International Finance test 2

Impact on Financial Flows in the Eurozone

-Bond investors who reside in the eurozone can invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros. --A single European currency forces the risk-free interest rate offered on government securities to be similar across the participating European countries. (Why?) --However, the yields offered on bonds issued within the eurozone need not be similar. (Why?) -Equity investors who reside in the eurozone can invest in stocks in these countries without concern about exchange rate.

Smithsonian Agreement 1971 - 1973

-By 1971, it appeared that some currency values would need to be adjusted in order to restore a more balanced flow of payments between countries. -It called for a devaluation of the U.S. dollar by about 8% against other currencies. -Boundaries for the currency values were expanded to within 2.25% above or below the initially set rates. -By March 1973, most governments of the major countries were no longer attempting to maintain their home currency values within the boundaries.

Pegged Exchange Rate System

-Home currency's value is pegged to one foreign currency or to an index of currencies. --is fixed in terms of the foreign currency to which it is pegged. --moves in line with that currency against other currencies. -Governments might implement a pegged exchange rate when its currency is very volatile due to uncertain economic or political conditions. -Limitations of pegged exchange rate: --Although countries with a pegged exchange rate may attract foreign investment because exchange rate is expected to remain stable, Weak economic or political conditions can cause firms and investors to question whether the peg will be broken. --If the peg is broken and if the exchange rate is dictated by market forces, then the local currency's value could immediately decline substantially.

Impact on a Country that Abandons the Euro

-If a country's government faces a crisis and is unable to obtain sufficient funding in the eurozone, it might seek to abandon the euro as its home currency. -If the country had its own currency, then it might be able to set its exchange rate low enough that its currency become inexpensive to potential importers. --However, a weak home currency is not a perfect cure because it can cause higher inflation. --In addition, if the country planned to repay its debt and if the debt was denominated in a different currency, repayment of debt with a weak currency would be more expensive. -The typical risk-free market interest rate in such a country would likely be very high. -The credit risk premium would also be high for borrowers -It would possibly be expelled from the European Union, which would almost certainly reduce its trade with other European Union countries.

Impact of Abandoning the Euro on Eurozone Conditions

-Investors may fear other countries abandoning the euro and a possible collapse of the euro, so they may not be willing to invest any more funds in the eurozone. -Investors may also be concerned that existing investments in the eurozone may perform poorly when the proceeds are converted into their home currency, so they may sell their assets. -Critics agree that the threat of abandonment creates more problems than actual abandonment. --Countries that want additional credit under favorable terms might use the threat of abandonment to obtain more funding.

Managed Float Exchange Rate System

-It allows its currency's value to float on a daily basis. -Governments sometimes intervene to prevent their currencies from moving too far in a certain direction, or to achieve other economic conditions. -Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks. -Criticisms of the managed float system: managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others.

Impact of Crises within the Eurozone

-It may affect the economic conditions of the other participating countries both in a favorable way and in an unfavorable way, because they all rely on the same currency and same monetary policy. -The eurozone arrangement might commit the government of each eurozone country (legally or politically) to bail out any other eurozone country that experiences an economic crisis. -Greece debt crisis in 2010, 2012 & 2015.

Bretton Woods Agreement 1944 - 1971

-Most exchange rates were fixed -Each currency was valued in terms of gold. --Eg: the U.S. dollar was valued as 1/35 ounce of gold. -Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1% above or below the initially set rates.

Impacts on Firms in the Eurozone

-Prices of products are now more comparable among European countries. Thus firms can more easily determine where they can purchase products at the lowest cost. -Firms can engage in international trade within the eurozone without incurring foreign exchange transactions costs. -It also encourages more long-term international trade arrangements between firms within the eurozone. -Firms in the eurozone may face more competition. -Firm's performance can be compared more easily to others.

Speculating on Intervention

-Some traders in the foreign exchange market attempt to determine when Federal Reserve intervention is occurring and the extent of the intervention in order to capitalize on the anticipated results of the intervention effort. -Speculating on Intervention Intended to Strengthen a Currency --Take a long position: purchase the currency at a lower price than the price at which they can sell the currency after the central bank intervention has had its effect. -Speculating on Intervention Intended to Weaken a Currency --Take a short positions: borrow the currency and exchange it for other currencies, then reverse the transaction after the intervention has occurred. -The obvious risk to these speculative strategies is that their expectations about a central bank intervening or the effects of the direct intervention may be wrong.

