Manual of International Financial Management

Manual of International Financial Management Jeff Madura 10Th Edition
CHAPTER 1
Multinational Financial Management: An Overview
1. Impact of September 11. Following the terrorist attack on the U.S., the valuations of many MNCs
declined by more than 10 percent. Explain why the expected cash flows of MNCs were reduced, even if
they were not directly hit by the terrorist attacks.
ANSWER: An MNC’s cash flows could be reduced in the following ways. First, a decline in travel
would affect any MNCs that have business in travel-related industries. The airline, hotel, and tourist-
related industries were expected to experience a decline in business. Layoffs were announced
immediately by many of these MNCs. Second, these effects on travel-related industries can carry over to
other industries, and weaken economies. Third, the cost of international trade increased as a result of
tighter restrictions on some products. Fourth, some MNCs incurred expenses as a result of increasing
security to protect their employees.
2. Impact of Political Risk. Explain why political risk may discourage international business.
ANSWER: Political risk increases the rate of return required to invest in foreign projects. Some foreign
projects would have been feasible if there was no political risk, but will not be feasible because of
political risk.
3. International Business Methods. Snyder Golf Co., a U.S. firm that sells high-quality golf clubs in the
U.S., wants to expand internationally by selling the same golf clubs in Brazil.
a. Describe the tradeoffs that are involved for each method (such as exporting, direct foreign investment,
etc.) that Snyder could use to achieve its goal.
ANSWER: Snyder can export the clubs, but the transportation expenses may be high. If could establish a
subsidiary in Brazil to produce and sell the clubs, but this may require a large investment of funds. It
could use licensing, in which it specifies to a Brazilian firm how to produce the clubs. In this way, it does
not have to establish its own subsidiary there.
b. Which method would you recommend for this firm? Justify your recommendation.
ANSWER: If the amount of golf clubs to be sold in Brazil is small, it may decide to export. However, if
the expected sales level is high, it may benefit from licensing. If it is confident that the expected sales
level will remain high, it may be willing to establish a subsidiary. The wages are lower in Brazil, and the
large investment needed to establish a subsidiary may be worthwhile.
4. Methods Used to Conduct International Business. Duve, Inc., desires to penetrate a foreign market
with either a licensing agreement with a foreign firm or by acquiring a foreign firm. Explain the
differences in potential risk and return between a licensing agreement with a foreign firm, and the
acquisition of a foreign firm.
ANSWER: A licensing agreement has limited potential for return, because the foreign firm will receive
much of the benefits as a result of the licensing agreement. Yet, the MNC has limited risk, because it did
not need to invest substantial funds in the foreign country. An acquisition by the MNC requires a
substantial investment. If this investment is not a success, the MNC may have trouble selling the firm it
acquired for a reasonable price. Thus, there is more risk. However, if this investment is successful, all of
the benefits accrue to the MNC.
6. Macro versus Micro Topics. Review the table of contents and indicate whether each of the chapters
from Chapter 2 through Chapter 21 has a macro or micro perspective.
ANSWER: Chapters 2 through 8 are macro, while Chapters 9 through 21 are micro.
7. Global Competition. Explain why more standardized product specifications across countries can
increase global competition.
ANSWER: Standardized product specifications allow firms to more easily expand their business across
other countries, which increases global competition.
Edited by M. Kashif Khurshid

NUML Faisalabad Campus Page 1
8. Centralization and Agency Costs. Would the agency problem be more pronounced for Berkley Corp.,
which has its parent company make most major decisions for its foreign subsidiaries, or Oakland Corp.,
which uses a decentralized approach?
ANSWER: The agency problem would be more pronounced for Oakland because of a higher probability
that subsidiary decisions would conflict with the parent. Assuming that the parent attempts to maximize
shareholder wealth, decisions by the parent should be compatible with shareholder objectives. If the
subsidiaries made their own decisions, the agency costs would be higher since the parent would need to
monitor the subsidiaries to assure that their decisions were intended to maximize shareholder wealth.
11. Impact of International Business on Cash Flows and Risk. Nantucket Travel Agency specializes in
tours for American tourists. Until recently, all of its business was in the U.S. It just established a
subsidiary in Athens, Greece, which provides tour services in the Greek islands for American tourists. It
rented a shop near the port of Athens. It also hired residents of Athens, who could speak English and
provide tours of the Greek islands. The subsidiary’s main costs are rent and salaries for its employees and
the lease of a few large boats in Athens that it uses for tours. American tourists pay for the entire tour in
dollars at Nantucket’s main U.S. office before they depart for Greece.
a. Explain why Nantucket may be able to effectively capitalize on international opportunities such as the
Greek island tours.
ANSWER: It already has established credibility with American tourists, but could penetrate a new
market with some of the same customers that it has served on tours in the U.S.
b. Nantucket is privately-owned by owners who reside in the U.S. and work in the main office. Explain
possible agency problems associated with the creation of a subsidiary in Athens, Greece. How can
Nantucket attempt to reduce these agency costs?
ANSWER: The employees of the subsidiary in Athens are not owners, and may have no incentive to
manage in a manner that maximizes the wealth of the owners. Thus, they may manage the tours
inefficiently. Nantucket could attempt to allow the employees a portion of the ownership of the company
so that they benefit more directly from good performance. Alternatively, Nantucket may consider having
one of its owners transfer to Athens to oversee the subsidiary’s operations.
c. Greece’s cost of labor and rent are relatively low. Explain why this information is relevant to
Nantucket’s decision to establish a tour business in Greece.
ANSWER: The low cost of rent and labor will be beneficial to Nantucket, because it enables Nantucket
to create the subsidiary at a low cost.
d. Explain how the cash flow situation of the Greek tour business exposes Nantucket to exchange rate
risk. Is Nantucket favorably or unfavorably affected when the euro (Greece’s currency) appreciates
against the dollar? Explain.
ANSWER: Nantucket’s tour business in Greece results in dollar cash inflows and euro cash outflows. It
will be adversely affected by the appreciation of the euro because it will require more dollars to cover the
costs in Athens if the euro’s value rises.
e. Nantucket plans to finance its Greek tour business. Its subsidiary could obtain loans in euros from a
bank in Greece to cover its rent, and its main office could pay off the loans over time. Alternatively, its
main office could borrow dollars and would periodically convert dollars to euros to pay the expenses in
Greece. Does either type of loan reduce the exposure of Nantucket to exchange rate risk? Explain.
ANSWER: No. The euro loans would be used to cover euro expenses, but Nantucket would need dollars
to pay off the loans. Alternatively, the U.S. dollar loans would still require conversion of dollars to euros.
With either type of loan, Nantucket is still adversely affected by the appreciation
f. Explain how the Greek island tour business could expose Nantucket to country risk.
ANSWER: The subsidiary could be subject to government restrictions or taxes in Greece that would
place it at a disadvantage relative to other Greek tour companies based in Athens.
12. Valuation of Wal-Mart’s International Business. In addition to all of its stores in the U.S., Wal-
Mart has 11 stores in Argentina, 24 stores in Brazil, 214 stores in Canada, 29 stores in China, 92 stores in

Germany, 15 stores in South Korea, 611 stores in Mexico, and 261 stores in the U.K. Consider the value
of Wal-Mart as being composed of two parts, a U.S. part (due to business in the U.S.) and a non-U.S. part
(due to business in other countries). Explain how to determine the present value (in dollars) of the non-
U.S. part assuming that you had access to all the details of Wal-Mart businesses outside the U.S.
ANSWER: The non-U.S. part can be measured as the present value of future dollar cash flows resulting
from the non-U.S. businesses. Based on recent earnings data for each store and applying an expected
growth rate, you can estimate the remitted earnings that will come from each country in each year in the
future. You can convert those cash flows to dollars using a forecasted exchange rate per year. Determine
the present value of cash flows of all stores within one country. Then repeat the process for other
countries. Then add up all the present values that you estimated to derive a consolidated present value of
all non-U.S. subsidiaries.

