1. You are a sales manager for Motorola and export cellular phones from the United States to
other countries. You have just signed a deal to ship phones to a British distributor. The deal is
denominated in pounds, and you will receive £700,000 when the phones arrive in London in
180 days. Assume that you can borrow and lend at 7% p.a. in U.S. dollars and at 10% p.a. in
British pounds. Both interest rate quotes are for a 360-day year. The spot exchange rate is
$1.4945/£, and the 180-day forward exchange rate is $1.4802/£.
a. Describe the nature and extent of your transaction foreign exchange risk.
b. Describe two ways of eliminating the transaction foreign exchange risk.
c. Which of the alternatives in part b is superior? Support your answer with calculation
d. Assume that the dollar interest rate and the exchange rates are correct. Determine what
sterling interest rate would make your firm indifferent between the two alternative
hedges.
2. Over the next 30 days, economists forecast that the pound may weaken relative to the dollar
by as much as 6%, or it may strengthen by as much as 7%. The possible values for the rate of
change of the dollar–pound spot exchange rate are –7%, –5%, –3%, –1%, 0%, 2%, 4%, and
6%. Suppose that each of these values is equally likely to happen. What is the most likely
value of the future spot exchange rate if the current rate is $1.5845/£?
3. Consider the following hypothetical facts about Mexico: The peso recently lost over 40% of
its value relative to the dollar. Over the course of the next 90 days, the Mexican government
risks losing control of the economy. If it does, the Mexican peso will lose 33% of its value
relative to the U.S. dollar, and the Mexican stock market will fall by 39%. There is a 35%
chance that the authorities will lose control of the economy. Alternatively, the U.S. Congress
may vote to help Mexico by offering collateral for Mexican government loans. In that case,
the Mexican peso will gain 27% in value relative to the U.S. dollar, and the Mexican stock
market will rise by 29%. As a U.S. investor with no current assets or liabilities in Mexico,
you have decided to speculate. Calculate your expected dollar return from investing dollars in
the Mexican stock market for the next 90 days.
4. Consider the following facts about Switzerland: The current spot exchange rate is
CHF1.7/USD. Over the next 90 days, there is a 30% probability that the Swiss franc will
strengthen relative to the dollar by 5%, and there is a 70% chance that the Swiss franc will
weaken by 3%. What is the expected future spot exchange rate of dollars per Swiss franc? If
the current forward rate is CHF1.71/USD, calculate your expected dollar profit from
contracting either to buy or to sell CHF10,000,000 for USD in the 90-day forward market. If
only one of these two events can occur, how much will you actually win or lose in 90 days?
5. Suppose the British pound (GBP) is pegged to the euro (EUR). You think there is a 5%
probability that the GBP will be devalued by 10% over the course of the next month. What
interest differential would prevent you from speculating by borrowing GBP and lending
EUR?
6. As a wheat futures trader, you observe the following futures prices for the purchase and sale
of wheat in 3 months: $3.00 per bushel in Chicago and ¥320 per bushel in Tokyo. Delivery
on the contracts is in Chicago and Tokyo, respectively. If the 3-month forward exchange rate
is ¥102/$, what is the magnitude of the transaction cost necessary to make this situation not
represent an unexploited profit opportunity?
7. Suppose that the rate of inflation in Japan is 2% in 2009. If the rate of inflation in Germany is
5% during 2009, by how much would the yen strengthen relative to the euro if relative
purchasing power parity is satisfied during 2009?
8. Suppose that you are trying to decide between two job offers. One consulting firm offers you
$150,000 per year to work out of its New York office. A second consulting firm wants you to
work out of its London office and offers you £100,000 per year. The current exchange rate is
$1.65/£. Which offer should you take, and why? Assume that the PPP exchange rate is
$1.40/£ and that you are indifferent between working in the two cities if the purchasing
power of your salary is the same.
9. Suppose that in 2008, the Japanese rate of inflation is 2%, and the German rate of inflation is
5%. If the euro weakens relative to the yen by 10% during 2008, what would be the
magnitude of the real depreciation of the euro relative to the yen?
10. Suppose that you have one domestic production facility that supplies both the domestic and
foreign markets. Assume that the demand for your product in the domestic market is
Q = 2,000 – 3P and in the foreign market, demand is given by Q* = 2,000 – 2P*. Assume that
your domestic marginal cost of production is 600. If the initial real exchange rate is 1, what
are your optimal prices and quantities sold in the two markets? By how much will you change
the relative prices of your product if the foreign currency appreciates in real terms by 10%?
What will you do to production?
11. Suppose the 1-year nominal interest rate in Zooropa is 9%, and Zooropa’s expected inflation
rate is 4%. What is the real interest rate in Zooropa?
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