International Financial Management: Canadian Perspective 3rd Edition Solution Manual
International Financial Management: Canadian Perspective 3rd Edition Solution Manual simplifies tough problems, making them easier to understand and solve.
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EUN RESNICK BREAN
INTERNATIONAL MANAGEMENT
Canadian Perspectives, Third Edition
SUGGESTED ANSWERS AND SOLUTIONS TO
END-OF-CHAPTER QUESTIONS AND PROBLEMS
EUN RESNICK BREAN
INTERNATIONAL MANAGEMENT
Canadian Perspectives, Third Edition
SUGGESTED ANSWERS AND SOLUTIONS TO
END-OF-CHAPTER QUESTIONS AND PROBLEMS
IM-2
CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM
SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS
QUESTIONS
1. Why is it important to study international financial management?
Answer: We live in a world where all the major economic functions, i.e., consumption, production, and
investment, are highly globalized. Above all, virtually all business is international business. For example,
firms export goods and services and, likewise, they import goods and services. Firms also invest abroad,
generating earnings in foreign places denominated in foreign currencies. It is thus essential for managers
to fully understand vital international dimensions of finance. The foreign dimensions of finance are
especially significant for Canadian business primarily because foreign markets are relatively more
important for Canadian firms than, for instance, is the case in the United States.
2. How is international financial management different from domestic financial management?
Answer: Three major dimensions set international finance apart from domestic finance. They are:
1. foreign exchange and political risks,
2. market imperfections, and
3. expanded opportunity set.
3. Discuss the major trends that have prevailed in international business during the last two decades.
Answer: The 1980s saw rapid integration of international capital and financial markets. Impetus for
globalized financial markets initially came from major countries where foreign exchange and capital
markets were significantly deregulated. The economic integration and globalization that began in the
1980s accelerated in the 1990s via privatization. Privatization is the process by which the state divests
itself of the ownership and operations while turning to the market system. Lastly, trade liberalization and
economic integration continued to proceed at both the regional and global levels such as the North
American Free Trade Agreement (among Canada, the United States and Mexico) and a strengthened
World Trade Organization (WTO).
4. How is Canada’s economic wellbeing enhanced through free international trade in goods and services?
CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM
SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS
QUESTIONS
1. Why is it important to study international financial management?
Answer: We live in a world where all the major economic functions, i.e., consumption, production, and
investment, are highly globalized. Above all, virtually all business is international business. For example,
firms export goods and services and, likewise, they import goods and services. Firms also invest abroad,
generating earnings in foreign places denominated in foreign currencies. It is thus essential for managers
to fully understand vital international dimensions of finance. The foreign dimensions of finance are
especially significant for Canadian business primarily because foreign markets are relatively more
important for Canadian firms than, for instance, is the case in the United States.
2. How is international financial management different from domestic financial management?
Answer: Three major dimensions set international finance apart from domestic finance. They are:
1. foreign exchange and political risks,
2. market imperfections, and
3. expanded opportunity set.
3. Discuss the major trends that have prevailed in international business during the last two decades.
Answer: The 1980s saw rapid integration of international capital and financial markets. Impetus for
globalized financial markets initially came from major countries where foreign exchange and capital
markets were significantly deregulated. The economic integration and globalization that began in the
1980s accelerated in the 1990s via privatization. Privatization is the process by which the state divests
itself of the ownership and operations while turning to the market system. Lastly, trade liberalization and
economic integration continued to proceed at both the regional and global levels such as the North
American Free Trade Agreement (among Canada, the United States and Mexico) and a strengthened
World Trade Organization (WTO).
4. How is Canada’s economic wellbeing enhanced through free international trade in goods and services?
IM-2
CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM
SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS
QUESTIONS
1. Why is it important to study international financial management?
Answer: We live in a world where all the major economic functions, i.e., consumption, production, and
investment, are highly globalized. Above all, virtually all business is international business. For example,
firms export goods and services and, likewise, they import goods and services. Firms also invest abroad,
generating earnings in foreign places denominated in foreign currencies. It is thus essential for managers
to fully understand vital international dimensions of finance. The foreign dimensions of finance are
especially significant for Canadian business primarily because foreign markets are relatively more
important for Canadian firms than, for instance, is the case in the United States.
2. How is international financial management different from domestic financial management?
Answer: Three major dimensions set international finance apart from domestic finance. They are:
1. foreign exchange and political risks,
2. market imperfections, and
3. expanded opportunity set.
3. Discuss the major trends that have prevailed in international business during the last two decades.
Answer: The 1980s saw rapid integration of international capital and financial markets. Impetus for
globalized financial markets initially came from major countries where foreign exchange and capital
markets were significantly deregulated. The economic integration and globalization that began in the
1980s accelerated in the 1990s via privatization. Privatization is the process by which the state divests
itself of the ownership and operations while turning to the market system. Lastly, trade liberalization and
economic integration continued to proceed at both the regional and global levels such as the North
American Free Trade Agreement (among Canada, the United States and Mexico) and a strengthened
World Trade Organization (WTO).
4. How is Canada’s economic wellbeing enhanced through free international trade in goods and services?
CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM
SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS
QUESTIONS
1. Why is it important to study international financial management?
Answer: We live in a world where all the major economic functions, i.e., consumption, production, and
investment, are highly globalized. Above all, virtually all business is international business. For example,
firms export goods and services and, likewise, they import goods and services. Firms also invest abroad,
generating earnings in foreign places denominated in foreign currencies. It is thus essential for managers
to fully understand vital international dimensions of finance. The foreign dimensions of finance are
especially significant for Canadian business primarily because foreign markets are relatively more
important for Canadian firms than, for instance, is the case in the United States.
2. How is international financial management different from domestic financial management?
Answer: Three major dimensions set international finance apart from domestic finance. They are:
1. foreign exchange and political risks,
2. market imperfections, and
3. expanded opportunity set.
3. Discuss the major trends that have prevailed in international business during the last two decades.
Answer: The 1980s saw rapid integration of international capital and financial markets. Impetus for
globalized financial markets initially came from major countries where foreign exchange and capital
markets were significantly deregulated. The economic integration and globalization that began in the
1980s accelerated in the 1990s via privatization. Privatization is the process by which the state divests
itself of the ownership and operations while turning to the market system. Lastly, trade liberalization and
economic integration continued to proceed at both the regional and global levels such as the North
American Free Trade Agreement (among Canada, the United States and Mexico) and a strengthened
World Trade Organization (WTO).
4. How is Canada’s economic wellbeing enhanced through free international trade in goods and services?
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Answer: In the absence of barriers to trade, market forces provide incentives for countries to organize the
production of traded goods to their mutual economic benefit. As per Ricardo’s principle of “comparative
advantage”, free trade goods will be produced where their cost of production is low and they will be
consumed where their value is high. Through trade, two countries can increase their combined production
(relative to the no trade situation), which allows both countries to consume more of both goods. This
argument remains valid even if one country can produce both goods more efficiently than the other.
International trade is not a ‘zero-sum’ game in which one country benefits at the expense of another
country. Rather, international trade is an ‘increasing-sum’ or “win-win” situation at which both countries
gain. The output and earnings that are unleashed by trade are referred to as “gains from trade”.
Canada’s ratio of trade to GDP is one of the highest in the world, reflecting Canada’s wealth-enhancing
commercial integration with the rest of the world.
5. What is Canada’s comparative advantage?
Answer: First, in a classical sense, “comparative advantage” as described by Ricardo abstracts from
many of the factors that underlie trade. In Ricardo’s framework, with its focus on only two countries and
two products, the incentive for trade derives from differences in productive efficiency without explicit
regard for why one country is more or less efficient. In a practical sense, indications of a country’s
comparative advantage are found in the mix of goods that it exports (indicating comparative advantage)
and imports (indicating comparative disadvantage). Therefore it would seem that Canada has a clear
comparative advantage in natural resources. The natural resources themselves are an endowment for
Canada and are not derived from our productive efficiency. However, we ought to be more efficient than
other countries (comparative advantage) in production that is based on our natural resources, such as
petroleum refining, aluminum smelting, or manufacturing of wood products. Canada also has comparative
advantage in certain skilled and research-intensive labour manufacturing sectors such as electronics. To
the extent that Canadian universities attract foreign students, and hence Canada “exports education”, the
indications are that Canada has comparative advantage in this sector.
6. What Canadian companies – and their products – reflect Canada’s comparative advantage?
Answer: Alcan (aluminum), Agrium (fertilizer), Saskatchewan Potash (potash), Research-in-Motion
(BlackBerries), CN (management and provision of transportation services).
Answer: In the absence of barriers to trade, market forces provide incentives for countries to organize the
production of traded goods to their mutual economic benefit. As per Ricardo’s principle of “comparative
advantage”, free trade goods will be produced where their cost of production is low and they will be
consumed where their value is high. Through trade, two countries can increase their combined production
(relative to the no trade situation), which allows both countries to consume more of both goods. This
argument remains valid even if one country can produce both goods more efficiently than the other.
International trade is not a ‘zero-sum’ game in which one country benefits at the expense of another
country. Rather, international trade is an ‘increasing-sum’ or “win-win” situation at which both countries
gain. The output and earnings that are unleashed by trade are referred to as “gains from trade”.
Canada’s ratio of trade to GDP is one of the highest in the world, reflecting Canada’s wealth-enhancing
commercial integration with the rest of the world.
5. What is Canada’s comparative advantage?
Answer: First, in a classical sense, “comparative advantage” as described by Ricardo abstracts from
many of the factors that underlie trade. In Ricardo’s framework, with its focus on only two countries and
two products, the incentive for trade derives from differences in productive efficiency without explicit
regard for why one country is more or less efficient. In a practical sense, indications of a country’s
comparative advantage are found in the mix of goods that it exports (indicating comparative advantage)
and imports (indicating comparative disadvantage). Therefore it would seem that Canada has a clear
comparative advantage in natural resources. The natural resources themselves are an endowment for
Canada and are not derived from our productive efficiency. However, we ought to be more efficient than
other countries (comparative advantage) in production that is based on our natural resources, such as
petroleum refining, aluminum smelting, or manufacturing of wood products. Canada also has comparative
advantage in certain skilled and research-intensive labour manufacturing sectors such as electronics. To
the extent that Canadian universities attract foreign students, and hence Canada “exports education”, the
indications are that Canada has comparative advantage in this sector.
6. What Canadian companies – and their products – reflect Canada’s comparative advantage?
Answer: Alcan (aluminum), Agrium (fertilizer), Saskatchewan Potash (potash), Research-in-Motion
(BlackBerries), CN (management and provision of transportation services).
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7. What considerations might limit the extent to which the theory of comparative advantage is realistic?
Answer: The concept of comparative advantage was originally advanced by Ricardo as an explanation
for why nations trade with one another. The idea is that economic well-being is enhanced if each country
produces goods in which that country has a comparative advantage. In a two country context, each
country exports goods for which it has a comparative advantage and imports goods for which it does not
have a comparative advantage. Underlying the theory is the assumption that the factors of production
(land, buildings, labour, technology and capital) are mobile within countries (although not necessarily
mobile between or among countries). To the extent that these assumptions do not hold, comparative
advantage will not realistically describe international trade.
8. What are multinational corporations (MNCs), and what economic roles do they play?
Answer: A multinational corporation (MNC) can be defined as a business firm incorporated in one
country that has production and sales operations in other countries. Some MNCs have operations in
dozens of different countries. MNCs are the vehicle for foreign direct investment. MNCs are an important
means by which productive capital, technology and business skills are transferred from one country to
another around the globe. Global operations require MNC treasurers to establish international banking
relationships, to monitor and manage funds in several currency denominations and to effectively manage
foreign exchange risk.
9. Critics of the North American Free Trade Agreement (NAFTA) in both the United States and Canada
feared the loss of jobs to Mexico where it is much cheaper to hire workers. What are the merits and
demerits of this position on NAFTA? Considering recent economic developments in North America, how
would you assess the success of NAFTA?
Answer: Since the inception of NAFTA, many American and Canadian companies indeed have invested
heavily in Mexico, sometimes relocating production from Canada and the United States to Mexico.
Although this might have temporarily caused unemployment of some Canadian and American workers,
they were eventually rehired by other industries often for higher wages. Currently, the unemployment rate
in both Canada and the U.S. is low by historical standard. At the same time, Mexico has been
7. What considerations might limit the extent to which the theory of comparative advantage is realistic?
Answer: The concept of comparative advantage was originally advanced by Ricardo as an explanation
for why nations trade with one another. The idea is that economic well-being is enhanced if each country
produces goods in which that country has a comparative advantage. In a two country context, each
country exports goods for which it has a comparative advantage and imports goods for which it does not
have a comparative advantage. Underlying the theory is the assumption that the factors of production
(land, buildings, labour, technology and capital) are mobile within countries (although not necessarily
mobile between or among countries). To the extent that these assumptions do not hold, comparative
advantage will not realistically describe international trade.
8. What are multinational corporations (MNCs), and what economic roles do they play?
Answer: A multinational corporation (MNC) can be defined as a business firm incorporated in one
country that has production and sales operations in other countries. Some MNCs have operations in
dozens of different countries. MNCs are the vehicle for foreign direct investment. MNCs are an important
means by which productive capital, technology and business skills are transferred from one country to
another around the globe. Global operations require MNC treasurers to establish international banking
relationships, to monitor and manage funds in several currency denominations and to effectively manage
foreign exchange risk.
9. Critics of the North American Free Trade Agreement (NAFTA) in both the United States and Canada
feared the loss of jobs to Mexico where it is much cheaper to hire workers. What are the merits and
demerits of this position on NAFTA? Considering recent economic developments in North America, how
would you assess the success of NAFTA?
Answer: Since the inception of NAFTA, many American and Canadian companies indeed have invested
heavily in Mexico, sometimes relocating production from Canada and the United States to Mexico.
Although this might have temporarily caused unemployment of some Canadian and American workers,
they were eventually rehired by other industries often for higher wages. Currently, the unemployment rate
in both Canada and the U.S. is low by historical standard. At the same time, Mexico has been
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experiencing a major economic boom. It seems clear that all three parties to NAFTA – Canada, Mexico
and the U.S. - have benefited from the agreement.
10. In 1995, a working group of French chief executive officers set up by the Confederation of French
Industry (CNPF) and the French Association of Private Companies (AFEP) examined French corporate
governance. The group reported the following: “The board of directors should not simply aim at
maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company,
whose interests should be clearly distinguished from those of its shareholders, employees, creditors,
suppliers and clients but still equated with their general common interest, which is to safeguard the
prosperity and continuity of the company.” Evaluate the recommendation.
Answer: The recommendations of the French working group show that shareholder wealth maximization
is not a universally accepted goal of corporate management, especially outside the so-called Anglo-Saxon
countries that include the United States, the United Kingdom and Canada. To some extent, this may
reflect the fact that share ownership is not widespread in many countries. In France, only about 15 percent
of households own shares whereas in the Canada and the United States the figure is closer to 75 percent
when one takes account of the asset composition of pension funds.
experiencing a major economic boom. It seems clear that all three parties to NAFTA – Canada, Mexico
and the U.S. - have benefited from the agreement.
10. In 1995, a working group of French chief executive officers set up by the Confederation of French
Industry (CNPF) and the French Association of Private Companies (AFEP) examined French corporate
governance. The group reported the following: “The board of directors should not simply aim at
maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company,
whose interests should be clearly distinguished from those of its shareholders, employees, creditors,
suppliers and clients but still equated with their general common interest, which is to safeguard the
prosperity and continuity of the company.” Evaluate the recommendation.
Answer: The recommendations of the French working group show that shareholder wealth maximization
is not a universally accepted goal of corporate management, especially outside the so-called Anglo-Saxon
countries that include the United States, the United Kingdom and Canada. To some extent, this may
reflect the fact that share ownership is not widespread in many countries. In France, only about 15 percent
of households own shares whereas in the Canada and the United States the figure is closer to 75 percent
when one takes account of the asset composition of pension funds.
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11. Emphasizing the importance of voluntary compliance, as opposed to enforcement, in the aftermath of
such corporate scandals as those involving Enron and WorldCom, US President Bush stated that while
tougher laws might help, “ultimately, the ethics of business depends on the conscience of business
leaders.” Describe your view on this statement.
Answer: There can be different answers to this question. If business leaders always behave with a high
ethical standard, many of the corporate scandals that we have seen lately might not have happened. Since
we cannot fully depend on the ethical behaviour on the part of business leaders, society should protect
itself by adopting the rules/regulations and governance structure that induce business leaders to behave in
the interest of the society at large.
12. Suppose you are interested in investing in the shares of Nokia Corporation of Finland, which is a
world leader in wireless communication. But before you make your investment decision, you would like
to learn about the company. Visit the website of CNN Financial Network (www.cnnfn.com) and collect
information about Nokia, including the recent share price history and analysts’ views of the company.
Discuss what you learn about the company. Also discuss how the instantaneous access to information via
the internet would affect the nature and workings of financial markets.
Answer: As students might have learned from visiting the website, information is readily available even
for foreign companies like Nokia. Ready access to international information helps integrate financial
markets, dismantling barriers to international investment and financing. Integration, however, may help a
financial shock in one market to be transmitted to other markets.
11. Emphasizing the importance of voluntary compliance, as opposed to enforcement, in the aftermath of
such corporate scandals as those involving Enron and WorldCom, US President Bush stated that while
tougher laws might help, “ultimately, the ethics of business depends on the conscience of business
leaders.” Describe your view on this statement.
Answer: There can be different answers to this question. If business leaders always behave with a high
ethical standard, many of the corporate scandals that we have seen lately might not have happened. Since
we cannot fully depend on the ethical behaviour on the part of business leaders, society should protect
itself by adopting the rules/regulations and governance structure that induce business leaders to behave in
the interest of the society at large.
