Solution Manual For International Financial Management, 3rd Edition

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IM-1EUN RESNICK BREANINTERNATIONAL MANAGEMENTCanadian Perspectives,ThirdEditionSUGGESTED ANSWERS AND SOLUTIONS TOEND-OF-CHAPTER QUESTIONS AND PROBLEMS

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IM-2CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRMSUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONSQUESTIONS1. 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, andinvestment, are highly globalized. Above all, virtually all business isinternationalbusiness. 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 managersto fully understand vital international dimensions of finance. The foreign dimensions of finance areespecially significant for Canadian business primarily because foreign markets are relatively moreimportant 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, and3. 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 forglobalized financial markets initially came from major countries where foreign exchange and capitalmarkets were significantly deregulated. The economic integration and globalization that began in the1980s accelerated in the 1990s via privatization. Privatization is the process by which the state divestsitself of the ownership and operations while turning to the market system. Lastly, trade liberalization andeconomic integration continued to proceed at both the regional and global levels such as the NorthAmerican Free Trade Agreement (among Canada, the United States and Mexico) and a strengthenedWorld Trade Organization (WTO).4.How is Canada’s economic wellbeing enhanced through free international trade in goods and services?

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IM-3Answer: In the absence of barriers to trade, market forces provide incentives for countries to organize theproduction of traded goods to their mutual economic benefit. As per Ricardo’s principle of “comparativeadvantage”, free trade goods will be produced where their cost of production is low and they will beconsumed 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. Thisargument 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 anothercountry. Rather, international trade is an ‘increasing-sum’ or “win-win” situation at which both countriesgain. 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-enhancingcommercial 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 frommany of the factors that underlie trade. In Ricardo’s framework, with its focus on only two countries andtwo products, the incentive for trade derives from differences in productive efficiency without explicitregard forwhyone country is more or less efficient.In a practical sense, indications of a country’scomparative 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 clearcomparative advantage in natural resources.The natural resources themselves are an endowment forCanada and are not derived from our productive efficiency. However, we ought to be more efficient thanother countries (comparative advantage) in production that is based on our natural resources, such aspetroleum refining, aluminum smelting, or manufacturing of wood products. Canada also has comparativeadvantage in certain skilled and research-intensive labour manufacturing sectors such as electronics.Tothe extent that Canadian universities attract foreign students, and hence Canada “exports education”, theindications 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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IM-47. 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 explanationfor why nations trade with one another. The idea is that economic well-being is enhanced if each countryproduces goods in which that country has a comparative advantage. In a two country context, eachcountry exports goods for which it has a comparative advantage and imports goods for which it does nothave 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 necessarilymobile between or among countries). To the extent that these assumptions do not hold, comparativeadvantage will not realistically describe international trade.8. What are multinational corporations (MNCs), and whateconomic roles do they play?Answer:A multinational corporation (MNC) can be defined as a business firm incorporated in onecountry that has production and sales operations in other countries. Some MNCs have operations indozens of different countries. MNCs are the vehicle forforeign direct investment. MNCs are an importantmeans by which productive capital, technology and business skills are transferred from one country toanother around the globe. Global operations require MNC treasurers to establish international bankingrelationships, to monitor and manage funds in several currency denominations and to effectively manageforeign exchange risk.9. Critics of the North AmericanFreeTrade Agreement (NAFTA) in both the United States and Canadafeared the loss of jobs to Mexico where it is much cheaper to hire workers. What are the merits anddemerits of this position on NAFTA? Considering recent economic developments in North America, howwould you assess the success of NAFTA?Answer: Since the inception of NAFTA, many American and Canadian companies indeed have investedheavily 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 ratein both Canada and the U.S. is low by historical standard. At the same time, Mexico has been

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IM-5experiencing a major economic boom. It seems clear that all three parties to NAFTA–Canada, Mexicoand 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 FrenchIndustry (CNPF) and the French Association of Private Companies (AFEP)examinedFrench corporategovernance.The group reported the following:“The board of directors should not simply aim atmaximizing 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 theprosperity and continuity of the company.” Evaluate the recommendation.Answer:The recommendations of the French working group show that shareholder wealth maximizationis not a universally accepted goal of corporate management, especially outside the so-called Anglo-Saxoncountries that include the United States, the United Kingdom and Canada. To some extent, this mayreflect the fact that share ownership is not widespread in many countries. In France, only about 15 percentof households own shares whereas in the Canada and the United States the figure is closer to 75 percentwhen one takes account of the asset composition of pension funds.

