International Finance Final

Compute the forward discount or premium for the Mexican peso whose 90- day forward rate is £0.05 and spot rate is £0.051. State whether your answer is a discount or premium.

(F - S) / S= (0.05 - 0.051)/0.051 x 360/90 = -.078 or -7.8% a discount therefore

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

(£0.51 - £0.54)/£0.54 = -5.55% (Depreciation)

Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg?

A country will usually attempt a peg to reduce speculative flows that occur because of exchange rate volatility. It tries to comfort investors by making them believe that the currency will be stable. In some cases, the peg is broken when there are adverse conditions in the country that make investors believe that the peg will be broken. For example, foreign investors become concerned that if the peg breaks, the currency may decline by 20 per cent or more against their home currency. This would adversely affect the return on their investment, so they attempt to liquidate their investment and move their fund out of that currency before the peg breaks. If many investors have this concern simultaneously, they are all selling that currency at the same time. They place downward pressure on the currency because there is a larger supply of the currency for sale than the demand for the currency. The central bank may attempt to offset these forces by buying the currency in the foreign exchange market. However, it has a limited amount of that currency as a reserve, and may be overwhelmed by market forces.

Differentiate between a currency call option and a currency put option.

A currency call option provides the right to purchase a specified currency at a specified price within a specified period of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time.

Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages?

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.

Assume that you obtain a quote for a one-year forward rate on theMexican peso. Assume that Mexico's one-year interest rate is 40 per cent, while the UK one-year interest rate is 7 per cent. Over the next year, the peso depreciates by 12 per cent. Do you think the forward rate overestimated the spot rate one year ahead in this case? Explain.

A quoted forward rate for the Mexican peso would contain a large discount because of the high interest rate in Mexico relative to the UK. The peso should depreciate by approximately the interest rate differential of 7% - 40% = -33% more than the 12%. The forward rate would have actually underestimated the future spot rate in this example. Potentially a profit can be made here from uncovered interest rate arbitrage except that we are failing to take into account that investing in Mexico is more risky than domestic investment. Any profits from doing so may be regarded as a risk premium.

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 British pound) be affected?

A relative decline in Asian economic growth will reduce Asian demand for UK 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 UK or other countries, thereby increasing the demand for pounds. 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.

Explain the potential feedback effects of a currency's changing value oninflation.

A weak home currency can cause inflation since it tends to reduce foreign 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.

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, other things being equal?

A weak home currency tends to increase a country's 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 strong home currency can keep inflation in the home country low, since it encourages consumers to buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be obtained cheaply. This also helps to maintain low 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 stronghome currency (imports become cheaper to that country but the country's exports become moreexpensive to foreign customers).

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

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

Compare and contrast forward and futures contracts.

Because currency futures contracts are standardized into small amounts, they can bevaluable for the speculator or small firm (a commercial bank's forward contracts are morecommon for larger amounts). However, the standardized format of futures forces limited maturities and amounts.

You are hired as a consultant to assess a firm's ability to forecast.The firm has developed a point forecast for two different currencies presented in the following table. The firm asks you to determine which currency was forecasted with greater accuracy.

Because the mean absolute forecast error of the dollar is lower than that of the yen, the dollar was forecasted with greater accuracy.

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?

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 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.

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.

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 currency's value may cause more volatile business cycles, and may causemore concern in financial markets (and therefore more volatility in these markets). Central bank intervention used to smooth exchange rate movements may stabilize the economy and financial markets.

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

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

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

Demand for pounds should increase, supply of pounds for sale should decrease, andthe pound's value should increase.

Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) UK demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?

Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease.

The treasurer of Glencoe Ltd detected a forecast bias when using the 30-day forward rate of the euro to forecast future spot rates of the euro over various periods. He believes he can use this information to determine whether imports orderedevery week should be hedged (payment is made 30 days after each order). Glencoe's presidentsays that in the long run the forward rate is unbiased and that the treasurer should not wastetime trying to "beat the forward rate" but should just hedge all orders. Who is correct?

Even if the forward rate is unbiased over the long run, Glencoe could save money if it could effectively detect a forward bias (assuming that the bias would continue after being detected). Glencoe may decide to hedge only when the forward rate is expected to be less than the future spot rate. The Treasurer is correct if the bias continues beyond the point at which it is detected.

UK Treasury bill prices are normally inversely related to UK interest rates. If the Bank of England planned to use intervention to weaken the British pound, how might bill prices be affected?

Expectations of a weak pound can cause expectations of higher inflation, because a weak pound places upward pressure on UK 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 bill (bond) prices, Treasury bill 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.

Wellington Ltd. believes that future real interest rate movements will affect exchange rates, and it has applied regression analysis to historical data to assess the relationship. It will use regression coefficients derived from this analysis, along with forecasted real interest rate movements, to predict exchange rates in the future. Explain at least three limitations of this method.

First, the timing of the impact of real interest rates on exchange rates may differ from what is specified by the model. Second, the forecasted real interest rates may be inaccurate, causing inaccurate forecasts of the exchange rate. Third, the sensitivity of exchange rates to real interest rate movements may change in the future (differ from what was determined when using historical data). Fourth, the model has ignored other factors that also influence exchange rates.

Why do foreign market participants attempt tomonitor the European Central Bank's direct intervention efforts? How does the ECB attempt tohide its intervention actions? The media frequently report that "the euro's value strengthened ahead of moves by the ECB to..." Explain why the euro's value may change even before the ECBtakes action (for example a change in interest rates).

Foreign market participants make investment and borrowing decisions that can be influenced by anticipated exchange rate movements and therefore by the ECB's directintervention efforts. Thus, they may attempt to obtain information from commercial banksabout the Fed's intervention actions. The ECB may attempt to disguise its actions by requesting bid and ask quotes on exchange rates, and even mixing some buy orders with sell orders, or vice versa. Foreign exchange market participants may anticipate that once the ECB increases interest rates, there will be an increased demand for dollars, which will result in a stronger dollar. Consequently, they may take positions in dollars immediately, which could place upward pressure on the dollar even before interest rates are affected.

Explain the fundamental technique for forecasting exchange rates. What are some limitations of using a fundamental technique to forecast exchange rates?

Fundamental forecasting is based on underlying relationships that are believed to exist between one or more variables and a currency's value. Given these relationships, a change in one or more of these variables (or a forecasted change in them) will lead to a forecast of thecurrency's value. Even if a fundamental relationship exists, it is difficult to accurately quantify that relationship in a form applicable to forecasting. Even if the relationship could be quantified, there is no guarantee that the historical relationship will persist in the future. It is difficult to determine the lagged impact of some variables. It is also difficult to incorporate some qualitative factors into the model.

When some countries in Eastern Europe initially allowed their currencies to fluctuate against the dollar, would the fundamental technique based on historical relationships have been useful for forecasting future exchange rates of these currencies? Explain.

Fundamental forecasting typically relies on historical relationships between economic factors and exchange rate movements. However, if exchange rates were not allowed to move in the past, historical relationships would not help predict future exchange rates of these currencies.

Brinnington plc. is a UK-based MNC with subsidiaries in most major countries. Each subsidiary is responsible for forecasting the future exchange rate of its local currency relative to the British pound. Comment on this policy. How might Brinnington ensure consistent forecasts among the different subsidiaries?

If each subsidiary uses its own data and techniques to forecast its local currency'sexchange rate, its forecast may be inconsistent with forecasts of other currencies by other subsidiaries. Subsidiary forecasts could be consistent if forecasts for all currencies were based on complete information from all subsidiaries (its beta).

Assume that there are substantial capital flows among the United Kingdom, the United States, and the Euro area. If interest rates in the United Kingdom declines to a level below the US interest rate, and inflationary expectations remain unchanged, how could this affect the value of the euro against the US dollar? How might this decline in theUnited Kingdom's interest rate possibly affect the value of the British pound against the euro?

If interest rates in the UK decline, there may be an increase in capital flows from the UK to the US In addition, US investors may attempt to capitalize on higher US interest rates, while US investors reduce their investments in UK's securities. This places downward pressure on the pond's value. Euro investors who previously invested in the UK may shift to the US. Thus, the increased demand for dollars by euros may increase the value of the dollar in relation to the euro.

Assume that the forward rate is an unbiased but not necessarily accurate forecast of the future exchange rate of the yen over the next several years. Based on this information, do you think Raven Ltd should hedge its remittance of expected Japanese yen profits to the UK parent by selling yen forward contracts? Why would this strategy be advantageous? Under what conditions would this strategy backfire?

If the forward rate is an unbiased forecast, the amount of pounds received from remittances when hedging should be the same (on average, over time) as the amount of pounds received from remittances when not hedging. Under these conditions, Raven may be able to more accurately predict the pound cash flows that will result from remitted foreign cash flows, without reducing the expected amount of pound cash flows received. This strategy could backfire in those periods that the spot rate of yen at the time of remittances exceeds the previously agreed upon forward rate at which the yen would be converted to pounds.

How can a forward contract backfire?

If the spot rate of the foreign currency at the time of the transaction is worth less than the forward rate that was negotiated, or is worth more than the forward rate that was negotiated, the forward contract has backfired..

Explain why a public forecast about the future value of the euro and about future interest rates by a respected economist could affect the value of the euro today. Why do some forecasts by well-respected economists have no impact on today'svalue of the euro?

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, sincetheir yield will be affected by changes in a currency's 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 marketparticipants or is not different from investors' original expectations, an announced forecast doesnot provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected.

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?

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).

Why would indirect intervention by a central bank have a stronger impacton some currencies than others? Why would a central bank's indirect intervention have astronger impact than its direct intervention?

Intervention may have a more pronounced impact when the market for a given currency is less active, such that the intervention can jolt the supply and demand conditions more. A central bank's indirect intervention can affect the factors that influence exchange rates andtherefore affect the natural equilibrium exchange rate. Conversely, direct intervention is a superficial method of affecting the demand and supply conditions for a currency, and could be overwhelmed by market forces.

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.

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.

Assume that the central bank of the country Zakow periodically intervenes in the foreign exchange market to prevent large upward or downward fluctuations in its currency (called the zak) against the US dollar. Today, the central bank announced that it will no longer intervene in the foreign exchange market. The spot rate of the zak against the dollar was not affected by this news. Will the news affect the premium on currency call options that are traded on the zak? Will the news affect the premium on currency put options that are traded on the zak? Explain.

It should cause the call option premium and put option premium to increase, because there is more uncertainty surrounding the zak. The seller of a call or put option will require a higher premium on the option, because the seller recognizes that the exchange rate may be more volatile than in the past.

Cooper plc periodically obtains euros to purchase German products. It assesses UK and German trade patterns and inflation rates to develop a fundamental forecast for the euro. How could Cooper possibly improve its method of fundamental forecasting as applied to the euro?

It should use data for all countries participating in the euro (not just the German data),as the euro's exchange rate is affected by all transactions between euros and dollars, not just the German transactions.

Explain the mixed technique for forecasting exchange rates.

Mixed forecasting involves a combination of two or more techniques. The specific combination can differ in terms of techniques included and the weight of importance assigned to each technique.

The September 11, 2001 terrorist attack on the US was quickly followed by lower interest rates in the US. How would this affect a fundamental forecast of foreign currencies? How would this affect the forward rate forecast of foreign currencies?

Lower interest rates in the U.S. reduce the capital flows into the US, which places upward pressure on foreign currencies against the dollar. The forward rates of foreign currencies would have more pronounced discounts, or higher premiums, which implies that the forecasts were revised to either reflect a smaller degree of depreciation of the foreign currency than the forecast before September 11, or a higher degree of appreciation of the foreign currency than the forecast before September 11.

Explain the market-based technique for forecasting exchange rates. What is the rationale for using market-based forecasts? If the euro appreciates substantially against the dollar during a specific period, would market-based forecasts have overestimated or underestimated the realized values over this period? Explain.

Market-based forecasts should reflect an expectation of the market on future rates. Ifthe market's expectation differed from existing rates, then the market participants should react by taking positions in various currencies until the current rates do reflect an expectation of the future. The market determines the spot exchange rate and forward exchange rate. These market-based rates can be used to forecast since if they were not good indicators of the future rates, speculators would take positions. This speculative movement would force the rates to gravitate toward the expectation of the future spot rate. Market-based forecasts would have underestimated the realized values of the euro over this period because the actual values were above the spot rates and forward rates quoted earlier.

Explain how to assess performance in forecasting exchange rates. Explain how to detect a bias in forecasting exchange rates.

Performance can be evaluated by computing the absolute forecast error as a percentage of the realized value for all periods where a forecast was necessary. Then an average of this type of error can be computed. This average can be compared among all currencies or among all forecasting models. A forecast bias exists from consistently underestimating or overestimating exchange rates. If the majority of points are above the 45 degree perfect forecast line, then the forecasts generally underestimate the realized values. If the majority of points are below the 45 degree perfect forecast line, then the forecasts generally overestimate the realized values.

The director of currency forecasting at Champaign-Urbana Ltd says, "The mostcritical task of forecasting exchange rates is not to derive a point estimate of a future exchange rate but to assess how wrong our estimate might be." What does this statement mean?

Point estimate forecasts of exchange rates are not likely to be perfectly accurate. MNCs that develop point estimate forecasts recognize this, but would like to determine how far off the forecast may be. They will have more confidence in the forecasts of currencies that have been forecasted with only minor errors. For other currencies in which forecast errors have been large, they would be very careful when basing policy decisions on forecasts of these currencies.

Explain corporate motives for forecasting exchange rates.

Several decisions of MNCs require an assessment of the future. Future exchange rates will affect all critical characteristics of the firm such as costs and revenues. To be more specific, various operations of MNCs use exchange rate projections, including hedging, short-term financing and investing, capital budgeting decisions, long-term financing, and earnings assessment. Such operations will be more effective if exchange rates are forecasted accurately.

Explain the difference between sterilized and nonsterilized intervention.

Sterilized intervention is conducted to ensure no change in the money supply while nonsterilized intervention is conducted without concern about maintaining the same money supply.

Assume that foreign exchange markets were found to be weak-form efficient. What does this suggest about utilizing technical analysis to speculate in euros? If MNCs believe that foreign exchange markets are strong-form efficient, why would they develop their own forecasts of future exchange rates? That is, why wouldn't they simply use today's quoted rates as indicators about future rates? After all, today's quoted rates shouldreflect all relevant information.

Technical analysis should not be able to achieve excess profits if foreign exchange markets are weak-form efficient. Today's rates do not provide information about the range of possible outcomes. MNCs may desire to assess the range of possible outcomes.

Explain the technical technique for forecasting exchange rates. What are some limitations of using technical forecasting to predict exchange rates?

Technical forecasting involves the review of historical exchange rates to search for a repetitive pattern that may occur in the future. This pattern would be the basis for future exchange rate movements. Even if a technical forecasting model turns out to be valuable, it will no longer be valuable once other market participants use it. This is because their actions in the market due to the model'sforecast will cause the currency values to move as suggested by the model immediately instead of in the future. Also, MNCs often prefer long-term forecasts. Technical forecasting is typically conducted for short time horizons.

If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth?

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.

