Assessing Future Exchange Rate Movements
1. How are percentage changes in a currency’s value measured? Illustrate your answer numerically by assuming a change in the Thai baht’s value from a value of $0.022 to $0.026. ANSWER: The percentage change in a currency’s value is measured as follows:
where S denotes the spot rate, and St −1 denotes the spot rate as of the earlier date. A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation. In the example provided, the percentage change in the Thai baht would be:
That is, the baht would be expected to appreciate by 18.18%. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currency’s value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. 3. How might the relatively high levels of inflation and interest rates have affected the baht’s value? (Assume a constant level of U.S. inflation and interest rates.) ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the U.S. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for U.S. goods, causing an increase in the Thai demand for dollars.
Furthermore, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for U.S. investors, causing an increase in the demand for baht. Furthermore, U.S. securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailand’s inflation.
4. How do you think the loss of confidence in the Thai baht, evidenced by the withdrawal of funds from Thailand, affected the baht’s value? Would Blades be affected by the change in value, given the primary Thai customer’s commitment? ANSWER: In general, a depreciation in the foreign currency results when investors liquidate their investments in the foreign currency, increasing the supply of its currency for sale. Blades would probably be affected by the change in value even though its Thai customer’s commitment, as the sales are denominated in baht. Thus, the depreciation in the baht would have caused a conversion of the baht revenue into fewer U.S. dollars.
5. Assume that Thailand’s central bank wishes to prevent a withdrawal of funds from its country in order to prevent further changes in the currency’s value. How could it accomplish this objective using interest rates? ANSWER: If Thailand’s central bank wishes to prevent further depreciation in the baht’s value, it would attempt to increase the level of interest rates in Thailand. In turn, this would increase the demand for Thai baht by U.S. investors, as Thai securities would now seem more attractive. This would place upward pressure on the currency’s value. However, the high interest rates could reduce local borrowing and spending.
6. Construct a spreadsheet illustrating the steps Blades’ treasurer would need to follow in order to speculate on expected movements in the baht’s value over the next 30 days. Also show the speculative profit (in dollars) resulting from each scenario. Use both of Ben Holt’s examples to illustrate possible speculation. Assume that Blades can borrow either $10 million or the baht equivalent of this amount. Furthermore, assume that the following short-term interest rates (annualized) are available to Blades:
Currency Dollars Thai baht
Lending Rate 8.10% 14.80%
Borrowing Rate 8.20% 15.40%
Depreciation of the Baht from $0.022 to $0.020
1. Borrow Thai baht ($10,000,000/0.022) 2. Convert the Thai baht to dollars ($454,545,454.50 million × $0.022). 3. Lend the dollars at 8.10% annualized, which represents a 0.68% return over the 30-day period [computed as 8.10% ×(30/360)]. After 30 days, Blades would receive ($10,000,000 × (1 + .0068)) 4. Use the proceeds of the dollar loan repayment (on Day 30) to repay the baht borrowed. The annual interest on the baht borrowed is 15.40%, or 1.28% over the 30-day period [computed as 15.40% ×(30/360)]. The total baht amount necessary to repay the loan is therefore (454,545,454.50 ×(1 + .0128)) 454,545,454.50 10,000,000.00
5. Number of dollars necessary to repay baht loan ($THB460,363,636.40 × $0.02) 6. Speculative profit ($10,068,000 – $9,207,272.73)
Appreciation of the Baht from $0.022 to $0.025
1. Borrow dollars. 2. Convert the dollars to Thai baht ($10 million/$0.022). 3. Lend the baht at 14.80% annualized, which represents a 1.23% return over the 30-day period [computed as 14.80% ×(30/360)]. After 30 days, Blades would receive (THB454,545,454.50 × (1 + .0123)) 4. Use the proceeds of the baht loan repayment (on Day 30) to repay the dollars borrowed. The annual interest on the dollars borrowed is 8.20%, or 0.68% over the 30-day period [computed as 8.20% × (30/360)]. The total dollar amount necessary to repay the loan is therefore ($10,000,000 ×(1 + .0068)) 5. Number of baht necessary to repay dollar loan ($10,068,000.00/$0.025) 6. Speculative profit (THB460,136,363.60 – THB402,720,000.00) 7. Dollar equivalent of speculative profit (THB57,416,363.60 ×$0.025) 10,000,000.00 454,545,454.50
10,068,000.00 402,720,000.00 57,416,363.60 1,435,409.09
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