9.1) The interest rate on South Korean government
securities with one-year maturity is 4% and the expected inflation rate for the
coming year is 2%. The
Drawing on what we know
about the Fisher effect, the real interest rate in both the
9.2) Two countries,
(a) According to PPP theory, what should the $/£ spot exchange rate be?
(b) Suppose the price of beef is expected to rise to $3.10 in the
(c) Given your answers to parts (a) and (b), and given that the current interest rate in the
(a) According to PPP, the
$/£ rate should be 2.80/3.70, or $0.76/£.
(b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or $0.67/£.
(c) Since the dollar is appreciating relative to the pound, and given the relationship of the international Fisher effect, the British must have higher interest rates than the
10.4) Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria for choosing between the systems? Which system is the more desirable for an international business?
The case for fixed exchange
rates rests on arguments about monetary discipline, speculation, uncertainty,
and the lack of connection between the trade balance and exchange rates. In terms of monetary discipline, the need to
maintain fixed exchange rate parity ensures that governments do not expand
their money supplies at inflationary rates.
In terms of speculation, a fixed exchange rate regime precludes the
possibility of speculation. In terms of
uncertainty, a fixed rate regime introduces a degree of certainty in the
international monetary system by reducing volatility in exchange rates. Finally, in terms of trade balance
adjustments, critics question the closeness of the link between the exchange
rate and the trade balance. The case for floating exchange rates has two main
elements: monetary policy autonomy and automatic trade balance
adjustments. In terms of the former, it
is argued that a floating exchange rate regime gives countries monetary policy
autonomy. Under a fixed rate system, a
country’s ability to expand or contract its money supply as it sees fit is
limited by the need to maintain exchange rate parity. In terms of the later, under the Bretton
Woods system, if a country developed a permanent deficit in its balance of
trade that could not be corrected by domestic policy, the IMF would agree to a
currency devaluation. Critics of this
system argue that the adjustment mechanism works much more smoothly under a
floating exchange rate regime. They
argue that if a country is running a trade deficit, the imbalance between the
supply and demand of that country’s currency in the foreign exchange markets
will lead to depreciation in its exchange rate.
An exchange rate depreciation should correct the trade deficit by making
the country’s exports cheaper and its imports more expensive. It is a matter of personal opinion in regard
to which system is better for an international business. We do know, however, that a fixed exchange
rate regime modeled along the lines of the Bretton Woods system will not
work. Nevertheless, a different kind of
fixed exchange rate system might be more enduring and might foster the kind of
stability that would facilitate more rapid growth in international trade and
11.4) Happy Company wants to raise $2 million with debt financing. The funds are needed to finance working capital, and the firm will repay them with interest in one year. Happy Company’s treasurer is considering three options:
(a) Borrowing U.S. dollars from Security Pacific Bank at 8 percent.
(b) Borrowing British pounds from Midland Bank at 14 percent.
(c) Borrowing Japanese yen from Sanwa Bank at 5 percent.
If Happy borrows foreign currency, it will not cover it; that is, it will simply change foreign currency for dollars at today’s spot rate and buy the same foreign currency a year later at the spot rate that is in effect. Happy Company estimates the pound will depreciate by 5 percent relative to the dollar and the yen will appreciate 3 percent relative to the dollar in the next year. From which bank should Happy Company borrow?
Happy Company needs to consider both the cost of
capital and foreign exchange risk. If
Happy Company borrows $2 million from Security Pacific Bank, in one year it
will owe the bank $2 million plus 8 percent.
If Happy Company borrows British pounds from