Tutorial 11 Questions
BF page 714 Questions 1, 2, 5, 8, 10 and 12
BF page 715 Problems 1, 7 and 8
Tutorial 11 Solutions
BF page 730 Questions 1, 2, 5, 8, 10 and 12
On the information given, Diana’s business appears to be entirely domestic—that is, all
costs and revenues will be in Australian dollars. Any influence from the exchange rate
would be very indirect. In short, Diana faces minimal exchange rate risk. However, if she
borrows US dollars, she will expose her business to exchange rate risk. If the Australian
dollar depreciates against the US dollar, then the US dollar interest payments, measured
in Australian dollar terms, will increase.
Borrowing US dollars will therefore increase risk. Is it likely to increase returns (by
reducing costs)? If the borrowing is hedged using the forward rate, the risk will be
eliminated, but interest rate parity implies that the cost advantage will also be eliminated.
Interest rate parity is supported by empirical evidence. If the borrowing is left unhedged,
then the international Fisher effect implies that no cost advantage can be expected on
average. Although the empirical evidence does not support the international Fisher
effect, this does not imply that the risk-expected return trade off is attractive.
Yes, it is possible for a currency to trade at a forward premium (or discount) for one time
period and simultaneously at a forward discount (or premium) for a different time period.
For any given time period, the forward premium or discount is due simply to the interest
rate differential for that time period.
The interest rate differential could be positive for
one time period and negative for another.
Purchasing power parity maintains that relative exchange rates adjust to reflect relative
inflation rates in different countries.
Factors that inhibit international trade may tend to
inhibit the achievement of purchasing power parity. Such factors include the presence of
non-traded goods, transport costs, tariffs and quotas.
The basic rule in this type of case is to centralise (or at least to coordinate) the activities
of the various subsidiaries. For example, through their export activities, Maple Leaf may
acquire a claim to receive a future cash flow in US dollars at the same time as Bald Eagle
has a claim to receive a cash flow in Canadian dollars. Left to themselves, Maple Leaf
will be converting US dollars to Canadian dollars while simultaneously, Bald Eagle will
be converting Canadian dollars to US dollars.
Obviously, there will be a saving in