Chap. 4 Part 1 2 Problems 2@10 marks = 20 marks 1.

1. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: U.S. dollar Mexican peso Lending Rate 8.0% 8.5% Borrowing Rate 8.3% 8.7%

Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds (It needs to borrow funds)? Estimate the profits that could be generated from this strategy. See Examples pages 112 and 113 10 Marks

1. Borrow 70 Million Pesos 2. Convert the 70 Million Pesos to USD = 70,000,000 $.15 = $10,500,000 USD 3. Lend/Invest the USD through the interbank market at 8% for 10 Days. Annual interest rate converted = 8% 10/360 = .22%. Interest Earned = $10,500,000 x (1+.22%) $10,523,100 (if you do not round the .22% and enter in the true interest rate of .2222222% the answer is $10,523,333) 4. The amount of Pesos needed to pay back the loan 70,000,000Pesos [1 + (8.7% 10/360)] = 70,000,000 [1.002417]= 70,169,167 Pesos 5. Using the expected spot rate of $.14, the amount needed in USD is 70,169,167 $.14 = $9,823,683 USD 6. If all forecasts are correct after repaying the loan the expected profit should be $10,523,333 $9,823,683 = $699,650 Estimated profit would be $699,650
b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. 10 Marks

1. Borrow $10 million 2. Convert the $10 million to pesos $10,000,000/$.15 = 66,666,667 Pesos 3. Lend/Invest the pesos through the interbank market at 8.5% for 30-day period. Annual Interest Rate converted = 8.5% x 30/360 = .7083333% Interest Earned = 66,666,667 Pesos x(1.00708333) = 67,138,889 Pesos 4. Amount needed to pay back the loan in USD. $10,000,000 x [1 + (8.3% 30/360)] = $10,000,000 [1.006917] = $10,069,170 5. Using the expected spot rate of $.17, the amount needed in USD is 67,138,889 x $.17 = $11,413,611 6. If all forecasts are correct after repaying the loan the expected profit should be $11,413,611 $10,069,170 = $1,344,441
Chap. 4 - Continuing Case Problem: Blades, Inc. 5@ 6=30 Marks. See Page 199. 1. How are percentage changes in a currencys value measured? Illustrate your answer numerically by assuming a change in the bahts value from a value of $0.026 to $0.020.

The percent change in a currencys value is measured by the following formula. In the below formula S = Spot Rate, St1 is the spot rate at an earlier date. Once calculated a positive change would equal an appreciation of a foreign currency, while a negative would indicate depreciation. S S t 1 .020 .026 % = % = % = 0.023 x100 = 23.08% S t 1 .026 The baht is expected to depreciate

2.

What are the basic forces that determine the value of a currency in the spot market? In equilibrium, what is the relationship between these forces? Draw a diagram showing the equilibrium price and the equilibrium quantity for the UK pound.

The basic forces that determine the value of a currency are the supply and demand for the currency. A high supply will decrease the value of the currency, while a high demand will increase the value. The equilibrium is when the supply and demand of a currency are equal.

3.

How might the relatively high levels of inflation and interest rates affect the bahts value relative to the U.S. dollar? (Assume a constant level of U.S. inflation and interest rates.)

Both a high interest rate and high inflation rate can affect the bahts value relative to the US dollar. As the inflation rates in Thailand increase the demand for US goods will increase, which will result in an increase in the demand for the US currency. As it becomes more expensive for consumers to buy goods from Thailand, there will be a reduction in the amount of US dollars for sale, which would lower the value of the baht due to a decreased in demand for the baht. However, high interest rates often cause an appreciation of a currencys value. As high interest rates attract more investors, which would in turn cause more demand to for the baht. As the demand for the baht increases the value of the baht will also increase, making investments in the US less attractive.
4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from Thailand, will affect the bahts value? Would Blades be affected by the change in value, given the primary Thai customers commitment?

The withdraw of funds from Thailand would cause the value of the currency to depreciate, as there will be a higher supply of the currency as the baht is sold and converted into dollars. Blades agreement was a fixed price in baht, so the depreciation of the baht will affect Blades as he is paid in baht and when this money is converted into dollars we will no longer have as favorable exchange rates.
5. Assume that Thailands central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currencys value. How could it accomplish this objective in the short run using interest rates only?

To prevent the withdraw of funds Thailands central bank can increase interest rates. The increase in the interest rate will make the baht more attractive to investors and provide

them with an incentive to maintain or further invest their money vs withdrawing the funds to invest elsewhere. The increase of interest rate will maintain/increase the demand for the baht causing the currency to maintain/appreciate in value.
Chap. 6 Part 1 2 Problem 1@15 and 1@8 = 23 marks 1. Intervention Effects on Corporate Performance. Assume you (a U.S. company) have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent US$100,000 in interest each month. Australia has just lowered its interest rate in order to boost domestic consumption, and the value of its currency falls (Australian dollar, A$). The Australian dollar depreciates against the dollar as a result. State and explain whether these actions would increase, reduce, or have no effect on the following: a. The volume of your subsidiarys sales in Australia (measured in A$) 5 Marks

The volume of sales for the subsidiary in Australia should increase. This increase should occur because the cost to consumers would decline. This decline would occur because as stated local consumers purchase most often with borrowed money. If the interest rate is decreased it would cost less for consumers to borrow.
b. The cost to your subsidiary of purchasing materials (measured in A$) 5 Marks

The cost of purchasing materials in A$ would increase. As the A$ depreciates the Australian subsidiary will have to spend more money to purchase HK$. The Australian subsidiary use to benefit from a higher currency, therefor the A$ would buy more HK$. As the A$ lowers the Australian subsidiary would no longer receive the benefits of a higher currency, therefore increasing the cost to buy one product. E.g. 1A$ = 5HK$, after depreciation 1A$=2HK$
c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). 5 Marks Briefly explain each answer.

