Reference no: EM131210055

Do the following problems

1. The country of Luta has large capital flows with the U.S.It has no trade with the U.S, and will not have trade with the U.S. in the future. Its interest rate is 6%, the same as the U.S. interest rate. Its rate of inflation is 5%, the same as the U.S. inflation rate. You expect that the inflation rate in Luta will rise to 8% this coming year, while the U.S. inflation rate will remain at 5%. You expect that Luta's interest rate will rise to 9% during the next year. You expect that the U.S. interest rate will remain at 6% this year. Do you think Luta's currency will appreciate, depreciate, or remain unchanged against the dollar? Briefly explain.

2. A foreign exchange dealer in Warsaw provides quotes for spot and 3-month forward rates for the Polish zloty against the dollar.

                              Bid (PZ/$)    Ask (PZ/$)
Spot                          4.0040       4.0200
3-month forward        3.9690        3.9888

a. What would you receive in dollars if you sold PZ 5 million at the spot rate?

b. What would it cost in dollars to purchase PZ 20 million forward three months?

3. Last year a dollar was equal to 7 Swedish kronor, and a Polish zloty was equal to $.40. Today, the dollar is equal to 8 Swedish kronor and a Polish zloty is equal to $.44. By what percentage did the cross exchange rate of the Polish zloty in Swedish kronor (that is, the number of kronor that can be purchased with one zloty) change over the last year?

4. 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.

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. How come U.S. investors do not try to capitalize on the high interest rates in Mexico?

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?

5. Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approxi¬mately $10 billion worth of investment transactions occur between these two countries each year. The total dollar 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 dollar. 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 dollar.

a. US inflation has suddenly increased substantially, while Country K's inflation remains low.

b. US interest rates have increase substantially, while Country K's interest rates remain low. Investors of both countries are attracted to high interest rates.

c. The U.S. income level increased substantially, while Country K's income level is unchanged.

d. The U.S. is expected to impose a small tariff on goods imported from Country K.

e. Combine all expected impacts to develop an overall forecast.