9.1)  The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is 2%.  The US interest rate on government securities with one-year maturity is 7% and the expected rate of inflation is 5%.  The current spot exchange rate for Korea won is $1 = W1,200.  Forecast the spot exchange rate one year from today.  Explain the logic of your answer.

Drawing on what we know about the Fisher effect, the real interest rate in both the US and South Korea is 2%.  The international Fisher effect suggests that the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates.  Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won.  Using the formula from the book:  (S1 - S2)/S2 x 100 = i$ - iWon   and substituting 7 for i$, 4 for iWon, and 1,200 for S1, yields a value for S2 of $1=W1,165.

9.2)  Two countries, Great Britain and the US, produce just one good: beef.  Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound.
(a) According to PPP theory, what should the $/£ spot exchange rate be?
(b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain.  What should be the one year forward $/£ exchange rate?
(c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10%, what would you expect current interest rate to be in Britain?

(a) According to PPP, the $/£ rate should be 2.80/3.70, or $0.76/£.
(b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or $0.67/£.
(c) Since the dollar is appreciating relative to the pound, and given the relationship of the international Fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.

10.4)  Debate the relative merits of fixed and floating exchange rate regimes.  From the perspective of an international business, what are the most important criteria for choosing between the systems?  Which system is the more desirable for an international business?

The case for fixed exchange rates rests on arguments about monetary discipline, speculation, uncertainty, and the lack of connection between the trade balance and exchange rates.  In terms of monetary discipline, the need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies at inflationary rates.  In terms of speculation, a fixed exchange rate regime precludes the possibility of speculation.  In terms of uncertainty, a fixed rate regime introduces a degree of certainty in the international monetary system by reducing volatility in exchange rates.  Finally, in terms of trade balance adjustments, critics question the closeness of the link between the exchange rate and the trade balance. The case for floating exchange rates has two main elements: monetary policy autonomy and automatic trade balance adjustments.  In terms of the former, it is argued that a floating exchange rate regime gives countries monetary policy autonomy.  Under a fixed rate system, a country’s ability to expand or contract its money supply as it sees fit is limited by the need to maintain exchange rate parity.  In terms of the later, under the Bretton Woods system, if a country developed a permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would agree to a currency devaluation.  Critics of this system argue that the adjustment mechanism works much more smoothly under a floating exchange rate regime.  They argue that if a country is running a trade deficit, the imbalance between the supply and demand of that country’s currency in the foreign exchange markets will lead to depreciation in its exchange rate.  An exchange rate depreciation should correct the trade deficit by making the country’s exports cheaper and its imports more expensive.  It is a matter of personal opinion in regard to which system is better for an international business.  We do know, however, that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work.  Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the kind of stability that would facilitate more rapid growth in international trade and investment.

11.4)  Happy Company wants to raise $2 million with debt financing.  The funds are needed to finance working capital, and the firm will repay them with interest in one year.  Happy Company’s treasurer is considering three options:
(a) Borrowing U.S. dollars from Security Pacific Bank at 8 percent.
(b) Borrowing British pounds from Midland Bank at 14 percent.
(c) Borrowing Japanese yen from Sanwa Bank at 5 percent.
If Happy borrows foreign currency, it will not cover it; that is, it will simply change foreign currency for dollars at today’s spot rate and buy the same foreign currency a year later at the spot rate that is in effect.  Happy Company estimates the pound will depreciate by 5 percent relative to the dollar and the yen will appreciate 3 percent relative to the dollar in the next year.  From which bank should Happy Company borrow?

Happy Company needs to consider both the cost of capital and foreign exchange risk.  If Happy Company borrows $2 million from Security Pacific Bank, in one year it will owe the bank $2 million plus 8 percent.  If Happy Company borrows British pounds from Midland it has to factor in the higher interest rate (14 percent), and also its estimate that the pound will depreciate by 5 percent.  If its prediction about the pound is accurate, this could prove to be an attractive option.  Finally, while the interest rate at the Japanese bank is the lowest of the three, if the yen does appreciate by 3 percent, this option becomes less attractive.  In the end, given that its expectations about the future value of the British pound and the Japanese yen are only guesses into the future, Happy Bank will have to decide how much risk it is willing to take on before it can choose which bank to approach.