IBF Test 2 Short Answer Questions

Assume that the annual U.S. interest rate is currently 8 percent and Germany's annual interest rate is currently 9 percent. The euro's one-year forward rate currently exhibits a discount of 2 percent. Does interest rate parity exist?

No, because the discount is larger than the interest rate differential

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

Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currency's value. These purchases of secur¬ities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investors' original expectations, an announced forecast does not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected.

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 U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on the cost to your subsidiary of purchasing materials (measured in A$)

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

The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year?

$.14 × (1 - .07273) = $.1298

Assume that the spot exchange rate of the Singapore dollar is $.70. The one year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? What is the force that causes the spot rate to change according to the IFE?

$.70 × (1 + .0374) = $.7262. The force that causes this expected effect on the spot rate is the inflation differential. The anticipated inflation differential can be derived from interest rate differential.

Assume the following information: Quoted Price Spot rate of CA dollar $.80 90 day forward rate of CA dollar $.79 90 day Canadian interest rate 4% 90 day U.S. interest rate 2.5% Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage?

$1,000,000/$.80 = C$1,250,000 × (1.04) = C$1,300,000 × $.79 = $1,027,000 Yield = ($1,027,000 - $1,000,000)/$1,000,000 = 2.7%, which exceeds the yield in the U.S. over the 90 day period. The Canadian dollar's spot rate should rise, and its forward rate should fall; in addition, the Canadian interest rate may fall and the U.S. interest rate may rise.

Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent. If the euro's spot rate is $1.10, what should the one-year forward rate of the euro be?

$1.079

As of today, assume the following information is available: Real rate of interest required by investors: US 2% MX 2%, Nominal interest rate: US 11% MX 15%, Spot rate: $.20, One year forward rate: $.19 Use the forward rate to forecast the percentage change in the Mexican peso over the next year.

($.19 - $.20)/$.20 = -.05, or -5%

Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect?

($1.66 - $1.73)/$1.73 = -4.05%, Expected depreciation of 4.05% percent

As of today, assume the following information is available: Real rate of interest required by investors: US 2% MX 2%, Nominal interest rate: US 11% MX 15%, Spot rate: $.20, One year forward rate: $.19 Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year.

(1.09)/(1.13) - 1 = -.0353 or -3.53%; the negative sign represents depreciation of

The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. What is the forward rate premium?

-.07273

Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent. According to IRP, what should the forward rate premium or discount of the euro be?

-1.89%

The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. Based on the international Fisher effect, what is the expected change in the spot rate over the next year?

-7.273%

Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. If the spot rate of the euro in one year is $1.00, what is Beth's percentage return from her strategy?

1. Convert dollars to euros: $100,000/$1.10 = €90,909.09 2. Invest euros for one year and receive €90,909.09 × 1.05 = €95,454.55 3. Convert euros back to dollars and receive €95,454.55 × $1.00 = $95,454.55 The percentage return is $95,454.55/$100,000 - 1 = -4.55%.

Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. If the spot rate of the euro in one year is $1.08, what is Beth's percentage return from her strategy?

1. Convert dollars to euros: $100,000/$1.10 = €90,909.09 2. Invest euros for one year and receive €90,909.09 × 1.05 = €95,454.55 3. Convert euros back to dollars and receive €95,454.55 × $1.08 = $103,090.91 The percentage return is $103,090.91/$100,000 - 1 = 3.09%.

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 the Mexican peso. Assume that Mexico's one-year interest rate is 40 percent, while the U.S. one-year interest rate is 7 percent. Over the next year, the peso depreciates by 12 percent. 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 U.S. Since the discount exceeds 12 percent, the forward rate would have actually underestimated the future spot rate in this example. (This answer may surprise many students; it deserves attention in class.)

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.

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

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 unem¬ployment. 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 pro¬ducers 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 competi¬tive. 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 strong home currency (imports become cheaper to that country but the country's exports become more expensive to foreign customers).

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 inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent?

