Chapter 4

As the chief financial officer of Blades, Inc., Ben Holt is pleased that his current system of exporting
“Speedos” to Thailand seems to be working well. Blades’ primary customer in Thailand, a retailer called
Entertainmens Products, has committed itself to purchasing a fixed number of Speedos annually for the next 3
years at a fixed price denominated in baht, Thailand’s currency. Furthermore, Blades is using a Thai supplier
for some of the components needed to manufacture Speedos. Nevertheless, Holt is concerned about recent
developments in Asia. Foreign investors from various countries had invested heavily in Thailand to take
advantage of the high interest rates there. As a result of the weak economy in Thailand, however, many foreign
investors have lost confidence in Thailand and have withdrawn their funds. Holt has two major concerns
regarding these developments. First, he is wondering how these changes in Thailand’s economy could affect
the value of the Thai baht and, consequently, Blades. More specifically, he is wondering whether the effects on
the Thai baht may affect Blades even though its primary Thai customer is committed to Blades over the next 3
years. Second, Holt believes that Blades may be able to speculate on the anticipated movement of the baht, but
he is uncertain about the procedure needed to accomplish this. To facilitate Holt’s understanding of exchange
rate speculation, he has asked you, Blades’ financial analyst, to provide him with detailed illustrations of two
scenarios. In the first, the baht would move from a current level of $.022 to $.020 within the next 30
days.Under the second scenario, the baht would move from its current level to $.025 within the next 30 days.
Based on Holt’s needs, he has provided you with the following list of questions to be answered:

How are percentage changes in a currency’s value measured? Illustrate your answer numerically by assuming a
change in the Thai baht’s value from a value of $.022 to $.026.

Currency’s value can be measured for percentage changes using the below formula

Under the mathematical framework, S is meant to represent the spot rate and St−1 is meant to represent the
spot rate from an earlier date in time. Utilizing the aforementioned formula and assuming the Thai baht’s value
changes from $0.022 to $0.026 the percentage change is 18.18%. This would mean the Thai baht appreciated
in value by 18.18%

Utilizing the aforementioned formula and assuming the Thai baht’s value changes
from $0.022 to $0.026 the percentage change is 18.18%. This would mean the Thai
baht appreciated in value by 18.18%
2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship
between these factors?

= The value of a currency can be determined by two fundamental factors, used in many economic applications,
which are the supply of the currency and the demand for the currency. As often the case with an increase in
supply, the value of the good/service (in this case currency) will decrease in value. Contrariwise, if there is
ahigh demand for currency the opposite holds true; the currency will often increase in value. In equilibrium,
the supply of currency and demand for the currency will equal one another.

3. How might the relatively high levels of inflation and interest rates in Thailand affect the baht’s value.
(Assume a constant leve Given the constant level of U.S. inflation and interest rates, the baht’s value would be
greatly affected in Thailand. As is typical for high levels of inflation, Thailand will see its currency depreciate
in value. Due to this depreciation, Thailand will alsosee an increase in demand for U.S. goods. This would, in
turn, cause an increase in the Thai demand for dollars. When examining a relatively high level of inflation in
Thailand, the opposite occurs. The U.S. would reduce its demand for Thai goodsl of U.S. inflation and interest
rates.)

= Given the constant level of U.S. inflation and interest rates, the baht’s value would be greatly affected in
Thailand. As is typical for high levels of inflation, Thailand will see its currency depreciate in value. Due to
this depreciation, Thailand will also see an increase in demand for U.S. goods. This would, in turn, cause an
increase in the Thai demand for dollars. When examining a relatively high level of inflation in Thailand, the
opposite occurs. The U.S. would reduce its demand for Thai goods which would result in an increase in supply
for the Thai Baht. However, this is only one of two economic outcomes.

A high level of interest rate in Thailand also has the potential to result in the baht appreciating in value
(relative to the dollar). U.S. investors would have been more attracted to Thailand in terms of investment. The
increase in U.S. investors in the Thai market would cause the demand for baht to increase as well.
Additionally, the supply of dollars would also increase, as Thailand’s investors would be less attracted to U.S.
investments e.g. securities. Give these factors; U.S. investors might still be reluctant to invest in Thailand’s
securities. The idea of the baht depreciating in value due to Thailand’s inflation may be cause for U.S.
investors to reconsider investing in Thailand.

