Question

In: Finance

Assume there are two countries, Australia and Japan, each produces a similar basket of goods and...

Assume there are two countries, Australia and Japan, each produces a similar basket of goods and services. Suppose the price of this basket of goods and services in Australia is AU$500 and the price of the same basket of goods and services in Japan is ¥ 50000. Calculate the following:

(a) According to PPP theory, calculate the dollar/yen and yen/dollar spot exchange rate.

(b) Suppose over the next 12 months the price of the basket is expected to rise to AUD$600 in Australia and to ¥65000 in Japan. Calculate the one-year forward dollar/yen exchange rate. Comment on the new rate compared to the rate in answer (a).

(c) Given your answers to (a) and (b) above, and given that the current interest rate in Australia is 3% per annum, what would you expect the current interest rate to be in Japan?

(d) If Japan’s nominal interest rate is 15% and inflation rate is 8%, what should be the real interest rate in Japan?

(e) You have a television manufacturing industry in China. In mid-June, you received an order from Australia for exporting 1000 TV sets. Payment of $1,000,000 is due in mid-December. You expect the dollar to fall from $1= ¥6 to $1= ¥5 by December. You can borrow dollar at 5% a year in China. Interest rate in Chinese bank is 4% a year. Required:

(i) Explain the implications to your business due to the change in the exchange rate.

(ii) Also discuss your strategy to face the foreign exchange risk if any due to the expected change in the exchange rate.

Solutions

Expert Solution

(a) As per Purchasing Price Parity the exchange rates will be

Dollar / Yen = AU$ 500 / Yen 50000 = AU$ 0.01/YEN

Yen / Dollar = Yen 50000 / AU$ 500 = Yen 100/AU$

(b) Exchange rate 12 months from now

Dollar / Yen = AU$ 600 / Yen 65000 = AU$ 0.0092/YEN

Yen / Dollar = Yen 65000 / AU$ 600 = Yen 108.33/AU$

(c) Given that interest rate in Australia is 3%. AU$ 100 invested today will become AU$ 103 after 12 months.

AU$ 100 today = 10,000 Yen today

AU$ 103 after 12 months = 11,157.99 Yen after 12 months

As per Interest Rate Parity, for 10,000 Yen to become 11,157.99 Yen after 12 months, the interest rate should be –

Interest rate in Japan = (11,157.99 - 10,000) / 10,000 = 11.58%

(d) Real Interest Rate = Nominal Interest Rate – Inflation Rate

Therefore, Real Interest Rate = 15% - 8% = 7%

(e)

(i) Due to change in interest rate the cash inflow received by the business will reduce by ¥ 1,000,000 as the exchange rate goes down from $1= ¥6 to $1= ¥5.

(ii) The business can enter into a 6-month forward contract to freeze the exchange rate at $1= ¥6. This will ensure that the business will not loose any money due to fluctuation in interest rate.

jeff jeffy answered 1 year ago
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