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33. IRP Versus IFE. You believe that interest rate parity and the international Fisher effect hold. Assume
the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables
of 1 million New Zealand dollars that you will receive in one year. You could hedge the receivables
with the one-year forward contract. Or you could decide to not hedge. Is your expected U.S. dollar
amount of the receivables in one year from hedging higher, lower, or the same as your expected U.S.
dollar amount of the receivables without hedging? Explain.
34. IRP, PPP, and Speculating in Currency Derivatives. The U.S. three-month interest rate
(unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. Interest rate
parity exists. The expected inflation over this period is 5% in the U.S. and 2% in Canada. A call option
with a three-month expiration date on Canadian dollars is available for a premium of $.02 and a strike
price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing
power parity.
a. Determine the dollar amount of your profit or loss from buying a call option contract specifying
C$100,000.
35. Implications of PPP. Today’s spot rate of the Mexican peso is $.10. Assume that purchasing power
parity holds. The U.S. inflation rate over this year is expected to be 7%, while the Mexican inflation
over this year is expected to be 3%. Wake Forest Co. plans to import from Mexico and will need 20
million Mexican pesos in one year. Determine the expected amount of dollars to be paid by the Wake
Forest Co. for the pesos in one year.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 2
ANSWER:
36. Investment Implications of IRP and IFE. The Argentine one-year CD (deposit) rate is 13%, while the
Mexico one-year CD rate is 11% and the U.S. one-year CD rate is 6%. All CDs have zero default risk.
Interest rate parity holds, and you believe that the international Fisher effect holds.
Jamie (based in the U.S.) invests in a one-year CD in Argentina.
Ann (based in the U.S.) invests in a one-year CD in Mexico.
Ken (based in the U.S.) invests in a one-year CD in Argentina and sells Argentina pesos one year
forward to cover his position.
Juan (who lives in Argentina) invests in a one-year CD in the U.S.
Maria (who lives in Mexico) invests in a one-year CD in the U.S.
Nina (who lives in Mexico) invests in a one-year CD in Argentina.
Carmen (who lives in Argentina) invests in a one-year CD in Mexico and sells Mexican pesos one year
forward to cover her position.
Corio (who lives in Mexico) invests in a one-year CD in Argentina and sells Argentina pesos one year
forward to cover his position.
Based on this information, which person will be expected to earn the highest return on the funds
invested? If you believe that multiple persons will tie for the highest expected return, name each of
them. Explain.
37. Investment Implications of IRP and the IFE. Today, a U.S. dollar can be exchanged for 3 New
Zealand dollars. The one-year CD (deposit) in New Zealand is 7% and the one-year CD rate in the
U.S. is 6%. Interest rate parity exists between the U.S. and New Zealand. The international Fisher
effect exists between the U.S. and New Zealand. Today a U.S. dollar can be exchanged for 2 Swiss
francs. The one-year CD rate in Switzerland is 5%. The spot rate of the Swiss franc is the same as the
one-year forward rate.
Karen (based in the U.S.) invests in a one-year CD in New Zealand and sells New Zealand dollars one
year forward to cover her position.
James (based in the U.S) invests in a one-year CD in New Zealand and does not cover his position.
Brian (based in the U.S.) invests in a one-year CD in Switzerland and sells Swiss francs one year
forward to cover his position.
Eric (who lives in Switzerland) invests in a one-year CD in Switzerland.
Tonya (who lives in New Zealand) invests in a one-year CD in the U.S. and sells U.S. dollars one year
forward to cover her position.
Based on this information, which person will be expected to earn the highest return on the funds
invested? If you believe that multiple persons will tie for the highest expected return, name each of
them. Explain.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 3
38. Real Interest Rates, Expected Inflation, IRP, and the Spot Rate. The U.S. and the country of
Rueland have the same real interest rate of 3%. The expected inflation over the next year is 6 percent in
the U.S. versus 21% in Rueland. Interest rate parity exists. The one-year currency futures contract on
Rueland’s currency (called the ru) is priced at $.40 per ru. What is the spot rate of the ru?
39. PPP and Real Interest Rates. The nominal (quoted) U.S. one-year interest rate is 6%, while the
nominal one-year interest rate in Canada is 5%. Assume you believe in purchasing power parity. You
believe the real one-year interest rate is 2% in the U.S, and that the real one-year interest rate is 3% in
Canada. Today the Canadian dollar spot rate at $.90. What do you think the spot rate of the Canadian
dollar will be in one year?
40. IFE, Cross Exchange Rates, and Cash Flows. Assume the Hong Kong dollar (HK$) value is tied to
the U.S. dollar and will remain tied to the U.S. dollar. Assume that interest rate parity exists. Today, an
Australian dollar (A$) is worth $.50 and HK$3.9. The one-year interest rate on the Australian dollar is
11%, while the one-year interest rate on the U.S. dollar is 7%. You believe in the international Fisher
effect.
