Assignment – II

I need all the steps, what I delivered in our class and refer the textbook to get more idea
for the answers
1. Exposure to International Flow of Funds
Ben Holt, chief financial officer (CFO) of Blades, Inc., has decided to counteract the decreasing demand for
“Speedos” roller blades by exporting this product to Thailand. Furthermore, due to the low cost of rubber
and plastic in Southeast Asia, Holt has decided to import some of the components needed to manufacture
“Speedos” from Thailand. Holt feels that importing rubber and plastic components from Thailand will
provide Blades with a cost advantage (the components imported from Thailand are about 20 percent cheaper
than similar components in the United States). Currently, approximately $20 million, or 10 percent, of
Blades’ sales are contributed by its sales in Thailand. Only about 4 percent of Blades’ cost of goods sold is
attributable to rubber and plastic imported from Thailand.

Blades faces little competition in Thailand from other U.S. roller blades manufacturers. Those competitors
that export roller blades to Thailand invoice their exports in U.S. dollars. Currently, Blades follows a policy
of invoicing in Thai baht (Thailand’s currency). Ben Holt felt that this strategy would give Blades a
competitive advantage, since Thai importers can plan more easily when they do not have to worry about
paying differing amounts due to currency fluctuations. Furthermore, Blades’ primary customer in Thailand
(a retail store) has committed itself to purchasing a certain number of “Speedos” annually if Blades will
invoice in baht for a period of three years. Blades’ purchases of components from Thai exporters are
currently invoiced in Thai baht.

Ben Holt is rather content with current arrangements and believes the lack of competitors in Thailand, the
quality of Blades’ products, and its approach to pricing will ensure Blades’ position in the Thai roller blade
market in the future. Holt also feels that Thai importers will prefer Blades over its competitors because
Blades invoices in Thai baht.

You, Blades’ financial analyst, have doubts as to Blades “guaranteed” future success. Although you believe
Blades’ strategy for its Thai sales and imports is sound, you are concerned about current expectations for the
Thai economy. Current forecasts indicate a high level of anticipated inflation, a decreasing level of national
income, and a continued depreciation of the Thai baht. In your opinion, all these future developments could
affect Blades financially given the company’s current arrangements with its suppliers and with the Thai
importers. Both Thai consumers and firms might adjust their spending habits should certain developments
occur.

In the past, you have had difficulty convincing Ben Holt that problems could arise in Thailand.
Consequently, you have developed a list of questions for yourself, which you plan to present to the
company’s CFO after you have answered them.

Your questions are listed here:

a. How could a higher level of inflation in Thailand affect Blades (assume U.S. inflation remains
constant)?
b. How could competition from fi rms in Thailand and from U.S. fi rms conducting business in Thailand
affect Blades?
c. How could a decreasing level of national income in Thailand affect Blades?
d. How could a continued depreciation of the Thai baht affect Blades? How would it affect Blades relative
to U.S. exporters invoicing their roller blades in U.S. dollars?
e. If Blades increases its business in Thailand and experiences serious financial problems, are there any
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 international agencies that the company could approach for loans or other financial assistance?

2. What are the Factors that Influence Exchange Rates, and explain each factor?

3. 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 Borrwing 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.
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.

4. Diamond Bank expects that the Singapore dollar will depreciate against the U.S. dollar from its
spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist:
Currency Lending Rate Borrwing Rate
U. S Dollar 7.0% 7.2%
Mexican Peso 22.0% 24.0%
Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing
the funds in U.S. dollars for 60 days. Estimate the profits (or losses) that could be earned from this
strategy. Should Diamond Bank pursue this strategy?

5. Assume the following information:

Beal Bank Yardley Bank
Bid price of New Zealand dollar $.401 $.398
Ask price of New Zealand $.404 $.400
dollar
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational
arbitrage, and compute the profit from this arbitrage if you had $1 million to use. What market forces
would occur to eliminate any further possibilities of locational arbitrage?

6. Assume the following information:

Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars NZ$3.02
Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect
triangular arbitrage, and compute the profit from this strategy if you had $1 million to use. What market
forces would occur to eliminate any further possibilities of triangular arbitrage?

7. Assume the following information:

Spot rate of Canadian dollar $.80

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 90-day forward rate of Canadian dollar $.79
90-day Canadian interest rate 4%
90-day U.S. interest rate 2.5%
Given this information, what would be the yield (percentage return) to a U.S. investor who used covered
interest arbitrage? (Assume the investor invests $1 million.) What market forces would occur to
eliminate any further possibilities of covered interest arbitrage?

8. Assume the following information:

Spot rate of Mexican peso $.100
180-day forward rate of Mexican peso $.098
180-day Mexican interest rate 6%
180-day U.S. interest rate 5%
Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos
to invest? Explain your answer.

9. 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. (Covered Interest Arbitrage in
Both Directions.)

10. The following information is available: (Covered Interest Arbitrage in Both Directions.)
 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 United States 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?

11. (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?
b. Can a U.S. fi rm benefit from investing funds in Germany using covered interest arbitrage?
c. Can a German subsidiary of a U.S. fi rm benefit by investing funds in the United States through covered
interest arbitrage?

12. Covered Interest Arbitrage. The South African rand has a one-year forward premium of 2 percent.
One-year interest rates in the United States 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?
Explain your answer.

13. Derivation of PPP.

14. Derivation of the IFE.

15. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is available:
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 U.S Mexico
Real rate of interest required by investors 2% 2%
Nominal interest rate 11% 15%
Spot rate - $.20
One-year forward rate - $.19
a. Use the forward rate to forecast the percentage change in the Mexican peso over the next year.
b. Use the differential in expected inflation to forecast the percentage change in the Mexican peso
over the next year.
c. Use the spot rate to forecast the percentage change in the Mexican peso over the next year.

16. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year
interest rates in Europe are 5 percent, while one-year interest rates in the United States are 3 percent.
Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros
back to dollars. The current spot rate of the euro is $1.10.
a) According to the IFE, what should the spot rate of the euro in one year be?
b) If the spot rate of the euro in one year is $1.00, what is Beth’s percentage return from her
strategy?
c) If the spot rate of the euro in one year is $1.08, what is Beth’s percentage return from her
strategy?
d) What must the spot rate of the euro be in one year for Beth’s strategy to be successful?

17. Assume the following information is available for the United States 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).

18. The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United
States is 2 percent. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.
a) What is the forward rate premium?
b) What is the one-year forward rate of the peso?
c) Based on the international Fisher effect, what is the expected change in the spot rate over the
next year?
d) If the spot rate changes as expected according to the IFE, what will be the spot rate in one year?
e) Compare your answers to (b) and (d) and explain the relationship.

19. Arbitrage and PPP. Assume that locational arbitrage ensures that spot exchange rates are properly
aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound is
$1.80. The spot rate of the Swiss franc is 0.3 pounds. You expect that the one-year inflation rate is 7
percent in the United Kingdom, 5 percent in Switzerland, and 1 percent in the United States. The one-
year interest rate is 6 percent in the United Kingdom, 2 percent in Switzerland, and 4 percent in the
United States. What is your expected spot rate of the Swiss franc in one year with respect to the U.S.
dollar? Show your work.

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20. Derivation of IRP.