Nhu Quynh Truong
Dr. Thapa
FIN436- International Finance
03/12/2012
Integrative Problem: The International Financial Environment
Question 1: Explain how the international trade flows should initially adjust in response to the
changes in inflation (holding exchange rates constant). Explain how the international capital
flows should adjust in response to the changes in interest rates (holding exchange rates constant).
When domestic inflation rate increase, the exports of U.S. will started declining as
importers in countries like U.K. will find it costly to import from USA. On the other
hand, import goods in USA will increase beacue it tends to be cheaper. However, this can
only occurs when the exchange rate does not adjust to inflation changes. If the exchange
rate does not adjust immediately to inflation differences between the two nations, exports
of USA to UK will be decrease. Therefore, the current account of USA will be expected
to decline, consumers in USA will purchase more goods from foreign countries, and
exports of USA will decrease. Thus, Mesa will have to worry in this example.
If the interest rate in USA will increase, it will attract more international capital inflows
in the country. This is because most of investors will find it more attractive to invest in
USA because of higher interest rates. Especially, when exchange rates will remain
constant, investors will spend capital in countries with higher interest rate to take
advantage of higher earning opportunity.
Question 2: Using the information provided, will Mesa expect the pound to appreciate or
depreciate in the future? Explain.
Mesa will expect the pound to depreciate in the future because both U.K. inflation rate
and interest rates are expected to be declines, which led to decline in demand for
currency. Therefore, it wills also delince in price of British pound.
Question 3: Mesa believes international capital flows shift in reponse to changing interest rate
differentials. Is there any reason why the changing interest rate differentials in this example will
not necessarily cause international capital flows to change significantly? Explain.
Yes, there are several reasons that can cause international capital flows to be unchanged
due to interest rate differentials. Some of the factors that can cause investors to avoid
investment in nations with higher interest rates are the relative of riskiness a country in
terms of debt rating, investment rating, unstable political environment, or constantly
changing laws. International capital inflows in nations with high risk ratings will not
necessarily see growth even with higher interest rates because relative risks of investing
in such countries will offset the attraction of high interest rates.
Question 4: Based on your answer to question 2, how would Mesas cash flows be affected by
the expected exchange rate movements? Explain.
Mesa expects the interest rate of USA to increase which mean the demand for currency of
USA to be increase, thus the value of US dollar is also increase. This will affect
investment in foreign securities, which influences the demand for, supply of currencies,
and thus influences the equilibrium exchange rate. Since US rates are now more attractive
relative to British rates, and there is less desire for British bank deposits. The supply of
pounds for sale by British investors should increase as they establish more bank deposits
in the United States because US rate is more attractive to investors than British pound.
Due to an inward shift in the demand for pounds and an outward shift in the supply of
pounds for sale, the equilibrium exchange rate should decrease.
Question 5: Based on your answer to question 4, should Mesa consider hedging its exchange rate
risk? If so, explain how it could hedge using forward contracts, futures contracts, and currency
options.
A forward contract would be an agreement between a corporation and a financial
institution to exchange a specified amount of a currency at a specified exchange rate on a
specified date in the future. Hedging by using forward contracts, Mesa can lock a
particular interest rate in order to guarantee the price would be available to them in the
future. When hedging by the future contracts, there will be a limited to a certain tradable
amount or a specific volume. Hedging a currency option, would allow Mesa to have the
right to buy a specifc currency at a designated price within a specific period of time.
Mesa could lock in the top price that the exchange rate has for a future return at that same
price. Since it is known that the price of the exchange rate and the inflation is going to
drop in the future all of these options would suffice in Mesa being able to capitalize on
the current rate in future market.