978-1133947837 Chapter 4 Solution Manual Part 2

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22. Relative Importance of Factors Affecting Exchange Rate Risk. Assume that the level of

capital flows between the U.S. and the country of Krendo is negligible (close to zero) and will

continue to be negligible. There is a substantial amount of trade between the U.S. and the country of

Krendo and no capital flows. How will high inflation and high interest rates affect the value of the

kren (Krendo’s currency)? Explain.

ANSWER: The inflation effect will be stronger than the interest rate effect because inflation affects

23. Assessing the Euro’s Potential Movements. You reside in the U.S. 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 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 the

U.S. 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 dollar over

the next year? Explain.

high inflation.

24. Weighing Factors That Affect Exchange Rates. Assume that the level of capital flows between

the U.S. and the country of Zeus is negligible (close to zero) and will continue to be negligible. There

is a substantial amount of trade between the U.S. and the country of Zeus. The main import by the

U.S. is basic clothing purchased by U.S. retail stores from Zeus, while the main import by Zeus is

special computer chips that are only made in the U.S. and are needed by many manufacturers in

Zeus. Suddenly, the U.S. government decides to impose a 20% tax on the clothing imports. The Zeus

government immediately retaliates by imposing a 20% tax on the computer chip imports. Second, the

Zeus government immediately imposes a 60% tax on any interest income that would be earned by

Zeus investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so

that they are now higher than interest rates in the U.S. Do you think the currency of Zeus (called the

zee) will appreciate or depreciate against the dollar as a result of all the government actions described

above? Explain.

ANSWER: The zee should depreciate, because Zeus imports of U.S. computer chips will continue,

25. How Factors Affect Exchange Rates. The country of Luta has large capital flows with the U.S.

It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%,

the same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You

expect that the inflation rate in Luta will rise to 8% this coming year, while the U.S. inflation rate will

remain at 5%. You expect that Luta’s interest rate will rise to 9% during the next year. You expect that

the U.S. interest rate will remain at 6% 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 dollar because the exchange rate should be

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Exchange Rate Determination 2

26. Speculation on Expected Exchange Rates. Kurnick Co. expects that the pound will depreciate

from $1.70 to $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 1 million dollars or 1 million pounds for one

year. It can borrow dollars at 6% or Bitish pounds at 5% for one year. It can invest in a risk-free

dollar deposit at 5% for one year or a risk-free British deposit at 4% for one year. Determine

the expected profit or loss (in dollars) if Kurnick Co. pursues a strategy to capitalize on the

expected depreciation of the pound.

ANSWER: Initial amount borrowed = 1,000,000 pounds

Dollars received when the pounds are converted to

27. Volatility of Exchange Rate Movements. Assume you want to determine whether the monthly

movements in the Polish zloty against the dollar are more volatile than monthly movements in some

other currencies against the dollar. The zloty was valued at $.4602 on May 1, $.4709 on June 1,

$.4888 on July 1, $.4406 on August 1, and $.4260 on September 1. Using Excel or another electronic

spreadsheet, compute the standard deviation (a measure of volatility) of the zloty’s monthly exchange

rate movements. Show your spreadsheet.

ANSWER:

First day in: Value Change

May 0.4602

28. Impact of Economy on Exchange Rates. Assume that inflation is zero in the U.S. and in Europe

and will remain at zero. U.S. interest rates are presently the same as in Europe. Assume that the

economic growth for the U.S. is presently similar to Europe. Assume that international capital flows

are much larger than international trade flows. Today, there is news that clearly signals economic

conditions in Europe will be weakening in the future, while economic conditions in the U.S. will

remain the same. Explain why and how (which direction) the euro’s value would change today based

on this information.

ANSWER: Expectations of weak economic conditions result in a reduced demand for loanable funds

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Exchange Rate Determination 3

29. Movements in Cross Exchange Rates. Last year a dollar was equal to 7 Swedish kronor, and a

Polish zloty was equal to $.40. Today, the dollar is equal to 8 Swedish kronor and a Polish zloty is

equal to $.44. By what percentage did the cross exchange rate of the Polish zloty in Swedish kronor

(that is, the number of kronor that can be purchased with one zloty) change over the last year?

