International Financial Management Canadian Canadian 3rd Edition Brean Solutions Manual

International Financial Management Canadian

Canadian 3rd Edition Brean Solutions Manual

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 CHAPTER 5 INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING
FOREIGN EXCHANGE RELATIONSHIPS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS

QUESTIONS

1. Give a full definition of arbitrage.

Answer: Arbitrage involves the simultaneous purchase and sale of the same or equivalent assets or
commodities – buying at a low price, selling at a high price – thus making a riskless profit.

2. Discuss the implications of interest rate parity for exchange rate determination.

Answer: Assuming the forward exchange rate is an unbiased predictor of the future spot rate, IRP
between dollars and pounds can be written as:
S = [(1 + i£)/(1 + i$)]E[St+1It].
The exchange rate is thus determined by relative interest rates and the expected future spot rate
conditional on available information, It, as of the present time. The expectation is self-fulfilling.
Since the information set is continuously updated as news hit the market, the exchange rate exhibits
a dynamic, random behavior.

3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the
future spot exchange rate.

Answer: The forward exchange rate is an unbiased predictor of the future spot exchange rate if …
i. the risk premium is insignificant, and
ii. foreign exchange markets are informationally efficient.

4. Explain purchasing power parity, both the absolute and relative versions. What causes deviations
from purchasing power parity?

Answer: Absolute (or static) purchasing power parity (PPP) is S = P$/P£ where S is the spot
exchange rate, P$ is the price level in the dollar country (Canada) and P£ is the price level in the

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 pound country (Britain). Relative (or dynamic) PPP is e = $ - £ where e is the rate of change of
the spot exchange rate, $ is the expected change of price level (expected inflation) in the dollar
country (Canada) and £.is the expected change of price level (expected inflation) in the pound
country (Britain).

PPP can be violated by barriers to trade – such as tariffs or transportation costs – or cross-country
differences in tastes. PPP is the law of one price applied to a standard consumption basket.

5. Discuss the implications of the deviations from purchasing power parity for countries’ competitive
positions in the world market.

Answer: If exchange rate changes satisfy PPP, the competitive positions of countries remain
unaffected by the exchange rate changes. Such exchange rate changes are strictly “nominal”.
Otherwise, exchange rate changes affect the relative competitiveness of industries in the countries
involved. If a country’s currency appreciates (depreciates) by more than it is warranted by PPP,
that country’s real exchange rate rises. The effect is to raise the relative price of that country’s
exported goods while reducing (for domestic use or consumption) the relative price of that
country’s imports. Exporters are hurt. Importers are helped.

6. Explain and derive the international Fisher effect.

Answer: The International Fisher Effect combines domestic Fisher effects in two countries and the
relative version of PPP in its expectational form. Specifically, the country-specific Fisher effect for
a dollar country and a pound country is, respectively …
E($) = i$ - $ where E($) is the expected rate of inflation, i$ is the nominal interest rate
and $ is the real rate of interest in the dollar country, and likewise,
E(£) = i£ - £. in the pound country.
Assuming the real interest rate is the same in the two countries, i.e., $ = £, and substituting the
above results into the PPP, i.e., E(e) = E($)- E(£), the international Fisher effect is: E(e) = i$ - i£.

7. Researchers found that it is very difficult to forecast future exchange rates more accurately than the
forward exchange rate or the current spot exchange rate. How would you interpret this finding?

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 Answer: Foreign exchange markets are informationally efficient. Unless one has private
information that is not yet reflected in the current market rates, which is the case for virtually all
participants in foreign exchange markets, all new relevant information is truly new. New
information that can either raise the exchange rate or lower it is equally likely to raise or lower the
exchange rate. The random flow of new information generates random movements of the exchange
rate.

8. Explain the random walk model for exchange rate forecasting. Can it be consistent with technical
analysis?

Answer: If exchange rates follow a random walk, the current exchange rate is the best predictor of
the future exchange rate. In that case the past history of the exchange rate is of no value in
predicting future exchange rate. A random walk model is inconsistent with technical analysis
which tries to use past history to predict future exchange rate.

9. Derive and explain the monetary approach to exchange rate determination.

Answer: The monetary approach to exchange rate movements is based on two tenets: purchasing
power parity and the quantity theory of money. Combining these two theories suggests the $/£ spot
exchange rate as: S($/£) = (M$/M£)(V$/V£)(y£/y$),
where M denotes the rate money supply, V is the velocity of money (essentially national income
divided by money supply) and y is national income. What matters in exchange rate determination are:
i. relative money supply,
ii. relative velocities of money, and
iii. relative national incomes.