According to PPP, the exchange rate of the pound will depreciate by 4.7 percent. Therefore, the spot rate would adjust to $1.73 × [1 + (-.0467)] = $1.649.

Assume the following information is available for the U.S. and Europe: Nominal interest rate US 4% EU 6% Expected inflation US 2% EU 5% Spot rate ----- $1.13 One-year forward rate ----- $1.10 According to PPP, what is the expected spot rate of the euro in one year?

According to PPP, the expected spot rate of the euro in one year is $1.13 × (1 - 2.86%) = $1.098

Shouldn't the IFE discourage investors from attempting to capitalize on higher foreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas?

According to the IFE, higher foreign interest rates should not attract investors because these rates imply high expected inflation rates, which in turn imply potential depreciation of these currencies. Yet, some investors still invest in foreign countries where nominal interest rates are high. This may suggest that some investors believe that (1) the anticipated inflation rate embedded in a high nominal interest rate is overestimated, or (2) the potentially high inflation will not cause substantial depreciation of the foreign currency (which could occur if adequate substitute products were not available elsewhere), or (3) there are other factors that can offset the possible impact of inflation on the foreign currency's value.

Assume the following information is available for the U.S. and Europe: Nominal interest rate US 4% EU 6% Expected inflation US 2% EU 5% Spot rate ----- $1.13 One-year forward rate ----- $1.10 According to the IFE, what is the expected spot rate of the euro in one year?

According to the IFE, the expected spot rate of the euro in one year is $1.13 × (1 - 1.89%) = $1.1086.

The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble.

As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian goods would be low. Thus, the ruble's value should depreciate against the dollar, and against other currencies.

Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

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.

Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. What must the spot rate of the euro be in one year for Beth's strategy to be successful?

Beth's strategy would be successful if the spot rate of the euro in one year is greater than $1.079.

Assume that the inflation rate in Brazil is expected to increase substantially. How will this affect Brazil's nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the higher inflation in Brazil? Explain.

Brazil's nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. If the IFE holds, the return to U.S. investors who invest in Brazil would not be affected. Even though they now earn a higher nominal interest rate, the expected decline in the Brazilian real offsets the additional interest to be earned.

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.

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

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

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 cause more 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.

Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible.

Covered interest arbitrage involves the short term investment in a foreign currency that is covered by a forward contract to sell that currency when the investment matures. Covered interest arbitrage is plausible when the forward premium does not reflect the interest rate differential between two countries specified by the interest rate parity formula. If transactions costs or other considerations are involved, the excess profit from covered interest arbitrage must more than offset these other considerations for covered interest arbitrage to be plausible.

Assume that the one-year U.S. interest rate is 11 percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase the currency of that country from you one year from now at a discount of 13 percent. Would covered interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest arbitrage in this situation? (Ignore tax effects.)

Covered interest arbitrage would be worth considering since the return would be 21.8 percent, which is much higher than the U.S. interest rate. Assuming a $1,000,000 initial investment, $1,000,000 × (1.40) × .87 = $1,218,000 Yield = ($1,218,000 - $1,000,000)/$1,000,000 = 21.8% However, the funds would be invested in Malaysia, which could cause some concern about default risk or government restrictions on convertibility of the currency back to dollars.

The following information is available: • You have $500,000 to invest • The current spot rate of the Moroccan dirham is $.110. • The 60-day forward rate of the Moroccan dirham is $.108. • The 60-day interest rate in the U.S. is 1 percent. • The 60-day interest rate in Morocco is 2 percent. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest arbitrage work for the investor in this case?

Covered interest arbitrage would involve the following steps: 1. Convert dollars to Moroccan dirham: $500,000/$.11 = MD4,545,454.55 2. Deposit the dirham in a Moroccan bank for 60 days. You will have MD4,545,454.55 × (1.02) = MD4,636,363.64 in 60 days. 3. In 60 days, convert the dirham back to dollars at the forward rate and receive MD4,636,363.64 × $.108 = $500,727.27 The yield to the U.S. investor is $500,727.27/$500,000 - 1 = .15%. Covered interest arbitrage did not work for the investor in this case. The lower Moroccan forward rate more than offsets the higher interest rate in Morocco.

Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ = 0.25 Singapore dollars. Today, a HK$=0.30 Singapore dollars. Assume that there is much trade in the computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as substitutes for each other and are of about the same quality. Assume that the firms invoice their products in their local currency and do not change their prices. a. Will the computer exports from the U.S. to Hong Kong increase, decrease, or remain the same? Briefly explain

Decrease. The H.K. dollar appreciated against the Singapore dollar while fixed against US dollar, so it should shift purchases to Singapore and away from the US

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

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

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. Explain why other Latin American currencies could be affected by a cut in Chile's interest rates.

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.

U.S. bond prices are normally inversely related to U.S. inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected?

Expectations of a weak dollar can cause expectations of higher inflation, because a weak dollar places upward pressure on U.S. prices for reasons mentioned in the chapter. Higher inflation tends to place upward pressure on interest rates. Because there is an inverse relationship between interest rates and bond prices, bond prices would be expected to decline. Such an expectation causes bond portfolio managers to liquidate some of their bond holdings, thereby causing bond prices to decline immediately.

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 infla¬tionary 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.

How is it possible for PPP to hold if the IFE does not?

For the IFE to hold, the following conditions are necessary: (1) investors across countries require the same real returns, (2) the expected inflation rate embedded in the nominal interest rate occurs, (3) the exchange rate adjusts to the inflation rate differential according to PPP. If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher returns when invest¬ing in a foreign country's securities. Thus, IFE would be refuted.

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 vari¬ables 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 the currency'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.

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. .

Lexington Co. is a U.S. 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 U.S. dollar. Comment on this policy. How might Lexington Co. ensure consistent forecasts among the different subsidiaries?

If each subsidiary uses its own data and techniques to forecast its local currency's exchange 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.

Given the recent conversion of several European currencies to the euro, explain what would cause the euro's value to change against the dollar according to the IFE.

If interest rates change in these European countries whose home currency is the euro, the expected inflation rate in those countries change, so that the inflation differential between those countries and the U.S. changes. Thus, there may be an impact on the value of the euro, because a change in the inflation differential affects trade flows and therefore affects the exchange rate.

Assume that there are substantial capital flows among Canada, the U.S., and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar against the U.S. dollar? How might this decline in Canada's interest rates possibly affect the value of the Canadian dollar against the Japanese yen?

If interest rates in Canada decline, there may be an increase in capital flows from Canada to the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S. interest rates, while U.S. investors reduce their investments in Canada's securities. This places downward pressure on the Canadian dollar's value. Japanese investors that previously invested in Canada may shift to the U.S. Thus, the reduced flow of funds from Japan would place downward pressure on the Canadian dollar against the Japanese yen.

Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one year securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico.

If investors from the U.S. and Mexico required the same real (inflation adjusted) return, then any difference in nominal interest rates is due to differences in expected inflation. Thus, the inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate. According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreci¬ation of the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact formula, since the concept is stressed here more than precision.)

Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. According to the IFE, what should the spot rate of the euro in one year be?

If the IFE holds, the euro should depreciate by 1.90 percent in one year. This translates to a spot rate of $1.10 × (1 - 1.90%) = $1.079.

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.

Every month, the U.S. trade deficit figures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced. 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.

Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ = 0.25 Singapore dollars. Today, a HK$=0.30 Singapore dollars. Assume that there is much trade in the computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as substitutes for each other and are of about the same quality. Assume that the firms invoice their products in their local currency and do not change their prices. Will the computer exports from Singapore to the U.S. increase, decrease, or remain the same? Briefly explain.

Increase. The U.S. dollar appreciated against the Singapore dollar, so it is cheaper to buy goods in Singapore

Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher effect (IFE).

Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium (or discount). PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate differentials, which are influenced by expected inflation. Thus, the IFE is closely related to PPP.

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.

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).

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.

