SELF-TEST

1. Explain why it would be virtually impossible to set an exchange rate between the Japanese yen and the
U.S. dollar and to maintain a fixed exchange rate.
Market forces cause the supply and demand of yen in the market to change, which cause a change in the
equilibrium exchange rate.
The central banks could intervene to affect the supply or demand conditions but this would not always be
a blessing to offset the changing market forces
*Example: large increase in U.S. demand for yen and no increase in supply of yen for sale, central banks
would have to increase the supply of yen in the market to offset increased demand
2. Assume the Federal Reserve believes that the dollar should be weakened against the Mexican peso.
Explain how the Fed could use direct and indirect intervention to weaken the dollar’s value with respect
to the peso. Assume that future inflation in the United States is expected to be low, regardless of the Fed’s
actions.
The Fed could use direct intervention by selling some of its dollar reserves in exchange for pesos in the
market.
The Fed could use indirect intervention by attempting to reduce U.S. interest rates through monetary
policy.
*Specifically it could increase the U.S. money supply which places downward pressure on U.S. interest
rates (assuming that inflationary expectations do not change)
**Lower U.S. interest rates should discourage foreign investment in U.S. and encourage increased
investment by U.S. investors in foreign securities.
3. Briefly explain why the Federal Reserve may attempt to weaken the dollar.
-Increase in foreign demand for U.S. goods because the price paid for a specified amount in dollars by
non-U.S. firms is reduced.
-U.S. (domestic) demand for foreign goods is reduced because it takes more dollars to obtain a specified
amount in foreign currency once the dollar weakens.
*Both tend to stimulate the economy and improve productivity/reduce unemployment
4. Assume the country of Sluban ties its currency (the slu) to the dollar and the exchange rate will remain
fixed. Sluban has frequent trade with countries in the eurozone and the United States. All traded products
can easily be produced by all the countries, and the demand for these products in any country is very
sensitive to the price because consumers can shift to wherever the products are relatively cheap. Assume
that the euro depreciates substantially against the dollar during the next year.
a. What is the likely effect (if any) of the euro’s exchange rate movement on the volume of Sluban’s
exports to the eurozone? Explain.
Since the euro depreciated with respect to the US dollar, it has also depreciated with respect to the
pegged Sluban slu. This makes Sluban exports more expensive for European buyers and thus Sluban
exports to the eurozone should decrease.
b. What is the likely effect (if any) of the euro’s exchange rate movement on the volume of Sluban’s
exports to the United States? Explain
There should be no direct effect on Sluban exports to the US as the Sluban slu is pegged to the US dollar
so its export prices will not change. However, since eurozone imports to the US will now be cheaper
compared to Sluban imports, eurozone imported goods will replace some of the more expensive Sluban
imported goods. Thus, the euro depreciation will reduce Sluban exports to the US.

QUESTIONS AND APPLICATIONS

1. 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?
The government attempted to maintain exchange rates within 1% of the initially set value under the fixed
exchange rate systems. Government intervention would be non-existent under a freely floating system.
Governments will allow exchange rates to move according to market forces, intervening when necessary,
under a managed float system.
A freely floating exchange system may assist in correcting balance-of-trade deficits because the currency
will adjust according to market forces. Countries are also more insulated from problems of foreign
countries under a freely floating exchange rate system. A disadvantage is that firms are open to exchange
rate risk. Floating rates can also have a significantly negative impact on a country’s unemployment or
inflation.
2. 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 U.S. dollar. Can it apply central bank
intervention to achieve this objective? Explain.
The European Central Bank (ECB) controls the money supply of euros therefore Belgium cannot apply
intervention on its own. Belgium must adhere to intervention decisions made by the ECB.
3. 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.
To place upward pressure on a currency, the central banks use their currency reserves to buy large
quantities of a specific currency in the foreign exchange market. To force currency depreciation, central
banks can attempt to flood the market with a specific currency. Central bank intervention is used to
smooth exchange rate movements to help stabilize the economy and financial markets. Abrupt movements
in a currency’s value can result in volatile business cycles and concern in financial markets.
