Words: 890
International Finance 535 Assignment #1 Explain how the international trade of flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interest rates (holding exchange rates constant). The international trade flows will increase if exchange rates hold constant and inflation raises. The exchange rates between two currencies, U. S and U. K is how much each currency is worth to each other.
If U. S. exports would increase this would create a decline in U. K. demand for U. S. exports, but the U. S. demand for U. K. goods would increase if U. S. prices increased. The International trade flow is an exchange of goods and services for money between countries. The inflation is a raise in pricing for goods and services in the economy over a period of time. The higher the interest rate the greater incentive for funds to flow across international boundaries and into the economy with the higher interest rates.
The international capital flow adjustment to the changes in interest rates while the exchange rates hold constant, the capital flows coming from U. S. to the U. K. will decrease because of the U. K. lower interest rate. The capital flow from the U. K. to U. S. will increase. “Most recently, however, foreign flows have become important. Controlling for various factors given by a standard macroeconomic model, we estimate that had there been no foreign official flows into U. S. government bonds over the past year, the 10 year Treasury yelled would currently be 90 basis points higher” said Veronica Warnock (www. ber. org). That’s statistically significant and impacted interest rates for the long-term. Using the information provided, will Mesa expect the pound to appreciate or depreciate in the future? Explain With the information provided Mesa would expect the pound to depreciate. With the U. K. inflation rate expected to decline Mesa can look forward to the pound ending up being worth less. Changes in interest rates affect investment in foreign securities, which influences the demand for supply of currencies and therefore influences exchange rates.
The U. K. pound would be less likely to have an abundance of supply for purchase as when the value is lower the supply of the currency. Mesa believes international capital flow shift in response to changing interest rate differentials. Is there any reason why the changing interest rate differentials in this example will not necessarily because international capital flows to change significantly? Explain According to the text “a sudden increase in U. S. inflation and a sudden increase in U. S. interest rates if the U. K. conomy is relatively unchanged the increase in U. S. inflation will put pressure on the pound’s value because of its impact on international trade. Yet the increase in U. S. interest rates place downward pressure on the pound’s value because of its impact on capital flows” (Madura, 2010, p. 104). The international capital flow will have to change significantly if interest rate and the inflation were to diminish or depreciate over the course of time, this would mean a drop in the capital spending budget, cash, stocks and bonds as well.
Based on your answer to question 2, how would Mesa/s cash flows is affected by the expected exchange rate movements? Explain. Mesa’s cash flows would be affected by the exchange rate movement if the interest rate and inflation rate of the price were to decrease. This decrease would lead to Mesa having significantly less cash flow then expected if the value of the currency were to drop to a value that it is not set at present time.
Being that the British pound is estimated to decrease over time shows that Mesa will have some form of cash flow affected by the expected change in the exchange rate and inflation rate Based on your answer to question 4, should Mesa consider hedging its exchange rate risk? If so, explain how it could hedge using forward contracts, futures contracts, and currency options. A forward contract would be an agreement between a corporation and financial institution to exchange a specified amount of a currency at a specified exchange rate on a specified date in the future (Madura, 2010, p 117).
Meaning that Mesa can lock a particular interest rate in order to guarantee the price would be available to them in the future. By hedging the futures contracts but it is limited to a certain tradable amount or a specific volume. Hedging a currency option would allow for Mesa to have the right to buy a specific currency at a designated price within a specific period of time. Mesa could lock in the top price that the exchange rate has for a future return at that same price.
Since it is known that the price of the exchange rate and the inflation is going to drop in the future all of these options would suffice in Mesa being able to capitalize on the current rate in future market. References Madura, J. (2010). International financial management: 2010 custom edition (10th Ed. ). Mason, OH: South-Western, Cengage Learning. Published: Warnock, Francis E. , and Veronica Cacdac Warnock, 2009, International Capital Flows and U. S. Interest Rates, Journal of International Money and Finance 28: 903-919. Retrieved October 21,2011