International Finance Exam 2

Speculating with Currency Call Options - Randy purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume there are 31,250 units in a British pound option. What was Randy's net profit on this option?

Profit per unit on exercising the option $1.46 - $1.46 = $0.01 Premium paid per unit = $0.02 Net Profit per unit- $0.01 - $0.02 = -$.01 Net Profit per option - 31,250 units x (-$.01) = -$312.50

Hedging with Currency Derivatives - Princeton Co. may purchase a company in Japan in the near future (but the deal may not go through).

Purchase Calls

Intervention Effects on Corporate Performance - Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the US dollar. Your subsidiary borrowed funds from the US parent, and must pay the parent $100,000 in interest each month. Australia has jsut raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciated against the US dollar as a result. Explain whether this action would increase, reduce, or have no affect on: (B) The cost to your subsidiary of purchasing materials (measured in A$)>

The cost of purchasing materials should decline because the A$ to make the monthly payment of $100,000.

Effects on Currencies Tied to the Dollar - The Hong Kong dollar's value is ties to the US dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar: (A) Hong Kong exports to Japan (B) Hong Kong exports to the US

(A) Hong Kong exports to Japan should increase because the yen will have appreciated against the Hong Kong dollar. Therefore, Hong Kong goods will be less expensive to Japanese importers. (B) Hong Kong exports to the US should increase because Japanese good become more expensive to US importers as a result of yen appreciation. Therefore, some US importers may find that even though the exchange rate between the US dollar and Hong Kong dollar is unchanged, the Hong Kong prices are not lower than Japanese prices (from a US Perspective) These answers assumes that Japanese exporters did not reduce their prices to compensate US importers for the weaker dollar. If Japanese exporters do reduce their prices to fully offset the effect of the stronger yen, there would be less of a shift to Hong Kong goods.

Selling Currency Call Options - Mike sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain i Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike's net profit on the call option?

- Premium received per unit (Mike receive this) = $0.01 - Amount per unit received from selling C$ (call exercise price, Mike receives this) = $0.76. - Amount per unit paid when purchasing C$ (spot transaction at call exercise, Mike pays this ) = $0.82 - Net Profit per unit - $0.76 - $0.82 = -$0.05 Net profit = 50,000 units x (-$0.05) = -$2,500

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 corporation with excess cash may not invest in the U.S. or other countries, thereby increading 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 impoct depends on the magnitude of the forces just described.

Hedging With Currency Option - When would a U.S. firm consider purchasing a call option on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging?

A call option can hedge a firm's future payables denominated in euros/ It effectively locks in the maximum price to be paid for euros. A put option on euros can hedge a U.S. firm's future receivables denominated in euros. It effectively locks in the minimum price at which it can exchange euros received.

Feedback Effects - Explain the potential feedback eggects of a currency;s changing value on inflation..

A weak 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, place upward pressure on the home currency.

Intervention with Euros - Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the US dollar. Can it apply central bank intervention to achieve this objective? Explain.

Belgium cannot 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.

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 movement 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.

Coordinated Central Bank Intervention - Assume that the US has a weak economy and that the Fed wants to correct this problem by adjusting the value of the dollar. The Fed is not worried about inflation. Assume that the eurozone has a somewhat similar economic situation as the US and the European Central Bank (ECB) wants to correct this problem by adjusting the value of the euro. The ECB is not worried about inflation. Do you think the European Central Bank and the Fed should engage in coordinated intervention in order to achieve their objectives? Briefly explain.

Coordinated intervention occurs when central banks agree to use similar direct intervention to push a specific currency's value in one direction. However, in this example, each central bank desires a different outcome, so coordinated intervention could not satisfy both objectives. The ECB would prefer to weaken the euro's value, so that Eurozone demand for US exports would decrease and US demand for Eurozone imports would increase, to reduce eurozone unemployment. But this strategy is opposite of the Fed's strategy so the ECB would want to engage in coordinated intervention in this case.

Forward Premium - What is D?

Days to forward rate

Aggregate Effects on Exchange Rates - U.S. interest rates have increased substantially, while Country K's interest rates remain low. Investors of both countries are attracted to high interest rates.

Decreased U.S. demand for the krank. Increased supply of kranks for sale. Downward pressure on the krank's value.

Self-test 2 - Assume the Federal Reserve believes that the dollar should be weakened against the Mexican peso. Explain how the Fed could use direct and indirect intervention to weaken the dollar's value with respect to the peso. Assume that future inflation in the United States is expected to be low,regardless of the Fed's actions.

Direct Intervention: 1. Central banks can use their Mexican Peso currency reserves to buy US dollars in the foreign exchange market in order to lace downward pressure on the US dollar. 2. Central banks can also attempt to force currency depreciation by flooding the market with that US dollars (selling the US dollars in the foreign exchange market in exchange for other currencies). Indirection Interventions: 1. 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.

Intervention Effects on Bond Prices - US bond prices are normally inversely related to US 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 US 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 process, 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.

Hedging with Currency Derivatives - Brown, Inc., needs to pay off existing loans that are denominated in Canadian Dollars.

Forward Purchase, Buy Futures, Purchase Calls

Hedging with Currency Derivatives - Georgetown Co. plans to purchase Japanese goods denominated in yen.

Forward Purchase, Buy Futures, Purchase Calls

Hedging with Currency Derivatives - Harvard, Inc., sold goods to Japan, denominated in yen.

Forward Sale, Sell Futures, Purchase Puts

Hedging with Currency Derivatives - Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent.

Forward Sale, Sell Futures, Purchase Puts

Forward Premium - What is F?

Forward rate

Effects of Central Bank Intervention - (C) The Hong Kong dollar is tied to the US dollar and will continue to be tied to the dollar. given your answer in part (a), how will the intervention by the Federal Reserve affect the cross exchange rates between the Canadian dollar and the Hong Kong dollar?

If the Canadian dollar weakens against the US dollar, it will weaken against the Hong Kong dollar.

Aggregate Effects on Exchange Rates - U.S. inflation has suddenly increased substantially, while Country K's inflation remains low

Increased U.S. demand for the krank. Decreased supply of kranks for sale. Upward pressure in the krank's value.

Aggregate Effects on Exchange Rates - The U.S. income level increased substantially, while Country K's income level has remained unchanged.

Increased U.S. demand for the krank. Upward pressure on the krank's value.

Effects of Central Bank Intervention - (A) Assume that the Federal Reserve engages in intervention by exchanging a very large amount of Canadian dollars for US dollars in the foreign exchange market. Should this increase, reduce, or have no effect on Canadian inflation? Briefly explain.

It should weaken the Canadian dollar, which should simulate Canada's economy, but that also places upward pressure on prices. In addition, the weak Canadian dollar reduces foreign competition, which cause higher inflation.

How Factors Affect Exchange Rates - The country of Luca has large capital flows with the United States. It has no trade with the United States and will not have trade with the United States in the future. It's interest rates is 6 percent, the same as the U.S. interest rate. It's rate of inflation is 5 percent, the same at the U.S. inflation rate. You expect that the inflation rate in Luca will rise to 8 percent this coming year, while the US inflation rate will remain at 5 percent. You expect that Luta's Interest rate will rise to 9 percent during the next year. You expect that the US interest rate will remain at 6 percent this year. Do you think Luta's currency will appreciate, depreciate, or remain unchanged against the dollar? Briefly explain.

Luta's currency should appreciate against the dollar because the exchange rate should be influenced by capital flows. Luta now has higher interest rate, which will attract US investors, especially since the effect of higher inflation in Luta is negligible because of no trade between the countries.

Assume the country of Sluban ties its currency (the slu) to the dollar and the exchange rate will remain fixed. Sluban has frequent trade with countries in the eurozone and the United States. All traded products can easily be produced by all the countries, and the demand for these products in any country is very sensitive to the price because consumers can shift to wherever the products are relatively cheap. Assume that the euro depreciates substantially against the dollar during the next year. What is the likely effect (if any) of the euro's exchange rate movement on the volume of Sluban's exports to the eurozone? Explain

Since the euro depreciated with respect to the US dollar, it has also depreciated with respect to the pegged Sluban slu. This makes Sluban exports more expensive for European buyers and thus Sluban exports to the eurozone should decrease.

Forward Premium - What is S?

Spot rate

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

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

Impact of Devaluation - The inflation rate in Yinland 14 percent last year. The government of Yinland just devalued its currency (the yin) by 40 percent against the dollar. Evan though it produces products similar to those of the US, it has much trade with the US and very little trade with other countries. It presently had trade restrictions imposed on all non-US countries. Will the devaluation of the yin increase or reduce inflation in Yinland? Briefly explain

The devaluation would increase inflation, because there is no competition from foreign producers

Currency Call Option Premiums - List the factors that affect currency call option premiums and briefly explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option in Mexican pesos (assuming the expiration date and the total dollar value represented by each option are the same for both options)?

The factors: - the higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal. - The longer the period prior to the expiration date, the greater is the call option value, other things equal. - The greater the variability of the currency, the greater os the call option value, other things equal. The at-the-money call option in euros should have a lower premium because the euro should have less volatility than the peso (assuming that the expected volatility of the euro is lower than of the peso.)

Effects of Central Bank Intervention - (B) Ignore the actions of the Federal Reserve in the question above and assume that the Canadian central bank rises its interest rates. Should this increase, reduce, or have no effect on Canadian inflation? Briefly explain.

The higher interest rates should slow economic growth and reduce inflationary pressure

Relative importance of Factors Affecting Exchange Rate Risk - Assume that the level of capital flows between the United States 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 United States and the country of Krendo and no capital flows. How will high inflation and hihg 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 downward pressure on the kren.

Intervention Effects on Corporate Performance - Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the US dollar. Your subsidiary borrowed funds from the US parent, and must pay the parent $100,000 in interest each month. Australia has jsut raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciated against the US dollar as a result. Explain whether this action would increase, reduce, or have no affect on: (C) The cost to you subsidiary of making the interest payments to the US parent (measured in A$).

