FIN3IFM :
International Financial Management
Tutorial 03: Questions

Semester 1, 2021
Subject Coordinator
Dr Muhammad Al Mamun


International
Financial Management

Tutorial 3 Questions
First 15 minutes:
Please provide a summary of the week 3 lecture materials.
Exchange Rate Equilibrium
• Demand for a Currency
• Supply of a Currency for Sale
• Equilibrium Exchange Rate
• Change in the Equilibrium Exchange Rate
Factors that Influence Exchange Rates
• Relative Inflation Rates
• Relative Interest Rates
• Relative Income Levels
• Government Controls
• Expectations
• Interaction of Factors
• Influence of Factors Across Multiple Currency Markets
• Impact of Liquidity on Exchange Rate Adjustments
History and Economics of Currency Standard
• Classical gold standard: 1876-1913

• Interwar period: 1919-1944
• Bretton Woods system: 1945-1973
• Current ‘system’: 1973-present.
Exchange Rate Systems
• fixed
• freely floating
• managed float
• pegged
Government Intervention


Question 1:
Here are the headlines from various newspapers that have a potential impact on the exchange
rate of US$ against other currencies.
Transactions
Nature of effect (demand &
Outlook for US$
supply dynamics)
Weakened
Fed slashes main interest rate to
Foreign demand for US
near zero in a historic move
deposits/treasuries will be
designed to cushion the economic
lower.
blow of coronavirus pandemic.
Stronger economic growth will Strengthen
American Rescue Plan (ARP) will
attract foreign investment which
boost growth.

will increase the demand for the
US dollar.
Weakened
American Rescue Plan (ARP) is
A higher level of deficit
increasing the deficit increasing
projection can increase
sovereign risk.
sovereign risk and reduce
foreign demand for US deposits.
Weakened
China's foreign reserves suffer the
A decline in China’s foreign
biggest monthly fall on record.
reserve will increase the supply
of dollars available for trade,
putting downward pressure on
the dollar.
Strengthen
The currency war intensified after
China devalues the yuan.
Weakened
Indian economy is likely to grow
A higher foreign economic
by 12%, higher than initially
growth is likely to attract US
predicted by analysts.
investment in India.
Weakened.
China lifts the import quota on

A higher Australian export is
Australian wool by 5 percent.
likely to increase the value of
the Australian Dollar.

Question 2:
‘Should China be forced to alter the value of its currency?’ – Present the points supporting and
opposing this motion. What would be your final position?
POINT:
US politicians frequently suggest that China needs to increase the value of the Chinese yuan
against the US dollar, even since China has allowed the yuan to float (within boundaries).
The US politicians claim that the yuan is the cause of the large US trade deficit with China.
This issue is periodically raised not only with currencies tied to the dollar but also with
currencies that have a floating rate. Some critics argue that the exchange rate can be used as a
form of trade protectionism. That is, a country can discourage or prevent imports and
encourage exports by keeping the value of its currency artificially low.
COUNTER-POINT:
China might counter that its large balance of trade surplus with the US has been due to the
differences in prices between the two countries and that it should not be blamed for the high
US prices. It might argue that the US trade deficit can be partially attributed to the very high
prices in the US, which are necessary to cover the excessive compensation for executives and


other employees at US companies. The high prices in the US encourage companies and
consumers to purchase goods from China. Even if China’s yuan is revalued upward, this does
not necessarily mean that the US companies and consumers will purchase US products. They
may shift their purchases from China to purchase products in Indonesia or other low-wage
countries rather than buy more products from the US. Thus, the underlying dilemma is not
China, but any country that has lower costs of production than the US.
WHO IS CORRECT?

Which argument do you support? Offer your own opinion on this issue.
ANSWER: The issue is important because it affects the potential degree of economic growth
in the US. The sustained trade deficit with China may suggest that the yuan is overvalued,
but if the yuan is revalued, the US may import more products from other countries where
there are low costs of production. Thus, the trade deficit with China may be reduced, but the
overall trade deficit may remain.
Question 3:
Some of the Latin currencies are persistently weak against US$. How can persistently weak
currencies be stabilized? Argue for and against relevant prescriptions to solve this issue.
POINT:
The currencies of some Latin American countries depreciate against the U.S. dollar
consistently. The governments of these countries could attract more capital flows by raising
interest rates and making their currencies more attractive. They also could insure bank
deposits so that foreign investors who invest in large bank deposits do not need to worry
about default risk. Also, they could impose capital restrictions on local investors to prevent
capital outflows.
COUNTER-POINT:
Some Latin American countries have had high inflation, which encourages local firms and
consumers to purchase products from the U.S. instead. By reducing inflation, these countries
could relieve the downward pressure on their local currencies. To reduce inflation, a country
may have to reduce its economic growth temporarily. These countries should not raise their
interest rates in an attempt to attract foreign investment, because they will still not attract
funds if investors fear that large capital outflows will occur at the first threat of continued
depreciation.
WHO IS CORRECT?
Which argument do you support? Offer your own opinion on this issue.
ANSWER: There is no perfect solution but recognize the trade-offs. 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.