12. Suppose you are interested in investing in the shares of Nokia Corporation of Finland, which is a
world leader in wireless communication. But before you make your investment decision, you would like
to learn about the company. Visit the website of CNN Financial Network (www.cnnfn.com) and collect
information about Nokia, including the recent share price history and analysts’ views of the company.
Discuss what you learn about the company. Also discuss how the instantaneous access to information via
the internet would affect the nature and workings of financial markets.
Answer: As students might have learned from visiting the website, information is readily available even
for foreign companies like Nokia. Ready access to international information helps integrate financial
markets, dismantling barriers to international investment and financing. Integration, however, may help a
financial shock in one market to be transmitted to other markets.
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Mini Case: Nike’s Decision
Refer to Chapter 1 pg. 26 in text.
Suggested Solution to Nike’s Decision
Obviously, Nike’s investments in such Asian countries as China, Indonesia, and Vietnam were motivated
to take advantage of low labour costs in those countries. While Nike was criticized for the poor working
conditions for its workers, the company has recognized the problem and has substantially improved the
working environments recently. Although Nike’s workers get paid very low wages by the Western
standard, they probably are making substantially more than their local compatriots who are either under-
or unemployed. While Nike’s detractors may have valid points, one should not ignore the fact that the
company is making contributions to the economic welfare of those Asian countries by creating job
opportunities.
Mini Case: Nike’s Decision
Refer to Chapter 1 pg. 26 in text.
Suggested Solution to Nike’s Decision
Obviously, Nike’s investments in such Asian countries as China, Indonesia, and Vietnam were motivated
to take advantage of low labour costs in those countries. While Nike was criticized for the poor working
conditions for its workers, the company has recognized the problem and has substantially improved the
working environments recently. Although Nike’s workers get paid very low wages by the Western
standard, they probably are making substantially more than their local compatriots who are either under-
or unemployed. While Nike’s detractors may have valid points, one should not ignore the fact that the
company is making contributions to the economic welfare of those Asian countries by creating job
opportunities.
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Appendix 1A
Gains from Trade: The Theory
of Comparative Advantage
SUGGESTED SOLUTIONS TO APPENDIX PROBLEMS
PROBLEMS
1. Country C can produce seven kilograms of food or four metres of textiles per unit of input. Compute
the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of
producing textiles instead of food.
Solution: The opportunity cost of producing food instead of textiles is one metre of textiles per 7/4 = 1.75
kilograms of food. A kilogram of food has an opportunity cost of 4/7 = 0.57 metres of textiles.
2. Consider the no-trade input/output situation presented in the following table for Countries X and Y.
Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries.
Appendix 1A
Gains from Trade: The Theory
of Comparative Advantage
SUGGESTED SOLUTIONS TO APPENDIX PROBLEMS
PROBLEMS
1. Country C can produce seven kilograms of food or four metres of textiles per unit of input. Compute
the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of
producing textiles instead of food.
Solution: The opportunity cost of producing food instead of textiles is one metre of textiles per 7/4 = 1.75
kilograms of food. A kilogram of food has an opportunity cost of 4/7 = 0.57 metres of textiles.
2. Consider the no-trade input/output situation presented in the following table for Countries X and Y.
Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries.
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INPUT/OUTPUT WITHOUT TRADE
_______________________________________________________________________
Country
X Y Total
________________________________________________________________________
I. Units of Input
(000,000)
_______________________ ______________________________
Food 70 60
Textiles 40 30
________________________________________________________________________
II. Output per Unit of Input
(Kilograms or metres)
______________________ ______________________________
Food 17 5
Textiles 5 2
________________________________________________________________________
III. Total Output
(Kilograms or metres)
(000,000)
______________________ ______________________________
Food 1,190 300 1,490
Textiles 200 60 260
________________________________________________________________________
IV. Consumption
(Kilograms or metres)
(000,000)
_____________________ ______________________________
Food 1,190 300 1,490
Textiles 200 60 260
________________________________________________________________________
INPUT/OUTPUT WITHOUT TRADE
_______________________________________________________________________
Country
X Y Total
________________________________________________________________________
I. Units of Input
(000,000)
_______________________ ______________________________
Food 70 60
Textiles 40 30
________________________________________________________________________
II. Output per Unit of Input
(Kilograms or metres)
______________________ ______________________________
Food 17 5
Textiles 5 2
________________________________________________________________________
III. Total Output
(Kilograms or metres)
(000,000)
______________________ ______________________________
Food 1,190 300 1,490
Textiles 200 60 260
________________________________________________________________________
IV. Consumption
(Kilograms or metres)
(000,000)
_____________________ ______________________________
Food 1,190 300 1,490
Textiles 200 60 260
________________________________________________________________________
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Solution:
The no-trade input/output table indicates that Country X has an absolute advantage in the production of
food and textiles. Country X can “trade off” one unit of production needed to produce 17 kilograms of
food for five metres of textiles. Thus, a metre of textiles has an opportunity cost of 17/5 = 3.40 kilograms
of food, or a kilogram of food has an opportunity cost of 5/17 = 0.29 metres of textiles. Analogously,
Country Y has an opportunity cost of 5/2 = 2.50 kilograms of food per metres of textiles, or 2/5 = 0.40
metres of textiles per kilogram of food. In terms of opportunity cost, it is clear that Country X is relatively
more efficient in producing food and Country Y is relatively more efficient in producing textiles. Thus,
Country X (Y) has a comparative advantage in producing food (textile) is comparison to Country Y (X).
When there are no restrictions or impediments to free trade the economic-well -being of the citizens of
both countries is enhanced through trade. Suppose that Country X shifts 20,000,000 units from the
production of textiles to the production of food where it has a comparative advantage and that Country Y
shifts 60,000,000 units from the production of food to the production of textiles where it has a
comparative advantage. Total output will now be (90,000,000 x 17 =) 1,530,000,000 kilograms of food
and [(20,000,000 x 5 =100,000,000) + (90,000,000 x 2 =180,000,000) =] 280,000,000 metres of textiles.
Further suppose that Country X and Country Y agree on a price of 3.00 kilograms of food for one metre
of textiles, and that Country X sells Country Y 330,000,000 kilograms of food for 110,000,000 metres of
textiles. Under free trade, the following table shows that the citizens of Country X (Y) have increased
their consumption of food by 10,000,000 (30,000,000) kilograms and textiles by 10,000,000 (10,000,000)
metres.
Solution:
The no-trade input/output table indicates that Country X has an absolute advantage in the production of
food and textiles. Country X can “trade off” one unit of production needed to produce 17 kilograms of
food for five metres of textiles. Thus, a metre of textiles has an opportunity cost of 17/5 = 3.40 kilograms
of food, or a kilogram of food has an opportunity cost of 5/17 = 0.29 metres of textiles. Analogously,
Country Y has an opportunity cost of 5/2 = 2.50 kilograms of food per metres of textiles, or 2/5 = 0.40
metres of textiles per kilogram of food. In terms of opportunity cost, it is clear that Country X is relatively
more efficient in producing food and Country Y is relatively more efficient in producing textiles. Thus,
Country X (Y) has a comparative advantage in producing food (textile) is comparison to Country Y (X).
When there are no restrictions or impediments to free trade the economic-well -being of the citizens of
both countries is enhanced through trade. Suppose that Country X shifts 20,000,000 units from the
production of textiles to the production of food where it has a comparative advantage and that Country Y
shifts 60,000,000 units from the production of food to the production of textiles where it has a
comparative advantage. Total output will now be (90,000,000 x 17 =) 1,530,000,000 kilograms of food
and [(20,000,000 x 5 =100,000,000) + (90,000,000 x 2 =180,000,000) =] 280,000,000 metres of textiles.
Further suppose that Country X and Country Y agree on a price of 3.00 kilograms of food for one metre
of textiles, and that Country X sells Country Y 330,000,000 kilograms of food for 110,000,000 metres of
textiles. Under free trade, the following table shows that the citizens of Country X (Y) have increased
their consumption of food by 10,000,000 (30,000,000) kilograms and textiles by 10,000,000 (10,000,000)
metres.
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INPUT/OUTPUT WITH FREE TRADE
__________________________________________________________________________
Country
X Y Total
__________________________________________________________________________
I. Units of Input
(000,000)
_______________________ ________________________________
Food 90 0
Textiles 20 90
__________________________________________________________________________
II. Output per Unit of Input
(Kilograms or metres)
______________________ ________________________________
Food 17 5
Textiles 5 2
__________________________________________________________________________
III. Total Output
(Kilograms or metres)
(000,000)
_____________________ ________________________________
Food 1,530 0 1,530
Textiles 100 180 280
__________________________________________________________________________
IV. Consumption
(Kilograms or metres)
(000,000)
_____________________ ________________________________
Food 1,200 330 1,530
Textiles 210 70 280
__________________________________________________________________________
INPUT/OUTPUT WITH FREE TRADE
__________________________________________________________________________
Country
X Y Total
__________________________________________________________________________
I. Units of Input
(000,000)
_______________________ ________________________________
Food 90 0
Textiles 20 90
__________________________________________________________________________
II. Output per Unit of Input
(Kilograms or metres)
______________________ ________________________________
Food 17 5
Textiles 5 2
__________________________________________________________________________
III. Total Output
(Kilograms or metres)
(000,000)
_____________________ ________________________________
Food 1,530 0 1,530
Textiles 100 180 280
__________________________________________________________________________
IV. Consumption
(Kilograms or metres)
(000,000)
_____________________ ________________________________
Food 1,200 330 1,530
Textiles 210 70 280
__________________________________________________________________________
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CHAPTER 2 INTERNATIONAL MONETARY SYSTEM
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain Gresham’s Law.
