FINS3616 International Business Finance - Week 2

A. Conceptual questions

1. What is likely to happen if a central bank suddenly prints a large amount of new money?

If a central bank prints a large amount of new money, there will be an increase in the
suppply of domestic currency and for it to depreciate. Demand for money depends on the
quantity of real transations and the amount of money needed to faciliate such
transactions. Hence the printing of new money would only cause domestic currency to
lose its value, and cause price inflation.

Wont add value unless to economy

Invest in infrasture
Quantitative easing when central bank purchases gov security to lower interest rate,
forces institutions to find better ways to make profit and be more productive rather than
holding in
Inverse of yield and price
Use printed money to drive down bonds

2. How can you quantify currency risk in a floating exchange rate system?

Currency risk can be quantified by using historical data, analysing its past distribution
and volatility. The greater the standard deviation, the more currency risk there is. It is
important to consider all historical and present data to forecast possible exchange rate
movements.

Exchange rate

Volatility can be skewed, exhibit kurtosis in foreign exchange rate and thus greater
probability of extreme values

3. What was the Bretton Woods currency system?

Bretton Woods currency system is an exchange rate stabilisation system based on a gold
standard ($35 per ounce), based on a fixed amount of gold each participating country
held and allowing for a 1% fluctuation band. It is an example of a target zone system.
Other curencies were all pegged to the US
The market became unstable due to shocks, ie oil shock, thus no longer viable if other
countries had to keep drawing from IMF to maintain their peg values
4. Describe two different currency systems that have been introduced in countries such as
Hong Kong and Ecuador to improve the credibility of pegged exchange rate systems.

Hong Kong has a currency board system, which is a monetary authority that issues base
money fully fixed to a widely traded currency i.e. USD, and fully backed by a foreign
reserve currency. This means that the HKMA is unable to provide credit to the
government and banks.

China sells domestic currency to buy USD to have enough reserves to maintain peg

Tools: capital controls, legal restrictions on acquistion of foreign currencies / products

Black market emerge due to restrictions

Pegged are not viable in the long run due to running out of reserves

Latent volatility sharp changes in rates due to changes not evident from historical data
ie. In change of peg value

HK takes power of printing from government

HK special banks acquire USD in order to print HK dollar, this prevents overprinting and
hyperinflation

Ecuador has officially adopted USD as official currency, meaning that it is a dollarized
system

Due to economic mismanagement, Zimbabwe has gone through hyperinflation. People

traded Zimbabwe immediately to protect value of currency. Thus resulting in the use of
other countries that are more stable.

Disadvantage of not having own currency. If US going into recession, Ecuador going into
a boom, there would be undesirable inflation.

They would lack monetary policy as a tool

5. What is the difference between a target zone and a crawling peg?

Both systems are types of fixed exchange rates with some flexibility to float to counter
inflation.

But, target zone arrangements are agreed exchange rate systems in which countries set to
maintain their exchange rate within a specified fluctuation band.

Whereas, crawling peg systems involve a fixed exchange rate being allowed to fluctuate
within an adjustable fluctuation band, dependent on the inflation differential of the
domestic and pegged currency.

CNY was undervalued and peg was increased as of 2005, more volatility in CNY/USD
due to moving into a crawling peg, previously a basket of currencies

When costs of living increase, more inflation, then it would be lower and thus it is
arguably now around equilibrium.

6. What was the EMS?

European Monetary System is a target zone system from 1979 to 1999 within the EU. EU
countries had exchange rates within a 2.25% range of a central rate.

British did not make it through EMS. British pound was overvalued in its target, the gov
did not have enough exchange reserves, george sorus discovered this and started selling
selling gov and borrowing from banks, this means that everyone started short-selling and
forced the government to float currency and result in depreciation of the GBP.

7. What did the Maastricht Treaty try to accomplish?

- Eliminate all remaining restrictions on capital movement and payments among EU

member states and EU trading partners
- Create the ECB
- Introduction of the Euro currency
8. Do you believe its monetary union will be beneficial for Europe?

Yes, the monetary union has enabled more competition, driving prices to drop and
converge, free movement of capital and greater trade opportunities has collectively
benefit all the member states in terms of economic growth. However, it has resulted in
some growth asymmetries emerge in which some states benefit greater than others. It also
led to more interdependence among the EU member states, i.e. Greeces sovereign debt
crises.
Eurozone has monetary union, not a fiscal union. Each country stil colelcted own taxes
 and some countries can get into more debt than other countries. People priced greek and
germans at the same interest rate despite differences. Moral hazard of IMF is that they
know IMF and funding countries will help them bail out, leading to governments
borrowing in the first place.
Greece entered contract with goldman sachs to hide their debt and borrow more than
what they should have been able to.

