Solution manual for Introduction to Finance: Markets, Investments, and Financial Management

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Markets, Investments, and Financial Management
Melicher Norton 15th edition

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 Chapter Six: International Finance and Trade

Chapter 6
International Finance and Trade
DISCUSSION QUESTIONS AND ANSWERS

1. What is the purpose of an international monetary system?

An international monetary system is designed to foster world trade, manage the flow of
financial capital, and determine currency exchange rates.

2. What is meant by the statement that the international monetary system has operated
mostly under a “gold standard”? What are the major criticisms associated with being
on a gold standard?

A gold standard exists when currencies of countries are convertible into gold at fixed
exchange rates. A gold standard has been in use for long periods in the past.

Major criticisms of being on a gold standard are: (1) as the volume of world trade
increases, the supply of new gold will fail to keep pace, and (2) there is a lack of an
international organization to monitor and report on whether countries are deviating from
the standard when it is in their own best interests.

3. Describe the Bretton Woods system for setting currency exchange rates. What are special
drawing rights (SDRs) and how are they used to foster world trade?

The Bretton Woods system was formulated in mid-1944 and was an international
monetary system in which the U.S. dollars was valued in gold and other exchange rates
were pegged to the dollar.

Special Drawing Rights is a reserve asset, consisting of a basket of currencies,

created by the International Monetary Fund to be used to make international payments
involving world trade.

4. What is an international monetary system based on “flexible exchange rates”?

An international monetary system based on flexible exchange rates is a system in which

currency exchange rates are determined by supply and demand

5. Describe the international monetary system currently in use.

Today, a large number of countries allow their currencies to float against other
currencies.

6. What is the European Union (EU)? How did it develop? Who are the current members of

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the EU?

The European Union (EU) is an organization established to promote trade and economic
development among European countries. Its history can be traced back to 1957 when a
treaty was agreed to that established the European Economic Community. This
organization became the European Community in 1978 and the Economic Union in
1944.

By 1995, there were 15 members of the European Union. Ten more members were
added in 2004. Two new members were added in 2007 and one in 2013. A listing of all
28 current members is provided in the text.

7. What is meant by the term eurozone members? Which countries are eurozone members?

The European Monetary Union (EMU) is an organization of European countries that

agreed to have a common overall monetary policy and the euro as their common
currency. It is common practice today to refer to the EMU as eurozone members. The
initial twelve members have grown to currently 18 eurozone (or EMU) members and are
a sub-set of the 28 current members of the EU.

The twelve members that originally joined the EMU are: Austria, Belgium, Finland,
France, Germany, Greece, Ireland, Italy Luxembourg, Netherlands, Portugal, and Spain.
The other three members of the 15-member EU existing in 1995, Denmark, Sweden,
and the United Kingdom, did not accept the euro as their common currencies. Slovenia,
Cyprus, Malta, Slovakia, Estonia, and Latvia bring the Eurozone membership total to 18
members.

8. What is the euro? Identify some of its distinguishing characteristics.

The euro is the official currency of the eighteen countries in the European Monetary
Union referred to as Eurozone members. The euro includes “gates” and “windows” for
the front of the bills. Designs of “bridges” are included on the reverse of bills. The
paper currency uses multicolored ink, 3D holographic images, and watermarks, to
thwart efforts to easily counterfeit the bills.

9. What types of financial crises have some countries in the EU faced in recent years?

The 2007-08 financial crisis impacted many European Union countries as it did the U.S.
However, the economies of many EU countries did not recover from the 2008-09
recession as the U.S. did, and high levels of unemployment remain. Because tax
receipts have lagged government expenditures, the national debt of many EU countries
has increased dramatically in recent years. Some EU countries (e.g., Greece) have been
forced into austerity government expenditure plans at a time when unemployment rates
remain high with the result being social unrest.

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10. What are currency or foreign exchange markets?

Foreign exchange markets of the world consist of a group of telephone, cable, and
electronic systems connecting the major financial centers. As such, these markets cannot
be visualized in terms of a specific geographical location. In a very narrow sense,
however, a local depository can be considered the relevant foreign exchange market for
the individual or business in terms of day-to-day business activity.

