1. Define the following foreign exchange risk terms:
Translation Risk
Transaction Risk
Economic Risk
2. What is the meaning of the term “spot rate”?
3. What is the meaning of the term “spread”?
4. What is a “forward rate”?
5. True of False?: Given the rates below, the GBP is trading at a premium in the forward market.
Spot Rate: 1 USD = 0.63 GBP
3 month Forward Rate: 1 USD = 0.61 GBP
6. What defines a currency as being considered a “hard” currency?
7. Some currencies have fixed exchange rates. What are the benefits of having a fixed exchange rate?
8. Some currencies are non-convertible. Why would a government wish to limit convertibility of its currency?
9. Draw a chart over time for one of the following exchange rate regimes, and then answer the questions below.
- fixed/pegged exchange rate
- crawling peg
- managed/dirty float
- floating
For your chosen regime:
a. Who or what determines the exchange rate?
b. What role does the government play in this exchange rate regime? (You may need to consider the role of the government in a broader context.)
c. When (or how often) is the rate revised?
10. Write the Fisher Effect equation and label each component:
11. What does the Fisher Effect theorize about the impact of inflation on future currency value?
12. You are a California manufacturer of electric fences. You must pay a German supplier for galvanized wire you are importing for a big project. The payment of Euro 50,000 is due in 3 months’ time.
Use the following information:
Spot rate 3 month Forward Rate
1 EUR = 1.33 USD 1 EUR = 1.41 USD
a. What will be the exchange rate between the USD and EUR on the date in three months’ time when your payment is due?
b. If you decide to enter into a forward contract, how many USD will you need on the contract date (in three months’ time) to purchase 50,000 Euros for your payment?
c. Assume the U.S. interest rate is 3.0% (APR). What amount of USD do you need to deposit in a bank savings account today to equal the amount of USD you will need in 3 months’ time for the Forward Contract (as calculated in 12 b. above)? (With no compounding of interest.)
13. Using the given spot rate and interest rates below, and the International Fisher Effect, calculate the 3 month and 6 month forward rate between US dollar (USD) and Indonesian Rupiah (IDR).
Interest Rate (Annual)
USD 2.00%
IDR 10.00%
Exchange Rates (IDR per USD) Spot Rate 3 Month Forward Rate 6 Month Forward Rate
1 USD = 8,862.5 IDR ? ?
3-Month Forward Rate: 1 USD = ____________________IDR
6-Month Forward Rate: 1 USD = ____________________IDR
14. What, if anything, guaranties the currency pair will actually be trading at the spot market in 3 and 6 months’ time at the same value as calculated for the forward rate in question 13 above?
1. Translation Risk: The risk that arises from the translation of a company's financial statements from one currency to another. It is the risk of fluctuations in exchange rates that can impact the value of assets, liabilities, and equity.
Transaction Risk: The risk that arises from the fluctuation in exchange rates between the time a transaction is agreed upon and the time it is settled. It is the risk of loss due to unfavorable exchange rate movements.
Economic Risk: The risk that arises from changes in economic conditions and macroeconomic factors, such as inflation, interest rates, and overall economic stability, which can impact the value of a currency and expose a company to potential losses.
2. Spot rate refers to the current exchange rate at which a currency can be bought or sold for immediate delivery.
3. Spread refers to the difference between the buying and selling price of a currency in the foreign exchange market. It represents the transaction cost or margin of profit for the market maker or intermediary.
4. A forward rate is the exchange rate at which a currency can be purchased or sold for delivery at a future date. It is determined in the forward market and is based on the spot rate and the interest rate differentials between the two currencies.
5. False. Given the rates provided, the GBP is trading at a discount in the forward market.
6. A currency is considered "hard" when it is stable, widely accepted, and freely convertible into other currencies. It is characterized by strong economic fundamentals, low inflation, and a sound financial system.
7. Benefits of having a fixed exchange rate include reducing uncertainty and promoting stability in international trade, attracting foreign investment, controlling inflation, and maintaining confidence in the currency.
8. A government may wish to limit convertibility of its currency to maintain control over its monetary system, protect against capital flight and volatility in the currency, manage balance of payments, and promote domestic economic policies.
9. The chart over time for a fixed/pegged exchange rate regime would show a flat horizontal line indicating a fixed exchange rate maintained by central bank intervention to buy or sell currencies at a predetermined rate.
a. The central bank or government determines and sets the exchange rate.
b. The government plays a crucial role in maintaining the fixed exchange rate by managing reserves, implementing monetary and fiscal policies, and intervening in the foreign exchange market.
c. The rate is typically revised infrequently, usually when economic conditions or policy objectives require adjustments.
10. The Fisher Effect equation is: (1 + i) = (1 + r) * (1 + h), where i is the nominal interest rate, r is the real interest rate, and h is the expected inflation rate.
11. The Fisher Effect theorizes that an increase in inflation will lead to an equal increase in nominal interest rates, resulting in no change in the real interest rate. Thus, the impact of inflation on future currency value is expected to be neutral.
12.
a. The exchange rate between USD and EUR in three months' time would be 1 EUR = 1.41 USD.
b. To purchase 50,000 Euros for the payment, you would need 50,000 Euros * 1.41 USD/EUR = 70,500 USD.
c. To calculate the amount of USD needed to deposit today, you need to consider the Time Value of Money. Assuming no compounding of interest, you would need to deposit 70,500 USD / (1 + (3%/4))^4 = 68,169.96 USD.
13.
To calculate the forward rates, use the formula: Forward Rate = Spot Rate * (1 + (Foreign Interest Rate - Domestic Interest Rate)), where the interest rates are converted to the corresponding period (e.g., for 3 months, divide the annual interest rates by 4).
3-Month Forward Rate: 1 USD = 8,862.5 IDR * (1 + (10% - 2%)/4) = 1 USD = 8,965.62 IDR
6-Month Forward Rate: 1 USD = 8,862.5 IDR * (1 + (10% - 2%)/2) = 1 USD = 9,109.25 IDR
14. The forward rate is a prediction based on interest rate differentials, expectations, and market conditions. There is no guarantee that the actual spot rate will be the same as the calculated forward rate in the future. The forward rate serves as a benchmark for market participants to manage their currency risk and make informed decisions.