BUS330: International Finance Workshop 03
Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: daixieit
BUS330: International Finance
Workshop 03 (Chapter 5): Exchange Rate Determination
Solutions to Problems
1. Percentage depreciation Assume the spot rate of the Indian rupee is A$0.0905. The expected spot rate one year from now is assumed to be A$0.0205. What percentage depreciation does this reflect?
ANSWER: (A$0.0205 – A$0.0905)/A$0.0905 = -77.34%
Expected depreciation of 77.3 per cent
2. Inflation effects on exchange rates Assume that the Australian inflation rate becomes high relative to Japanese inflation. Other things being equal, how should this affect the (a) Australian demand for Japanese yen, (b) supply of Japanese yen for sale, and (c) equilibrium value of the Japanese yen?
ANSWER: Demand for Japanese yen should increase, supply of Japanese yen for sale should decrease and the Japanese yen’s value should increase.
3. Interest rate effects on exchange rates Assume Australian interest rates fall relative to Malaysian interest rates. Other things being equal, how should this affect the (a) Australian demand for Malaysian ringgits, (b) supply of ringgit for sale, and (c) equilibrium value of the ringgit?
ANSWER: Demand for ringgits should increase, supply of ringgits for sale should decrease and the ringgit’s value should increase.
4. Income effects on exchange rates Assume that the Australian income level rises at a much higher rate than does the New Zealand income level. Other things being equal, how should this affect the (a) Australian demand for New Zealand dollars, (b) supply of New Zealand dollars for sale, and (c) equilibrium value of the New Zealand dollar?
ANSWER: Assuming no effect on Australian interest rates, demand for New Zealand dollars should increase, supply of New Zealand dollars for sale may not be affected and the New Zealand dollar’s value should increase.
7. Speculative effects on exchange rates Explain why a public forecast by a respected economist about future interest rates could affect the value of the Australian dollar today. Why do some forecasts by well-respected economists have no impact on today’s value of the Australian dollar?
ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currency’s value. These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates.
If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investors’ original expectations, an announced forecast does
not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected.
12. Factors affecting exchange rates In some periods, India’s inflation rate was very high. Explain why this places pressure on the Indian rupee.
ANSWER: High inflation in India can encourage its consumers to purchase products from other countries where products are cheaper, and can discourage consumers in other countries from purchasing imports from India. This shift in international trade represents an increase in the supply of the Indian rupee for sale, and a decrease in the demand for the Indian rupee by other countries, which places downward pressure on the Indian rupee.
14. Factors affecting exchange rates 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 Australian dollar) be affected?
ANSWER: A relative decline in Asian economic growth will reduce Asian demand for Australian products, which places upward pressure on Asian currencies. However, given the change in interest rates, Asian corporations with excess cash may now invest in Australia or other countries, thereby increasing the demand for Australian dollars. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. The overall impact depends on the magnitude of the forces just described.
19. Aggregate effects on exchange rates Assume that Australia invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in Australia. Approximately A$10 billion worth of investment transactions occur between these two countries each year. The total Australian dollar value of trade transactions per year is about A$8 million. This information is expected to also hold in the future.
Because your company exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K’s currency (the ‘krank’) with respect to the Australian dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank’s movement against the Australian dollar.
a. Australian inflation has suddenly increased substantially, while Country K’s inflation remains low.
ANSWER: Increased Australian demand for the krank, decreased supply of kranks for sale and upward pressure in the krank’s value.
b. Australian interest rates have increased substantially, while Country K’s interest rates remain low. Investors of both countries are attracted to high interest rates.
ANSWER: Decreased Australian demand for the krank, increased supply of kranks for sale and downward pressure on the krank’s value.
c. The Australian income level increased substantially, while Country K’s income level has remained unchanged.
ANSWER: Increased Australian demand for the krank, upward pressure on the krank’s value.
d. Australian is expected to impose a small tariff on goods imported from Country K.
ANSWER: The tariff will cause a decrease in Australia’s’ desire for Country K’s goods, will therefore reduce the demand for kranks for sale and put downward pressure on the krank’s value.
e. Combine all expected impacts to develop an overall forecast.
ANSWER: 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 Australia 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 Australia and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate.
