SMEG TOAE Intemational Financial Management Chapter 5 International Parity Conditions ™ Multiple Choice and True/False Questions The Economist publishes annually the “hamburger standard” by which they compare the prices of the McDonalds Corporation Big Mac hamburger around the world. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore, the price should be the same. Ifa Big Mac costs $2.54 in the United States and 294 yen in Japan, what isthe estimated exchange rate of yen per dollar as hypothesized by the Hamburger index? (a) S.0086% (b) 124¥/8 (©) So0sia (@ 115.75¥S Topic: PPP, Skill: Analytical Answer: D 2. Ifthe current exchange rate is 124 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is $2.54, and the price of a Big Mac hamburger in Japan is 294 yen, then other things equal, the Big Mac hamburger in Japan is (@) correctly priced (b) under priced (©) over priced (d) not enough information to determine if the price is appropriate or not Topie: PPP, Skill: Analytical Answer: B 3. If according to the law of one price the current exchange rate of dollars per British pound is $1 43/6, then at an exchange rate of $1.28/£, the dollar is (a) overvalued (b) undervalued (©) comectly valued (@) unknown relative valuation Topic: Law of One Price Skill: Analytical Answer: AS AER TOA E Intemational Financial Management ‘Other things equal, and assuming efficient markets, 'a Honda Accord costs $18,365 in the US. then at an exchange rate of §1.43/£, the Honda Accord should cost in Great Britain. (a) 262626 (b) 183658 (©) 128403 (@) 9,183£ Topic: Law of One Price Skill: Analytical Answer: C (One year ago the spot rate of U'S. dollars for Canadian dollars was $1/CS1. Since that time the rate of inflation in the U.S. has been 4% greater than that in Canada. Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be approximately (@) S0.s6ics (b) suicsi (©) SLosicst (@) Relative PPP provides no guide for this type of question, Topic: PPP, Skill: Analytical Answer: C If we set the real effective exchange rate index between Canada and the United States equal to 100 ‘in 1998, and find that the U.S. dollar has risen to a value of 112.6, then from a competitive perspective the U.S, dollar is (a) overvalued. (b) undervalued, (©) very competitive, (@) There is not enough information to answer this question, Topic: Real Effective Exchange Rate Skill: Analytical Answer: A. Research by Dimson, Marsh, and Staunton (2002) found that for the 1900-2000 period, relative purchasing power parity did not hold (@) True (b) False Topic: PPP Skill: Recognition Answer: B Dimson, Marsh, and Staunton (2002) found that real exchange rates to exhibit along. term upward or downward trend, and they clearly volatile (@) appear; are (b) appear; are not (©) do not appear; are (a) do not appear; are not Topic: PPP, Skill: RecognitionUE Anse thre Intemational Financial Management Answer © Deviations from PPP appear to be related to (a) changes in relative inflation (b) changes in productivity differentials (©) confounding economic and political factors (a) Allof the above Topie: PPP. Skill: Recognition Answer: D Products that are relatively price inelastic tend to also demonstrate a low degree of exchange rate pass-through. (@) True (b) False Topic: Exchange Rate Pass-Through Skill: Conceptual Answer: B Empirical tests show thatthe Fisher effeet usually exists for short maturity government securities but less so for longer-term maturity securities, (@) True (b) False Topic: Fisher Effect Skill: Conceptual ‘Answer: A Criticisms of the intemational Fisher effect include (@) the lack of intemational capital flows. (b) false impressions due to Dollarization, (©) the existence of a foreign exchange risk premium for most currencies. (@) Allof the above. Topic: Intemational Fisher Effect Skill: Conceptual Answer: C Which of the following is necessary for the calculation of the forward rate? (a) the spot rate (b) the foreign currency deposit rate (©) the home currency deposit rate (@ Allofthe above Topic: Forward Rate Skill: Recognition Answer: DMEG EEAE Intemational Financial Management Exchange raie pass-through may be defined as (@) the bid/ask spread on currency exchange rate transactions (b) the degree to which the prices of imported and exported goods change as a result of exchange rate changes: (©) the PPP of lesser-developed countries. (@) the practice by Great Britain of maintaining the relative strength of the currencies of the ‘Commonwealth countries under the current floating exchange rate regime. Topic: Exchange Rate Pass-through Skill: Recognition Answer: B Sony of Japan produces DVD players and exports them to the United States. Last year the exchange rate was 130¥/$ and Sony charged $150 per DVD player. Currently the spot exchange rate is 110WS. and Sony is charging $170 per DVD player. What is the degree of pass through by Sony of Japan on ‘heir DVD players? @) 9. (b) 86.7% © 73 @ 4.1% Topic: Exchange Rate Pass-through Skill: Analytical Answer: C Consider the price elasticity of demand. If a product has price elasticity less than one itis considered to have relatively elastic demand, (@) Tre (b) False Topic: Price Elasticity Skill: Conceptual Answer: B ‘The price elasticity of demand for DVD players manufactured by Sony of Japan is greater than one, Ifthe Japanese yen appreciates against the U.S. dollar by 10% and the price of the Sony DVD. players in the U.S. also rises by 10%, then other things equal, the total dollar sales revenues of Sony DVDs would (@) decline (b) increase (©) stay the same (@) insufficient information Topic: Price Elasticity Skill: Analytical Answer: ASMEG TOAE Intemational Financial Menagerneat 20. 21 Th its approximate form the Fisher effect may be written as, Where: i= the nominal rate of interest, r= the real rate of return and x = the expected rate of inflation. ©) i= 06 (b) i=r+ +O) (© iron @ izrs2e Topic: Fisher Effeet Skill: Recognition Answer: C Assume a nominal interest rate on one-year U.S. Treasury Bills of 4.60% and a real rate of interest of 2.50%, Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the USS. over the next year? (a) 2.10% (b) 2.05% (©) 2.00% (@ 1.90% Topic: Fisher Effeet Skill: Analytical Answer: A The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as (a) absolute PPP. (b) the law of one price (©) relative PPP (@) the intemational Fisher Effect Topic: International Fisher Effect Skill: Recognition Answer: D From the viewpoint of a U.S. investor or trader, the inditect quote for a currency exchange rate ‘would be quoted in (a) terms of dollars per unit of forcign currency (e.g., $/£) (b) cents (©) \8ths (a) terms of foreign curreney units per dollar (e.2, £/S) Topic: Intemational Fisher Effect Skill: Conceptual Answer: DMEG EEAE International Financial Management R. 24. 26. ‘According to the Intemational Fisher Effect, ran investor purchases a five-year U.S, bond that has aan annual interest rate of 5% rather than a comparable British bond that has an annual interest rate of 66%, then the investor must be expecting the to ata rate of atleast 1% per year over the next 5 years. (a) British pound; appreciate (b) British pound; revalue (©) US. dollar; appreciate (a) USS. dollar; depreciate Topic: Intemational Fisher Effect Skill: Analytical Answer: C A is an exchange rate quoted today for settlement at some time in the future, (a) spotrate (b) forward rate (©) currency rate @ yield curve Topic: Forward Rate Skill: Recognition Answer: B The eurrent U.S. dollar-yen spot rate is 125¥/S. Ifthe 90-day forward exchange rate is 127 ¥/S then the yen is selling at a per annum of (@) premium; 1.57% (b) premium; 6.30% (©) discount; 1.57% (@) discount; 6.30: Topic: Forward Rate PremiunvDiscount Skill: Analytical Answer: D With covered interest arbitrage, (@) the market must be out of equilibrium. (b) a“riskloss” arbitrage opportunity exists. (©) the arbitrageur trades in both the spot and future currency exchange markets. (@ Allof the above. Topic: Covered Interest Arbitrage Skill: Recognition Answer: D Covered interest arbitrage moves the market ‘equilibrium because (2) toward; purchasing a currency on the spot market and selling in the forward market narrows the 4ifferential between the two (b) toward; investors are now more willing to invest in risky securities (©) away from; purchasing a curreney on the spot market and selling in the forward market increases the differential between the two (d) away from; demand for the stronger currency forces up interest rates on the weaker security Topic: Covered Interest Arbitrage Skill: Conceptual2. MEG EEAE ‘Answer A Intemational Financial Management When the spot and forward exchange markets are not in equilibrium as described by interest rate parity, the potential for “riskless” arbitrage profit exists. This is called (@) covered interest arbitrage (CIA) (b) interest rate parity (©) the Fisher Effect (@) dancing on the head of a pin Topic: Covered Interest Arbitrage Skill: Recognition Answer: A Use the following information to answer problems 28 and 29 Suppose that on January 1 a firm in Mexico borrows $20 million from Citibank (USA) for one year at 8.00% interest per annum (bullet repayment of principal). During the year U.S. inflation is 2.00% and. Mexican inflation is 12.00%. The loan was taken when the spot rate was Peso 3,40/USS, At the end of the ‘one year loan period the exchange rate was Peso S.80/USS. 28, 28, 30. Based on the above information, what is the cost to the firm of the loan in Mexican peso’s (percent)? (2) 8.00% (b) 20.00% (©) 45.72 @ 84.24 Topic: Interest Rate Parity Skill: Analytical Answer: A Based on the above information, what is the real cost of the loan to the firm in peso terms? () 357% (b) 20.96%. (©) 80.63% (@) 72.24% Topic: Interest Rate Parity Skill: Analytical Answer: D Based on the following market information for France and Germany, calculate the One-Year “bill” rate for Germany. France Spot exchange rate FF3.4375/DM DM 0.2909/FF Expected inflation rate 8.00% p.a. 2.00% pa. One-year “t-bill” rate 1.00% pa, ”MEG EEAE Intemational Financial Management 32. 