Answer: Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce)
money out of circulation. The phenomenon was often observed under the bimetallic standard under which
both gold and silver were used as means of payments, with the exchange ratio between the two metals
fixed.
2. Explain the mechanism that restores the balance-of-payments equilibrium when it is disturbed under
the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow
mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium
will be corrected by a counter-flow of gold. Suppose that the US imports more from the UK than it
exports to the latter. Under the classical gold standard, gold is the only means to settle international
payments. Since in our example the US owes money to the UK gold must flow from the U.S. to the UK
As a result, the US (UK) will experience a corresponding decrease (increase) in money supply. This
means that the price level will tend to fall in the US and rise in the UK Consequently, US products
become more competitive in the export market, while UK products become less competitive. This change
will improve US balance of payments and at the same time hurt the UK balance of payments, eventually
eliminating the initial BOP disequilibrium.
3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at
12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be 2 francs per
pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this
situation? What would be the effect of shipping costs?
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain Gresham’s Law.
Answer: Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce)
money out of circulation. The phenomenon was often observed under the bimetallic standard under which
both gold and silver were used as means of payments, with the exchange ratio between the two metals
fixed.
2. Explain the mechanism that restores the balance-of-payments equilibrium when it is disturbed under
the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow
mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium
will be corrected by a counter-flow of gold. Suppose that the US imports more from the UK than it
exports to the latter. Under the classical gold standard, gold is the only means to settle international
payments. Since in our example the US owes money to the UK gold must flow from the U.S. to the UK
As a result, the US (UK) will experience a corresponding decrease (increase) in money supply. This
means that the price level will tend to fall in the US and rise in the UK Consequently, US products
become more competitive in the export market, while UK products become less competitive. This change
will improve US balance of payments and at the same time hurt the UK balance of payments, eventually
eliminating the initial BOP disequilibrium.
3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at
12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be 2 francs per
pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this
situation? What would be the effect of shipping costs?
Loading page 13...
Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in the
foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for
12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12
francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course,
you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The
arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more
than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.
4. Discuss the advantages and disadvantages of the gold standard.
Answer: The advantages of the gold standard include: (i)) since the supply of gold is restricted, countries
cannot have high inflation; (ii) any BOP disequilibrium can be corrected automatically through cross-
border flows of gold. On the other hand, the main disadvantages of the gold standard are: (i) the world
economy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standard
itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic
policies (like de-monetization of gold) that are incompatible with the gold standard.
5. What were the main objectives of the Bretton Woods system?
Answer: The main objectives of the Bretton Woods system were to achieve exchange rate stability as a
means to promote international trade, cross-border investment and economic development.
6. Comment on the proposition that the Bretton Woods system was programmed to an eventual demise.
Answer: The answer to this question is related to the Triffin paradox. Under the gold-exchange system,
the reserve-currency country should run BOP deficits to supply reserves to the world economy, but if the
deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself,
eventually causing the downfall of the system.
foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for
12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12
francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course,
you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The
arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more
than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.
4. Discuss the advantages and disadvantages of the gold standard.
Answer: The advantages of the gold standard include: (i)) since the supply of gold is restricted, countries
cannot have high inflation; (ii) any BOP disequilibrium can be corrected automatically through cross-
border flows of gold. On the other hand, the main disadvantages of the gold standard are: (i) the world
economy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standard
itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic
policies (like de-monetization of gold) that are incompatible with the gold standard.
5. What were the main objectives of the Bretton Woods system?
Answer: The main objectives of the Bretton Woods system were to achieve exchange rate stability as a
means to promote international trade, cross-border investment and economic development.
6. Comment on the proposition that the Bretton Woods system was programmed to an eventual demise.
Answer: The answer to this question is related to the Triffin paradox. Under the gold-exchange system,
the reserve-currency country should run BOP deficits to supply reserves to the world economy, but if the
deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself,
eventually causing the downfall of the system.
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7. How are special drawing rights (SDR) constructed? Discuss the circumstances under which the SDR
was created.
Answer: The SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the
pressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency, currently
comprised of four currencies: US Dollar (42% in the SDR weighting), European Euro (37 %), Japanese
Yen (9 %), British Pound (11 %). The weights for the constituent currencies tend to change over time,
reflecting the relative importance of each currency in international trade and finance.
8. Explain the arrangements and workings of the European Monetary System (EMS).
Answer: EMS was launched in 1979 in order to (i) establish a zone of monetary stability in Europe, (ii)
coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the way for the eventual
European Monetary Union. The main instruments of EMS are the European Currency Unit (ECU) and the
Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency constructed as a weighted
average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays
an important role in the workings of the ERM. The ERM is the procedure by which EMS member
countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first
computed by defining the par values of EMS currencies in terms of the ECU. These par values are called
the ECU central rates. If a country’s ECU market exchange rate diverges from the central rate by as much
as the maximum allowable deviation, the country has to adjust its policies to maintain its par values
relative to other currencies. EMS achieved a complete monetary union in 1999 when the common
European currency, the euro, was adopted.
9. There are arguments for and against the alternative exchange rate regimes.
a. List the advantages of flexible exchange rates.
b. Criticize flexible exchange rates from the viewpoint of the proponents of fixed exchange rates.
c. Rebut the above criticism from the viewpoint of the proponents of flexible exchange rates.
was created.
Answer: The SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the
pressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency, currently
comprised of four currencies: US Dollar (42% in the SDR weighting), European Euro (37 %), Japanese
Yen (9 %), British Pound (11 %). The weights for the constituent currencies tend to change over time,
reflecting the relative importance of each currency in international trade and finance.
8. Explain the arrangements and workings of the European Monetary System (EMS).
Answer: EMS was launched in 1979 in order to (i) establish a zone of monetary stability in Europe, (ii)
coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the way for the eventual
European Monetary Union. The main instruments of EMS are the European Currency Unit (ECU) and the
Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency constructed as a weighted
average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays
an important role in the workings of the ERM. The ERM is the procedure by which EMS member
countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first
computed by defining the par values of EMS currencies in terms of the ECU. These par values are called
the ECU central rates. If a country’s ECU market exchange rate diverges from the central rate by as much
as the maximum allowable deviation, the country has to adjust its policies to maintain its par values
relative to other currencies. EMS achieved a complete monetary union in 1999 when the common
European currency, the euro, was adopted.
9. There are arguments for and against the alternative exchange rate regimes.
a. List the advantages of flexible exchange rates.
b. Criticize flexible exchange rates from the viewpoint of the proponents of fixed exchange rates.
c. Rebut the above criticism from the viewpoint of the proponents of flexible exchange rates.
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Answer:
a. The advantages of the flexible exchange rate system include:
i. automatic achievement of balance of payments equilibrium
ii. maintenance of national policy autonomy.
b. If exchange rates fluctuate randomly, that may discourage international trade and encourage market
segmentation. This, in turn, may lead to suboptimal allocation of resources.
c. Economic agents can hedge exchange risk by means of forward contracts and other techniques. They
don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime,
governments often restrict international trade in order to maintain the exchange rate. This is a self-
defeating measure. What’s good about the fixed exchange rate if international trade needs to be
restricted?
10. Discuss the criteria for a ‘good’ international monetary system.
Answer:
A good international monetary system should provide
i. sufficient liquidity to the world economy
ii. smooth adjustments to BOP disequilibrium as it arises
iii. safeguard against the crisis of confidence in the system.
11. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate.
Explain why this may be so.
Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and out
of a country in a short time period. Such volatile demands for the domestic currency (on Capital
Account) make it difficult for a country to maintain a fixed exchange rate.
12. Assess the possibility for the euro to become another global currency rivalling the US dollar. If the
euro really becomes a global currency, what impact will it have on the US dollar and the world economy?
Answer: In light of the large transactions domain of the euro, which is comparable to that of the U.S.
dollar, and the mandate for the European Central Bank (ECB) to guarantee the monetary stability in
Europe, the euro is likely to become a global currency over time. A major uncertainty about this prospect
is the lack of political integration of Europe. If Europe becomes politically more integrated, the euro is
a. The advantages of the flexible exchange rate system include:
i. automatic achievement of balance of payments equilibrium
ii. maintenance of national policy autonomy.
b. If exchange rates fluctuate randomly, that may discourage international trade and encourage market
segmentation. This, in turn, may lead to suboptimal allocation of resources.
c. Economic agents can hedge exchange risk by means of forward contracts and other techniques. They
don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime,
governments often restrict international trade in order to maintain the exchange rate. This is a self-
defeating measure. What’s good about the fixed exchange rate if international trade needs to be
restricted?