The cost for the subsidiary to make interest payments will increase as it will take more A$ to make the monthly interest payments. The same situation that occurred with the HK$ will occur with the US$
2. Implications of a Fixed Currency for International Trade. Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ = 0.25 Singapore dollars. Today, a HK$=0.30 Singapore dollars. Assume that there is much trade in the computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as substitutes for each other and are of about the same quality. Assume that the firms invoice their products in their local currency and do not change their prices. a. Will the computer exports from the U.S. to Hong Kong increase, decrease, or remain the same? Briefly explain. 4 Marks

Decrease The HK$ has appreciated in value against the S$. As a result Hong Kong should decrease the volume of computers they import from the US and increase the volume from Singapore
b. Will the computer exports from Singapore to the U.S. increase, decrease, or remain the same? Briefly explain. 4 Marks

Increase For the same reasons why Hong Kong should shift its imports to Singapore, the US should also increase its exports from Singapore. The US and HK$ are tied therefore when the HK appreciated against the S$, so did the US$. This has made it cheaper for the US to purchase goods in Singapore.
Chap. 6 - Continuing Case Problem: Blades, Inc. 12 marks 1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.

The intervention effort by the Thai government was a direct intervention. To raise the value of the baht the Thai government intentionally intervened in the foreign exchange 3

market. It did so by swapping its baht reserve for dollars reserve at other central banks and then used its dollar reserve to purchase the baht in the foreign exchange market. The success of the intervention is irrelevant; the intent was to directly intervene.
2. Did the intervention by the Thai government constitute sterilized or nonsterilized intervention? Explain the difference between the two types of intervention.

Sterilized intervention by a government in the foreign exchange market with simultaneous intervention in Treasury securities to offset any effects on the money supply, resulting in the intervention in the market without affecting the existing money supply. Non-Sterilization intervention in the forging market without making any adjustment for the change in the money supply The Thai government intervened by the use of non-sterilization, as the intent was to alter the foreign market.
3. Which type do you think would be more effective in increasing the value of the baht in the short run? Why? (Hint: Think about the effect of nonsterilized intervention on U.S. interest rates.)

Non-sterilization would be more successful in the short run to effectively increase the value of the baht. By not making adjustments in the market to ensure the market remains unchanged, the government could have the opportunity to increase their currency, which would encourage foreign investors. Investors would be encouraged because the increase in currency would make the interest rate more appealing and in return increase the demand for the domestic currency.
Chap. 8 Part 3 1@ 10 marks, and 4 @5 marks = 30 marks 1. Beth Miller who lives in the US does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 8 percent, while one-year interest rates in the U.S. are 6 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. (Assume the home country is the US)

a.

Explain the IFE theory and how it works.

The IFE theory uses the difference between the interest rate of the home country against the interest rate in the foreign country to explain currency changes. The theory states that a currencys exchange rate will depreciate against another currency when its interest rate is higher than that of the other country. This will than cause an increase in the inflation rate.
b.
According to the IFE, what should the spot rate of the euro in one year be?

In the IFE theory comes to fruition the Euro should depreciate by 1.85 in one year. The a spot rate of $1.10 x (1-1.85%) = $1.0791
ef = = (1 + i h ) 1 (1 + i f )

(1.06) 1 = 1.85% (1.08) c. If the spot rate of the euro in one year is $1.00, what is Beths percentage return from her strategy? 10 Marks US to Euros = $100,000/$1.10 = 90,909.09 ROI for one year of investment = 90,909.09 x 1.08 = 98, 181.82

Euros to US = 98, 181.82 x $1.00 = $98, 181.82 The percent of return is = $98, 181.82/$100, 000-1 = -1.82%
1. Assume that U.S. and British investors require a real return of 1%. If the nominal U.S. interest rate is 6%, and the nominal British rate is 3%, then according to the IFE, how much is the British inflation rate is expected to be? What will be the U.S. inflation rate? What will happen to the British pound? 5 Marks

ef = =

(1 + ih ) 1 (1 + i f )

(1.06) 1 = 2.9% (1.03)

Inflation = Nominal Interest Real Rate US Inflation = 6%-1% = 5% UK Inflation 3% - 1% = 2% The IFE Theory states that the exchange rate will depreciate against another countries currency when the interest rate is higher. Therefore the British pound appreciate relative to the US dollar
4. Assume U.S. and Swiss investors require a real rate of return of 2%. Assume the nominal U.S. interest rate is 6% and the nominal Swiss rate is 4%. According to the international Fisher effect what will happen to the franc? By how much will it change? 5 Marks

ef = =

(1 + ih ) 1 (1 + i f )

(1.06) 1 = 1.92% (1.04)

According to the IFE the fran will appreciate by 1.92%

5. Assume that the Canadian and Chile nominal interest rates are equal. Then, the Canadian nominal interest rate decreases while the Chilean nominal interest rate remains stable. What expectations does this imply according to the international Fisher effect? What should happen to the Chilean peso? (Assume Canada is home) 5 Marks

According to the IFE if the interest rate in Canada is decreasing the currency will appreciate. As the Chile interest rate did not change, the decrease in the CND interest rate and the appreciation of the CND would cause the Chilean peso to depreciate relevant to the CND.
5. Assume that the inflation rate in Barbados is 4.20%, while the inflation rate in the U.S. is 4.00%. What should the Barbados dollar do relative to the US dollar? (Assume US is home)

(1 + I h ) ef = 1 (1 + I f ) =

5 Marks

(1.04) 1 = 0.19% (1.042)

According to the purchasing power parity theory the foreign currency should depreciate by .19% in response to the higher inflation rate. 5

Total 115 MarksPlus 5 Marks for Quality = 120 Marks