20. Speculation Blue Demon Bank expects that the Mexican peso will depreciate against the US
dollar from its spot rate of US$0.15 to US$0.14 in 10 days. The following interbank lending and
borrowing rates exist:
US 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 US$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 capitalise on its expectations without using
deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalise on its expectations about pesos (MXP) as follows:
1. Borrow MXP70 million
2. Convert the MXP70 million to dollars: MXP70,000,000 × $.15 = $10,500,000
3. Lend the dollars through the interbank market at 8.0% annualised over a 10-day period. The amount accumulated in 10 days is:
$10,500,000 × [1 + (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333
4. Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 × [1 + (8.7% × 10/360)] = 70,000,000 × [1.002417]=MXP70,169,167
5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is:
MXP70,169,167 × $.14 = $9,823,683
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of:
$10,523,333 – $9,823,683 = $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 US$0.15 to US$0.17 in 30 days. How could it attempt to capitalise on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy.
ANSWER: Blue Demon Bank can capitalise on its expectations as follows:
1. Borrow $10 million
2. Convert the $10 million to pesos (MXP): $10,000,000/$.15 = MXP66,666,667
3. Lend the pesos through the interbank market at 8.5% annualised over a 30-day period. The amount accumulated in 30 days is:
MXP66,666,667 × [1 + (8.5% × 30/360)] = 66,666,667 × [1.007083] = MXP67,138,889
4. Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 × [1 + (8.3% × 30/360)] = $10,000,000 × [1.006917] = $10,069,170
5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $.17) is:
MXP67,138,889 × $.17 = $11,413,611
6. The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 – $10,069,170 = $1,344,441
21. Speculation Diamond Bank expects that the Singapore dollar will depreciate against the Australian dollar from its spot rate of A$0.9856 to A$0.9756 in 60 days. The following interbank
lending and borrowing rates exist:
Australian dollar
Singapore dollar
Diamond Bank considers borrowing
Borrowing Rate
2.2%
7%
10 million Singapore dollars in the interbank market and
investing the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy?
ANSWER:
Borrow S$10,000,000 and convert to Australian dollar (A$):
S$10,000,000 × A$0.9856 = A$9,856,000
Invest funds for 60 days. The rate earned in Australia for 60 days is:
2% × (60/360) = 0.33%
Total amount accumulated in 60 days:
A$9,856,000 × (1 + 0.0033) = A$9,888,525
Convert A$ back to S$ in 60 days:
A$9,888,525/A$0.9756 = S$10,135,839
The rate to be paid on loan is:
7% × (60/360) = 1.17%
Amount owed on S$ loan is:
S$10,000,000 × (1 + 0.0117) = S$10,117,000
This strategy results in a profit:
S$10,135,839 – S$10,117,000 = S$18,839
Diamond Bank should not pursue this strategy.
23. Assessing the euro’s potential movements You reside in Australia 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 Australian 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 Australia 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 Australian dollar over the next year? Explain.
ANSWER: The euro should depreciate because most countries in the eurozone are presumed to have high inflation.
25. How factors affect exchange rates The country of Luta has large capital flows with Australia. It has no trade with Australia and will not have trade with Australia in the future. Its interest rate is
6 per cent, the same as the Australian interest rate. Its rate of inflation is 5 per cent, the same as the Australian inflation rate. You expect that the inflation rate in Luta will rise to 8 per cent this coming year, while the Australian inflation rate will remain at 5 per cent. You expect that Luta’s interest rate will rise to 9 per cent during the next year. You expect that the Australian interest rate will remain at 6 per cent this year. Do you think Luta’s currency will appreciate, depreciate, or remain unchanged against the dollar? Briefly explain.
ANSWER: Luta’s currency should appreciate against the Australian dollar because the exchange rate should be influenced by capital flows. Luta now has a higher interest rate, which will attract Australian investors, especially since the effect of higher inflation in Luta is negligible because of no trade between the countries.
26. Speculation on expected exchange rates Kurnick Co. expects that the pound will depreciate from US$1.70 to US$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 US$1 million or 1 million pounds for one year. It can borrow US dollars at 6 per cent or British pounds at 5 per cent for one year. It can invest in a risk-free dollar deposit at 5 per cent for one year or a risk-free British deposit at 4 per cent for one year. Determine the expected profit or loss (in US dollars) if Kurnick Co. pursues a strategy to capitalise on the expected depreciation of the pound.
