Question

(a) According to the law of one price, if the exchange rate between British pound and Australian dollar is £1 = $2, a laptop that is sold for £500 in London, calculate what should be the selling price of the same laptop in Sydney?

(b) After six months, if the price of the laptop in question (a) above expected to decrease from £500 to £450 in London and the price of the same laptop decreases to $810 in Sydney, calculate the 6 months forward exchange rate in pound/dollar and dollar/pound. Comment about the changes in the values of the two currencies.

(c) Given your answers to (a) and (b) above, and given that the current interest rate in Australia is 4 per cent per annum, what would you expect the current interest rate to be in UK?   

(d) If UK’s nominal interest rate is 15% and inflation rate is 5%, calculate the real interest rate in UK?

(e) You are a Manager of an international business firm in Sydney. Your firm has exported
some goods in Japan, the export earning ¥1,000,000 is receivable by next 3 month. Current
exchange rate is $1 = ¥100. You expect that the Japanese Yen may depreciate to $1 = ¥120
by the next 3 months.
Required:
(i) Explain the implication(s) to your business if Yen depreciates.

(ii) Except buying forward and using swaps, explain the collection strategy you will take to
minimize your business risk if any due to the expected change in the exchange rate.
  

Answer 1

(a) Price of the laptop in London= £500

The exchange rate between the British pound and the Australian dollar is £1 = $2

Price of laptop in Australia = $500*2 = $1,000

(b) After six months, the price of a laptop in England = £450

After six months, the price of a laptop in England = $810

Given the  law of one price, exchange rate = $(810/450) for every £

Exchange rate after six months = $1.8 for every £1

(c) Using the interest rate parity

Exchange rate after 6 months = Exchange rate today *(1+Interest rate in Australia for 6 months) / (1+Interest rate in London for 6 months)

$1.8 = $2* (1+0.04/2) / (1+Interest rate in London for 6 months)

Interest rate in London for 6 months = 0.13333

Annual Interest rate in London = 2*0.13333 = 0.266 = 26.6%

(d) UK’s nominal interest rate is 15% and inflation rate is 5%

UKs real interest rate = UK’s nominal interest rate - inflation rate

UKs real interest rate = 15% -5% = 10%

(e) i) Current expected receivable is $ = 1,000,000/100 = $10,000

If  the Japanese Yen may depreciate to $1 = ¥120 by the next 3 months

Receivable after Yen depreciation after 3 months = 1,000,000/120 = $8333.333

Hence, a loss of $10,000-$8333.333 = $1666.67 if the Yen depreciates.

(e) ii) If the Yen is expected to decrease, the Australian firm may grant a lower collection period for the Japanese firm and hence can minimize the losses due to higher depreciation. Also, if the Australian firm manages to strike a deal for the Japanese firm to pay in Australian dollar at the spot rate, the the exchange rate risk would lie on the Japanese firm and the exchange rate risk would be altogether eliminated for the Australian firm.