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Herd Co is based in a country whose currency is the dollar ($). The company expects to
receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance
director of Herd Co is concerned that the euro (€) may depreciate against the dollar before
the foreign customer makes payment and she is looking at hedging the receipt.
Herd Co has in issue loan notes with a total nominal value of $4 million which can be
redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked
to the central bank base rate. The finance director of Herd Co believes that interest rates
may increase in the near future.
The spot exchange rate is €1.543 per $1. The domestic short?term interest rate is 2% per
year, while the foreign short?term interest rate is 5% per year.Which of the following statements support the finance director’s belief that the
euro will depreciate against the dollar?1 The dollar inflation rate is greater than the euro inflation rate.
2 The dollar nominal interest rate is less than the euro nominal interest rate.
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2If you put the interest rates into the IRP formula, you will find that $1 will buy more than €1.543, so the euro would be depreciating against the dollar.
If you look at the PPP formula, then if Hc (the euro inflation rate) is lower than Hb (the dollar inflation rate) then should be clear that S1 will be lower that So. That would mean that $1 will buy less than €1.543, so the euro would be appreciating against the dollar.
(If you are looking at this in the BPP Revision Kit, then they have mistyped the answer regarding the inflation rates, even though the final answer is correct. They should have typed: ‘If the dollar inflation rate is greater than the euro inflation rate, PPP indicated that the euro will appreciate against the dollar.)
But there is no mention of inflation rates of either country , so how do we know that the euro is appreciated against dollar?
The first of the four choices is asking if the dollar inflation rate is higher than the euro inflation rate then will this mean that the euro will depreciate against the dollar.
The second part of my earlier reply explains why this is not true.
Hi,
How are you today?
sorry for come back to this question.
I have a doubt about this questionin the first question they ask:
What is the six-month forward exchange rate predicted by interest rate parity?
€1·499 per $1
€1·520 per $1
€1·566 per $1
€1·588 per $1I did wrong as I assumed that 2% interest is related to Dinar and 5% related to dollar.
I thought as my spot rate is dinar per dollar, my domestic interest rate should be in dinars. I know that I am wrong but I do not why.It says that Herd is based in a country with $
It gives you the spot rate euro 1.543 to $1
spot * 1 +[( int rate counter rate) /( 1+ int rate base rate) ]
or
Spot exchange rate * (1 + Foreign interest rate) / (1 + Domestic interest rate)The finance director of Herd Co believes that interest rates may increase in the near future. The spot exchange rate is €1.543 per $1.
That means the domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.
The finance director’s belief that the euro will depreciate against the dollar is supported by the fact that the domestic interest rate is lower than the foreign interest rate.
So the base rate is 6m * 2% / 12m or half of 2% = 1% or domestic IR
It states that the counter currency = 5% * 6m /12m or half = 2.5% or foreign IR
So the 6m fwd for ex rate is:
1.543 * [1.025/1.01] = 1.566 euro per $1It says that Herd is based in a country with $
It gives you the spot rate euro 1.543 to $1
spot * 1 +[( int rate counter rate) /( 1+ int rate base rate) ]
or
Spot exchange rate * (1 + Foreign interest rate) / (1 + Domestic interest rate)The finance director of Herd Co is worried about the euro depreciating against the dollar because it would mean that when they receive €1,500,000 from Find Co in six months’ time, it would be worth less in terms of dollars. By hedging the receipt, the finance director is looking to protect against potential losses due to currency depreciation.
Then the domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.
So again, the finance director’s belief that the euro will depreciate against the dollar is supported by the fact that the domestic interest rate is lower than the foreign interest rate.So the base rate is 6m * 2% / 12m or half of 2% = 1% or domestic IR
It states that the counter currency = 5% * 6m /12m or half = 2.5% or foreign IR
So the 6m fwd for ex rate is:
1.543 * [1.025/1.01] = 1.566 euro per $1
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