Exchange rates

Exchange rates

A. See Figure 8.4 attached.

1. Calculate the annualized forward premium or discount on
six-month forward yen.

2. If you are planning to go to Japan
this summer, should you buy your yen today? Why or why not?

3. According to the covered-interest arbitrage theory, is
the United States
or Japan
expected to have higher interest rates?

4. According to the covered-interest arbitrage theory, what
is the expected difference between interest rates in the United
States and Japan?

5. According to the international Fisher effect, is expected
inflation higher in Japan
or the United States?

B. Consider Belgian Lace Products (BLP), a hypothetical
table linens manufacturer. BLP consists of a parent corporation, a wholly owned
manufacturing subsidiary in Belgium,
and four wholly owned distribution subsidiaries in Belgium,
the United Kingdom,
Japan, and the United
States. Its manufacturing subsidiary buys
inputs from various suppliers, manufactures highquality lace napkins and
tablecloths, and sells the output to the four BLP-owned distribution
subsidiaries. The four distribution subsidiaries in turn sell the products to
retail customers in the subsidiaries’ marketing areas. The distribution
subsidiaries buy certain inputs, such as labor, warehouse space, electricity,
and computers, from outside suppliers as well. The following summarizes typical
monthly transactions for each of the BLP operating units (note that the symbol
for the euro is € ):

Manufacturing
Subsidiary

Sales to Belgian distribution subsidiary: € 15,000 Sales to
British distribution subsidiary: €12,500 Sales to Japanese distribution subsidiary:
€ 17,500 Sales to U.S.
distribution subsidiary: €11,250 Costs of inputs purchased from Belgian
suppliers: €7,500 Costs of inputs purchased from British suppliers: £25,000
Costs of inputs purchased from Japanese suppliers: ¥3,000,000 Costs of inputs
purchased from U.S.
suppliers: $5,000

Belgian Distribution
Subsidiary

Sales to retail customers: €50,000 Payments to BLP
manufacturing subsidiary: €15,000 Payments to external suppliers: €750 and
£10,000

British Distribution

Subsidiary Sales to retail customers: £75,000 Payments to
BLP manufacturing subsidiary: €12,500 Payments to external suppliers: £5,000,
€1,000, and $9,000

Japanese Distribution
Subsidiary

Sales to retail customers: ¥5,000,000 Payments to BLP
manufacturing subsidiary: €17,500 Payments to external suppliers: ¥3,000,000
and $8,000

U.S. Distribution Subsidiary

Sales to retail customers: $40,000 Payments to BLP
manufacturing subsidiary: €11,250 Payments to external suppliers: $10,000 and
¥300,000

Exchange Rates

€1.33=€1

€1=$1.00

€1= €1 ¥120

Use the above information to answer the following questions:

1. Calculate the profitability of each of BLP’s five
subsidiaries. (Because BLP is Belgian, perform the calculations in terms of
euros, which Belgium
began using as its national currency in 2002.) Are any of the subsidiaries
unprofitable? On the basis of the information provided, would you recommend
shutting down an unprofitable subsidiary? Why or why not?

2. Suppose it costs each subsidiary 1 percent of the
transaction amount each time it converts its home currency into another
currency to pay its suppliers. Develop a strategy by which BLP as a corporation
can reduce its total currency conversion costs. Suppose your strategy costs BLP
400 euros per month to implement. Should the firm still adopt your approach?

3. If the United Kingdom
decided to join the EU’s single currency bloc and use the euro, what effect
would this have on BLP? What effect would it have on the benefits and costs of
the strategy you developed to reduce BLP’s currency conversion costs?

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