Assume there is concern that the USA may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might US exporters react to this policy (favorably or unfavorably)? What about US importing firms?

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 US exporting firms and adversely affect US importing firms. If the US interest rates rise in response to the possible increase in economic growth and inflation in the US, this could offset the downward pressure on the US dollar. In this case, US exporting and importing firms would not be affected as much.

Royce Ltd is a UK firm with future receivables one year from now in Canadian dollars and Brazilian real. Its Brazilian real receivables are known with certainty, and its estimated Canadian dollar receivables are subject to a 2 per cent error in either direction. The pound values of both types of receivables are similar. There is no chance of default by the customers involved.Royce's treasurer says that the estimate of pound cash flows to be generated from the Brazilianreal receivables is subject to greater uncertainty than that of the Canadian dollar receivables.Explain the rationale for the treasurer's statement.

The cash flows are subject to uncertainty with regard to the amount of the receivablesand the exchange rate. The greater uncertainty with regards to the Real's exchange rate outweighs the less certain Canadian receivables.

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.

The euro's value changes in response to the flow of funds between the US and thecountries using the euro or their currency. The pound's value changes in response to the flow offunds between the US and the UK. As the UK economy is different from the euro economy, economic events will have a different impact, the events themselves may also differ. Assuming that the market is efficient and that the exchange rates do move according to relevant information the fact that the relevant information sets differ justifies a less than perfect correlation of movements. That they are similar is understandable as although different, the differences are not that great.

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 moreUS demand for European goods than the European demand for US goods. The capital flows between the US and Europe will also affect the US demand for euros and the supply of euros for sale (to be exchanged for dollars).

Bolivia currently has a nominal one-year risk-free interest rate of 40 %, which is primarily due to the high level of expected inflation. The euro nominal one- year risk-free interest rate is 8 %. The spot rate of Bolivia's currency (called the boliviana) is 0.14euro. The one-year forward rate of the boliviana is 0.108 euro. What is the forecasted percentage change in the boliviana if the spot rate is used as a one-year forecast? What is the forecasted percentage change in the boliviana if the one-year forward rate is used as a one-year forecast? Which forecast do you think will be more accurate? Why?

The forecasted percentage change in the boliviana is zero percent based on the spot rate, while the forecasted percentage change in the boliviana is -22.86 percent based on the forward rate. The forward rate should be a better forecast in this example because it captures the effect of expected inflation on the exchange rate. The spot rate ignores this information.

You believe that the Singapore dollar'sexchange rate movements are mostly attributed to purchasing power parity. Today, the nominal annual interest rate in Singapore is 18%. The nominal annual interest rate in the United Kingdom is 3%. You expect that annual inflation will be about 4% in Singapore and 1% in the United Kingdom. Assume that interest rate parity holds. Today the spot rate of the Singapore dollar is £0.41. Do you think the one-year forward rate would underestimate, overestimate, or be an unbiased estimate of the future spot rate in one year? Explain.

The forward rate will likely underestimate the future spot rate. The inflation differential suggests that the Singapore dollar should decline slightly. Yet, the forward rate would have a large discount due to the interest differential. Thus, the forward rate would predict a very weak Singapore dollar, which means that it would underestimate the future spot rate.

During the Asian crisis, some Asian central banks raised their interest rates to prevent their currencies from weakening. Yet, the currencies weakened anyway. Offer youropinion as to why the central banks' efforts at indirect intervention did not work.

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.

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.

In the 1990s, Russia was attempting to import more goodsbut had little to offer other countries in terms of potential exports. In addition, Russia's inflationrate was high. Explain the type of pressure that these factors placed on the Russian currency.

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.

Within a few days after the September 11, 2001 terrorist attack on the US, the Federal Reserve reduced short-term interest rates in the US to stimulate the US economy. How might this action have affected the foreign flow of funds into the US and affected the value of the dollar? How could such an effect on the dollar increase the probability that the US economy would strengthen?