10. CFA question: Explain the following three concepts of purchasing power parity (PPP):
a. The law of one price
b. Absolute PPP
c. Relative PPP
Answer:
a. The Law of One Price (LOP) maintains that the same good (or basket of goods) must have the
same price in two places. Otherwise, arbitrage – arbitragers buying at the low-priced site and
selling at the higher priced site – will ensue until the prices are the same in the two sites.

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b. Absolute Purchasing Power Parity (absolute PPP) holds that the price level in a country is equal
to the price level in another country times the exchange rate between the two countries. i.e., P1/P2
= S1/2 There is virtually no empirical evidence to support Absolute Purchasing Power Parity.

c. Relative Purchasing Power Parity (relative PPP) holds that the rate of exchange rate change
between a pair of countries is equal to the difference in expected inflation rates between the two
countries.

11. CFA question: Evaluate the usefulness of relative PPP in predicting movements in foreign exchange
rates on:
a. Short-term basis (e.g., three months)
b. Long-term basis (e.g., six years)
Answer:
a. PPP is not useful for predicting exchange rates on the short-term basis mainly because
international commodity arbitrage is a costly process.

b. PPP is at most useful for predicting exchange rates on the long-term basis.

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PROBLEMS

1. Suppose that the treasurer of Weston’s has an extra cash reserve of $10 million to invest for six
months. The six-month interest rate is 4 percent per annum in Canada and 5 percent per annum in
Germany. Currently, the spot exchange rate is €0.65 per dollar and the six-month forward
exchange rate is €0.66 per dollar. The treasurer of Weston’s does not wish to bear any exchange
risk. Where should he invest?

Solution: The market conditions are summarized as follows:

i$ = 4%; i€ = 5%; S = €0.65/$; F = €0.66/$.
If $10 million is invested in Canada, the maturity value in six months will be
$10,200,000 = $10,000,000 (1 + (.04/2)).

Alternatively, $10 million can be converted into euro and invested at the European interest rate,
with the euro maturity value sold forward for forward cover. In this case the dollar maturity value
will be … $10,094,697 = ($10,000,000 x 0.65)(1 + (.05/2))(1/0.66)

Clearly it is better to invest $10 million in Canada. Even though the European interest rate exceeds
the interest rate in Canada, the expected depreciation of the euro vis-à-vis the Canadian dollar that
is built into the relation between the spot and forward rates more than offsets the international
interest differential.

2. While you were visiting Paris, you purchased a Renault for €10,000, payable in three months. You
have enough cash at your bank in Vancouver, which pays 0.35 percent interest per month,
compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/€ and the
three-month forward exchange rate is $1.40/€. In Paris, the money market interest rate is 2
percent for a three-month investment. There are two alternative ways of paying for your Renault.

a. Keep the funds at your bank in Canada and buy €10,000 forward.
b. Buy a certain euro amount spot today and invest the amount in Europe for three months so that
the maturity value becomes equal to €10,000. Evaluate each payment method. Which method
would you prefer? Why?

Solution: The problem situation is summarized as follows:

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 Obligation = €10,000 payable in 3 months
i$ = 0.35 percent per month compounded monthly
i€ = 2.0 percent for 3 months
S = $1.45/€
F = $1.40/€

Option a:
To buy €10,000 forward, you will need 10,000*1.40 or $14,000 in 3 months to fulfill the forward
contract. The present value of $14,000 discounted at the dollar interest rate is:
$14,000/(1.0035)3 = $13,854
Thus, the cost of the car as of today is $13,854.

Option b:
The present value of €10,000 is €9,804 = €10,000/(1.02). To buy €9,804 today will cost $14,216
= $9,804 x1.45. Thus the dollar cost of the Renault as of today is $14,216.

Option “a” is preferred. The difference between Options “a” and “b” is $362, or $14,216 minus
$13,854.

3. Currently, the spot exchange rate is $1.50/€ and the three-month forward exchange rate is $1.49/€.
The three-month interest rate is 4 percent per annum in Canada and 5 percent per annum in Europe.
Assume that you can borrow as much as $1,500,000 or €1,000,000.
a. Determine whether interest rate parity is currently holding.
a. If IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.
c. Explain how IRP will be restored as a result of covered arbitrage activities.

