FIN 439 Exam 1 EOC Questions
The country of Quinland has large capital flows with the U.S. It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%, the same as the U.S. interest rate. You expect that the inflation rate in Quinland will be 1% this coming year, while the U.S. inflation rate will be 9%. You expect that Quinland's interest rate will be 2% during the next year, while the U.S. interest rate will rise to 10% during the next year. Quinland's currency adjusts in response to market forces. Will Quinland's currency appreciate, depreciate, or remain unchanged against the dollar?
Quinland's currency should depreciate against the dollar because the US has higher interest rates and that is where investors will go.
Why would a multinational corporation invest funds in a financial market outside its own country?
may be able to earn a higher interest rate on funds invested; exchange rate of currency may be expected to appreciate
Explain how the appreciation of the Japanese yen against the U.S. dollar would affect the return to a U.S. firm that borrowed Japanese yen and used the proceeds for a U.S. project.
the cost of borrowing will be higher because when they repay the loan the exchange rate will be higher than when initially borrowed
Explain how the appreciation of the Australian dollar against the US dollar would affect the return to a US firm that invested in an Australian money market security
the return will be higher because they invested at a lower interest rate than what it will be when the investment period is over
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
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 decline in economic growth will reduce Asian demand for US exports, placing upward pressure on Asian currencies. The decline in interest rates will cause Asian corporations to invest in the US or other countries with higher interest rates, increasing the demand for US dollars. Decline in interest rates will put downward pressure on the value of Asian currencies.
Tarheel Co. plans to determine how changes in U.S. and Mexican real interest rates will affect the value of the U.S. dollar. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have affected exchange rates, how might this be accounted for in the regression model?
A dummy variable could be included in the model. Assign a value of one for periods when a quota existed, and a value of zero when it did not exist.
Explain how syndicated loans are used in international markets.
A large multinational corporation may want to take out a large loan that no single bank wants to take on by itself. Thus, a bank creates a syndicate where several other banks can participate in the loan.
Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a weaker dollar could affect the U.S. balance of trade deficit.
A strong dollar makes US exports more expensive to importers and may reduce imports. That will make US imports cheap and may increase US imports. A weaker dollar will make import purchases more expensive and make purchases by foreign businesses cheaper.
Explain the process used by banks in the Eurocredit market to determine the rate to charge on loans.
Banks set loan rate based on prevailing LIBOR, and allow the loan rate to float in accordance with changes in LIBOR
Bloomington Co. is a large U.S.-based MNC with large subsidiaries in Germany. It has issued stock in Germany in order to establish its business. It could have issued stock in the U.S. and then used the proceeds in order to support the growth in Europe. What is a possible advantage of issuing the stock in Germany to finance German operations? Also, why might the German investors prefer to purchase the stock that was issued in Germany rather than purchase the stock of Bloomington on a U.S. stock exchange?
By issuing in Germany, Bloomington can use Euro proceeds to support growth in Germany. It can also establish a secondary market in Germany. This is good for German investors because they do not have to worry about exchange rate risk.
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. Crises cause investors to expect fewer investment opportunities within the country and the belief that any existing investments will generate poor returns. Investors will liquidate those investments and shift to other currencies, placing downward pressure on the local currency.
As of today, the interest rate in Countries X, Y, and Z, are similar. In the next month, Country X is expected to have a weak economy, while Countries Y and Z are expected to experience a 6% increase in economic growth. However, conditions this month will also cause an increase in default risk of borrowers in Country Z in the next month because of political concerns, while the default risk of Countries X and Y remain unchanged. During the next month, which country should have the highest interest rate? Which country should have the lowest interest rate?
Country Z will have the highest interest rate because it will experience economic growth while also have a high level of default risk. Country X will have the lowest interest rate because it has a weak economy and a low level of default risk.
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?
Demand for Canadian dollars should increase, supply may not be affected, and value of the Canadian dollar should increase.
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 dollar for sale should decrease, and Canadian dollar 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 value of pound should increase.
Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?
Demand for the yen should not be affected, supply of yen for sale should increase, and value of the yen should decrease.
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.
Euro value changes in accordance with flow of funds between the US and countries that use the Euro for currency. The pound's value changes in accordance with flow of funds between the US and the UK.
You just came back from Canada, where the Canadian dollar was worth $.70. You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain.
Exchange with the tourist. If you exchange at the desk you will only get $120 US back which will buy you 1,200 pesos. Exchanging with the tourist gets you an extra 100 pesos, which is $10.
