Seminar 4

1. Explain why some financial institutions prefer to provide credit in financial markets
outside their own country.

ANSWER: Financial institutions may believe that they can earn a higher return by providing
credit in foreign financial markets if interest rate levels are higher and if the economic
conditions are strong so that the risk of default on credit provided is low. The institutions may
also want to diversity their credit so that they are not too exposed to the economic conditions
in any single country.

2. Explain how the appreciation of the Australian dollar against the euro would affect
the return to a French firm that invested in an Australian money market security.

ANSWER: If the Australian dollar appreciates over the investment period, this implies that
the French firm purchased the Australian dollars to make its investment at a lower exchange
rate than the rate at which it will convert A$ to euros when the investment period is over.
Thus, it benefits from the appreciation. Its return will be higher as a result of this
appreciation.

3. In 1999, the euro was trading at $0.90 per euro. If the euro is now trading at $1.18 per
euro, what is the percentage change in the euro’s value? Is this an appreciation or
depreciation?

ANSWER: % change = (1.18 – 0.90)/0.90 = 31.11%; the euro has appreciated by 31.11%.

4. Explain how the appreciation of the Japanese yen against the UK pound would affect
the return to a UK firm that borrowed Japanese yen and used the proceeds for a UK
project.

ANSWER: If the Japanese yen appreciates over the borrowing period, this implies that the
UK firm converted yen to pounds at a lower exchange rate than the rate at which it paid for
yen at the time it would repay the loan. Thus, it is adversely affected by the appreciation. Its
cost of borrowing will be higher as a result of this appreciation.

5. Income effects on exchange rates. Assume that the income level in the Euro Area
rises at a much higher rate than does the UK income level. Other things being equal,
how should this affect the: (a) Euro Area demand for British pounds, (b) supply of
British pounds for sale and (c) equilibrium value of the British pound in terms of the
euro?

ANSWER: Assuming no effect on interest rates, demand for pounds should increase, supply
of pounds for sale may not be affected, and the pound’s value should increase.

6. “A country is always worse off when its currency is weak (falls in value).” Is this
statement true, false, or uncertain? Explain your answer.

ANSWER: False. Although a weak currency has the negative effect of making it more
expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic
goods become cheaper relative to foreign goods, and the demand for domestically produced
goods increases. The resulting higher sales of domestic products may lead to higher
employment, a beneficial effect on the economy.

7. Suppose the president of the United States announces a new set of reforms that
includes a new anti-inflation program. Assuming the announcement is believed by the
public, what will happen to the exchange rate on the U.S. dollar?
ANSWER: The dollar will appreciate. Because expected U.S. inflation falls as a result of the
announcement, there will be an expected appreciation of the dollar and so the expected return
on dollar assets will rise. As a result, the demand curve will shift to the right and the
equilibrium value of the dollar will rise.

8. Assume that the UK invests heavily in government and corporate securities of

Country K. In addition, residents of Country K invest heavily in UK. Approximately
£10 billion worth of investment transactions occur between these two countries each
year. The total value of trade transactions per year is about £8 million. This
information is expected to also hold in the dollar.

Because your firm exports goods to Country K, your job as international cash
manager requires you to forecast the value of Country K’s currency (the 'krank') with
respect to the dollar. Explain how each of the following conditions will affect the
value of the krank, holding other things equal. Then, aggregate all of these impacts to
develop an overall forecast of the krank’s movement against the pound.

a. UK inflation has suddenly increased substantially, while Country K’s inflation

remains low.

ANSWER: Increased UK demand for the krank. Decreased supply of kranks for sale.
Upward pressure in the krank’s value.

b. UK interest rates have increased substantially, while Country K’s interest rates
remain low. Investors of both countries are attracted to high interest rates.

ANSWER: Decreased UK demand for the krank. Increased supply of kranks for sale.
Downward pressure on the krank’s value.

c. The UK income level has increased substantially, while Country K’s income
level has remained unchanged.

ANSWER: Increased UK demand for the krank. Upward pressure on the krank’s value.
d. The UK is expected to impose a small tariff on goods imported from Country
K.

ANSWER: The tariff will cause a decrease in the United Kingdom’ desire for Country K’s
goods and will therefore reduce the demand for kranks for sale. Downward pressure on the
krank’s value.

e. Combine all expected impacts to develop an overall forecast.

ANSWER: Two of 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 UK and Country K. The interest rate scenario places downward pressure on the
krank’s value. Since the interest rates affect capital flows and capital flows dominate trade
flows between the UK 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.

9. Blue Demon Bank expects that the Mexican New peso will depreciate against the
dollar from its spot rate of $0.15 to $0.14 in 10 days. The following annual interbank
lending and borrowing rates exist:

Currency Lending rate Borrowing rate

US dollar 8.0% 8.3%
Mexican New peso 8.5% 8.7%

Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million
New pesos in the interbank market, depending on which currency it wants to borrow.

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 New pesos (MXP) as
follows:

1. Borrow MXP70 million.

2. Convert the MXP70 million to dollars:

MXP70,000,000 × $0.15 = $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 New peso loan. The repayment amount on the New 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 $0.14, the amount of dollars needed to
repay the New peso loan is:
MXP70,169,167 × $0.14 = $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 New peso to appreciate from its present spot rate of $0.15 to $0.17 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 New pesos (MXP):

$10,000,000/$0.15 = MXP66,666,667

3. Lend the New pesos through the interbank market at 8.5% annualized over a
30 day period. 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 New pesos to dollars to repay the loan. The amount of dollars to
be received in 30 days (based on the expected spot rate of $0.17) is:

MXP67,138,889 × $0.17 = $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

 Answers to activities discuss in class.
Topic: Foreign Exchange Market
1. Delay Bank’s bid price for US dollars is £0.53 and its ask price is £0.55. What is the
bid/ask percentage spread?