CHAPTER 2
International Flow of Funds
1. Effects of Tariffs. Assume a simple world in which the U.S. exports soft drinks and beer to France and
imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the likely impact
on the values of the U.S. beverage firms, U.S. wine producers, the French beverage firms, and the French
wine producers.
ANSWER: The U.S. wine producers benefit from the U.S. tariffs, while the French wine producers are
adversely affected. The French government would likely retaliate by imposing tariffs on the U.S.
beverage firms, which would adversely affect their value. The French beverage firms would benefit.
2. Currency Effects. When South Korea’s export growth stalled, some South Korean firms suggested
that South Korea’s primary export problem was the weakness in the Japanese yen. How would you
interpret this statement?
ANSWER: One of South Korea’s primary competitors in exporting is Japan, which produces and exports
many of the same types of products to the same countries. When the Japanese yen is weak, some
importers switch to Japanese products in place of South Korean products. For this reason, it is often
suggested that South Korea’s primary export problem is weakness in the Japanese yen.
4. Effects of the Euro. Explain how the existence of the euro may affect U.S. international trade.
ANSWER: The euro allowed for a single currency among many European countries. It could encourage
firms in those countries to trade among each other since there is no exchange rate risk. This would
possibly cause them to trade less with the U.S. The euro can increase trade within Europe because it
eliminates the need for several European countries to exchange currencies when trading with each other.
5. Demand for Exports. A relatively small U.S. balance of trade deficit is commonly attributed to a
strong demand for U.S. exports. What do you think is the underlying reason for the strong demand for
U.S. exports?
ANSWER: The strong demand for U.S. exports is commonly attributed to strong foreign economies or to
a weak dollar.
6. Free Trade. There has been considerable momentum to reduce or remove trade barriers in an effort to
achieve “free trade.” Yet, one disgruntled executive of an exporting firm stated, “Free trade is not
conceivable; we are always at the mercy of the exchange rate. Any country can use this mechanism to
impose trade barriers.” What does this statement mean?
ANSWER: This statement implies that even if there were no explicit barriers, a government could
attempt to manipulate exchange rates to a level that would effectively reduce foreign competition. For
example, a U.S. firm may be discouraged from attempting to export to Japan if the value of the dollar is
very high against the yen. The prices of the U.S. goods from the Japanese perspective are too high
because of the strong dollar. The reverse situation could also be possible in which a Japanese exporting
firm is priced out of the U.S. market because of a strong yen (weak dollar). [Answer is based on opinion.]
7. Exchange Rate Effects on Trade.
a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a weaker
dollar could affect the U.S. balance of trade deficit.
ANSWER: A stronger dollar makes U.S. exports more expensive to importers and may reduce imports. It
makes U.S. imports cheap and may increase U.S. imports. A weaker home currency increases the prices
of imports purchased by the home country and reduces the prices paid by foreign businesses for the home
country’s exports. This should cause a decrease in the home country’s demand for imports and an
increase in the foreign demand for the home country’s exports, and therefore increase the current account.
However, this relationship can be distorted by other factors.
b. It is sometimes suggested that a floating exchange rate will adjust to reduce or eliminate any current
account deficit. Explain why this adjustment would occur.

ANSWER: A current account deficit reflects a net sale of the home currency in exchange for other
currencies. This places downward pressure on that home currency’s value. If the currency weakens, it will
reduce the home demand for foreign goods (since goods will now be more expensive), and will increase
the home export volume (since exports will appear cheaper to foreign countries).
c. Why does the exchange rate not always adjust to a current account deficit?
ANSWER: In some cases, the home currency will remain strong even though a current account deficit
exists, since other factors (such as international capital flows) can offset the forces placed on the currency
by the current account.

CHAPTER 3
International Financial Markets
2. Foreign Stock Markets. Explain why firms may issue stock in foreign markets. Why might U.S. firms
issue more stock in Europe since the conversion to a single currency in 1999?
ANSWER: Firms may issue stock in foreign markets when they are concerned that their home market
may be unable to absorb the entire issue. In addition, these firms may have foreign currency inflows in the
foreign country that can be used to pay dividends on foreign-issued stock. They may also desire to
enhance their global image. Since the euro can be used in several countries, firms may need a large
amount of euros if they are expanding across Europe.
3. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth $.70.
You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport
foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will
need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at
the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 130
pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain.
ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the
cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged for 120 pesos (computed as 200 × 6). If
you exchange Canadian dollars for pesos with the tourist, you will receive 130 pesos.
4. Eurocredit Loans.
a. With regard to Eurocredit loans, who are the borrowers?
b. Why would a bank desire to participate in syndicated Eurocredit loans?
c. What is LIBOR and how is it used in the Eurocredit market?
ANSWER:
a. Large corporations and some government agencies commonly request Eurocredit loans.
b. With a Eurocredit loan, no single bank would be totally exposed to the risk that the borrower may fail
to repay the loan. The risk is spread among all lending banks within the syndicate.
c. LIBOR (London interbank offer rate) is the rate of interest at which banks in Europe lend to each other.
It is used as a base from which loan rates on other loans are determined in the Eurocredit market.
5. International Diversification. Explain how the Asian crisis would have affected the returns to a U.S.
firm investing in the Asian stock markets as a means of international diversification. [See the chapter
appendix.]
ANSWER: The returns to the U.S. firm would have been reduced substantially as a result of the Asian
crisis because of both declines in the Asian stock markets and because of currency depreciation. For
example, the Indonesian stock market declined by about 27% from June 1997 to June 1998. Furthermore,
the Indonesian rupiah declined again the U.S. dollar by 84%.
6. Evolution of Floating Rates. Briefly describe the historical developments that led to floating exchange
rates as of 1973.
ANSWER: Country governments had difficulty in maintaining fixed exchange rates. In 1971, the bands
were widened. Yet, the difficulty of controlling exchange rates even within these wider bands continued.
As of 1973, the bands were eliminated so that rates could respond to market forces without limits
(although governments still did intervene periodically).
7. International Markets. What is the function of the international money market? Briefly describe the
reasons for the development and growth of the European money market. Explain how the international
money, credit, and bond markets differ from one another.
ANSWER: The function of the international money market is to efficiently facilitate the flow of
international funds from firms or governments with excess funds to those in need of funds. Growth of the
European money market was largely due to (1) regulations in the U.S. that limited foreign lending by U.S.

banks; and (2) regulated ceilings placed on interest rates of dollar deposits in the U.S. that encouraged
deposits to be placed in the Eurocurrency market where ceilings were nonexistent.
8. Loan Rates. Explain the process used by banks in the Eurocredit market to determine the rate to charge
on loans.
ANSWER: Banks set the loan rate based on the prevailing LIBOR, and allow the loan rate to float
(change every 6 months) in accordance with changes in LIBOR.
9. Syndicated Loans. Explain how syndicated loans are used in international markets.
ANSWER: A large MNC may want to obtain a large loan that no single bank wants to accommodate by
itself. Thus, a bank may create a syndicate whereby several other banks also participate in the loan.
10. Cross Exchange Rate. Assume Poland’s currency (the zloty) is worth $.17 and the Japanese yen is
worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty?
ANSWER: $.17/$.008 = 21.25
1 zloty = 21.25 yen
11. International Financial Markets. Recently, Wal-Mart established two retail outlets in the city of
Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products
purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it
may remit those earnings back to the United States. Wal-Mart is likely to build additional outlets in
Shanzen or in other Chinese cities in the future.
a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange.
ANSWER: The Wal-Mart stores in China need other currencies to buy products from other countries,
and must convert the Chinese currency (yuan) into the other currencies in the spot market to purchase
these products. They also could use the spot market to convert excess earnings denominated in yuan into
dollars, which would be remitted to the U.S. parent.
b. Explain how Wal-Mart might utilize the international money market when it is establishing other Wal-
Mart stores in Asia.
ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be used
(when needed) to support the growth of Wal-Mart stores in various foreign markets. When some Wal-
Mart stores in foreign markets need funds, they borrow from banks in the Eurocurrency market. Thus, the
Eurocurrency market serves as a deposit or lending source for Wal-Mart and other MNCs on a short-term
basis.
c. Explain how Wal-Mart could use the international bond market to finance the establishment of new
outlets in foreign markets.
ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish
new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are
established, some of the cash flows generated by those stores could be used to pay interest on the bonds.

CHAPTER 4
Exchange Rate Determination
1. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro
against the dollar?
ANSWER: The euro’s value could change because of the balance of trade, which reflects more U.S.
demand for European goods than the European demand for U.S. goods. The capital flows between the
U.S. and Europe will also affect the U.S. demand for euros and the supply of euros for sale (to be
exchanged for dollars).
2. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist
about future interest rates could affect the value of the dollar today. Why do some forecasts by well-
respected economists have no impact on today’s value of the dollar?
ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest rate
movements to forecast exchange rate movements. They may decide to purchase securities in particular
countries because of their expectations about currency movements, since their yield will be affected by
changes in a currency’s value. These purchases of securities require an exchange of currencies, which can
immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected
economist was already anticipated by market participants or is not different from investors’ original
expectations, an announced forecast does not provide new information. Thus, there would be no reaction
by investors to such an announcement, and exchange rates would not be affected.
3. Effects of Real Interest Rates. What is the expected relationship between the relative real interest
rates of two countries and the exchange rate of their currencies?
ANSWER: The higher the real interest rate of a country relative to another country, the stronger will be
its home currency, other things equal.
4. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its
controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S.
demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?
ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the value
of yen should decrease.
5. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate
than does the Canadian income level. Other things being equal, how should this affect the (a) U.S.
demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the
Canadian dollar?
ANSWER: Assuming no effect on U.S. interest rates, demand for dollars should increase, supply of
dollars for sale may not be affected, and the dollar’s value should increase.
6. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest
rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply
of pounds for sale, and (c) equilibrium value of the pound?
ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the
pound’s value should increase.
7. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to
Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadian
dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?
ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should
decrease, and the Canadian dollar’s value should increase.
8. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate
one year from now is assumed to be $1.66. What percentage depreciation does this reflect?
ANSWER: ($1.66 – $1.73)/$1.73 = –4.05%
Expected depreciation of 4.05% percent