There has been considerable momentum to reduce or remove trade barriers in an effort to achieve "free trade." Yet, one disgruntled executive of an exporting firm stated, "Free trade is not conceivable; we are always at the mercy of the exchange rate. Any country can use this mechanism to impose trade barriers." What does this statement mean?
For example, if the US dollar is very strong, the US could attempt to take advantage of countries with weaker currencies. Also, the US might be less willing to export goods to Japan because the yen is so weak.
Briefly describe the historical developments that led to floating exchange rates as of 1973.
Governments had trouble maintaining fixed exchange rates. In 1971, the bands were widened; yet controlling rates remained difficult. In 1973, bands were eliminated so rates could respond to market forces.
The Wolfpack Corporation is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract?
Hedging with a forward contract can protect from exchange rate risk, but in this case Wolfpack Corporation stands to gain from the appreciation of the pound.
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 will encourage consumer to purchase products from foreign countries. This will also discourage foreign countries for purchasing products from Brazil. Supply of the Brazilian currency will increase, and the value will decrease because of downward pressure.
Assume that during this semester, the euro appreciated against the dollar. Did the direct exchange rate of the euro increase or decrease? Did the indirect exchange rate of the euro increase or decrease?
Indirect and direct exchange rates are commensurate, so when the Euro appreciates against the US dollar, direct rate increases while indirect rate decreases.
Would the U.S. balance of trade deficit be larger or smaller if the dollar depreciates against all currencies, versus depreciating against some currencies but appreciated against others? Explain.
If the dollar weakens against all currencies, the US balance will be smaller. US importers would have to consider purchasing their goods from within the US because all other currencies are strengthening against the dollar. If only some currencies weaken, US importers will just shift from one foreign country to another.
Explain the relationship between transparency of firms and investor participation (or trading activity) among stock markets. Based on this relationship, how can governments of countries increase the amount of trading activity (and therefore liquidity) of their stock markets?
In general, participation and trading activity are higher in countries where the managers are working to please shareholder interests and where investors can easily monitor the firms. An active stock market requires trust of the local investors.
Explain how the international integration of financial markets caused the credit crisis to spread across many countries.
Integrated financial markets allows investors in one country to invest in securities in other countries. Thus, problems from the US and UK markets spread to other markets.
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 often try to predict interest rate movements. They may purchase a security in a particular country because they are expecting currency movements. If a forecast was already anticipated, or is not different from original expectations, the announced forecast does not provide any new information.
Why do interest rates vary among countries? Why are interest rates normally similar for those European countries that use the euro as their currency? Offer a reason why the government interest rate of one country could be slightly higher than the government interest rate of another country, even though the euro is the currency used in both countries.
Interest rates are based on the supply and demand of funds. Supply and demand conditions for countries using the Euro are aggregate. However, interest rates can be slightly different depending on default risk.
Why do you think international trade volume has increased over time? In general, how are inefficient firms affected by the reduction in trade restrictions among countries and the continuous increase in international trade?
International trade volume has increased because of the reduction in trade restrictions. Another reason is increased information flow between firms in different countries. Inefficient firms will face tougher competition because of reduced trade restrictions.
The country of Luta has large capital flows with the U.S. It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%, the same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You expect that the inflation rate in Luta will rise to 8% this coming year, while the U.S. inflation rate will remain at 5%. You expect that Luta's interest rate will rise to 9% during the next year. You expect that the U.S. interest rate will remain at 6% this year. Do you think Luta's currency will appreciate, depreciate, or remain unchanged against the dollar? Briefly explain.
Luta's should appreciate against the dollar because the exchange rate should be influenced by cash flows. Luta's high interest rate will attract US investors, and the inflation rate is not a factor because of no trade.
Explain why firms may issue stock in foreign markets. Why might U.S. firms issue more stock in Europe since the conversion to the euro in 1999?
May be concerned that their home market cannot absorb the entire issue. They may desire to enhance their global image. The firms can also expand across Europe because of the fact that many countries use the Euro.
When South Korea's export growth stalled, some South Korean firms suggested that South Korea's primary export problem was the weakness in the Japanese yen. How would you interpret this statement?
One of South Korea's main competitors in exporting is Japan. The fact that the Japanese yen is weak means many countries were eager to trade with them instead of South Korea.
