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International Corporate Finance

Solution Manual

Chapter 2: International Flow of Funds

Effect s o f Tar i f f s

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.

A N S W E R : T h e U . S . w i n e p r o d u c e r s b e n e f i t f r o m t h e U . S . t a r i f f s , w h i l e t h e

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.

C u r r e n c y E f f e c t s

W h e n S o u t h K o r e a s e x p o r t g r o w t h s t a l l e d , s o m e S o u t h K o r e a n f i r m s 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.

E x c h a n g e R a t e E f f e c t o n T r a d e B a l a n c e

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.

G o v e r n m e n t R e s t r i c t i o n s 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

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

payments among countries.

I n f l a t i o n E f f e c t o n T r a d e

a. How would a relatively high home inflation rate affect the home countrys current account, other things being equal?

A N S W E R : A h i g h i n f l a t i o n r a t e t en d s t o i n c r e a s e i m p o r t s a n d d e c r e a s e

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.

B a l a n c e o f P a y m e n t s

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 ye 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 ed 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 . E x p l a i n h o w l o w U . S . i n t e r e s t r a t e s c a n a f f e c t t h e t e n d e n c y o f U . S . -

b a s e d M N C s t o i n v e s t abroad.

A N S W E R : Lo w U . S . i n t e r e s t r a t e s c a n e n c o u r a g e U . S . - b a s e d M N C s t o

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 countrys 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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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 . H o w c o u l d c o m p e t i t i o n f r o m f i r m s i n T h a i l a n d a n d f r o m U . S . f i r m s

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 relative 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 ex c e s s o f t h e o r i g i n a l t h r e e ye 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 baht-

d e n o m i n a t e d r e v e n u e i n T h a i l a n d w i l l c o n v e r t t o f e w e r U . S . d o l l a r s . B l a d e s

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 dollar-

denominated 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 I d e n t i f y i n g F a c t o r s T h a t W i l l A f f ec t t h e F o r e i g n D e m a n d a t t h e S p o r t s

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

Indirec t 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

d e s k , t h e c r o s s - r a t e i s $ . 6 0 / $ 1 0 = 6 . T h u s , t h e C $ 2 0 0 w o u l d b e ex c h an g e d

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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B i d / a s k S p r e a d

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%.

B i d / a s k S p r e a d

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 massive 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 currency (Yuan) into the other

currencies in the spot m a r k e t t o p u r c h as 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 ex 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

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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?

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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 Lending Rates Borrowing rates

US$ 7.0% 7.2%

Singapore $ 22.0% 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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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.

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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

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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.

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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.

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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

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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

$.72 -$ .03

$.73 -$0.02

$.74 -$0.01

$.75 00

$.76 $0.01

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.

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Answer:

Spot Rate Net profit / loss per unit

$ 1.53 1.58 1.58 + 0.06 = 0.11

1.55 1.58 1.55 + 0.06 = 0.09

1.57 1.58 1.57 + 0.06 = 0.07

1.60 1.58 1.60 + 0.06 = 0.04

1.62 1.58 1.62 + 0.06 = 0.02

1.64 1.58 1.64 + 0.06 = 0.00

1.68 1.58 1.68 + 0.06 = -0.04

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

Net loss of gain per unit

$ 0.76 0.86 0.76 0.02 = 0.08

0.79 0.86 0.79 0.02 = 0.05

0.84 0.86 0.84 0.02 = 0.00

0.87 0.86 0.87 0.02 = -0.03

0.89 0.86 0.89 0.02 = -0.05

0.91 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

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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?

A nsw er : In t e r v en t io n m ay h av e a m or e p r on ou n ced im pac t w h en th e m arke t

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 fo r e a f f ec t t h e n a tu r a l eq u i l i b r i um ex ch an ge

r a t e . C o n ve r s e l y, d i rec t i n t e rv en t i on 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 . F e e d b a c k E f f e c t s .

Explain the potential feedback effects of a currencys changing value on inflation.

A ns w er : A w eak ho m e cu r r en c y can cau s e i n f l a t i on s i nce i t t end s t o r educe

f o r e i gn 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 ho u ld th e go v er nm en t s o f A s i an cou n t r i e s a l l ow th 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.

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5 . C u r r e n c y E f f e c t s o n E c o n o m y .

Wh a t i s t he im p ac t o f a w eak hom e cu r r enc y o n t h e hom 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 on g h om e cu r r en c y can k eep in f l a t i o n in t he

h om e co un t r y l o w , s i n ce i t en cou r ages 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

cu r r en c y ( i m po r t s b ecom e ch eap er t o t h a t co un t r y b u t t h e cou n t r y s ex p o r t s b ecom e mo 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 wo uld th e cen t ra l b ank s o f o the r La t i n Am er i can co un t r i es l i k e l y ad ju s t t he 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.

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7 . I n t e r v e n t i o n E f f e c t s .

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 he U .S . , t h i s co u ld o f f s e t t he

d o wn w ard p r e s s u r e o n t he U .S . do l l a r . In t h i s c as 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 . I n d i r e c t I n t e r v e n t i o n .

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.

1 1 . D i r e c t I n t e r v e n t i o n .

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

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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 managers to liquidate some of their bond holdings,

thereby causing bond prices to decline immediately.

1 3 . I n t e r v e n t i o n w i t h E u r o s .

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.

1 4 . E f f e c t s o n C u r r e n c i e s T i e d t o t h e D o l l a r .

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 . Th e r e fo r e , Ho n g K o n g go o ds wi l l b e l e s s

ex p en s i ve t o J ap anes e importers.

b . H o n g K o n g e x p o r t s t o t h e U . S . s h o u l d i n c r e a s e b e c a u s e J a p a n e s e

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 ch anged , t he H o n g K on g p r i c es a r e n ow l o w er t h an J ap an ese

p r i c e s ( f r om 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.

1 5 . E x c h a n g e R a t e S y s t e m s .

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 balance-

of-trade deficits since the currency will adjust according to market forces. Also, countries are more

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insulated from problems of foreign countries u n de r a f r e e l y f l oa t i n g e x ch an ge r a t e

s ys t em. H ow ev er , a d i s adv an t age o f f r e e l y f l o a t in 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.

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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

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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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11. Covered Interest Arbitrage in Both Directions.

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

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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 Yardley Bank

Bid price of New Zealand dollar $.401 $.398

Ask price of New Zealand dollar $.404 $.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

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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.

ANS