34, @ FR pa. (0) 5.00% pa (©) $:06% paa (@) 3.00% pa Topic: Interest Rate Parity Skill: Analytical ‘Answer: C An intemational currency exchange rate arbitrage rule of thumb is (@) Ifthe difference in interest rates is greater than the forward premium, invest in the lower interest yielding curreney. (b) Ifthe difference in interest rates is greater than the forward premium, invest in the higher interest yielding currency. (©) Ifthe difference in interest rates is less than the forward premium, invest in the higher interest yielding currency. (@ Ifthe difference in interest rates is zero, invest in the options market. Topic: Covered Interest Arbitrage Skill: Conceptual Answer: B Which of the following is NOT true regarding the “yen curreney trade”? (@) Itis a common application of uncovered interest arbitrage. (b) Investors borrow in Japan at low rates, invest the proceeds elsewhere at higher rates, then repay the Japanese loan making a profit on the proceeds. (©) Investors borrow elsewhere at low rates, invest the proceeds in Japan at higher rates, then repay. the initial loan making a profit on the proceeds. (@) This designed to take advantage of Japan’s extremely low interest rates, Topie: Yen Curreney Trade Skill: Conceptual Answer: C Howard borrows ¥5,000,000 for 6 months at an annual rate of 60% and uses the proceeds to invest in the U.S. money market at an annual rate of 4.50%. If the spot rate today is ¥115/$ and the spot rate in 6 months is ¥113/$ Howard’s net proceeds will be: (a) ¥104,130 (b) $8,587 (©) $921 (@) ¥8,587 Topie: Uncovered Interest Arbitrage Skill: Analytical Answer: D If foreign exchange markets are efficient, then forward exchange rates are unbiased predictors of future spot rates, (@) True (b) False Topic: Forward Rates Skill: ConceptualMEG EEAE International Financial Management ‘Answer A = End-of-Chapter Questions Purchasing power parity. Define the following terms: (a) The law of one price. Answer: The law of one prices states that producers" prices for goods or services of identical quality should be the same in different markets; ic. different countries (assuming no restrictions on the sale and allowing for transportation costs). Ifa country has higher inflation than other countries, its currency should devalue or depreciate so thatthe real price remains the same as in all countries. Application of this law results in the theory of Purchasing Power Parity (PPP), (b) Absolute purchasing power parity Answer: Ifthe law of one price were true forall goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical produets denominated in different currencies, one could determine the ‘real” or PPP exchange rate which should exist if markets were efficient. This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate is determined by the relative prices of similar baskets of goods. (©) Relative purchasing power parity, Answer: Ifthe assumptions of the absolute version of PPP theory are relaxed a bit more, we observe what is termed relative purchasing power parity. This more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. More specifically, ifthe spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the ‘pot exchange rate 2. Nominal effective exchange rate index, Explain how a nominal effective exchange rate index is constructed. Answer: An exchange rate index is an index that measures the value of @ given country's exchange rate against all other exchange rates in order to determine if that currency is overvalued or undervalued, A nominal effective exchange rate index is based on a weighted average of actual exchange rates over a period of time. It is unrelated to PPP and simply measures changes in the exchange rate (.c., currency value) relative to some arbitrary base period. It is used in calculating the real effective exchange rate index,MEG EEAE International Financial Management 3. Realeffective exchange ate index. What formula is used to convert a nominal effective exchange rate index into a real effective exchange rate index? Answer: A real effective exchange rate index adjusts the nominal effective exchange rate index to reflect differences in inflation. The adjustment is achicved by multiplying the nominal index by the ratio of domestic costs to foreign costs. The real index measures deviation from purchasing power party, and consequently pressures on a country’s current account and foreign exchange rate. ‘The real effective exchange rate index for the U.S, dollar, Ey, is found by multiplying the nominal effective exchange rac index, E'y, by the ratio of U.S dollar costs, C°, over foreign curreney costs, C*, both in index form: c EL Eh x = 4. Realeffective exchange rates: Japan and the United States. Exhibit 4.3 compares the real effective exchange rates for Japan and the United States, Ifthe comparative real effective exchange