The lower interest rates are expected to stimulate the US economy, by encouraging more borrowing and spending. Lower US interest rates may reduce the amount of foreign flows to the US, which could have reduced the value of the dollar. If the dollar weakened US exports would be cheaper, which could have increased the demand for products produced by US exporters.

How can a central bank use indirect intervention to change the value of a currency?

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.

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?

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 insulated from problems of foreign countries under a freely floating exchange rate system. However, a disadvantage of freely floating 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 country's unemployment orinflation.

How do you think weaker economic conditions would affect trade flows in a Developing Country? How would weaker conditions affect the value of its currency (holding other factors constant)? How do you think interest rates would be affected?

Weak world economic conditions would result in a reduced demand for foreign products, which results in a decline in the demand for foreign currencies, particularly the currencies of developing countries that rely on exports. Taking the US as the dominant economy there would therefore be downward pressure on currencies relative to the dollar (upwardpressure on the dollar's value). The lower US interest rates that accompany weaker economic conditions should reduce the capital flows to the US, which place downward pressure on the value of the dollar.

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 Chile's interestrates. 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 interventions? c. How would a US firm that exports products to Latin American countries be affected by the central bank interventions? (Assume the exports are denominated in the corresponding Latin American currency for each country.)

a. 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. 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. 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.

The Hong Kong dollar's value is tied to the US 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.

a. Hong Kong exports to Japan should increase because the yen will have appreciated against the Hong Kong dollar. Therefore, Hong Kong goods will be less expensive to Japanese importers. b. Hong Kong exports to the US should increase because Japanese goods become more expensive to US importers as a result of yen appreciation. Therefore, some US importers may find that even though the exchange rate between the US dollar and Hong Kong dollar is unchanged, the Hong Kong prices are now lower than Japanese prices (from a US perspective). This answer assumes that Japanese exporters did not reduce their prices to compensate US 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.

Assume that the United Kingdom invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United Kingdom. Approximately £10 billion worth of investment transactions occur between these two countries each year. The total pound 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 requiresyou to forecast the value of Country K's currency (the "krank") with respect to the pound. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank'smovement against the pound. a. UK inflation has suddenly increased substantially, while Country K's inflation remains low. b. UK interest rates have increased substantially, while Country K's interest rates remain low.Investors of both countries are attracted to high interest rates. c. The UK income level increased substantially, while Country K's income level has remainedunchanged. d. The UK is expected to impose a small tariff on goods imported from Country K. e. Combine all expected impacts to develop an overall forecast.

a. Increased UK demand for the krank. Decreased supply of kranks for sale. Upwardpressure in the krank's value. b. Decreased UK demand for the krank. Increased supply of kranks for sale. Downwardpressure on the krank's value. c. Increased UK demand for the krank. Upward pressure on the krank's value. d. The tariff will cause a decrease in the United Kingdom' desire for Country K's goods,and will therefore reduce the demand for kranks for sale. Downward pressure on the krank'svalue. e. Two of the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the UK and Country K. The interest rate scenario places downward pressure on thekrank's value. Since the interest rates affect capital flows and capital flows dominate trade flows between the UK and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate.

The value of each Latin American currency relative to the British pound is dictated by supply and demand conditions between that currency and the pound. The values of Latin American currencies have generally declined substantially against the pound over time. Most of these countries have high inflation rates and high interest rates. The data on inflation rates, economic growth, and other economic indicators are subject to error, as limited resources are used to compile the data. a. If the forward rate is used as a market-based forecast, will this rate result in a forecast of appreciation, depreciation, or no change in any particular Latin American currency? Explain. b. If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no change in the value of a specific Latin American currency? Explain. c. Do you think that UK firms can accurately forecast the future values of Latin American currencies? Explain.

a. The forward rate of each Latin American currency would have a large discount, because the Latin American interest rate would be much higher than the UK interest rate. The discount serves as the forecast of the percentage change in the value of the Latin American currency over the length of time represented by the forward contract period. b. Technical forecasting would result in a forecast of depreciation, because the Latin American currencies have declined consistently in the past, and most technical methods would apply the past trends to the future. c. UK firms cannot forecast Latin American currency values accurately, because they are so volatile. UK firms even have trouble forecasting the values of currencies of industrialized countries. The values change in response to economic conditions, which are volatile and difficult to anticipate. The values are also affected by political conditions, which are also difficult to predict.

