2. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it exports to the latter. Under the classical gold standard, gold, which is the only means of international payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become more competitive in the export market, while U.K. products become less competitive. This change will improve U.S. balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.
12. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate. Explain why this may be so.
Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and out of a country in a short time period. This will make it very difficult for the country to maintain a fixed exchange rate.
3. The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits?
Answer: The current account deficits of U.S. may have reflected a few reasons such as (I) a historically high real interest rate in the U.S., which is due to ballooning federal budget deficits, that kept the dollar strong, and (ii) weak competitiveness of the U.S. industries.
8. Explain how to compute the overall balance and discuss its significance. Answer: The overall BOP is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall BOP is significant because it indicates a country’s international payment gap that must be financed by the government’s official reserve transactions. 9. Explain and compare forward vs. backward internalization.
Answer: Forward internalization occurs when MNCs with intangible assets make FDI in order to utilize the assets on a larger scale and at the same time internalize any possible
externalities generated by the assets. Backward internalization, on the other hand, occurs when MNCs acquire foreign firms in order to gain access to the intangible assets residing in the foreign firms and at the same time internalize any externalities generated by the assets.
1. Why is capital budgeting analysis so important to the firm?
Answer: The fundamental goal of the financial manager is to maximize shareholder wealth. Capital investments with positive NPV or APV contribute to shareholder wealth. Additionally, capital investments generally represent large expenditures relative to the value of the entire firm. These investments determine how efficiently and expensively the firm will produce its product. Consequently, capital expenditures determine the long-run competitive position of the firm in the product marketplace. PROBLEMS
3. Currently, the spot exchange rate is $1.50/￡ and the three-month forward exchange rate is $1.52/￡. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or ￡1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities. Let’s summarize the given data first:
S = $1.5/￡; F = $1.52/￡; I$ = 2.0%; I￡ = 1.45% Credit = $1,500,000 or ￡1,000,000. a. (1+I$) = 1.02
(1+I￡)(F/S) = (1.0145)(1.52/1.50) = 1.0280 Thus, IRP is not holding exactly.
b. (1) Borrow $1,500,000; repayment will be $1,530,000. (2) Buy ￡1,000,000 spot using $1,500,000.
(3) Invest ￡1,000,000 at the pound interest rate of 1.45%; maturity value will be ￡1,014,500.
(4) Sell ￡1,014,500 forward for $1,542,040 Arbitrage profit will be $12,040
c. Following the arbitrage transactions described above, The dollar interest rate will rise; The pound interest rate will fall; The spot exchange rate will rise; The forward exchange rate will fall.
These adjustments will continue until IRP holds.
4. Suppose that the current spot exchange rate is