4. Indirect Intervention How can a central bank use indirect intervention to change the value of a
currency?
To increase the value of the home currency, the central bank can increase interest rates, sub sequentially
attracting foreign demand for the currency to purchase high-yield securities. To decrease the value, a
central bank can lower interest rates sub sequentially reducing foreign investors demand for the currency.
5. 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?
Normally the Federal Reserve considers a loose money policy to stimulate the economy. However, the
policy places upward pressure on economic growth and inflation, thus weakening the dollar. A week
dollar is favorable to US exporting, and adversely effects US importing. A rise in interest rates can offset
the downward pressure on the US dollar, which does not really affect US importing or exporting.
6. 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?
A weak home currency usually results in an increase in the country’s exports and a decrease in imports,
which also lowers unemployment. It can cause higher inflation due to a reduction in foreign competition
and local producers are able to greatly increase their prices without concern.
A strong home currency usually results in low inflation because consumers are encouraged to purchase
good from abroad. Local producers must keep prices low in competition with other producers. Foreign
supplies can be purchased for cheap prices which contributes to low inflation. However, unemployment
tends to increase due to a strong economy. This occurs due to the increase in imports and decrease in
exports, it become cheaper to import goods and exports become more expensive for foreign investors.
7. Feedback Effects Explain the potential feedback effects of a currency’s changing value on inflation.
Inflation is associated with a weak home currency because it causes a reduction in foreign competition,
causing inflation. Higher inflation further weakens a currency because consumers are encouraged to
purchase goods. On the contrary, a strong home currency reduces the price of foreign goods forcing
producers to offer competitive prices, which reduces inflation. Low inflation places upward pressure on
the home currency.
8. 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?
When a currency with a lower market demand experiences intervention, the impact of the intervention
can have greater effect on the supply and demand conditions. The central banks indirect intervention can
affect factors that affect influence exchange rates. Direct intervention is a method used to superficially
affect supple and demand conditions of a currency, which can be overwhelmed by market forces.
9. Effects on Currencies Tied to the Dollar The Hong Kong dollar’s value is tied to the U.S. dollar.
Explain how the following trade patterns would be affected by the appreciation of the Japanese yen
against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States.
a. Exports from Hong Kong to Japan should increase if the yen appreciates against the Hong Kong
dollar. The Hong Kong goods will be cheaper to Japanese importers.
b. Exports from Hong Kong to the US should increase because if the yen appreciates then Japanese goods
will become more expensive to US importers. The Hong Kong prices will be lower than Japanese prices,
despite the unchanged exchange rate, due to appreciation of the yen.
10. Intervention Effects on Bond Prices U.S. bond prices are normally inversely related to U.S.
inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected?
A weak dollar causes expectation of higher inflation because a weak dollar places upward pressure on
US prices. Higher inflation places upward pressure on interest rates and bond prices, and bond prices
will decline. This expectation causes portfolio managers to liquidate a portion of their bond holdings,
causing bond prices to drop.
11. Direct Intervention in Europe If most countries in Europe experience a recession, how might the
European Central Bank use direct intervention to stimulate economic growth?
The ECB could sell euros in the foreign exchange market, which may result in a depreciation of the euro
against other currencies. Therefore, there would be an increase in the demand of European imports.
12. Sterilized Intervention Explain the difference between sterilized and nonsterilized intervention.
Sterilized intervention is used to ensure there in no change in the money supply. Nonsterilized
intervention is used when there is no concern with maintaining money supply.
13. Effects of Indirect Intervention Suppose that the government of Chile reduces one of its key interest
rates. The values of several other Latin American currencies are expected to change substantially against
the Chilean peso in response to the news.
a. Explain why other Latin American currencies could be affected by a cut in Chile’s interest rates.
Interest rates play a role in exchange rates. When Chile’s interest rates decline, a smaller flow of funds is
exchanged into the Chilean pesos because the Chile interest rate is no longer attractive to investors.
Investors will look to other Latin American countries with higher interest rates. If these countries are
expected to lower their rates as well, they will not attract capital.
b. How would the central banks of other Latin American countries be likely to adjust their interest rates?
How would the currencies of these countries respond to the central bank intervention?
The central banks would likely lower interest rates, causing the currency to weaken. Weaker currencies
and low interest rates stimulate the economy.
c. How would a U.S. firm that exports products to Latin American countries be affected by the central
bank intervention? (Assume the exports are denominated in the corresponding Latin American currency
for each country.)
Exporters are adversely affected by the depreciation of Latin American currencies. The exporter is
favorably affected by the appreciation of Latin American currencies.
14. Freely Floating Exchange Rates Should the governments of Asian countries allow their currencies to
float freely? What would be the advantages of letting their currencies float freely? What would be the
disadvantages?
A freely floating currency allows the exchange rate to adjust to market conditions, stabilizing flow of
funds between countries. Exchange rates weaken when there is a larger outflow of funds than inflow due
to the forces and flows may change because the currency will be cheaper, discouraging outflows.
However, speculators may take positions that force the free-floating currency to deviate from the
perceived desirable exchange rate.
15. Indirect Intervention During the Asian crisis, some Asian central banks raised their interest rates to
prevent their currencies from weakening. Yet, the currencies weakened anyway. Offer your opinion as to
why the central banks’ efforts at indirect intervention did not work.
Investors had no confidence the currencies were going to stabilize so they were not conducting business
in Asia. Higher interest rates failed to attract investors and an inflow of funds to offset the outflow.

Advanced Questions
16. 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 report 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.
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.
17. Effects of September 11 Within a few days after the September 11, 2001, terrorist attack on the
United States, the Federal Reserve reduced short-term interest rates to stimulate the U.S. economy. How
might this action have affected the foreign flow of funds into the United States and affected the value of
the dollar? How could such an effect on the dollar have increased the probability that the U.S. economy
would strengthen?
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.
18. 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 U.S. 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$).
Briefly explain each answer.
a. The volume of the sales should decline as the cost to consumers who finance their purchases would rise
due to the higher interest rates.
b. The cost of purchasing materials should decline because the A$ 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.
19. Pegged Currencies Why do you think a country suddenly decides to peg its currency to the dollar or
some other currency? When a currency is unable to maintain the peg, what do you think are the typical
forces that break the peg?
A country will usually attempt a peg to reduce speculative flows that occur because of exchange rate
volatility. It tries to comfort investors by making them believe that the currency will be stable. In some
cases, the peg is broken when there are adverse conditions in the country that make investors believe that
the peg will be broken. For example, foreign investors become concerned that if the peg breaks, the
currency may decline by 20 percent or more against their home currency. This would adversely affect the
return on their investment, so they attempt to liquidate their investment and move their fund out of that
currency before the peg breaks. If many investors have this concern simultaneously, they are all selling
that currency at the same time. They place downward pressure on the currency because there is a larger
supply of the currency for sale than the demand for the currency. The central bank may attempt to offset
these forces by buying the currency in the foreign exchange market. However, it has a limited amount of
that currency as a reserve, and may be overwhelmed by market forces.
20. Impact of Intervention on Currency Option Premiums Assume that the central bank of the country
Zakow periodically intervenes in the foreign exchange market to prevent large upward or downward
fluctuations in its currency (the zak) against the U.S. dollar. Today, the central bank announced that it
would no longer intervene in the foreign exchange market. The spot rate of the zak against the dollar was
not affected by this news. Will the news affect the premium on currency call options that are traded on the
zak? Will the news affect the premium on currency put options that are traded on the zak? Explain.
It should cause the call option premium and put option premium to increase, because there is more
uncertainty surrounding the zak. The seller of a call or put option will require a higher premium on the
option, because the seller recognizes that the exchange rate may be more volatile than in the past.
21. Impact of Information on Currency Option Premiums As of 10:00 a.m., the premium on a specific
1-year call option on British pounds is $.04. Assume that the Bank of England had not been intervening in
the foreign exchange markets in the last several months. However, it announces at 10:01 a.m. that it will
begin to frequently intervene in the foreign exchange market in order to reduce fluctuations in the pound’s
value against the U.S. dollar over the next year, but it will not attempt to push the pound’s value higher or
lower than what is dictated by market forces. Also, the Bank of England has no plans to affect economic
conditions with this intervention. Most participants who trade currency options did not anticipate this
announcement. When they heard the announcement, they expected that the intervention would be
successful in achieving its goal. Will this announcement cause the premium on the 1-year call option on
British pounds to increase, decrease, or be unaffected? Explain.
The premium on the call option should decrease because pound's anticipated volatility should decrease in
response to the intervention.
22. Speculating Based on Intervention Assume that you expect that the European Central Bank (ECB)
plans to engage in central bank intervention in which it plans to use euros to purchase a substantial
amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct
intervention is expected to be successful at influencing the exchange rate.
a. Would you purchase or sell call options on euros today?
b. Would you purchase or sell futures on euros today?
a. The intervention should result in a weaker euro, so sell call options on euros today.
b. The intervention should result in a weaker euro, so sell futures on euros today.
23. Pegged Currency and International Trade Assume the Hong Kong dollar (HK$) value is tied to the
U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ = 0.25 Singapore dollars. Today, a
HK$ = 0.30 Singapore dollars. Assume that there is much trade in the computer industry among
Singapore, Hong Kong, and the United States and that all products are viewed as substitutes for each
other and are of about the same quality. Assume that the firms invoice their products in their local
currency and do not change their prices.
a. Will the computer exports from the United States to Hong Kong increase, decrease, or remain the
same? Briefly explain.
b. Will the computer exports from Singapore to the United States increase, decrease, or remain the same?
Briefly explain.
a. Decrease. The H.K. dollar appreciated against the Singapore dollar while fixed against US dollar, so it
should shift purchases to Singapore and away from the US.
b. Increase. The U.S. dollar appreciated against the Singapore dollar, so it is cheaper to buy goods in
Singapore.
24. Implications of a Revised Peg The country of Zapakar has much international trade with the United
States and other countries as it has no significant barriers on trade or capital flows. Many firms in Zapakar
export common products (denominated in zaps) that serve as substitutes for products produced in the
United States and many other countries. Zapakar’s currency (called the zap) has been pegged at 8 zaps =
$1 for the last several years. Yesterday, the government of Zapakar reset the zap’s currency value so that it
is now pegged at 7 zaps = $1.
a. How should this adjustment in the pegged rate against the dollar affect the volume of exports by
Zapakar firms to the United States?
b. Will this adjustment in the pegged rate against the dollar affect the volume of exports by Zapakar firms
to non-U.S. countries? If so, explain.
c. Assume that the Federal Reserve significantly raises U.S. interest rates today. Do you think Zapakar’s
interest rate would increase, decrease, or remain the same?
a. The zap’s value is higher. Demand for Zapakar’s exports will be reduced.
b. The zap’s value is higher against all currencies. The demand for Zapakar’s exports by non-U.S.
countries will be reduced.
c. A rise in the U.S. interest rate will be followed by a rise in Zapakar’s interest rate
25. Pegged Currency and International Trade Assume that Canada decides to peg its currency (the
Canadian dollar) to the U.S. dollar and that the exchange rate will remain fixed. Assume that Canada
commonly obtains its imports from the United States and Mexico. The United States commonly obtains
its imports from Canada and Mexico. Mexico commonly obtains its imports from the United States and
Canada. The traded products are always invoiced in the exporting country’s currency. Assume that the
Mexican peso appreciates substantially against the U.S. dollar during the next year.
a. What is the likely effect (if any) of the peso’s exchange rate movement on the volume of Canada’s
exports to Mexico? Explain.
b. What is the likely effect (if any) of the peso’s exchange rate movement on the volume of Canada’s
exports to the United States? Explain.
a. The peso appreciates against Canadian dollar, so Canadian exports to Mexico should increase.
b. The U.S should demand more from Canada (shift away from Mexico), so Canadian exports should
increase.
26. Impact of Devaluation The inflation rate in Yinland was 14 percent last year. The government of
Yinland just devalued its currency (the yin) by 40 percent against the dollar. Even though it produces
products similar to those of the United States, it has much trade with the United States and very little
trade with other countries. It presently has trade restrictions imposed on all non-U.S. countries. Will the
devaluation of the yin increase or reduce inflation in Yinland? Briefly explain.
The devaluation would increase inflation, because there is no competition from foreign producers.
27. Intervention and Pegged Exchange Rates Interest rate parity exists and will continue to exist. The
1-year interest rates in the United States and in the eurozone is 6 percent and will continue to be 6
percent. Assume that the country of Latvia’s currency (called the Lat) is presently pegged to the euro and
will remain pegged to the euro in the future. Assume that you expect that the European central bank
(ECB) to engage in central bank intervention in which it plans to use euros to purchase a substantial
amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct
intervention is expected to be successful at influencing the exchange rate.
a. Will the spot rate of the Lat against the dollar increase, decrease, or remain the same as a result of
central bank intervention?
b. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a result of
central bank intervention?
c. Would the ECB’s intervention be intended to reduce unemployment or reduce inflation in the
eurozone?
d. If the ECB decided to use indirect intervention instead of direct intervention to achieve its objective of
influencing the exchange rate, would it increase or reduce the interest rate in the eurozone?
e. Based on your answer to part (d), will the interest rate of Latvia increase, decrease, or remain the same
as a result of the ECB’s indirect intervention?
a. The spot rate of the euro will decline, and therefore the spot rate of the Lat will decline as well.
b. The forward rate of the euro will decline since it will move in tandem with the spot rate of the euro.
c. The intervention is intended to reduce unemployment (weaken currency in order to attract more
purchases of its products).
d. It could attempt to reduce its interest rate, which reduces the cost of borrowing, and may encourage
consumers and firms to borrow more and spend more.
e. The interest rate in Latvia would decrease because it would remain consistent with the euro's interest
rate since the Lat is pegged to the euro.
28. Pegged Exchange Rates The United States, Argentina, and Canada commonly engage in
international trade with each other. All the products traded can easily be produced in all three countries.
The traded products are always invoiced in the exporting country’s currency. Assume that Argentina
decides to peg its currency (called the peso) to the U.S. dollar and the exchange rate will remain fixed.
Assume that the Canadian dollar appreciates substantially against the U.S. dollar during the next year.
a. What is the likely effect (if any) of the Canadian dollar’s exchange rate movement over the year on the
volume of Argentina’s exports to Canada? Briefly explain.
b. What is the likely effect (if any) of the Canadian dollar’s exchange rate movement on the volume of
Argentina’s exports to the United States? Briefly explain.
a. The Canadian dollar appreciates against the U.S. dollar, so this means that the Canadian dollar will
also appreciate against the peso, which should increase the volume of Argentina’s exports to Canada.
b. The U.S should demand more from Argentina because imports are now cheaper there as compared to
in Canada, so the volume of Argentina's exports to the U.S. would increase.

BLADES, INC. CASE

1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.
The intervention effort by the Thai government constituted direct intervention, since the government
exchanged dollar reserves for baht in order to strengthen the currency. This action would increase the
demand for baht and the supply of dollars for sale, which puts upward pressure on the baht. In indirect
intervention, a central bank attempts to influence the value of a currency by influencing the factors that
determine it. For example, if the Thai government wanted to strengthen the baht, it could have increased
interest rates by decreasing the Thai money supply.
2. Did the intervention by the Thai government constitute sterilized or nonsterilized intervention? What is
the difference between the two types of intervention? Which type do you think would be more effective in
increasing the value of the baht? Why? (Hint: Think about the effect of nonsterilized intervention on U.S.
interest rates.)
The intervention by the Thai government constituted nonsterilized intervention.
Using nonsterilized intervention, a central bank intervenes in the foreign exchange market without
adjusting for the change in money supply. Using sterilized intervention, a central bank intervenes in the
foreign exchange market while retaining the money supply. Since the Thai government exchanged dollar
reserves for baht in the foreign exchange market, the dollar money supply is increased.
An increase in the money supply may decrease U.S. interest rates, which may additionally weaken the
dollar with respect to the baht. Therefore, nonsterilized intervention may compound the desired effects of
the intervention effort. If the Thai government’s objective is to increase the value of the baht, nonsterilized
intervention may be more effective.
3. If the Thai baht is virtually fixed with respect to the dollar, how could this affect U.S. levels of
inflation? Do you think these effects on the U.S. economy will be more pronounced for companies such
as Blades that operate under trade arrangements involving commitments or for firms that do not? How are
companies such as Blades affected by a fixed exchange rate?
Under a fixed exchange rate system, inflation may be exported from one country to another. For example,
if Thailand experienced relatively high levels of inflation during a fixed exchange rate system, Thai
consumers may have switched some of their purchases to U.S. products. Similarly, U.S. consumers may
have reduced their imports of Thai goods. This would send Thai production down and unemployment up.
Also, it could cause higher inflation in the U.S. due to the excessive demand for U.S. products. Thus, the
high inflation in Thailand could cause high inflation in the U.S.
For companies such as Blades, this effect would probably be more pronounced as their cost of production
would rise, but they export at a fixed price.
4. What are some of the potential disadvantages for Thai levels of inflation associated with the floating
exchange rate system that is now used in Thailand? Do you think Blades contributes to these
disadvantages to a great extent? How are companies such as Blades affected by a freely floating exchange
rate?
A freely floating exchange rate may compound Thailand’s inflationary problems. For example, if
Thailand experiences high levels of inflation, the baht may weaken. In turn, a weaker baht can cause
import prices to be higher, which can increase the prices of Thai materials and supplies and thus increase
the price of finished goods. Additionally, higher foreign prices (from the Thai perspective) can force Thai
consumers to purchase domestic products.
Blades does not contribute to these problems, as both its exports and imports are denominated in baht.
Consequently, a weaker baht would have no direct impact on companies importing from Blades.
Blades could still be affected by a freely floating exchange rate system, as it is now subject to exchange
rate risk when converting the net baht received to dollars.
5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed? How
will this affect Blades?
Under the terms of the agreement, completion of the swap arrangement requires Thailand to reverse the
swap of its baht reserves for dollars. Specifically, it will have to exchange dollars for baht at a future
date. Due to the decline in the value of the baht, however, Thailand’s central bank will need more baht to
be exchanged for the dollars needed to repay the other central banks. The purchase of dollars by the Thai
government in the foreign exchange market will increase the demand for dollars and the supply of baht
for sale, which will put downward pressure on the value of the baht.
Since Blades has net inflows in baht, it will be negatively affected by the completion of the swap
agreement if the actions needed to complete the agreement result in further weakening of the baht.

SMALL BUSINESS DILEMMA

1. Forecast whether the British pound will weaken or strengthen based on the information provided.
If the Bank of England floods the foreign exchange market with pounds, there will bedownward pressure
on the value of the pound. However, this pressure could be overwhelmed byother economic forces that
place upward pressure on the value of the pound.
2. How would the performance of the Sports Exports Company be affected by the Bank of England’s
policy of flooding the foreign exchange market with British pounds (assuming that it does not hedge its
exchange rate risk)?
The performance of the Sports Exports Company would be adversely affected by theBank of England’s
policy to flood the foreign exchange market with pounds because this policyplaces downward pressure on
the value of the pound. If the pound weakens, the receivables of theSports Exports Company will convert
to fewer dollars, which reflects a reduction in revenue.