You will receive A$1 million in one year from selling products to Australia, and will convert these
proceeds into Hong Kong dollars in the spot market at that time to purchase imports from Hong Kong.
Forecast the amount of Hong Kong dollars that you will be able to purchase in the spot market one
year from now with A$1 million. Show your work.
41. PPP and Cash Flows. Boston Co. will receive 1 million euros in one year from selling exports. It did
not hedge this future transaction. Boston believes that the future value of the euro will be determined by
purchasing power parity (PPP). It expects that inflation in countries using the euro will be 12% next
year, while inflation in the U.S. will be 7% next year. Today the spot rate of the euro is $1.46, and the
one-year forward rate is $1.50.
a. Estimate the amount of U.S. dollars that Boston will receive in one year when converting its euro
receivables into U.S. dollars.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 4
b. Today, the spot rate of the Hong Kong dollar is pegged at $.13. Boston believes that the Hong
Kong dollar will remain pegged to the dollar for the next year. If Boston Co. decides to convert its
1 million euros into Hong Kong dollars instead of U.S. dollars at the end of one year, estimate the
amount of Hong Kong dollars that Boston will receive in one year when converting its euro
receivables into Hong Kong dollars.
ANSWER:
42. PPP and Speculating with Currency Futures. Assume that you believe purchasing power parity (PPP)
exists. You expect that inflation in Canada during the next year will be 3%, and inflation in the U.S. will
be 8%. Today the spot rate of the Canadian dollar is $.90 and the one-year futures contract of the
Canadian dollar is priced at $.88. Estimate the expected profit or loss if an investor sold a one-year
futures contract today on one million Canadian dollars and settled this contract on the settlement date.
ANSWER:
43. PPP and Changes in the Real Interest Rate. Assume that you believe exchange rate movements are
mostly driven by purchasing power parity. The U.S. and Canada presently have the same nominal
(quoted) interest rate. The central bank of Canada just made an announcement that causes you to revise
your estimate of Canada’s real interest rate downward. Nominal interest rates were not affected by the
announcement. Do you expect that the Canadian dollar to appreciate, depreciate, or remain the same
against the dollar in response to the announcement? Briefly explain your answer.
44. IFE and Forward Rate. The one-year Treasury (risk-free) interest rate in the U.S. is presently 6%,
while the one-year Treasury interest rate in Switzerland is 13%. The spot rate of the Swiss franc is
$.80. Assume that you believe in the international Fisher effect. You will receive 1 million Swiss francs
in one year.
a. What is the estimated amount of dollars you will receive when converting the francs to U.S. dollars
in one year at the spot rate at that time?
b. Assume that interest rate parity exists. If you hedged your future receivables with a one-year
forward contract, how many dollars will you receive when converting the francs to U.S. dollars in
one year?
ANSWER:
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Relationships Among Inflation, Interest Rates, and Exchange Rates 5
45. PPP. You believe that the future value of the Australian dollar will be determined by purchasing power
parity (PPP). You expect that inflation in Australia will be 6% next year, while inflation in the U.S. will
be 2% next year. Today the spot rate of the Australian dollar is $.81, and the one-year forward rate is
$.77. What is the expected spot rate of the Australian dollar in one year?
46. Logic Behind IFE. Investors based in the U.S. can earn 11% interest on a one-year bank deposit in
Argentina (with no default risk) or 2% on a one-year U.S. bank deposit in the U.S. (with no default
risk). Assess the following statement: "According to the international Fisher effect (IFE), if U.S.
investors invest 1000 Argentine pesos in an Argentine bank deposit, they are expected to receive only
20 pesos (2% x 1,000 pesos) as interest. " Is this statement a correct explanation of why the
international Fisher effect would discourage U.S. investors from investing in Argentina? If not, provide
a more accurate explanation for why investors who believe in IFE would not pursue the Argentine
investment in this example.
47. Influence of PPP. The U.S. has expected inflation of 2%, while Country A, Country B, and Country C
have expected inflation of 7%. Country A engages in much international trade with the U.S. The
products that are traded between Country A and the U.S. can easily be produced by either country.
Country B engages in much international trade with the U.S. The products that are traded between
Country B and the U.S. are important health products, and there are not substitutes for these products
that are exported from the U.S. to Country B or from Country B to the U.S. Country C engages in
considerable international financial flows with the U.S. but very little trade. If you were to use
purchasing power parity to predict the future exchange rate over the next year for the local currency of
each country against the dollar, do you think PPP would provide the most accurate forecast for the
currency of Country A, Country B, or Country C? Briefly explain.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 6
CRITICAL THINKING
Integrating IRP and PPP Assume that interest rate parity exists. Assume that you have payables in
Argentine pesos. You have noticed that historically, the forward rate of the Argentine peso quoted by the
banks exhibits a large discount. Write a short essay on the likely reason why the peso exhibits a discount
over time. Does the discount mean that the forward rate is underpriced (that the bank should quote a higher
forward rate)? Do you think that you may be more likely to hedge your payables when the Argentine peso
exhibits a more pronounced discount? Explain.
ANSWER
Solution to Continuing Case Problem: Blades, Inc.
1. What is the relationship between the exchange rates and relative inflation levels of the two countries?
How will this relationship affect Blades’ Thai revenue and costs given that the baht is freely floating?
What is the net effect of this relationship on Blades?
ANSWER: The relationship between exchange rates and relative inflation rates is summarized by the
2. What are some of the factors that prevent PPP from occurring in the short run? Would you expect PPP
to hold better if countries negotiate trade arrangements under which they commit themselves to the
purchase or sale of a fixed number of products over a specified time period? Why or why not?
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Relationships Among Inflation, Interest Rates, and Exchange Rates 7
3. How do you reconcile the high level of interest rates in Thailand with the expected change of the baht-
dollar exchange rate according to PPP?
4. Given Blades’ future plans in Thailand, should the company be concerned with PPP? Why or why not?
5. PPP may hold better for some countries than for others. The Thai baht has been freely floating for more
than a decade. How do you think Blades can gain insight into whether PPP holds for Thailand? Offer
some logic to explain why the PPP relationship may not hold here.
Solution to Supplemental Case: Flame Fixtures, Inc.
a. If the peso depreciates by more than the inflation differential, then the dollar cost to Flame will be even
lower than expected.
b. If the peso depreciates by less than the inflation differential, then the dollar cost to Flame will be even
higher than expected. Consider a scenario in which the Mexican inflation rate is 80 percent or so,
causing the bill in pesos to be 80 percent higher. Yet, if the peso depreciated by a relatively small
amount over this period (say 20 percent or so), the dollar cost to Flame will increase substantially.
Since there are other factors in addition to inflation that also affect the peso’s exchange rate, the peso
will not necessarily depreciate by an amount that fully offsets the high inflation.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 8
c. Stable dollar payments would only occur if the peso depreciated by an amount that offset its high
inflation rate. It is unlikely that there will be a perfect offset in any given period. Therefore, Flame’s
dollar payments would be unstable, and so would its profits.
d. The risk would increase, because its payments for parts would now be more volatile, and so would its
profits. Given that it does not have much liquidity, it will suffer a cash squeeze if the peso does not
depreciate much while Mexican inflation is high. Over the long run, there may be periods in which this
happens. Flame would be locked into this arrangement with Coron for ten years, and therefore cannot
back out, even if the peso’s depreciation does not offset the inflation differential.
Small Business Dilemma
Assessment of the IFE by the Sports Exports Company
1. Is Jim’s interpretation of the IFE theory correct?
2. If you were in Jim’s position, would you spend time trying to decide whether to hedge the receivables
each month, or do you believe that the results would be the same (on average) whether you hedged or
not?
Part 2—Integrative Problem
Exchange Rate Behavior
1. As an employee of the foreign exchange department for a large company, you have been given the
following information.
Beginning of Year
Spot rate of £ = $1.596
Spot rate of Australian dollar (A$) = $.70
Cross exchange rate: £1 = A$2.28
One-year forward rate of A$ = $.71
One-year forward rate of £ = $1.58004
One-year U.S. interest rate = 8.00%
One-year British interest rate = 9.09%
One-year Australian interest rate = 7.00%
Determine whether triangular arbitrage is feasible, and if so, how it should be conducted to make a
profit.
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Relationships Among Inflation, Interest Rates, and Exchange Rates 9
2.28 =
$.7
$1.596
=
A$ of rateSpot
£ of rateSpot
= rate exchange CrossProper
2. Using the information in question 1, determine whether covered interest arbitrage is feasible and, if so,
how it should be conducted to make a profit.
ANSWER: Covered interest arbitrage is only feasible when interest rate parity does not exist. To test
3. Based on the information in question 1 for the beginning of the year, use the international Fisher effect
(IFE) theory to forecast the annual percentage change in the British pound’s value over the year.
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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.
4. Assume that at the beginning of the year, the pound’s value is in equilibrium. Assume that over the
year the British inflation rate is 6 percent while the U.S. inflation rate is 4 percent. Assume that any
change in the pound’s value due to the inflation differential has occurred by the end of the year. Using
this information and the information provided in question 1, determine how the pound’s value changed
over the year.