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IM-611. Emphasizing the importance of voluntary compliance,as opposed to enforcement,in the aftermath ofsuchcorporate scandals as those involving Enron and WorldCom, US President Bush stated that whiletougher laws might help, “ultimately, the ethics of business depends on the conscience of businessleaders.”Describe your view on this statement.Answer:There can be different answers to this question. If business leaders always behave with a highethical standard, many of the corporate scandals that we have seen lately might not have happened. Sincewe cannot fully depend on the ethical behaviour on the part of business leaders, society should protectitself by adopting the rules/regulations and governance structure that induce business leaders to behave inthe interest of the society at large.12. Suppose you are interested in investing intheshares of Nokia Corporation of Finland, which is aworld leader in wireless communication. But before you makeyourinvestment decision, you would liketo learn about the company. Visit the website of CNN Financial Network (www.cnnfn.com) and collectinformation 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 viatheinternetwould affect the nature and workings of financial markets.Answer: As students might have learned from visiting the website, information is readily available evenfor foreign companies like Nokia. Ready access to international information helps integrate financialmarkets, dismantling barriers to international investment and financing. Integration, however, may help afinancial shock in one market to be transmitted to other markets.

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IM-7Mini Case: Nike’s DecisionRefer to Chapter 1 pg.26in text.Suggested Solution to Nike’s DecisionObviously, Nike’s investments in such Asian countries as China, Indonesia, and Vietnam were motivatedto take advantage of low labour costs in those countries. While Nike was criticized for the poor workingconditions for its workers, the company has recognized the problem and has substantially improved theworking environments recently. Although Nike’s workers get paid very low wages by the Westernstandard, 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 thecompany is making contributions to the economic welfare of those Asian countries by creating jobopportunities.

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IM-8Appendix1AGains from Trade: The Theoryof Comparative AdvantageSUGGESTED SOLUTIONS TO APPENDIX PROBLEMSPROBLEMS1. Country C can produce seven kilograms of food or four metres of textiles per unit of input. Computethe opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost ofproducing textiles instead of food.Solution: The opportunity cost of producing food instead of textiles is one metre of textiles per 7/4 = 1.75kilograms 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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IM-9INPUT/OUTPUT WITHOUT TRADE_______________________________________________________________________CountryXYTotal________________________________________________________________________I. Units of Input(000,000)_____________________________________________________Food7060Textiles4030________________________________________________________________________II. Output per Unit of Input(Kilogramsor metres)____________________________________________________Food175Textiles52________________________________________________________________________III. Total Output(Kilogramsor metres)(000,000)____________________________________________________Food1,1903001,490Textiles20060260________________________________________________________________________IV. Consumption(Kilogramsor metres)(000,000)___________________________________________________Food1,1903001,490Textiles20060260________________________________________________________________________

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IM-10Solution:The no-trade input/output table indicates that Country X has an absolute advantage in the production offood and textiles. Country X can “trade off” one unit of production needed to produce 17 kilograms offood for five metres of textiles. Thus, a metre of textiles has an opportunity cost of 17/5 = 3.40 kilogramsof 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 permetresof textiles, or 2/5 =0.40metres of textiles per kilogram of food. In terms of opportunity cost, it is clear that Country X is relativelymore 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 ofboth countries is enhanced through trade. Suppose that Country X shifts 20,000,000 units from theproduction of textiles to the production of food where it has a comparative advantage and that Country Yshifts 60,000,000 units from the production of food to the production of textiles where it has acomparative advantage. Total output will now be (90,000,000 x 17 =) 1,530,000,000 kilograms of foodand [(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 metreof textiles, and that Country X sells Country Y 330,000,000 kilograms of food for 110,000,000 metres oftextiles. Under free trade, the following table shows that the citizens of Country X (Y) have increasedtheir 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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IM-11INPUT/OUTPUT WITH FREE TRADE__________________________________________________________________________CountryXYTotal__________________________________________________________________________I. Units of Input(000,000)_______________________________________________________Food900Textiles2090__________________________________________________________________________II. Output per Unit of Input(Kilogramsor metres)______________________________________________________Food175Textiles52__________________________________________________________________________III. Total Output(Kilogramsor metres)(000,000)_____________________________________________________Food1,53001,530Textiles100180280__________________________________________________________________________IV. Consumption(Kilogramsor metres)(000,000)_____________________________________________________Food1,2003301,530Textiles21070280__________________________________________________________________________

