Factors Affecting Exchange Rates. Mexico tends to ...


Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. a.Identify the most obvious economic reason for the persistent depreciation of the peso. b-High interest rates are commonly expected to strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso’s value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico? c-Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico? 2-Assessing the Euro’s Potential Movements. You reside in the U.S. and are planning to make a one-year investment in Germany during the next year. Since the investment is denominated in euros, you want to forecast how the euro’s value may change against the dollar over the one-year period. You expect that Germany will experience an inflation rate of 1% during the next year, while all other European countries will experience an inflation rate of 8% over the next year. You expect that the U.S. will experience an annual inflation rate of 2% during the next year. You believe that the primary factor that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate, or stay at about the same level against the dollar over the next year? Explain. 3-Impact of Economy on Exchange Rates. Assume that inflation is zero in the U.S. and in Europe and will remain at zero. U.S. interest rates are presently the same as in Europe. Assume that the economic growth for the U.S. is presently similar to Europe. Assume that international capital flows are much larger than international trade flows. Today, there is news that clearly signals economic conditions in Europe will be weakening in the future, while economic conditions in the U.S. will remain the same. Explain why and how (which direction) the euro’s value would change today based on this information. 4-Risk of Currency Futures. Currency futures markets are commonly used as a means of capitalizing on shifts in currency values, because the value of a futures contract tends to move in line with the change in the corresponding currency value. Recently, many currencies appreciated against the dollar. Most speculators anticipated that these currencies would continue to strengthen and took large buy positions in currency futures. However, the Fed intervened in the foreign exchange market by immediately selling foreign currencies in exchange for dollars, causing an abrupt decline in the values of foreign currencies (as the dollar strengthened). Participants that had purchased currency futures contracts incurred large losses. One floor broker responded to the effects of the Fed’s intervention by immediately selling 300 futures contracts on British pounds (with a value of about $30 million). Such actions caused even more panic in the futures market. a-Explain why the central bank’s intervention caused such panic among currency futures traders with buy positions. b-Explain why the floor broker’s willingness to sell 300 pound futures contracts at the going market rate aroused such concern. What might this action signal to other brokers? c-Explain why speculators with short (sell) positions could benefit as a result of the central bank’s intervention. d-Some traders with buy positions may have responded immediately to the central bank’s intervention by selling futures contracts. Why would some speculators with buy positions leave their positions unchanged or even increase their positions by purchasing more futures contracts in response to the central bank’s intervention? 5-Estimating Profits From Currency Futures and Options. One year ago, you sold a put option on 100,000 euros with an expiration date of one year. You received a premium on the put option of $.04 per unit. The exercise price was $1.22. Assume that one year ago, the spot rate of the euro was $1.20, the one-year forward rate exhibited a discount of 2%, and the one-year futures price was the same as the one-year forward rate. From one year ago to today, the euro depreciated against the dollar by 4 percent. Today the put option will be exercised (if it is feasible for the buyer to do so). a-Determine the total dollar amount of your profit or loss from your position in the put option. b-Now assume that instead of taking a position in the put option one year ago, you sold a futures contract on 100,000 euros with a settlement date of one year. Determine the total dollar amount of your profit or loss. 6- Speculating with Currency Straddles. Maggie Hawthorne is a currency speculator. She has noticed recently that the euro has appreciated substantially against the U.S. dollar. The current exchange rate of the euro is $1.15. After reading a variety of articles on the subject, she believes that the euro will continue to fluctuate substantially in the months to come. Although most forecasters believe that the euro will depreciate against the dollar in the near future, Maggie thinks that there is also a good possibility of further appreciation. Currently, a call option on euros is available with an exercise price of $1.17 and a premium of $.04. A euro put option with an exercise price of $1.17 and a premium of $.03 is also available. (See Appendix B in this chapter.) a-Describe how Maggie could use straddles to speculate on the euro’s value. b-At option expiration, the value of the euro is $1.30. What is Maggie’s total profit or loss from a long straddle position? c-What is Maggie’s total profit or loss from a long straddle position if the value of the euro is $1.05 at option expiration? d-What is Maggie’s total profit or loss from a long straddle position if the value of the euro at option expiration is still $1.15? e-Given your answers to the questions above, when is it advantageous for a speculator to engage in a long straddle? When is it advantageous to engage in a short straddle?

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