Solution: First, summarize the given data:

S = $1.50/€; F = $1.49/€; i$ = 4 %; i€ = 5 %
Credit = $1,500,000 or €1,000,000

a. In Canada investment: (1+i$) = (1 + (0.04/4)) = 1.0100

Covered investment in Europe: (1+i€)(F/S) = (1 + (0.05/4))*(1.49/1.50) = 1.00575
Thus, IRP is not holding exactly.
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 The arbitrager will borrow in Euro and invest in Canadian dollar securities.

b. 1. Borrow €1,000,000; repayment will be €1,012,500 = €1,000,000 *(1.0125)

2. Buy $1,500,000 spot using €1,000,000.
3. Invest $1,500,000 at 4 interest rate; maturity value will be $1,515,000
4. Buy €1,012,500 forward for $1,508,625 = €1,012,500 * 1.49
Arbitrage profit will be $6,375.

c. In the process of the arbitrage transactions described above,

The dollar interest rate will fall. ( Canadian securities prices rise. )
The euro interest rate will rise. ( European securities prices fall. )
The spot exchange rate (in $/€ ) will fall. ( Up from S = $1.50/ € )
The forward exchange rate (in $/€ ) will rise. ( Down from F = $1.49/€ )
These adjustments continue until IRP holds.

4. Suppose that the current spot exchange rate is €0.65/$ and the three-month forward exchange rate
is €0.64/$. The three-month interest rate is 5.6 percent per annum in Canada and 5.40 percent per
annum in France. Assume that you can borrow up to $1,000,000 or €1,060,000.
a. Show how to realize a certain profit via covered interest arbitrage, assuming that you
want to realize profit in terms of 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.

Solution: The market data are summarized as follows:

S = €0.65/$ = $1.5385/€;
F = €0.64/$ = $1.5625/€;
On a 3-month basis: i$ = (0.056/4) = 0.014; i€ = (0.054/4) = 0.0135
(1+i$) = 1.014 > (1+i€)(F/S) = (1.0135)*(0.64/0.65) =
0.9979

a. 1. Borrow $1,000,000; repayment will be $1,014,000

2. Buy €649,984 spot for $1,000,000.

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 3. Invest in France at 5.4 % for 3 months; maturity value will be €658,759
4. Sell €658,759 forward for $1,029,310 = €658,759* ($1.5625/€)
Arbitrage profit will be $15,310 = $1,029,310 - $1,014,000

b. 1. Borrow $1,000,000; repayment will be $1,014,000.

2. Buy €649,984 spot for $1,000,000.
3. Invest in France at 5.4 % for 3 months; maturity value will be €658,759
4. Buy $1,014,000 forward for €648,960 = $1,014,000 / ($1.5625/€)
Arbitrage profit will be €9,799 = €658,759 - €648,960

Note that only step (4) is different.

5. The Economist reports that the interest rate per annum is 5 percent in Canada and 50 percent in
Turkey. Why do you think the interest rate is so high in Turkey? On the basis of the reported
interest rates, how would you predict the change of the exchange rate between the Canadian
dollar and the Turkish lira?

Solution: The high Turkish interest rate reflects high expected inflation in Turkey. According to
international Fisher effect (IFE), we have
E(e) = i$ - iLira
= 5 - 50 = - 45 %
The Turkish lira thus is expected to depreciate against the Canadian dollar at the rate of
approximately 45 percent per annum.

6. As of November 1, 2007, the exchange rate between the Brazilian real and US dollar was
R$2.10/$. The consensus forecast for the US and Brazil inflation rates for the next one-year
period is 3percent and 15 percent, respectively. What would you forecast the exchange rate to be
at around November 1, 2008?

Solution:
In view of the significant difference in inflation rates between the US and Brazil, we may invoke
purchasing power parity to forecast the exchange rate.
E(e) = E($) - E(R$)

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 = 3.0% - 15.0%
= -12.0%

E(ST) = So(1 + E(e))

= (R$2.10/$) (1 + 0.12)
= R$2.35/$

7. 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 price level 100

Current Canadian 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 Canadian inflation 7%
Expected annual South African inflation 5%
Expected Canadian one-year interest rate 10 %
Expected South African one-year interest rate 8%

Calculate the following exchange rates (ZAR refers to the South African rand):
a. The current ZAR spot rate in dollars that would have been forecast by PPP
b. Using the IFE, the expected ZAR spot rate in dollars one year from now
c. Using PPP, the expected ZAR spot rate in dollars four years from now

Solutions:
a. ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/ZAR.
b. Expected ZAR spot rate = [1.10/1.08] (0.158) = $0.1609/ZAR.
c. Expected ZAR spot under PPP = [(1.07)4/(1.05)4] (0.158) = $0.1704/ZAR.

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 percent in euros and 5.2 percent in pounds. You can
borrow at most €1,000,000 or the equivalent pound amount, that is, ₤666,667, at the current spot
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 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 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.

Solutions:

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. The steps are …

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 percent; maturity value is ₤701,334.
4. To hedge exchange risk, sell the maturity value ₤701,334 forward in exchange for €1,122,134.
Arbitrage profit is €1,122,134 minus €1,054,000, i.e., €68,134.

b. As a result of the above arbitrage transactions, capital flows from the euro to the pound causing
the euro interest rate to rise and the pound interest rate to fall. In addition, because of spot
buying pressure on the euro (selling pressure on the pound) the spot exchange rate (€/₤) will
rise. Because of the reverse covering forward transactions, the forward rate (€/₤) will fall.
These adjustments continue until interest rate parity is restored.

c. The pound-based investor will carry out the same transactions 1, 2 and 3 in the solution to Part
“a”. To hedge, she will buy €1,054,000 forward in exchange for ₤658,750. The arbitrage profit
in sterling will then be ₤701,334 minus ₤658,750, i.e., ₤42,584 .

9. Due to the integrated nature of their capital markets, investors in both Canada and the United
Kingdom require the same real interest rate, 2.5 percent, on their lending. There is a consensus in
capital markets that the annual inflation rate is likely to be 3.5 percent in Canada and 1.5 percent in
the United Kingdom for the next three years. The spot exchange rate is currently $2.30/£.

a. Compute the nominal interest rate per annum in both Canada and the United Kingdom, 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?

Solutions:

a. Nominal rate in Canada = ((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] (2.30) = $2.4387/₤

c. F = [1.0609/1.0404](2.30) = $2.3453/₤

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Problems 10 to 15 are based on the following information.
SPOT 1 mo. 3 mo. 6 mo. 1 yr. 2 yr. 3 yr. 4 yr. 5 yr.
US$ 0.9340 0.9343 0.9350 0.9370 0.9418 0.9501 0.9569 0.9608 0.9603
Euro 1.4411 1.4414 1.4423 1.4435 1.4454 1.4563 1.4646 1.4751 1.4961
Yen 115.42 115.20 114.78 114.18 112.89 109.96 107.04 103.99 100.76
£ 2.1382 2.1343 2.1259 2.1131 2.0902 2.0570 2.0339 2.0148 2.0128

10. Spot and forward foreign exchange quotes for the Canadian dollar against four major currencies are
recorded above for June 26, 2007.

US$ and Yen are Indirect quotes - foreign currency units per Canadian dollar.
Euro and British pound are direct quotes - Canadian dollars per unit of foreign currency.

a. According to the forward rate structure, which currencies are expected to appreciate against the
Canadian dollar over the next year? Explain briefly.
b. According to the forward rate structure, which currencies are expected to depreciate against the
Canadian dollar over the next year? Explain briefly.
c. For each case (a. and b.), express the expected currency appreciation (or depreciation) rate in
annual terms.

Solutions:

a.Expected to appreciate against Canadian dollar… Euro and Yen

Euro (direct quote) … further into the future, increasing amounts of Canadian dollars are
required to buy one Euro.
Yen (indirect quote) … further into the future, fewer yen are required to buy one Canadian
dollar.

b.Expected to depreciate against Canadian dollar… US dollar and British pound

US dollar (indirect quote) … further into the future, increasing amounts of US dollars are
required to buy one Canadian dollar.
British pound (direct quote) … further into the future, decreasing amounts of Canadian
dollars are required to by one British pound.

c.Expected annual rate of appreciation, outward to one year …

Euro 0.2984
Yen 2.1920

Expected annual rate of depreciation, outward to one year …

US$ -0.8351
Pound -2.2449

11. On the same day as mentioned in Problem 10, the yield on Canadian six-month Treasury bills (annual
terms) was 4.71percent. The corresponding yield on US 6-month Treasury bills (in US dollars) was
4.96 percent.
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 Does interest rate parity hold between Canada and the US in view of the difference in six-month
Treasury bill rates? Explain the difference, if any.

Solution:

Interest Rate Parity requires …

rUS - rCAN = rate of US$ depreciation = (F/S) -1

Treasury Bill Rates ( 6-month TB rate, not annualized )

rCAN ... 6 months 0.023279 = 2.328 %
rUS … 6 months 0.024500 = 2.450 %
rUS - rCAN … 6 months 0.001221 = 12.2 bps

Expected US$ 6-month depreciation = (F/S) - 1

6-months 0.003212 = 32.1 bps

According to the 6-month TB rate differential, interest rate parity does not hold
… 12.21 bps  32.12 bps

12. Where should an investor invest for 6-month Treasury Bills, Canada or the United States? Explain.

Solution:

Invest $1,000 in US 6-month Treasury Bills with forward cover …

= 1,000 x (1+rUS) x (F/S)
= 1,000 x (1+[(1.0496)^.5)-1]) x (1/0.9370)/(1/0.934)
= 1,021.22

Invest $1,000 in Canada 6-month Treasury Bills …

= 1,000 x (1+rCAN)
= 1,000 x (1+ [(1.0471)^.5)-1])
= 1,023.28

Therefore, invest in Canada.

