Answer： The adjustment mechanism under the gold standard is referred to as the price—specie-flow mechanism expounded by David Hume。 Under the gold standard， a balance of payment disequilibrium will be corrected by a counter—flow of gold。 Suppose that the U.S。 imports more from the U.K。 than it exports to the latter. Under the classical gold standard, gold， which is the only means of international payments, will flow from the U.S. to the U。K. As a result, the U.S。 (U.K。) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S。 and rise in the U。K。 Consequently， the U。S。 products become more competitive in the export market, while U。K. products become less competitive. This change will improve U。S。 balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium。
12。 Once capital markets are integrated， it is difficult for a country to maintain a fixed exchange rate。 Explain why this may be so。
Answer: Once capital markets are integrated internationally， vast amounts of money may flow in and out of a country in a short time period. This will make it very difficult for the country to maintain a fixed exchange rate.
3. The United States has experienced continuous current account deficits since the early 1980s。 What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits?
Answer： The current account deficits of U.S。 may have reflected a few reasons such as (I） a historically high real interest rate in the U。S。, which is due to ballooning federal budget deficits, that kept the dollar strong, and （ii） weak competitiveness of the U。S。 industries.
8。 Explain how to compute the overall balance and discuss its significance. Answer: The overall BOP is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall BOP is significant because it indicates a country’s international payment gap that must be financed by the government’s official reserve transactions。 9. Explain and compare forward vs. backward internalization.
Answer： Forward internalization occurs when MNCs with intangible assets make FDI in order to utilize the assets on a larger scale and at the same time internalize any possible
externalities generated by the assets。 Backward internalization， on the other hand， occurs when MNCs acquire foreign firms in order to gain access to the intangible assets residing in the foreign firms and at the same time internalize any externalities generated by the assets。
1. Why is capital budgeting analysis so important to the firm？
Answer: The fundamental goal of the financial manager is to maximize shareholder wealth。 Capital investments with positive NPV or APV contribute to shareholder wealth. Additionally， capital investments generally represent large expenditures relative to the value of the entire firm。 These investments determine how efficiently and expensively the firm will produce its product. Consequently， capital expenditures determine the long-run competitive position of the firm in the product marketplace. PROBLEMS
3。 Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is ＄1。52/£。 The three-month interest rate is 8。0％ per annum in the U。S. and 5.8% per annum in the U。K。 Assume that you can borrow as much as ＄1,500，000 or £1，000，000.
a。 Determine whether the interest rate parity is currently holding。
b。 If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities。 Let’s summarize the given data first:
S = ＄1。5/£； F = $1。52/£; I$ = 2。0％; I£ = 1.45％ Credit = ＄1,500，000 or £1,000，000。 a. (1+I＄) = 1.02
（1+I£)（F/S) = （1.0145)（1.52/1。50） = 1.0280 Thus， IRP is not holding exactly.
b. （1) Borrow $1,500,000； repayment will be ＄1,530,000. (2) Buy £1，000,000 spot using $1，500，000.
（3) Invest £1，000,000 at the pound interest rate of 1.45%; maturity value will be £1,014，500.
(4） Sell £1,014,500 forward for $1,542，040 Arbitrage profit will be ＄12,040
c. Following the arbitrage transactions described above， The dollar interest rate will rise; The pound interest rate will fall; The spot exchange rate will rise； The forward exchange rate will fall.
These adjustments will continue until IRP holds。
4。 Suppose that the current spot exchange rate is €0。80/$ and the three-month forward exchange rate is €0。7813/$。 The three—month interest rate is 5.6 percent per annum in the United States and 5。40 percent per annum in France. Assume that you can borrow up to ＄1，000,000 or €800,000.
a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit。
b。 Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros。
a. (1+ i ＄) = 1。014 < (F/S） （1+ i € ) = 1.053. Thus, one has to borrow dollars and
invest in euros to make arbitrage profit。
1. Borrow $1,000，000 and repay $1，014，000 in three months。 2. Sell $1,000，000 spot for €1,060,000.
3. Invest €1,060,000 at the euro interest rate of 1。35 ％ for three months and
receive €1,074，310 at maturity.
4. Sell €1,074,310 forward for ＄1,053，245.
Arbitrage profit = $1,053,245 — ＄1，014,000 = ＄39，245.
b. Follow the first three steps above. But the last step, involving exchange risk hedging，
will be different。
5. Buy $1,014，000 forward for €1,034，280。 Arbitrage profit = €1,074,310 - €1,034，280 = €40,030
6。 As of November 1， 1999, the exchange rate between the Brazilian real and U。S. dollar is R＄1。95/＄. The consensus forecast for the U.S。 and Brazil inflation rates for the next 1—year period is 2。6％ and 20。0％, respectively. How would you forecast the exchange rate to be at around November 1, 2000？
: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to
forecast the exchange rate。
E(e） = E（$） — E（R＄）
= 2.6% — 20.0% = —17。4% = So(1 + E(e））
E(ST）
= （R$1。95/＄） （1 + 0。174) = R$2。29/$
7。 （CFA question） Omni Advisors, an international pension fund manager， uses the concepts of purchasing power parity （PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows: Base 100
Current U。S. price level 105 Current South African price level 111
Base rand spot exchange rate ＄0。175 Current rand spot exchange rate ＄0.158 Expected annual U。S。 inflation 7％ Expected annual South African inflation 5% Expected U.S。 one-year interest rate 10％ Expected South African one—year interest rate 8%
Calculate the following exchange rates (ZAR and USD refer to the South African and U.S。 dollar， respectively)。
a. The current ZAR spot rate in USD that would have been forecast by PPP。 b. Using the IFE， the expected ZAR spot rate in USD one year from now. c. Using PPP, the expected ZAR spot rate in USD four years from now。 a. ZAR spot rate under PPP = ［1.05/1.11］(0.175) = $0.1655/rand。 b. Expected ZAR spot rate = [1。10/1。08］ （0。158) = ＄0.1609/rand。
c。 Expected ZAR under PPP = [（1.07)4/(1。05)4] （0.158） = ＄0。1704/rand。
price
level
8. Suppose that the current spot exchange rate is €1.50/₤ and the one—year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4％ in euros and 5.2％ in pounds。 You can borrow at most €1,000，000 or the equivalent pound amount， i。e。, ₤666,667, at the current spot exchange rate.
