Chapter 4

In some periods, Brazil's inflation rate was very high. Explain why this places pressure on the Brazilian currency (called the Brazilian real).

High inflation in Brazil can encourage its consumers to purchase products from other countries where products are cheaper, and can discourage consumers in other countries from purchasing imports from Brazil. This shift in international trade represents an increase in the supply of the Brazilian currency for sale, and a decrease in the demand for the Brazilian currency by other countries, which places downward pressure on the Brazilian real.

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.

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.

Government controls

Imposing foreign exchange barriers Imposing foreign trade barriers Intervening in foreign exchange markets Affecting macro variables such as inflation, interest rates, and income levels.

relative income levels

Increase in U.S. income leads to increased in U.S. demand for foreign goods and increased demand for foreign currency relative to the dollar and an increase in the exchange rate for the foreign currency

impact of signals on currency speculation

Speculators may overreact to signals causing currency to be temporarily overvalued or undervalued.

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.

The high inflation in Mexico places continual downward pressure on the value of the peso.

How do you think the weaker U.S. economic conditions could affect capital flows? If capital flows are affected, how would this influence the value of the dollar (holding other factors constant)?

Weaker U.S. economic conditions commonly result in lower interest rates. 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.

The country of Zars has large capital flows with the U.S. It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%, the same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You expect that the inflation rate in Zars will rise to 8% this coming year, while the U.S. inflation rate will remain at 5%. You expect that Zars' interest rate will rise to 9% during the next year. You expect that the U.S. interest rate will remain at 6% this year. Zars' currency adjusts in response to market forces and is not subject to direct central bank intervention. Will Zars currency appreciate, depreciate, or remain unchanged against the dollar?

Zars' currency should appreciate against the dollar, because the exchange rate should be driven by capital flows, and money should be moving into Zars to capitalize on the high interest rate. The inflation should not be influential since the countries have no international trade

Depreciation

decline in a currency's value. a negative percent change indicates that a currency has depreciated.

Equilibrium

equates the quantity of pounds demanded with the supply of pounds for sale

Appreciation

increase in a currency's value. a positive percent change indicates that a currency has appreciated

If 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?

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.

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

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 dollar's value should increase.

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: Lending Rate Borrowing Rate U.S. dollar 8.0% 8.3% Mexican peso 8.5% 8.7% Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the interbank market, depending on which currency it wants to borrow. 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.

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

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: Lending Rate Borrowing Rate U.S. dollar 8.0% 8.3% Mexican peso 8.5% 8.7% Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the interbank market, depending on which currency it wants to borrow. 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.

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-day period. The amount accumulated in 30 days is: MXP66,666,667 × [1 + (8.5% × 30/360)] = 66,666,667 × [1.007083] = MXP67,138,889 4. Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 × [1 + (8.3% × 30/360)] = $10,000,000 × [1.006917] = $10,069,170 5. Convert the 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

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?

Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollar's value should increase.

Assume that inflation is zero in the U.S. and in Europe and will remain at zero. U.S. interest rates are presently the same as in Europe. Assume that the economic growth for the U.S. is presently similar to Europe. Assume that international capital flows are much larger than international trade flows. Today, there is news that clearly signals economic conditions in Europe will be weakening in the future, while economic conditions in the U.S. will remain the same. Explain why and how (which direction) the euro's value would change today based on this information

Expectations of weak economic conditions result in a reduced demand for loanable funds within Europe, which should reduce interest rates in the future. Thus, there will a reduction in U.S. demand for euros because of lower interest rates there. The supply of euros to be exchanged for dollars should increase as European investors attempt to benefit from relatively high U.S. interest 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. High interest rates are commonly expected to strengthen a country's currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso's 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 Mexico's securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico?

High interest rates are commonly expected to strengthen a country's currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso's 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 Mexico's securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico?

impact of favorable expectations

If investors expect interest rates in one country to rise, they may invest in that country leading to a rise in the demand for foreign currency and an increase in the exchange rate for foreign currency.