Covered Interest Arbitrage

-The process of capitalizing on the difference in interest rates between two countries (interest arbitrage) while covering your exchange rate risk with a forward contract (covered). -The forward rate of a currency for a specified future date is determined by the interaction of demand for the contract (forward purchases) versus the supply (forward sales). -The funds are tied up for a period of time (90 days in our example). -The term arbitrage here suggests that you can guarantee a return on your funds that exceeds the returns you could achieve domestically. -This strategy would not be advantageous if it earned 2 percent or less, as you could earn 2 percent on a domestic deposit. -Realignment due to covered interest arbitrage forces forward rates back into equilibrium. --As many investors capitalize on covered interest arbitrage by selling British pounds forward, there is downward pressure on the 90-day forward rate. --Once the forward rate has a discount from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage will no longer be feasible.

Nominal Interest Rate

= real interest rate + expected inflation rate

Direct Intervention

A country's central bank can use direct intervention by engaging in foreign exchange transactions that affect the demand or supply market conditions for its currency.

European Central Bank (ECB)

Based in Frankfurt and is responsible for setting monetary policy for all participating European countries. Its objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.

Relative Form of Purchasing Power Parity (PPP)

Due to market imperfections, prices of the same basket of products in different countries will not necessarily be the same, but the rate of change in prices should be similar when measured in a common currency. -The exchange rate should adjust to offset the differential in the two countries' inflation rates, in which case the prices of products in the two countries should appear similar to consumers.

Freely Floating Exchange Rate System

Exchange rates are determined by market forces without government intervention. A freely floating exchange rate adjusts on a continual basis in response to the demand and supply conditions for that currency. Advantages: -Country is more insulated from inflation of other countries. -Country is more insulated from unemployment of other countries. -Does not require central bank to maintain exchange rates within specified boundaries. Disadvantages: -Can adversely affect a country that has high unemployment. -Can adversely affect a country with high inflation.

Limitation of PPP

Other country characteristics besides inflation (income levels, government controls) can affect exchange rate movements. Even if the expected inflation derived from the Fisher effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to error.

Reasons for Government Direct Intervention

Reliance on reserves: The potential effectiveness of a central bank's direct intervention is the amount of reserves it can use. -If the central bank has a low level of reserves, it may not be able to exert much pressure on the currency's value; in that case, market forces would likely overwhelm its actions. Frequency of Intervention: the number of direct interventions has declined. -As foreign exchange activity has grown, central bank intervention has become less effective. The volume of foreign exchange transactions on a single day now exceeds the combined values of reserves at all central banks. Non-sterilized versus sterilized intervention -When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a non-sterilized intervention. -In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets.

Reasons for Government Intervention

Smoothing exchange rate movements -If a central bank is concerned that its economy will be affected by abrupt movements in its home currency's value, it may attempt to smooth the currency movements over time. Establishing implicit exchange rate boundaries -Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries. Responding to temporary disturbances -A central bank may intervene to insulate a currency's value from a temporary disturbance.

Indirect Intervention

The Fed can affect the dollar's value indirectly by influencing the factors that determine it. A weak home currency can stimulate foreign demand for products. -A weak dollar can substantially boost U.S. exports and U.S. jobs; in addition, it may also reduce U.S. imports. -However, a weak currency can lead to higher inflation. A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. -A strong dollar can intensify foreign competition and forces U.S. producers to refrain from increasing prices, which leads to a lower inflation. -However, a strong currency may increase home unemployment.

Eurozone

The countries that participate in the euro make up a region

Limitation of the Fisher Effect

The difference between the nominal interest rate and actual inflation rate is not consistent. Thus, while the Fisher effect can effectively use nominal interest rates to estimate the market's expected inflation over a particular period, the market may be wrong.

Locational Arbitrage

The process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. -Example: Assume the exchange rate quoted at Akron Bank for a British pound is $1.60 while the exchange rate quoted at Zyn Bank is $1.61. You could conduct locational arbitrage by purchasing pounds at Akron Bank for $1.60 per pound and then selling them at Zyn Bank for $1.61 per pound. Locational arbitrage is normally conducted by banks or other foreign exchange dealers whose computers can continuously monitor the quotes provided by other banks.

Absolute Form of Purchasing Power Parity (PPP)

Without international barriers, consumers shift their demand to wherever prices are lower. -Prices of the same basket of products in two different countries should be equal when measured in a common currency. -If there is a discrepancy in the prices, then demand should shift so that these prices converge.