rate was the main determinant, does Japan or the United States have a competitive advantage in exporting? ‘Which ofthe two has an advantage in importing? Explain why. Answer: Exhibit 4.3 shows that the rel effective exchange rate has varied considerably from year to year for both the U.S, dollar and the Japanese yen, and the data lends Some support to the concept that PPP may hold—even for the long nun. For example, the index of the real effective exchange rate for the U.S. dollar rase from a level of 135 in 1981 to a value level of 166 in 1985, only to fall to 100 (the index base year) in 1995. The dollar immediately rose again, rising to nearly 132 in 2000 before falling back in 2002 and 2003. The Japanese yen has been undervalued every year for which the dollar was overvalued. Beginning with a value of 63 in 1981, the yen rose relatively steadily toward parity in 1995, After 1995, however, the yen returned to its undervalued ways, falling fo an index value of 85 in 1999, In theory, a country with an undervalued currency should have a relative advantage in exporting over those countries suffering an overvalued currency. Similarly, an overvalued currency should result in increased purchasing power for imports 5. Exchange rate pass-through, Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate can deviate for lengthy periods from its purchasing power equilibrium level of 100, What is meant by the term exchange rate pass-through? Answer: Incomplete exchange rate pass-through is one reason that a country’s real effective exchange rate index ean deviate for lengthy periods from its PPP-equilibrium level of 100, The degree to which the prices of imported and exported goods change as a result of exchange rate changes is termed pass-through. Although PPP implies that all exchange rate changes are passed through by equivalent changes in prices to trading partners, empirical rescarch in the 1980s questioned this long-held assumption, For example, sizeable current account deficits of the United States in the 1980s and 1990s did not respond to changes in the value of the dollar. -10-MEG EEAE International Financial Management %. _ThpFisher effect. Define the Fisher effect. To what extent do empirical test confirm that the Fisher ‘effect exists in practice? Answer: The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in cach country are equal to the required real rate of rcturn plus compensation for expected inflation. More formally, ths is derived from (1 + r)(1 + x)-1 iaresere ‘where jis the nominal rate of interest, ris the real rate of interest, and x is the expected rate of inflation over the period of time for which funds are to be lent, The final compound is frequently dropped from consideration due to its relatively minor value. The then reduces to (approximate form): tts ‘The Fisher effect applied to two different countries like the United States and Japan would be: Pav aa yier ea" where the superscripts $ and ¥ pertain tothe respective nominal (1), real ®), and expected inflation (.) components of financial instruments denominated in dollars and yen, respectively. We need to forecast the future rate of inflaton, not what inflation has been, Predicting the future can be difficult. 7. The international Fisher effect, Define the international Fisher effect. To what extent do empirical ‘ests confirm that the infemational Fisher effect exists in practice? Answer: Irving Fisher stated that the spot exchange rate should change in an equal amount but ‘opposite in direction to the difference in nominal interest rates. Stated differently, the real return in different countries should be the same, so that if one country has a higher nominal interest rate the gain from investing in that currency will be lost by a deterioration of its exchange rate ‘The relationship between the percentage change in the spot exchange rate overtime and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect. “Fisher-opcn,” as its often termed, states that the spot exchange rate should change in an equal amount bul in the opposite direction to the difference in interest rates between two countries. More formally: ‘where If and I¥ are the respective national interest rates, and S is the spot exchange rate using indirect quotes (an indirect quote on the dollar is, for example, ¥/S) at the beginning of the period (S;) and the end of the period (S;). This is the approximation form commonly used in industry, The precise formulation is: one10. MEG EEAE International Financial Management Empirical tests using ex-post national inflation rates have shown the Fisher effect usually exists for short-maturity government securities such as treasury bills and notes, Comparisons based on longer maturities suffer from the inereased financial risk inherent in fluctuations of the market value of the bonds prior to maturity. Comparisons of private sector securities are influenced by unequal creditworthiness of the issuers. Al the tests are inconclusive