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CHAPTER 2 INTERNATIONAL MONETARY SYSTEMSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. Explain Gresham’s Law.Answer:Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce)money out of circulation. Thephenomenon was often observed under the bimetallic standard under whichboth gold and silver were used as means of payments, with the exchangeratiobetween the two metalsfixed.2.Explain the mechanismthatrestores the balance-of-payments equilibrium when it is disturbed underthe gold standard.Answer:The adjustment mechanism under the gold standard is referred to as the price-specie-flowmechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibriumwill be corrected by a counter-flow of gold.Suppose that the US imports more from the UK than itexports to the latter.Under the classical gold standard,goldis the only meansto settle internationalpayments. Since in our example the US owes money to the UK gold mustflow from the U.S. to the UKAs a result, the US (UK) will experience acorrespondingdecrease (increase) in money supply. Thismeans that the price level will tend to fall in the US and rise in the UKConsequently,US productsbecome more competitive in the export market, while UK products become less competitive. This changewill improve US balance of payments and at the same time hurt the UK balance of payments, eventuallyeliminating 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 at12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be2francs perpound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of thissituation? What would be the effect of shipping costs?

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Answer:Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in theforeign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12francs 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. Thearbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs morethan 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, countriescannot 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 worldeconomy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standarditself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economicpolicies (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 objectivesof the Bretton Woods system wereto achieve exchange rate stabilityas ameans topromote international trade, cross-border investmentandeconomicdevelopment.6.Comment on the proposition thatthe 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 thedeficits 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 SDRwas created.Answer:TheSDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate thepressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency,currentlycomprised offour currencies: US Dollar (42% in the SDR weighting), European Euro (37%), JapaneseYen (9%), British Pound (11 %).The weights forthe constituentcurrencies 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 eventualEuropeanMonetary Union. The main instruments of EMS are the European Currency Unit (ECU) and theExchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency constructed as a weightedaverage of currencies of EU member countries. The ECU works as the accounting unit of EMS and playsan important role in the workings of the ERM. The ERM is the procedure by which EMS membercountries manage their exchange rates. The ERM is based on a parity grid system, with parity grids firstcomputed by defining the par values of EMS currencies in terms of the ECU.These par values are calledthe ECU central rates.If a country’s ECU market exchange rate diverges from the central rate by as muchas the maximum allowable deviation, the country has to adjust its policies to maintain its par valuesrelative to other currencies.EMS achieved a complete monetary union in 1999 when the commonEuropean 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 ratesfrom 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 flexibleexchange rate system include:i. automaticachievement of balance of payments equilibriumii.maintenance of national policy autonomy.b.If exchange rates fluctuaterandomly, that may discourage international trade and encourage marketsegmentation.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. Theydon’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 needsto berestricted?10. Discuss the criteria for a ‘good’ international monetary system.Answer:A good international monetary system should providei.sufficient liquidity to theworld economyii.smooth adjustments to BOP disequilibrium as it arisesiii.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 outof a country in a short timeperiod.Such volatile demands for the domestic currency (on CapitalAccount) make it difficult for acountry to maintain a fixed exchange rate.12.Assess the possibility for the euro to become another global currency rivalling the US dollar.If theeuroreally becomesa global currency, whatimpactwill it haveon 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 inEurope, the euro is likely to become aglobal currency over time. A major uncertainty about this prospectis the lack of political integration of Europe. If Europe becomes politically more integrated, the euro is

