International Finance Test 2 Practice Problems

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.

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).

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. True/False

False

If investors in the United States and Canada require the same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary expectations suggest about future exchange rates?

Expected inflation in Canada is 2 percent above expected inflation in the U.S. If these inflationary expectations come true, PPP would suggest that the value of the Canadian dollar should depreciate by 2 percent against the U.S. dollar.

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?

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.

Explain the concept of interest rate parity. Provide the rationale for its possible existence.

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.

Why would the Fed's indirect intervention have a stronger impact on some currencies than others? Why would a central bank's indirect intervention have a stronger 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.

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.

Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yen's value? Why does this expected relationship not always occur?

Japan's low inflation should place upward pressure on the yen's value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yen's value.

PPP may hold better for some countries than for others. The Thai baht has been freely floating for more than a decade. How do you think Blades can gain insight into whether PPP holds for Thailand? Offer some logic to explain why the PPP relationship may not hold here.

One possible way to determine whether PPP holds between two countries is to regress historical exchange rate changes on the inflation differential between two countries. The PPP relationship may not hold because other factors also influence the baht exchange rate.

Explain why PPP does not hold.

PPP does not consistently hold because there are other factors besides inflation that influences 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 a country's inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available.

Assume that France wants to change the prevailing spot rate of its currency (euro) in order to improve its economy, while Switzerland wants to change the prevailing value of its currency (Swiss franc) in order to improve its economy. Which of these two countries is more likely to have more control over its currency? Briefly explain.

Switzerland should have more control over its currency. France does not have control over its currency because many other countries also use the euro as their currency.

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 U.S. interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if they believe in the IFE?

The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased U.S. securities would on average receive a similar yield as what they receive in their own country, and U.S. investors that purchased foreign securities would on average receive a yield similar to U.S. rates.

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.

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 decreased, or the forward discount became more pronounced.

During the Asian crisis, some Asian central banks raised their interest 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.

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.

Inflation differentials between the U.S. and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP?

The information suggests that there are other factors besides inflation differentials that influence exchange rate movements. Thus, the exchange rate movements will not necessarily conform to inflation differentials, and therefore PPP will not necessarily hold.

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?

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

Why do you think currencies of countries with high inflation rates tend to have forward discounts?

These currencies have high interest rates, which cause forward rates to have discounts as a result of interest rate parity.

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.

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. True/False

True

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. True/False

True