98. What is the international Fisher effect and how would you test it, knowing that 6%
inflation is expected in the United States but only 3% is expected in Spain. The nominal U.S.
interest rate is 9%.
99. Would you be willing to exchange dollars for pounds at a rate of $1.50/£ to invest in
London and earn a 1-year rate of 10%, as opposed to investing in the United States for a 5%
return? What things might you first consider before investing?
100. Why should interest rate parity mean that the forward premium should equal the interest
rate differential between countries?
101. Assume that the British pound is selling at a forward premium to the U.S. dollar. Explain
what this means in terms of the spot and forward markets. Which currency is expected to
appreciate in this situation?
102. A firm has a legal obligation to pay FFr5 million one year from now and is wondering how
it can hedge the exchange risk. The spot exchange rate is FFr5.5/$ and the 1-year forward rate is
FFr5.6/$. The 1-year U.S. interest rate is 5% and the French rate is 5.5%. What do you suggest?
103. Knowing the value of compounding, you consider the opportunity to invest for 10 years in
a Japanese investment that will return 12% annually. The U.S. alternative for a 10-year
investment appears to offer 7% annually. The spot exchange rate is ¥96/$. What other concern
should you have?
The logical concern is what the spot exchange rate will be in 10 years. Let’s illustrate with the
example of an initial investment of $1,000: The $1,000 is exchanged for ¥96,000, which will grow
to ¥298,161.43 after 10 years at 12% annually. On the other hand, $1,000 invested for 10 years in
the United States at 7% will grow to only $1,967.15. If the same spot exchange rate is in effect 10
years from now, the ¥298,161.43 can be exchanged for $3,105.85—which is $1,138.70 more than
the U.S. investment will generate. Since this is a virtual money machine, it must be the case that
the yen is expected to depreciate by an approximate rate of 4.67% annually over the next 10
years. Any actual depreciation in the yen of less than 4.67% annually makes the yen investment
better. The question is, are you willing to bet against the international financial community that
the yen will
not
depreciate by 4.67% annually?
104. A firm can invest €10 million in its German subsidiary and receive a return of €4.3 million
annually for 3 years. The spot rate is €1.6/$, the U.S. rate of inflation is expected to be 4%
annually, and the German rate is expected to be 3% annually. If the appropriate risk-adjusted
cost of capital in dollars is 14%, does the project appear to have a positive NPV?
105. An American investor buys 100 shares of London Enterprises at a price of £50 when the
exchange rate is $1.60/£. A year later the shares are selling at £52. No dividends have been paid.
a. What is the rate of return to the American investor if the exchange rate is still $1.60/£?
b. What if the exchange rate is $1.70/£?
c. What if the exchange rate is $1.50/£?
106. Suppose the interest rate on 1-year loans in the United States is 5% while in the United
Kingdom the interest rate is 6%. The spot exchange rate is $1.55/£ and the forward rate is
$1.54/£. In what country would you choose to borrow? To lend? Can you profit from this
situation?
107. Suppose that the inflation rate in the United States is 4% and in Canada it is 5%. What
would you expect is happening to the exchange rate between the U.S. and Canadian dollars?
108. You have bid for a possible export order that would provide a cash inflow of €1 million in
1 year. The spot exchange rate is $0.9644/€ and the 1–year forward rate is $0.9503/€. There are
two sources of uncertainty: (1) the euro could appreciate to $1.00/€ or depreciate to $0.90/€, and
(2) you may or may not receive the export order. Illustrate in each case the profits or losses that
you would make if you sell €1 million forward.
109. General Gadget Corp. (GGC) is a U.S.-based multinational firm that makes electrical
coconut scrapers. These gadgets are made only in the United States using local inputs. The
scrapers are sold mainly to Asian and West Indian countries where coconuts are grown.
a. If GGC sells scrapers in Trinidad, what is the currency risk faced by the firm?
b. In what currency should GGC borrow funds to pay for its investment in order to mitigate its
foreign exchange exposure?
c. Suppose that GGC begins manufacturing its products in Trinidad using local (Trinidadian)
inputs and labor. How does this affect its exchange rate risk?
110. What is the difference between spot and forward exchange rates?
111. What are the basic relationships between spot exchange rates, forward exchange rates,
interest rates, and inflation rates?
112. What are some simple strategies to protect the firm against exchange rate risk?
113. How do we perform an NPV analysis for projects with cash flows in foreign currencies?
114. The following table shows the price of a Starbuck’s tall latte coffee in different locations
expressed in local currencies and converted into dollars using the spot rate of exchange. For
example, a tall latte in London costs £1.90; at an exchange rate of $1.989 per pound, this is
equivalent to a price of £1.90 × $1.989/£ = $3.78. This is 24% higher than the cost of a similar
coffee in New York; for the costs to be equal, the pound would need to depreciate against the
dollar.
a. Make an educated guess before doing any calculation: Which currency is least undervalued or
overvalued against the U.S. dollar? Why do you guess so?
b. What spot exchange rate establishes the law of one price for the tall latte in New York and in
each of the foreign cities?
c. If the nominal spot exchange rates are as given, what are the real exchange rates (latte
exchange rates)? What are the units of the calculation?
d. According to your calculation, are the foreign currencies overvalued or undervalued against
U.S. Dollar?
