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International Finance, Homework 4, chapter 4,6,7,8

Chapter 4

2. Inflation Effects on Exchange Rates.Assume that the U.S. inflation rate becomes high relative toCanadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadiandollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

ANSWER: The PPP theory suggests that, higher inflation in US leads to higher price of US products.Therefore, US consumers will buy more Canadian goods and thus demand for Canadian dollarsshould increase. At the same time, Canadians demand for US goods will decrease, so the supply ofCanadian dollars for sale should decrease, and the Canadian dollars value should increase.

3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interestrates. 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: Investors will go for investment in UK due to the higher interest rate. Demand for poundsshould increase, supply of pounds for sale should decrease, and the pounds value should increase.

4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher ratethan 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 theCanadian dollar?

ANSWER: Assuming no effect on U.S. interest rates, demand for Canadian dollars should increase,supply of Canadian dollars for sale may not be affected, and the Canadian dollars value shouldincrease.

12. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods buthad little to offer other countries in terms of potential exports. In addition, Russias 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 downwardpressure on the Russian currency. The high inflation rate in Russia also placed downward pressure onthe Russian currency.

14. 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, Asiancorporations with excess cash may now invest in the U.S. or other countries, thereby increasing thedemand for U.S. dollars. Thus, a decline in Asian interest rates will place downward pressure on thevalue of the Asian currencies. The overall impact depends on the magnitude of the forces justdescribed.

19. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in governmentand corporate securities of Country K. In addition, residents of Country K invest heavily in the United


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States. Approximately $10 billion worth of investment transactions occur between these two countrieseach year. The total dollar value of trade transactions per year is about $8 million. This information isexpected to also hold in the future.

Because your firm exports goods to Country K, your job as international cash manager requires youto forecast the value of Country Ks 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 kranks movement against thedollar.

a. U.S. inflation has suddenly increased substantially, while Country Ks inflation remains low.

ANSWER: Increased U.S. demand for the krank. Decreased supply of kranks for sale. Upwardpressure in the kranks value.

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 krank. Increased supply of kranks for sale. Downwardpressure on the kranks value.

c. The U.S. income level increased substantially, while Country Ks income level has remainedunchanged.

ANSWER: Increased U.S. demand for the krank. 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, andwill therefore reduce the demand for kranks for sale. Downward pressure on the kranks 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 U.S.and Country K. The interest rate scenario places downward pressure on the kranks value. Since theinterest rates affect capital flows and capital flows dominate trade flows between the U.S. andCountry K, the interest rate scenario should overwhelm all other scenarios. Thus, when consideringthe importance of implications of all scenarios, the krank is expected to depreciate.


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Chapter 6

6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy,other things being equal? What is the impact of a strong home currency on the home economy, otherthings 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 areduction in foreign competition due to decreased import. Thus, local producers can more easilyincrease prices without concern about pricing themselves out of the market.

A strong home currency can keep inflation in the home country low, since it encourages consumers tobuy abroad. Local producers must maintain low prices to remain competitive. Also, foreign suppliescan be obtained cheaply. This also helps to maintain low inflation. However, a strong home currencycan increase unemployment in the home country. This is due to the increase in imports and decreasein exports often associated with a strong home currency (imports become cheaper to that country butthe countrys exports become more expensive to foreign customers).

13. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its keyinterest rates. The values of several other Latin American currencies are expected to changesubstantially 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 Chiles interest rates decline, there is a smaller flow of funds to be exchanged into Chileanpesos because the Chile interest rate is not as attractive to investors. There may be a shift ofinvestment 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. How would the central banks of other Latin American countries likely adjust their interest rates?How would the currencies of these countries respond to the central bank intervention?

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 affected by thecentral bank intervention? (Assume the exports are denominated in the corresponding LatinAmerican 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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18. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. Thesubsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostlyborrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong.The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S.parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interestrate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar

appreciates against the dollar as a result. Explain whether these actions would increase, reduce, orhave no effect on:

a. The volume of your subsidiarys sales in Australia (measured in A$)b. The cost to your subsidiary of purchasing materials (measured in A$)c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$).

Briefly explain each answer.

ANSWER:

a. The volume of the sales should decline as the cost to consumers who finance their purchases

would rise due to the higher interest rates.

b. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as itappreciates against the U.S. dollar.

c. The interest expenses should decline because it will take fewer A$ to make the monthly paymentof $100,000.


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Chapter 7

8. Effects of September 11. The terrorist attack on the U.S. on September 11, 2001 caused expectationsof a weaker U.S. economy. Explain how such expectations could have affected U.S. interest rates, andtherefore 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 interestrates (in fact, the Fed expedited the movement by increasing liquidity in the banking system). TheU.S. interest rate was reduced while foreign interest rates were not. Therefore, the forward premiumon foreign currencies decreased, or the forward discount became more pronounced.

10. Inflation Effects on the Forward Rate.Why do you think currencies of countries with high inflationrates tend to have forward discounts?

ANSWER: These currencies usually have high interest rates, which cause forward rates to havediscounts as a result of interest rate parity.

14. 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 theinterest rates is reduced. We would expect the premium to change because as U.S. interest ratesdecrease, U.S. investors could benefit from covered interest arbitrage if the forward premium staysthe same. The return earned by U.S. investors who use covered interest arbitrage would not be anyhigher than before, but the return would now exceed the interest rate earned in the U.S. Thus, there isdownward pressure on the forward premium.

15. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher lastmonth than it is today. What does this imply about interest rate differentials between the United Statesand Europe today compared to those last month?

ANSWER: The interest rate differential is smaller now than it was last month.

21. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, whileinterest 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. %89.10189.1)06.1(

)04.1(1

1

1

f

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i

ip


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b. 0792.1$)]0189.(1[10.1$ F

30. Testing IRP.The one-year interest rate in Singapore is 11 percent. The one-year interest rate in theU.S. is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is$.46. Assume zero transactions costs.

a. Does interest rate parity exist?ANSWER: No,

F= 46.04775.011.1

06.15.0

1

1

f

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i

iS

b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage?ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage ofinvesting in Singapore.


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Chapter 8

5. Limitations of PPP. Explain why PPP does not hold.

ANSWER: PPP does not consistently hold because there are other factors besides inflation thatinfluences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation

differentials. In addition, there may not be substitutes for traded goods. Therefore, even when acountrys inflation increases, the foreign demand for its products will not necessarily decrease (in themanner suggested by PPP) if substitutes are not available.

18. Estimating Depreciation Due to PPP.Assume that the spot exchange rate of the British pound is$1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflationrate of 7 percent while the United States experiences an inflation rate of 2 percent?

ANSWER:

0467.0107.01

02.01

fe

According to PPP, the exchange rate of the pound will depreciate by 4.67 percent. Therefore, the spotrate would adjust to $1.73 [1 + (.0467)] = $1.6492.

26. IRP. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.

a. What is the forward rate premium?b. What is the one-year forward rate of the peso?c. Based on the international Fisher effect, what is the expected change in the spot rate over the next

year?d. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year?e. Compare your answers to (b) and (d) and explain the relationship.ANSWER:

a. According to interest rate parity, the forward premium is07273.1

)10.1(

)02.1(

b. The forward rate is $.14 (1.07273) = $.1298.

c. According to the IFE on page 252, the expected change in the peso is:

07273.1)10.1(

)02.1(

or7.273%; depreciate by 7.273%

d. $.14 (1.07273) = $.1298


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e. The answers are the same. When IRP holds, the forward rate premium and the expectedpercentage change in the spot rate are derived in the same manner. Thus, the forward premiumserves as the forecasted percentage change in the spot rate according to IFE.

35. Implications of PPP.Todays spot rate of the Mexican peso is $.10. Assume that purchasing powerparity holds. The U.S. inflation rate over this year is expected to be 7%, while the Mexican inflation

over this year is expected to be 3%. Wake Forest Co. plans to import from Mexico and will need 20million Mexican pesos in one year. Determine the expected amount of dollars to be paid by the WakeForest Co. for the pesos in one year.

ANSWER: [(1.07)/(1.03)]1 = 0.03883495. So the expected future spot rate is

0.10x(1+0.03883495)=$.103883495.

Carolina will need to pay $.103883495 20 million pesos = $2,077,670.

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