to the extent that recent past rates of inflation are not a correet measure of future expected inflation. Interest rate parity. Define interest rate parity. What is the relationship between interest rate parity and forward rates? Answer: The theory of interest rate parity (IRP) provides the linkage between the foreign exchange ‘markets and the international moncy markets. The theory states: The difference in the rational interest rates for securities of similar risk and maturity should be equal to, but ‘opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction cost. Covered interest arbitrage, Define the terms covered interest arbitrage and uncovered interest arbitrage. What is the difference between these two transactions? Answer: The spot and forward exchange markets are not, however, constantly inthe state of equilibrium described by interest rate parity. When the market is notin equilibrium, the potential for “riskless” or arbitrage profit exists, The arbitrager who recognizes such an imbalance will move to take advantage of the disequilibrium by investing in whichever currency offers the higher return on a covered basis. This is called covered interest arbitrage (CIA), A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA), wherein investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is “uncovered” because the investor does nat sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Exhibit 4.8 demonstrates the steps an uncovered interest arbitrager takes when undertaking what is termed the yen carry trade. Forward rate as an unbiased predictor of the future spot rate. Some forecasters believe that foreign ‘exchange markets for the major floating currencies arc “efficient” and forward exchange rates arc unbiased predictors of future spot exchange rates. What is meant by “unbiased predictor” in terms ‘of how the forward rate performs in estimating future spot exchange rates? Answer: Some forceasters believe that foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates. Exhibit 4.10 demonstrates the meaning of “unbiased prediction” in terms of how the forward rate performs in estimating future spot exchange rates. Ifthe forward rate is an unbiased predictor of the future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now, E(S3) = Fy Intuitively this means thatthe distribution of possible actual spot rates in the future is centered on the forward rate, The fact that itis an unbiased predictor, however, does not ‘mean that the future spot rate will actually be equal to what the forward rate predicts Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. The forward rate ‘may, in fact, never actually equal the future spot rate “2.MEG EEAE International Financial Management The rationale for his relationship is based on the hypothesis that the foreign exchange ‘market is reasonably efficient. Market efficiency assumes that (a) all relevant information is quickly reflected in both the spot and forward exchange markets, (b) transaction costs are low, and (C) instruments denominated in different currencies are perfect substitutes for one another. Mini-Case: The Introduction of the Porsche 911 Carrera 4S Cabriolet leary, at some point sooner or later, Porsche must raise the US dollar price of this model and all product models (particularly ifthe euro continues to strengthen and maintains this strength compared to the dollar). But when would that be? Answer: This pricing dilemma—when to pass through to final price cost pressures—is experienced in all industries all of the time. In the case of Porsche, the firm has publicly argued that it can afford to maintain its pricing by way of the ‘subsidization’ coming from its successful option hedging program over the past few years. The second factor which aids in the postponement of price changes is that exchange rates, unlike many other input prices, do not just go one direction (up). Many believe that the dollas/euro exchange rate will return ‘to a more traditional trading range (and Porsche appears to be one of them by way ofits Public announcements) which would eliminate the need. But, ifthese subsidies and market movements do not oceur in the near term—say by early to mid 2005—the retail price of the Porsche in target markets like the US would have to be raised to simply cover the costs of production, independent of degree of profitability as seen in margins, ‘What would it take to convince Porsche's management that ‘now is the time’ to pass-through more of the exchange rate change in the price? Answer: Ironically, much of the news in late 2004 and early 2005 in which senior government and ‘weasury officials in the United States publicly stated that exchange rates are best set by ‘markets (meaning there will be no concerted effort by the Bush administration to push the dollar up against the euro), adds to a market opinion that $1.30 or better is where the euro ‘may stay for some time to come. If this rate of exchange is sustained, and several