ANSWER: (£0.55– £0.53)/£0.55 = .036 or 3.6%

2. Compute the bid/ask percentage spread for Mexican pesos in which the ask rate is
20.6 New peso to the dollar and the bid rate is 21.5 New peso.

ANSWER: direct rates are 1/20.6 = $0.485:1 peso as the ask rate and 1/21.5 = $0.465:1 peso
as the bid rate so the spread is

[($0.485 – $0.465)/$0.485] = .041, or 4.1%. Note that the spread is for the Mexican peso not
the dollar.

3. If the direct exchange rate of the euro is worth £0.685, what is the indirect rate of the
euro? Note that the pound is the home currency.

ANSWER: 1/0.685 = 1.46 euros.

4. Assume Poland’s currency (the zloty) is worth £0.17 and the Japanese yen is worth
£0.005. What is the cross (implied) rate of the zloty with respect to the yen?

ANSWER: £0.17/£0.005 = 34 zloty:1 yen

5. You just came back from Canada, where the Canadian dollar was worth £0.43. You
still have C$200 from your trip and could exchange them for pounds at the airport, but
the airport foreign exchange desk will only buy them for £0.40. Next week, you will
be going to Mexico and will need pesos. The airport foreign exchange desk will sell
you pesos for £0.055 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 1,500 New 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 C$200 is multiplied by £0.40 and then divided by £0.055 i.e. a ratio of
£0.40/0.055 = 7.27 pesos to the C$. The total pesos would be 200 x 7.27 = 1454 pesos, a little
less than is being offered by the tourist.

Topic: Exchange rate changes

1. Assume the spot rate of the US dollar is £0.54. The expected spot rate 1 year from
now is assumed to be £0.51. What percentage depreciation does this reflect?

ANSWER: (£0.51 - £0.54)/£0.54 = –5.55%

Expected depreciation of 5.55% per cent

 2. Assume that the UK inflation rate becomes high relative to euro inflation. Other
things being equal, how should this affect the: (a) UK demand for euros, (b) supply of
euros for foreign currency and (c) equilibrium value of the euro?

ANSWER: Demand for euros should increase (euro prices cheaper), supply of euros for sale
should decrease (£ prices more expensive), and the euro’s value should increase (supply and
demand).

3. Assume euro interest rates fall relative to British interest rates. Other things being
equal, how should this affect the: (a) euro demand for British pounds, (b) supply of
pounds for sale and (c) equilibrium value of the British pound?
ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease,
and the pound’s value should increase.

4. Mexico tends to have much higher inflation than the US and also much higher interest
rates than the US. Inflation and interest rates are much more volatile in Mexico than
in industrialized countries. The value of the Mexican New peso is typically more
volatile than the currencies of industrialized countries from a US 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 New peso than for
currencies of industrialized countries.
a. What’s the most obvious economic reason for the persistent depreciation of
the New peso.
ANSWER: The high inflation in Mexico places continual downward pressure on the value of
the New peso.

b. High interest rates are commonly expected to strengthen a country’s 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
New peso’s value has declined against the dollar over most years even though
Mexican interest rates are typically much higher than US interest rates. Thus,
it appears that the high Mexican interest rates do not attract substantial US
investment in Mexico’s securities. Why do you think US 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 US real interest rate. Given
the high inflationary expectations, US investors recognize the potential weakness of the New
peso, which could more than offset the high interest rate (when they convert the New pesos
back to dollars at the end of the investment period). Therefore, the high Mexican interest
rates do not encourage US investment in Mexican securities, and do not help to strengthen the
value of the New peso.
c. Why do you think the bid/ask spread is higher for New pesos than for
currencies of industrialized countries? How does this affect a US 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 New peso that
could decline abruptly at any time. A wider bid/ask spread adversely affects the US firm that
does business in Mexico because it increases the transactions costs associated with
conversion of dollars to New pesos, or New pesos to dollars.
 5. Diamond Bank expects that the Singapore dollar will depreciate against the euro from
its spot rate of 0.48 euros to 0.45 euros in 60 days. The following interbank lending
and borrowing rates exist:

Currency Lending rate Borrowing rate

Euro 7.0% 7.2%
Singapore dollar 22.0% 24.0%

Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and
investing the funds in euros 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 euros:
S$10,000,000 × 0.48 = 4,800,000 euros

Invest funds for 60 days. The rate earned in the euros for 60 days is:
7% × (60/360) = 1.17%

Total amount accumulated in 60 days:

4,800,000 euros × (1 + .0117) = 4,856,160 euros

Convert euros back to S$ in 60 days:

4,856,160 /0.45 = S$10,791,467

The rate to be paid on loan is:

0.24 × (60/360) = 0.04

Amount owed on S$ loan is:

S$10,000,000 × (1 + 0.04) = S$10,400,000

This strategy results in a profit:

S$10,791,467 – S$10,400,000 = S$391,467

Diamond Bank should pursue this strategy.