Q1.– Howdoes the gold standard adjust trade deficits and surpluses? Give anexample detailing all the steps that ensue after a trade deficit isincurred.
Agoldstandardexistsin theeventwherebythegoldmetalendorsesa country`scurrency.Thegoldstandardusuallydeterminestheexchangerateforthepapercurrencythusfixingthecurrencyvaluein relationto theworthiness of thegold.In the international trade thestandardgoldsystemusuallyhas an endogenousworldpricesystemthat determinedtheworth of gold. Goldhas an intrinsicvaluethusprovidinga standardvalueforalltradecommoditiesbecauseof its abilityto storevalue.Trade patterns are avoided by the abilityto convertmoneyformsinto goldat a fixedpricewhich enables thegovernmentto avoidinflationary standards.Henceforth, pricedenominationin goldusuallyexhibitlittleperiodicvariationhencereducingthetendencyof tradedeficitsandsurpluses
Q2.– There are current news reports about the European Monetary Unionbeing in substantial trouble – even that the Euro as a currency maycollapse. If this were to be the case, what forces do you think wouldmake the collapse of the union and the Euro possible?
TheEuro may collapse as a result of increased external borrowing thatEuropean nations may be practicing. Increased borrowing usuallyresults into reduced domestic investment hence causing a propertybubble which is unpredictable. Increased property bubble indicates anincrease in housing prices and when the property bubble bursts, thedevelopers would result into foreign and private debt. Additionally,the step to pay generous wages to employees would reduce thepurchasing power of the Euro thus its collapse.
Q3.– What is Interest Rate Parity? Can IRP be broken, and if so, whatis involved in this process?
Interestrateparityis a theorywherebythedifferenceof interestratebetween two countriesis equivalentto thedifferencebetween thecountries`forwardexchangerateandthespotexchangerate.. TheIRP theoremimpliesthata hedged investmentinformof a depositdenominatedin foreigncurrencyshould earnan equivalentvalueas therelevantdollaramount.Thus,theIRP`s useof theinterestrateassistsinprovidinga linkage between thespotrateandtheassociatedforwardrate.Thus,itwould be possibleto breaktheinterestrateparitybecauseonecan borrowin thecountrywith low-interest rateandinvestin thehigh-interest ratecountry.Whenthe payment deadline comes, one could payat thelowerrate.Q4.– What is the forward market? Central Bank intervention? CrossExchange Rates? Forward Premiums?
A forward market is a market situation which has over-the-countertransactions and involves the price determination of individualfinancial assets and financial instruments that are to be deliveredon a future basis. Thus, in the commodity and currency marketplaces,a forward market provides a place for hedging of financialinstruments against unexpected future price fluctuations.
Central Bank Intervention is the process through which central bankspurchase and sell both domestic and foreign currencies as in order toinfluence the existing exchange rates of a given economy to favorablelevels.
Cross Exchange rate refers to that currency exchange rate thatprevails whenever two currencies are exchanged on a pre-determinedexchange rate quote without respect of the currency’s country oforigin. For example, across exchange rate would prevail when the U.S.Dollar and the Chinese Yuan were quoted in a British newspaper.
Forward Premiums refer to a financial situation during a forwarddelivery contract whereby the spot future exchange rate is trading ata relatively higher spot exchange level within the context of therelative domestic currency
Q5.– Discuss the determinants of foreign exchange rates. Develop yourdiscussion from the simple PPPT model [e* = p (i) / p (j)], where thelong-run exchange rate depends solely on relative national prices tothe model e* = f (m, y, r,) and then to e = f (m, y, r, a, w). Here[e*] is the long-run exchange rate and [e] is the short-run exchangerate. (In textbook, p. 159, e* = f (m, v, y) where v = Y/M, thevelocity of money).
The differencein inflationratesmay determinetheforeignexchangerate.Acountrywhoseinflationratelowersconsistentlymeans that theircurrency’s valuerisesrelativeto othercurrencies.Thisincreases thepurchasing powerof thatcurrency.However, the Interest ratedifferences refer to the modificationof theinterestrate which causestheexchangerateto vary hence directlyaffecting the currencyvalue.
Current-Account Deficitsalsocausesthecountryto requiremoreforeigncurrencybecauseitmeansthatlessbeingexportedcomparedto whatis exported.Furthermore the needforforeigncurrencyraisestheexchangerate.Theotheroneis Public Debt.An enormouspublicdebtincreasesinflation,andifinflationis high,thedebtwill haveto be servicedandultimatelypaidusingcheaperdollarsin future.
Q6.– What is hedging? Describe the main steps a treasurer would taketo hedge $20 million against interest rate volatility usingEurodollar futures to construct the hedge.
Hedgingis an investmenttechniqueusedto managefinancialrisksthrough reducingthepossibilitiesof futureeconomiclosses.Hedging influences the variationsin thecurrencyexchangerates,pricesof goods,interestratesorinvestmentuncertainties.Hedging techniquesincludeforeignexchangeforwards, currencyoptionsandcurrencyfuturessuchas Eurodollar futures.Tohedge $20 million against interestratevolatility,thetreasurerneedsto borrowtheUS dollarsat theprevailinginterestrateandhedgetheinterestrateby buyingEurodollar futurescontractsat thecurrentpriceandagreeto paytheloanat a specificrateregardlessof whethertheratewill haverisenorfallenQ7.– Compare hedging with forwards and options. Detail the advantagesand drawbacks of these alternatives. Can you hedge purchases ofshares in foreign stock markets?
Hedginginvolvesfixingthepricesof somecommoditiesusuallyin thederivativemarketswhereasoptionsgivetheholderof the options the choice toeitherbuyorselltheunderlying asset at someagreedpriceinto thefuture.Forwards are similartooptionsto some extent becausetheyare contractsenteredtodaybut are executedin thefuture.Purchasesof sharesin theforeignmarketmay be hedged by usingtakinga shortpositionin thesharesandenteringinto a futurecontractto sellthesharesat an agreedprice.
Q8.– Are Offshore Banking Centers set up to deal primarily withillegal money? Describe the International Debt Crisis which began in1982. Trace its origins to the early 1970’s. Here raw materialprices were thought could never fall but would always rise. Does itcompare in any way to 2008-2009?
OffshoreBanking Centers are formedpurposelytohandleforeigncurrenciesapartfrom thatof thecountriesin which theyareestablished.The1982 debtcrisiswastheworld`smostturbulentoccurrenceswhich affectedLatin America after Mexico claimedthatshecould not furtherserviceher publicsectordebt.His observationwasseeninEastern Europe andSubsequently in African countriesthusinfluencing creditorbanksto lowerloanlimits.Thisperiodwasassociatedwith irresponsiblelendersandcreditors,unexpectedglobaleconomyshiftsandoverdependence of theNorth by theSouth. The1982 crisesstartedbackin 1972 during theglobal foodshortageandincreasein oilprices.Similarly,the2008-2009 economiccrisesweretriggered by U.S. massiverecessionresultingin a fallin domesticprices,devaluation of localsecuritiesanda collapsein financialinstitutions.Mexico`s relianceon U.S wasmainlyhitsince her GDP contractedby about6.6%.