Rad_Ariana_FIN 535_ Week 3 Activity

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Strayer University *

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FIN 535

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Finance

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Feb 20, 2024

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Week 3 Assignment - Homework Chapters 4 and 5 1. Interest Rate Effects on Exchange Rates Assume the U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? When U.S. interest rates fall relative to British interest rates, assuming all other factors remain equal, the following effects are typically observed: (a) U.S. Demand for British Pounds: The demand for British pounds by U.S. investors is likely to increase. This is because higher British interest rates would make investments in the UK more attractive, leading to a capital flow from the U.S. to the UK as investors seek higher returns. To invest in the UK, U.S. investors would need to purchase British pounds, thus increasing the demand for the currency. (b) Supply of Pounds for Sale: On the other side, the supply of pounds for sale in the exchange markets might decrease. Since U.S. investments become less attractive due to the fall in U.S. interest rates, there would be less incentive for UK investors to hold assets denominated in U.S. dollars. As a result, UK investors would be less likely to sell pounds to acquire dollars, reducing the supply of pounds in the foreign exchange market. (c) Equilibrium Value of the Pound:

The equilibrium value of the pound is determined by the demand and supply in the foreign exchange market. With increased demand for pounds from U.S. investors and a decrease in the supply of pounds from UK investors, the equilibrium price of pounds in terms of dollars would likely rise. In other words, the pound would appreciate relative to the dollar. This appreciation reflects a higher equilibrium value for the pound due to the comparative attractiveness of British assets stemming from relatively higher interest rates in the UK. 2. Movements in Cross Exchange Rates Last year a dollar was equal to 7 Swedish kronor, and a Polish zloty was equal to $.40. Today, the dollar is equal to 8 Swedish kronor and a Polish zloty is equal to $.44. By what percentage did the cross-exchange rate of the Polish zloty in Swedish kronor (that is, the number of kronor that can be purchased with one zloty) change over the last year? here's the calculation for the percentage change in the cross-exchange rate of the Polish zloty in Swedish kronor over the last year: First, let's calculate the old cross exchange rate of the Polish zloty in Swedish kronor: Old Rate = (1 Polish zloty) / (0.40 dollars) * (7 Swedish kronor / 1 dollar) Old Rate = (1 / 0.40) * 7 Old Rate = 17.5 Swedish kronor per Polish zloty Next, let's calculate the new cross exchange rate of the Polish zloty in Swedish kronor: New Rate = (1 Polish zloty) / (0.44 dollars) * (8 Swedish kronor / 1 dollar) New Rate = (1 / 0.44) * 8

New Rate = 18.18 Swedish kronor per Polish zloty Now, we can use these values to calculate the percentage change in the cross-exchange rate: Percentage Change = ((New Rate - Old Rate) / Old Rate) x 100 Percentage Change = ((18.18 - 17.5) / 17.5) x 100 Percentage Change = (0.68 / 17.5) x 100 Percentage Change ≈ 3.89% So, the cross-exchange rate of the Polish zloty in Swedish kronor increased by approximately 3.89% over the last year. 3. Speculation on Expected Exchange Rates Kurnick Co. expects that the pound will depreciate from $1.70 to $1.68 in one year. It has no money to invest, but it could borrow money to invest. It has been approved by a bank to borrow either 1 million dollars or 1 million pounds for one year. It can borrow dollars at 6% or British pounds at 5% for one year. It can invest in a risk-free dollar deposit at 5% for one year or a risk-free British deposit at 4% for one year. Determine the expected profit or loss (in dollars) if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the pound. To determine the expected profit or loss in dollars if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the pound, we can calculate the potential outcomes based on the given information. Strategy 1: Borrow in Dollars

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Kurnick Co. borrows $1,000,000 at a 6% interest rate. Invest in British Pounds: Convert dollars to pounds at the current rate of $1.70/£: $1,000,000 / $1.70/£ = £588,235.29. Invest £588,235.29 at a 4% interest rate for one year: £588,235.29 * 1.04 = £611,764.70. After One Year: Convert the pounds back to dollars at the expected rate of $1.68/£: £611,764.70 * $1.68/£ = $1,027,764.30. Repay the dollar loan with interest: $1,000,000 * 1.06 = $1,060,000. Profit or Loss: Final amount after investment: $1,027,764.30. Loan repayment amount: $1,060,000. Loss = $1,060,000 - $1,027,764.30 = -$32,235.70. Kurnick Co. would incur a loss of $32,235.70 if they pursued this strategy. Strategy 2: Borrow in Pounds Kurnick Co. borrows £1,000,000 at a 5% interest rate. Invest in Dollars: Convert pounds to dollars at the current rate of $1.70/£: £1,000,000 * $1.70/£ = $1,700,000. Invest $1,700,000 at a 5% interest rate for one year: $1,700,000 * 1.05 = $1,785,000.

After One Year: Repay the pound loan with interest: £1,000,000 * 1.05 = £1,050,000. Since they have dollars now and need to repay in pounds, they will convert their dollars back to pounds at the expected future rate of $1.68/£. The amount required to repay the loan in dollars would be: £1,050,000 * $1.68/£ = $1,764,000. Profit or Loss: Final amount after investment: $1,785,000. Amount needed to repay the loan: $1,764,000. Profit = $1,785,000 - $1,764,000 = $21,000. Kurnick Co. would make a profit of $21,000 if they pursued this strategy. So based on these calculations: Strategy 1 (borrowing in dollars) results in a loss of -$32,235.70. Strategy 2 (borrowing in pounds) results in a profit of $21,000. Therefore, Kurnick Co. should choose Strategy 2 as it capitalizes on the expected depreciation of the pound and results in a profit. 4. Speculating with Currency Call Options Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume

there are 31,250 units in a British pound option. What was Randy's net profit on this option? To calculate Randy's net profit on the call option, we can use the following formula: Net Profit = (Spot Rate - Strike Price - Option Premium) * Number of Units Given: Option Premium = $0.02 per unit Strike Price = $1.45 Spot Rate = $1.46 Number of Units = 31,250 Net Profit = ($1.46 - $1.45 - $0.02) * 31,250 Net Profit = ($0.01 - $0.02) * 31,250 Net Profit = (-$0.01) * 31,250 Net Profit = -$312.50 Randy's net profit on this option was -$312.50.

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