ANSWER:

Old rates last year

Spot rate of kronor = (1.00/7) = $.142857

30. Measuring Exchange Rate Volatility. Here are exchange rates for the Japanese yen and British

pound at the beginning of each of the last 5 years. Your firm wants to determine which currency is

more volatile as it assesses its exposure to exchange rate risk. Estimate the volatility of each

currency’s movements.

Beginning of Year Yen Pound

10.008 1.47

20.011 1.46

30.008 1.51

40.01 1.54

50.012 1.52

ANSWER:The standard deviation of the yen’s movements is about 28%, versus about 2% for the

31. Impact of Economy on Exchange Rate. The country of Quinland has large capital flows with the

U.S. It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is

6%, the same as the U.S. interest rate. You expect that the inflation rate in Quinland will be 1% this

coming year, while the U.S. inflation rate will be 9%. You expect that Quinland’s interest rate will be

2% during the next year, while the U.S. interest rate will rise to 10% during the next year. Quinland’s

currency adjusts in response to market forces. Will Quinland’s currency appreciate, depreciate, or

remain unchanged against the dollar?

ANSWER: Quinland’s currency should depreciate against the dollar because money should flow to

32. Impact of Economy on Exchange Rate. The country of Zars has large capital flows with the U.S. It

has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%,

the same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Exchange Rate Determination 4

expect that the inflation rate in Zars will rise to 8% this coming year, while the U.S. inflation rate will

remain at 5%. You expect that Zars’ interest rate will rise to 9% during the next year. You expect that

the U.S. interest rate will remain at 6% 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 dollar?

ANSWER: Zars’currency should appreciate against the dollar, because the exchange rate should be

33. Impact of Economy on Exchange Rates. The country of Vezot has massive capital flows with the

U.S. 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 U.S. inflation rate remains unchanged.

Vezot’s interest rate just increased substantially, while the U.S. interest rate remains unchanged.

Vezot’s income level just increased substantially, which will increase consumption of products within

its country. The U.S. income level remains unchanged. There is negligible international trade between

Vezot and the U.S. Vezot can easily obtain all of its imported products from border countries instead

of the U.S. The U.S. just imposed very large taxes on U.S. importers that import products from

Vezot from today forward. Vezot does not impose restrictions on imports from the U.S. 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 dollar? Briefly explain.

ANSWER: Vezot’s currency should appreciate against the dollar, because its value should be

34. Foreign Exchange Transactions. Assume the country of Neeland has stable and predictable

international trade flows with the U.S. Neeland is periodically in the news because its government

might have problems repaying its debt owed to local banks. The value of its currency (the “nee”)

commonly declines on one day, but then jumps back up a few days later. There is much day to day

volatility in the value of the nee. Briefly explain what types of transactions are likely causing the

shifts in demand for the nee and supply of nee for sale in the foreign exchange market.

ANSWER: In general, this can be explained by speculative flows of funds. Speculators tend to move

out of the nee when there is bad news like this, because such news might discourage foreign

35. Weighing the Influence of Factors on Exchange Rates. The New Zealand dollar’s spot rate was

equal to $.60 last month. New Zealand conducts much international trade with the U.S. but that the

financial (investment) transactions between the two countries are negligible. Assume the following

conditions have occurred in the last year. First, interest rates in New Zealand increased but decreased

in the U.S. Second, inflation in New Zealand increased but decreased in the U.S. Third, the New

Zealand central bank intervened in the foreign exchange market by exchanging a very small amount

of U.S. dollars to purchase a very small amount of New Zealand dollars. How should the New

Zealand dollar change over the year based on the information provided here?

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Exchange Rate Determination 5

ANSWER: The key is to weigh the influence of each effect in order to derive a total effect. Two of

the factors described above place upward pressure on the value of the New Zealand dollar. The high

Solution to Continuing Case Problem: Blades, Inc.

1. How are percentage changes in a currency’s value measured? Illustrate your answer numerically by

assuming a change in the Thai baht’s value from a value of $0.022 to $0.026.