4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from
Thailand, will affect the baht’s value? Would Blades be affected by the change in value, given the primary
Thai customer’s commitment?

= As is the case with many currencies, the loss in confidence in the Thai baht would cause a depreciation in its
value. When there is a loss of confidence, it can be said that investors are not satisfied that their investments
will prove lucrative in the current market. In which case, investors will often liquidate their investments in the
market. The same holds true for Thailand’s baht. Investors will liquidate their investments in the baht, which
will cause the supply of the baht to increase in the market.

Blades would also be greatly affected by the change of value in Thailand’s currency. The sales for the
company are held, for the majority, in the foreign currency baht. As previously aforementioned, when their
increase in the supply of baht in the market, the price for the baht depreciates. The company is now at a loss in
profit because of the new exchange rate. The company will receive less in terms of U.S. dollars for the
exchange of their baht

5. Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its country in order to
prevent further changes in the currency’s value. How could it accomplish this objective using interest rates?

= If Thailand’s central bank is looking to prevent any further withdrawal of funds from the country, it is
looking to stop the depreciation in the baht. In order to do so, Thailand would have to increase the interest rates
within the country. This would cause internal spending or borrowing to decrease, but Thailand’s investments
(e.g. securities) would now become more appealing to U.S. investors. Having this influx of U.S. investors
would cause demand for the baht to increase. The demand for the baht would cause its value to increase
(appreciate) and would solve the problem of funds being withdrawn from the country.
 Chapter 6

Recall that Blades, the U.S. manufacturer of roller blades, generates most of its revenue and incurs most of its
expenses in the United States. However, the company has recently begun exporting roller blades to Thailand.
The company has an agreement with Entertainment Products, Inc., a Thai importer, for a 3-year period.
According to the terms of the agreement, Entertainment Products will purchase 180,000 pairs of “Speedos,”
Blades’ primary product, annually at a fixed price of 4,594 Thai baht per pair. Due to quality and cost
considerations, Blades is also importing certain rubber and plastic components from a Thai exporter. The cost
of these components is approximately 2,871 Thai baht per pair of Speedos. No contractual agreement exists
between Blades, Inc., and the Thai exporter.

Consequently, the cost of the rubber and plastic components imported from Thailand is subject not only to
exchange rate considerations but to economic conditions (such as inflation) in Thailand as well. Shortly after
Blades began exporting to and importing from Thailand, Asia experienced weak economic conditions.
Consequently, foreign investors in Thailand feared the baht’s potential weakness and withdrew their
investments, resulting in an excess supply of Thai baht for sale. Because of the resulting downward pressure on
the baht’s value, the Thai government attempted to stabilize the baht’s exchange rate. To maintain the baht’s
value, the Thai government intervened in the foreign exchange market. Specifically, it swapped its baht
reserves for dollar reserves at other central banks and then used its dollar reserves to purchase the baht in the
foreign exchange market. However, this agreement required Thailand to reverse this transaction by exchanging
dollars for baht at a future date. Unfortunately, the Thai government’s intervention was unsuccessful, as it was
overwhelmed by market forces. Consequently, the Thai government ceased its intervention efforts, and the
value of the Thai baht declined substantially against the dollar over a 3-month period. When the Thai
government stopped intervening in the foreign exchange market, Ben Holt, Blades’ CFO, was concerned that
the value of the Thai baht would continue to decline indefinitely. Since Blades generates net inflow in Thai
baht, this would seriously affect the company’s profit margin. Furthermore, one of the reasons Blades had
expanded into Thailand was to appease the company’s shareholders. At last year’s annual shareholder meeting,
they had demanded that senior management take action to improve the firm’s low profit margins. Expanding
into Thailand had been Holt’s suggestion, and he is now afraid that his career might be at stake. For these
reasons, Holt feels that the Asian crisis and its impact on Blades demand his serious attention. One of the
factors Holt thinks he should consider is the issue of government intervention and how it could affect Blades in
particular. Specifically, he wonders whether the decision to enter into a fixed agreement with Entertainment
Products was a good idea under the circumstances. Another issue is how the future completion of the swap
agreement initiated by the Thai government will affect Blades. To address these issues and to gain a little more
understanding of the process of government intervention, Holt has prepared the following list of questions for
you, Blades’ financial analyst, since he knows that you understand international financial management.