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. b. High interest rates are commonly expected to strengthen a country's currency because theycan 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 dollarover most years even though Mexican interest rates are typically much higher than US interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial US investment in Mexico's securities. Why do you think US investors do not try to capitalizeon the high interest rates in Mexico? c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a US firm that does substantial business in Mexico?

a. The high inflation in Mexico places continual downward pressure on the value of the peso. b. The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the US real interest rate. Given the high inflationary expectations, US investors recognize the potential weakness of the peso, which could more than offset the high interest rate (when they convert the pesos back to dollars at the end of the investment period). Therefore, the high Mexican interest rates do not encourage US investment in Mexican securities, and do not help to strengthen the value of the peso. c. 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 US firm that does business in Mexico because it increases the transactions costs associated with conversion of dollars to pesos, or pesos to dollars.

For all parts of this question, assume that interest rate parity exists, the prevailing one-year UK nominal interest rate is low, and that you expect UK inflation to be low this year. a. Assume that the country Dinland engages in much trade with the United Kingdom and the trade involves many different products. Dinland has had a zero trade balance with the United Kingdom (the value of exports and imports is about the same) in the past. Assume that you expect a high level of inflation (about 40 %) in Dinland over the next year because of a large increase in the prices of many products that Dinland produces. Dinland presently has a one-year risk-free interest rate of more than 40 %. Do you think that the prevailing spot rate or the one-year forward rate would result in a more accurate forecast of Dinland's currency (the din) one yearfrom now? Explain. b. Assume that the country Freeland engages in much trade with the United Kingdom and the trade involves many different products. Freeland has had a zero trade balance with the United Kingdom (the value of exports and imports is about the same) in the past. You expect high inflation (about 40 %) in Freeland over the next year because of a large increase in the cost of land (and therefore housing) in Freeland. You believe that the prices of products that Freeland produces will not be affected. Freeland presently has a one-year risk-free interest rate of more than 40 %. Do you think that the prevailing one-year forward rate of Freeland's currency (the fre)would overestimate, underestimate, or be a reasonably accurate forecast of the spot rate one year from now? [Presume a direct quotation of the exchange rate, so that if the forward rate underestimates, it means that its value is less than the realized spot rate in one year. If the forward rate overestimates, it means that its value is more than the realized spot rate in one year.]

a. The high inflation should create a shift in international trade, which will place severe downward pressure on the value of the din. Since the forward rate of the din would have a large discount, it should provide a better forecast than the spot rate. b. The inflation in Freeland does not affect the trade balance between the UK and Freeland.Therefore, the value of Freeland's currency should not be substantially affected by trade flows. Since the forward rate of the fre would contain a large discount, it would likely underestimate the spot of the fre in one year.

Every month, the UK 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? 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.

a. 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 UK demand for foreign currencies may be larger than initially anticipated. Thus, the pound would be expected to weaken. Some speculators may take a position in foreign currencies immediately and could cause an immediate decline in the pound. b. 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.

Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the US dollar. Your subsidiary borrowed funds from the US parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on: a. The volume of your subsidiary's 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 US parent (measured in A$).

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 it appreciates against the US dollar. c. The interest expenses should decline because it will take fewer A$ to make the monthly payment of $100,000.

a. How can currency futures be used by corporations? b. How can currency futures be used by speculators?

a. US corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. US corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. b. Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency.