Tutorial 3 Week 4_Solutions

FIN3IFM : International Financial Management Tutorial 03: Questions Semester 1, 2021 Subject Coordinator Dr Muhammad Al Mamun International Financial Management Tutorial Questions First 15 minutes: Please provide a summary of the week lecture materials Exchange Rate Equilibrium • Demand for a Currency • Supply of a Currency for Sale • Equilibrium Exchange Rate • Change in the Equilibrium Exchange Rate Factors that Influence Exchange Rates • Relative Inflation Rates • Relative Interest Rates • Relative Income Levels • Government Controls • Expectations • Interaction of Factors • Influence of Factors Across Multiple Currency Markets • Impact of Liquidity on Exchange Rate Adjustments History and Economics of Currency Standard • Classical gold standard: 1876-1913 • Interwar period: 1919-1944 • Bretton Woods system: 1945-1973 • Current ‘system’: 1973-present Exchange Rate Systems • fixed • freely floating • managed float • pegged Government Intervention Question 1: Here are the headlines from various newspapers that have a potential impact on the exchange rate of US$ against other currencies Transactions Nature of effect (demand & Outlook for US$ supply dynamics) Weakened Fed slashes main interest rate to Foreign demand for US near zero in a historic move deposits/treasuries will be designed to cushion the economic lower blow of coronavirus pandemic Stronger economic growth will Strengthen American Rescue Plan (ARP) will attract foreign investment which boost growth will increase the demand for the US dollar Weakened American Rescue Plan (ARP) is A higher level of deficit increasing the deficit increasing projection can increase sovereign risk sovereign risk and reduce foreign demand for US deposits Weakened China's foreign reserves suffer the A decline in China’s foreign biggest monthly fall on record reserve will increase the supply of dollars available for trade, putting downward pressure on the dollar Strengthen The currency war intensified after China devalues the yuan Weakened Indian economy is likely to grow A higher foreign economic by 12%, higher than initially growth is likely to attract US predicted by analysts investment in India Weakened China lifts the import quota on A higher Australian export is Australian wool by percent likely to increase the value of the Australian Dollar Question 2: ‘Should China be forced to alter the value of its currency?’ – Present the points supporting and opposing this motion What would be your final position? POINT: US politicians frequently suggest that China needs to increase the value of the Chinese yuan against the US dollar, even since China has allowed the yuan to float (within boundaries) The US politicians claim that the yuan is the cause of the large US trade deficit with China This issue is periodically raised not only with currencies tied to the dollar but also with currencies that have a floating rate Some critics argue that the exchange rate can be used as a form of trade protectionism That is, a country can discourage or prevent imports and encourage exports by keeping the value of its currency artificially low COUNTER-POINT: China might counter that its large balance of trade surplus with the US has been due to the differences in prices between the two countries and that it should not be blamed for the high US prices It might argue that the US trade deficit can be partially attributed to the very high prices in the US, which are necessary to cover the excessive compensation for executives and other employees at US companies The high prices in the US encourage companies and consumers to purchase goods from China Even if China’s yuan is revalued upward, this does not necessarily mean that the US companies and consumers will purchase US products They may shift their purchases from China to purchase products in Indonesia or other low-wage countries rather than buy more products from the US Thus, the underlying dilemma is not China, but any country that has lower costs of production than the US WHO IS CORRECT? Which argument you support? Offer your own opinion on this issue ANSWER: The issue is important because it affects the potential degree of economic growth in the US The sustained trade deficit with China may suggest that the yuan is overvalued, but if the yuan is revalued, the US may import more products from other countries where there are low costs of production Thus, the trade deficit with China may be reduced, but the overall trade deficit may remain Question 3: Some of the Latin currencies are persistently weak against US$ How can persistently weak currencies be stabilized? Argue for and against relevant prescriptions to solve this issue POINT: The currencies of some Latin American countries depreciate against the U.S dollar consistently The governments of these countries could attract more capital flows by raising interest rates and making their currencies more attractive They also could insure bank deposits so that foreign investors who invest in large bank deposits not need to worry about default risk Also, they could impose capital restrictions on local investors to prevent capital outflows COUNTER-POINT: Some Latin American countries have had high inflation, which encourages local firms and consumers to purchase products from the U.S instead By reducing inflation, these countries could relieve the downward pressure on their local currencies To reduce inflation, a country may have to reduce its economic growth temporarily These countries should not raise their interest rates in an attempt to attract foreign investment, because they will still not attract funds if investors fear that large capital outflows will occur at the first threat of continued depreciation WHO IS CORRECT? Which argument you support? Offer your own opinion on this issue ANSWER: There is no perfect solution but recognize the trade-offs The proposal to raise interest rates is not a good solution in the long run, because it will cause higher loan rates, and may slow down the economies in the long run Effective anti-inflationary policies are needed to prevent further depreciation However, the elimination of inflation that is caused by a wage-price spiral may cause some pain among the workers in the country, as some form of wage controls may be needed The government has various means of reducing inflation, but all of them can have adverse effects on the economy in the short run Question 4: Currency board What is the difference between central banks and currency boards? ANSWER: • In a pegged exchange system, a currency board (CB) is a monetary authority that is committed to maintaining the pegged exchange rate while renouncing independent monetary policy • Like a central bank, in a pegged system, a CB issues notes and coins (backed by the volume of pegged currency or other forms of deposits) and offers the service of converting local currency into the anchor currency at a fixed rate of exchange • However, the central bank still exists and performs the role of ‘lender of last resort’ for domestic banks If a country’s banking system fails, the central bank, not CB comes and bails them out • Unlike a central bank, a CB does not hold bank deposits earning interest and yielding profit Moreover, CB is not the government's bank and cannot influence interest rates by setting the discount rate Question 5: Every month, the U.S trade deficit figures are announced Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced a Why you think the trade deficit announcement sometimes has such an impact on foreign exchange trading? ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits and therefore has implications about supply and demand conditions in the foreign exchange market For example, if the trade deficit was larger than anticipated, and is expected to continue, this implies that the U.S demand for foreign currencies may be larger than initially anticipated Thus, the dollar would be expected to weaken Some speculators may take a position in foreign currencies immediately and could cause an immediate decline in the dollar b In some periods, foreign exchange traders not respond to a trade deficit announcement, even when the announced deficit is very large Offer an explanation for such a lack of response ANSWER: If the market correctly anticipated the trade deficit figure, then any news contained in the announcement has already been accounted for in the market The market should only respond to an announcement about the trade deficit if the announcement contains new information Question 6: 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: Lending Rate Borrowing Rate U.S dollar 8% 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: Borrow MXP70 million Convert the MXP70 million to dollars: MXP70,000,000 × $.15 = $10,500,000 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 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 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 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: Borrow $10 million Convert the $10 million to pesos (MXP): $10,000,000/$.15 = MXP66,666,667 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 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 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 The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 – $10,069,170 = $1,344,441 Question 7: (Reading list) In the reading list this week ‘Free exchange: Change for the dollar’ the author argues that the role of US$ as the reserve currency is secure, even though the dominance of the American economy is declining Briefly discuss the reason upon which such assertion is made Cite one example of why you would disagree with the author? ANSWER: The authors argue that a reserve-currency issuer should play an outsize role in global trade, which encourages partners to draw up contracts in its currency Moreover, the historical role as a global creditor helps to expand the use of the currency and encourage its accumulation in reserves History of monetary stability matters, too, as deep and open financial markets While the author points that America exhibits these attributes less than it used to, yet the greenback’s status is as secure as American global leadership The assertion is based on two premises: Firstly, the premise that America is not as weak relative to its rivals as often assumed Moreover, an often-fractious euro area and authoritarian China inspire still less confidence The euro’s members and China are saddled with their debt problems and potential crisis points Secondly, the fact that Dollar dominance also reflects factors that conventional economic analyses sometimes omit geopolitics Sterling ruled during a long period of increasing global integration to which Britain— as a financial, industrial, and military powerhouse—was central It was not just American economic superiority that put the dollar at the center of the postwar order, but it is unrivaled geopolitical might as well, which is used to reforge an integrated global economy Eichengreen, Mehl, & Chiţu, (2019) highlights the role of power politics in currency choice Question 8: (Self-preparation) What are the benefits and costs to the Indian Economy and Indian MNCs if Indian Rupee becomes the global reserve currency? ANSWER: Use the article in the Reading list “The costs and benefits of the US role as a reserve currency country” and prepare the answer Benefits: • The flexibility argument • The Income Advantage • The ability to influence the domestic policy of other countries Cost: • The Devaluation Constraint • The Burden of Supplying Reserves to Other Countries Additional Self-preparation Question for Final Exam: Assuming a change in the Thai baht’s value from a value of $0.022 to $0.026 in 30 days, the treasurer of Blades’ Inc would like to speculate on expected movements in the baht’s value over the next 30 days Blades can borrow either $10 million or the baht equivalent of this amount in US$ Furthermore, assume that the following short-term interest rates (annualized) are available to Blades: Currency Lending Rate Borrowing Rate Dollars 8.10% 8.20% Thai baht 14.80% 15.40% Design a speculation strategy for Blades Depreciation of the Baht from $0.022 to $0.020 Borrow Thai baht ($10,000,000/0.022) Convert the Thai baht to dollars ($454,545,454.50 million × $0.022) 454,545,454.50 10,000,000.00 Lend the dollars at 8.10% annualized, which represents a 0.68% return 10,068,000.00 over the 30-day period [computed as 8.10% × (30/360)] After 30 days, Blades would receive ($10,000,000 × (1 + 0068)) Use the proceeds of the dollar loan repayment (on Day 30) to repay 460,363,636.40 the baht borrowed The annual interest on the baht borrowed is 15.40% or 1.28% over the 30 days [computed as 15.40% × (30/360)] The total baht amount necessary to repay the loan is therefore (454,545,454.50 × (1 + 0128)) Number of dollars necessary to repay baht loan ($THB460,363,636.40 × $0.02) Speculative profit ($10,068,000 – $9,207,272.73) 9,207,272.73 860,727.27 Additional Questions from Textbook: Q 13, Q 19 Reference: Eichengreen, B., Mehl, A., & Chiţu, L (2019) Mars or Mercury? The geopolitics of international currency choice Economic Policy, 34(98), 315-363  ... MXP70,169,167 × $.14 = $9,8 23, 6 83 After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of: $10,5 23, 333 – $9,8 23, 6 83 = $699,650 b Assume... the 30 -day period [computed as 8.10% × (30 /36 0)] After 30 days, Blades would receive ($10,000,000 × (1 + 0068)) Use the proceeds of the dollar loan repayment (on Day 30 ) to repay 460 ,36 3, 636 .40... market at 8.5% annualized over a 30 -day period The amount accumulated in 30 days is: MXP66,666,667 × [1 + (8.5% × 30 /36 0)] = 66,666,667 × [1.0070 83] = MXP67, 138 ,889 Repay the dollar loan The