Answers to End-of-Chapter 16 Questions

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ANSWERS TO END-OF-CHAPTER 16 QUESTIONS

16-1The U.S. dollar. The primary reason for using the dollar was that it provided a relatively stable benchmark, and it was accepted universally for transactions.

16-2Under the fixed exchange rate system, the fluctuations were limited to +1 percent and -1 percent. Under the floating exchange rate system, there are no agreed-upon limits. Currently, the 12 countries making up the EMU have their national currencies fixed to the euro; however, the value of the euro continues to fluctuate. Beginning in 2002, these national currencies will be phased out and only the euro will exist.

16-3A dollar will buy more euros.

16-4There will be an excess supply of dollars in the foreign exchange markets, and thus, this will tend to drive down the value of the dollar. Foreign investments in the United States will increase.

16-5Taking into account differential labor costs abroad, transportation, tax advantages, and so forth, U.S. corporations can maximize long-run profits. There are also nonprofit behavioral and strategic considerations, such as maximizing market share and enhancing the prestige of corporate officers.

16-6The foreign project’s cash flows have to be converted to U.S. dollars, since the shareholders of the U.S. corporation (assuming they are mainly U.S. residents) are interested in dollar returns. This subjects them to exchange rate risk, and therefore requires an additional risk premium. There is also a risk premium for political risk (mainly the risk of expropriation) that should be included.

16-7A Eurodollar is a dollar deposit in a foreign bank, normally a European bank. The foreign bank need not be owned by foreigners--it only has to be located in a foreign country. For example, a Citibank subsidiary in Paris accepts Eurodollar deposits. The Frenchman’s deposit at Chase Manhattan Bank in New York is not a Eurodollar deposit. However, if he transfers his deposit to a bank in London or Paris, it would be. The existence of the Eurodollar market makes the Federal Reserve’s job of controlling U.S. interest rates more difficult. Eurodollars are outside the direct control of the U.S. monetary authorities. Because of this, interest rates in the U.S. cannot be insulated from those in other parts of the world. Thus, any domestic policies the Federal Reserve might take toward interest rates would be affected by the Eurodollar market.

16-8No, interest rate parity implies that an investment in the U.S. with the same risk as a similar investment in a foreign country should have the same return. Interest rate parity is expressed as follows:

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Interest rate parity shows why a particular currency might be at a forward premium or discount. A currency is at a forward premium whenever domestic interest rates are higher than foreign interest rates. Discounts prevail if domestic interest rates are lower than foreign interest rates. If these conditions do not hold, then arbitrage will soon force interest rates back to parity.

16-9Purchasing power parity assumes there are neither transaction costs nor regulations that limit the ability to buy and sell goods across different countries. In many cases, these assumptions are incorrect, which explains why PPP is often violated. An additional complication, when empirically testing to see whether PPP holds, is that products in different countries are rarely identical. Frequently, there are real or perceived differences in quality, which can lead to price differences in different countries.

16-10The euro is the currency of the 12 countries making up the EMU. While the value of the euro fluctuates, each of the national currencies of those 12 countries participating in the EMU are fixed relative to the euro. Consequently, the cross exchange rates between the participating currencies are also fixed.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

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