Answers to End of Chapter Questions
1. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate
one year from now is assumed to be $1.66. What percentage depreciation does this reflect?
ANSWER: ($1.66 – $1.73)/$1.73 = –4.05%
2. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to
Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for
Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian
dollar?
ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should
3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest
rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b)
supply of pounds for sale, and (c) equilibrium value of the pound?
ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the
4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate
than does the Canadian income level. Other things being equal, how should this affect the (a) U.S.
demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the
Canadian dollar?
ANSWER: Assuming no effect on U.S. interest rates, demand for Canadian dollars should increase,
5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its
controls on imports by Japanese companies. Other things being equal, how should this affect the (a)
U.S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?
ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the
6. Effects of Real Interest Rates. What is the expected relationship between the relative real interest
rates of two countries and the exchange rate of their currencies?
ANSWER: The higher the real interest rate of a country relative to another country, the stronger will
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 dollar today. Why do some forecasts by
well-respected economists have no impact on today’s value of the dollar?
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Exchange Rate Determination 2
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
If a forecast of interest rates by a respected economist was already anticipated by market participants
8. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the
euro against the dollar?
ANSWER: The euro’s value could change because of the balance of trade, which reflects more U.S.
9. Interaction of Exchange Rates. Assume that there are substantial capital flows among Canada, the
U.S., and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and
inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar
against the U.S. dollar? How might this decline in Canada’s interest rates possibly affect the value of
the Canadian dollar against the Japanese yen?
ANSWER: If interest rates in Canada decline, there may be an increase in capital flows from Canada
10. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures are
announced. Foreign exchange traders often react to this announcement and even attempt to forecast
the figures before they are announced.
a. Why do you think the trade deficit announcement sometimes has such an impact on foreign
exchange trading?
ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits
b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even
when the announced deficit is very large. Offer an explanation for such a lack of response.
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Exchange Rate Determination 3
ANSWER: If the market correctly anticipated the trade deficit figure, then any news contained in the
11. Comovements of Exchange Rates. Explain why the value of the British pound against the dollar will
not always move in tandem with the value of the euro against the dollar.
ANSWER: The euro’s value changes in response to the flow of funds between the U.S. and the
12. Factors Affecting Exchange Rates. In some periods, Brazil’s inflation rate was very high.
Explain why this places pressure on the Brazilian currency (called the Brazilian real).
ANSWER: High inflation in Brazil can encourage its consumers to purchase products from other
countries where products are cheaper, and can discourage consumers in other countries from
13. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations
that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held
constant, increased national income could increase imports and cause the local currency to weaken.
In reality, other factors are not constant. What other factor is likely to be affected by increased
economic growth and could place upward pressure on the value of the local currency?
ANSWER: Interest rates tend to rise in response to a stronger economy, and higher interest rates can
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 U.S. dollar) be affected?
ANSWER: A relative decline in Asian economic growth will reduce Asian demand for U.S. products,
which places upward pressure on Asian currencies. However, given the change in interest rates, Asian
15. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local
currency to weaken abruptly? Is it because of trade or capital flows?
ANSWER: Capital flows have a larger influence. In general, crises tend to cause investors to expect
that there will be less investment in the country in the future and also cause concern that any existing
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Exchange Rate Determination 4
16. Economic Impact on Capital Flows. How do you think the weaker U.S. economic conditions
could affect capital flows? If capital flows are affected, how would this influence the value of the
dollar (holding other factors constant)?
ANSWER: Weaker U.S. economic conditions commonly result in lower interest rates. The lower
Advanced Questions
17. Measuring Effects on Exchange Rates. Tarheel Co. plans to determine how changes in U.S. and
Mexican real interest rates will affect the value of the U.S. dollar. (See Appendix C for the basics of
regression analysis.)
a. Describe a regression model that could be used to achieve this purpose. Also explain the
expected sign of the regression coefficient.
ANSWER: Various models are possible. One model would be:
Where
rU.S. = real interest rate in the U.S.
Based on the model above, the regression coefficient is expected to have a negative sign. A relatively
b. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have
affected exchange rates, how might this be accounted for in the regression model?
ANSWER: A dummy variable could be included in the model, assigned a value of one for periods
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Exchange Rate Determination 5
18. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United
States and also much higher interest rates than the United States. Inflation and interest rates are much
more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically
more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically
depreciated from one year to the next, but the degree of depreciation has varied substantially. The
bid/ask spread tends to be wider for the peso than for currencies of industrialized countries.
a. Identify the most obvious economic reason for the persistent depreciation of the peso.
peso.
b. High interest rates are commonly expected to strengthen a country’s currency because they can
encourage foreign investment in securities in that country, which results in the exchange of other
currencies for that currency. Yet, the peso’s value has declined against the dollar over most years
even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it
appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s
securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in
Mexico?
ANSWER: The high interest rates in Mexico result from expectations of high inflation. That is, the
real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high
c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized
countries? How does this affect a U.S. firm that does substantial business in Mexico?
ANSWER: The bid/ask spread is wider because the banks that provide foreign exchange services are
19. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government
and corporate securities of Country K. In addition, residents of Country K invest heavily in the
United States. Approximately $10 billion worth of investment transactions occur between these two
countries each year. The total dollar value of trade transactions per year is about $8 million. This
information is expected to also hold in the future.
Because your firm 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 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
dollar.
a. U.S. inflation has suddenly increased substantially, while Country K’s inflation remains low.
ANSWER: Increased U.S. demand for the krank. Decreased supply of kranks for sale. Upward
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Exchange Rate Determination 6
b. U.S. 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 U.S. demand for the krank. Increased supply of kranks for sale. Downward
c. The U.S. income level increased substantially, while Country K’s income level has remained
unchanged.
d. The U.S. is expected to impose a small tariff on goods imported from Country K.
ANSWER: The tariff will cause a decrease in the United States’ desire for Country K’s goods, and
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 the U.S.
20. Speculation. 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:
Lending Rate Borrowing Rate
U.S. dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%
Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos 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? Estimate the profits that could be generated from this strategy.
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Exchange Rate Determination 7
ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows:
1. Borrow MXP70 million
2. Convert the MXP70 million to dollars:
3. Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The
amount accumulated in 10 days is:
4. Repay the peso loan. The repayment amount on the peso loan is:
5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is:
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted
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.
ANSWER: Blue Demon Bank can capitalize on its expectations as follows:
1. Borrow $10 million
2. Convert the $10 million to pesos (MXP):
3. Lend the pesos through the interbank market at 8.5% annualized over a 30-day period. The
4. Repay the dollar loan. The repayment amount on the dollar loan is:
5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days
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Exchange Rate Determination 8
6. The profits are determined by estimating the dollars available after repaying the loan:
21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from
its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 7.0% 7.2%
Singapore dollar 22.0% 24.0%
Diamond Bank considers borrowing 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 U.S. $:
Invest funds for 60 days. The rate earned in the U.S. for 60 days is:
7% × (60/360) = 1.17%
Total amount accumulated in 60 days:
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