11. Explain the role of supply and demand as it relates to the establishment of exchange rates
between countries.
Exchange rates reflect the forces of supply and demand. In a “free” market in which
governmental controls are absent, exchange rates tend to move upward in response to an
increase in net demand and vice versa. Demand exists whenever it becomes necessary
for an individual or an institution of this country to make a payment to a foreigner.
Supply exists when a foreigner must make a payment to this country.

12. Describe the activities and economic role of the arbitrageur in international finance.
Arbitrage may be defined as the simultaneous, or nearly simultaneous, purchasing of
commodities, securities, or bills of exchange in one market and selling them in another
where the price is higher. In international exchange, variations in quotations between
countries at any time are quickly brought into alignment through the arbitrage activities
of international financiers who buy currency in the market in which the price is low and
sell it in the market in which it is high.

13. What is meant by the statement that foreign exchange quotations may be given in terms of
sight drafts, cable orders, and time drafts?
The cable order costs more than a banker’s sight draft because it reduces the balance of
the bank’s foreign deposit almost immediately. Banker’s time drafts cost less than both
of these because they involve a reduction in the balance of the foreign branch or
correspondent only after a specified period of time.

14. Describe the various ways by which an exporter may finance an international shipment of
goods. How may commercial banks assist the exporter in the collection of drafts?
Should an exporter have confidence in the foreign customer and be in a position to carry
sales to these customers on open book accounts, there is no reason why the arrangement
should not operate very much as it operates in domestic trade. There will, of course, be
the added complication involved when payment is made in a different currency. Goods
may be shipped by using a sight draft, requiring immediate payment, or a time draft,
which requires acceptance on the part of the importer and payment at a specified future
time. A draft is generally accompanied by an order bill of lading and papers such as
insurance receipts. The bill of lading gives title to the goods, and only its holder may
claim the merchandise from the transportation company.
A New York exporter who is dealing with a foreign importer with whom there has
been little relationship in the past may ship goods on the basis of a documentary draft

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that has been deposited for collection with the local bank. That bank, following the
specific instructions set out regarding the manner of collection, then forwards the draft
together with the accompanying documents to its correspondent bank in the foreign
country involved. The correspondent bank is instructed to hold the documents until
payment is made if a sight draft is used, or until acceptance is obtained if a time draft is
used. Remittance is made to the exporter when collection is made on the sight draft.

15. How do importers protect themselves against improper delivery of goods when they are
required to make payment as they place an order?
When the importer is required to make payment with the order but wishes some protection
against the failure of the exporter to make shipment in accordance with the provisions of
the order, the payment may be sent to a representative bank in the country of the exporter.
The bank is instructed not to release payment until certain documents are presented to the
bank to confirm shipment of the goods according to the terms of the transaction.

16. Describe the process by which an importing firm may substitute the credit of its bank for
its own credit in financing international transactions.
The importing firm substitutes the credit of its bank for its own through the use of a
commercial letter of credit. The commercial letter of credit may be described as a
written statement on the part of the bank to an individual or firm guaranteeing
acceptance and payment of a draft up to a specified sum if it is presented to the bank in
accordance with the terms of the commercial letter of credit. Figure 6.5 provides an
illustration of a commercial letter of credit.

17. How may a bank protect itself after having issued a commercial letter of credit on behalf
of a customer?

After having issued a commercial letter of credit, the bank, for added protection, may
prefer to establish an agency arrangement between the firm and the bank whereby the
bank retains title to the merchandise. A trust receipt is utilized to retain title to the
goods. Under the trust receipt, as the merchandise is sold, the proceeds from the sale are
turned over to the bank until the acceptance has been paid.

18. Describe the costs involved in connection with financing exports through bankers’
acceptances.
Two charges are involved in an export transaction based on the bankers’ acceptance.
First, the exporter typically permits her or his bank, or a correspondent bank, to hold the
acceptance until it is to be presented to the importer’s bank for payment. The exporter’s
bank or correspondent bank discounts the acceptance and deposits to the exporter’s
account the face of the acceptance less the discount. The exporter, therefore, pays a fee
to his or her bank for the privilege of receiving immediate payment from the transaction.
Second, a commission charge is paid to the importer’s accepting bank.

