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Currency Exchange: International Finance

1. Assume that foreign currencies X, Y, and Z are highly correl¬ated. If a firm diversifies its financing among these three currencies, will it substantially reduce its exchange rate exposure (as opposed to borrowing all funds from one of these foreign currencies)? Explain.
2. Assume that your company needs dollars. It borrows euros at a lower interest rate than that for dollars. If interest rate parity exists and if the forward rate of the euro is a reliable predictor of the future spot rate, what does this suggest about the feasibility of such a strategy?
3. Assume that as a treasurer of a U.S. corporation, you believe that the British pound's forward rate is an accurate forecast of the pound's future spot rate. What does this imply about your decision of whether to invest cash in the U.S. or in the U.K.?
4. Explain how the MNC's optimization of cash flow can distort the profits of each subsidiary.

Solution Preview

1. If the foreign currencies X, Y, and Z are highly correlated and the firm diversifies its financing among the three currencies. It will not reduce exchange rate exposure substantially when compared with borrowing all funds from one of these foreign currencies. Since, the three currencies are highly correlated an increase or a decrease in the exchange rate will also be reflected in changes in other currencies. To reduce its exchange rate exposure, the firm has to borrow its funds from foreign currencies what are un-correlated. This will reduce its exchange rate exposure. For example, if the exchange rate of X goes down if it is uncorrelated to Y, the exchange rate of Y may increase cancelling out losses from exposure to X.

2. If a company borrows euros at lower interest rate than for dollars, if interest rate parity ...

Solution Summary

The answer to this problem explains important issues related to currency conversion and international finance. The references related to the answer are also included.

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