Question 1

The officials of the Governmentof Guam are of the opinion that the country’scurrency has appreciated significantly in recent past and the appreciation is hurting the country’s exports.It has therefore decided to intervene directlyin the foreign exchange marketto stimulate exports and economic activities in general.

a)                 Discuss why governments intervene in the foreignexchange market and why such interventions are generally not effective in the long term?

b)                 How can governments stimulate export by using exchange rates as a policy tool?

c)                 Describe how the government of Guam shouldgo about intervening directly in the market using its reservesto achieve its goals and discuss the consequences of suchactions. Use diagrams to illustrate your answer.

d)                 If you were a consultant to the Governmentof Guam, what would you recommend to

the authorities in order to ensure that money supplyand economic activities in the country are not affected by the government’s foreign exchange dealings?

2a) Mesa Companyspecializes in the production of small fancy picture frames,which are exported from the U.S. to the UnitedKingdom. Mesa invoicesthe exports in pounds and converts the pounds to dollars when they are received. The British demandfor these frames is positively related to economic conditions in the United Kingdom. Assume that British inflation and interest rates aresimilar to the rates in the U.S. Mesa believesthat the U.S. balance-of-trade deficitfrom trade between the U.S. and the United Kingdomwill adjust to changing pricesbetween the two countries, while capital flows will adjustto interest rate differentials. Mesa believes that the value ofthe pound is very sensitive to changing international capital flows, and is moderately sensitive to international trade flows. Mesa is considering the following information:

•      The U.K. inflationrate is expected to decline,while U.S. inflationrate is expected to rise.

•      British interest ratesare expected to decline, while U.S. interestrates are expectedto

increase.

1.    Explain how the international trade flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interestrates (holding exchange rates constant).                                                                                                                 

2.     Using the information provided, will Mesa expect the pound to appreciate or depreciate in thefuture?  Explain.

3.    Mesa believes international capitalflows shift in response to changing interestrate differentials. Is there any reason why the changinginterest rate differentials in this example will not necessarily cause international capitalflows to changesignificantly? Explain.

4.     Based on your answer to question 2, how would Mesa’s cash flows be affected by the expectedexchange rate movements? Explain.     

5.    Based on your answerto question 4, should Mesa consider hedgingits exchange rate risk? If so, explainhow it could hedge usingforward contracts, futurescontracts, and currency options.   

At the current time, Wang Guo Ent. is willing to receive payment in British pounds for the

monthly exports it sends to the UK. While all of its receivables are denominated in pounds, it has no payables in pounds or in any other foreign currency. Shao Yang, the manager of the firm wants to assess her firm’s exposureto exchange rate risk.

a)     Would you describe the exposure of the Wang Guo Ent to exchangerate risk as transaction

exposure? Economicexposure? Translation exposure?                                                                                                  

b)      The manager is considering a change in the pricingpolicy in which the importermust pay in dollars,so that the manager will not have to worry about converting pounds to dollars every month. If implemented, would this policy eliminate the transaction exposureof Wang Guo Ent? Would it eliminate the firm’s economicexposure? Explain.  

c)      If the manager decides to implement the policy describedin the previous question, how wouldWang Guo Ent be affected(if at all) by appreciation of the pound?By depreciation of the pound? Would these effects on Wang Guo Ent differ if the manager retained her original policy of pricingthe exports in British pounds?                       

3A :Use the table below to answer questions i-v.

Assume the following exchangerates

i)               How many US dollars would it cost to buyAUD 1,000,000 spot?                                                                                      

ii)                How much AUD would it cost to buy USD 10,000,000 for settlement in 30 days’ time?

iii)              How many GBP would you get if you sold AUD 10,000,000 for settlement in 90 days’time?

iv)               How many euros (EUR)would you get if you sold 1,000,000 Australian dollars for forward

i)          Youremployer, XYZ Company has just sold USD 5,000,000 of computer equipmentto a US company. It is expecting payment in ninety days. To reduce risk, it sells the USD forward. If the spot AUD / USD exchangerate is 0.6305 – 10 in ninety days time, howmuch has XYZ company gained or lost by hedging?The current SPOT AUD/USD (i.e AUD1) is 0.6244 – 49 and the90 day forward pointsare 22 /12.               

ii) ABC Ltd is going to receive GBP 10,000,000 in 90 days time. The current spot rate is AUD/GBP= 0.3345 – 50. If ABC enters a forwardcontract on a principal of GBP10,000,000 at a rate of 16/23, how manyAUD will it receive?                    

(i). If the AUD/USD exchangerate is 0.5234 – 39, how many AUD would you get if you soldUSD 10,000,000                                                                                                      

(ii) ABC Ltd is going to receiveGBP 10,000,000 in 90 days time. The current spot rate is AUD/GBP = 0.3345 – 50. If ABC enters into a forward contracton a principal of GBP 10,000,000 at a rate (forward points)of 16/23, how many AUD will it receive?                                                                                                   

(iii) Assuming the Spot AUD/USDis quoted as 0.5430 – 35. What is the percentage bid ask spread for the AUD/ USD spot?                                                                                                            

iv) HSBC Bank expects that the Singapore dollar will depreciate against the dollarfrom its spot rate of $0.43 to $0.42 in 60 days. The followinginterbank lending and borrowing rates exist:

Lending Rate          Borrowing Rate

HSBC Bank considersborrowing 10 millionSingapore dollars in the interbankmarket and investing the funds in dollars for 60 days.Should Diamond Bank pursue this strategy?

Questions4

i) ABC Limited,an Australian company,is going to receive USD 10,000,000 in 90 days’ time,and it is concerned that the USD will depreciate relative to the AUD over this period.Management is considering four strategies to deal with this situation. These are:

a)       Remain unhedged.                                                                                               

b)       Sell the USD forward for settlement in 90 days.  It gets a quote from its bank of AUD / USD 0.5440– 45 spot with 90 daysforward points of 34 / 60.                                                                                                      

c)       Buy a USD put option with a strikeprice of AUD / USD = 0.5500and a premium of 0.01 USDper USD of principal.                                                                                                      

d)       Buy an AUD call option with a strike price of AUD / USD = 0.5495 and a premium of 0.01AUD per AUD of principal.                                                                                                        

The currentexchange rate is AUD / USD is 0.5450

What will be the net proceedsunder each strategyif the spot exchange rate is AUD / USD 0.5400,0.5460 or 0.5520 in 90 days’ time?

a)      a) Why do companies borrow, lend and issue and buy sharesin international markets, ratherthan the domestic market? What risks does this expose the company to? To what extent will the use of derivatives overcomethese problems?                              

b)   Which factors influence the determination of the exchangerate in a floating rate system?

How can these factorsexplain the onset of a financial crisis and the collapse of a fixed rate system?