Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the
U.S. demand for British pounds
Demand for British pound should increase
Supply of pounds for sale
Decrease in supply of pounds
(c) Equilibrium value of the pound?
Pounds value should increase.
Movements in Cross Exchange Rates.
Last year a dollar was equal to 7 Swedish kronor, and a Polish zloty was equal to $.40. Today, the dollar is equal to 8 Swedish kronor and a Polish zloty is equal to $.44. By what percentage did the cross exchange rate of the Polish zloty in Swedish kronor (that is, the number of kronor that can be purchased with one zloty) change over the last year?
Delegate your assignment to our experts and they will do the rest.
As of last year, 1 Swedish Kronor dollar equivalent =
$1/7Sk = $0.143
As of today $1/8SK= $0.125
Cross rate of Polish Zloty a year ago =
40/0.143 = 2.77 Rounded off, 1PZ=2.8SK
Cross exchange rate of PZ today = 44/0.125
= 3.52
:. Today 1PZ= 3.52 Swedish Kronor dollar
Thus the difference = 3.52-2.8
=0.72/2.8*100
= 25.71%
Speculation on Expected Exchange Rates.
Kurnick Co. expects that the pound will depreciate from $1.70 to $1.68 in one year. It has no money to invest, but it could borrow money to invest. It has been approved by a bank to borrow either 1 million dollars or 1 million pounds for one year. It can borrow dollars at 6% or British pounds at 5% for one year. It can invest in a risk-free dollar deposit at 5% for one year or a risk-free British deposit at 4% for one year. Determine the expected profit or loss (in dollars) if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the pound.
Amount borrowed initially = 1,000,000 pounds
Convert them to dollars = (1.70)*1000, 000
= 1,700,000
One year investment with 5% = (1.05)*1,700,000
=1,785,000
Expected dollars for loan repayment purposes=
1,000,000*1.68
=1,680,000
= (1.05)* (1,680,000)
=1,764,000
Therefore if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the pound, it will make a profit
Profit = (1,785,000)-(1,764,000)
=$21,000
Chapter 6: Exchange Rate Systems
Compare and contrast the fixed, freely floating, and managed float exchange rate systems.
Under a fixed exchange rate system, governments can attempt to maintain the exchange rates within 1% of the initially set value. However, under a freely floating exchange rate system, the intervention of the government is considered non-existent. On the other hand, under a floating exchange rate system, the exchange rate is allowed to move according to the market force (Madura, 2011). However, government intervenes when it is deemed necessary.
What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system?
Advantages of a floating exchange rate is that it allows countries control its supply of money and choose the inflation trend rate it prefers. Another importance is linked to the symmetry characteristic. At its core, the floating exchange rate is symmetric meaning that there is no currency that can control other because exchange rates are dependent on the market force. Floating exchange rates can also stabilize the economy in case of an unanticipated fall. Disadvantages on the other hand, include high levels of uncertainty, the possibility of eliminating asymmetry in case the most powerful currency is reserved, and the speculative nature of persistent capital flows (Madura, 2011). This prevents exchange rates from adjusting to the current account disequilibria.
Fixed exchange reduce the costs and complexity when it comes to international trade. Also, it enables strengthen the monetary policy through which countries can engage in free expansionary policies independently. Notably the downsides of the fixed exchange rates include the inability to use monetary policy by countries in a bid to offset domestic shocks (Madura, 2011). If the exchange rate is overvalued, it is open to speculative attacks from other countries. This can lead to consequences such as the loss of international reserves.
Currency Effects on Economy
What is the impact of a weak home currency on the home economy, other things being equal?
Other things being equal, a weak home currency has inverse effects on exports and impacts of the economy. The latter decreases and the former increases. Consequently, resulting in high levels of unemployment. Another impact is inflation. Furthermore, a weak currency results in reduction in foreign competition (Madura, 2011). Local producers increase prices of their products and services, without necessarily pricing themselves out of the market.
What is the impact of a strong home currency on the home economy, other things being equal?
On the other hand, a strong home currency results in low inflation. This is because consumers purchase their goods abroad. Sequentially, local producers have to lower the prices of their good to remain competitive (Madura, 2011). As a direct result of increase in import and reduced exports, a strong home currency will increase the rates of employment in the hoe country.
Chapter 7
Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent.
a). According to IRP, what should the forward rate premium or discount of the euro be?
P= (1.04)/ (1.06) -1
= - 0.0189*100
= - 1.89%
b). If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?