9. What factors contributed to the Mexican peso crisis of 1995 and to the Asian crises of
1997
In both Mexico and Asian, both instances, the governments pegged their domestic
currency to artificially high values against the USD, which caused the foreign reserves to
deplete. Local businesses and governments also borrowed mainly in USD, which exposed
them to drop in value of local currency.
Self-perpetuating spiral, use reserves to maintain unstable exchange rates. In economic
slow down, they had to devalue, every dolar in interest owned, now cost more to pay off,
more money taken away from productive purposes, less money spent in Mexico and their
productive activities, -> leads to self perpetuating spiral. As mexico needs to devalue
again.
When undervalue the problems are not as spiraling, when they are not competitive then
undervalue would become an issue.

10. What is the moral hazard of IMF rescue packages for emerging markets which
experienced crises?

The existence of IMF rescue packages results in emerging markets underestimating the
risks they expose themselves. They also lose incentive to protect themselves against risk
due to the assurance from bailout funds.

B. True or False questions

1. The exchange rate system in which a country allows the value of the currency to be
determined by the market forces of supply and demand is known as a pegged exchange rate
system.
 False determining currency value by supply and demand is called floating, not pegged.

2. In the pegged exchange rate system, the currency has limited flexibility and the rate is kept
within a fixed band.
False a pegged system fixes the exchange rate to a constant value, not within a fixed band.

3. Decreases in currency values within a floating rate system are called devaluations.
False it is called depreciation due to market forces. Devaluation is for fixed systems.

4. IMF loans to troubled economies are unlikely to change the behaviors of investors, because
investors can assess the risks of moral hazard for themselves.
False countries will underestimate risks, with the existence of IMF loans for bailouts.

5. Currency in circulation should be included in the asset section of a central bank balance
sheet.
False

6. Official international reserves consist of the major components like gold reserves and
foreign exchange reserves
True

7. Capital control means the set of regulations pertaining to flows of capital into and out of a
country

True

8. If a central bank suddenly prints a large amount of new money, it may result in high inflation
True sudden increase in supply of money causes value of money to depreciate due to no
change in real transactions in the market.
C. MCQ

1. Which of the following currencies is currently linked to the price of gold?

a. British pound
b. Japanese yen
c. U.S. dollar
d. All of the above
e. None of the above

2. Common elements in many currency crises include each of the following except:
a. a fixed exchange rate system that overvalued the local currency
b. a large amount of foreign currency debt
c. a steep drop in the value of the local currency
d. IMF intervention to provide short-term assistance
e. All of the above are common during currency crises

3. Which account should NOT be included in the asset section of a central bank balance sheet?
a. deposits of domestic financial institutions ????????
b. official international reserves
c. domestic credit
d. government bonds
e. All of the above should be included

4. What is the negative side effect on the money supply of a non-sterilized foreign exchange intervention?
a. A higher money supply eventually leads to lower inflation, and the foreign exchange objective of the
IMF's policy may conflict with its abroad goal of price stability.
b. A higher money supply eventually leads to higher inflation, and the foreign exchange objective of the
IMF's policy may conflict with its domestic goal of price stability.
c. A higher money supply eventually leads to lower inflation, and the foreign exchange objective of the
central bank's policy may conflict with its domestic goal of price stability.
d. A higher money supply eventually leads to higher inflation, and the foreign exchange objective of the
central bank's policy may conflict with its domestic goal of price stability. ????
e. None of the above
Central bnk with good access to current state might think it is undervalued and send 5 bil of foreign reserve to
drive up value. Forex market is very big, 5 bil is nothing due to size of market, but why does it work? It
is a signal to the entire market that the reserve bank knows the situation. RBA is trustworthy with their
access of information and 5bil is a risky large sum.
Bought gov bond,

5. When a central bank buys foreign currency, its international reserves ________.
a. decrease
b. increase
c. remain unchanged
d. are difficult to determine
e. All of the above are possible

6. What is the most likely outcome if a central bank suddenly prints a large amount of new money?
a. no change in the inflation rate
b. higher inflation
c. recession
d. prosperity
e. nothing will be changed