Currency Boards

a system for pegging the value of the local currency to some other specified currency. -The board must maintain currency reserves for all the currency that it has printed. -It is effective only if investors believe that it will last. -A currency board that is expected to remain in place for a long period may reduce fears that the local currency will weaken, thereby encouraging investors to maintain their investments within the country.

If the interest rate is lower in the United States than in the United Kingdom, and if the forward rate of the British pound is the same as its spot rate: a. U.S. investors could possibly benefit from covered interest arbitrage b. British investors could possibly benefit from covered interest arbitrage. c. neither U.S. nor British investors could benefit from covered interest arbitrage. d. A and B

a. U.S. investors could possibly benefit from covered interest arbitrage

Because there are sometimes no substitutes for traded goods, this will: a. reduce the probability that PPP will hold. b. increase the probability that PPP will hold. c. increase the probability the IFE will hold. d. B and C

a. reduce the probability that PPP will hold.

Assume a two-country world: Country A and Country B. Which of the following is correct about purchasing power parity (PPP) as related to these two countries? a.If Country A's inflation rate exceeds Country B's inflation rate, Country A's currency will weaken. b.If Country A's interest rate exceeds Country B's inflation rate, Country A's currency will weaken. c.If Country A's interest rate exceeds Country B's inflation rate, Country A's currency will strengthen. d.If Country B's inflation rate exceeds Country A's inflation rate, Country A's currency will weaken.

a.If Country A's inflation rate exceeds Country B's inflation rate, Country A's currency will weaken.

Interest Rate Parity

an equilibrium state that the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies. -when the forward rate is more than the spot rate, this implies that the forward rate exhibits a premium. -when the forward rate is less than the spot rate, this implies that the forward rate exhibits a discount.

Assume the following information: Spot rate today of Swiss franc =$.60 1-year forward rate as of today for Swiss franc =$.63 Expected spot rate 1 year from now =$.64 Rate on 1-year deposits denominated in Swiss francs =7% Rate on 1-year deposits denominated in U.S. dollars =9% From the perspective of U.S. investors with $1,000,000, covered interest arbitrage would yield a rate of return of ____ percent. a. 5.00 b. 12.35 c. 15.50 d. 14.13

b. 12.35

It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S. government would like to reduce inflation. Which of the following is an appropriate action given this scenario? a. Sell dollars for foreign currency b. Buy dollars with foreign currency c. Lower interest rates d. Implement a tight monetary policy

b. Buy dollars with foreign currency

Points below the IRP line represent situations where: a. covered interest arbitrage is feasible from the perspective of domestic investors and results in the same yield as investing domestically. b. covered interest arbitrage is feasible from the perspective of domestic investors and results in a yield above what is possible domestically. c. covered interest arbitrage is feasible from the perspective of foreign investors and results in a yield above what is possible in their local markets. d. covered interest arbitrage is feasible for neither domestic nor foreign investors.

b. covered interest arbitrage is feasible from the perspective of domestic investors and results in a yield above what is possible domestically.

A strong dollar is normally expected to cause: a. high unemployment and high inflation in the U.S. b. high unemployment and low inflation in the U.S. c. low unemployment and low inflation in the U.S. d. low unemployment and high inflation in the U.S.

b. high unemployment and low inflation in the U.S.

Based on interest rate parity, the larger the degree by which the U.S. interest rate exceeds the foreign interest rate, the: a. larger will be the forward discount of the foreign currency. b. larger will be the forward premium of the foreign currency. c. smaller will be the forward premium of the foreign currency. d. smaller will be the forward discount of the foreign currency.

b. larger will be the forward premium of the foreign currency.

When using ____, funds are not tied up for any length of time a. covered interest arbitrage b. locational arbitrage c. triangular arbitrage d. B and C

b. locational arbitrage c. triangular arbitrage

To weaken the dollar using sterilized intervention, the Fed will ____ U.S. dollars and simultaneously ____ Treasury securities. a. buy; sell b. sell; sell c. sell; buy d. buy; buy

b. sell; sell

Due to ____, market forces should realign the cross exchange rate between two foreign currencies based on the spot exchange rates of the two currencies against the U.S. dollar. a. forward realignment arbitrage b. triangular arbitrage c. covered interest arbitrage d. locational arbitrage

b. triangular arbitrage

A primary result of the Bretton Woods Agreement was: a. the establishment of the European Monetary System (EMS). b. establishing specific rules for when tariffs and quotas could be imposed by governments. c. establishing that exchange rates of most major currencies were to be allowed to fluctuate 1% above or below their initially set values. d. establishing that exchange rates of most major currencies were to be allowed to fluctuate freely without boundaries (although the central banks did have the right to intervene when necessary).

c. establishing that exchange rates of most major currencies were to be allowed to fluctuate 1% above or below their initially set values.