19. Describe the ultimate sources of funds for export financing with bankers’ acceptances.
How are acceptances acquired for investment by these sources?

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The ultimate sources of funds for export financing with bankers’ acceptances are
primarily foreign central banks and both foreign and domestic commercial banks. Non-
financial corporations also play a small role as a source of funds. There are relatively
few firms that deal in bankers’ acceptances. These dealers arrange nearly simultaneous
exchanges of purchases and sales.

20. Explain the role played by the Export-Import Bank in international trade. Do you
consider this bank to be in competition with private lending institutions?
The purpose of the Export-Import Bank is to aid in financing and to facilitate exports
and imports between the United States and other countries. The bank serves only to
supplement regular financial facilities and is not regarded as being in competition with
private lending institutions.

21. Commercial letters of credit, traveler’s letters of credit, and traveler’s checks all play an
important role in international finance. Distinguish among these three types of
instruments.

A commercial letter of credit is prepared by a bank and commits the bank to

acceptance and payment of a draft or order drawn on it up to a certain amount if the
terms of the letter of credit are met. In international trade, such letters of credit are
usually issued for a single transaction. The traveler’s letter of credit is similar except
the seller of the merchandise to be acquired is not known in advance. The traveler’s
letter of credit specifies a series of foreign banks against which the letter of credit may
be presented for acceptance. Again, a dollar limit is set for such letters of credit. The
traveler’s check is a convenience to individual travelers, although it may serve
commercial purposes as well. The traveler’s check is issued by an internationally
reputable financial institution, and the accepting party need only confirm the signature
of the person presenting the check. These checks are purchased at face value plus a fee
and are signed once when purchased and again in the presence of the institution
accepting the check.

22. Briefly indicate the problems facing the United States in its attempt to maintain
international financial equilibrium.
After World War II, the United States engaged in a massive program of international
aid. This, coupled with large military expenditures, more than offset a favorable U.S.
balance of trade (which existed until 1970). Competition in international markets in
terms of goods and services is intense, and since 1977 the balance of trade position of
the U.S. has become increasingly more negative (i.e., imports exceeding exports). The
heavy reliance on imported oil has been another major factor in the ongoing unfavorable
balance of trade position.

23. The U.S. international balance-of-payments position is measured in terms of the current
account balance. Describe the current account balance and indicate its major
components.

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The current account balance for 2011 is shown in Table 6.3. It gives U.S. international
transactions in terms of receipts and expenditures and, thus, shows the flow of income into
and out of the U.S. over a year. The current account balance is comprised of: (a) the
merchandise trade balance (merchandise exports minus merchandise imports); (b) the net
position of various other goods and services, which include military transactions,
investment income, and other service transactions; and (c) other adjustments in the form
of remittances, pensions, and other transfers, plus U.S. government grants (excluding
military).

The balance on goods generally became increasingly negative as we moved from the
1980s through 2011. See the presentation under the “Balance-of-Payments” heading in
the chapter.

24. Discuss the meaning of the capital account balance and identify its major components.
The capital account balance, except for statistical discrepancies, must exactly offset
deficits or surpluses in the current account. That is, changes in investments must be
recorded to offset differences between the flow of income into and out of the country.
The capital account balance includes: (a) changes in foreign government and private
investment in the U.S.; (b) changes in U.S. government and private investments or
holdings in foreign countries; and (c) changes in U.S. official reserve assets. The capital
account involves changes in terms of bank deposits, the holding of government and
corporate securities, investment in plant and equipment, loans, and other liabilities
involving international transfers and transactions. U.S. official reserve assets include
gold, Special Drawing Rights, the reserve position in the International Monetary Fund,
and foreign currency holdings.

EXERCISES AND ANSWERS

1. You are the owner of a business that has offices and production facilities in several
foreign countries. Your product is sold in all of these countries, and you maintain bank
accounts in the cities in which you have offices. At present you have short-term notes
outstanding at most of the banks with which you maintain deposits. This borrowing is to
support seasonal production activity. One of the countries in which you have offices is
now strongly rumored to be on the point of a devaluation, or lowering, of their currency
relative to that of the rest of the world. What actions might this rumor cause you to
take?

You could try to hedge against your financial claims in that country losing value by
moving some of the funds in your bank account to another country. In anticipation of
moving the funds, you could try to accelerate the collection of your receivables. You
might also slow down your payments on liabilities with the expectation of moving funds
back into the country after devaluation, receiving more local funds in so doing. Other
devices, such as dealing in futures contracts, may also be available to you.

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2. Explain the concept of “balance” as it relates to a nation’s balance of payments.

In one sense there is never a precise count that establishes a balance since it is
impossible to record all transactions that enter into the schedule. Hence, an item referred
to as statistical discrepancy solves that problem nicely. Aside from the practical matter
of counting, however, the schedule must always be in balance in a theoretical sense. For
example, while we can have deficits in our current account because our export of goods
and services are less than our imports, this difference must be made up in one or both of
the other parts of the schedule. It can be made up by a reduction in our gold reserves or
other reserve assets, or we can increase the amount that we owe abroad.

3. As an exporter of relatively expensive electronic equipment, you have a substantial

investment in the merchandise that you ship. Your foreign importers are typically small- or
medium-size firms without a long history of operations. Although your terms of sales
require payment upon receipt of the merchandise, you are concerned about the possible
problem of nonpayment and the need to reclaim merchandise that you have shipped. How
might the banking system assist and protect you in this situation?

As an exporter shipping merchandise to a little-known foreign customer, you can protect

yourself by forwarding certain documents to a bank in the town or city of the importer.
These documents provide for the foreign bank to release the merchandise at the shipping
terminal only when the importer provides the funds specified in the terms of sale. The
funds are then forwarded to you by the bank. Although you may consult a banking
directory to find a bank in the exporter’s community to direct the transaction, it is more
efficient to simply ask your banker for such information. Your banker is in a position to
not only provide a list of such banks but to identify one that he or she considers the most
appropriate.

4. As an importer of merchandise, you depend upon the sale of the merchandise for funds to
make payment. Although customary terms of sale are 90 days for this type of merchandise,
you are not well known to foreign suppliers because of your recent entry into business.
Furthermore, your suppliers require almost immediate payment to meet their own
expenses of operations. How might the banking systems of the exporter and importer
accommodate your situation?

This problem offers an excellent opportunity to describe the important role of banks in
international commerce. Before placing your order for merchandise you would obtain
from or through your local bank a commercial letter of credit. This letter of credit would
spell out the conditions under which the bank would accept a time draft drawn on it by
the exporter. Your order for merchandise along with the letter of credit would then be
forwarded to the exporter.

The exporter can, with confidence, ship the merchandise and submit to his or her
bank the time draft to be forwarded to the bank that issued the letter of credit. The
exporter’s bank “discounts” the draft, that is, deposits to the exporter’s account the

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Section Two Specific Suggestions by Chapter

amount of the sale less an interest charge for the 90 days that this draft will be
outstanding, (As specified in the problem, terms of sale are customarily 90 days for this
type of merchandise.) The exporter’s bank will now forward the draft to the bank that
has issued the letter of credit. That bank, after satisfying itself that the merchandise has
been shipped according to terms of sale, will “accept” the draft which now becomes a
bankers’ acceptance.
The banker’s acceptance may then be returned to the exporter’s bank or it may be
sold upon instructions from the exporter’s bank in the open market. If it is held by the
exporter’s bank for the 90 days, that bank has financed the transaction. If the draft is
sold in the open market, the funds are returned to the exporter’s bank and it is the third-
party’s financial interest that has financed the transaction. Sales in the open market are
ordinarily made in the country of the bank issuing the letter of credit since the draft will
usually sell at a lower interest rate. As the importer, you simply sign a promissory note
in favor of the bank that has issued the letter of credit in the amount to which that bank
has committed itself, and you receive the documents necessary to claim the merchandise
at the transportation terminal. Your sale of the merchandise provides the funds to meet
the obligation to the bank under the terms of the promissory note. Your bank then
forwards payment to the exporter’s bank when the 90-day banker’s acceptance matures
and is presented for payment.

5. As a speculator in the financial markets, you notice that for the last few minutes Swiss
Francs are being quoted in New York at a price of $0.5849 and in Frankfurt at $0.5851.
a. Assuming that you have access to international trading facilities, what action might
you take?

Purchase Swiss Francs in New York at $0.5849 and simultaneously sell Francs in
Frankfurt at $0.05851 in order to “lock in” a profit of $0.0002 per Franc. Such an
arbitrage activity involving one million Francs would produce a profit of $200,000.

b. What would be the effect of your actions and those of other speculators on these
exchange rates?
The arbitrage actions in Part (a) would cause the Franc prices in New York and in
Frankfurt to converge to a “same” new price.

6. You manage the cash for a large multinational industrial enterprise. As a result of credit
sales on 90-day payment terms you have a large claim against a customer in Madrid. You
have heard rumors of the possible devaluation of the Spanish peseta. What actions, if any,
can you take to protect your firm against the consequences of a prospective devaluation?

You could hedge against the devaluation of the Spanish peseta by entering into a futures
contract (discussed in the Appendix to Chapter 11) for the delivery of an amount of
pesetas equal to the value of the credit sales at the existing exchange rate today.

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7. Assume, as the loan officer of a commercial bank, one of your customers has asked for a
“commercial letter of credit” to enable his firm to import a supply of well-known French
wines. This customer has a long record of commercial success yet has large outstanding
debts to other creditors. In what way might you accommodate the customer and at the
same time establish protection for your bank?

The initial step in the process is for your customer (an importer) to substitute your
bank’s credit for its own through the use of a letter of credit issued by your bank. You
would not issue the letter of credit unless you are satisfied that your customer is in a
satisfactory financial condition. The letter of credit is sent to an exporter who draws a
draft on your bank for the price of the goods that are being sent to the importer. The
draft, shipping documents, etc., are forwarded to you. Once your bank is satisfied that
the terms of the letter of credit have been met, your bank accepts the draft which now
becomes a bankers’ acceptance. The shipping documents are transferred to your
customer who then acquires the goods that have been shipped by the exporter. For your
protection, the importer is required to deposit the proceeds from the sale of the goods in
its account at your bank until the amount of the bankers’ acceptance has been met. This
requirement provides some protection for your bank since funds are recovered as sales
are made.

8. For the entire year, the nation’s balance of trade with other nations has been in a
substantial deficit position, yet, as always, the overall balance of payments will be in
“balance.” Describe the various factors that accomplish this overall balance, in spite of
the deficit in the balance of trade.

Since the balance of payments must, by definition, always be in balance, any deficit in
the balance of trade must be offset by a surplus in the capital account balance. The
principal factor in the capital account is the net increase in investments in the U.S. by
foreign government and private investors.

9. Assume you are the international vice president of a small U.S.-based manufacturing
corporation. You are trying to expand your business in several developing countries.
You are also aware that some business practices are considered to be “acceptable” in
these countries but not necessarily in the United States. How would your react to the
following situations?

a. You met yesterday with a government official from one of the countries you would like
to make sales in. He said that he could speed up the process for acquiring the
necessary licenses for conducting business in his country if you would pay him for his
time and effort. What would you do?

We know that the concept of what is “acceptable” ethical behavior differs across
cultures and countries. In some countries it seems to be acceptable practice for
government officials and others to request “side” payments and even bribes as a
means for foreign companies being able to do business in these countries. Such

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actions are morally wrong. Furthermore, with this said, the Foreign Corrupt Practices
Act prohibits U.S. firms from bribing foreign officials. Violators of this Act are
subject to fines, prison time, and lost reputation. Business-related bribes are both
illegal and unethical.

b. You are trying to make a major sale of your firm’s products to the government of a
foreign country. You have identified the key decision maker. You are considering
offering the official a monetary payment if she would recommend buying your firm’s
products. What would you do?

See the comments for (a.) above.

c. Your firm has a local office in a developing country where you are trying to increase
business opportunities. Representatives from a local crime syndicate have
approached you and have offered to provide “local security” in exchange for a
monthly payment to them. What would you do?

Extortion payments are morally wrong. Furthermore, paying organized criminals is

not different from paying corrupt government officials. See the comments for (a.)
above.

PROBLEMS AND ANSWERS

1. Exchange rate relationships between the U.S. dollar and the euro have been quite
volatile. When the euro began trading at the beginning of 1999, it was valued at 1.17
U.S. dollars. By late-2000, a euro was worth only $.83 and peaked at $1.60 in mid-2008.
Calculate the percentage changes in the value of a euro from its initial value to its late-
2000 value and to its high mid-2008 value.

Beg.-1999 to late-2000 percentage change = (.83 – 1.17)/1.17 = -.34/1.17 = -.2906 or

-29.06%
Beg.-1999 to mid-2008 percentage change = (1.60 – 1.17)/1.17 = .43/1.17 = .3675 or
36.75%
Late-2000 to mid-2008 percentage change = (1.60 - .83)/.83 = .77/.83 = .9277 or
92.77%

2. Over a two-year period, the U.S. dollar equivalent of a euro increased from $1.3310 to
1.4116. Using the indirect quotation method, determine the currency per U.S. dollar for
each of these dates.

Beginning (First) Date: Indirect Quotation = 1/$1.3310 = .7513 euros

Ending (Second) Date: Indirect Quotation = 1/$1.4116 = .7084 euros

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3. Over a two-year period, the U.S. dollar equivalent of a euro increased from $1.3310 to
1.4116. Determine the percentage change of the euro between these two dates.

Percentage change = (1.4116 – 1.3310)/1.3310 = .0806/1.3310 = .0606 or 6.06%

4. A few years ago the U.S. dollar equivalent of a foreign currency was $1.2167. Today, the
U.S. dollar equivalent of a foreign currency is $1.3310. Using the indirect quotation
method, determine the currency per U.S. dollar for each of these dates.

A few years ago: Indirect Quotation = 1/$1.2167 = .8219 foreign currency

Today: Indirect Quotation = 1/$1.3310 = .7513 foreign currency

5. A few years ago the U.S. dollar equivalent of a foreign currency was $1.2167. Today, the
U.S. dollar equivalent of a foreign currency is $1.3310. Determine the percentage
change of the euro between these two dates.

Percentage change = (1.3310 – 1.2167)/1.267 = .1143/1.2167 = .0939 or 9.39%

The foreign currency has appreciated by nearly 9.4% relative to the U.S. dollar.

6. If the U.S dollar value of a British Pound is $1.95 and a euro is $1.55, calculate the
implied value of a euro in terms of a British Pound.

Implied value of a euro = 1.55/1.95 = .7949 British pounds

7. Assume a U.S. dollar is worth 10.38 Mexican Pesos and .64 euros. Calculate the implied
value of a Mexican Peso in terms of a euro.

Implied value of a Mexican Peso = .64/10.38 = .0617 euros

8. Assume that five years a euro was trading at a direct method quotation of $.8767. Also
assume that recently the indirect method quotation was .8219 euros per U.S. dollar.

a. Calculate euro “currency per U.S. dollar” five years ago.

1/$.8767 = 1.1406 euros

b. Calculate the “U.S. dollar equivalent” of a euro this year.

1/.8219 = $1.2167

c. Determine the percentage change (appreciation or depreciation) of the U.S. dollar

value of one euro between five years ago and this year.

% Euro Change = ($1.2167 - $.8767)/$.8767 = $.3400/$.8767 = 38.78%

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d. Determine the percentage change (appreciation or depreciation) of the U.S. dollar

value of the euro currency per U.S. dollar between five years ago and this year.

(1.1406 - .8219)/.8219 = .3187/.8219 = 38.78%

9. Assume that last year the Australian dollar was trading at $.5527, the Mexican peso at
$.1102, and the British pound was worth $1.4233. By this year the U.S. dollar value of an
Australian dollar was $.7056, the Mexican peso at $.0867, and the British pound was
$1.8203. Calculate the percentage appreciation or depreciation of each of these three
currencies between last year and this year.

Australian dollar:
($.7056 - $.5527)/$.5527 = $.1529/$.5527 = 27.7%
Mexican peso:
($.0867 - $.1102)/$.1102 = -$.0235/$.1102 = -21.3%
British pound:
($1.8203 - $1.4233)/$1.4233 = $.3970/$1.4233 = 27.9%

10. Assume that the Danish krone (DK) has a current dollar ($US) value of $0.18
.
a. Determine the number of DK that can be purchased with one $US.
$1.00/$0.18 = 5.556 Danish krone (DK) per one $US

b. Calculate the percentage change (appreciation or depreciation) in the Danish krone

if it falls to $0.16.

($0.16 – $0.18)/$0.18 = –$0.02/$0.18 = –11.1%

c. Calculate the percentage change (appreciation or depreciation) in the U.S. dollar if

the DK falls to $0.16.

[($1.00/$0.16) – ($1.00/$0.18)]/($1.00/$0.18) = (6.250 – 5.556)/5.556 = .694/5.556

= 12.5%

Note: The percentage increase in the U.S. dollar is not the same as the percentage
decrease in the DK because the “bases” from which the calculations are made are not
the same.

11. Assume the U.S. dollar ($US) value of the Australian dollar is $0.73 while the U.S. dollar
value of the Hong Kong dollar is $0.13
.
a. Determine the number of Australian dollars that can be purchased with one $US.

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$1.00/$0.73 = 1.370 Australian dollars per one $US

b. Determine the number of Hong Kong dollars that can be purchased with one $US.

$1.00/$0.13 = 7.692 Hong Kong dollars per one $US

c. In $US terms, determine how many Hong Kong dollars can be purchased with one
Australian dollar.

$0.73/$0.13 = 5.615 Hong Kong dollars per one Australian dollar

12. Assume one U.S. dollar ($US) can currently purchase 1.316 Swiss francs. However, it
has been predicted that one $US soon will be exchangeable for 1.450 Swiss francs.

a. Calculate the percentage change in the $US if the exchange rate change occurs.

(1.450 – 1.316)/1.316 = .134/1.316 = 10.2%

b. Determine the dollar value of one Swiss franc at both of the above exchange rates.

1/1.316 = $0.76

1/1.450 = $0.69

c. Calculate the percentage change in the dollar value of one Swiss franc based on the
above exchange rates.

($0.69 – $0.76)/$0.76 = –$0.07/$0.76 = –9.2%

13. Assume inflation is expected to be 3 percent in the United States next year compared
with 6 percent in Australia. If the U.S. dollar value of an Australian dollar is currently
$0.500, what is the expected exchange rate one-year from now based on purchasing
power parity?

FR1 = $0.500[(1.03)/(1.06)] = $0.500(.9717) = $0.486

14. Assume inflation is expected to be 8 percent in New Zealand next year compared with 4
percent in France. If the New Zealand dollar value of a euro $0.400, what is the
expected exchange rate one-year from now based on purchasing power parity?

FR1 = $0.400[(1.08)/(1.04)] = $0.400(1.0385) = $0.415

15. Assume the interest rate on a one-year U.S. government debt security is currently 9.5
percent compared with a 7.5 percent on a foreign country’s comparable maturity debt

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security. If the U.S. dollar value of the foreign country’s currency is $1.50, what is the
expected exchange rate one year from now based on interest rate parity (IRP)?

FR1 = $1.50[(1.095/1.075)] = $1.50(1.0186) = $1.528

16. Assume the interest rate in Australia on one-year government debt securities is 10
percent and the interest rate on Japanese one-year debt is 5 percent. Assume the
current Australian dollar value of the Japanese yen is $0.0200. Using interest rate
parity (IRP), estimate the expected value of the Japanese yen in terms of Australian
dollars one-year from now.

FR1 = $0.0200[(1.10)/(1.05)] = $0.0200(1.0476) = $0.0210

17. Challenge Problem Following are currency exchange “crossrates” between pairs of
major currencies. Currency crossrates include both direct and indirect methods for
expressing relative exchange rates.

U.S. U.K. Swiss Japanese European

Dollar Pound Franc Yen Euro
European
Monetary Union 1.1406 ? 0.6783 0.0087 ---
Japan 130.66 185.98 77.705 --- 114.60
Switzerland 1.6817 2.3936 --- 0.0129 ?
United Kingdom ? --- 0.4178 ? 0.6162
United States --- 1.4231 ? 0.0077 0.8767

a. Fill in the missing exchange rates in the crossrates table.

European Union with UK Pound = 1/(United Kingdom with Euro) = 1/0.6162 =

1.6228
Switzerland with Euro = 1/(European Union with Sfranc) = 1/0.6783 = 1.4743
United Kingdom with $U.S. = 1/(United States Dollar with UK Pound) = 1/1.4231 =
.7027
United Kingdom with Yen = 1/(Japan with UK Pound) = 1/185.98 = 0.0054
United States with Sfranc = 1/(Switzerland with $U.S.) = 1/1.6817 = .5946

b. If the inflation rate is expected to be 3 percent in the European Monetary Union

(EMU) and 4 percent in the United States next year, estimate the forward rate of one
euro in U.S. dollars one year from now.

FR1 = SR0[(1 + US inflation rate)/(1 + EU inflation rate)] = $.8767(1.04/1.03) =

$.8767(1.010) = $.8855

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Solution manual for Introduction to Finance: Markets, Investments, and Financial Manageme

Chapter Six: International Finance and Trade

c. If the one-year government interest rate is 6 percent in Japan and 4 percent in the
United Kingdom, estimate the amount of Yen that will be needed to purchase one
British pound one year from now.

Indirect Method:
FR1 = SR0[(1 + Japan inflation rate)/(1 + UK inflation rate) = (185.98 Yen)(1.06/1.04)
= (185.98 Yen)(1.019) = 189.51 Yen

d. Based solely on purchasing power parity (PPP), calculate the expected one-year
inflation rate in the U.S. if the Swiss inflation rate is expected to be 3.5 percent next
year, and the one-year forward rate of a Swiss franc is $.6100.

SR0 $U.S. value of a Sfranc is 1/1.6817 = $.5946

$.6100 = $.5946(x/1.035)
x = ($.6100)/($.5946/1.035) = $.6100/$.5745 = 1.062
The expected one-year inflation rate in U.S. would be: 1.062 – 1.0 = .062 or 6.2 %
Check: FR1 = $.5946(1.062/1.035) = $.5946(1.026) = $.61006

e. Assume the U.S. dollar is expected to depreciate by 15 percent relative to the euro at
the end of one-year from now and the interest rate on one-year government securities
in the EMU is 5.5 percent. What would be the current U.S. one-year government
security interest rate based solely on the use of interest rate parity to forecast forward
currency exchange rates?

Current Euro value in $U.S.: $.8767

$U.S. value after depreciation: -0.15 = (x - $.8767)/$.8767 = x = (1 – 0.15)$.8767 =
$.7452
Check: Percent Dollar Change: -15.00% = ($.7452 - $.8767)/$.8767 = -.1315/$.8767 =
-15.00%

$.7452 = $.8767(1.055/x)
x = ($.7452)/(1.055/$.8767) = $.7452/1.2034 = .900
The expected one-year U.S. interest rate would be: .900 – 1.00 = -.100 = -10.0%

Check: FR1 = $.8767(.900/1.055) = $.8767(.850) = $.7452

Of course it is not reasonable to have a negative one-year interest rate. Thus, interest
rate parity can not explain the expected 15% depreciation in the U.S. dollar.

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