CHAPTER 22 B-1
Answers to Concepts Review and Critical Thinking Questions
1.
a.
b.
c.
The dollar is selling at a premium because it is more expensive in the forward market
than in the spot market (SFr 1.53 versus SFr 1.50).
The franc is expected to depreciate relative to the dollar because it will take more
francs to buy one dollar in the future than it does today.
Inflation in Switzerland is higher than in the United States, as are interest rates.
2.
The exchange rate will increase, as it will take progressively more pesos to purchase a dollar. This is
the relative PPP relationship.
3.
a.
b.
c.
The Australian dollar is expected to weaken relative to the dollar, because it will take
more A$ in the future to buy one dollar than it does today.
The inflation rate in Australia is higher.
Nominal interest rates in Australia are higher; relative real rates in the two countries are
the same.
4.
A Yankee bond is most accurately described by d.
5.
No. For example, if a country’s currency strengthens, imports become cheaper (good), but
its exports become more expensive for others to buy (bad). The reverse is true for a currency
depreciation.
6.
Additional advantages include being closer to the final consumer and, thereby, saving on
transportation, significantly lower wages, and less exposure to exchange rate risk.
Disadvantages include political risk and costs of supervising distant operations.
7.
One key thing to remember is that dividend payments are made in the home currency. More
generally, it may be that the owners of the multinational are primarily domestic and are
ultimately concerned about their wealth denominated in their home currency because, unlike
a multinational, they are not internationally diversified.
8.
a.
b.
c.
False. If prices are rising faster in Great Britain, it will take more pounds to buy the
same amount of goods that one dollar can buy; the pound will depreciate relative to the
dollar.
False. The forward market would already reflect the projected deterioration of the
deutsche mark relative to the dollar. Only if you feel that there might be additional,
unanticipated weakening of the deutsche mark that isn’t reflected in forward rates today
will the forward hedge protect you against additional declines.
True. The market would only be correct on average, while you would be correct all the
time.
CHAPTER 22 B-2
9.
a.
b.
c.
American exporters: their situation in general improves because a sale of the exported
goods for a fixed number of DMs will be worth more dollars.
American importers: their situation in general worsens because the purchase of the
imported goods for a fixed number of DMs will cost more in dollars.
American exporters: they would generally be better off if the British government’s
intentions result in a strengthened pound.
American importers: they would generally be worse off if the pound strengthens.
American exporters: would generally be much worse off, because an extreme case of
fiscal expansion like this one will make American goods prohibitively expensive to
buy, or else Brazilian sales, if fixed in cruzeiros, would become worth an unacceptably
low number of dollars.
American importers: would generally be much better off, because Brazilian goods will
become much cheaper to purchase in dollars.
10. IRP is the most likely to hold because it presents the easiest and least costly means to exploit any
arbitrage opportunities. Relative PPP is least likely to hold since it depends on the absence of market
imperfections and frictions in order to hold strictly.
Solutions to Questions and Problems
Basic
1.
a.
b.
c.
d.
e.
f.
g.
$100(€1.1257/$1) = €112.57
$0.8883
€5M($0.8883/€) = $4,441,500
Singapore dollar
Mexican peso
(SFr 1.7032/$1)($0.8883/€1) = SFr 1.513/€; this is a cross rate.
Most valuable: Bahrain Dinar = $2.6525
Least valuable: Turkish Lira = $0.00000070
2.
a.
b.
c.
£100, since (£100)($1.4435/£1) = $144.35
£100, since (£100)($1.4435/£1)(FF 7.3848/$1) = FF 1,065.996
(FF 7.3848/$1)($1.4435/£1) = FF 10.65996/£1 ; 1/10.66 = £0.0938/FF 1
3.
a.
F180 = ¥117.10 (per $). The yen is selling at a premium because it is more expensive in
the forward market than in the spot market ($0.008392 versus $0.008539).
F90 = $0.4533/DM 1. The dollar is selling at a premium because it is more expensive in
the forward market than in the spot market (DM 2.2019 versus DM 2.2062).
The value of the dollar will fall relative to the yen, since it takes more dollars to buy
one yen in the future than it does today. The value of the dollar will rise relative to the
deutsche mark, because it will take fewer dollars to buy one deutsche mark in the future
than it does today.
b.
c.
CHAPTER 22 B-3
4.
a.
b.
c.
d.
e.
The U.S. dollar, since (Can$1)/(Can$1.30/$1) = $0.7692
(Can$2.19)/(Can$1.30/$1) = $1.68. Among the reasons that absolute PPP doesn’t hold
are tariffs and other barriers to trade, transactions costs, taxes, and different tastes.
The U.S. dollar is selling at a discount, because it is less expensive in the forward
market than in the spot market (Can$1.27 versus Can$1.30).
The Canadian dollar is expected to appreciate in value relative to the dollar, because it
takes fewer Canadian dollars to buy one U.S. dollar in the future than it does today.
Interest rates in the United States are probably higher than they are in Canada.
5.
a.
b.
6.
France:
Japan:
Switzerland:
7.
US:
Great Britain:
8.