Assume the country of Neeland has stable and predictable international trade flows with the U.S. Neeland is periodically in the news because its government might have problems repaying its debt owed to local banks. The value of its currency (the "nee") commonly declines on one day, but then jumps back up a few days later. There is much day to day volatility in the value of the nee. Briefly explain what types of transactions are likely causing the shifts in demand for the nee and supply of nee for sale in the foreign exchange market.

In general, this can be explained by speculative flows of funds. Speculators tend to move out of the nee when there is bad news like this, because such news might discourage foreign investment by MNCs that are concerned about the country's political instability. So speculators sell the nee upon the news, which places downward pressure on the nee's value immediately. However, if there is favorable news the next day in which fears of debt repayment are reduced, speculative money can move back in, and the demand for the nee in the foreign exchange market can increase the value of the nee.

relative inflation rates

Increase in U.S. inflation leads to increase in U.S. demand for foreign goods, an increase in U.S. demand for foreign currency, and an increase in the exchange rate for the foreign currency.

relative interest rates

Increase in U.S. rates leads to increase in demand for U.S. deposits and a decrease in demand for foreign deposits, leading to a increase in demand for dollars and an increased exchange rate for the dollar

Kurnick Co. expects that the pound will depreciate from $1.70 to $1.68 in one year. It has no money to invest, but it could borrow money to invest. It has been approved by a bank to borrow either 1 million dollars or 1 million pounds for one year. It can borrow dollars at 6% or Bitish pounds at 5% for one year. It can invest in a risk-free dollar deposit at 5% for one year or a risk-free British deposit at 4% for one year. Determine the expected profit or loss (in dollars) if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the pound.

Initial amount borrowed = 1,000,000 pounds Dollars received when the pounds are converted to dollars = 1,000,000 * 1.70 = $1,700,000. Total dollar amount at the end of 1 year = $1,700,000 x 1.05= $1,785,000. Total owed on the pounds borrowed = 1,000,000*1.05 = 1,050,000 pounds. Expected amount of dollars needed to repay the loan = 1,050,000 x 1.68 = $1,764,000. Profit = $1,785,000 - $1,764,000 = $21,000.

Fisher Effect

Real interest rates are about equal to the nominal interest rate minus the inflation rate

impact of unfavorable expectations

Speculators can place downward pressure on a currency when they expect it to depreciate.

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. 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?

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.

What factors affect the future movements in the value of the euro against the dollar?

The euro's 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).

What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies

The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal

Assume that the level of capital flows between the U.S. and the country of Krendo is negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade between the U.S. and the country of Krendo and no capital flows. How will high inflation and high interest rates affect the value of the kren (Krendo's currency)? Explain. ANSWER

The inflation effect will be stronger than the interest rate effect because inflation affects trade flows. The high inflation should cause downward pressure on the kren.

Why do you think the trade deficit announcement sometimes has such an impact on foreign exchange trading?

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.

Assume that the level of capital flows between the U.S. and the country of Zeus is negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade between the U.S. and the country of Zeus. The main import by the U.S. is basic clothing purchased by U.S. retail stores from Zeus, while the main import by Zeus is special computer chips that are only made in the U.S. and are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to impose a 20% tax on the clothing imports. The Zeus government immediately retaliates by imposing a 20% tax on the computer chip imports. Second, the Zeus government immediately imposes a 60% tax on any interest income that would be earned by Zeus investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so that they are now higher than interest rates in the U.S. Do you think the currency of Zeus (called the zee) will appreciate or depreciate against the dollar as a result of all the government actions described above? Explain.

The zee should depreciate, because Zeus imports of U.S. computer chips will continue, while the U.S. imports of Zeus clothing will decrease. The Zeus tax on capital flows and the central bank actions will not have an effect because the Zeus investors do not buy U.S. securities anyway.

Demand for a Currency

increases when the value of the currency decreases. leading to a downward sloping demand schedule.

Supply of a currency for sale

increases when the value of the currency increases, leading to an upward sloping supply schedule

exchange rate

represents the price of a currency or the rate at which one currency can be exchanged for another.

equilibrium exchange rate

will change over time as supply and demand schedules change