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more likely to become a global currency. If the euro becomes a global currency, it will come at theexpense of the dollar.Currently, the U.S.derives substantial benefitfrom the dollar’s status asthedominant global currency. For instance, the U.S. can run trade deficits without having to maintainsubstantial foreign exchange reserves and itcan carry out international commercial and financialtransactions in dollars without bearing exchange risk. If the euro becomes a major transactional, reserveand invoice currency in the world economy, dollar-based agents will come tobear more exchange risk.13.What are the basic characteristics of a bona fide common currency area?Is Canada a commoncurrency area?Answer: Abona fidecommon currency area is characterized by a high degree of internal factor (capitaland labour) mobility, price flexibility and relatively little occurrence ofinternalasymmetric shocks.Canada’s recent economic experience with its “economic dualism”–with extraordinary growth in the oiland energy rich West and a slumping manufacturing sector in the East suggest that Canada is NOTalways well-served by our single currency.The rising value of the Canadian dollar through the 2003–2008 period was due in part tothe rise in the price of oil and energy, which serves Western Canadianinterests, whereas Easter Canada would have benefitted from a somewhat lower value of the Canadiandollar. Since Canada has a nationwide monetary policy, the Bank of Canada is not in a position todifferentially address the economic interests of the West and the East simultaneously.

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Mini Case: Will the United Kingdom Join the Euro Club?Suggested Solution toWill 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, theUK economy was converging with those of euro-zone countries. Economic conditions in terms ofgovernment budgets, interest rates, and inflation rate are becoming similar to those in euro-zonecountries. On an economic ground, this convergence is creating a condition that is conducive to UK’sjoining the euro club. Aspointed out by Wim Duisenberg, when he wasPresident of the European CentralBank, British opposition to joining the euro club is more “psycho-political” than justified on economicgrounds. Since many political leaders in France and Germany consider adoption of the euro as a steptoward the European political union, the UK is likely to join the euro-zone if it is prepared to join theEuropean political union as well. Once the UK joins the euro-zone, the euro will likelybecome a globalcurrency rivaling the US dollar.

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IM-1CHAPTER 3 BALANCE OF PAYMENTSSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. DefineBalance ofPayments.Answer: TheBalanceofPayments(BOP) is astatistical record of a country’s international transactions–whether inbound or outbound–over a certain period of time presented in the form of double-entrybookkeeping.2. Whywould it beuseful to examinea country’s balance-of-paymentsdata?Answer: It isuseful to examine a country’s BOP for at least two reasons. First,theBOP provides detailedinformation about the supply and demand of the country’s currency.The trade statistics in the CurrentAccount, for example, show the composition of trade–what a country imports and what it exports. TheCapital Account shows inflows and outflows of capital in various categories.Second,viewed over time,BOPdatacanshed lightonimportantdevelopmentsinacountry’scomparativeadvantageandinternational competitiveness.3.The United States hasruncurrent account deficitscontinuouslysince the early 1980s. What do youthink are the main causes for the deficits? Whatare the globalconsequences of continuousUScurrentaccount deficits?Answer:The current account deficits ofUSmay be linked to factors such asi.the relative ease by which the United States could borrow abroad to finance CurrentAccount deficitsii.the highUSrate of consumption (and correspondingly low savings rate) associatedwith large governmentdeficitsiii.USmonetary policy that sustained relatively highUSinterest rates and a high value for

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IM-2theUSdollar.4. In contrast to theUnited States, Japanhas realized continuous Current Account surpluses. What couldbe the main causes for these surpluses?Is it desirable to have continuous Current Account surpluses?Answer:Japan’s continuousCurrent Account surpluses may have reflected a weak yen and highcompetitiveness of Japanese industries.Massive capital exports by Japan(purchases ofUSSecurities,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.SustainedCurrent Account surplusessometimes reflect export-promotion, import-discouraging policiesinthe country.Though it is desirable by the countries, but such surpluses are inconsistent with free-trade tothe extent that they arebrought about by the mercantilist policies.5. Comment on the following statement: “When Canada imports more than it exports, it is necessary forCanada to import capital from foreign countries to finance its Current Account deficits.”Answer: TheBalance of Paymentsmustbalance. A deficit on Current Account ( “When Canada importsmore than it exports ..”) means that Canada has spent more on imported goods and services than it hasreceived in sales of (Canadian exported) goods and services.The Current Account deficit must befinanced with an inflow of foreign capital involving the purchase of Canadian securities by foreignerswho have more Canadian dollars than they know what to do with ( …“it is necessary for Canada toimport capital from foreign countries to finance its Current Account deficits.”) which, of course, is asurplus 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 reservetransactions. For example,Canada could run an overall BOP deficit by drawing down The Bank ofCanada’sreserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the centralbank’s reserve holdings.The Bank of Canada generally does not intervene–by using or accumulatingforeign exchange reserves–to establish a specific value for the Canadian dollar vis-à-vis, say, theUSdollar. The Bank of Canada is committed to a flexible exchange rate.As a result, the foreign exchangereserves of the Bank of Canada are relatively small unlike, say, Asian countries that hold substantial

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IM-3reserves 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 ofpayments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges, (iii) special drawingrights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most importantofficial reserves.8. Explain how to compute the overall balance,anddiscussits significance.Answer:The overallBOP is sum of the Current Account, the CapitalAccountand the statisticaldiscrepancies. The overall BOPindicates a country’s international payment gap that must be financed bythe government’s official reserve transactions.9. Since the early 1980s, foreign portfolio investors have purchased a significant portion ofUSTreasurybond issues.Discuss the short-term and long-term effects of foreigners’ portfolio investment on theUSBalanceofPayments.Answer: As foreigners purchaseUSTreasury bonds,USBOP is supportedin the short run, i.e., the Balance ofPayments deficit is financed with capital inflows. In the longerrun,theUSBalance of Payments may deterioratesincetheUSmust eventually pay interest and principalto foreignersas the Treasurybondsmature.However, iftheforeign funds are used productivelyin theUSandtheUSeconomy “grows out of its foreign debt”, then thelonger term implications are less significant.In other words, a Current Account deficit may be good thing foreconomic growth, especially if the imported goods and the imported capital are used for investment rather thanconsumption.10.Describe thebalance-of-payments identity, and discussits implications underthefixed and flexibleexchange rate regimes.Answer:The balance-of-payments identity is an accounting relationship that in principle (thatis, aside.from statistical errors) must hold. The Balance-of-Payments Identity is:BCA + BKA + BRA = 0,Where,

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IM-4BCA =Balance on Current AccountBKA =Balance on Capital AccountBRA =Balance on Reserves AccountUnderflexible exchange rate:The Balance of Payments identity holds that the combined balance on the Current and Capital Accountsare equal in size but opposite in sign (assuming zero change inofficial reserves).BCA + BKA =-BRA= 0Under aflexible 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 afixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as thecentral bank will accommodate it viaofficial reserve transactions ( BRA≠0andBCAdoes notnecessarily equal BKA ).11.Occasionally,a country will have a Current Account deficit andaCapital Account deficitat thesame time.Explain how this can happen.Answer:A Current Accountdeficit means that imports are greater thanexports.A Capital Accountdeficit means that the country is exporting capital.A Current Account deficit could be explained bystrong economic growth, investment or domestic consumption, any or all of which may be explained bylow domestic interest rates.A Capital Account deficit at the same time could also be explained by thesame relatively low interest rates that cause capital to flow to more attractive interest rates abroad.Inshort, loose monetary policy is the most likely cause of simultaneous Current Account and CapitalAccount deficits, the simultaneity of which isa likelyindicator of currency weakening.

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IM-512. Explain how each of the following transactions will be classified and recorded inthe debit and creditof the CanadianBalanceofPayments:a.A Japanese insurancecompany purchasesGovernment ofOntariobonds and pays outof its bank account kept in Toronto.b.A Canadiancitizenhasa meal at a restaurant in Paris and pays with herRoyal BankVISAcard.c.An Indian immigrant living in Halifax sends a cheque drawn on hisHalifaxbankaccount as a gift to his parents living inNewDelhi.d.A Canadian computer programmerishired by a Britishcompanyfor consulting andgets paidfromaCanadianbank account maintained by the British company.Answer:_________________________________________________________________TransactionsCreditDebit_________________________________________________________________Japanese purchase of OntariobondsJapanese payment out of TorontoaccountCanadianhaving 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Britishpayment out of its account in Canada_________________________________________________________________

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IM-613.Construct the balance-of-paymentstable for Japanforthe year2012,which is comparableinformat to Exhibit 3.4,and interpret the numerical data.You may consultInternationalFinancial Statistics published bytheIMF or search for useful websites forthedatayourself.Answer:A summary of the Japanese Balance of Payments for 2012Current AccountGoods & ServicesGoods-5814.1ServiceTravel-1061.7Transportation-1211.9Other Services-216.4Goods & Service Total-8304.1InvestmentDirect Investment income4214.2Portfolio Income9396.0Other Investment662.1Investment Total14272.3Transfers-1144.5Balance on Current Account4823.7Capital & Financial AccountFinancial AccountDirect investment-9640.1Portfolio investment-6116.1Equity securities4486.3Debt securities-10602.4Financial Derivatives-590.3Other investment8239.1Financial Account Total-8107.4Capital account-80.4Balance on Capital & Financial Account-8187.8Statistical discrepancies312.6Official Reserve Account3051.5Source: Bank of Japan,http://www.boj.or.jp/en/research/brp/ron_2013/data/ron130724a.pdf

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IM-7Assumption: security lending transitions all go to other investment

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IM-8Mini Case: Mexico’s Balance-of-Payments ProblemRefer to Chapter 3 pg.70in text.Suggested Solution to Mexico’s Balance-of-Payments ProblemItis useful to review Chapter 2, especially the section on the Mexican peso crisis.WhileMexico hadexperienced continuous trade deficits until December 1994, the country’s currency was not allowed todepreciate for political reasons.The Mexican government did not want the peso devaluation before thePresidential election held in 1994. If the Mexican peso had been allowed to gradually depreciate againstthe major currencies, the peso crisis could have been prevented.The key lessons tobe derived from the peso crisis are:First, Mexico depended too much on short-term foreign portfolio capital (which is easily reversible) forits economic growth.The countryshould have saved more domestically and depended more on long-termforeign capital.This can be a valuable lesson for many developing countries.Second, the lack of reliable economic information wascontributing factor to the peso crisis. The Salinasadministration was reluctant to fully disclose the true state of the Mexican economy.If investors hadknown that Mexico was experiencing serious trade deficits and rapid depletion of foreign exchangereserves, the peso might have been gradually depreciating, rather than suddenly collapsed as it did. Thetransparent 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, amultinational safety net needs to be in place to contain the peso-type crisis in the early stage.

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IM-1CHAPTER 4THE MARKET FOR FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1.Give a full definition of the market for foreign exchange.Answer: Broadly defined,themarketforforeign exchange (FXor FOREX)includes the means (throughbanks) by which one currency is exchanged for another,bank deposits of foreign currency, creditdenominated in foreign currencies,the finance of foreign tradeand trading in foreign currency options andfutures 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 orinterbankmarket forforeign exchange?Answer:The market for foreign exchange can be viewed as a two-tier market.One tier is thewholesaleorinterbankmarket.The other tier is theretailorclient market.International banksprovide the core of the FX market, both wholesale and retail.In the retail market, banksbuy or sellforeign currency serving their (retail) clients–non-financial business andindividuals–in cross-currency exchange for trade and international investment.Retail transactions account forabout9percent of FX trades. The other91percent isinterbanktrades betweenand amonginternational banksor non-bank dealers large enough to transact in theinterbankmarket.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.Internationalbanksprovide the core of the FX market. Approximately 100 to 200 banks worldwide make a marketin foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account.These international banks serve their retail clients, thebank customers, in conducting foreigncommerce or making international investment in financial assets that requires foreign exchange.Non-bank dealersare large non-bank financial institutions, such as investment banks, whose size and