10. Discuss the criteria for a ‘good’ international monetary system.
Answer:
A good international monetary system should provide
i. sufficient liquidity to the world economy
ii. smooth adjustments to BOP disequilibrium as it arises
iii. safeguard against the crisis of confidence in the system.
11. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate.
Explain why this may be so.
Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and out
of a country in a short time period. Such volatile demands for the domestic currency (on Capital
Account) make it difficult for a country to maintain a fixed exchange rate.
12. Assess the possibility for the euro to become another global currency rivalling the US dollar. If the
euro really becomes a global currency, what impact will it have on the US dollar and the world economy?
Answer: In light of the large transactions domain of the euro, which is comparable to that of the U.S.
dollar, and the mandate for the European Central Bank (ECB) to guarantee the monetary stability in
Europe, the euro is likely to become a global currency over time. A major uncertainty about this prospect
is the lack of political integration of Europe. If Europe becomes politically more integrated, the euro is
Loading page 16...
more likely to become a global currency. If the euro becomes a global currency, it will come at the
expense of the dollar. Currently, the U.S. derives substantial benefit from the dollar’s status as the
dominant global currency. For instance, the U.S. can run trade deficits without having to maintain
substantial foreign exchange reserves and it can carry out international commercial and financial
transactions in dollars without bearing exchange risk. If the euro becomes a major transactional, reserve
and invoice currency in the world economy, dollar-based agents will come to bear more exchange risk.
13. What are the basic characteristics of a bona fide common currency area? Is Canada a common
currency area?
Answer: A bona fide common currency area is characterized by a high degree of internal factor (capital
and labour) mobility, price flexibility and relatively little occurrence of internal asymmetric shocks.
Canada’s recent economic experience with its “economic dualism” – with extraordinary growth in the oil
and energy rich West and a slumping manufacturing sector in the East suggest that Canada is NOT
always well-served by our single currency. The rising value of the Canadian dollar through the 2003 –
2008 period was due in part to the rise in the price of oil and energy, which serves Western Canadian
interests, whereas Easter Canada would have benefitted from a somewhat lower value of the Canadian
dollar. Since Canada has a nationwide monetary policy, the Bank of Canada is not in a position to
differentially address the economic interests of the West and the East simultaneously.
expense of the dollar. Currently, the U.S. derives substantial benefit from the dollar’s status as the
dominant global currency. For instance, the U.S. can run trade deficits without having to maintain
substantial foreign exchange reserves and it can carry out international commercial and financial
transactions in dollars without bearing exchange risk. If the euro becomes a major transactional, reserve
and invoice currency in the world economy, dollar-based agents will come to bear more exchange risk.
13. What are the basic characteristics of a bona fide common currency area? Is Canada a common
currency area?
Answer: A bona fide common currency area is characterized by a high degree of internal factor (capital
and labour) mobility, price flexibility and relatively little occurrence of internal asymmetric shocks.
Canada’s recent economic experience with its “economic dualism” – with extraordinary growth in the oil
and energy rich West and a slumping manufacturing sector in the East suggest that Canada is NOT
always well-served by our single currency. The rising value of the Canadian dollar through the 2003 –
2008 period was due in part to the rise in the price of oil and energy, which serves Western Canadian
interests, whereas Easter Canada would have benefitted from a somewhat lower value of the Canadian
dollar. Since Canada has a nationwide monetary policy, the Bank of Canada is not in a position to
differentially address the economic interests of the West and the East simultaneously.
Loading page 17...
Mini Case: Will the United Kingdom Join the Euro Club?
Suggested Solution to Will the United Kingdom Join the Euro Club?
Whether the UK will join the euro club will be a political as much as economic decision. Recently, the
UK economy was converging with those of euro-zone countries. Economic conditions in terms of
government budgets, interest rates, and inflation rate are becoming similar to those in euro-zone
countries. On an economic ground, this convergence is creating a condition that is conducive to UK’s
joining the euro club. As pointed out by Wim Duisenberg, when he was President of the European Central
Bank, British opposition to joining the euro club is more “psycho-political” than justified on economic
grounds. Since many political leaders in France and Germany consider adoption of the euro as a step
toward the European political union, the UK is likely to join the euro-zone if it is prepared to join the
European political union as well. Once the UK joins the euro-zone, the euro will likely become a global
currency rivaling the US dollar.
Suggested Solution to Will the United Kingdom Join the Euro Club?
Whether the UK will join the euro club will be a political as much as economic decision. Recently, the
UK economy was converging with those of euro-zone countries. Economic conditions in terms of
government budgets, interest rates, and inflation rate are becoming similar to those in euro-zone
countries. On an economic ground, this convergence is creating a condition that is conducive to UK’s
joining the euro club. As pointed out by Wim Duisenberg, when he was President of the European Central
Bank, British opposition to joining the euro club is more “psycho-political” than justified on economic
grounds. Since many political leaders in France and Germany consider adoption of the euro as a step
toward the European political union, the UK is likely to join the euro-zone if it is prepared to join the
European political union as well. Once the UK joins the euro-zone, the euro will likely become a global
currency rivaling the US dollar.
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IM-1
CHAPTER 3 BALANCE OF PAYMENTS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Define Balance of Payments.
Answer: The Balance of Payments (BOP) is a statistical record of a country’s international transactions –
whether inbound or outbound – over a certain period of time presented in the form of double-entry
bookkeeping.
2. Why would it be useful to examine a country’s balance-of-payments data?
Answer: It is useful to examine a country’s BOP for at least two reasons. First, the BOP provides detailed
information about the supply and demand of the country’s currency. The trade statistics in the Current
Account, for example, show the composition of trade – what a country imports and what it exports. The
Capital Account shows inflows and outflows of capital in various categories. Second, viewed over time,
BOP data can shed light on important developments in a country’s comparative advantage and
international competitiveness.
3. The United States has run current account deficits continuously since the early 1980s. What do you
think are the main causes for the deficits? What are the global consequences of continuous US current
account deficits?
Answer:
The current account deficits of US may be linked to factors such as
i. the relative ease by which the United States could borrow abroad to finance Current
Account deficits
ii. the high US rate of consumption (and correspondingly low savings rate) associated
with large government deficits
iii. US monetary policy that sustained relatively high US interest rates and a high value for
CHAPTER 3 BALANCE OF PAYMENTS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Define Balance of Payments.
Answer: The Balance of Payments (BOP) is a statistical record of a country’s international transactions –
whether inbound or outbound – over a certain period of time presented in the form of double-entry
bookkeeping.
2. Why would it be useful to examine a country’s balance-of-payments data?
Answer: It is useful to examine a country’s BOP for at least two reasons. First, the BOP provides detailed
information about the supply and demand of the country’s currency. The trade statistics in the Current
Account, for example, show the composition of trade – what a country imports and what it exports. The
Capital Account shows inflows and outflows of capital in various categories. Second, viewed over time,
BOP data can shed light on important developments in a country’s comparative advantage and
international competitiveness.
3. The United States has run current account deficits continuously since the early 1980s. What do you
think are the main causes for the deficits? What are the global consequences of continuous US current
account deficits?
Answer:
The current account deficits of US may be linked to factors such as
i. the relative ease by which the United States could borrow abroad to finance Current
Account deficits
ii. the high US rate of consumption (and correspondingly low savings rate) associated
with large government deficits
iii. US monetary policy that sustained relatively high US interest rates and a high value for
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IM-2
the US dollar.
4. In contrast to the United States, Japan has realized continuous Current Account surpluses. What could
be the main causes for these surpluses? Is it desirable to have continuous Current Account surpluses?
Answer: Japan’s continuous Current Account surpluses may have reflected a weak yen and high
competitiveness of Japanese industries. Massive capital exports by Japan (purchases of US Securities,
especially Treasury Bills) prevented yen from appreciating more than it did. At the same time,
foreigners’ exports (of goods and services) to Japan were hampered by closed nature of Japanese markets.
Sustained Current Account surpluses sometimes reflect export-promotion, import-discouraging policies in
the country. Though it is desirable by the countries, but such surpluses are inconsistent with free-trade to
the extent that they are brought about by the mercantilist policies.
5. Comment on the following statement: “When Canada imports more than it exports, it is necessary for
Canada to import capital from foreign countries to finance its Current Account deficits.”
Answer: The Balance of Payments must balance. A deficit on Current Account ( “When Canada imports
more than it exports ..”) means that Canada has spent more on imported goods and services than it has
received in sales of (Canadian exported) goods and services. The Current Account deficit must be
financed with an inflow of foreign capital involving the purchase of Canadian securities by foreigners
who have more Canadian dollars than they know what to do with ( … “it is necessary for Canada to
import capital from foreign countries to finance its Current Account deficits.”) which, of course, is a
surplus on Capital Account.
