International Business Chapter 8 Canada During The Next Year Will 3

Unlock access to all the studying documents.

View Full Document

Inflation, Interest Rates, and Exchange Rates  13

28. Testing the IFE. Describe a statistical test for the IFE.

ANSWER: A regression model could be applied to historical data to test IFE. The model is

specified as:

29. Impact of Barriers on PPP and IFE. Would PPP be more likely to hold between the United States

and Hungary if trade barriers were completely removed and if Hungary’s currency were allowed to

float without any government intervention? Would the IFE be more likely to hold between the United

States and Hungary if trade barriers were completely removed and if Hungary’s currency were

allowed to float without any government intervention? Explain.

ANSWER: Changes in international trade result from inflation differences and affects the exchange

14  Inflation, Interest Rates, and Exchange Rates

30. Interactive Effects of PPP. Assume that the inflation rates of the countries that use the euro are very

low, while other European countries that have their own currencies experience high inflation.

Explain how and why the euro’s value could be expected to change against these currencies

according to the PPP theory.

ANSWER: According to the PPP theory, the euro’s value would increase against the value of the

31. Applying IRP and IFE. Assume that Mexico has a one-year interest rate that is higher than the U.S.

one-year interest rate. Assume that you believe in the international Fisher effect (IFE), and interest

rate parity. Assume zero transactions costs.

Ed is based in the U.S. and he attempts to speculate by purchasing Mexican pesos today, investing

the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of one

year. Ed did not cover his position in the forward market.

Maria is based in Mexico and she attempts covered interest arbitrage by purchasing dollars today and

simultaneously selling dollars one year forward, investing the dollars in a risk-free asset for a year,

and then converting the dollars back to pesos at the end of one year.

Do you think the rate of return on Ed’s investment will be higher than, lower than, or the same as the

rate of return on Maria’s investment? Explain.

ANSWER: Maria’s rate of return will be higher. Since interest rate parity exists, she will earn

32. Arbitrage and PPP. Assume that locational arbitrage ensures that spot exchange rates are properly

aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound

is $1.80. The spot rate of the Swiss franc is .3 pounds. You expect that the one-year inflation rate is

7 percent in the U.K., 5 percent in Switzerland, and 1 percent in the U.S. The one-year interest rate is

6% in the U.K., 2% in Switzerland, and 4% in the U.S. What is your expected spot rate of the Swiss

franc in one year with respect to the U.S. dollar? Show your work.

ANSWER: SF spot rate in $ = 1.80 × .3 = $.54.

Inflation, Interest Rates, and Exchange Rates  15

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.

ANSWER: The expected amount is the same, because the forward rate reflects the interest rate

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.

ANSWER: The expected change in the Canadian dollar’s spot rate is:

b. Determine the dollar amount of your profit or loss from buying a futures contract specifying

C$100,000.

ANSWER: According to IRP, the futures rate premium should be (1.01)/(1.04) – 1 = –2.88%

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.

16  Inflation, Interest Rates, and Exchange Rates

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.

ANSWER: Jose and Carmen will earn the highest return. When the IFE holds, the expected return

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.

Inflation, Interest Rates, and Exchange Rates  17

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.

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?

ANSWER

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?

ANSWER: Expected inflation in the U.S. = 6% – 2%=4%.

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.

ANSWER:

18  Inflation, Interest Rates, and Exchange Rates

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.

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:

a. Expected appreciation of euro = (1+.07)/(1+.12)-1=-.04464

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:

Expected appreciation of C$ = (1+.08)/(1+.03)-1=.04854

Inflation, Interest Rates, and Exchange Rates  19

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.

A decrease in the real interest rate (with no change in the nominal interest rate) means that Canada’s

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?

a. Expected movement in Swiss franc = [(1.06)/(1.13) – 1]= -6.19%

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?

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?

20  Inflation, Interest Rates, and Exchange Rates

ANSWER: The relationship between exchange rates and relative inflation rates is summarized by the

purchasing power parity (PPP) theory. When one country’s inflation rate rises relative to that of

another, the demand for the former country’s currency declines as its exports decline (due to its

higher prices). Furthermore, consumers and firms in the country with higher inflation tend to increase

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 goods over a specified time period? Why or why not?

ANSWER: PPP may not hold because exchange rates are affected by other factors in addition to the

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?

ANSWER: High levels of real interest rates in a given country may increase the demand for that

country’s currency as foreign investors can earn higher rates of return in the foreign country than

Inflation, Interest Rates, and Exchange Rates  21

4. Given Blades’ future plans in Thailand, should the company be concerned with PPP? Why or why

not?

ANSWER: Although PPP may not hold well in the short run, it has been found to hold reasonably

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.

ANSWER: One possible way to determine whether PPP holds between two countries is to regress

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

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

22  Inflation, Interest Rates, and Exchange Rates

Small Business Dilemma

Assessment of the IFE by the Sports Exports Company

1. Is Jim’s interpretation of the IFE theory correct?

ANSWER: Yes. The expected future spot rate derived from the IFE theory is the same as the

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?

ANSWER: There is some question as to whether the IFE theory holds. Therefore, it is naive to think

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.

ANSWER: Triangular arbitrage is not feasible because the cross exchange rate between £ and A$ is

properly specified:

Inflation, Interest Rates, and Exchange Rates  23

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

Forward Premium Actual

Currency that Should Exist Forward Premium

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.

ANSWER: The IFE suggests that given two currencies, the currency with a higher interest rate

reflects higher expected inflation, which will place downward pressure on the value of that currency

24  Inflation, Interest Rates, and Exchange Rates

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.

ANSWER: If PPP held, the pound would have changed by:

5. Assume that the pound’s depreciation over the year was attributed directly to central bank

intervention. Explain the type of direct intervention that would place downward pressure on the

value of the pound.

ANSWER: If central banks used pounds to purchase dollars in the foreign exchange market, they