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Answers to Chapter 9
Questions:
1. Cash flows from the sale of products, services, or assets denominated in a foreign currency are transacted in
foreign exchange (FX) markets. A foreign exchange rate is the price at which one currency (e.g., the U.S. dollar) can
be exchanged for another currency (e.g., the Swiss franc) in the foreign exchange markets. These transactions
2. The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of
3. In this case, the insurance company is worried about the value of the £ falling. If this happens, the insurance
4. From 1944 to 1971, the Bretton Woods Agreement called for the exchange rate of one currency for another to be
fixed within narrow bands around a specified rate with the help of government intervention. The Bretton Woods
5. Since 1982 when Singapore opened its market, foreign exchange markets have operated 24 hours a day: when the
6. The spot market for foreign exchange involves transactions for immediate delivery of a currency, while the
forward market involves agreements to deliver a currency at a later time for a price or exchange rate that is
7. FIs hedge to manage their exposure to currency risks, not to eliminate it. As in the case of interest rate risk
8. The manager of an FI can hedge using on-balance-sheet techniques or off-balance-sheet techniques.
On-balance-sheet hedging requires matching currency positions and durations of assets and liabilities. If the duration
Advantages of off-balance-sheet FX hedging: The use of off-balance-sheet hedging devices, such as forward
contracts, enables an FI to reduce or eliminate its FX risk exposure without forfeiting potentially lucrative
Disadvantages of off-balance-sheet FX Hedging: There is some credit risk associated with off-balance-sheet hedging
9. If there are no real or financial barriers to international capital and goods flows, FIs can eliminate all foreign
10. A financial institution’s position in the foreign exchange markets generally reflects four trading activities:
• The purchase and sale of foreign currencies to allow customers to partake in and complete international
commercial trade transactions.
11. If interest rate parity holds, then it is not possible for FIs to borrow and lend in different currencies to take
12. As relative inflation rates (and interest rates) change, foreign currency exchange rates that are not constrained by
government regulation should also adjust to account for relative differences in the price levels (inflation rates)
13. Interest rate parity argues that the discounted spread between domestic and foreign interest rates is equal to the
percentage spread between forward and spot exchange rates. If interest rate parity holds, then it is not possible for
16. The U.S. has had a substantial trade deficit resulting from imports of foreign goods relative to exports of
domestic goods, $741.475 billion in 2012. This deficit has increased in the 1990s and 2000s. For example, the
17. Transactions recorded to the balance of payment accounts use standard double-entry bookkeeping. Thus, any
payment of funds by a U.S. citizen to a foreign country, such as payment for the purchase of a foreign car (a debit to
a balance of payment current account), must be offset with a receipt credit received from the foreign country, such as
Problems:
3. At the beginning of the month you convert $500,000 to yen at a rate of 97.89 yen per dollar, or you will have
b. Bank USA converts the $10 million to euros as follows:
c. Bank USA converts the $10 million to euros as follows:
c. Bankone receives the $200 million from reals as follows:
b. The net cost of deposits should be $294,750 - $125,000 = $169,750
8. a. Amount of loan in £ = $2 million / 1.45 = £1,379,310.
b. If hedged, net interest income = £1,379,310 x 1.08 = £1,489,655
9. a. Amount of loan in ¥ = $5 million / 0.001172 = ¥4,266,211,604.
Interest and principal at year-end in dollars = ¥4,266,211,604 x 1.06 = ¥4,522,184,300 x 0.001155 = $5,223,123
b. If hedged, net interest income = ¥4,266,211,604 x 1.06 = ¥4,522,184,300
c. To maintain a 2% spread: ¥4,266,211,604 (1 + x) x 0.001165 = $5.30m => x = 6.637%
10. a. At the beginning of the year, the FI sells $200 million for euros on the spot currency markets at an exchange
rate of $1.25 to € => $200 million/1.25 = €160 million.
b. At the end of the year, euro revenue from these loans will be €160(1.10) = €176 million.
Then the dollar proceeds from the German loan are:
c. At the end of the year, euro revenue from the loans will be €160(1.10) = €176 million.
Then the dollar proceeds from the German loan are:
11. a. As in part b in question 10, when the euro falls in value to $1.15/€1 at the end of the year, euro revenue from
the German loans is be €160(1.10) = €176 million.
and the weighted return on the FI’s portfolio of investments would be:
On the liability side of the balance sheet, at the beginning of the year, the FI borrows $200 million equivalent in euro
CDs for one year at a promised interest rate of 7 percent. At an exchange rate of $1.25/€1, this is a euro equivalent
amount of borrowing of $200 million/1.25 = €160 million.
At the end of the year, the FI must pay the pound CD holders their principal and interest, €160 million (1.07) =
€171.20 million.
Thus, at the end of the year,
b. As in part c in question 10, when the euro rises in value to $1.35/€1 at the end of the year, euro revenue from the
German loans is be €160(1.10) = €176 million.
Then the dollar proceeds from the German loan are:
and the weighted return on the FI’s portfolio of investments would be:
On the liability side of the balance sheet, at the beginning of the year, the FI borrows $200 million equivalent in euro
CDs for one year at a promised interest rate of 7 percent. At an exchange rate of $1.25/€1, this is a euro equivalent
At the end of the year, the FI must pay the pound CD holders their principal and interest, €160 million (1.07) =
€171.20 million.
If the euro increases to $1.35/€1 over the year, the repayment in dollar terms would be
Thus, at the end of the year,
Average cost of funds:
Net return:
Average return on assets - Average cost of funds
12. EXCEL Problem: Gain/loss = $330,300
13. Net foreign exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi)
= Net foreign assetsi + Net FX boughti
a. Thus, for Citybank, net foreign assets = $23 million - $18 million = $5 million.
14. Net foreign exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi)
= Net foreign assetsi + Net FX boughti
a. Thus, for P.J. Chase Stanley, net foreign assets = $75 million - $68 million = $7 million.
17. According to PPP, the 5 percent rise in the price of Australian goods relative to the 3 percent rise in the price of
U.S. goods results in a depreciation of the Australian dollar (by 2 percent). Specifically, the exchange rate of
Australian dollars to U.S. dollars should fall, so that:
Plugging in the inflation and exchange rates, we get:
Thus, it costs 2.0554 cents less to receive an Australian dollar (or $1.007146 ($1.0277 - $0.020554), can be received
for 1 Australian dollar). The Australian dollar depreciates in value by 2 percent against the U.S. dollar as a result of
its higher inflation rate.
18. Since direct exchange rates are being used, (1+rUS) = 1/S x (1+rUK) x F
19. In this case, interest rates in the U.S. are "too high" relative to the U.K. An investor could take advantage of this
20. The current exchange rate is $40,000/¥4,000,000 or $.01/¥1.
21. a. Borrow $1,000,000 in U.S. by issuing CDs:
Interest and principal at year-end = $1,000,000 x 1.08 = $1,080,000
Make a loan in Switzerland:
b. Forward rate that will prevent any arbitrage:
Ft = [(1 + 0.08) x 0.60]/(1.04) = $0.62308/Sf
22. a. Borrow $5,000,000 in U.S. by issuing CDs:
Interest and principal at year-end = $5,000,000 x 1.05 = $5,250,000
Make a loan in Turkey:
b. Forward rate that will prevent any arbitrage:
23. a. Total current accounts = $168,953 - $150,936 - $9,421 = $8,596