6. Explain how a country can run an overall balance-of-payments deficit or surplus.
Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve
transactions. For example, Canada could run an overall BOP deficit by drawing down The Bank of
Canada’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central
bank’s reserve holdings. The Bank of Canada generally does not intervene – by using or accumulating
foreign exchange reserves – to establish a specific value for the Canadian dollar vis-à-vis, say, the US
dollar. The Bank of Canada is committed to a flexible exchange rate. As a result, the foreign exchange
reserves of the Bank of Canada are relatively small unlike, say, Asian countries that hold substantial
the US dollar.
4. In contrast to the United States, Japan has realized continuous Current Account surpluses. What could
be the main causes for these surpluses? Is it desirable to have continuous Current Account surpluses?
Answer: Japan’s continuous Current Account surpluses may have reflected a weak yen and high
competitiveness of Japanese industries. Massive capital exports by Japan (purchases of US Securities,
especially Treasury Bills) prevented yen from appreciating more than it did. At the same time,
foreigners’ exports (of goods and services) to Japan were hampered by closed nature of Japanese markets.
Sustained Current Account surpluses sometimes reflect export-promotion, import-discouraging policies in
the country. Though it is desirable by the countries, but such surpluses are inconsistent with free-trade to
the extent that they are brought about by the mercantilist policies.
5. Comment on the following statement: “When Canada imports more than it exports, it is necessary for
Canada to import capital from foreign countries to finance its Current Account deficits.”
Answer: The Balance of Payments must balance. A deficit on Current Account ( “When Canada imports
more than it exports ..”) means that Canada has spent more on imported goods and services than it has
received in sales of (Canadian exported) goods and services. The Current Account deficit must be
financed with an inflow of foreign capital involving the purchase of Canadian securities by foreigners
who have more Canadian dollars than they know what to do with ( … “it is necessary for Canada to
import capital from foreign countries to finance its Current Account deficits.”) which, of course, is a
surplus on Capital Account.
6. Explain how a country can run an overall balance-of-payments deficit or surplus.
Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve
transactions. For example, Canada could run an overall BOP deficit by drawing down The Bank of
Canada’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central
bank’s reserve holdings. The Bank of Canada generally does not intervene – by using or accumulating
foreign exchange reserves – to establish a specific value for the Canadian dollar vis-à-vis, say, the US
dollar. The Bank of Canada is committed to a flexible exchange rate. As a result, the foreign exchange
reserves of the Bank of Canada are relatively small unlike, say, Asian countries that hold substantial
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IM-3
reserves in order to protect their currencies in the face of excess volatility.
7. Explain official reserve assets and its major components.
Answer: Official reserve assets are those financial assets that can be used as international means of
payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges, (iii) special drawing
rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most important
official reserves.
8. Explain how to compute the overall balance, and discuss its significance.
Answer: The overall BOP is sum of the Current Account, the Capital Account and the statistical
discrepancies. The overall BOP indicates a country’s international payment gap that must be financed by
the government’s official reserve transactions.
9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of US Treasury
bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment on the US
Balance of Payments.
Answer: As foreigners purchase US Treasury bonds, US BOP is supported in the short run, i.e., the Balance of
Payments deficit is financed with capital inflows. In the longer run, the US Balance of Payments may deteriorate
since the US must eventually pay interest and principal to foreigners as the Treasury bonds mature. However, if
the foreign funds are used productively in the US and the US economy “grows out of its foreign debt”, then the
longer term implications are less significant. In other words, a Current Account deficit may be good thing for
economic growth, especially if the imported goods and the imported capital are used for investment rather than
consumption.
10. Describe the balance-of-payments identity, and discuss its implications under the fixed and flexible
exchange rate regimes.
Answer: The balance-of-payments identity is an accounting relationship that in principle (that
is, aside .from statistical errors) must hold. The Balance-of-Payments Identity is:
BCA + BKA + BRA = 0,
Where,
reserves in order to protect their currencies in the face of excess volatility.
7. Explain official reserve assets and its major components.
Answer: Official reserve assets are those financial assets that can be used as international means of
payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges, (iii) special drawing
rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most important
official reserves.
8. Explain how to compute the overall balance, and discuss its significance.
Answer: The overall BOP is sum of the Current Account, the Capital Account and the statistical
discrepancies. The overall BOP indicates a country’s international payment gap that must be financed by
the government’s official reserve transactions.
9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of US Treasury
bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment on the US
Balance of Payments.
Answer: As foreigners purchase US Treasury bonds, US BOP is supported in the short run, i.e., the Balance of
Payments deficit is financed with capital inflows. In the longer run, the US Balance of Payments may deteriorate
since the US must eventually pay interest and principal to foreigners as the Treasury bonds mature. However, if
the foreign funds are used productively in the US and the US economy “grows out of its foreign debt”, then the
longer term implications are less significant. In other words, a Current Account deficit may be good thing for
economic growth, especially if the imported goods and the imported capital are used for investment rather than
consumption.
10. Describe the balance-of-payments identity, and discuss its implications under the fixed and flexible
exchange rate regimes.
Answer: The balance-of-payments identity is an accounting relationship that in principle (that
is, aside .from statistical errors) must hold. The Balance-of-Payments Identity is:
BCA + BKA + BRA = 0,
Where,
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IM-4
BCA = Balance on Current Account
BKA = Balance on Capital Account
BRA = Balance on Reserves Account
Under flexible exchange rate:
The Balance of Payments identity holds that the combined balance on the Current and Capital Accounts
are equal in size but opposite in sign (assuming zero change in official reserves).
BCA + BKA = -BRA = 0
Under a flexible exchange rate regime, central banks do not engage in official reserve transactions (BRA
= 0 by virtue of central bank policy of non-intervention). Thus, the overall balance must balance, i.e.,
BCA = -BKA.
Under a fixed exchange rate:
Under a fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the
central bank will accommodate it via official reserve transactions ( BRA ≠ 0 and BCA does not
necessarily equal BKA ).
11. Occasionally, a country will have a Current Account deficit and a Capital Account deficit at the
same time. Explain how this can happen.
Answer: A Current Account deficit means that imports are greater than exports. A Capital Account
deficit means that the country is exporting capital. A Current Account deficit could be explained by
strong economic growth, investment or domestic consumption, any or all of which may be explained by
low domestic interest rates. A Capital Account deficit at the same time could also be explained by the
same relatively low interest rates that cause capital to flow to more attractive interest rates abroad. In
short, loose monetary policy is the most likely cause of simultaneous Current Account and Capital
Account deficits, the simultaneity of which is a likely indicator of currency weakening.
BCA = Balance on Current Account
BKA = Balance on Capital Account
BRA = Balance on Reserves Account
Under flexible exchange rate:
The Balance of Payments identity holds that the combined balance on the Current and Capital Accounts
are equal in size but opposite in sign (assuming zero change in official reserves).
BCA + BKA = -BRA = 0
Under a flexible exchange rate regime, central banks do not engage in official reserve transactions (BRA
= 0 by virtue of central bank policy of non-intervention). Thus, the overall balance must balance, i.e.,
BCA = -BKA.
Under a fixed exchange rate:
Under a fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the
central bank will accommodate it via official reserve transactions ( BRA ≠ 0 and BCA does not
necessarily equal BKA ).
11. Occasionally, a country will have a Current Account deficit and a Capital Account deficit at the
same time. Explain how this can happen.
Answer: A Current Account deficit means that imports are greater than exports. A Capital Account
deficit means that the country is exporting capital. A Current Account deficit could be explained by
strong economic growth, investment or domestic consumption, any or all of which may be explained by
low domestic interest rates. A Capital Account deficit at the same time could also be explained by the
same relatively low interest rates that cause capital to flow to more attractive interest rates abroad. In
short, loose monetary policy is the most likely cause of simultaneous Current Account and Capital
Account deficits, the simultaneity of which is a likely indicator of currency weakening.
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IM-5
12. Explain how each of the following transactions will be classified and recorded in the debit and credit
of the Canadian Balance of Payments:
a. A Japanese insurance company purchases Government of Ontario bonds and pays out
of its bank account kept in Toronto.
b. A Canadian citizen has a meal at a restaurant in Paris and pays with her Royal Bank
VISA card.
c. An Indian immigrant living in Halifax sends a cheque drawn on his Halifax bank
account as a gift to his parents living in New Delhi.
d. A Canadian computer programmer is hired by a British company for consulting and
gets paid from a Canadian bank account maintained by the British company.
Answer:
_________________________________________________________________
Transactions Credit Debit
_________________________________________________________________
Japanese purchase of Ontario bonds
Japanese payment out of Toronto account
Canadian having a meal in Paris
Paying for the meal with Royal Bank VISA
Halifax resident’s gift to parents in India
Receipt of cheque by parents
Canadian consultant’s fee paid by U.K. firm
British payment out of its account in Canada
_________________________________________________________________
12. Explain how each of the following transactions will be classified and recorded in the debit and credit
of the Canadian Balance of Payments:
a. A Japanese insurance company purchases Government of Ontario bonds and pays out
of its bank account kept in Toronto.
b. A Canadian citizen has a meal at a restaurant in Paris and pays with her Royal Bank
VISA card.
c. An Indian immigrant living in Halifax sends a cheque drawn on his Halifax bank
account as a gift to his parents living in New Delhi.
d. A Canadian computer programmer is hired by a British company for consulting and
gets paid from a Canadian bank account maintained by the British company.
Answer:
_________________________________________________________________
Transactions Credit Debit
_________________________________________________________________
Japanese purchase of Ontario bonds
Japanese payment out of Toronto account
Canadian having a meal in Paris
Paying for the meal with Royal Bank VISA
Halifax resident’s gift to parents in India
Receipt of cheque by parents
Canadian consultant’s fee paid by U.K. firm
British payment out of its account in Canada
_________________________________________________________________
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IM-6
13. Construct the balance-of-payments table for Japan for the year 2012, which is comparable in
format to Exhibit 3.4, and interpret the numerical data. You may consult International
Financial Statistics published by the IMF or search for useful websites for the data yourself.
Answer: A summary of the Japanese Balance of Payments for 2012Current Account
Goods & Services
Goods -5814.1
Service
Travel -1061.7
Transportation -1211.9
Other Services -216.4
Goods & Service Total -8304.1
Investment
Direct Investment income 4214.2
Portfolio Income 9396.0
Other Investment 662.1
Investment Total 14272.3
Transfers -1144.5
Balance on Current Account 4823.7
Capital & Financial Account
Financial Account
Direct investment -9640.1
Portfolio investment -6116.1
Equity securities 4486.3
Debt securities -10602.4
Financial Derivatives -590.3
Other investment 8239.1
Financial Account Total -8107.4
Capital account -80.4
Balance on Capital & Financial Account -8187.8
Statistical discrepancies 312.6
Official Reserve Account 3051.5
Source: Bank of Japan, http://www.boj.or.jp/en/research/brp/ron_2013/data/ron130724a.pdf
13. Construct the balance-of-payments table for Japan for the year 2012, which is comparable in
format to Exhibit 3.4, and interpret the numerical data. You may consult International
Financial Statistics published by the IMF or search for useful websites for the data yourself.
Answer: A summary of the Japanese Balance of Payments for 2012Current Account
Goods & Services
Goods -5814.1
Service
Travel -1061.7
Transportation -1211.9
Other Services -216.4
Goods & Service Total -8304.1
Investment
Direct Investment income 4214.2
Portfolio Income 9396.0
Other Investment 662.1
Investment Total 14272.3
Transfers -1144.5
Balance on Current Account 4823.7
Capital & Financial Account
Financial Account
Direct investment -9640.1
Portfolio investment -6116.1
Equity securities 4486.3
Debt securities -10602.4
Financial Derivatives -590.3
Other investment 8239.1
Financial Account Total -8107.4
Capital account -80.4
Balance on Capital & Financial Account -8187.8
Statistical discrepancies 312.6
Official Reserve Account 3051.5
Source: Bank of Japan, http://www.boj.or.jp/en/research/brp/ron_2013/data/ron130724a.pdf
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IM-7
Assumption: security lending transitions all go to other investment
Assumption: security lending transitions all go to other investment
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IM-8
Mini Case: Mexico’s Balance-of-Payments Problem
Refer to Chapter 3 pg. 70 in text.
Suggested Solution to Mexico’s Balance-of-Payments Problem
It is useful to review Chapter 2, especially the section on the Mexican peso crisis. While Mexico had
experienced continuous trade deficits until December 1994, the country’s currency was not allowed to
depreciate for political reasons. The Mexican government did not want the peso devaluation before the
Presidential election held in 1994. If the Mexican peso had been allowed to gradually depreciate against
the major currencies, the peso crisis could have been prevented.
The key lessons to be derived from the peso crisis are:
First, Mexico depended too much on short-term foreign portfolio capital (which is easily reversible) for
its economic growth. The country should have saved more domestically and depended more on long-term
foreign capital. This can be a valuable lesson for many developing countries.
Second, the lack of reliable economic information was contributing factor to the peso crisis. The Salinas
administration was reluctant to fully disclose the true state of the Mexican economy. If investors had
known that Mexico was experiencing serious trade deficits and rapid depletion of foreign exchange
reserves, the peso might have been gradually depreciating, rather than suddenly collapsed as it did. The
transparent disclosure of economic data can help prevent the peso-type crisis.
Third, it is important to safeguard the world financial system from the peso-type crisis. To this end, a
multinational safety net needs to be in place to contain the peso-type crisis in the early stage.
Mini Case: Mexico’s Balance-of-Payments Problem
Refer to Chapter 3 pg. 70 in text.
Suggested Solution to Mexico’s Balance-of-Payments Problem
It is useful to review Chapter 2, especially the section on the Mexican peso crisis. While Mexico had
experienced continuous trade deficits until December 1994, the country’s currency was not allowed to
depreciate for political reasons. The Mexican government did not want the peso devaluation before the
Presidential election held in 1994. If the Mexican peso had been allowed to gradually depreciate against
the major currencies, the peso crisis could have been prevented.
The key lessons to be derived from the peso crisis are:
First, Mexico depended too much on short-term foreign portfolio capital (which is easily reversible) for
its economic growth. The country should have saved more domestically and depended more on long-term
foreign capital. This can be a valuable lesson for many developing countries.
Second, the lack of reliable economic information was contributing factor to the peso crisis. The Salinas
administration was reluctant to fully disclose the true state of the Mexican economy. If investors had
known that Mexico was experiencing serious trade deficits and rapid depletion of foreign exchange
reserves, the peso might have been gradually depreciating, rather than suddenly collapsed as it did. The
transparent disclosure of economic data can help prevent the peso-type crisis.
Third, it is important to safeguard the world financial system from the peso-type crisis. To this end, a
multinational safety net needs to be in place to contain the peso-type crisis in the early stage.
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IM-1
CHAPTER 4 THE MARKET FOR FOREIGN EXCHANGE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of the market for foreign exchange.
Answer: Broadly defined, the market for foreign exchange (FX or FOREX) includes the means (through
banks) by which one currency is exchanged for another, bank deposits of foreign currency, credit
denominated in foreign currencies, the finance of foreign trade and trading in foreign currency options and
futures contracts. It encompasses the conversion of purchasing power from one country into another.
2. What is the difference between the retail or client market and the wholesale or interbank market for
foreign exchange?
Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the
wholesale or interbank market. The other tier is the retail or client market. International banks
provide the core of the FX market, both wholesale and retail. In the retail market, banks buy or sell
foreign currency serving their (retail) clients – non-financial business and individuals – in cross-
currency exchange for trade and international investment. Retail transactions account for about 9
percent of FX trades. The other 91 percent is interbank trades between and among international banks
or non-bank dealers large enough to transact in the interbank market.
3. Who are the market participants in the foreign exchange market?
Answer: The market participants that comprise the FX market can be categorized into five groups:
international banks, bank customers, non-bank dealers, FX brokers, and central banks. International
banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market
in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account.
These international banks serve their retail clients, the bank customers, in conducting foreign
commerce or making international investment in financial assets that requires foreign exchange. Non-
bank dealers are large non-bank financial institutions, such as investment banks, whose size and
CHAPTER 4 THE MARKET FOR FOREIGN EXCHANGE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of the market for foreign exchange.
Answer: Broadly defined, the market for foreign exchange (FX or FOREX) includes the means (through
banks) by which one currency is exchanged for another, bank deposits of foreign currency, credit
denominated in foreign currencies, the finance of foreign trade and trading in foreign currency options and
futures contracts. It encompasses the conversion of purchasing power from one country into another.
2. What is the difference between the retail or client market and the wholesale or interbank market for
foreign exchange?
Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the
wholesale or interbank market. The other tier is the retail or client market. International banks
provide the core of the FX market, both wholesale and retail. In the retail market, banks buy or sell
foreign currency serving their (retail) clients – non-financial business and individuals – in cross-
currency exchange for trade and international investment. Retail transactions account for about 9
percent of FX trades. The other 91 percent is interbank trades between and among international banks
or non-bank dealers large enough to transact in the interbank market.
3. Who are the market participants in the foreign exchange market?
Answer: The market participants that comprise the FX market can be categorized into five groups:
international banks, bank customers, non-bank dealers, FX brokers, and central banks. International
banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market
in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account.
These international banks serve their retail clients, the bank customers, in conducting foreign
commerce or making international investment in financial assets that requires foreign exchange. Non-
bank dealers are large non-bank financial institutions, such as investment banks, whose size and
Loading page 27...
IM-2
frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the
interbank market for their foreign exchange needs.