ANSWER: The percentage change in a currency’s value is measured as follows:

% 



S S

2. What are the basic factors that determine the value of a currency? In equilibrium, what is the

relationship between these factors?

ANSWER: The basic factors that determine the value of a currency are the supply of the currency for

sale and the demand for the currency. A high level of supply of a currency generally decreases the

3. How might the relatively high levels of inflation and interest rates affect the baht’s value? (Assume a

constant level of U.S. inflation and interest rates.)

ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative

to levels of these variables in the U.S. A high level of inflation tends to result in currency

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Exchange Rate Determination 6

4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from

Thailand, will affect the baht’s value? Would Blades be affected by the change in value, given the

primary Thai customer’s commitment?

ANSWER: In general, depreciation in the foreign currency results when investors liquidate their

5. Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its country in

order to prevent further changes in the currency’s value. How could it accomplish this objective using

interest rates?

ANSWER: If Thailand’s central bank wishes to prevent further depreciation in the baht’s value, it

would attempt to increase the level of interest rates in Thailand. In turn, this would increase the

6. Construct a spreadsheet illustrating the steps Blades’ treasurer would need to follow in order to

speculate on expected movements in the baht’s value over the next 30 days. Also show the speculative

profit (in dollars) resulting from each scenario. Use both of Ben Holt’s examples to illustrate possible

speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount.

Furthermore, assume that the following short-term interest rates (annualized) are available to Blades:

Currency Lending Rate Borrowing Rate

Dollars 8.10% 8.20%

Thai baht 14.80% 15.40%

16 ANSWER: (See spreadsheet attached.)

Depreciation of the Baht from $0.022 to $0.020

1. Borrow Thai baht ($10,000,000/0.022) 454,545,454.50

2. Convert the Thai baht to dollars ($454,545,454.50 million × $0.022). 10,000,000.00

3. Lend the dollars at 8.10% annualized, which represents a 0.68% return over

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Exchange Rate Determination 7

baht borrowed. The annual interest on the baht borrowed is 15.40%, or 1.28%

Appreciation of the Baht from $0.022 to $0.025

1. Borrow dollars. 10,000,000.00

2. Convert the dollars to Thai baht ($10 million/$0.022). 454,545,454.50

3. Lend the baht at 14.80% annualized, which represents a 1.23% return

4. Use the proceeds of the baht loan repayment (on Day 30) to repay

the dollars borrowed. The annual interest on the dollars borrowed is

8.20%, or 0.68% over the 30-day period [computed as 8.20% × (30/360)].

7. Dollar equivalent of speculative profit (THB57,416,363.60 × $0.025) 1,435,409.09

Solution to Supplemental Case: Bruin Aircraft, Inc.

Some of the more commonly cited factors are listed as follows. This exercise forces students to recognize

how factors influence the value of each currency.

Check (X) Here if the Factor Check (X) Here if the Factor

Factors that Can Affect Influences the U.S. Demand Influences the Supply of

the Value of the Pound for Pounds Pounds for Sale

iU.S. – iU.K. X X

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Exchange Rate Determination 8

New U.S. Quotas on Imports

U.S. Tariffs on Imports

Check (X) Here if the Factor Check (X) Here if the Factor

Factors that Can Affect Influences the U.S. Demand Influences the Supply of

the Value of the Pound for Pounds Pounds for Sale

Government Intervention to

Government Tax to be Imposed

on Interest Income Earned by U.K.

Government Tax to be Imposed on Interest

Income Earned by U.S. Investors from

Small Business Dilemma

Assessment by the Sports Exports Company of Factors That Affect the British Pound’s

Value

1. Given Jim’s expectations, forecast whether the pound will appreciate or depreciate against the dollar

over time.

ANSWER: The pound should depreciate because the British inflation is expected to be higher than

2. Given Jim’s expectations, will the Sports Exports Company be favorably or unfavorably affected by

the future changes in the value of the pound?

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Exchange Rate Determination 9

ANSWER: The Sports Exports Company will be unfavorably affected, because depreciation in the

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