Assume that inflation is zero in the U.S. and in Europe and will remain at zero. U.S. interest rates are presently the same as in Europe. Assume that the economic growth for the U.S. is presently similar to Europe. Assume that international capital flows are much larger than international trade flows. Today, there is news that clearly signals economic conditions in Europe will be weakening in the future, while economic conditions in the U.S. will remain the same. Explain why and how (which direction) the euro's value would change today based on this information.
Poor economic conditions will result in reduced demand for European funds, lowering interest rates. The US demand for Euros will decline because of lower interest rates. European investors will look to the US for investment opportunities.
Why does the exchange rate not always adjust to a current account deficit?
Sometimes the home currency will remain strong even though a current account deficit exists. Other factors can offset the forces placed on the currency.
Assume the country of Neeland has stable and predictable international trade flows with the U.S. Neeland is periodically in the news because its government might have problems repaying its debt owed to local banks. The value of its currency (the "nee") commonly declines on one day, but then jumps back up a few days later. There is much day to day volatility in the value of the nee. Briefly explain what types of transactions are likely causing the shifts in demand for the nee and supply of nee for sale in the foreign exchange market.
Speculative flows of funds could be causing this. Speculators move out of the nee when there is bad news. They sell the nee upon the news, which places a downward pressure on the nee's value immediately. However, if there is favorable news the next day, speculative money can move back in, and demand will increase the value of the nee.
A relatively small U.S. balance of trade deficit is commonly attributed to a strong demand for U.S. exports. What do you think is the underlying reason for the strong demand for U.S. exports?
Strong demand for US exports is commonly attributed to strong foreign economies, aka a weak dollar.
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?
Strong economies typically cause interest rates to rise, placing upward pressure on the local currency.
Explain how the existence of the euro may affect U.S. international trade.
The Euro is used by a number of different European countries, which may lead to those countries only trading with one another and not the US (as a way of avoiding exchange rate risk).
Why do you think the terrorist attack on the U.S. was expected to cause a decline in U.S. interest rates? Given the expectations for a potential decline in U.S. interest rates and stock prices, how were capital flows between the U.S. and other countries likely affected?
The attack would cause a weaker economy, and therefore lower interest rates and stock prices. This causes the amount of funds invested by foreign investors to reduce.
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 effect of inflation will be stronger than that of interest because inflation affects trade flows. High inflation will cause downward pressure on the kren.
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 expected to have high inflation.
What is the function of the international money market? Briefly describe the reasons for the development and growth of the European money market. Explain how the international money, credit, and bond markets differ from one another.
The function is to organize the flow of funds from firms or governments with excess funds to those in need of funds. Growth of the European market is due to strict US regulations on foreign lending and the existence of regulated ceilings on US interest rates.
Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. Identify the most obvious economic reason for the persistent depreciation of the peso.
The high inflation in Mexico places consistent downward pressure on the value of the peso.
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 result from expectations of high inflation. Therefore, the real interest rate in Mexico might not be much different than the real interest rate in the US. High inflation expectations could offset the high interest rate. Overall, high interest rates do not encourage US investment in Mexican securities.
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, the stronger its currency will be.
The New Zealand dollar's spot rate was equal to $.60 last month. New Zealand conducts much international trade with the U.S. but that the financial (investment) transactions between the two countries are negligible. Assume the following conditions have occurred in the last year. First, interest rates in New Zealand increased but decreased in the U.S. Second, inflation in New Zealand increased but decreased in the U.S. Third, the New Zealand central bank intervened in the foreign exchange market by exchanging a very small amount of U.S. dollars to purchase a very small amount of New Zealand dollars. How should the New Zealand dollar change over the year based on the information provided here?
The key is to weigh the influence of each effect in order to derive a total effect. Two of the factors place upward pressure on the value of the New Zealand dollar. The high interest rates do not mean much because the financial flows are negligible. Central bank intervention could place upward pressure on the NZ$, but it will be a small impact. Inflation will place downward pressure and will have a large impact because trade flows are large. Overall, the NZ$ should depreciate over the year.
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 spread is wider because the banks are taking more risk with a currency such as the peso that could decline abruptly at any time. It is also due to increases in transaction costs associated with conversion rates.
Assume that the level of capital flows between the U.S. and the country of Zeus is negligible (close to zero) and will continue to be negligible. There is a substantial amount of trade between the U.S. and the country of Zeus. The main import by the U.S. is basic clothing purchased by U.S. retail stores from Zeus, while the main import by Zeus is special computer chips that are only made in the U.S. and are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to impose a 20% tax on the clothing imports. The Zeus government immediately retaliates by imposing a 20% tax on the computer chip imports. Second, the Zeus government immediately imposes a 60% tax on any interest income that would be earned by Zeus investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so that they are now higher than interest rates in the U.S. Do you think the currency of Zeus (called the zee) will appreciate or depreciate against the dollar as a result of all the government actions described above? Explain.