ANSWER: Initial amount borrowed = 1,000,000 pounds
US dollars received when the pounds are converted to dollars = 1,000,000 * 1.70 = US$1,700,000. Total dollar amount at the end of 1 year = $1,700,000 x 1.05 = US$1,785,000.
Total owed on the pounds borrowed = 1,000,000*1.05 = 1,050,000 pounds.
Expected amount of US dollars needed to repay the loan = 1,050,000 x 1.68 = US$1,764,000. Profit = US$1,785,000 - US$1,764,000 = US$21,000.
29. Movements in cross exchange rates Last year an Australian dollar was equal to 3 Malaysian ringgit, and a Chinese yuan was equal to A$0.2073. Today, the Australian dollar is equal to 4 Malaysian ringgit, and a Chinese yuan is equal to A$0.2473. By what percentage did the cross exchange rate of the Chinese yuan in Malaysian ringgit (that is, the number of ringgit that can be purchased with 1 yuan) change over the last year?
ANSWER:
Old rates last year
Spot rate of Malaysian ringgit (MYR) = (1/3) = A$0.3333/MYR
Spot rate of Chinese yuan (CNY)= A$0.2073/CNY
Spot rate of Chinese yuan in Malaysian ringgit = [(A$0.2073/CNY) / (A$0.3333/MYR)] = MYR 0.6219/CNY
New rates after 1 year
Spot rate of Malaysian ringgit = (1/4) = A$0.2500/MYR
Spot rate of Chinese yuan = A$0.2473/CNY
Spot rate of Chinese yuan in Malaysian ringgit = [ (A$0.2473/CNY) / (A$0.2500/MYR)] = MYR 0.9892/CNY
This indicates that the cross exchange rate of Chinese yuan in Malaysian ringgit has appreciated. % of appreciation = (0.9892 – 0.6219)/0.6219 = 59.06%
31. Impact of economy on exchange rate The country of Quinland 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. Its interest rate is 6 per cent, the same as the US interest rate. You expect that the inflation rate in Quinland will be 1 per cent this coming year, while the US inflation rate will be 9 per cent. You expect that Quinland's interest rate will be 2 per cent during the next year, while the US interest rate will rise to 10 per cent during the next year. Quinland's currency adjusts in response to market forces. Will Quinland's currency appreciate, depreciate, or remain unchanged against the US dollar?
ANSWER: Quinland's currency should depreciate against the US dollar because money should flow to the United States where interest rates are higher.
32. Impact of economy on exchange rate The country of Zars 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. Its interest rate is 6 per cent, the same as the US interest rate. Its rate of inflation is 5 per cent, the same as the US inflation rate. You expect that the inflation rate in Zars will rise to 8 per cent this coming year, while the US inflation rate will remain at 5 per cent. You expect that Zars’ interest rate will rise to 9 per cent during the next year. You expect that the US interest rate will remain at 6 per cent 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 US dollar?
ANSWER: Zars’ currency should appreciate against the US dollar, because the exchange rate should be driven by capital flows, and money should be moving into Zars to capitalise on the high interest rate. The inflation should not be influential since the countries have no international trade.
33. Impact of economy on exchange rates The country of Vezot has massive capital flows with the Australia 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 Australian inflation rate remains unchanged. Vezot's interest rate just increased substantially, while the Australian interest rate remains unchanged. Vezot's income level just increased substantially, which will increase consumption of products within its country. The Australian income level remains unchanged. There is negligible international trade between Vezot and Australia. Vezot can easily obtain all of its imported products from border countries instead of Australia. Australia just imposed very large taxes on Australian importers that import products from Vezot from today forward. Vezot does not impose restrictions on imports from Australia. 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 Australian dollar? Briefly explain.
ANSWER: Vezot's currency should appreciate against the Australian dollar, because its value should be influenced mostly by capital flows, and the increased interest rate should attract capital flows, especially since the other factors should not cause concerns by investors of future weakness in the currency's value.
2022-03-21
Exchange Rate Determination