Сhapter 4 Global Finance Essay

Custom Student Mr. Teacher ENG 1001-04 6 March 2016

Сhapter 4 Global Finance

Topics to Stimulate Class Discussion
1. Why are MNCs affected by exchange rate movements?
2. Why did exchange rates change recently?
3. Show the class a current exchange rate table from a periodical—identify spot and forward quotations. Then show the class an exchange rate table from a date a month ago, or three months ago. The comparison of tables will illustrate how exchange rates change, and how forward rates of the earlier date will differ from the spot rate of the future date for a given currency. 4. Make up several scenarios and ask the class how each scenario would, other things equal, affect the demand for a currency, the supply of a currency for sale, and the equilibrium exchange rate. Then integrate several scenarios together to illustrate that in reality other things are not held constant, which makes the assessment of exchange rate movements more difficult.

Critical Debate:
The currencies of some Latin American countries depreciate against other currencies on a consistent basis. How can persistently weak currencies be stabilized? Proposition: The governments of these countries need to increase the demand for their currency by attracting more capital flows. Raising interest rates will make their currencies more attractive to foreign investors. They also need to insure bank deposits so that foreign investors who invest in large bank deposits do not need to worry about default risk. In addition, they could impose capital restrictions on local investors to prevent capital outflows.

Opposing view: The governments of these countries print too much money because they make too many promises to the electorate that would otherwise have to be funded by higher taxes or borrowing at high interest rates. Printing money is the easy way out; but prices rise, exports decrease and imports increase. Thus, these countries could relieve the downward pressure on their local currencies by printing less money and thereby reducing the money supply and hence inflation. The outcome is likely to be a temporary reduction in economic growth and business failures. Higher interest rates would merely increase inflation.

Reply: Solutions that cause riots are not very clever.
With whom do you agree? Which argument do you support? Offer your own opinion on this issue.

ANSWER: There is no perfect solution, but recognize the tradeoffs. The proposal to raise interest rates is not a good solution in the long run, because it will cause higher loan rates, and may slow down the economies in the long run. Effective anti-inflationary policies are needed to prevent further depreciation. However, the elimination of inflation that is caused by a wage-price spiral may cause some pain among the workers in the country, as some form of wage controls may be needed. The government has various means of reducing inflation, but all of them can have adverse effects on the economy in the short run. As intimated in the question, inflation is a form of taxation, another way in which governments can raise money and inevitably reduce the value of ones earnings. Where governments are corrupt or have a poor control over the economy, inflation may be the only reliable way of “taxing”. In terms of economic welfare, the question is perhaps who suffers from inflation and a depreciating currency, perhaps not so many as long as the inflation is predictable.

Answers to End of Chapter Questions
1. Percentage Depreciation. Assume the spot rate of the US dollar is £0.54. The expected spot rate one year from now is assumed to be £0.51. What percentage depreciation does this reflect? ANSWER: (£0.51 – £0.54)/£0.54 = –5.55%

Expected depreciation of 5.55% percent
2. Inflation Effects on Exchange Rates. Assume that the UK inflation rate becomes high relative to euro inflation. Other things being equal, how should this affect the (a) UK demand for euros, (b) supply of euros for foreign currency, and (c) equilibrium value of the euro? ANSWER: Demand for euros should increase (euro prices cheaper), supply of euros for sale should decrease (£ prices more expensive), and the euro’s value should increase (supply and demand).

3. Interest Rate Effects on Exchange Rates. Assume euro interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) euro demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the pound’s value should increase.

4. Income Effects on Exchange Rates. Assume that the income level in the euro area rises at a much higher rate than does the UK income level. Other things being equal, how should this affect the (a) euro area demand for British pounds, (b) supply of British pounds for sale, and (c) equilibrium value of the British pound in terms of the euro? ANSWER: Assuming no effect on interest rates, demand for pounds should increase, supply of pounds for sale may not be affected, and the pound’s value should increase. 5. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) UK demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?

ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease.
6. Effects of Real Interest Rates. What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies? ANSWER: The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal.

7. Speculative Effects on Exchange Rates. Explain why a public forecast about the future value of the euro and about future interest rates by a respected economist could affect the value of the euro today. Why do some forecasts by well-respected economists have no impact on today’s value of the euro?

ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currency’s value. These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investors’ original expectations, an announced forecast does not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected.

8. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro against the dollar?
ANSWER: The euro’s value could change because of the balance of trade, which reflects more U.S. demand for European goods than the European demand for U.S. goods. The capital flows between the U.S. and Europe will also affect the U.S. demand for euros and the supply of euros for sale (to be exchanged for dollars).

9. Interaction of Exchange Rates. Assume that there are substantial capital flows among the United Kingdom, the United States, and the Euro area. If interest rates in the United Kingdom declines to a level below the U.S. interest rate, and inflationary expectations remain unchanged, how could this affect the value of the euro against the U.S. dollar? How might this decline in the United Kingdom’s interest rate possibly affect the value of the British pound against the euro? ANSWER: If interest rates in the UK decline, there may be an increase in capital flows from the UK to the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S. interest rates, while U.S. investors reduce their investments in UK’s securities. This places downward pressure on the pond’s value.

Euro investors who previously invested in the UK may shift to the U.S. Thus, the increased demand for dollars by euros may increase the value of the dollar in relation to the euro. 10. Trade Deficit Effects on Exchange Rates. Every month, the UK trade deficit figures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced.

a. Why do you think the trade deficit announcement sometimes has such an impact on foreign exchange trading?
ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits and therefore has implications about supply and demand conditions in the foreign exchange market. For example, if the trade deficit was larger than anticipated, and is expected to continue, this implies that the UK demand for foreign currencies may be larger than initially anticipated. Thus, the pound would be expected to weaken. Some speculators may take a position in foreign currencies immediately and could cause an immediate decline in the pound. b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even when the announced deficit is very large. Offer an explanation for such a lack of response.

ANSWER: If the market correctly anticipated the trade deficit figure, then any news contained in the announcement has already been accounted for in the market. The market should only respond to an announcement about the trade deficit if the announcement contains new information. 11. Comovements of Exchange Rates. Explain why the value of the British pound against the dollar will not always move in tandem with the value of the euro against the dollar. ANSWER: The euro’s value changes in response to the flow of funds between the U.S. and the countries using the euro or their currency. The pound’s value changes in response to the flow of funds between the U.S. and the U.K. As the UK economy is different from the euro economy, economic events will have a different impact, the events themselves may also differ. Assuming that the market is efficient and that the exchange rates do move according to relevant information the fact that the relevant information sets differ justifies a less than perfect correlation of movements. That they are similar is understandable as although different, the differences are not that great.

12. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods but had little to offer other countries in terms of potential exports. In addition, Russia’s inflation rate was high. Explain the type of pressure that these factors placed on the Russian currency. ANSWER: The large amount of Russian imports and lack of Russian exports placed downward pressure on the Russian currency. The high inflation rate in Russia also placed downward pressure on the Russian currency.

13. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held constant, increased national income could increase imports and cause the local currency to weaken. In reality, other factors are not constant. What other factor is likely to be affected by increased economic growth and could place upward pressure on the value of the local currency?

ANSWER: Interest rates tend to rise in response to a stronger economy, and higher interest rates can place upward pressure on the local currency (as long as there is not offsetting pressure by higher expected inflation).

14. Factors Affecting Exchange Rates. If the Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result), how will their currency values (relative to the British pound) be affected?

ANSWER: A relative decline in Asian economic growth will reduce Asian demand for UK products, which places upward pressure on Asian currencies. However, given the change in interest rates, Asian corporations with excess cash may now invest in the UK or other countries, thereby increasing the demand for pounds. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. The overall impact depends on the magnitude of the forces just described.

15. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital flows? ANSWER: Capital flows have a larger influence. In general, crises tend to cause investors to expect that there will be less investment in the country in the future and also cause concern that any existing investments will generate poor returns (because of defaults on loans or reduced valuations of stocks). Thus, as investors liquidate their investments and convert the local currency into other currencies to invest elsewhere, downward pressure is placed on the local currency. 16. How do you think weaker economic conditions would affect trade flows in a Developing Country? How would weaker conditions affect the value of its currency (holding other factors constant)? How do you think interest rates would be affected? ANSWER: Weak world economic conditions would result in a reduced demand for foreign products, which results in a decline in the demand for foreign currencies, particularly the currencies of developing countries that rely on exports. Taking the US as the dominant economy there would therefore be downward pressure on currencies relative to the dollar (upward pressure on the dollar’s value). The lower U.S. interest rates that accompany weaker economic conditions should reduce the capital flows to the U.S., which place downward pressure on the value of the dollar.

Advanced Questions
17. Measuring Effects on Exchange Rates. Tarheel Co. plans to determine how changes in UK and euro real interest rates will affect the value of the British pound. a. Describe a regression model that could be used to achieve this purpose. Also explain the expected sign of the regression coefficient.

ANSWER: Various models are possible.

Based on the model above, the regression coefficient is expected to have a negative sign. A relatively high real interest rate differential would likely cause a weaker euro value, other things being equal. An appropriate model would also include other independent variables that may influence the percentage change in the peso’s value.

b. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have affected exchange rates, how might this be accounted for in the regression model? ANSWER: A dummy variable could be included in the model, assigned a value of one for periods when a quota existed and a value of zero when it did not exist. This answer requires some creative thinking, as it is not drawn directly from the text.

18. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries.

a. Identify the most obvious economic reason for the persistent depreciation of the peso. ANSWER: The high inflation in Mexico places continual downward pressure on the value of the peso.
b. High interest rates are commonly expected to strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso’s value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico?

ANSWER: The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate (when they convert the pesos back to dollars at the end of the investment period). Therefore, the high Mexican interest rates do not encourage U.S. investment in Mexican securities, and do not help to strengthen the value of the peso. c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico? ANSWER: The bid/ask spread is wider because the banks that provide foreign exchange services are subject to more risk when they maintain currencies such as the peso that could decline abruptly at any time. A wider bid/ask spread adversely affects the U.S. firm that does business in Mexico because it increases the transactions costs associated with conversion of dollars to pesos, or pesos to dollars.

19. Aggregate Effects on Exchange Rates. Assume that the United Kingdom invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United Kingdom. Approximately £10 billion worth of investment transactions occur between these two countries each year. The total pound value of trade transactions per year is about £8 million. This information is expected to also hold in the future. Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K’s currency (the “krank”) with respect to the pound. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank’s movement against the pound.

a. UK inflation has suddenly increased substantially, while Country K’s inflation remains low. ANSWER: Increased UK demand for the krank. Decreased supply of kranks for sale. Upward pressure in the krank’s value.

b. UK interest rates have increased substantially, while Country K’s interest rates remain low. Investors of both countries are attracted to high interest rates. ANSWER: Decreased UK demand for the krank. Increased supply of kranks for sale. Downward pressure on the krank’s value.

c. The UK income level increased substantially, while Country K’s income level has remained unchanged.
ANSWER: Increased UK demand for the krank. Upward pressure on the krank’s value. d. The UK is expected to impose a small tariff on goods imported from Country K. ANSWER: The tariff will cause a decrease in the United Kingdom’ desire for Country K’s goods, and will therefore reduce the demand for kranks for sale. Downward pressure on the krank’s value.

e. Combine all expected impacts to develop an overall forecast. ANSWER: Two of the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the UK and Country K. The interest rate scenario places downward pressure on the krank’s value. Since the interest rates affect capital flows and capital flows dominate trade flows between the UK and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate.

20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days.
The following interbank lending and borrowing rates exist:

U.S. dollar
Mexican peso

Lending Rate
8.0%
8.5%

Borrowing Rate
8.3%
8.7%

Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows: 1. Borrow MXP70 million

2. Convert the MXP70 million to dollars:
MXP70,000,000 × $.15 = $10,500,000
3. Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The amount accumulated in 10 days is:
$10,500,000 × [1 + (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333 4. Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 × [1 + (8.7% × 10/360)] = 70,000,000 × [1.002417]=MXP70,169,167 5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is:

MXP70,169,167 × $.14 = $9,823,683
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of:
$10,523,333 – $9,823,683 = $699,650
b. Assume all the preceding information with this exception: Blue Demon Bank
expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy.

ANSWER: Blue Demon Bank can capitalize on its expectations as follows: 1. Borrow $10 million
2. Convert the $10 million to pesos (MXP):
$10,000,000/$.15 = MXP66,666,667
3. Lend the pesos through the interbank market at 8.5% annualized over a 30-day period. The amount accumulated in 30 days is:
MXP66,666,667 × [1 + (8.5% × 30/360)] = 66,666,667 × [1.007083] = MXP67,138,889 4. Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 × [1 + (8.3% × 30/360)] = $10,000,000 × [1.006917] = $10,069,170 5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $.17) is:

MXP67,138,889 × $.17 = $11,413,611
6. The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 – $10,069,170 = $1,344,441
21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the euro from its spot rate of 0.48 euros to 0.45 euros in 60 days. The following interbank lending and borrowing rates exist:

Lending Rate
euro
Singapore dollar

7.0%
22.0%

Borrowing Rate
7.2%
24.0%

Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in euros for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy?

ANSWER:
Borrow S$10,000,000 and convert to euros:
S$10,000,000 × 0.48 = 4,800,000 euros
Invest funds for 60 days. The rate earned in the euros for 60 days is: 7% × (60/360) = 1.17%
Total amount accumulated in 60 days:
4,800,000 euros × (1 + .0117) = 4,856,160 euros

Convert euros back to S$ in 60 days:
4,856,160 /0.45 = S$10,791,467
The rate to be paid on loan is:
.24 × (60/360) = .04
Amount owed on S$ loan is:
S$10,000,000 × (1 + .04) = S$10,400,000
This strategy results in a profit:
S$10,791,467 – S$10,400,000 = S$391,467
Diamond Bank should pursue this strategy.

Blades plc Case Study
As the chief financial officer of Blades plc Ben Holt is pleased that his current system of exporting “Speedos” to Thailand seems to be working well. Blades’ primary customer in Thailand, a retailer called Entertainment Products, has committed itself to purchasing a fixed number of Speedos annually for the next three years at a fixed price denominated in baht, Thailand’s currency. Furthermore, Blades is using a Thai supplier for some of the components needed to manufacture Speedos. Nevertheless, Holt is concerned about recent developments in Asia. Foreign investors from various countries had invested heavily in Thailand to take advantage of the high interest rates there. As a result of the weak economy in Thailand, however, many foreign investors have lost confidence in Thailand and have withdrawn their funds.

Ben Holt has two major concerns regarding these developments. First, he is wondering how these changes in Thailand’s economy could affect the value of the Thai baht and, consequently, Blades. More specifically, he is wondering whether the effects on the Thai baht may affect Blades even though its primary Thai customer is committed to Blades over the next three years. Second, Holt believes that Blades may be able to speculate on the anticipated movement of the baht, but he is uncertain about the procedure needed to accomplish this. To facilitate Holt’s understanding of exchange rate speculation, he has asked you, Blades’ financial analyst, to provide him with detailed illustrations of two scenarios. In the first, the baht would move from a current level of £0.0147 to £0.0133 within the next 30 days. Under the second scenario, the baht would move from its current level to £0.0167 within the next 30 days.

Based on Holt’s needs, he has provided you with the following list of questions to be answered: 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 £0.0147 to £0.0173. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors?

3. How might the relatively high levels of inflation and interest rates in Thailand have affected the baht’s value? (Assume a constant level of UK inflation and interest rates.) 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?

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?

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 pounds) resulting from each scenario. Use both of Ben Holt’s examples to illustrate possible speculation. Assume that Blades can borrow either £7 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%

Solution to Continuing Case Problem: Blades.
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 £0.0147 to £0.0173. ANSWER: The percentage change in a currency’s value is measured as follows:

%

S

St
St

1

1

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: = 17.69%
£0.0173 – £0.0147
£0.0147
That is, the baht would be expected to appreciate by 17.69%. 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 UK 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 UK. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for UK goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the UK 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 UK investors, causing an increase in the demand for baht. Furthermore, UK 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 pounds.

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 UK 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%

ANSWER: (See spreadsheet attached.)

Depreciation of the Baht from £0.0147 to £0.0133
1. Borrow Thai baht (£10,000,000/0.0147)
2. Convert the Thai baht to pounds 680,272,109 baht× £0.0147). 3. Lend the pounds 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 (680,272,109 × (1 + .0128))

680,272,109
10,000,000

10,068,000.00

688,979,592

5. Number of pounds necessary to repay baht loan (688,979,592 baht× £0.0133)

9,163,429

6. Speculative profit (£10,068,000 – £9,163,429)

£904,571

Appreciation of the Baht from £0.0147 to £0.0167
1. Borrow pounds.
2. Convert the pounds to Thai baht (£10 million/£0.0147).
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,

10,000,000.00
680,272,109

Blades would receive (THB 680,272,109× (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/£0.0167) 6. Speculative profit (THB688,639,456– THB602,874,251)
7. Dollar equivalent of speculative profit (THB 85,765,205×£0.0167)

688,639,456

10,068,000.00
602,874,251
85,765,205
1,432,278

Blades would be ill advised to speculate in this way as it is not a specialist in the financial markets and does not have specialist abilities or information to use. These actions are thyerfore little better than gambling and are highly ill advised.

Small Business Dilemma
Assessment by the Sports Exports Company of Factors That Affect the British Pound’s Value
1. Given Jim’s expectations, forecast whether the pound will appreciate or depreciate against the euro over time.
ANSWER: The pound should depreciate because the British inflation is expected to be higher than the euro. This could cause a shift in trade flows that would place downward pressure on the pound’s value. The interest rate movements of both countries are expected to be similar for both countries. Therefore, there should not be any adjustment in the capital flows between the two countries.

2. Given Jim’s expectations, will the Sports Exports Company be favourably or unfavourably affected by the future changes in the value of the pound?
ANSWER: The Sports Exports Company will be unfavourably affected, because depreciation in the British pound will cause the pound receivables to convert into fewer euros.

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