Relative PPP: FF 8.05 = (FF 7.47)(1 + {hFC – hUS})3 ; (8.05/7.47)1/3 – 1 = .02524
Inflation in France is expected to exceed that in the U.S. by 2.52% over this period.
9.
No change in exchange rate: profit = 30,000[$150 – {(S$172.50)/(S$1.7465/$1)}] = $1,536,931.01
If exchange rate rises: profit = 30,000[$150 – {(S$172.50)/1.1(S$1.7465/$1)}] = $1,806,300.91
If exchange rate falls: profit = 30,000[$150 – {(S$172.50)/0.9(S$1.7465/$1)}] = $1,207,701.12
Breakeven: $150 = S$172.50/ST ; ST = S$1.15/$1 = – 31.89% decline
10. a.
b.
(¥110/$1)($1.60/£1) = ¥176/£1
The yen is quoted too low relative to the pound. Take out a loan for $1 and buy ¥110.
Use the ¥110 to purchase pounds at the cross-rate—110/160 = £0.6875. Use the pounds
to buy back dollars and repay the loan—£0.6875(1.60) = $1.100; arbitrage profit is 10¢
per dollar used.
RFC = (FF 7.4086 – FF 7.3848)/FF 7.3848 + .035 = 3.82%
RFC = (¥117.10 – ¥119.16)/¥119.16 + .035 = 1.77%
RFC = (SFr 1.6987 – SFr 1.7032)/SFr 1.7032 + .035 = 3.24%
$30M(1.0040)3 = $30,361,441.92
($30M)(£0.59/$1)(1.0070)3/(£0.61/$1) = $29,630,013.07; invest in U.S.
If IRP holds, then F180 = (DM 1.55)[1 + (.08 – .05)]1/2 = DM 1.5731
Since given F180 = DM 1.62, an arbitrage exists; the forward premium is too high.
Borrow DM 1 today at 8% interest. Agree to a 180-day forward contract at DM 1.62.
Convert the loan proceeds into DM: $1/DM 1.55 = $0.6452 today. Invest these dollars
at 5%, ending up with $0.6611. Convert the dollars back into deutsche marks as
$0.6611(DM 1.62/$1) = DM 1.0710. Repay the DM 1 loan, ending with a profit of
1.0710 – 1.0392 = DM 0.0318.
F180 = (DM 1.55)[1 + (.08 – .05)]1/2 = DM 1.5731
11. a.
b.
c.
hNETH = .05 + .03 – .037 = 4.3%
hCAN = .07 + .03 – .037 = 6.3%
hFRA = .10 + .03 – .037 = 9.3%
12. a.
The yen is expected to get stronger, since it will take fewer yen to buy one dollar in the
future than it does today.
hUS – hJAP  (¥122 – ¥124)/¥124 = – .0161; (1 – .0161)4 – 1 = –.0630
The approximate inflation differential between the U.S. and Japan is – 6.30% annually.
b.
CHAPTER 22 B-4
13. Relative PPP:
E[S1] = 280{1 + (.105 – .035)}1 = HUF 299.60
E[S1] = 280{1 + (.105 – .035)}2 = HUF 320.57
E[S5] = 280{1 + (.105 – .035)}5 = HUF 392.71
Intermediate
14. a.
b.
Implicitly, it is assumed that interest rates won’t change over the life of the project, but
the exchange rate is projected to decline because the Euroswiss rate is lower than the
Eurodollar rate.
E[ST] = (SFr 1.72){1 + (.07 – .08)}T = 1.72(.99)T
t
0
1
2
3
4
5
c.
SFr
–27.0M
+7.5M
+7.5M
+7.5M
+7.5M
+7.5M
E[St]
1.7200
1.7028
1.6858
1.6689
1.6522
1.6357
US$
–$15,697,674.42
$4,405,510.22
$4,449,000.22
$4,493,939.62
$4,539,332.95
$4,585,184.79
NPV @ 13% = $72,465.05
RSFr = 1.13(.99) – 1 = 11.87%
NPV = –27.0M + 7.5M(PVIFA11.87%,5)
= SFr 123,117.76
= 123,117.76/1.72 = $71,580.09
The numbers differ slightly due to rounding.
Challenge
15. a.
b.
c.
d.
1 + rUS = (1 + RUS)/(1 + hUS) = (1 + RFC)/(1 + hFC) = 1 + rFC
E[ST] = FT = S0 [(1 + RFC)/(1 + RUS)]T
E[ST] = S0 [(1 + hFC)/(1 + hUS)]T
Home currency approach:
E[ST] = (€0.5)[1.07/1.05]T = (€0.5)(1.019)T
NPV = – [€2M/(€0.5)] + {€0.9M/[1.019(€0.5)]}/1.1 + {€0.9M/[1.0192(€0.5)]}/1.12 +
{€0.9M/[1.0193(€0.5/$1)]}/1.13 = $316,230.72
Foreign currency approach:
RFC = 1.10(1.07/1.05) – 1 = 0.121
NPV = – €2M + (€0.9M)/1.121 + (€0.9M)/1.1212 + (€0.9M)/1.1213 = €158,115.36
NPV ($) = €158,116.36 /(€0.5/$1) = $316,230.72