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Chapter 12
Questions
1.
2.
3.
Cite and discuss the theories and hypotheses related to the exchange rate
equivalency model.
The exchange rate equivalency model may be considered as a combination of the
following theories and hypotheses.
Expectation Theory of exchange rate: The expectation theory of exchange rates
regards todays forward foreign currency exchange rate as reasonable expectation of
the future spot rate.
Fisher effect (closed hypothesis): The fisher effect describes the long-run relationship
between expectations about a countrys future inflation and interest rates. Normally, a
rise in a countrys expected inflation rate should eventually cause an equal rise in the
interest rate (and vice versa).
International Fisher effect (opened hypothesis): The international Fisher effect states
that an expected change in a foreign currency spot exchange rate between two
countries is approximately equivalent to the difference between the nominal interest
rates of the two countries for that time.
Interest Rate Parity Theory: The theory that lending and borrowing interest rate
differential between two countries is equal to the differential between the forward
foreign currency exchange rate of the two countries and the spot exchange rate.
Purchasing Power Parity: The theory that foreign currency exchange rates are in
equilibrium when their purchasing power is the same in each of the two countries at
the prevailing exchange rates. This means that the exchange rates between two
countries should equal the rate of the two countries price level of fixed basket of
goods and services. When a country experiences inflation and its domestic price level
is increasing, its exchange rate must depreciate in order to return to purchasing power
parity.
KT/T1/2010
BFN3104
Problems
4. On 1 May 2007 Cookies Plc needed to make a payment of US$730,000 in three
months time. The company considered three different ways in which it may hedge its
transaction exposure foreign exchange forward contract; money market; currency
option based on the following foreign currency exchange rate and interest rate data:
Exchange rates:
US$/ sterling spot rate
Three month US$/ forward rate
1.8188-1.8199
1.8109-1.8120
Interest rates:
US$
sterling
Borrowing
%
3.15
5
Lending
%
2.85
4.5
Foreign currency option prices in cents per US$ for a contract size of 25,000:
Exercise price
Call option (July 2007)
Put option (July 2007)
US$1.90/
2.5
7.5
Calculate the cost of the transaction using each of the three different methods considered
by Cookies Plc to determine which is the cheapest for the company.
Solution:
Foreign exchange forward contract
Forward contract fixed at 1 Aug 2007
KT/T1/2010
BFN3104
Cost of buying US $724,836 at the currency spot rate is
KT/T1/2010