Thai revenue and costs given that the baht is freely floating? What is the net effect of this relationship on Blades?

## The relationship between exchange rates and relative inflation rate:

The relationship is summarized by the purchasing power parity (PPP) theory. Suppose, one countrys inflation rate rises relative to that of another. So, the former countrys exports will decline due to higher prices and thus the demand for its currency will also decline. Additionally, the countrys consumers and businesses will look for increased importing in order to compensate for the rise in inflation. The absolute form of PPP suggests that prices of the same basket of products in two different countries should be equal when measured in a common currency. If a discrepancy in prices as measured by a common currency exists, the demand should shift so that these prices converge. The relative form of PPP states that because of various market imperfections, prices of the same basket of products in different countries will not necessarily be the same when measured in a common currency. However, the rate of change in the prices of the baskets should be somewhat similar when measured in a common currency, as long as the transportation costs and trade barriers are unchanged. Both forms of the theory suggest that the currency of the country with the higher level of inflation should depreciate to offset the inflation differential.

## Effect on Blades Thai Revenue:

In the given case, high inflation levels is prevailing in Thailand. Thus the demand for its currency, baht will decrease. Since the baht has become a freely floating currency, according to the theories of PPP, the currency should be expected to depreciate. This depreciation will negatively affect Blades 10% revenue generation from Thailand. Blades needs to either increase its prices if not increase exports, to compensate for the negative effect. Blades fixed and baht-denominated export arrangement makes it impossible for Blades to increase its prices according to Thai levels of inflation. On the other hand, Blades cost of goods sold generated in Thailand will increase as Thai exporters would adjust their prices according to Thai inflation rates. However, the high prices resulting from high levels of inflation in Thailand may be somewhat offset by a depreciation of the baht.

The net effect of the relationship between exchange rates and relative inflation rates, on Blades can be concluded as- since Blades generates net cash inflows from its Thai operations, it will be negatively affected by PPP. Although, the inflation differential may be somewhat offset in the long run.

Question 2

What are some of the factors that prevent PPP from occurring in the short run? Would you expect PPP to hold better if countries negotiate trade arrangements under which they commit themselves to the purchase or sale of a fixed number of goods over a specified time period? Why or why not?

## Factors disapproving PPP in the Short Run:

PPP may not hold because exchange rates are affected by other factors in addition to the inflation differential between two countries, such as relative interest rates, national income levels, government controls, expectations etc. Furthermore, PPP does not consistently occur because of confounding effects and because of a lack of substitutes for some traded goods. Thus, the trade relationships between two countries for these goods may not be affected by inflation rate differentials in the manner suggested by PPP.

## PPP Application in Trade Agreements

Between firms of countries with differing inflation rates, arrangements to purchase a fixed number of goods over a specified period of time will cause PPP not to hold, at least in the short run. Because contractual agreements are not easily terminated. Such agreement will restrain firms to adjust prices according to change in inflation rates causing a delayed impact of inflation rates on trade relationships and, consequently, exchange rates. Also, inflation rate fluctuations occur in an indiscriminate manner, they can happen frequently within a short period of time and can also stay stable for another period. Contractual agreements will possess possibilities of facing multiple inflation rate fluctuations, in both cases short term agreements and long term agreements.

Question 3

How do you reconcile the high level of interest rates in Thailand with the expected change of the baht-dollar exchange rate according to PPP?

## Answer to the question number: 3

A way to reconcile the interest rate difference is to consider the possible effects on two currencies, one of which is subject to extreme interest rate and inflation conditions. High levels of real interest rates in a given country may increase the demand for that countrys currency as foreign investors can earn higher rates of return in the foreign country than may be available domestically. This would place upward pressure on the currency of the country with the higher level of real interest rates. However, according to the International Fisher Effect (IFE), nominal risk-free interest rates contain a real rate of return and anticipated inflation. If investors of all countries require the same real return, interest rate differentials between countries may be the result of differentials in expected inflation. So, the high level of nominal interest rates in Thailand are primarily the result of high expected levels of Thai inflation. Therefore, according IFE, the Thai baht should depreciate by an amount sufficient to offset the nominal interest rate differential between Thailand and the U.S.

Question 4
Given Blades future plans in Thailand, should the company be concerned with PPP? Why or why not?

## Answer to the question number: 4

Studies and instances show that purchasing power parity (PPP) has not held over certain periods, especially in the short run. Although it has been found to hold reasonably well in the long run. Since Blades is under a three-year export arrangement with Entertainment Products, Inc. and since it is considering the expansion into Thailand, the company should be concerned with PPP. In the long run, the relatively high level of Thai inflation may result in a depreciation of the baht sufficient to offset the inflation differential. Yet, Blades will be able to renegotiate its arrangement once the three-year period for the existing arrangement is over.

Question 5

PPP may hold better for some countries than for others. The Thai baht has been freely floating for more than a decade. How do you think Blades can gain insight into whether PPP holds for Thailand? Offer some logic to explain why the PPP relationship may not hold here.

## Answer to the question number: 5

Given the economic and financial structure of a country or depending on which level of development the country is currently in, the PPP may hold better or worse for a country. This can be judged by examining the correlation between exchange rate changes and inflation based on historical. The higher the degree of correlation, the more likely it is that PPP will hold for that particular country. Examining the historical trends of currency exchange rate and inflation for correlation is how Blades can gain insight into whether PP will hold for Thailand. However, the PPP relationship may not hold because other factors (e.g. interest rates, General level of income, Government intervention or speculation about currency price) also influence the baht exchange rate.