a. Show how you can realize a guaranteed profit from covered interest arbitrage.
Assume that you are a euro-based investor。 Also determine the size of the arbitrage profit。
b. Discuss how the interest rate parity may be restored as a result of the above transactions。
c. Suppose you are a pound-based investor。 Show the covered arbitrage process
and
determine the pound profit amount.
a. First, note that （1+i €) = 1.054 is less than (F/S）(1+i €) = (1.60/1。50)(1.052) = 1。1221。 You should thus borrow in euros and lend in pounds。
1) Borrow €1,000,000 and promise to repay €1,054，000 in one year. 2) Buy ₤666，667 spot for €1,000，000。
3) Invest ₤666，667 at the pound interest rate of 5.2％； the maturity value will be
₤701,334.
4) To hedge exchange risk, sell the maturity value ₤701,334 forward in exchange for
€1,122,134。 The arbitrage profit will be the difference between €1，122,134 and €1,054，000, i.e。， €68，134。
b。 As a result of the above arbitrage transactions, the euro interest rate will rise， the pound
interest rate will fall。 In addition， the spot exchange rate （euros per pound) will rise and the forward rate will fall. These adjustments will continue until the interest rate parity is restored。
c. The pound—based investor will carry out the same transactions 1)， 2）， and 3) in a. But to hedge, he/she will buy €1,054,000 forward in exchange for ₤658，750。 The arbitrage profit will then be ₤42,584 = ₤701，334 — ₤658,750.
9。 Due to the integrated nature of their capital markets， investors in both the U。
S. and U.K. require the same real interest rate, 2。5%， on their lending。 There is a consensus in capital markets that the annual inflation rate is likely to be 3。5％ in the U。S。 and 1.5％ in the U。K. for the next three years. The spot exchange rate is currently ＄1。50/£。
a. Compute the nominal interest rate per annum in both the U。S. and U。K。,
assuming that the Fisher effect holds.
b. What is your expected future spot dollar—pound exchange rate in three years
from now?
c. Can you infer the forward dollar—pound exchange rate for one-year maturity？ a。 Nominal rate in US = (1+ρ) （1+E(π$）） – 1 = (1.025）(1。035） – 1 = 0。0609 or 6.09％.
Nominal rate in UK= （1+ρ) (1+E（π₤)） – 1 = （1.025）(1。015) – 1 = 0。0404 or 4.04%.
b。 E(ST） = ［（1.0609)3/(1。0404）3］ (1.50） = ＄1.5904/₤. c。 F = [1.0609/1.0404］(1。50) = $1。5296/₤。
2。 A bank sells a “three against six” ＄3,000，000 FRA for a three—month period beginning three months from today and ending six months from today。 The purpose of the FRA is to cover the interest rate risk caused by the maturity mismatch from having made a three—month Eurodollar loan and having accepted a six-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent。 There are actually 92 days in the three—month FRA period. Assume that three months from today the settlement rate is 4 7/8 percent. Determine how much the FRA is worth and who pays who—-the buyer pays the seller or the seller pays the buyer.
Solution： Since the settlement rate is less than the agreement rate， the buyer pays the seller the absolute value of the FRA. The absolute value of the FRA is：
＄3，000,000 x [(.04875—.055） x 92/360］/[1 + （。04875 x 92/360）] = $3，000,000 x ［-。001597/(1.012458）］ = $4,732。05.
3。 Assume the settlement rate in problem 2 is 6 1/8 percent. What is the solution
now?
Since the settlement rate is greater than the agreement rate， the seller pays the buyer the absolute value of the FRA。 The absolute value of the FRA is:
＄3，000,000 x ［(.06125-。055) x 92/360]/[1 + (.06125 x 92/360）] = ＄3,000,000 x ［。001597/(1.015653）] = $4，717.16.
4。 A “three—against—nine” FRA has an agreement rate of 4。75 percent。 You believe six-month LIBOR in three months will be 5.125 percent。 You decide to take a speculative position in a FRA with a $1，000，000 notional value. There are 183 days in the FRA period. Determine whether you should buy or sell the FRA and what your expected profit will be if your forecast is correct about the six—month LIBOR rate。
: Since the agreement rate is less than your forecast, you should buy a FRA。 If your forecast is correct your expected profit will be:
＄1，000,000 x [(.05125—.0475) x 183/360]/[1 + (.05125 x 183/360）］ = $1,000，000 x [。001906/（1.026052)］ = ＄1，857.61。
1。 Your firm has just issued five-year floating—rate notes indexed to six—month U.S. dollar LIBOR plus 1/4％。 What is the amount of the first coupon payment your firm will pay per U.S. $1，000 of face value, if six—month LIBOR is currently 7。2％?
0。5 x (.072 + .0025) x ＄1，000 = $37。25.
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