F= $1.10 (1-0.0189)
=$1.079
Profit from Triangular Arbitrage. The bank is willing to buy dollars for 0.9 euros per dollar. It is willing to sell dollars for .91 euros per dollar. You can sell Australian dollars (A$) to the bank for $.72. You can buy Australian dollars from the bank for $.74. The bank is willing to buy Australian dollars (A$) for 0.68 euros per A$. The bank is willing to sell Australian dollars (A$) for 0.70 euros per A$. You have $100,000. Estimate your profit or loss if you were to attempt triangular arbitrage by converting your dollars to Australian dollars, and then converting Australian dollars to euros, and then converting euros to U.S. dollars.
First convert USD to AUD
1 Australian Dollar goes for 0.74 USD
Therefore 1,000,000/0.74
=135,135.14 Australian Dollars
Then converts the Australian Dollars to Euros
Since the bank is willing to buy 1 AUD for 0.68 Euros,
135,135.14*0.68 Euros
=91, 891.89 Euros
Convert the Euros back to USD
Since the bank is willing to sell 1 USD for 0.91 Euros,
= 91,891.89/0.91
=100,980.10 Euros
Therefore the above triangular arbitrage yielded a profit of
$(100,980.10-100,000)
= $980.10
Chapter 5
4. 4. Speculating with Currency Call Options. Randy Rudecki 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= $.01
Premium paid per unit = $.02
The Net profit per unit = –$.01
Net profit per option = 31,250 units × (–$.01)
= –$312.50
Chapter 10
1. Factors That Affect a Firm's Transaction Exposure
What factors affect a firm's degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure.
Factors that affect a firm’s degree of transaction exposure for a particular currency include variability in currency and correlation with currency (Madura, 2011). The desirable characteristics for variability in currency is its low level. On the other hand, currency correlations also have low levels desirability for currencies that are net inflows and high levels for those in which one currency shows net inflows and the other net outflows.
Chapter 11 2. Hedging Translation Exposure
Explain how a firm can hedge its translation exposure.
At its core, a translation exposure is the risk that a company’s equities, assets, liabilities, and income changes in value as a result of changes in exchange rates (Madura, 2011). A firm can hedge its translation exposure by selling forward the currency of the firms’ foreign subsidiary. Therefore, if the foreign currency depreciates, the loss incurred in the process of translation will be offset by the gains in the forward contract.
3. Forecasting with IFE and Hedging. Assume that Calumet Co. will receive 10 million pesos in 15 months. It does not have a relationship with a bank at this time, and therefore cannot obtain a forward contract to hedge its receivables at this time. However, in three months, it will be able to obtain a one-year (12-month) forward contract to hedge its receivables. Today the three-month U.S. interest rate is 2% (not annualized), the 12-month U.S. interest rate is 8%, the three-month Mexican peso interest rate is 5% (not annualized), and the 12-month peso interest rate is 20%. Assume that interest rate parity exists. Assume the international Fisher effect exists. Assume that the existing interest rates are expected to remain constant over time. The spot rate of the Mexican peso today is $.10. Based on this information, estimate the amount of dollars that Calumet Co. will receive in 15 months .
Value of Peso expected in 3 months =
1.02/1.05
= 0.9714
:. 0.9174*$ 0.10
= 0.09174
Expected 1 year FR prem in 3 months = (1.08/1.2) -1
= -10%
Expected 1 year FR in 3 months =
0.09174*9
= $0. 087426
Therefore the expected amount to be received from hedging =
0.087426*10 million pesos
= $874,260
4. Long-term Hedging With Forward Contracts. Tampa Co. will build airplanes and export them to Mexico for delivery in 3 years. The total payment to be received in 3 years for these exports is 900 million pesos. Today the peso’s spot rate is $.10. The annual U.S. interest rate is 4%, regardless of the debt maturity. The annual peso interest rate is 9% regardless of the debt maturity. Tampa plans to hedge its exposure with a forward contract that it will arrange today. Assume that interest rate parity exists. Determine the dollar amount that Tampa will receive in 3 years
Forward premium = (1+ih)/ (1+if) – 1
FP = (1.04 3 /1.09 3 ) -1
FP = (1.124864) / (1.29503) – 1
FP = -0.1314 = -13.14%
3 year forward rate = $.10 x (1 - 0.1314) = $0.08686
Therefore in a span of 3 years Tampa Co. will get 900million pesos x $0.0868 = $78,174,000 USD.
Reference
Madura, J. (2011). International financial management . Cengage Learning.
