International Business Finance
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FINS3616 International Business Finance
Week 2 Reading Guide and Tutorial Questions
Chapters 7, 4: Foreign Exchange Markets, Parity Conditions: PPP
Week 2 Readings (Shapiro, 10E)
Chapter 7 – The Foreign Exchange Market
7.1 Organization of the Foreign Exchange Market
7.2 The Spot Market
7.3 The Forward Market
Chapter 4 – Parity Conditions in International Finance and Currency Forecasting
4.1 Arbitrage and the Law of One Price
4.2 Purchasing Power Parity
Chapter 7:
Forward Markets: Problems 1, 6, 7, 8
Chapter 4:
Conceptual Questions 1, 3
Absolute PPP: Problem 2
Relative PPP: Problem 7, 8
(Non-Shapiro) Addition Questions 1, 2
Chapter 7
Chapter 7, Problem 1
The $/€ exchange rate is €1 = $1.45, and the €/SFr exchange rate is SFr 1 = €0.71. What is the SFr/$
exchange rate?
ANSWER. SFr1 = €0.71 x 1.45 = $1.0295. USD 1 = 1/1.0295 = SFR0.9713
Chapter 7, Problem 6
Suppose Credit Suisse quotes spot and 90-day forward rates on the Swiss franc of $0.7957-60, 8-13.
a. What are the outright 90-day forward rates that Credit Suisse is quoting?
ANSWER. The outright forwards are: bid rate = $0.7965 (0.7957 + 0.0008) and ask rate =
$0.7973 (0.7960 + 0.0013).
b. What is the forward discount or premium associated with buying 90-day Swiss francs?
ANSWER. The annualized forward premium = [(0.7973 - 0.7960)/0.7960]x 4 = 0.65%.
c. Compute the percentage bid-ask spreads on spot and forward Swiss francs.
ANSWER. The bid-ask spread is calculated as follows:
Substituting in the numbers yields a spot bid-ask spread of (0.7960 - 0.7957)/0.7960 =
0.04%. The corresponding forward bid-ask spread is (0.7973 - 0.7965)/0.7973 = 0.10%.
Chapter 7, Problem 7
Suppose Dow Chemical receives quotes of $0.009369-71 for the yen and $0.03675-6 for the Taiwan
dollar (NT$).
a. How many U.S. dollars will Dow Chemical receive from the sale of ¥50 million?
ANSWER. Dow must sell yen at the bid rate, meaning it will receive from this sale
$468,450 (50,000,000 x 0.009369).
b. What is the U.S. dollar cost to Dow Chemical of buying ¥1 billion?
ANSWER. Dow must buy at the ask rate, meaning it will cost Dow $9,371,000
(1,000,000,000 x 0.009371) to buy ¥1 billion.
c. How many NT$ will Dow Chemical receive for U.S.$500,000?
ANSWER. Dow must sell at the bid rate for U.S. dollars (which is the reciprocal of the ask
rate for NT$, or 1/0.03676), meaning it will receive from this sale of U.S. dollars
NT$13,601,741 (500,000/0.03676).
d. How many yen will Dow Chemical receive for NT$200 million?
ANSWER. To buy yen, Dow must first sell the NT$200 million for U.S. dollars at the bid
rate and then use these dollars to buy yen at the ask rate. The net result from these
transactions is ¥784,334,649.45 (200,000,000 x 0.03675/0.009371).
e. What is the yen cost to Dow Chemical of buying NT$80 million?
ANSWER. Dow must sell the yen for dollars at the bid rate and then buy NT$ at the ask
rate with the U.S. dollars. The net yen cost to Dow from carrying out these transactions is
¥313,886,220.51 (80,000,000 x 0.03676/0.009369)
Chapter 7, Problem 8
Suppose the euro is quoted at 0.6064 80 in London, and the pound sterling is quoted at 1.6244-59 in
Frankfurt.
a. Is there a profitable arbitrage situation? Describe it.
100 x
price Ask
price Bid - price Ask
= spreadPercent
ANSWER. Sell pounds for €1.6447/£ (1/0.6080) in London. Use the euros to buy pounds
for €1.6259/£ in Frankfurt. There is a net profit of €0.0188 per pound bought and sold–a
percentage yield of 1.15% (0.0188/1.6447).
b. Compute the percentage bid ask spreads on the pound and euro.
ANSWER. The percentage bid-ask spreads on the pound and euro are calculated as
follows:
£ bid-ask spread = (1.6259 - 1.6244)/1.6259 = 0.09%
euro bid-ask spread = (0.6080 - 0.6064)/0.6080 = 0.26%
Chapter 4
Chapter 4, Question 1
1. a. What is purchasing power parity?
ANSWER. In its absolute version, purchasing power parity states that price levels should
be equal worldwide when expressed in a common currency. In other words, a unit of
home currency (HC) should have the same purchasing power around the world. The
relative version of purchasing power parity, which is used more commonly now, states
that the exchange rate between the home currency and any foreign currency will adjust
to reflect changes in the price levels of the two countries. For example, if inflation is 5%
in the United States and 1% in Japan, then the dollar value of the Japanese yen must rise
by about 4% to equalize the dollar price of goods in the two countries.
b. What are some reasons for deviations from purchasing power parity?
ANSWER. PPP might not hold because:
• The price indices used to measure PPP may use different weights or different
goods and services.
• Arbitrage may be too costly, because of tariffs and other trade barriers and high
transportation costs, or too risky, because prices could change during the time
that an item is in transit between countries.
• Since some goods and services used in the indices are not traded, there could be
price discrepancies between countries.
• Relative price changes could lead to exchange rate changes even in the absence of
an inflation differential.
• Government intervention could lead to a disequilibrium exchange rate.
c. Under what circumstances can purchasing power parity be applied?
ANSWER. The relative version of purchasing power parity holds up best in two
circumstances: (a) over long periods of time among countries with a moderate inflation
differential since the general trend in the price level ratio will tend to dominate the effects
of relative price changes, and (b) in the short run during periods of hyperinflation since
with high inflation changes in the general level of prices quickly swamp the effects of
relative price changes.
Chapter 4, Question 3
3. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S.
prices. Is the Indonesian rupiah appreciating or depreciating in real terms?
ANSWER. The rupiah's real value is rising since it is not depreciating to compensate for
higher Indonesian inflation.
Chapter 4, Problem 2
2. Two countries, the United States and England, produce only one good, wheat. Suppose the
price of wheat is $3.25 in the United States and is £1.35 in England.
a. According to the law of one price, what should the USD/GBP spot exchange rate be?
ANSWER. Since the price of wheat must be the same in both nations, the exchange rate, e,
is 3.25/1.35 or e = $2.4074.
b. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States
and to £1.60 in England. What should the one year USD/GBP forward rate be?
ANSWER. In the absence of uncertainty, the forward rate, f, should be 3.50/1.60 or f =
$2.1875.
c. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England,
what is the maximum possible change in the spot exchange rate that could occur?
ANSWER. If e is the exchange rate, then wheat selling in England at £1.35 will sell in the
United States for 1.35e + 0.5, where 0.5 is the U.S. tariff on English wheat. In order to
eliminate the possibility of arbitrage, 1.35e + 0.5 must be greater than or equal to $3.25,
the price of wheat in the U.S. or e > $2.0370. Thus the maximum exchange rate change
that could occur is (2.4074 2.0370)/2.4074 = 15.38%. This solution assumes that the
pound and dollar prices of wheat remain the same as before the tariff.
Chapter 4, Problem 7
7. Chase Econometrics has just published projected inflation rates for the United States and
Germany for the next five years. U.S. inflation is expected to be 10 percent per year, and German
inflation is expected to be 4 percent per year.
a. If the current exchange rate is $0.95/€, what should the exchange rates for the next five
years be?
ANSWER. According to PPP, the exchange rate for the euro at the end of year t should
equal 0.95(1.10/1.04)t. Hence, projected exchange rates for the next 5 years are $1.0048,
$1.0628, $1.1241, $1.1889, $1.2575.
b. Suppose that U.S. inflation over the next five years turns out to average 3.2%, German
inflation averages 1.5%, and the exchange rate in five years is $0.99/€. What has happened to the
real value of the euro over this five-year period?
ANSWER. According to Equation 4.7, the real value of the euro at the end of five years is
0.9111 = )
1.032
1.015
( x 0.99 =
)i + (1
)i + (1
e = e
5
t
h
t
f
t
’
t
Hence, even though the euro has appreciated in nominal terms over this five-year period,
it has fallen in real terms by 4.09% [(0.9111 - 0.95)/0.95].
Chapter 4, Problem 8
8. During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7.64/U.S.$.
At the same time, U.S. inflation was approximately 3% in contrast to Mexican inflation of about
48.7%.
a. By how much did the nominal value of the peso change during 1995?
ANSWER. During 1995, the peso fell from $0.1876 (1/5.33) to $0.1309 (1/7.64), which is
equivalent to a devaluation of 30.24% ((0.1309 - 0.1876)/0.1876)
b. By how much did the real value of the peso change over this period?
ANSWER. Using Equation 4.7, the real value of the peso by the end of 1995 was $0.1890:
0.1890 =
1.03
1.487
x 0.1309 =
)i + (1
)i + (1
e = e t
h
t
f
t
’
t
Based on this real exchange rate, the peso has appreciated during 1995 by 0.72% ((0.1890
- 0.1876)/0.1876). In other words, the real exchange rate stayed virtually constant,
implying the purchasing power parity held during the year.
Additional Questions
1. Assume that the price level in Canada is CAD16,600, the price level in France is EUR11,750,
and the spot exchange rate is CAD1.35/EUR.
a. What is the implied exchange rate of CAD/EUR that satisfies absolute PPP?
ANSWER. The spot rate that satisfies absolute PPP is the ratio of the Canadian price level
in Canadian dollars to the French price level in Euros: CAD16,600/EUR11,750 =
CAD1.4128/EUR.
b. Is the Euro over- or undervalued relative to the Canadian Dollar?
ANSWER. As the actual exchange rate of CAD1.35/EUR is lower than the PPP exchange
rate, the Euro is undervalued. To go back to equilibrium, it would have to increase to CAD
1.4128/EUR.
c. What amount of appreciation or depreciation of the Euro would be required to return the
actual exchange rate to its PPP value?
ANSWER. (CAD1.4128/EUR-CAD1.35/EUR) / CAD1.35/EUR = 0.0466 → 4.66%
appreciation.
2. If the spot JPY/EUR exchange rate is YEN114/EUR, and expected inflation rates in Japan and
Europe are 3% and 5%, respectively, what is the expected change in the EUR over this one year
period?
ANSWER. Based on relative PPP, the expected exchange rate at t+1 = 114 YEN/EUR x
[(1+0.03)/(1+0.05)] = 111.83 YEN/EUR. The change in JPY/EUR rate is then (111.83 –
114)/114 = -1.905%.
We can also calculate this directly from the relative inflation rates: [(1+0.03)/(1+0.05)] –
1 = -0.01905 → -1.905%