Question

1. Do Financial Institutions need to consider foreign exchange market conditions when making domestic security market decisions?
2. Assume that Mexico suddenly experiences high and unexpected inflation. How could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory?
3. Assume the following information: Swiss one-year interest rate = 8%, U.S. one-year interest rate = 4%, Franc spot rate = 0.11 USD/CHF, Franc forward rate = 0.08 USD/CHF. If interest rate parity exists, how do you take advantage of this opportunity? Explain.

Answer 1

Part 1: Yes, Financial institutions need to consider foreign exchange market conditions when making domestic security market decisions. The primary reason is that exchange rates and inflation are closely related and can influence each other. A weak currency helps businesses and industries that depend on exports for their income. As the currency drops, the cost to their foreign consumers falls and they are likely to buy more. This results in higher profits and output. When the output goes up, inflation goes up. Central banks tend to intervene by increasing interest rates and the currency gets stronger. The cycle repeats.

Part 2: Using the purchasing power parity (PPP) theory, once Mexico experiences high and unexpected inflation, the prices of Mexican goods go up. Demand for Mexican goods may go down and hence, the inflow of Mexican peso decreases. Given the fact the supply of Mexican peso decreases, it appreciates in value. Another explanation can be that in case the inflation increases, central bankers tend to increase interest rates to slow the economy down and bring back the inflation in control. When interest rates go up, it becomes more attractive for foreign investors to move funds into Mexico for deposits and for buying bonds. This increases the demand for Mexican peso and leads to an appreciation in its value.

Part 3: Using the concept of interest-rate parity,

However, in this case, they are not equal.

,

To take advantage of this situation, I'd follow the following steps:

• I borrow an amount in CHF. Say 100 CHF.
• I convert 100 CHF into USD in the spot market at 0.11 $/CHF. I obtain 100 X 0.11 = $11
• I invest $11 in US deposits for a year at 4% rate. I also purchase a forward contract to convert the investment proceeds in CHF after one year. I end up having 11 X 1.04 = $11.44 at the end of one year.
• I convert $11.44 back into CHF after one year at forward rate of 0.08 $/CHF. I obtain 11.44/0.08 = 143 CHF
• Hence, I make a profit of 43 CHF using interest-rate arbitrage.