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Interest Rate Parity

Look at Table 6.5. If the 3-month interest rate on dollars is 6.0 percent (annualized), what do you think is the 3-month sterling (U.K.) interest rate? Explain what would happen if the rate were substantially above your figure. Hint: In your calculations remember to convert the annually compounded interest rate into a rate for 3 months.

12. Expectations Theory. Table 6.5 shows the 1-year forward rate on the Canadian dollar.

a. Is the Canadian dollar at a forward discount or a premium on the U.S. dollar?

b. What is the annualized percentage discount or premium?

c. If you have no other information about the two currencies, what is your best guess about the spot rate in 1 year?

d. Suppose that you expect to receive 100,000 Canadian dollars in 1 year. How many U.S. dollars is this likely to be worth?

13. Interest Rate Parity. Suppose the interest rate on 1-year loans in the United States is 5 percent while in the United Kingdom the interest rate is 6 percent. The spot exchange rate is $1.55/АВАі and the forward rate is $1.54/АВАі. In what country would you choose to borrow? To lend? Can you profit from this situation?

14. Purchasing Power Parity. Suppose that the inflation rate in the United States is 4 percent and in Canada it is 5 percent. What would you expect is happening to the exchange rate between the United States and Canadian dollars?

15. Cross Rates. Look at Table 6.5. How many Swiss francs can you buy for $1? How many yen can you buy? What rate do you think a Japanese bank would quote for buying or selling Swiss francs? Explain what would happen if it quoted a rate that was substantially less than your figure.

16. International Capital Budgeting. Suppose that you do use your own views about exchange rates when valuing an overseas investment proposal. Specifically, suppose that you believe that the leo will depreciate by 2 percent per year. Recalculate the NPV of KW`s project.

17. Currency Risk. You have bid for a possible export order that would provide a cash inflow of БІАИј1 million in 6 months. The spot exchange rate is БІАИј1.06/$ and the 1-year forward rate is БІАИј1.07/$. There are two sources of uncertainty: (1) the euro could appreciate or depreciate, and (2) you may or may not receive the export order. Illustrate in each case the profits or losses that you would make if you sell БІАИј1 million forward by filling in the following table. Assume that the exchange rate in 1 year will be either БІАИј1.02/$ or БІАИј1.12/$.

18. Managing Currency Risk. General Gadget Corp. (GGC) is a United States based multinational firm that makes electrical coconut scrapers. These gadgets are made only in the United States using local inputs. The scrapers are sold mainly to Asian and West Indian

countries where coconuts are grown.

a. If GGC sells scrapers in Trinidad, what is the currency risk faced by the firm?

b. In what currency should GGC borrow funds to pay for its investment in order to mitigate its foreign exchange exposure?

c. Suppose that GGC begins manufacturing its products in Trinidad using local (Trinidadian) inputs and labor. How does this affect its exchange rate risk?

19. Currency Risk. If investors recognize the impacts of inflation and exchange rate changes on a firm`s cash flows, changes in exchange rates should be reflected in stock prices. How would the stock price of each of the following Swiss companies be affected by an unanticipated appreciation in the Swiss franc of 10 percent, only 2 percent of which could be justified by comparing Swiss inflation to that in the rest of the world?

a. Swiss Air: More than two-thirds of its employees are Swiss. Most revenues come from international fares set in U.S. dollars.

b. NestlАГАЎ: Fewer than 5 percent of its employees are Swiss. Most revenues are derived from sales of consumer goods in a wide range of countries with competition from local producers.

c. Union Bank of Switzerland: Most employees are Swiss. All non Swiss franc monetary positions are fully hedged.

20. International Capital Budgeting. An American firm is evaluating an investment in Indonesia. The project costs 500 billion Indonesian rupiah and it is expected to produce an income of 250 billion Indonesian rupiah a year in real terms for each of the next 3 years. The expected inflation rate in Indonesia is 12 percent a year and the firm estimates that an appropriate discount rate for the project would be about 8 percent above the risk-free rate of interest. Calculate the net present value of the project in U.S. dollars. Exchange rates are given in Table 6.5. The interest rate is about 15.3 percent in Indonesia and 6 percent in the United States.

8 According to the expectations theory of exchange rates, the forward rate equals the expected future spot exchange rate. Therefore, the expected cost of the hedgeБІАААдthe difference between the forward rate and expected spot rateБІАААдis zero!

9 a. The lower interest rate in Narnia than in the United States suggests that forecast inflation is lower in Narnia. If real interest rates are the same in the two countries, then the difference in inflation rates is about 5 3 = 2 percent.

b. The lower interest rate (and lower expected inflation rate) in Narnia suggests that investors are expecting the leo to appreciate against the dollar.

c. Since KW can now expect to change its leo cash flows into more dollars than before, the project`s NPV is increased. Forecast exchange rates will be as follows: