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The value of each Latin American currency relative to the dollar is dictated by supply and demand conditions between that currency and the dollar. The values of Latin American currencies have generally declined substantially against the dollar over time. Most of these countries have high inflation rates and high interest rates. The data on inflation rates, economic growth, and other economic indicators are subject to error, because limited resources are used to compile the data.

a. If the forward rate is used as a market-based forecast, will this rate result in a forecast of appreciation, depreciation, or no change in any particular Latin American currency? Explain.
b. If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no change in the value of a specific Latin American currency? Explain.
c. Do you think that U.S. firms can accurately forecast the future values of Latin American currencies

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Patrina Schowalter
Patrina SchowalterLv2
29 Sep 2019

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Mexico tends to have much higher inflation than the United States, as well as much higher interest rates. 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. Why do you think 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 it is for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico?

Short- and Long-Run Exchange Rate Risk Exercise

Worksheet (v1.2)

In this exercise you are asked to choose a currency in which it is assumed you have foreign exchange exposure both in trade (short-run) and investment (long-run). In this exercise you are asked to find both spot and forward exchange rates for a chosen currency and also inflation rates associated with that currency. You are encouraged to read through the exercise first before choosing your currency to ensure the requested data is accessible via the links provided.

Short-Run Exchange Rate Risk

Assume you have a trade receivable denominated in a foreign currency of your choice that is payable to you by your customer in 6 months. At the current spot rate the trade receivable is worth the equivalent of US$5,000,000. To find the current spot rate for the chosen currency pair go to http://www.hsbcnet.com/gbm/fxcalc-disp.[1] Enter 5,000,000 in the “Convert” box, United States dollar in the “From:” box, and your chosen currency in the “To:” box. Click on “Go” for the spot rate, which will be expressed in European terms, that is, units of foreign currency per one US dollar. Enter the name of the chosen currency, the date the site is accessed, and the spot rate in European terms in the table below.

To find a 180 day forward rate for the currency pair, go to http://www.hsbcnet.com/gbm/fwcalc-disp#. For “Amount” you can just enter 1 and enter US dollars in the “Buy” box and the foreign currency in the “Sell” box. For “Value Date” enter “6 Months” and click “Go” for the forward rate. (Clicking on the Inverse box will switch the rate from European to American terms.) Enter the one-year forward rate in the table below. Make sure the forward rate is expressed in the same way as the forward rate, that is, in European terms.

Foreign Currency

Date

Current Spot Rate in European terms: FX per 1 US dollar

Six -Month Forward Rate in European terms: FX per 1 US dollar

Based on the data above, answer the following questions:

At the current spot rate how much in the foreign currency are you owed in 6 months?

Assuming you fully hedge your FX exposure in the forward market, how many US dollars will you receive in 6 months?

Is the foreign currency selling in the forward market at a premium, i.e. it appreciates relative to the spot rate, or a discount, i.e., it depreciates relative to the spot rate? Provide numbers to support your answer.

Long-Run Exchange Rate Risk

Assume you have undertaken a 3-year investment abroad with expected cash flows denominated in your chosen currency. At the current spot rate those cash flows are expected to provide a positive net present value (NPV) in US dollar terms. Based on relative purchasing power parity you are asked to estimate future spot rates over the next three years based on comparative inflation data.[2] With that data complete the table below.

S0 = Current Spot Rate in European Terms (Foreign currency per US dollar)

E(St) = Expected Exchange Rate Spot Rate in t Years in European Terms (Foreign currency per US dollar)

hUS= Annual Inflation Rate in the United States

hFC = Annual Foreign Country Inflation Rate

Using the data above and textbook equation (18.3) E(St) = S0 ∙ [1 + (hFC - hUS)]t and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following:

Based on relative purchasing power parity, estimate S1.

Based on relative purchasing power parity, estimate S2.

Based on relative purchasing power parity, estimate S3.

Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar? Explain.

Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.

[1] Please note currencies are grouped according to their region: Americas (where the United States dollar may be found), Asia-Pacific, Europe, and MENA. Please advise your instructor should this or any other link in the assignment be broken.

[2] Sources of Inflation data include http://stats.oecd.org/ for OECD countries and http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG at the World Bank site. It is viewed important to be consistent in the definition and source of inflation numbers for the US and the other currency that you use for the relative PPP equation. The most basic definitions of inflation are consumer price index (CPI), producer price index (PPI), and GDP deflator. Estimates of the next year’s inflation are preferred but it is also common to use the past year’s inflation as the best estimate of next year’s and subsequent years’ inflation. You are encouraged to share any useful websites for this data you find with the class.

Under a system of floating exchange rates, which of the following would not tend to cause an increase in the value of a country's currency?

Question 1 options:

An increased demand for the country's goods.

Offering higher interest rates than other countries.

A downturn in the country's business activity.

A lower rate of inflation than other countries.

2.

Foreign currency is usually referred to as

Question 2 options:

"foreign commodities."

"foreign exchange."

"foreign investment."

"foreign value."

3.

All else held constant, the near-term result of a decrease in the exchange value of country A's currency against country B's currency would most likely

Question 3 options:

increase A's exports to B.

decrease B's trade deficit with A.

increase B's exports to A.

decrease B's imports from A.

4.

When international trade occurs, currency exchange

Question 4 options:

is usually optional and rarely necessary.

can be avoided through careful planning.

is both necessary and unavoidable.

cannot occur unless both parties are coerced.

5.

Question 5 (1 point)

In order to purchase a vacation home in Great Britain, an American buyer would

Question 5 options:

demand British pounds and supply U.S. dollars in the foreign exchange market.

demand U.S. dollars and supply British pounds in the foreign exchange market.

demand and supply British pounds, but not U.S. dollars, in the foreign exchange market.

demand and supply U.S. dollars, but not British pounds, in the foreign exchange market.

6.

Which of the following will lead an American to exchange U.S. dollars for British pounds?

Question 6 options:

Importing a case of British salmon

Purchasing a cottage in the British countryside

Investing in a British manufacturing company

All of the above

7.

Which of the following was established as a result of the Bretton Woods Conference?
I. The International Monetary Fund (IMF)
II. The World Bank
III. The Geneva Conventions

Question 7 options:

I and II only

I and III only

II and III only

I, II, and III

8.

A "weak" (i.e., decreased value) U.S. dollar in relation to other currencies will typically have which of the following effects?

Question 8 options:

U.S. exports to other countries will decline.

Foreign countries will sell more goods in U.S. markets.

The U.S. trade deficit will increase.

None of the above.

9.

Special Drawing Rights (SDRs)

Question 9 options:

constitute an international currency created by the International Monetary Fund.

are considered as "paper gold", used as a substitute for gold in international exchange.

are used as part of the official reserves of central banks to settle international debt.

all of the above.

10.

Which of the following will lead to an inflow of U.S. dollars in the U.S. Balance of Payments account?

Question 10 options:

Exports of U.S. goods and services

Gifts (aid) received by the U.S. from foreign countries

Foreign investment in U.S. Treasury securities

All of the above

11.

If the U.S. sells $150 million of wheat to Brazil in return for $200 million of Brazilian oil, the $50 million difference will necessarily

Question 11 options:

be balanced by other transactions in the U.S. Balance of Payments account.

never by paid back, resulting in a $50 million loss for Brazil.

result in the sale of $50 million more wheat to Brazil later on.

obligate the U.S. to provide $50 million in foreign aid to Brazil.

12.

An inflow of U.S. dollars to the U.S. Balance of Payments account will occur when

Question 12 options:

the U.S. buys foreign currency in international markets.

the U.S. donates foreign aid to other countries.

Americans make investments in foreign assets.

the U.S. exports merchandise to foreign countries.

Save

13.

A demand for foreign goods

Question 13 options:

is a demand for foreign currency.

requires supplying domestic currency.

both of the above.

none of the above.

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