Explanation:
The expected rate of US dollar depreciation over the next six months [(F/S)-1] exceeds the six-
month interest differential on US and Canadian Treasury Bills.

13. Assume that US-Canada six-month interest rate parity holds on a net-of-cost basis.
What does your analysis imply about the cost of obtaining forward cover?

Solution:

In Canadian dollars, the 6-month yield on the Canadian TB investment is 2.328 percent.
In Canadian dollars, the 6-month yield on the US TB investment is 2.450 percent.

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 The difference, 12.2 basis points, represents the transactions cost in 6-month covered interest
arbitrage.

14. Record the accuracy of the forward rates on June 26, 2007 as a predictor of the spot rates for the
most recent relevant date for the reader today. For instance, if today is July 1, 2008, the (one year)
forward rates observed on June 26, 2007 imply the following expected exchange rates on June 26,
2008:
US$ 0.9418
Euro 1.4454
Yen 112.89
£ 2.0902

Find the spot rates on June 26, 2008 (or closest) and compare to the one-year forward rates
observed on June 26, 2007. Compute the errors vis-à-vis the (forward rate) forecast implied by the
forward rates observed on June 26, 2007.

(The results of this exercise depend on time-specific data collected to answer the questions.)

15. The one year Canadian Treasury bill rate is 4.71 percent. In view of the observed spot and one-year
forward foreign exchange rates for the euro, British pound and Japanese yen, what are respectively
the interest-rate-parity-satisfying one-year Treasury bill rates in Europe, Britain and Japan? Ignore
transactions costs.

Solution:

Interest Rate Parity requires …

… with indirect quotes for the SPOT and FORWARD exchange rates on the Canadian dollar (units
of foreign currency per one Canadian dollar) …

1 + iCAN = (1 + iFOREIGN)*(F/S)

iFOREIGN = [(1 + iCAN) *(S/F)] - 1

… with direct quotes for the SPOT and FORWARD exchange rates on the Canadian dollar
(Canadian dollars per unit is foreign currency) …

1 + iCAN = (1 + iFOREIGN)*((1/F)/(1/S))

iFOREIGN = [(1 + iCAN) *((1/S/(1/F))] - 1

The SPOT and FORWARD quotes for the Japanese yen are INDIRECT.
The SPOT and FORWARD quotes for the Euro and British pound are DIRECT.

Solution values for interest-rate-parity satisfying country-specific one-year Treasury Bill rates …

For Japanese one-year Treasury Bills …

i¥ = {1.0471 x [(112.89)/(115.42)]} -1
= 0.024147626
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 = 2.41 percent

For Euro one-year Treasury Bills …

i€ = {1.0471 x [(1/1.4454)/(1/1.4411)]} -1
= 0.043984925
= 4.40 percent

For British one-year Treasury Bills …

i£ = {1.0471 x [(1/2.0902)/(1/2.1382)]} -1
= 0.071145929
= 7.11 percent

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International Financial Management Canadian Canadian 3rd Edition Brean Solutions Manual

Mini Case: Turkish Lira and Purchasing Power Parity

Refer to Chapter 5 pg. 130 in text.

Solution:

a. In the current solution, we use the monthly data from January 1999 – December 2002.

Turkey vs. U.S.

0.15
Rate of Change of TL/$ (e)

0.10
β̂ = 1.47

0.05

0.00
α̂ = −0.011

-0.05
-0.05 0 0.05 0.1 0.15
Inf_Turkey - Inf_US

b. We regress exchange rate changes (e) on the inflation rate differential and estimate the
intercept (α ) and slope coefficient (β):

e t = α̂ + β̂( Inf_Turkey - Inf_US) + ε t

α̂ = −0.011 (t = - 0.649)
β̂ = 1.472 (t = 3.095)

The estimated intercept is insignificantly different from zero, whereas the slope coefficient is positive and
significantly different from zero. In fact, the slope coefficient is insignificantly different from unity. [Note
that t-statistics for β = 1 is 0.992 = (1.472 – 1)/0.476 where standard error is 0.476]. In other words,
we cannot reject the hypothesis that the intercept is zero and the slope coefficient is one. The results are
thus supportive of purchasing power parity.

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