The zee should depreciate. Zeus imports of US computer chips will continue, but US imports of Zeus clothing will decrease. Zeus tax on capital flows and the banks actions will not have any effect because Zeus investors do not buy US securities.
Explain the foreign exchange situation for countries that use the euro when they engage in international trade among themselves.
There is no foreign exchange. Euros are used as the medium of exchange.
Chapman Co. is a privately owned MNC in the U.S. that plans to engage in an initial public offering (IPO) of stock, so that it can finance its international expansion. At the present time, world stock market conditions are very weak but are expected to improve. The U.S. market tends to be weak in periods when the other stock markets around the world are weak. A financial manager of Chapman Co. recommends that it wait until the world stock markets recover before it issues stock. Another manager believes that Chapman Co. could issue its stock now even if the price would be low, since its stock price should rise later once world stock markets recover. Who is correct? Explain.
They should wait until the world stock market recovers and US conditions improve. If they issue stock now, they will receive lower dollar amounts for their international expansion. Even if stock prices improve later, they wouldn't benefit because they would have already sold the shares.
What factors affect the future movements in the value of the euro against the dollar?
US demand from European goods will be greater than European demand for US goods.
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?
US investors will try to capitalize on the higher interest rates in the US, while also reducing investments in Canadian securities. This puts downward pressure on the Canadian dollar value. Japanese investors that invested in Canada may decide to switch to the US because of their better interest rates. This would also put downward pressure on the Canadian dollar value.
Explain how the Asian crisis would have affected the returns to a U.S. firm investing in the Asian stock markets as a means of international diversification.
US returns from investing in the Asian market would be substantially lower because of the crisis. The main factors are decline in the market and currency depreciation.
Assume a simple world in which the U.S. exports soft drinks and beer to France and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French beverage firms, and the French wine producers.
US wine producers benefit, while French wine producers are adversely affected. The French government will likely retaliate by imposing tariffs on US beverage firms, which will benefit French beverage firms.
The country of Vezot has massive capital flows with the U.S. because it has no restrictions on the movement of investment funds into or out of the country. Vezot's inflation rate just increased substantially, while the U.S. inflation rate remains unchanged. Vezot's interest rate just increased substantially, while the U.S. interest rate remains unchanged. Vezot's income level just increased substantially, which will increase consumption of products within its country. The U.S. income level remains unchanged. There is negligible international trade between Vezot and the U.S. Vezot can easily obtain all of its imported products from border countries instead of the U.S. The U.S. just imposed very large taxes on U.S. importers that import products from Vezot from today forward. Vezot does not impose restrictions on imports from the U.S. Vezot's currency is freely floating. Based on the information above, do you think Vezot's currency will appreciate, depreciate, or remain unchanged against the dollar? Briefly explain.
Vezot's currency should appreciate because they have higher interest rates, and the other factors are not a concern.
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)?
Weak US economic conditions usually result in lower interest rates, causing foreign investors to turn elsewhere with their investments. Lower interest rates will reduce the capital flows to the US, placing downward pressure on the value of the dollar.
Tarheel Co. plans to determine how changes in U.S. and Mexican real interest rates will affect the value of the U.S. dollar. -Describe a regression model that could be used to achieve this purpose. Also explain the expected sign of the regression coefficient. -Various models are possible. One model would be: % Change in peso = a0 + a1 (rU.S. - rM) + u Where: -rU.S.=real interest rate in the U.S. -rM= real interest rate in Mexico -a0= intercept -a1=regression coefficient measuring the relationship between the real interest rate differential and the percentage change in the peso's value -u =error term
With this model, the regression coefficient is expected to have a negative sign. High interest rate differential would likely cause a weaker peso value.
The country of Zars has large capital flows with the U.S. It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%, the same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You expect that the inflation rate in Zars will rise to 8% this coming year, while the U.S. inflation rate will remain at 5%. You expect that Zars' interest rate will rise to 9% during the next year. You expect that the U.S. interest rate will remain at 6% this year. Zars' currency adjusts in response to market forces and is not subject to direct central bank intervention. Will Zars currency appreciate, depreciate, or remain unchanged against the dollar?
Zars currency should appreciate against the dollar because it has higher interest rates than the US and investors will want to invest in Zars.