Question 4: Currency board
What is the difference between central banks and currency boards?
ANSWER:
• In a pegged exchange system, a currency board (CB) is a monetary authority that is
committed to maintaining the pegged exchange rate while renouncing independent
monetary policy.
• Like a central bank, in a pegged system, a CB issues notes and coins (backed by the
volume of pegged currency or other forms of deposits) and offers the service of
converting local currency into the anchor currency at a fixed rate of exchange.
• However, the central bank still exists and performs the role of ‘lender of last resort’ for
domestic banks. If a country’s banking system fails, the central bank, not CB comes and
bails them out.
• Unlike a central bank, a CB does not hold bank deposits earning interest and
yielding profit. Moreover, CB is not the government's bank and cannot influence interest
rates by setting the discount rate.
Question 5:
Every month, the U.S. 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 U.S. demand for foreign currencies may be larger than initially

anticipated. Thus, the dollar would be expected to weaken. Some speculators may take a
position in foreign currencies immediately and could cause an immediate decline in the
dollar.
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.


Question 6: 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:
Lending Rate
Borrowing Rate
U.S. dollar
8%
8.3%
Mexican peso
8.5%
8.7%
Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million
pesos 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 = $1,344,441
Question 7: (Reading list)
In the reading list this week ‘Free exchange: Change for the dollar’ the author argues that the
role of US$ as the reserve currency is secure, even though the dominance of the American
economy is declining. Briefly discuss the reason upon which such assertion is made. Cite one
example of why you would disagree with the author?
ANSWER:
The authors argue that a reserve-currency issuer should play an outsize role in global trade,
which encourages partners to draw up contracts in its currency. Moreover, the historical role
as a global creditor helps to expand the use of the currency and encourage its accumulation in
reserves. History of monetary stability matters, too, as do deep and open financial markets.
While the author points that America exhibits these attributes less than it used to, yet the
greenback’s status is as secure as American global leadership.
The assertion is based on two premises:
Firstly, the premise that America is not as weak relative to its rivals as often assumed.
Moreover, an often-fractious euro area and authoritarian China inspire still less confidence.
The euro’s members and China are saddled with their debt problems and potential crisis
points.

Secondly, the fact that Dollar dominance also reflects factors that conventional economic


analyses sometimes omit geopolitics. Sterling ruled during a long period of increasing global
integration to which Britain— as a financial, industrial, and military powerhouse—was
central.
It was not just American economic superiority that put the dollar at the center of the postwar order, but it is unrivaled geopolitical might as well, which is used to reforge an integrated
global economy. Eichengreen, Mehl, & Chiţu, (2019) highlights the role of power politics in
currency choice.
Question 8: (Self-preparation)
What are the benefits and costs to the Indian Economy and Indian MNCs if Indian Rupee
becomes the global reserve currency?
ANSWER:
Use the article in the Reading list “The costs and benefits of the US role as a reserve
currency country” and prepare the answer.
Benefits:
• The flexibility argument
• The Income Advantage
• The ability to influence the domestic policy of other countries.
Cost:
• The Devaluation Constraint
• The Burden of Supplying Reserves to Other Countries


Additional Self-preparation Question for Final Exam:
Assuming a change in the Thai baht’s value from a value of $0.022 to $0.026 in 30 days, the
treasurer of Blades’ Inc would like to speculate on expected movements in the baht’s value over
the next 30 days. Blades can borrow either $10 million or the baht equivalent of this amount in
US$. Furthermore, assume that the following short-term interest rates (annualized) are available
to Blades:
Currency
Lending Rate

Borrowing Rate
Dollars
8.10%
8.20%
Thai baht
14.80%
15.40%
Design a speculation strategy for Blades.
Depreciation of the Baht from $0.022 to $0.020
1. Borrow Thai baht ($10,000,000/0.022)
2. Convert the Thai baht to dollars ($454,545,454.50 million × $0.022).

454,545,454.50
10,000,000.00

3. Lend the dollars at 8.10% annualized, which represents a 0.68% return 10,068,000.00
over the 30-day period [computed as 8.10% × (30/360)]. After 30
days, Blades would receive ($10,000,000 × (1 + .0068))
4. Use the proceeds of the dollar loan repayment (on Day 30) to repay 460,363,636.40
the baht borrowed. The annual interest on the baht borrowed is
15.40% or 1.28% over the 30 days [computed as 15.40% × (30/360)].
The total baht amount necessary to repay the loan is therefore
(454,545,454.50 × (1 + .0128))
5. Number of dollars necessary to repay baht loan ($THB460,363,636.40
× $0.02)
6.

Speculative profit ($10,068,000 – $9,207,272.73)

9,207,272.73

860,727.27

Additional Questions from Textbook: Q 13, Q 19.

Reference:
Eichengreen, B., Mehl, A., & Chiţu, L. (2019). Mars or Mercury? The geopolitics of
international currency choice. Economic Policy, 34(98), 315-363.