As a finance officer at your company, you have been asked to conduct an analysis

Question

As a finance officer at your company, you have been asked to conduct an analysis of the possible impact on your corporation of the new currency, the euro, which started circulating on January 1, 2002, in 12 of the 15 European Union member countries. International sales are important to the company and are expected to increase continuously in the future. The prospects for substantial growth from international sales will depend on the correct management of European markets and finances. (Although the euro started circulating on January 1, 2002, it was launched on January 1, 1999 and so euro-denominated bonds and equity already existed on January 1, 2002 and are increasing.)

1.      In the long run, will the creation of the euro boost your company's international business volume?

2.      Your company plans to issue euro-denominated bonds. Will it matter whether you hire a Dutch bank or an Italian bank? Why or why not?

3.      Use the dollar and interest rate figures in your text to explain the need to distinguish between real and nominal interest rates when predicting exchange rate movements.

4.      Assume that today is January 1, U.S. $1.00 = .90 euros, and the interest rate on dollar deposits is 3%. If in one year:

a.       the dollar appreciates relative to the euro by 10%, what will be the return on dollar deposits in terms of euros?

b.      the dollar depreciates relative to the euro by 20%, what will be the return on dollar deposits in terms of euros?

c.       the expected exchange rate is U.S. $1.00 = .95 euros, what is the expected rate of depreciation for the dollar?

d.      the dollar is expected to appreciate 5%, what interest rate on euro deposits is required if the concepts of interest-rate parity and capital mobility are to hold?

Explanation / Answer

Solution-1

We can`t tell by just looking at the short term rates. Boost’s when investors expect higher long term rate than short term rates.

Solution-2

It will not matter; because the banks belong to euro zone hence they use the same currency.

Solution-3

The distinction helps in predicting and understanding present spot currency price movements Nominal rates interest reflects the rate of return and expected inflation rate. So expected inflation rates determines the difference between real and nominal interest rates. The nominal    rate of return is equal to expected rate of inflation plus real rate of return. E.g, if expected inflation is 4.6% and the real rate of return is 3.2% and the approximate nominal rate of return is given by 0.032 + 0.046 = 0.078 or 7.8%.

Solution-(a)

Current dollar value=0.9*1.1=0.99

Returns = current value-initial value-interest / Initial value

Returns = 0.99-0.90-0.03 / 0.90

Returns = 6.6%

Solution-(b)

Current dollar value = 0.9*0.8=0.72

Returns = 0.72-0.03-0.90 / 0.90 *100

Returns = -23%

Solution-(c)

Current price-initial price

Initial price = 0.90-0.95 / 0.95 *100

Initial price = 5%           

Solution-(d)

Interest rate will also appreciate by 5%

Increase in Interest rate =1.05*3

Increase in Interest rate = 3.15%

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