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