Answers to Chapter 8 Questions



Answers to Chapter 8 Questions

1. From 1944 to 1971, the Bretton Woods Agreement called for the exchange rate of one currency for another to be fixed within narrow bands around a specified rate with the help of government intervention. The Bretton Woods Agreement, however, led to a situation in which some currencies (such as the U.S. dollar) became very overvalued and others (such as the German mark) became very undervalued. The Smithsonian Agreement of 1971 sought to address this situation. Under this agreement, major countries allowed the dollar to be devalued and the boundaries in which exchange rates could fluctuate were increased from 1 percent to 2 ( percent.

In 1973 under the so-called Smithsonian Agreement II, the exchange rate boundaries were eliminated altogether. This change effectively allowed exchange rates of major currencies to float freely. This free floating foreign exchange rate system is still partially in place. However, central governments may still intervene in the foreign exchange markets by altering interest rates to affect the value of their currency relative to others, and the major European countries have chosen to peg (fix) their exchange rates with each other as they move towards a single currency and full monetary union in the year 2002. Indeed, on January 1, 1999, eleven major European countries pegged their currency values to a single currency, called the European Currency Unit. While these individual countries continue to issue their own currency, their currencies values are pegged to each other. Similar to the government intervention under the Bretton Woods agreement, European governments intervene to insure that exchange rates between the European Union countries are maintained.

2. a. The spot exchange rate of Canadian dollars for U.S. dollars was 1.2332 on December 16,

2004.

b. The 6-month forward exchange rate of Canadian dollars for U.S. dollars was 1.2329 on

December 16, 2004.

c. The 3-month forward exchange rate of U.S. dollars for Swiss francs was 0.8677 on

December 15, 2004.

3. a. The exchange rate of British pounds for U.S. dollars on December 16, 2004 was 0.5177. The U.S. dollar has depreciated in value relative to the pound.

b. Initial investment was $1 million ( 0.5262 = 526,200 pounds.

Exchanging the funds back to dollars on December 16, 2004 you will have

526,200 pounds / 0.5177 = $1,016,418.78

Your gain is $1,0016,418.78 - $1,000,000 = $16,418.78.

4. At the beginning of the month you convert $500,000 to yen at a rate of 104.76 yen per dollar, or you will have 500,000 ( 104.76 = (52,380,000.

The 1-month forward rate for the U.S. dollar for Japanese yen on December 16, 2004 was .009565. So at the end of the month you will convert (52,380,000 to dollars at $.009565 per (, or you will have

52,380,000 ( .009565 = $501,014.70

5. a. Bank USA is exposed to an appreciation of the dollar relative to the euro.

b. Bank USA converts the $10 million to euros as follows:

$10m/1.3 = euros 7,692,300

At the end of the year Bank USA gets back principal and interest on euros 7,692,300 CDs and converts them to dollars as follows:

euros 7,692,300 x (1.1) x 1.20 = $10,153,846

The resulting return is ($10,153,846 - $10,000,000)/$10,000,000 = 1.54%

c. Bank USA converts the $10 million to euros as follows:

$10m/1.3 = euros 7,692,300

At the end of the year Bank USA gets back principal and interest on euros 7,692,300 CDs and converts them to dollars as follows:

euros 7,692,300 x (1.1) x 1.40 = $11,846,154

The resulting return is ($11,846,154 - $10,000,000)/$10,000,000 = 18.46%

6. a. Bank One is exposed to a depreciation of the dollar relative to the euro.

b. Bank One receives the $200 million from reals as follows:

$200m/1 = Br 200m

At the end of the year Bank One converts dollars to reals and pays back principal and interest on Br200,000,000 CDs as follows:

Br200,000,000 x (1.065) x 1.20 = $255,600,000

The resulting percentage cost is ($255,600,000 - $200,000,000)/$200,000,000 = 27.8%

c. Bank One receives the $200 million from reals as follows:

$200m/1 = Br 200m

At the end of the year Bank One converts dollars to reals and pays back principal and interest on Br200,000,000 CDs as follows:

Br200,000,000 x (1.065) x 0.90 = $191,700,000

The resulting percentage cost is ($191,700,000 - $200,000,000)/$200,000,000 = -4.15%

7. a. Loan amount = A$16m ( 0.625 = $10 million

Deposit amount = $10m/1.60 = (6,250,000

Interest income at the end of the year = A$16m x 0.12 = A$1,920,000 ( .588 =

$1,128,960

Interest expense at the end of the year = (6,250,000 x 0.10 = (625,000 ( 1.848 =

$1,155,000

Net interest income = $1,128,960 - $1,155,000 = -$26,040

b. The net cost of deposits should be $1,128,960 - 200,000 = $928,960.

Rate of U.S. dollars for BPs = 928,960 ( 625,000 = 1.486336.

Thus, the spot rate of U.S. dollars for BPs should be 1.486 in order for the bank to earn $200,000.

8. a. Amount of loan in ( = $2 million / 1.45 = (1,379,310.

Interest and principal at year-end in dollars = (1,379,310 x 1.08 = (1,489,655 x 1.43 = $2,130,207

Interest and principal of CDs = $2m x 1.06 = $2.12m

Net income = $2,130,207 - $2,120,000 = $10,207

Spread = $10,207/2,000,000 = 0.51%

In order to maintain a 2% spread, the interest and principal earned at 1.43 U.S. dollars for (s should be: (1,379,310 (1 + x) x 1.43 = $2.16m (Because ($2.16m - $2.12m)/2.00m = 2% spread)

x = ($2.16m / 1.43) / (1,379,310 = 1.0951, or 9.51%

That is, a loan rate of 9.51% will produce a spread of 2%.

b. If hedged, net interest income = (1,379,310 x 1.08 = (1,489,655

( (1,489,655/1.44 = $2,145,103

( $2,145,103 - $2.12m = $25,103

Net interest margin = $25,103/$2m = 1.26%

c. To maintain a 2% spread: (1,379,310(1 + x) x 1.44 = $2.16m => x = 8.75%

The bank should increase the rate on the loan to 8.75% and hedge with the sale of forward (s to maintain a 2% spread.

9. EXCEL Problem: Gain/loss = $330,300

Gain/loss = $0

Gain/loss = $123,000

Gain/loss = $210,000

10. Since 1982 when Singapore opened its market, foreign exchange markets have operated 24 hours a day: when the New York market closes, operations in the San Francisco area are still open; when the San Francisco operations close, the Hong Kong and Singapore markets open; when Tokyo and Singapore close the Frankfurt market opens; an hour later the London market opens; and before these markets close the New York market reopens.

11. Net foreign exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi)

= Net foreign assetsi + Net FX boughti

a. Thus, for Citibank, net foreign assets = $23 million - $18 million = $5 million.

b. Citibank(s net foreign exchange bought = $5 million - $12 million = -$7 million.

c. Citibank(s net foreign exposure = $5 million + (-$7 million) = -$2 million.

12. A financial institution’s position in the foreign exchange markets generally reflects four trading activities:

1) The purchase and sale of foreign currencies to allow customers to partake in

and complete international commercial trade transactions.

2) The purchase and sale of foreign currencies to allow customers (or the

financial institution itself) to take positions in foreign real and financial investments.

3) The purchase and sale of foreign currencies for hedging purposes to offset

customer (or financial institution) exposure in any given currency.

4) The purchase and sale of foreign currencies for speculative purposes through

forecasting or anticipating future movements in foreign exchange rates.

13. Since direct exchange rates are being used, (1+rUS) = 1/S * (1+rUK) * F

1.10 = 1/1.75 ( 1.08 ( F

F = 1.10 ( (1/1.75 ( 1.08) = 1.10 ( 1.75 ( 1.08 = $1.782/(

The dollar is expected to depreciate against the pound.

14. In this case, interest rates in the U.S. are "too high" relative to the U.K. An investor could take advantage of this by borrowing pounds, converting to dollars in the spot market while simultaneously selling dollars in the forward market. In one year, the investor could deliver the dollars for pounds, pay off the loan, and have extra pounds left over.

15. The current exchange rate is $40,000/4,000,000( or $.01/(. Next year, the Japanese goods will cost 4,240,000(, and the U.S. goods will cost $44,000. Thus, the dollar will depreciate against the yen.

16. If interest rate parity holds, then it is not possible for FIs to borrow and lend in different currencies to take advantage of the differences in interest rates between countries. This is because the spot and forward rates will adjust to ensure that no arbitrage can take place through cross-border investments. If a disparity exists, then the sale and purchase of spot and forward currencies by arbitragers will ensure that in equilibrium interest rate parity is maintained.

17. Among the impediments to its holding are the impediments to arbitrage: unequal borrowing and lending rates, bid ask spreads, other transactions costs, tax differentials, and even central bank intervention in the foreign exchange markets.

18. In this case, the equation would be written as (1 + rDust) = (1/Ft) x (1 + rLukt) x St

19. a. Borrow $1,000,000 in U.S. by issuing CDs:

Interest and principal at year-end = $1,000,000 x 1.08 = $1,080,000

Make a loan in Switerland:

Interest earned = ($1,000,000/0.60) ( 1.04 = Sf1,666.667 x 1.04 =Sf1,733,333

Purchase U.S. dollars at the forward rate of $0.64 x 1,733,333 = $1,109,333.33

Spread = ($1,109,333.33 - $1,080,000)/1,000,000 = $29,333.33/$1,000,000 = 2.93%

b. Forward rate that will prevent any arbitrage:

Ft = [(1 + 0.08) * 0.60]/(1.04) = $0.6231/Sf

20. The U.S. has had a substantial trade deficit resulting from imports of foreign goods relative to exports of domestic goods, $620.517 billion in 2004. This deficit has increased in the 1990s and earlry 2000s. For example, the deficit in the trade of foreign goods was just $19.350 billion in 1991. This is mainly due to the relatively high economic growth rate in the U.S. As an economy grows relative to other countries, its currency appreciates relative to other currencies. This makes domestic goods relatively expensive and foreign goods relatively cheap.

In contrast, the U.S. ran a surplus in the services component of the balance of payments current accounts, $49.998 billion in 2004 versus $13.830 billion in 1991. The U.S. service sector (e.g., financial services, transportation fares, defense expenditures) generally generates a substantial positive balance. Thus, these services have a positive impact on the overall U.S. balance of payment accounts.

21. a. Total current accounts = $168,953 - $150,936 - $9,421 = $8,596.

b. Balance on goods = lines 2 + 6 = $92,543 - $84,107 = $8,436.

c. Balance on services = lines 3 + 7 = $45,689 - $31,689 = $14,000

d. Balance on investments = lines 4 + 8 = $30,721 - $35,140 = -$4,419

22. Transactions recorded to the balance of payment accounts use standard double-entry bookkeeping. Thus, any payment of funds by a U.S. citizen to a foreign country, such as payment for the purchase of a foreign car (a debit to a balance of payment current account), must be offset with a receipt credit received from the foreign country, such as a reduction in U.S. international reserves (a credit to a balance of payment capital account). Any receipt of funds by a U.S. citizen to a foreign country, such as payment on the sale of a domestic car (a credit to a balance of payment current account), must be offset with a recording of credit given to the foreign country, such as an increase in U.S. international reserves (a debit to a balance of payment capital account). Therefore, when all transactions are summed, total debits recorded must equal total credits.

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