Advanced Questions
9. Weighing Factors That Affect Exchange Rates. Assume that the level of capital flows between the
U.S. and the country of Zeus is negligible (close to zero) and will continue to be negligible. There is a
substantial amount of trade between the U.S. and the country of Zeus. The main import by the U.S. is
basic clothing purchased by U.S. retail stores from Zeus, while the main import by Zeus is special
computer chips that are only made in the U.S. and are needed by many manufacturers in Zeus. Suddenly,
the U.S. government decides to impose a 20% tax on the clothing imports. The Zeus government
immediately retaliates by imposing a 20% tax on the computer chip imports. Second, the Zeus
government immediately imposes a 60% tax on any interest income that would be earned by Zeus
investors if they buy U.S. securities. Third, the Zeus central bank raises its local interest rates so that they
are now higher than interest rates in the U.S. Do you think the currency of Zeus (called the zee) will
appreciate or depreciate against the dollar as a result of all the government actions described above?
Explain.
ANSWER: The zee should depreciate, because Zeus imports of U.S. computer chips will continue, while
the U.S. imports of Zeus clothing will decrease. The Zeus tax on capital flows and the central bank
actions will not have an effect because the Zeus investors do not buy U.S. securities anyway.
10. Assessing the Euro’s Potential Movements. You reside in the U.S. and are planning to make a one-
year investment in Germany during the next year. Since the investment is denominated in euros, you want
to forecast how the euro’s value may change against the dollar over the one-year period. You expect that
Germany will experience an inflation rate of 1% during the next year, while all other European countries
will experience an inflation rate of 8% over the next year. You expect that the U.S. will experience an
annual inflation rate of 2% during the next year. You believe that the primary factor that affects any
exchange rate is the inflation rate. Based on the information provided in this question, will the euro
appreciate, depreciate, or stay at about the same level against the dollar over the next year? Explain.
ANSWER: The euro should depreciate because most countries in the Eurozone are presumed to have
high inflation.
11. Relative Importance of Factors Affecting Exchange Rate Risk. Assume that the level of capital
flows between the U.S. and the country of Krendo is negligible (close to zero) and will continue to be
negligible. There is a substantial amount of trade between the U.S. and the country of Krendo and no
capital flows. How will high inflation and high interest rates affect the value of the kren (Krendo’s
currency)? Explain.
ANSWER: The inflation effect will be stronger than the interest rate effect because inflation affects trade
flows. The high inflation should cause downward pressure on the kren.
12. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from
its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist:
Currency Lending Rate Borrowing Rate
U.S. dollar 7.0% 7.2%
Singapore dollar 22.0% 24.0%
Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing
the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy.
Should Diamond Bank pursue this strategy?
ANSWER:
Borrow S$10,000,000 and convert to U.S. $:
S$10,000,000 × $.43 = $4,300,000
Invest funds for 60 days. The rate earned in the U.S. for 60 days is:
7% × (60/360) = 1.17%
Total amount accumulated in 60 days:
$4,300,000 × (1 + .0117) = $4,350,310
Convert U.S. $ back to S$ in 60 days:
$4,350,310/$.42 = S$10,357,881

The rate to be paid on loan is:
.24 × (60/360) = .04
Amount owed on S$ loan is:
S$10,000,000 × (1 + .04) = S$10,400,000
This strategy results in a loss:
S$10,357,881 – S$10,400,000 = –S$42,119
Diamond Bank should not pursue this strategy.
13. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from
its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist:
Currency Lending Rate Borrowing Rate
U.S. dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%
Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the
interbank market, depending on which currency it wants to borrow.
a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited
funds? Estimate the profits that could be generated from this strategy.
ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows:
1. Borrow MXP70 million
2. Convert the MXP70 million to dollars: MXP70,000,000 × $.15 = $10,500,000
3. Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The amount
accumulated in 10 days is:
$10,500,000 × [1 + (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333
4. Repay the peso loan. The repayment amount on the peso loan is:
MXP70,000,000 × [1 + (8.7% × 10/360)] = 70,000,000 × [1.002417]=MXP70,169,167
5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is:
MXP70,169,167 × $.14 = $9,823,683
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange
rate is accurate) of: $10,523,333 – $9,823,683 = $699,650
b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to
appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on
its expectations without using deposited funds? Estimate the profits that could be generated from
this strategy.
ANSWER: Blue Demon Bank can capitalize on its expectations as follows:
1. Borrow $10 million
2. Convert the $10 million to pesos (MXP):
$10,000,000/$.15 = MXP66,666,667
3. Lend the pesos through the interbank market at 8.5% annualized over a 30-day period. The amount
accumulated in 30 days is:
MXP66,666,667 × [1 + (8.5% × 30/360)] = 66,666,667 × [1.007083] = MXP67,138,889
4. Repay the dollar loan. The repayment amount on the dollar loan is:
$10,000,000 × [1 + (8.3% × 30/360)] = $10,000,000 × [1.006917] = $10,069,170
5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based
on the expected spot rate of $.17) is: MXP67, 138,889 × $.17 = $11,413,611
6. The profits are determined by estimating the dollars available after repaying the loan:
$11,413,611 – $10,069,170 = $1,344,441

CHAPTER 5
Currency Derivatives
1. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per unit.
The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike
did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in
a Canadian dollar option. What was Mike’s net profit on the call option?
ANSWER:
Premium received per unit = $.01
Amount per unit received from selling C$ = $.76
Amount per unit paid when purchasing C$ = $.82
Net profit per unit = –$.05
Net Profit = 50,000 units × (–$.05) = –$2,500
2. Speculating with Currency Put Options. Alice Duever purchased a put option on British pounds for
$.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was exercised was
$1.59. Assume there are 31,250 units in a British pound option. What was Alice’s net profit on the
option?
ANSWER:
Profit per unit on exercising the option = $.21
Premium paid per unit = $.04
Net profit per unit = $.17
Net profit for one option = 31,250 units × $.17 = $5,312.50
3. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds
for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was
$1.46. Assume there are 31,250 units in a British pound option. What was Randy’s net profit on this
option?
ANSWER:
Profit per unit on exercising the option = $.01
Premium paid per unit = $.02
Net profit per unit = –$.01
Net profit per option = 31,250 units × (–$.01) = –$312.50
4. Currency Put Option Premiums. List the factors that affect currency put options and briefly explain
the relationship that exists for each.
ANSWER: These factors are listed below:
1. The lower the existing spot rate relative to the strike price, the greater is the put option value,
other things equal.
2. The longer the period prior to the expiration date, the greater is the put option value, other things
equal.
3. The greater the variability of the currency, the greater is the put option value, other things equal.
5. Currency Call Option Premiums. List the factors that affect currency call option premiums and
briefly explain the relationship that exists for each. Do you think an at-the money call option in euros has
a higher or lower premium than an at-the-money call option in British pounds (assuming the expiration
date and the total dollar value represented by each option are the same for both options)?

ANSWER: These factors are listed below:
1. The higher the existing spot rate relative to the strike price, the greater is the call option value,
other things equal.
2. The longer the period prior to the expiration date, the greater is the call option value, other things
equal.
3. The greater the variability of the currency, the greater is the call option value, other things equal.
The at-the-money call option in euros should have a lower premium because the euro should have
less volatility than the pound.
6. Speculating With Currency Options. When should a speculator purchase a call option on Australian
dollars? When should a speculator purchase a put option on Australian dollars?
ANSWER: Speculators should purchase a call option on Australian dollars if they expect the Australian
dollar value to appreciate substantially over the period specified by the option contract.
Speculators should purchase a put option on Australian dollars if they expect the Australian dollar value
to depreciate substantially over the period specified by the option contract.
7. Hedging With Currency Options. When would a U.S. firm consider purchasing a call option on euros
for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging?
ANSWER: A call option can hedge a firm’s future payables denominated in euros. It effectively locks in
the maximum price to be paid for euros.
A put option on euros can hedge a U.S. firm’s future receivables denominated in euros. It effectively
locks in the minimum price at which it can exchange euros received.
8. Effects of a Forward Contract. How can a forward contract backfire?