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IM-2frequency of trades make it cost-effective to establish their own dealing rooms to trade directly in theinterbankmarket for their foreign exchange needs.Mostinterbanktrades arespeculativeorarbitragetransactions where market participants attempt tocorrectly judge the future direction of price movements in one currency versus another or attempt toprofit from temporary price discrepancies in currencies between competing dealers.FX brokersmatch dealer orders to buy and sell currencies for a fee, but do not take a positionthemselves.Interbanktraders use a broker primarily to disseminate as quickly as possible a currencyquote to many other dealers.Central bankssometimes intervene in the foreign exchange market in an attempt to influence the priceof its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its currencyagainst.Intervention is the process of using foreign currency reserves to buy one’s own currency inordertodecreaseitssupplyandthusincreaseits valuein theforeignexchange market,oralternatively, selling one’s own currency for foreign currency in order to increase its supply and lowerits price.4. How are foreign exchange transactions between international banks settled?Answer:Theinterbankmarket is a network ofcorrespondent banking relationships, with largecommercial banks maintaining demand deposit accounts with one another, called correspondent bankaccounts. The correspondent bank account network allows for the efficient functioning of the foreignexchange market.As an example of how the network of correspondent bank accounts facilitiesinternational foreign exchange transactions, consider a Canadian importer who wantsto purchasemerchandise invoiced in guildersfrom a Dutch exporter. The Canadianimporter will contact his bankand inquire aboutthe exchange rate.If theimporter accepts the offered exchange rate, the bank willdebit theimporter’s account for the purchase of the Dutch guilders.The bank will instruct itscorrespondent bank in the Netherlands to debit its correspondent bank account the appropriate amountof guilders and to credit the Dutch exporter’s bank account.The importer’s bank will then debit itsbooks to offset the debit ofimporter’s account, reflecting the decrease in its correspondent bankaccount balance.In short, the foreign exchange aspect of the Canadian importer’s business inimportingfromHollandishandledthroughinternationalcooperativearrangementsinvolvingcommercial banks.

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IM-35. 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 foreignexchange. 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 mostinterbankcurrency trading worldwide involve theUSdollar?Answer:Trading in currencies worldwide is against a common currency that hasaninternationalappeal. That currency has been theUSdollar since the end of World War II. However, theEuroandJapanese yenalsohave started to be used much more as international currencies in recent years. Moreimportantly, trading would be exceedingly cumbersome and difficult to manage if each trader made amarket against all other currencies.7.Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward,in manyinstances for hedging purposes. How can the bank eliminate the currency exposure it has created foritself by accommodating a client’s forward transaction?Answer:Swap transactions provide a means for the bank to mitigate the currency exposure in aforward trade.Aswap transactionis the simultaneous sale (or purchase) of spot foreign exchangeagainst a forward purchase (or sale) of an approximately equal amount of the foreign currency.Toillustrate, suppose a bank customer wants to buy dollars three months forward against British poundsterling.The bank can handle this trade for its customer and simultaneously neutralize the exchangerate risk in the trade by selling (borrowed) British pound sterling spot against dollars.The bank willlend the dollars for three months until they are needed to deliver againstthe dollars it has soldforward. The British pounds received will be used to liquidate the sterling loan.8.A$/€bank traderis currently quoting asmall figurebid-ask of83-88, when the rest ofthe market istrading at $1.2989-$1.2995. What is implied about the trader’s beliefs by his prices?Answer:The foreign exchange traderis acting as if he believesthe Canadian dollar is going toappreciate against the Euro. He ispricing his Canadian dollar:Euro transactions so asto increase his

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IM-4inventory of Canadian dollars whilediscouraging purchases of Eurosby offeringto buy Canadiandollarsat only$1.2983/€1.00(whereas others are offering $1.2989/€) and offering to sell Euros frominventory atthe lower-than-market price of $1.2988/€1.00.

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IM-5PROBLEMS1.Using Exhibit 4.4,construct a “Latin America”cross-rate matrix for thecurrencies of Argentina,Brazil, Colombia and Mexico. Present “indirect” quotes (units of foreign currency per one unit ofdomestic currency) above the matrix diagonal and “direct” quotes (units of domestic per one unit offoreign currency) below the diagonal, as was done in Exhibit 4.6.Solution:Theconventionalcross-rate formulais: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--ArgentinaBrazilColombiaMexicoHArgentina1.00000.38653512.3118OBrazil2.58811.00009085.9819MColombia0.00260.00101.00000.0060EMexico0.43290.16731521.0000Note 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.UsingUS dollar data inExhibit 4.4(the first two data columns) for forward cross-exchange rates forthe Canadian dollar and the swiss franc, calculate the one-, three-and six-month forward ratesbetween the Canadian dollar and the Swiss franc. State the cross-rates in Canadian-direct terms.Solution:The formulaewe want to use are:FN(C$/CHF)=FN($/CHF)/FN($/C$)orFN(C$/CHF)=FN(C$/$)/FN(CHF/$).

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