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

Speculating Based on Intervention - Assume that you expect that the European Central Bank (ECB) plans to engage in central bank intervention in which it plans to use euros to purchase a substantial amount of US dollars in the foreign exchange market over the next month. Assume that the direct intervention is expected to be successful at influencing the exchange rate. (A) Would you purchase or sell options on euros today?

The intervention should result in a weaker euro, so sell call option is on euros today

Speculating Based on Intervention - Assume that you expect that the European Central Bank (ECB) plans to engage in central bank intervention in which it plans to use euros to purchase a substantial amount of US dollars in the foreign exchange market over the next month. Assume that the direct intervention is expected to be successful at influencing the exchange rate. (B) Would you purchase or sell futures on euro today?

The intervention should result in a weaker euro, so sell futures on euros today.

Weighing the Influence of Factors and Exchange Rates - The New Zealans dollar's spot rate was equal to $.60 last month. New Zealand conducts much international trade with the United States but the financial (investment) transactions between the two countries are negligible. Assume the following conditions have occurred in the last year. First, interest rates increased in New Zealand but decreased in the United States. Second, inflation increased in New Zealand but decreased in the United States. 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 base 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 described above place upward pressure on the value of the NZ dollar. The high interest rate could increase financial flows into NZ but the financial flows negligible so this factor will not have much of an impact. The central bank intervention could place upward pressure on the NZ $, but it is a very small amount and therefore should not have much of an impact. The inflation effect will place downward pressure on the NZ $ and this factor should have a large impact, because trade flows are large. Overall, the NZ $ should depreciate over the year.

Impact of Information on Currency Option Premiums - As of 10:00am, the premium on a specific one-year call option on British pounds is $.04. Assume that the Bank of England had not been intervening in the foreign exchange markets in the last several months. However, it announces at 10:01 am that it will begin to frequently intervene in the foreign exchange market in order to reduce fluctuations in the pound's value against the US dollar over the next year, but it will not attempt to push the pound's value higher or lower than what is dictated by market forces. Also, the Bank of England has no plans to affect economic conditions with this intervention. Most participants who trade currency options did not anticipate this announcement. When they heard the announcement, they expected that the intervention would be successful in achieving its goal. (A) Will this announcement cause the premium on the one-year call option on British pounds to increase, decrease, or be unaffected? Explain

The premium on the call option should decrease pound's anticipated volatility should decrease in response to the intervention.

Weighing Factors That Affect Exchange Rates - Assume that the level of capital flows between the United States 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 United Stated and the country of Zeus. The main import by the United States is basic clothing purchased by U.S. retail stores form Zeus, while the main import by Zeus is special computer chips that are only made in the United States and are needed by many manufacturers in Zeus. Suddenly, the U.S. government decides to impose a 20 percent tax on the clothing imports. The Zeus government immediately retaliates by imposing a 20 percent tax on the computer chip imports. Second, the Zeus government immediately imposes a 60 percent 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 thy are not higher than interest rates in the United States. Do you think the currency of Zeus (called the see) will appreciate or depreciate against the dollar as a result of all the government actions described above? Explain.

The see should depreciate, because Zeus imports of the U.S. computer chips will continue, while the U.S. imports of Zeus clothing will decrease. The Zeus tax on capital flows and the central bank actions will not have an effect because the Zeus investors do not buy U.S. securities anyway.

Aggregate Effects on Exchange Rates - The United States is expected to impose a small tariff on goods imported from Country K.

The tariff will cause a decrease in the United States' desire for Country K's goods, and will therefore reduce the demand for kranks for sale. Downward pressure on the krank's value.

Intervention Effects on Corporate Performance - Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the US dollar. Your subsidiary borrowed funds from the US parent, and must pay the parent $100,000 in interest each month. Australia has jsut raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciated against the US dollar as a result. Explain whether this action would increase, reduce, or have no affect on: (A) 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 country of Sluban ties its currency (the slu) to the dollar and the exchange rate will remain fixed. Sluban has frequent trade with countries in the eurozone and the United States. All traded products can easily be produced by all the countries, and the demand for these products in any country is very sensitive to the price because consumers can shift to wherever the products are relatively cheap. Assume that the euro depreciates substantially against the dollar during the next year. What is the likely effect (if any) of the euro's exchange rate movement on the volume of Sluban's exports to the United States? Explain.

There should be no direct effect on SLuban exports to the US as the Sluban slu is pegged to the US dollar so its export prices will not change. however, since eurozone imports to the US will now be cheaper compared to Sluban imports, eurozone imported goods will replace some of the more expensive Sluban imported goods. Thus, the euro depreciation will reduce Sluban exports to the US.

Compute the annualized forward discount or premium for the Mexican peso whose 90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium.

This reflects a 8% premium

Indirect Intervention - 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 increase interest rates, thereby attracting a foreign demand for the home currency to buy high yield securities.

Aggregate Effects on Exchange Rates - Combine all expected impacts to develop on overall forecast.

Two of the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the U.S. and Country K. The interest rate scenario places downward pressure on the krank's value. Since the interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implication of all scenarios, the krank is expected to depreciate.