other ‘major European-based automakers like Volkswagen and Mereedes start pushing dollar prices up, Porsche may indeed decide the time is now. Mini-Case: Turkey's Kriz (B) Uncovered Interest Arbitrage Was the Turkish lira's collapse the result of a balance of payments crisis, an inflation crisis, a political crisis, or an economic crisis? Answer: Although we are tempted to say “all of the above,” the more rigorous response is a political landscape which Ied to many of the common economic ills ofa struggling emerging market. The inflationary pressures, continual volatility in current and financial balance of payment accounts, and struggling process of privatization all reflect an economy in both political and structural transition. Although the struggles with BOP accounts and inflation had been recurring, the Turkish lias fixed rate could probably have survived ifit had not been for the dollar-debt obligations acquired by the Turkish ‘banks. The activities of the banks served to not only undermine some of the economic reforms underway, they threatened the stability of the banking system itself—the pillar of any market economy's ability to grow and develop. -13-AEG DEAE International Financial Management 2. Describe precisely how the Turkish banks were performing uncovered interest arbitrage. Do you feel this was an inappropriate investment policy? Answer: Turkish banks simply took advantage for as long as it lasted, of an easy arbitrage ‘opportunity. As illustrated in the following diagram, the Turkish banks borrowed Eurodollars at relatively attractive rates, 8.000% per annum. They then exchanged the dollars for Turkish lira at the currently fixed or managed exchange rate, TLS00,000/S. The ‘Turkish ira procceds were then invested in Turkish government bonds yielding the higher inflation-based rates of 20.00% per annum. At the end of the period, the Turkish lira were then converted back to U.S. dollars at the fixed exchange rate of TLS00,000/$, yielding an ‘uncovered interest rate arbitrage profit of $120,000, ee ter saree (4005 pe nr) ie epgresofie U8 Beto ate deta les ‘on fot deimae hee Sep Series” (nmemlage ikem fy PSgE BS senainsws semanmes | Temenos 5 <1 ————-mecopeeare gor Comveridallr process Ate end oft period, he banks indo Tupac fig aad rest comet the fra bakto US doles in Taha government bonds de fiz exchange rae “Rash goecmaet end ect C2 pec amma) ‘Note that the profits from the arbitrage activity as described here are in U.S. dollars. This ‘was also a characteristic of the Turkish bank positions—ultimately positioning their profitability in the foreign hard currency, the U.S. dollar. The arbitrage activity could continue as long as the exchange rate at the end of the period did not change radically ‘against the banks—a severe devaluation of the lira, This was what, in the end, occurred. How could the Turkish banks be contributing to financial criss if they were purchasing Turkish government bonds and helping finance and support their own government? Answer: While it sounds helpful that the Turkish banks were promoting an active and growing market for Turkish government debt, and in the process allowing the goverment to finance its expenditures at a lower cost than without their activity, the source of their funds was the problem. By acquiring large quantities of dollar-denominated debt, for & country already running a current account deficit, this would inevitably lead to a currency crisis as the ability of the Turkish economy to generate sufficient hard-currency earnings (US. dollars in this ease) in onder to service this debt would fall short. o14-MEG EEAE International Financial Management Which do you think is more eritical to a country such as Turkey, fighting inflation or fighting a large trade and current account deficit? Answer: The consensus among most international economists and various international organizations is that inflation is the frst and foremost problem that must be controlled in order to establish a solid foundation for economic growth, industrial development, full employment, and managed trade. Current account deficits are not of themselves necessarily cvil or destructive, but actually often a characteristic of a fully employed rapidly expanding economy, 5. The quote from Corporate Finance magazine, although noting the outside possibility of a dovaluation, was largely positive regarding Turkey's future in January 2001. What would you have thought? Answer: Ir seems that throughout history, after every curtency crisis, there isthe wailing voice crying out “why didn’t you see this coming?" This quotation is rather useful in pointing out that in many (most?) currency crises ‘hore wre at least murmurs in the marketplace prior tothe crisis, The quotation points out that there have been some. positive actions—the IMF capital injections —but that there ere continuing problems with inflaton. The latter was expected to drive the value ofthe lira down in the near future. “18