Which of the following theories suggests the percentage change in spot exchange rate of a currency should be equal to the interest rate differential between two countries? a. absolute form of PPP b. relative form of PPP c. international Fisher effect (IFE) d. interest rate parity (IRP)

c. international Fisher effect (IFE)

To force the value of the British pound to depreciate against the dollar, the Federal Reserve should: a. sell dollars for pounds in the foreign exchange market and the Bank of England should sell dollars for pounds in the foreign exchange market. b. sell pounds for dollars in the foreign exchange market and the Bank of England should sell dollars for pounds in the foreign exchange market. c. sell pounds for dollars in the foreign exchange market and the Bank of England should sell pounds for dollars in the foreign exchange market. d. sell dollars for pounds in the foreign exchange market and the Bank of England should sell pounds for dollars in the foreign exchange market.

c. sell pounds for dollars in the foreign exchange market and the Bank of England should sell pounds for dollars in the foreign exchange market.

A weaker dollar places ____ pressure on U.S. inflation, which in turn places ____ pressure on U.S. interest rates, which places ____ pressure on U.S. bond prices. a. upward; downward; upward b. upward; downward; downward c. upward; upward; downward d. downward; upward; upward

c. upward; upward; downward

Arbitrage

can be loosely defined as capitalizing on a discrepancy in quoted prices by making a riskless profit. -The strategy involves no risk. -It does not require that funds be tied up (in most of the cases). -Arbitrage will cause prices to realign.

Assume the bid rate of an Australian dollar is $.60 while the ask rate is $.61 at Bank Q. Assume the bid rate of an Australian dollar is $.62 while the ask rate is $.625 at Bank V. Given this information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with? a. $10,003 b. $12,063 c. $14,441 d. $16,393

d. $16,393

Assume U.S. and Swiss investors require a real rate of return of 3 percent. Assume the nominal U.S. interest rate is 6 percent and the nominal Swiss rate is 4 percent. According to the international Fisher effect, the franc will ____ by about ____. a. appreciate; 3 percent b. depreciate; 3 percent d. depreciate; 2 percent e. appreciate; 2 percent

d. depreciate; 2 percent

The currency of Country X is pegged to the currency of Country Y. Assume that Country Y's currency appreciates against the currency of Country Z. It is likely that Country X will export ____ to Country Z and import ____ from Country Z. a. more; more b. more; less c. less; less d. less; more

d. less; more

Assume that Swiss investors are benefiting from covered interest arbitrage due to a high U.S. interest rate. Which of the following forces results from this covered interest arbitrage activity? a. upward pressure on the Swiss franc's spot rate b. upward pressure on the U.S. interest rate c. downward pressure on the Swiss interest rate d. upward pressure on the Swiss franc's forward rate

d. upward pressure on the Swiss franc's forward rate

Change in foreign currency value

ef = 1+I_h/1+I_f - 1 >> ef ≅ I_h - I_f 𝐼_ℎ -- the home country inflation rate, 𝐼_𝑓 -- the foreign country inflation rate

Triangular Arbitrage

is referred to as currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies. -Like locational arbitrage, triangular arbitrage does not tie up funds. -The strategy is risk free because there is no uncertainty about the prices at which you will buy and sell the currencies. -Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage.

Fixed Exchange Rate Systems

requires central bank intervention in order to maintain a currency's value within narrow boundaries. Advantages: -Exporters and importers could engage in international trade without currency risk. --Any firms that accept the foreign currency as payment would be insulated from the risk that the currency could depreciate over time. --Any firm that need to obtain the foreign currency in the future would be insulated from the risk that the currency could appreciate over time. -Firms could engage in direct foreign investment without currency risk. -Investors could engage in investing funds in foreign countries without currency risk. Disadvantages: -Risk that government will alter value of currency. -Governments of countries with low interest rates would need to impose capital flow restrictions. -Country and MNC may be more vulnerable to economic conditions in other countries.

Forward Premium/Discount

𝑝=(1+𝑖_ℎ)/(1+𝑖_𝑓 )−1=(𝐹−𝑆)/𝑆 ≅ 𝑖_ℎ−𝑖_𝑓 𝑖_ℎ= home interest rate 𝑖_𝑓= foreign interest rate F -- the forward rate in dollars at which the foreign currency will be converted back to U.S. dollars. S -- the spot rate in dollars when the foreign currency is purchased