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. A central bank's indirect intervention can affect the factors that influence exchange rates and therefore 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.

Cooper, Inc., a U.S.-based MNC, periodically obtains euros to purchase German products. It assesses U.S. 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.

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.

Currencies of some Latin American countries, such as Brazil and Venezuela, frequently weaken against most other currencies. What concept in this chapter explains this occurrence? Why don't all U.S.-based MNCs use forward contracts to hedge their future remittances of funds from Latin American countries to the U.S. even if they expect depreciation of the currencies against the dollar?

Latin American countries typically have very high infla¬tion, as much as 200 percent or more. PPP theory would suggest that currencies of these countries will depreciate against the U.S. dollar (and other major currencies) in order to retain purchasing power across countries. The high inflation dis¬courages demand for Latin American imports and places downward pressure in their Latin American currencies. Depreciation of the currencies offsets the increased prices on Latin American goods from the perspective of importers in other countries. Interest rate parity forces the forward rates to contain a large discount due to the high interest rates in Latin America, which reflects a disadvantage of hedging these currencies. The decision to hedge makes more sense if the expected degree of depreciation exceeds the degree of the forward discount. Also, keep in mind that some remittances cannot be perfectly hedged anyway because the amount of future remittances is uncertain.

Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.

Locational arbitrage can occur when the spot rate of a given currency varies among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations should become realigned

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. If the 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 specu¬lative 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.

Assume that the annual U.S. interest rate is currently 8 percent and Germany's annual interest rate is currently 9 percent. The euro's one-year forward rate currently exhibits a discount of 2 percent. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage?

No, because the discount on a forward sale exceeds the interest rate advantage of investing in Germany

The South African rand has a one-year forward premium of 2 percent. One-year interest rates in the U.S. are 3 percentage points higher than in South Africa. Based on this information, is covered interest arbitrage possible for a U.S. investor if interest rate parity holds?

No, covered interest arbitrage is not possible for a U.S. investor. Although the investor can lock in the higher exchange rate in one year, interest rates are 3 percent lower in South Africa.

Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds.

One method is to choose two countries and compare the inflation differential to the exchange rate change for several different periods. Then, determine whether the exchange rate changes were similar to what would have been expected under PPP theory. A second method is to choose a variety of countries and compare the inflation differential of each foreign country relative to the home country for a given period. Then, determine whether the exchange rate changes of each foreign currency were what would have been expected based on the inflation differentials under PPP theory. A limitation in testing PPP is that the results will vary with the base period chosen. The base period should reflect an equilibrium position, but it is difficult to determine when such a period exists.

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 sug¬gested by PPP) if substitutes are not available.

Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of curren¬cies in countries with high inflation?

PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar.

Assume the following information is available for the U.S. and Europe: Nominal interest rate US 4% EU 6% Expected inflation US 2% EU 5% Spot rate ----- $1.13 One-year forward rate ----- $1.10 Reconcile your answers to parts (a). and (c).

Parts a and c combined say that the forward rate premium or discount is exactly equal to the expected percentage appreciation or depreciation of the euro

The director of currency forecasting at Champaign Urbana Corp. says, "The most critical task of forecasting exchange rates is not to derive a point estimate of a future exchange rate but to assess how wrong our esti¬mate 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.

The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the perspective of Russian consumers (after considering exchange rates)? Explain.

Russian prices might be higher than U.S. prices, even after considering exchange rates, because the ruble might not depreciate enough to fully offset the Russian inflation. The exchange rate cannot fully adjust if there are barriers on trade or currency convertibility.

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 effec¬tive 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.

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's forecast 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.

Assume that the existing U.S. one year interest rate is 10 percent and the Canadian one year interest rate is 11 percent. Also assume that interest rate parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return?

The Canadian dollar's forward rate should exhibit a discount because its interest rate exceeds the U.S. interest rate. U.S. investors would earn a return of 10 percent using covered interest arbitrage, the same as what they would earn in the U.S. Canadian investors would earn a return of 11 percent using covered interest arbitrage, the same as they would earn in Canada.