ANSWER: If the spot rate of the foreign currency at the time of the transaction is worth less than the
forward rate that was negotiated, or is worth more than the forward rate that was negotiated, the forward
contract has backfired.
9. Forward Premium. Compute the forward discount or premium for the Mexican peso whose 90- day
forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium.
ANSWER: (F - S) / S
=($.098 - $.10) / $.10 × (360/90)
= –.02, or –2%, which reflects a 8% discount
10. Currency Options. Differentiate between a currency call option and a currency put option.
ANSWER: A currency call option provides the right to purchase a specified currency at a specified price
within a specified period of time. A currency put option provides the right to sell a specified currency for
a specified price within a specified period of time.
11. Using Currency Futures.

a. How can currency futures be used by corporations?
ANSWER: U.S. corporations that desire to lock in a price at which they can sell a foreign currency
would sell currency futures. U.S. corporations that desire to lock in a price at which they can purchase a
foreign currency would purchase currency futures.
b. How can currency futures be used by speculators?
ANSWER: Speculators who expect a currency to appreciate could purchase currency futures contracts
for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts
for that currency.

12. Forward versus Futures Contracts. Compare and contrast forward and futures contracts.
ANSWER: Because currency futures contracts are standardized into small amounts, they can be valuable
for the speculator or small firm (a commercial bank’s forward contracts are more common for larger
amounts). However, the standardized format of futures forces limited maturities and amounts.
13. Profits from Using Currency Options and Futures. On July 2, the two-month futures rate of the
Mexican peso contained a 2 percent discount (unannualized). There was a call option on pesos with an
exercise price that was equal to the spot rate. There was also a put option on pesos with an exercise price
equal to the spot rate. The premium on each of these options was 3 percent of the spot rate at that time.
On September 2, the option expired. Go to the oanda.com website (or any site that has foreign exchange
rate quotations) and determine the direct quote of the Mexican peso. You exercised the option on this date
if it was feasible to do so.
a. What was your net profit per unit if you had purchased the call option?
b. What was your net profit per unit if you had purchased the put option?
c. What was your net profit per unit if you had purchased a futures contract on July 2 that had a
settlement date of September 2?
d. What was your net profit per unit if you sold a futures contract on July 2 that had a settlement date
of September 2?
ANSWER: The answer depends on exchange rates on the specified dates. This question forces students
to look up exchange rate information before determining the net profit.
14. Bullspreads and Bearspreads. Two British pound (₤) put options are available with exercise prices
of $1.60 and $1.62. The premiums associated with these options are $.03 and $.04 per unit, respectively.
(See Appendix B in this chapter.)
a. Describe how a bullspread can be constructed using these put options. What is the difference
between using put options versus call options to construct a bullspread?
b. Complete the following worksheet.
Value of British Pound at Option Expiration
$1.55 $1.60 $1.62 $1.67
Put @ $1.60
Put @ $1.62
Net
c. At option expiration, the spot rate of the pound is $1.60. What is the bullspreader’s total gain or
loss?
d. At option expiration, the spot rate of the pound is $1.58. What is the bearspreader’s total gain or
loss?
ANSWER:
a. Using put options to construct a bullspread involves exactly the same actions as constructing a
bullspread using call options. The bullspreader would buy the $1.60 put option and write the $1.62
put option. The difference between using call and put options to construct a bullspread is that using
put options results in a credit spread.

b.
$1.55 $1.60 $1.62 $1.67
Put @ $1.60 +$.02 –$.03 –$.03 –$.03
Put @ $1.62 –$.03 +$.02 +$.04 +$.04
Net –$.01 –$.01 +$.01 +$.01
c.
Per Unit Per Contract
Selling price of ₤ $1.60 $50,000 ($1.60 × 31,250 units)
– Purchase price of ₤ –1.62 –50,625 ($1.62 × 31,250 units)
– Premium paid for put option –.03 –937.50 ($.03 × 31,250 units)
+ Premium received for put option +.04 +1,250 ($.04 × 31,250 units)
= Net profit –$.01 –$312.50 ($.01 × 31,250 units)
d. A bearspread using these put options would be constructed by writing the $1.60 put option and
buying the $1.62 put option.
Selling price of ₤ $1.58 $49,375 ($1.58 × 31,250 units)
+ Premium received for put option +.03 +937.50 ($.03 × 31,250 units)
+ Selling price of ₤ $1.62 +50,625 ($1.62 × 31,250 units)
– Premium paid for put option –.04 –1,250 ($.04 × 31,250 units)
= Net profit +$.01 $312.50 ($.01 × 31,250 units)
15. Currency Bullspreads and Bearspreads. A call option on British pounds (₤) exists with a strike
price of $1.56 and a premium of $.08 per unit. Another call option on British pounds has a strike price of
$1.59 and a premium of $.06 per unit. (See Appendix B in this chapter.)
a. Complete the worksheet for a bullspread below.
$1.50 $1.56 $1.59 $1.65
Call @ $1.56
Call @ $1.59
Net
b. What is the breakeven point for this bullspread?
c. What is the maximum profit of this bullspread? What is the maximum loss?
d. If the British pound spot rate is $1.58 at option expiration, what is the total profit or loss for the
bullspread?
e. If the British pound spot rate is $1.55 at option expiration, what is the total profit or loss for a
bearspread?
ANSWER:
a.
$1.50 $1.56 $1.59 $1.65
Call @ $1.56 –$.08 –$.08 –$.05 +$.01
Call @ $1.59 +$.06 +$.06 +$.06 $.00
Net –$.02 –$.02 +$.01 +$.01
b. The breakeven point of a bullspread occurs at the lower exercise price plus the difference in
premiums, at $1.58 = $1.56 + ($.08 – $.06).

c. The maximum gain for the bullspread is limited to the difference between the strike prices less the
difference in the premiums, or $.01 = ($1.59 – $1.56) – ($.08 – $.06). The maximum loss for the
bullspreader limited to the difference in the option premiums, or $.02.
d.
Selling Price of ₤ $1.58 $49,375 ($1.58 × 31,250 units)
– Premium paid for call option –.08 –2,500 ($.08 × 31,250 units)
+ Premium received for call option +.06 +1,875 ($.06 × 31,250 units)
= Net profit $.00 $0 ($.00 × 31,250 units)
e. A bearspread using these options involves writing the call option with the $1.56 exercise price and
buying the call option with the $1.59 exercise price. At a spot price of $1.55, neither call option will
be exercised, so the bearspreader nets the difference in options premiums.
+ Premium paid for call option +.08 +2,500 ($.08 × 31,250 units)
– Premium received for call option –.06 –1,875 ($.06 × 31,250 units)
= Net profit $.02 $625 ($.02 × 31,250 units)
16. Speculating with Currency Options. Barry Egan is a currency speculator. Barry believes that the
Japanese yen will fluctuate widely against the U.S. dollar in the coming month. Currently, one month call
options on Japanese yen (¥) are available with a strike price of $.0085 and a premium of $.0007 per unit.
One-month put options on Japanese yen are available with a strike price of$.0084 and a premium of
$.0005 per unit. One option contract on Japanese yen contains 6.25 million yen. (See Appendix B in this
chapter.)
a. Describe how Barry Egan could utilize these options to speculate on the movement of the Japanese
yen.
b. Assume Barry decides to construct a long strangle in yen. What are the break-even points of this
strangle?
c. What is Barry’s total profit or loss if the value of the yen in one month is $.0070?
d. What is Barry’s total profit or loss if the value of the yen in one month is $.0090?
ANSWER:
a. Since Barry seems uncertain as to the direction of the yen fluctuation, he could construct a long
straddle using the call and put option. The long strangle would become profitable if the yen either
depreciates or appreciates substantially.
b. Lower BE point = $.0084 – ($.0007 + $.0005) = $.0072
Upper BE point = $.0085 + ($.0007 + $.0005) = $.0097
c.
Selling Price of ¥ $.0084 $52,500 ($.0084 × 6.25 million units)
– Purchase price of ¥ –.0070 –43,750 ($.0070 × 6.25 million units)
– Premium paid for call option –.0007 –4,375 ($.0007 × 6.26 million units)
– Premium paid for put option –.0005 –3,125 ($.0005 × 6.25 million units)
= Net profit $.0002 $1,250 ($.0002 × 6.25 million units)
d.
Selling Price of ¥ $.0090 $56,250 ($.0090 × 6.25 million units)
– Purchase price of ¥ –.0085 –53,125 ($.0085 × 6.25 million units)
– Premium paid for call option –.0007 –4,375 ($.0007 × 6.26 million units)
– Premium paid for put option –.0005 –3,125 ($.0005 × 6.25 million units)

= Net profit –$.0007 –$4,375 ($.0007 × 6.25 million units)
17. Currency Strangles. For the following options available on Australian dollars (A$), construct a
worksheet and contingency graph for a long strangle. Locate the break-even points for this strangle. (See
Appendix B in this chapter.)
 Put option strike price = $.67
 Call option strike price = $.65
 Put option premium = $.01 per unit
 Call option premium = $.02 per unit
ANSWER:
Note that the put strike price exceeds the call strike price in this case.
Value of Australian dollar at Option Expiration
$.60 $.65 $.67 $.70
Own a Call –$.02 –$.02 $.00 +$.03
Own a Put +$.06 +$.01 –$.01 –$.01
Net +$.04 –$.01 –$.01 +$.02
The plotted points should create a U shape that cuts through the horizontal (break-even) axis at $.64 and
$.68. The bottom of the U shape occurs from $.65 to $.67 and reflects a net profit of –$.01.
Net profit per unit
The break-even points for a strangle where the put option exercise price exceeds the call option exercise
price can be obtained by subtracting the difference in premiums from the call option strike price and by
adding the difference in premiums to the put option strike price:
Lower BE = $.65 – ($.02 – $.01) = $.64
Upper BE = $.67 + ($.02 – $.01) = $.68
18. Currency Strangles. The following information is currently available for Canadian dollar (C$)
options (see Appendix B in this chapter):
 Put option exercise price = $.75
 Put option premium = $.014 per unit
 Call option exercise price = $.76
 Call option premium = $.01 per unit
 One option contract represents C$50,000
a. What is the maximum possible gain the purchaser of a strangle can achieve using these options?
b. What is the maximum possible loss the writer of a strangle can incur?
c. Locate the break-even point(s) of the strangle.

ANSWER:
a. The maximum gain of a long strangle is unlimited for currency appreciation. For currency
depreciation, the maximum gain is limited to the lower strike price ($.75) less both premiums ($.024),
or $.726.
b. The maximum loss of a short strangle is unlimited for currency appreciation. For currency
depreciation, it is limited to the lower strike price ($.75) less both premiums ($.024), or $.726.
c. The lower break-even point is obtained by subtracting both premiums from the put option exercise
price, at $.726 = $.75 – ($.014 + $.01). The upper break-even points is obtained by adding both
premiums to the call option exercise price, at $.784 = $.76 + ($.014 + $.01).

CHAPTER 6
Government Influence on Exchange Rates
1. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some
currencies than others? Why would a central bank’s indirect intervention have a stronger impact than its
direct intervention?
ANSWER: Intervention may have a more pronounced impact when the market for a given currency is
less active, such that the intervention can jolt the supply and demand conditions more. A central bank’s
indirect intervention can affect the factors that influence exchange rates and therefore affect the natural
equilibrium exchange rate. Conversely, direct intervention is a superficial method of affecting the demand
and supply conditions for a currency, and could be overwhelmed by market forces.
2. Feedback Effects. Explain the potential feedback effects of a currency’s changing value on inflation.
ANSWER: A weak home currency can cause inflation since it tends to reduce foreign competition within
any given industry. Higher inflation can weaken the currency further since it encourages consumers to
purchase goods abroad (where prices are not inflated). A strong home currency can reduce inflation since
it reduces the prices of foreign goods and forces home producers to offer competitive prices. Low
inflation, in turn, places upward pressure on the home currency.
3. Currency Effects on Economy. What is the impact of a weak home currency on the home economy,
other things being equal? What is the impact of a strong home currency on the home economy, other
things being equal?
ANSWER: A weak home currency tends to increase a country’s exports and decrease its imports, thereby
lowering its unemployment. However, it also can cause higher inflation since there is a reduction in
foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local
producers can more easily increase prices without concern about pricing themselves out of the market.
A strong home currency can keep inflation in the home country low, since it encourages consumers to buy
abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be
obtained cheaply. This also helps to maintain low inflation. However, a strong home currency can
increase unemployment in the home country. This is due to the increase in imports and decrease in
exports often associated with a strong home currency (imports become cheaper to that country but the
country’s exports become more expensive to foreign customers).
4. Intervention Effects. Assume there is concern that the United States may experience a recession. How
should the Federal Reserve influence the dollar to prevent a recession? How might U.S. exporters react to
this policy (favorably or unfavorably)? What about U.S. importing firms?
ANSWER: The Federal Reserve would normally consider a loose money policy to stimulate the
economy. However, to the extent that the policy puts upward pressure on economic growth and inflation,
it could weaken the dollar. A weak dollar is expected to favorably affect U.S. exporting firms and
adversely affect U.S. importing firms. If the U.S. interest rates rise in response to the possible increase in
economic growth and inflation in the U.S., this could offset the downward pressure on the U.S. dollar. In
this case, U.S. exporting and importing firms would not be affected as much.
5. Indirect Intervention. How can a central bank use indirect intervention to change the value of a
currency?
ANSWER: To increase the value of its home currency, a central bank could attempt to increase interest
rates, thereby attracting a foreign demand for the home currency to buy high-yield securities.
To decrease the value of its home currency, a central bank could attempt to lower interest rates in order to
reduce demand for the home currency by foreign investors.
6. Direct Intervention. How can a central bank use direct intervention to change the value of a currency?
Explain why a central bank may desire to smooth exchange rate movements of its currency.
ANSWER: Central banks can use their currency reserves to buy up a specific currency in the foreign
exchange market in order to place upward pressure on that currency. Central banks can also attempt to

force currency depreciation by flooding the market with that specific currency (selling that currency in the
foreign exchange market in exchange for other currencies).
Abrupt movements in a currency’s value may cause more volatile business cycles, and may cause more
concern in financial markets (and therefore more volatility in these markets). Central bank intervention
used to smooth exchange rate movements may stabilize the economy and financial markets.
7. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as its
currency, would prefer that its currency depreciate against the dollar. Can it apply central bank
intervention to achieve this objective? Explain.
ANSWER: It can not apply intervention on its own because the European Central Bank (ECB) controls
the money supply of euros. Belgium is subject to the intervention decisions of the ECB.
8. Exchange Rate Systems. Compare and contrast the fixed, freely floating, and managed float exchange
rate systems. What are some advantages and disadvantages of a freely floating exchange rate system
versus a fixed exchange rate system?
ANSWER: Under a fixed exchange rate system, the governments attempted to maintain exchange rates
within 1% of the initially set value (slightly widening the bands in 1971). Under a freely floating system,
government intervention would be non-existent. Under a managed float system, governments will allow
exchange rates move according to market forces; however, they will intervene when they believe it is
necessary.
A freely floating system may help correct balance-of-trade deficits since the currency will adjust
according to market forces. Also, countries are more insulated from problems of foreign countries under a
freely floating exchange rate system. However, a disadvantage of freely floating exchange rates is that
firms have to manage their exposure to exchange rate risk. Also, floating rates still can often have a
significant adverse impact on a country’s unemployment or inflation.
9. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The
subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed
funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong
dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the
parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value
of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result.
Explain whether these actions would increase, reduce, or have no effect on:
a. The volume of your subsidiary’s sales in Australia (measured in A$),
b. The cost to your subsidiary of purchasing materials (measured in A$)
c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$).
Briefly explain each answer.
ANSWER:
a. The volume of the sales should decline as the cost to consumers who finance their purchases would rise
due to the higher interest rates.
b. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as it
appreciates against the U.S. dollar.
c. The interest expenses should decline because it will take fewer A$ to make the monthly payment of
$100,000.
10. Effects of September 11. Within a few days after the September 11, 2001 terrorist attack on the U.S.,
the Federal Reserve reduced short-term interest rates in the U.S. to stimulate the U.S. economy. How
might this action have affected the foreign flow of funds into the U.S. and affected the value of the dollar?
How could such an effect on the dollar increase the probability that the U.S. economy would strengthen?
ANSWER: The lower interest rates are expected to stimulate the U.S. economy, by encouraging more
borrowing and spending. Lower U.S. interest rates may reduce the amount of foreign flows to the U.S.,
which could have reduced the value of the dollar. If the dollar weakened U.S. exports would be cheaper,
which could have increased the demand for products produced by U.S. exporters.
11. Monitoring of the Fed’s Intervention. Why do foreign market participants attempt to monitor the
Fed’s direct intervention efforts? How does the Fed attempt to hide its intervention actions?

The media frequently reports that “the dollar’s value strengthened against many currencies in response to
the Federal Reserve’s plan to increase interest rates.” Explain why the dollar’s value may change even
before the Federal Reserve affects interest rates.
ANSWER: Foreign market participants make investment and borrowing decisions that can be influenced
by anticipated exchange rate movements and therefore by the Fed’s direct intervention efforts. Thus, they
may attempt to obtain information from commercial banks about the Fed’s intervention actions. The Fed
may attempt to disguise its actions by requesting bid and ask quotes on exchange rates, and even mixing
some buy orders with sell orders, or vice versa.
Foreign exchange market participants may anticipate that once the Fed increases interest rates, there will
be an increased demand for dollars, which will result in a stronger dollar.
Consequently, they may take positions in dollars immediately, which could place upward pressure on the
dollar even before interest rates are affected.