Most interbank trades are speculative or arbitrage transactions where market participants attempt to
correctly judge the future direction of price movements in one currency versus another or attempt to
profit from temporary price discrepancies in currencies between competing dealers.
FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position
themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency
quote to many other dealers.
Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price
of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its currency
against. Intervention is the process of using foreign currency reserves to buy one’s own currency in
order to decrease its supply and thus increase its value in the foreign exchange market, or
alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower
its price.
4. How are foreign exchange transactions between international banks settled?
Answer: The interbank market is a network of correspondent banking relationships, with large
commercial banks maintaining demand deposit accounts with one another, called correspondent bank
accounts. The correspondent bank account network allows for the efficient functioning of the foreign
exchange market. As an example of how the network of correspondent bank accounts facilities
international foreign exchange transactions, consider a Canadian importer who wants to purchase
merchandise invoiced in guilders from a Dutch exporter. The Canadian importer will contact his bank
and inquire about the exchange rate. If the importer accepts the offered exchange rate, the bank will
debit the importer’s account for the purchase of the Dutch guilders. The bank will instruct its
correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount
of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its
books to offset the debit of importer’s account, reflecting the decrease in its correspondent bank
account balance. In short, the foreign exchange aspect of the Canadian importer’s business in
importing from Holland is handled through international cooperative arrangements involving
commercial banks.
frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the
interbank market for their foreign exchange needs.
Most interbank trades are speculative or arbitrage transactions where market participants attempt to
correctly judge the future direction of price movements in one currency versus another or attempt to
profit from temporary price discrepancies in currencies between competing dealers.
FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position
themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency
quote to many other dealers.
Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price
of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its currency
against. Intervention is the process of using foreign currency reserves to buy one’s own currency in
order to decrease its supply and thus increase its value in the foreign exchange market, or
alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower
its price.
4. How are foreign exchange transactions between international banks settled?
Answer: The interbank market is a network of correspondent banking relationships, with large
commercial banks maintaining demand deposit accounts with one another, called correspondent bank
accounts. The correspondent bank account network allows for the efficient functioning of the foreign
exchange market. As an example of how the network of correspondent bank accounts facilities
international foreign exchange transactions, consider a Canadian importer who wants to purchase
merchandise invoiced in guilders from a Dutch exporter. The Canadian importer will contact his bank
and inquire about the exchange rate. If the importer accepts the offered exchange rate, the bank will
debit the importer’s account for the purchase of the Dutch guilders. The bank will instruct its
correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount
of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its
books to offset the debit of importer’s account, reflecting the decrease in its correspondent bank
account balance. In short, the foreign exchange aspect of the Canadian importer’s business in
importing from Holland is handled through international cooperative arrangements involving
commercial banks.
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IM-3
5. What is meant by a currency trading at a discount or at a premium in the forward market?
Answer: The forward market involves contracting today for the future purchase or sale of foreign
exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium)
or lower (at a discount) than the spot price. In other words, if a currency is trading at a premium
(discount), themarket expects the currency to appreciate (depreciate) in the future.
6. Why does most interbank currency trading worldwide involve the US dollar?
Answer: Trading in currencies worldwide is against a common currency that has an international
appeal. That currency has been the US dollar since the end of World War II. However, the Euro and
Japanese yen also have started to be used much more as international currencies in recent years. More
importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a
market against all other currencies.
7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in many
instances for hedging purposes. How can the bank eliminate the currency exposure it has created for
itself by accommodating a client’s forward transaction?
Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a
forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange
against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To
illustrate, suppose a bank customer wants to buy dollars three months forward against British pound
sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange
rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will
lend the dollars for three months until they are needed to deliver against the dollars it has sold
forward. The British pounds received will be used to liquidate the sterling loan.
8. A $/€ bank trader is currently quoting a small figure bid-ask of 83-88, when the rest of the market is
trading at $1.2989 - $1.2995. What is implied about the trader’s beliefs by his prices?
Answer: The foreign exchange trader is acting as if he believes the Canadian dollar is going to
appreciate against the Euro. He is pricing his Canadian dollar: Euro transactions so as to increase his
5. What is meant by a currency trading at a discount or at a premium in the forward market?
Answer: The forward market involves contracting today for the future purchase or sale of foreign
exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium)
or lower (at a discount) than the spot price. In other words, if a currency is trading at a premium
(discount), themarket expects the currency to appreciate (depreciate) in the future.
6. Why does most interbank currency trading worldwide involve the US dollar?
Answer: Trading in currencies worldwide is against a common currency that has an international
appeal. That currency has been the US dollar since the end of World War II. However, the Euro and
Japanese yen also have started to be used much more as international currencies in recent years. More
importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a
market against all other currencies.
7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in many
instances for hedging purposes. How can the bank eliminate the currency exposure it has created for
itself by accommodating a client’s forward transaction?
Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a
forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange
against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To
illustrate, suppose a bank customer wants to buy dollars three months forward against British pound
sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange
rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will
lend the dollars for three months until they are needed to deliver against the dollars it has sold
forward. The British pounds received will be used to liquidate the sterling loan.
8. A $/€ bank trader is currently quoting a small figure bid-ask of 83-88, when the rest of the market is
trading at $1.2989 - $1.2995. What is implied about the trader’s beliefs by his prices?
Answer: The foreign exchange trader is acting as if he believes the Canadian dollar is going to
appreciate against the Euro. He is pricing his Canadian dollar: Euro transactions so as to increase his
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IM-4
inventory of Canadian dollars while discouraging purchases of Euros by offering to buy Canadian
dollars at only $1.2983/€1.00 (whereas others are offering $1.2989/€) and offering to sell Euros from
inventory at the lower-than-market price of $1.2988/€1.00.
inventory of Canadian dollars while discouraging purchases of Euros by offering to buy Canadian
dollars at only $1.2983/€1.00 (whereas others are offering $1.2989/€) and offering to sell Euros from
inventory at the lower-than-market price of $1.2988/€1.00.
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IM-5
PROBLEMS
1. Using Exhibit 4.4, construct a “Latin America” cross-rate matrix for the currencies of Argentina,
Brazil, Colombia and Mexico. Present “indirect” quotes (units of foreign currency per one unit of
domestic currency) above the matrix diagonal and “direct” quotes (units of domestic per one unit of
foreign currency) below the diagonal, as was done in Exhibit 4.6.
Solution: The conventional cross-rate formula is:
S(j/k) = S($/k)/S($/j).
An alternative representation of the cross rate is:
S(j/k) = S(j/$)* S($/k).
The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.
- - FOREIGN - -
Argentina Brazil Colombia Mexico
H Argentina 1.0000 0.3865 351 2.3118
O Brazil 2.5881 1.0000 908 5.9819
M Colombia 0.0026 0.0010 1.0000 0.0060
E Mexico 0.4329 0.1673 152 1.0000
Note that the cross-rate matrix read as follows:
Along the US dollar row the cells show the number of foreign units of currency per US dollar.
Down the US dollar column the cells show the number of US dollars per unit of foreign currency.
2. Using US dollar data in Exhibit 4.4 (the first two data columns) for forward cross-exchange rates for
the Canadian dollar and the swiss franc, calculate the one-, three- and six-month forward rates
between the Canadian dollar and the Swiss franc. State the cross-rates in Canadian-direct terms.
Solution:
The formulae we want to use are:
FN(C$/CHF) = FN($/CHF)/FN($/C$)
or
FN(C$/CHF) = FN(C$/$)/FN(CHF/$).
PROBLEMS
1. Using Exhibit 4.4, construct a “Latin America” cross-rate matrix for the currencies of Argentina,
Brazil, Colombia and Mexico. Present “indirect” quotes (units of foreign currency per one unit of
domestic currency) above the matrix diagonal and “direct” quotes (units of domestic per one unit of
foreign currency) below the diagonal, as was done in Exhibit 4.6.
Solution: The conventional cross-rate formula is:
S(j/k) = S($/k)/S($/j).
An alternative representation of the cross rate is:
S(j/k) = S(j/$)* S($/k).
The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.
- - FOREIGN - -
Argentina Brazil Colombia Mexico
H Argentina 1.0000 0.3865 351 2.3118
O Brazil 2.5881 1.0000 908 5.9819
M Colombia 0.0026 0.0010 1.0000 0.0060
E Mexico 0.4329 0.1673 152 1.0000
Note that the cross-rate matrix read as follows:
Along the US dollar row the cells show the number of foreign units of currency per US dollar.
Down the US dollar column the cells show the number of US dollars per unit of foreign currency.
2. Using US dollar data in Exhibit 4.4 (the first two data columns) for forward cross-exchange rates for
the Canadian dollar and the swiss franc, calculate the one-, three- and six-month forward rates
between the Canadian dollar and the Swiss franc. State the cross-rates in Canadian-direct terms.
Solution:
The formulae we want to use are:
FN(C$/CHF) = FN($/CHF)/FN($/C$)
or
FN(C$/CHF) = FN(C$/$)/FN(CHF/$).
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