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.

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

The Federal Reserve would normally consider a loose money policy to stimulate the economy. However, to the extent that the policy puts upward pressure on economic growth and inflation, it could weaken the dollar. A weak dollar is expected to favorably affect U.S. exporting firms and adversely affect U.S. importing firms. If the U.S. interest rates rise in response to the possible increase in economic growth and inflation in the U.S., this could offset the downward pressure on the U.S. dollar. In this case, U.S. exporting and importing firms would not be affected as much.

Explain the international Fisher effect (IFE). What is the rationale for the existence of the IFE? What are the implications of the IFE for firms with excess cash that consistently invest in foreign Treasury bills? Explain why the IFE may not hold.

The IFE suggests that a currency's value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currency's value if it occurs. The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addi¬tion to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold.

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 depreci¬ate 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 one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. Compare your answers to (b) and (d) and explain the relationship

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

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.

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. How would the central banks of other Latin American countries be likely to adjust their interest rates? How would the currencies of these countries respond to the central bank intervention?

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.

You reside in the U.S. and are planning to make a one-year investment in Germany during the next year. Since the investment is denominated in euros, you want to forecast how the euro's value may change against the dollar over the one-year period. You expect that Germany will experience an inflation rate of 1% during the next year, while all other European countries will experience an inflation rate of 8% over the next year. You expect that the U.S. will experience an annual inflation rate of 2% during the next year. You believe that the primary factor that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate, or stay at about the same level against the dollar over the next year? Explain.

The euro should depreciate because most countries in the Eurozone are presumed to have high inflation.

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 U.S. and the countries using the euro or their currency. The pound's value changes in response to the flow of funds between the U.S. and the U.K. [Answer is based on intuition, is not directly from the text.]

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).

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.

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. How would a U.S. firm that exports products to Latin American countries be affected by the central bank intervention? (Assume the exports are denominated in the corresponding Latin American currency for each country.)

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 one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. What is the one-year forward rate of the peso?

The forward rate is $.14 × (1 - .07273) = $.1298

One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean?

The real return is the nominal return minus the inflation rate. If all investors require the same real return, then the differentials in nominal interest rates should be solely due to differentials in anticipated inflation among countries.

You believe that the Singapore dollar's exchange 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 U.S. is 3%. You expect that annual inflation will be about 4% in Singapore and 1% in the U.S. Assume that interest rate parity holds. Today the spot rate of the Singapore dollar is $.63. 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.

The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. Does the effect of Russian inflation on the decline in the ruble's value support the PPP theory? How might the relationship be distorted by political conditions in Russia?

The general relationship suggested by PPP is supported, but the ruble's value will not normally move exactly as specified by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the ruble may not decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the government may not allow the ruble to float freely to its proper equilibrium level.

Assume that several European countries that use the euro as their currency experience higher inflation than the United States, while two other European countries that use the euro as their currency experience lower inflation than the United States. According to PPP, how will the euro's value against the dollar be affected?

The high European inflation overall would reduce the U.S. demand for European products, increase the European demand for U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro's value would adjust in response to the weighted inflation rates of the European countries that are represented by the euro relative to the inflation in the U.S. If the European inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro.

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. 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.

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?

The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate (when they convert the pesos back to dollars at the end of the investment period). Therefore, the high Mexican interest rates do not encourage U.S. investment in Mexican securities, and do not help to strengthen the value of the peso.

During the Asian crisis (see Appendix 6 at the end of this chapter), 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.

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.

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.

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 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 U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on the cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$).

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

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.

Before the Asian crisis, many investors attempted to capitalize on the high interest rates prevailing in the Southeast Asian countries although the level of interest rates primarily reflected expectations of inflation. Explain why investors behaved in this manner. Why does the IFE suggest that the Southeast Asian countries would not have attracted foreign investment before the Asian crisis despite the high interest rates prevailing in those countries?

