978-1337269964 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.

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.

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.

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.

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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.

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.

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.

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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:

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

1 0.008 1.47

2 0.011 1.46

3 0.008 1.51

4 0.01 1.54

5 0.012 1.52

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?

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

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

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Exchange Rate Determination  4

and is not subject to direct central bank intervention. Will Zars currency appreciate, depreciate, or

remain unchanged against the dollar?

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.

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.

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

CRITICAL THINKING

Solving a Currency Crisis Review a recent currency crisis in a foreign country in the last year or so,

using an online search term such as “currency crisis.” Summarize the details of the currency crisis, and

write a short essay to offer your opinion on whether the country should have attempted to impose a fixed

exchange rate system for its currency to prevent the currency crisis.

ANSWER:

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.

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

relationship between these factors?

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Exchange Rate Determination  6

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.)

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Exchange Rate Determination  7

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?

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?

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%

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Exchange Rate Determination  8

Appreciation of the Baht from $0.022 to $0.025

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

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Exchange Rate Determination  9

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

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.

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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