1. Did the intervention effort by the Thai government constitute direct or indirect intervention?

= The intervention effort by the Thai government constituted direct intervention, since the government
exchanged dollar reserves for baht in order to strengthen the currency. This action
would increase the demand for baht and the supply of dollars for sale, which puts upward pressure on the baht.
In indirect intervention, a central bank attempts to influence the value of a currency
by influencing the factors that determine it. For example, if the Thai government wanted to strengthen the baht,
it could have increased interest rates by decreasing the Thai money supply.

2. Did the intervention by the Thai government constitute sterilized or nonsterilized intervention?
What is the difference between the two types of intervention? Which type do you think would be more
effective in increasing the value of the baht? Why? (Hint: Think about the effect of nonsterilized intervention
on U.S. interest rates.)

= The intervention by the Thai government constituted nonsterilized intervention. Using nonsterilized
intervention, a central bank intervenes in the foreign exchange market without adjusting for the change in
money supply.
Using sterilized intervention, a central bank intervenes in the foreign exchange market while retaining the
money supply.

Since the Thai government exchanged dollar reserves for baht in the foreign exchange market, the dollar
money supply is increased. An increase in the money supply may decrease U.S. interest rates, which may
additionally weaken the dollar with respect to the baht. Therefore, nonsterilized intervention may compound
the desired effects of the intervention effort. If the Thai government’s objective is to increase the value of the
baht, nonsterilized intervention may be more effective.

3. If the Thai baht is virtually fixed with respect to the dollar, how could this affect U.S. levels of inflation? Do
you think these effects on the U.S. economy will be more pronounced for companies such as Blades that
operate under trade arrangements involving commitments or for firms that do not? How are companies such as
Blades affected by a fixed exchange rate?

= Under a fixed exchange rate system, inflation may be exported from one country to another. For example, if
Thailand experienced relatively high levels of inflation during a fixed exchange rate system, Thai consumers
may have switched some of their purchases to U.S. products. Similarly, U.S. consumers may have reduced
their imports of Thai goods. This would send Thai production down and unemployment up. Also, it could
cause higher inflation in the U.S. due to the excessive demand for U.S. products. Thus, the high inflation in
Thailand could cause high inflation in the U.S. For companies such as Blades, this effect would probably be
more pronounced as their cost of production would rise, but they export at a fixed price.

4. What are some of the potential disadvantages for Thai levels of inflation associated with the floating
exchange rate system that is now used in Thailand? Do you think Blades contributes to these disadvantages to
a great extent? How are companies such as Blades affected by a freely floating exchange rate?

= A freely floating exchange rate may compound Thailand’s inflationary problems. For example, if Thailand
experiences high levels of inflation, the baht may weaken. In turn, a weaker baht can cause import prices to be
higher, which can increase the prices of Thai materials and supplies and thus increase the price of finished
goods. Additionally, higher foreign prices (from the Thai perspective) can force Thai consumers to purchase
domestic products. Blades does not contribute to these problems, as both its exports and imports are
denominated in baht. Consequently, a weaker baht would have no direct impact on companies importing from
Blades. Blades could still be affected by a freely floating exchange rate system, as it is now subject to
exchange rate risk when converting the net baht received to dollars.

5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed?
How will this affect Blades?

= Under the terms of the agreement, completion of the swap arrangement requires Thailand to reverse the swap
of its baht reserves for dollars. Specifically, it will have to exchange dollars for baht at a future date. Due to the
decline in the value of the baht, however, Thailand’s central bank will need more baht to be exchanged for the
dollars needed to repay the other central banks. The purchase of dollars by the Thai government in the foreign
exchange market will increase the demand for dollars and the supply of baht for sale, which will put downward
pressure on the value of the baht. Since Blades has net inflows in baht, it will be negatively affected by the
completion of the swap agreement if the actions needed to complete the agreement result in further weakening
of the baht.