The investors' behavior suggests that they did not expect the international Fisher effect (IFE) to hold. Since central banks of some Asian countries were maintaining their currencies within narrow bands, they were effectively preventing the exchange rate from depreciating in a manner that would offset the interest rate differential. Consequently, superior profits from investing in the foreign countries were possible. If investors believed in the IFE, the Asian countries would not attract a high level of foreign investment because of exchange rate expectations. Specifically, the high nominal interest rate should reflect a high level of expected inflation. According to purchasing power parity (PPP), the higher interest rate should result in a weaker currency because of the implied market expectations of high inflation.

Assume that the Japanese yen's 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?

The premium will decrease in order to maintain IRP, because the difference between the interest rates is reduced. We would expect the premium to change because as U.S. interest rates decrease, U.S. investors could benefit from covered interest arbitrage if the forward premium stays the same. The return earned by U.S. investors who use covered interest arbitrage would not be any higher than before, but the return would now exceed the interest rate earned in the U.S. Thus, there is downward pressure on the forward premium.

Every month, the U.S. trade deficit figures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced. 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 implica¬tions 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 curren¬cies immediately and could cause an immediate decline in the dollar.

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 U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on the volume of your subsidiary's sales in Australia (measured in 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.

Assume the following information is available for the U.S. and Europe: Nominal interest rate US 4% EU 6% Expected inflation US 2% EU 5% Spot rate ----- $1.13 One-year forward rate ----- $1.10 Does IRP hold?

Therefore, the forward rate of the euro should be $1.13 × (1 - .0189) = $1.109. IRP does not hold in this case.

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.

Assume that the four year annualized interest rate in the United States is 9 percent and the four year annualized interest rate in Singapore is 6 percent. Assume interest rate parity holds for a four year horizon. Assume that the spot rate of the Singapore dollar is $.60. If the forward rate is used to forecast exchange rates, what will be the forecast for the Singapore dollar's spot rate in four years? What percentage appreciation or depreciation does this forecast imply over the four year period? Country Four Year Compounded Return U.S. (1.09)4 - 1 = 41% Singapore (1.06)4 - 1 = 26% Premium = 1.41/1.26 - 1 = 11.9%

Thus, the four year forward rate should contain an 11.9% premium above today's spot rate of $.60, which means the forward rate is $.60 × (1 + .119) = $.6714. The forecast for the Singapore dollar's spot rate in four years is $.6714, which represents an appreciation of 11.9% over the four year period.

Covered Interest Arbitrage. Assume the following information: Spot rate of Mexican peso = $.100 180 day forward rate of MX peso = $.098 180 day Mexican interest rate = 6% 180 day U.S. interest rate = 5% Given this information, is covered interest arbitrage worth¬while for Mexican investors who have pesos to invest? Explain your answer.

To answer this question, begin with an assumed amount of pesos and determine the yield to Mexican investors who attempt covered interest arbitrage. Using MXP1,000,000 as the initial investment: MXP1,000,000 × $.100 = $100,000 × (1.05) = $105,000/$.098 = MXP1,071,429 Mexican investors would generate a yield of about 7.1% ([MXP1,071,429 - MXP1,000,000]/MXP1,000,000), which exceeds their domestic yield. Thus, it is worthwhile for them.

The one year interest rate in New Zealand is 6 percent. The one year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible.

To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed initial investment, such as $1,000,000. $1,000,000/$.50 = NZ$2,000,000 × (1.06) = NZ$2,120,000 × $.54 = $1,144,800 Yield = ($1,144,800 - $1,000,000)/$1,000,000 = 14.48% Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S. interest rate of 10 percent. To determine the yield from covered interest arbitrage by New Zealand investors, start with an assumed initial investment, such as NZ$1,000,000: NZ$1,000,000 × $.50 = $500,000 × (1.10) = $550,000/$.54 = NZ$1,018,519 Yield = (NZ$1,018,519 - NZ$1,000,000)/NZ$1,000,000 = 1.85% Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of 1.85% is less than the 6% that they could receive from investing their funds in New Zealand.

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.

Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible.

