9.

1) The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is
2%. The US interest rate on government securities with one-year maturity is 7% and the expected rate of inflation is 5%. The current spot
exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.
Drawing on what we know about the Fisher effect, the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that
the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates. Hence since the nominal interest
rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book:
(S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1,200 for S1, yields a value for S2 of $1=W1,165.
9.2) Two countries, Great Britain and the US, produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in
Britain it is 3.70 per pound.
(a) According to PPP theory, what should the $/ spot exchange rate be?
(b) Suppose the price of beef is expected to rise to $3.10 in the US, and to 4.65 in Britain. What should be the one year forward $/ exchange
rate?(c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10%, what would you expect current interest
rate to be in Britain?
(a) According to PPP, the $/ rate should be 2.80/3.70, or $0.76/.(b) According to PPP, the $/ one year forward exchange rate should be 3.10/4.65, or
$0.67/.(c) Since the dollar is appreciating relative to the pound, and given the relationship of the international Fisher effect, the British must have higher
interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i - i$ we can solve the equation for i, with S1=.76, S2=.67, I$ = 10, yielding a value of
23.4% for the British interest rates.
10.4) Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most
important criteria for choosing between the systems? Which system is the more desirable for an international business?
The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade
balance and exchange rates. In terms of monetary discipline, the need to maintain fixed exchange rate parity ensures that governments do not expand their
money supplies at inflationary rates. In terms of speculation, a fixed exchange rate regime precludes the possibility of speculation. In terms of uncertainty, a
fixed rate regime introduces a degree of certainty in the international monetary system by reducing volatility in exchange rates. Finally, in terms of trade
balance adjustments, critics question the closeness of the link between the exchange rate and the trade balance. The case for floating exchange rates has
two main elements: monetary policy autonomy and automatic trade balance adjustments. In terms of the former, it is argued that a floating exchange rate
regime gives countries monetary policy autonomy. Under a fixed rate system, a countrys ability to expand or contract its money supply as it sees fit is limited
by the need to maintain exchange rate parity. In terms of the later, under the Bretton Woods system, if a country developed a permanent deficit in its balance
of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation. Critics of this system argue that the adjustment
mechanism works much more smoothly under a floating exchange rate regime. They argue that if a country is running a trade deficit, the imbalance between
the supply and demand of that countrys currency in the foreign exchange markets will lead to depreciation in its exchange rate. An exchange rate
depreciation should correct the trade deficit by making the countrys exports cheaper and its imports more expensive. It is a matter of personal opinion in
regard to which system is better for an international business. We do know, however, that a fixed exchange rate regime modeled along the lines of the
Bretton Woods system will not work. Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of
stability that would facilitate more rapid growth in international trade and investment.
11.4) Happy Company wants to raise $2 million with debt financing. The funds are needed to finance working capital, and the firm will repay
them with interest in one year. Happy Companys treasurer is considering three options:
(a) Borrowing U.S. dollars from Security Pacific Bank at 8 percent.
(b) Borrowing British pounds from Midland Bank at 14 percent.
(c) Borrowing Japanese yen from Sanwa Bank at 5 percent.
If Happy borrows foreign currency, it will not cover it; that is, it will simply change foreign currency for dollars at todays spot rate and buy the
same foreign currency a year later at the spot rate that is in effect. Happy Company estimates the pound will depreciate by 5 percent relative to
the dollar and the yen will appreciate 3 percent relative to the dollar in the next year. From which bank should Happy Company borrow?
Happy Company needs to consider both the cost of capital and foreign exchange risk. If Happy Company borrows $2 million from Security Pacific Bank, in
one year it will owe the bank $2 million plus 8 percent. If Happy Company borrows British pounds from Midland it has to factor in the higher interest rate (14
percent), and also its estimate that the pound will depreciate by 5 percent. If its prediction about the pound is accurate, this could prove to be an attractive
option. Finally, while the interest rate at the Japanese bank is the lowest of the three, if the yen does appreciate by 3 percent, this option becomes less
attractive. In the end, given that its expectations about the future value of the British pound and the Japanese yen are only guesses into the future, Happy
Bank will have to decide how much risk it is willing to take on before it can choose which bank to approach. CRITICAL THINKING AND DISCUSSION
QUESTIONS
QUESTION 1: The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for
the coming year is 2%. The U.S. interest rate on government securities with one-year maturity is 7%, and the expected rate of inflation is
5%. The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the
logic of your answer.
QUESTION 2: Two countries, Great Britain and the US, produce just one good: beef. Suppose that the price of beef in the US is $2.80 per
pound, and in Britain it is 3.70 per pound.
a. According to PPP theory, what should the $/ spot exchange rate be?
b. Suppose the price of beef is expected to rise to $3.10 in the US, and to 4.65 in Britain. What should the one year forward $/
exchange rate be?
c. Given your answers to parts a and b, and given that the current interest rate in the United States is 10%, what would you expect
current interest rate to be in Britain?
QUESTION 3: Reread the Management Focus on Volkswagen, then answer the following questions:
a. Why do you think management at Volkswagen decided to hedge only 30 percent of their foreign currency exposure in 2003? What
would have happened if they had hedged 70 percent of their exposure?
b. Why do you think the value of the U.S. dollar declined against that of the euro in 2003?
c. Apart from hedging through the foreign exchange market, what else can Volkswagen do to reduce its exposure to future declines in the
value of the U.S. dollar against the euro?
QUESTION 4: You manufacture wine goblets. In mid-June you receive an order for 10,000 goblets from Japan. Payment of 400,000 is
due in mid-December. You expect the yen to rise from its present rate of $1=130 to $1=100 by December. You can borrow yen at 6%
per year. What should you do?
QUESTION 5: You are the CFO of a US firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S.
assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the
Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What
actions, if any, should you take?