CHAPTER 7
International Arbitrage and Interest Rate Parity
1. Covered Interest Arbitrage in Both Directions. The following information is available:
 You have $500,000 to invest
 The current spot rate of the Moroccan dirham is $.110.
 The 60-day forward rate of the Moroccan dirham is $.108.
 The 60-day interest rate in the U.S. is 1 percent.
 The 60-day interest rate in Morocco is 2 percent.
a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest
arbitrage work for the investor in this case?
b. Would covered interest arbitrage be possible for a Moroccan investor in this case?
ANSWER:
a. Covered interest arbitrage would involve the following steps:
1. Convert dollars to Moroccan dirham: $500,000/$.11 = MD4,545,454.55
2. Deposit the dirham in a Moroccan bank for 60 days.
You will have MD4,545,454.55 × (1.02) = MD4,636,363.64 in 60 days.
3. In 60 days, convert the dirham back to dollars at the forward rate and receive
MD4,636,363.64 × $.108 = $500,727.27
The yield to the U.S. investor is $500,727.27/$500,000 – 1 = .15%. Covered interest arbitrage did not
work for the investor in this case. The lower Moroccan forward rate more than offsets the higher interest
rate in Morocco.
b. Yes, covered interest arbitrage would be possible for a Moroccan investor. The investor would convert
dirham to dollars, invest the dollars at a 1 percent interest rate in the U.S., and sell the dollars forward 60
days. Even though the Moroccan investor would earn an interest rate that is 1 percent lower in the U.S.,
the forward rate discount of the dirham more than offsets that differential.
2. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while interest
rates in France are 6 percent.
a. According to IRP, what should the forward rate premium or discount of the euro be?
b. If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?
ANSWER:
( )
a. ( )
b. F =$1.10(1-.0189 ) =$1.079
3. Covered Interest Arbitrage. The South African rand has a one-year forward premium of 2 percent.
One-year interest rates in the U.S. are 3 percentage points higher than in South Africa. Based on this
information, is covered interest arbitrage possible for a U.S. investor if interest rate parity holds?
ANSWER:
No, covered interest arbitrage is not possible for a U.S. investor. Although the investor can lock in the
higher exchange rate in one year, interest rates are 3 percent lower in South Africa.
4. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is currently
8 percent and Germany’s annual interest rate is currently 9 percent. The euro’s one-year forward rate
currently exhibits a discount of 2 percent.
a. Does interest rate parity exist?
ANSWER: No, because the discount is larger than the interest rate differential.
b. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage?
ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of investing in
Germany.
c. Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through covered
interest arbitrage?

ANSWER: Yes, because even though it would earn 1 percent less interest over the year by investing in
U.S. dollars, it would be able to sell dollars for 2 percent more than it paid for them (it would be buying
euros forward at a discount of 2 percent).
5. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is 11 percent,
while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase
the currency of that country from you one year from now at a discount of 13 percent. Would covered
interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest
arbitrage in this situation? (Ignore tax effects.)
ANSWER: Covered interest arbitrage would be worth considering since the return would be 21.8
percent, which is much higher than the U.S. interest rate. Assuming a $1,000,000 initial investment,
$1,000,000 × (1.40) × .87 = $1,218,000
Yield = ($1,218,000 – $1,000,000)/$1,000,000 = 21.8%
However, the funds would be invested in Malaysia, which could cause some concern about default risk or
government restrictions on convertibility of the currency back to dollars.
6. Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6
percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is
$.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S.
investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is
or is not feasible.
ANSWER:
To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed initial
investment, such as $1,000,000.
$1,000,000/$.50 = NZ$2,000,000 × (1.06)

= NZ$2,120,000 × $.54 = $1,144,800
Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%
Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S.
interest rate of 10 percent.
To determine the yield from covered interest arbitrage by New Zealand investors, start with an assumed
initial investment, such as NZ$1,000,000:
NZ$1,000,000 × $.50 = $500,000 × (1.10)

= $550,000/$.54 = NZ$1,018,519
Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 = 1.85%
Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of
1.85% is less than the 6% that they could receive from investing their funds in New Zealand.
7. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher last
month than it is today. What does this imply about interest rate differentials between the United States
and Europe today compared to those last month?
ANSWER: The interest rate differential is smaller now than it was last month.
8. Interest Rate Parity. If the relationship that is specified by interest rate parity does not exist at any
period but does exist on average, then covered interest arbitrage should not be considered by U.S. firms.
Do you agree or disagree with this statement? Explain.
ANSWER: Disagree. If at any point in time, interest rate parity does not exist, covered interest arbitrage
could earn excess returns (unless transactions costs, tax differences, etc., offset the excess returns).

9. Changes in Forward Premiums. Assume that the Japanese yen’s forward rate currently exhibits a
premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must this
premium change to maintain interest rate parity? Why might we expect the premium to change?
ANSWER: The premium will decrease in order to maintain IRP, because the difference between the
interest rates is reduced. We would expect the premium to change because as U.S. interest rates decrease,
U.S. investors could benefit from covered interest arbitrage if the forward premium stays the same. The
return earned by U.S. investors who use covered interest arbitrage would not be any higher than before,
but the return would now exceed the interest rate earned in the U.S. Thus, there is downward pressure on
the forward premium.
10. Interest Rate Parity. Consider investors who invest in either U.S. or British one-year Treasury bills.
Assume zero transaction costs and no taxes.
a. If interest rate parity exists, then the return for U.S. investors who use covered interest arbitrage will be
the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this statement true or false?
If false, correct the statement.
ANSWER: True
b. If interest rate parity exists, then the return for British investors who use covered interest arbitrage will
be the same as the return for British investors who invest in British Treasury bills. Is this statement true or
false? If false, correct the statement.
ANSWER: True
11. Interest Rate Parity. Why would U.S. investors consider covered interest arbitrage in France when
the interest rate on euros in France is lower than the U.S. interest rate?
ANSWER: If the forward premium on euros more than offsets the lower interest rate, investors could use
covered interest arbitrage by investing in euros and achieve higher returns than in the U.S.
13. Testing IRP. The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the
U.S. is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46.
Assume zero transactions costs.
a. Does interest rate parity exist?
ANSWER: No, because the discount is larger than the interest rate differential.
b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage?
ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of investing in
Singapore.
14. Change in the Forward Premium. At the end of this month, you (owner of a U.S. firm) are meeting
with a Japanese firm to which you will try to sell supplies. If you receive an order from that firm, you will
obtain a forward contract to hedge the future receivables in yen. As of this morning, the forward rate of
the yen and spot rate are the same. You believe that interest rate parity holds.
This afternoon, news occurs that makes you believe that the U.S. interest rates will increase substantially
by the end of this month, and that the Japanese interest rate will not change. However, your expectations
of the spot rate of the Japanese yen are not affected at all in the future. How will your expected dollar
amount of receivables from the Japanese transaction be affected (if at all) by the news that occurred this
afternoon? Explain.
ANSWER: If U.S. interest rates increase, then the forward rate of the yen will exhibit a premium.
Therefore, if you hedge your receivables at the end of this month, the dollar amount to be received would
be higher.
15. Interpreting a Large Forward Discount. The interest rate in Indonesia is commonly higher than the
interest rate in the U.S., which reflects a higher expected rate of inflation there. Why should Nike
consider hedging its future remittances from Indonesia to the U.S. parent even when the forward discount
on the currency (rupiah) is so large?
ANSWER: Nike may still consider hedging under these conditions because the alternative is to be
exposed to the risk that the rupiah may depreciate over the six-month period by an amount that exceeds
the degree of the discount. A large forward discount implies that the nominal interest rate in Indonesia is

much higher than in the U.S., which may suggest a higher rate of expected inflation. Thus, there may be
severe downward pressure on the rupiah’s spot rate over time.
16. Interpreting Changes in the Forward Premium. Assume that interest rate parity holds. At the
beginning of the month, the spot rate of the Canadian dollar is $.70, while the one-year forward rate is
$.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the one-
year forward rate is higher than it was at the beginning of the month. Yet, the oneyear forward discount is
larger (the one-year premium is more negative) at the end of the month than it was at the beginning of the
month. Explain how the relationship between the U.S. interest rate and the Canadian interest rate changed
from the beginning of the month until the end of the month.
ANSWER: The forward discount at the beginning of the month implies that the U.S. interest rate is lower
than the Canadian interest rate. During the month, the Canadian interest rate must have increased by a
greater degree than the U.S. interest rate. At the end of the month, the gap between the Canadian dollar
and the U.S. dollar is greater than it was at the beginning of the month. This results in a more pronounced
forward discount.

CHAPTER 8
Relationships among Inflation, Interest Rates, and Exchange Rates
1. PPP. Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general
forecast of the values of currencies in countries with high inflation?
ANSWER: PPP suggests that the purchasing power of a consumer will be similar when purchasing goods
in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the
home country, the exchange rate will adjust to maintain equal purchasing power.
Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power
of goods in the home country versus these countries to be similar.
2. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation in testing
whether PPP holds.
ANSWER: One method is to choose two countries and compare the inflation differential to the exchange
rate change for several different periods. Then, determine whether the exchange rate changes were similar
to what would have been expected under PPP theory.
A second method is to choose a variety of countries and compare the inflation differential of each foreign
country relative to the home country for a given period. Then, determine whether the exchange rate
changes of each foreign currency were what would have been expected based on the inflation differentials
under PPP theory.
A limitation in testing PPP is that the results will vary with the base period chosen. The base period
should reflect an equilibrium position, but it is difficult to determine when such a period exists.
3. Limitations of PPP. Explain why PPP does not hold.
ANSWER: PPP does not consistently hold because there are other factors besides inflation that
influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation
differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a country’s
inflation increases, the foreign demand for its products will not necessarily decrease (in the manner
suggested by PPP) if substitutes are not available.
4. Implications of IFE. Assume U.S. interest rates are generally above foreign interest rates. What does
this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors
invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if
they believe in the IFE?
ANSWER: The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates are
currently higher than foreign interest rates. Consequently, foreign investors who purchased U.S. securities
would on average receive a similar yield as what they receive in their own country, and U.S. investors
that purchased foreign securities would on average receive a yield similar to U.S. rates.
5. Real Interest Rate. One assumption made in developing the IFE is that all investors in all countries
have the same real interest rate. What does this mean?
ANSWER: The real return is the nominal return minus the inflation rate. If all investors require the same
real return, then the differentials in nominal interest rates should be solely due to differentials in
anticipated inflation among countries.
6. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency
experience higher inflation than the United States, while two other European countries that use the euro as
their currency experience lower inflation than the United States. According to PPP, how will the euro’s
value against the dollar be affected?
ANSWER: The high European inflation overall would reduce the U.S. demand for European products,
increase the European demand for U.S. products, and cause the euro to depreciate against the dollar.
According to the PPP theory, the euro's value would adjust in response to the weighted inflation rates of
the European countries that are represented by the euro relative to the inflation in the U.S. If the European
inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro.

7. PPP. Japan has typically had lower inflation than the United States. How would one expect this to
affect the Japanese yen’s value? Why does this expected relationship not always occur?
ANSWER: Japan’s low inflation should place upward pressure on the yen’s value. Yet, other factors can
sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places
downward pressure on the yen’s value.
8. IFE. Shouldn’t the IFE discourage investors from attempting to capitalize on higher foreign interest
rates? Why do some investors continue to invest overseas, even when they have no other transactions
overseas?
ANSWER: According to the IFE, higher foreign interest rates should not attract investors because these
rates imply high expected inflation rates, which in turn imply potential depreciation of these currencies.
Yet, some investors still invest in foreign countries where nominal interest rates are high. This may
suggest that some investors believe that (1) the anticipated inflation rate embedded in a high nominal
interest rate is overestimated, or (2) the potentially high inflation will not cause substantial depreciation of
the foreign currency (which could occur if adequate substitute products were not available elsewhere), or
(3) there are other factors that can offset the possible impact of inflation on the foreign currency’s value.
9. Comparing PPP and IFE. How is it possible for PPP to hold if the IFE does not?
ANSWER: For the IFE to hold, the following conditions are necessary:
(1) Investors across countries require the same real returns,
(2) The expected inflation rate embedded in the nominal interest rate occurs,
(3) The exchange rate adjusts to the inflation rate differential according to PPP.
If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher
returns when investing in a foreign country’s securities. Thus, IFE would be refuted.
10. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the
Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in
Singapore. What will the spot rate be in one year according to the IFE? (You may use the approximate
formula to answer this question.)
ANSWER: $.70 × (1 + .04) = $.728
11. Inflation and Interest Rate Effects. The opening of Russia's market has resulted in a highly volatile
Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian
interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in
Russia.
a. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble.
ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was
declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a
large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase
Russian goods would be low. Thus, the ruble’s value should depreciate against the dollar, and against
other currencies.
b. Does the effect of Russian inflation on the decline in the ruble’s value support the PPP theory? How
might the relationship be distorted by political conditions in Russia?
ANSWER: The general relationship suggested by PPP is supported, but the ruble’s value will not
normally move exactly as specified by PPP. The political conditions that could restrict trade or currency
convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the ruble may not
decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the
government may not allow the ruble to float freely to its proper equilibrium level.
c. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the
perspective of Russian consumers (after considering exchange rates)? Explain.
ANSWER: Russian prices might be higher than U.S. prices, even after considering exchange rates,
because the ruble might not depreciate enough to fully offset the Russian inflation. The exchange rate
cannot fully adjust if there are barriers on trade or currency convertibility.
d. Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S.
importers? That is, how will U.S. importers of Russian goods be affected by the conditions?

ANSWER: U.S. importers will likely experience higher prices, because the Russian inflation may not be
completely offset by the decline in the ruble’s value. This may cause a reduction in the U.S. demand for
Russian goods.
12. IFE Applied to the Euro. Given the recent conversion of several European currencies to the euro,
explain what would cause the euro’s value to change against the dollar according to the IFE.
ANSWER: If interest rates change in these European countries whose home currency is the euro, the
expected inflation rate in those countries change, so that the inflation differential between those countries
and the U.S. changes. Thus, there may be an impact on the value of the euro, because a change in the
inflation differential affects trade flows and therefore affects the exchange rate.
Advanced Questions
13. Integrating IRP and IFE. Assume the following information is available for the U.S. and Europe:
U.S. Europe
Nominal interest rate 4% 6%
Expected inflation 2% 5%
Spot rate ----- $1.13
One-year forward rate ----- $1.10
a. Does IRP hold?
b. According to PPP, what is the expected spot rate of the euro in one year?
c. According to the IFE, what is the expected spot rate of the euro in one year?
d. Reconcile your answers to parts (a). and (c).
ANSWER:
( ) ( )
a. ( )
1.89%
( )
Therefore, the forward rate of the euro should be $1.13 × (1 – 1.89%) = $1.109.
IRP does not hold in this case.
( ) ( )
b. ( )
( )
According to PPP, the expected spot rate of the euro in one year is $1.13 × (1 – 2.86%) = $1.098.
( ) ( )
c. ( )
1.89%
( )
According to the IFE, the expected spot rate of the euro in one year is $1.13 × (1 – 2.86%) = $1.098.
d. Parts a and c combined say that the forward rate premium or discount is exactly equal to the expected
percentage appreciation or depreciation of the euro.
15. 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 rate
(by affecting the demand for the currency and the supply of the currency for sale). The effect on the
exchange rate is more likely to occur if (a) free trade is allowed and (b) the currency’s exchange rate is
allowed to fluctuate without any government intervention. The underlying force of IFE is the differential
in expected inflation between two countries, which can affect trade and capital flows. The effects on the
exchange rate are more likely to occur if (a) free trade is allowed, and (b) the currency’s exchange rate is
allowed to fluctuate without government intervention.
16. 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 whatever
the local risk-free interest rate is in Mexico. Ed’s expected rate of return is whatever the risk-free rate is in
the U.S. (based on the IFE).
17. 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
differential, and the expected spot rate (if you do not hedge) according to IFE reflects the interest rate
differential.

CHAPTER 9
Forecasting Exchange Rates
1. Motives for Forecasting. Explain corporate motives for forecasting exchange rates.
ANSWER: Several decisions of MNCs require an assessment of the future. Future exchange rates will
affect all critical characteristics of the firm such as costs and revenues. To be more specific, various
operations of MNCs use exchange rate projections, including hedging, short-term financing and investing,
capital budgeting decisions, long-term financing, and earnings assessment. Such operations will be more
effective if exchange rates are forecasted accurately.
2. Fundamental Forecasting. Explain the fundamental technique for forecasting exchange rates. What
are some limitations of using a fundamental technique to forecast exchange rates?
ANSWER: Fundamental forecasting is based on underlying relationships that are believed to exist
between one or more variables and a currency’s value. Given these relationships, a change in one or more
of these variables (or a forecasted change in them) will lead to a forecast of the currency’s value.
Even if a fundamental relationship exists, it is difficult to accurately quantify that relationship in a form
applicable to forecasting. Even if the relationship could be quantified, there is no guarantee that the
historical relationship will persist in the future. It is difficult to determine the lagged impact of some
variables. It is also difficult to incorporate some qualitative factors into the model.
3. Mixed Forecasting. Explain the mixed technique for forecasting exchange rates.
ANSWER: Mixed forecasting involves a combination of two or more techniques. The specific
combination can differ in terms of techniques included and the weight of importance assigned to each
technique.
4. Measuring Forecast Accuracy. You are hired as a consultant to assess a firm’s ability to forecast. The
firm has developed a point forecast for two different currencies presented in the following table. The firm
asks you to determine which currency was forecasted with greater accuracy.
ANSWER:
Yen Actual Pound Actual
Period Forecast Yen Value Forecast Pound Value
1 $.0050 $.0051 $1.50 $1.51
2 .0048 .0052 1.53 1.50
3 .0053 .0052 1.55 1.58
4 .0055 .0056 1.49 1.52
Absolute Forecast Error as a Percentage of the Realized Value
Period Yen Forecast Pound Forecast
1 1.96% .66%
2 7.69 2.00
3 1.92 1.89
4 1.78 1.97
Mean 3.34% 1.63%
Because the mean absolute forecast error of the pound is lower than that of the yen, the pound was
forecasted with greater accuracy.
5. Consistent Forecasts. Lexington Co. is a U.S.-based MNC with subsidiaries in most major countries.
Each subsidiary is responsible for forecasting the future exchange rate of its local currency relative to the
U.S. dollar. Comment on this policy. How might Lexington Co. ensure consistent forecasts among the
different subsidiaries?
ANSWER: If each subsidiary uses its own data and techniques to forecast its local currency’s exchange
rate, its forecast may be inconsistent with forecasts of other currencies by other subsidiaries. Subsidiary

forecasts could be consistent if forecasts for all currencies were based on complete information from all
subsidiaries (its beta).
6. Foreign Exchange Market Efficiency. Assume that foreign exchange markets were found to be weak-
form efficient. What does this suggest about utilizing technical analysis to speculate in euros? If MNCs
believe that foreign exchange markets are strong-form efficient, why would they develop their own
forecasts of future exchange rates? That is, why wouldn’t they simply use today’s quoted rates as
indicators about future rates? After all, today’s quoted rates should reflect all relevant information.
ANSWER: Technical analysis should not be able to achieve excess profits if foreign exchange markets
are weak-form efficient.
Today’s rates do not provide information about the range of possible outcomes. MNCs may desire to
assess the range of possible outcomes.
7. Forecasting Exchange Rates of Currencies That Previously Were Fixed. When some countries in
Eastern Europe initially allowed their currencies to fluctuate against the dollar, would the fundamental
technique based on historical relationships have been useful for forecasting future exchange rates of these
currencies? Explain.
ANSWER: Fundamental forecasting typically relies on historical relationships between economic factors
and exchange rate movements. However, if exchange rates were not allowed to move in the past,
historical relationships would not help predict future exchange rates of these currencies.
8. Forecasting the Euro. Cooper, Inc., a U.S.-based MNC, periodically obtains euros to purchase
German products. It assesses U.S. and German trade patterns and inflation rates to develop a fundamental
forecast for the euro. How could Cooper possibly improve its method of fundamental forecasting as
applied to the euro?
ANSWER: It should use data for all countries participating in the euro (not just the German data), as the
euro’s exchange rate is affected by all transactions between euros and dollars, not just the German
transactions.
9. Forecasting Based on PPP versus the Forward Rate. You believe that the Singapore dollar’s
exchange rate movements are mostly attributed to purchasing power parity. Today, the nominal annual
interest rate in Singapore is 18%. The nominal annual interest rate in the U.S. is 3%. You expect that
annual inflation will be about 4% in Singapore and 1% in the U.S. Assume that interest rate parity holds.
Today the spot rate of the Singapore dollar is $.63. Do you think the one-year forward rate would
underestimate, overestimate, or be an unbiased estimate of the future spot rate in one year? Explain.
ANSWER: The forward rate will likely underestimate the future spot rate. The inflation differential
suggests that the Singapore dollar should decline slightly. Yet, the forward rate would have a large
discount due to the interest differential. Thus, the forward rate would predict a very weak Singapore
dollar, which means that it would underestimate the future spot rate.
Advanced Questions
10. Probability Distribution of Forecasts. Assume that the following regression model was applied to
historical quarterly data:
et = a0 + a1INTt + a2INFt-1 + mt
Where et = percentage change in the exchange rate of the Japanese yen in period t
INTt = average real interest rate differential (U.S. interest rate minus Japanese interest rate) over
period t
INFt-1 = inflation differential (U.S. inflation rate minus Japanese inflation rate) in the previous period
a0, a1, a2 = regression coefficients
mt = error term
Assume that the regression coefficients were estimated as follows:
a0 = 0.0
a1 = 0.9
a2 = 0.8

Also assume that the inflation differential in the most recent period was 3 percent. The real interest rate
differential in the upcoming period is forecasted as follows:
Interest Rate
Differential Probability
0% 30%
1 60
2 10
If Stillwater, Inc., uses this information to forecast the Japanese yen’s exchange rate, what will be the
probability distribution of the yen’s percentage change over the upcoming period?
ANSWER:
Forecast of Forecast of the
Interest Rate Percentage Change
Differential in the Japanese Yen Probability
0% .9(0%) + .8(3%) = 2.4% 30%
1% .9(1%) + .8(3%) = 3.3% 60%
2% .9(2%) + .8(3%) = 4.2% 10%
11. Effect of September 11 on Forward Rate Forecasts. The September 11, 2001 terrorist attack on the
U.S. was quickly followed by lower interest rates in the U.S. How would this affect a fundamental
forecast of foreign currencies? How would this affect the forward rate forecast of foreign currencies?
ANSWER: Lower interest rates in the U.S. reduce the capital flows into the U.S., which places upward
pressure on foreign currencies against the dollar.
The forward rates of foreign currencies would have more pronounced discounts, or a higher premium,
which implies that the forecasts were revised to either reflect a smaller degree of depreciation of the
foreign currency than the forecast before September 11, or a higher degree of appreciation of the foreign
currency than the forecast before September 11.
12. Forecasting Latin American Currencies. The value of each Latin American currency relative to the
dollar is dictated by supply and demand conditions between that currency and the dollar. The values of
Latin American currencies have generally declined substantially against the dollar over time. Most of
these countries have high inflation rates and high interest rates. The data on inflation rates, economic
growth, and other economic indicators are subject to error, as limited resources are used to compile the
data.
a. If the forward rate is used as a market-based forecast, will this rate result in a forecast of appreciation,
depreciation, or no change in any particular Latin American currency? Explain.
ANSWER: The forward rate of each Latin American currency would have a large discount, because the
Latin American interest rate would be much higher than the U.S. interest rate. The discount serves as the
forecast of the percentage change in the value of the Latin American currency over the length of time
represented by the forward contract period.
b. If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no change
in the value of a specific Latin American currency? Explain.
ANSWER: Technical forecasting would result in a forecast of depreciation, because the Latin American
currencies have declined consistently in the past, and most technical methods would apply the past trends
to the future.
c. Do you think that U.S. firms can accurately forecast the future values of Latin American currencies?
Explain.
ANSWER: U.S. firms cannot forecast Latin American currency values accurately, because they are so
volatile. U.S. firms even have trouble forecasting the values of currencies of industrialized countries. The
values change in response to economic conditions, which are volatile and difficult to anticipate. The
values are also affected by political conditions, which are also difficult to predict.
13. Comparing Market-based Forecasts. For all parts of this question, assume that interest rate parity
exists, the prevailing one-year U.S. nominal interest rate is low, and that you expect the U.S. inflation to
be low this year.

a. Assume that the country Dinland engages in much trade with the U.S. and the trade involves many
different products. Dinland has had a zero trade balance with the U.S. (the value of exports and imports is
about the same) in the past. Assume that you expect a high level of inflation (perhaps about 40%) in
Dinland over the next year because of a large increase in the prices of many products that Dinland
produces. Dinland presently has a one-year risk-free interest rate of more than 40%. Do you think that the
prevailing spot rate or the one-year forward rate would result in a more accurate forecast of Dinland’s
currency (the din) one year from now? Explain.
ANSWER: The high inflation should create a shift in international trade, which will place severe
downward pressure on the value of the din. Since the forward rate of the din would have a large discount,
it should provide a better forecast than the spot rate.
b. Assume that the country Freeland engages in much trade with the U.S. and the trade involves many
different products. Freeland has had a zero trade balance with the U.S. (the value of exports and imports
is about the same) in the past. You expect high inflation (perhaps about 40%) in Freeland over the next
year because of a large increase in the cost of land (and therefore housing) in Freeland. You believe that
the prices of products that Freeland produces will not be affected.
Freeland presently has a one-year risk-free interest rate of more than 40%. Do you think that the
prevailing one-year forward rate of Freeland’s currency (the fre) would overestimate, underestimate, or be
a reasonably accurate forecast of the spot rate one year from now? [Presume a direct quotation of the
exchange rate, so that if the forward rate underestimates, it means that its value is less than the realized
spot rate in one year. If the forward rate overestimates, it means that its value is more than the realized
spot rate in one year.]
ANSWER: The inflation in Freeland does not affect the trade balance between the U.S. and Freeland.
Therefore, the value of Freeland’s currency should not be substantially affected by trade flows. Since the
forward rate of the fre would contain a large discount, it would likely underestimate the spot of the fre in
one year.


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Manual of International Financial Management Jeff Madura 10Th Edition

Edited by M. Kashif Khurshid

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8. Effects of a Forward Contract. How can a forward contract backfire?

11. Using Currency Futures.

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Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

$1,000,000/$.50 = NZ$2,000,000 × (1.06)

NZ$1,000,000 × $.50 = $500,000 × (1.10)

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Mean 3.34% 1.63%

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

Edited by M. Kashif Khurshid

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