Triangular arbitrage is possible when the actual cross exchange rate between two currencies differs from what it should be. The appropriate cross rate can be determined given the values of the two currencies with respect to some other currency.

Consider investors who invest in either U.S. or British one year Treasury bills. Assume zero transaction costs and no taxes. If interest rate parity exists, then the return for British investors who use covered interest arbitrage will be the same as the return for British investors who invest in British Treasury bills. Is this statement true or false? If false, correct the statement.

True

Consider investors who invest in either U.S. or British one year Treasury bills. Assume zero transaction costs and no taxes. If interest rate parity exists, then the return for U.S. investors who use covered interest arbitrage will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this statement true or false? If false, correct the statement.

True

The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S. importers? That is, how will U.S. importers of Russian goods be affected by the conditions?

U.S. importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the ruble's value. This may cause a reduction in the U.S. demand for Russian goods.

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 or inflation.

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.

Explain the rationale of the PPP theory.

When inflation is high in a particular country, foreign demand for goods in that country will decrease. In addition, that country's demand for foreign goods should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that a foreign country's goods are no more attractive than the home country's goods. Inflation differentials are offset by exchange rate changes.

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

Yen Actual Pound Actual Period Forecast Yen Value Forecast Pound Value 1 $.0050 $.0051 $1.50 $1.51 2 .0048 .0052 1.53 1.50 3 .0053 .0052 1.55 1.58 4 .0055 .0056 1.49 1.52 Absolute Forecast Error as a Percentage of the Realized Value Period Yen Forecast Pound Forecast 1 1.96% .66% 2 7.69 2.00 3 1.92 1.89 4 1.78 1.97 Mean 3.34% 1.63% Because the mean absolute forecast error of the pound is lower than that of the yen, the pound was forecasted with greater accuracy.

Assume that the annual U.S. interest rate is currently 8 percent and Germany's annual interest rate is currently 9 percent. The euro's one-year forward rate currently exhibits a discount of 2 percent. Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through covered interest arbitrage?

Yes, because even though it would earn 1 percent less interest over the year by investing in U.S. dollars, it would be able to sell dollars for 2 percent more than it paid for them (it would be buying euros forward at a discount of 2 percent).

The following information is available: • You have $500,000 to invest • The current spot rate of the Moroccan dirham is $.110. • The 60-day forward rate of the Moroccan dirham is $.108. • The 60-day interest rate in the U.S. is 1 percent. • The 60-day interest rate in Morocco is 2 percent. Would covered interest arbitrage be possible for a Moroccan investor in this case?

Yes, covered interest arbitrage would be possible for a Moroccan investor. The investor would convert dirham to dollars, invest the dollars at a 1 percent interest rate in the U.S., and sell the dollars forward 60 days. Even though the Moroccan investor would earn an interest rate that is 1 percent lower in the U.S., the forward rate discount of the dirham more than offsets that differential.

Assume the following information: Beal Bank Yardley Bank Bid price of NZ dollar $.401 $.398 Ask price of NZ dollar $.404 $.400 Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of locational arbitrage?

Yes. One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby generating a profit of $2,500. The large demand for New Zealand dollars at Yardley Bank will force this bank's ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial.

The Hong Kong dollar's value is tied to the U.S. dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States.

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 U.S. should increase because Japanese goods become more expensive to U.S. importers as a result of yen appreciation. Therefore, some U.S. importers may find that even though the exchange rate between the U.S. dollar and Hong Kong dollar is unchanged, the Hong Kong prices are now lower than Japanese prices (from a U.S. perspective). This answer assumes that Japanese exporters did not reduce their prices to compensate U.S. importers for the weaker dollar. If Japanese exporters do reduce their prices to fully offset the effect of the stronger yen, there would be less of a shift to Hong Kong goods.

As of today, assume the following information is available: Real rate of interest required by investors: US 2% MX 2%, Nominal interest rate: US 11% MX 15%, Spot rate: $.20, One year forward rate: $.19 Use the spot rate to forecast the percentage change in the Mexican peso over the next year.

zero percent change