Corporate Foreign Exchange Risk Management
1. Assume the interest rate is higher in the U.K. than in the U.S.A. How should this affect the U.S. demand for British pounds, the supply of pounds for sale, and the equilibrium value of the pound?
An increase in the interest rate in the UK relative to the interest rate in USA will result in an increased demand for the British pounds, decrease in the supply of British pounds and an increase in the value of the British pound will increase relative to the US dollar. On the other hand, there will be a reduced demand for the US dollar, an increased supply of the US dollar and a reduction of the price of the US dollar.
A higher interest rate in the UK relative to that in USA will increase capital inflow into the UK while reducing capital outflow out of the UK. With higher interest rates in UK, rational investors would prefer to invest their money in UK since it will earn a higher return and maximize their wealth. Investors in USA and in other countries in the world who previously invested in the USA will divert their investments to UK.
They will demand the British pounds in exchange of their foreign currencies. On the other hand investors in the UK would prefer to invest in their home country rather than investing in the USA. They will demand less of foreign currency and in turn supply fewer British pounds in the currency exchange market. The high demand for British pounds coupled by low supply will put an upward pressure on the price of the British pound relative to the US dollar. Therefore, the value of the British pound will increase relative to the US dollar.
This will only be the case if foreign exchange rate is determined by market forces of demand and supply, without external intervention. The increase in the value of the pound will depend on the Interest rate difference between UK and USA.
2. If the U.S. trade balance with the U.K. is expected to improve next year, what is the likely relationship between the forward rate on the British pound and its current spot rate?
A forward exchange rate is the price of a currency that will be paid for delivery of that currency at a future date. The exchange rate between the currencies is established at the inception of the contract however, delivery of the currency is not required until some predetermined date in the future. Participants in the forward market buy and sell foreign currencies to mitigate exchange risk from unforeseen fluctuation of currency exchange rate in the future. Current spot rate is the price of a currency relative to other currencies as determined by market forces.
In a case where the trade balance of USA with the U.K. is projected to improve next year, the future rate on the British pound is likely to fall relative to the current spot rate. An improvement in the trade balance of U.S with the United Kingdom implies that there will be more capital inflows than outflows in the USA. This implies that there will be more British pounds in the USA reserves than the dollars that are moving out. The supply of the British pound is likely to increase due to increase demand for exports from USA while the demand of the pound falls or remains constant. This is likely to lead to a reduction in the value of the British pound. Participants in the currency forward market will therefore anticipate a fall in the value of the British pound. They will be less willing to sell forward contracts at higher prices since they expect the value of the dollars to fall. Sellers of futures will be forced to lower the forward exchange rate relative to the current spot rate.
3. If the Swiss franc is selling for $0.5618 and the Japanese yen is selling for $0.00777, what is the cross rate between these two currencies?
Cross exchange rate of the Swiss franc/ Japanese Yen = $0.5618/ $0.00777 = Swiss franc 72.30373/Japanese Yen
4. An American company sells yen futures contracts to cover possible exchange losses on its export orders denominated in Japanese yen. The amount of the initial margin is $20,000, and the maintenance margin is 75 percent of the initial margin. The value of the company's position declines by $6,000 because the spot rate for yen has increased. What is the dollar amount of the maintenance margin?
Maintenance margin is 75% of the initial amount. The dollar amount of the maintenance margin = 75% * $20,000 = $15,000
References
Kim, S. H., & Kim, S. H. (2006). Global corporate finance: text and cases (6, illustrated ed.). New York: John Wiley & Sons.
Madura, J., & Fox, R. (2007). International financial management (illustrated ed.). London: Cengage Learning EMEA.
Sercu, P. (2011). International Finance: Theory Into Practice. New Jersey: Princeton University Press.
