Why would the Fed’s indirect intervention have a stronger impact on some currencies than others?

Chapter 6
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.
1. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some currencies than others? Why would a central bank’s Indirect intervention have a stronger impact than its direct intervention?
2. 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 this 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

b) The cost of 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
4. 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 this 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

b) The cost of 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
Chapter 7:
Assume the following information:

Beal Bank Yardley Bank
Bid price of New Zealand dollar $.401 $.398
Ask price of New Zealand dollar $.404 $.400

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 $1,000,000 to use. What market forces would occur to eliminate any further possibilities of locational arbitrage?

ANSWER: Yes, One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby gener¬ating a profit of $2,500.

The large demand for New Zealand dollars at Yardley Bank will force this bank’s ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial.
4. Triangular Arbitrage. 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 $1,000,000 to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage?
ANSWER: Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand dollars. Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what it should be. One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this strategy would generate $1,006,667 thereby representing a profit of $6,667.

[$1,000,000/$.90 = C$1,111,111 × 3.02 = NZ$3,355,556 × $.30 = $1,006,667]

The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the Canadian dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the U.S. dollar would fall.

17. Covered Interest Arbitrage in Both Directions. The one year interest rate in New Zealand is 6 percent. The one year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible.

ANSWER:
To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed initial investment, such as $1,000,000.

$1,000,000/$.50 = NZ$2,000,000 × (1.06)
= NZ$2,120,000 × $.54 = $1,144,800
Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%

Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S. interest rate of 10 percent.

To determine the yield from covered interest arbitrage by New Zealand investors, start with an assumed initial investment, such as NZ$1,000,000:

NZ$1,000,000 × $.50 = $500,000 × (1.10)
= $550,000/$.54 = NZ$1,018,519
Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 = 1.85%

Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of 1.85% is less than the 6% that they could receive from investing their funds in New Zealand.
35. Assume that the annual U.S. Interest rate is currently 6% and Germany;s annual interest rate is currently 8%. The spot rate of the euro is $1.10 and the 1-year forward rate of the euro is $1.10. Assume that as covered interest arbitrage occurs, the interest rates are not affected, and the spot rate is not affected. Explain how the 1-year forward rate of the euro will change in order to restore interest rate parity, and why it will change. Your explanation should specify which type of investor (German or U.S.) would be engaging in covered interest arbitrage, whether they are buying or selling euros forward, and how that affects the forward rate of the euro.
36. Assume that interest rate parity exists. As of this morning, the 1-month interest rate in Canada was lower than the 1-month interest rate in the United States. Assume that as a result of the Fed’s monetary policy this afternoon, the 1-month interest rate in the United States delined this afternoon, but was still higher than the Canadian 1-month interest rate. The 1-month interest rate in Canada remained unchanged. Based on the information,the forward rate of the Canadian dollar exhibited a ____ [discount or premium] this morning that _____[increased or decreased] this afternoon. Explain.
Chapter 8
1. PPP.Explain the theory of purchasing power parity (PPP).Based on this theory, what is a general forecast of the values of currencies in countries with high inflation?ANSWER:PPPsuggeststhatthepurchasingpowerofaconsumerwillbesimilarwhenpurchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country,theexchangeratewilladjusttomaintainequalpurchasing power.Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar.

5. Explain why PPP does not hold.

ANSWER: PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the manner sug¬gested by PPP) if substitutes are not available.
6. Implications of IFE. Explain the international Fisher effect (IFE). What is the rationale for the existence of the IFE? What are the implications of the IFE for firms with excess cash that consis¬tently invest in foreign Treasury bills? Explain why the IFE may not hold.

ANSWER: The IFE suggests that a currency’s value will adjust in accordance with the differential in interest rates between two countries.

The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currency’s value if it occurs.

The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills.

The IFE may not hold because exchange rate movements react to other factors in addi¬tion to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold.
21. Inflation and Interest Rate Effects. The opening of Russia’s market has resulted in a highly volatile Russian currency (the ruble). Russia’s inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia.

a. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble.

ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian goods would be low. Thus, the ruble’s value should depreciate against the dollar, and against other currencies.

b. Does the effect of Russian inflation on the decline in the ruble’s value support the PPP theory? How might the relationship be distorted by political conditions in Russia?

ANSWER: The general relationship suggested by PPP is supported, but the ruble’s value will not normally move exactly as specified by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the ruble may not decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the government may not allow the ruble to float freely to its proper equilibrium level.

c. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the perspective of Russian consumers (after considering exchange rates)? Explain.

ANSWER: Russian prices might be higher than U.S. prices, even after considering exchange rates, because the ruble might not depreciate enough to fully offset the Russian inflation. The exchange rate cannot fully adjust if there are barriers on trade or currency convertibility.

d. Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S. importers? That is, how will U.S. importers of Russian goods be affected by the conditions?

ANSWER: U.S. importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the ruble’s value. This may cause a reduction in the U.S. demand for Russian goods.
26. IRP. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. 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.

ANSWER:

a. According to interest rate parity, the forward premium is

b. The forward rate is $.14 × (1 – .07273) = $.1298.

c. According to the IFE, the expected change in the peso is:

or –7.273%

d. $.14 × (1 – .07273) = $.1298

e. The answers are the same. When IRP holds, the forward rate premium and the expected percentage change in the spot rate are derived in the same manner. Thus, the forward premium serves as the forecasted percentage change in the spot rate according to IFE.

31. Applying IRP and IFE. Assume that Mexico has a one-year interest rate that is higher than the U.S. one-year interest rate. Assume that you believe in the international Fisher effect (IFE), and interest rate parity. Assume zero transactions costs.

Ed is based in the U.S. and he attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of one year. Ed did not cover his position in the forward market.

Maria is based in Mexico and she attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars one year forward, investing the dollars in a risk-free asset for a year, and then converting the dollars back to pesos at the end of one year.

Do you think the rate of return on Ed’s investment will be higher than, lower than, or the same as the rate of return on Maria’s investment? Explain.

ANSWER: Maria’s rate of return will be higher. Since interest rate parity exists, she will earn whatever the local risk-free interest rate is in Mexico. Ed’s expected rate of return is whatever the risk-free rate is in the U.S. (based on the IFE).

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