International Finance – Final Take home Exam

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INTERNATIONAL FINANCE
Done by:
Nouran Amr Abel Rahman El-Bakly
Submitted to:
Dr. Ahmed Fikry

FINAL TAKE-HOME EXAM

10/8/2022

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Question One
Read the following case and answer the question that follows:
In a word, the 1994 economic crisis in Mexico – often referred to as the Mexican peso crisis – can be
attributed to overspending. But, as with all crises, there is far more to it than just living beyond one’s
means. This story involves rebellion, assassination, fratricide, corruption, money laundering,
deregulation, a lot of investor doubt and a near $50 billion bailout. For the country at least, it has a
happy ending. Although the Mexican peso crisis had a long lead-in time, it came to a head rather quickly
and was dispatched with equal haste. Following almost a decade of economic stagnation and hyper-
inflation, the Mexican government took its first step towards the liberalization of trade when it signed up
to the General Agreement on Tariffs and Trade (GATT) in 1986. Deregulation of the capital markets and
the banking system followed. In 1992, the ruling Institutional Revolutionary Party (PRI) signed up to
reduce trade barriers with the US and Canada through the structure known as the North American Free
Trade Area (NAFTA). By the end of 1993, inflation had dropped to 7.05%, the lowest figure in 22 years,
and foreign investment was coming in on the back of low US borrowing rates. To the casual observer, the
future for Mexico looked rosy. But there was a catch. Not only was growth crawling along at an average
of only 2.8% a year, but in the build-up to his final year of office in 1994, Mexico’s President, Carlos
Salinas de Gortari, had set out on a vote-winning but unsustainable spending spree. Major investment
programs in public health and education were underway which, whilst socially responsible and largely
popular, were very public signs of the country’s profligacy. With the new banking freedom going largely
unchecked, the level and quality of lending started to create ripples of 5 concern amongst the domestic
and international investor community. This concern was exacerbated by the realization that government
spending had expanded the country’s deficit (it went from $6 billion in 1989 to around $20 billion by
1992 when it signed the NAFTA agreement) and it kept on growing. All the while, the peso’s strength was
constricting exports and pushing up imports, further widening the gap. It was not long before talk of an
overvalued peso started to circulate, in effect signaling the beginning of the end. Adding to international
investor concern was a widely held (but not necessarily correct) view that Mexico was undergoing a
period of political instability. Chief among the worries was the January 1994 uprising in the state of
Chiapas. The Zapatista Army of National Liberation (Ejército Zapatista de Liberación Nacional, EZLN), a
revolutionary leftist group, had declared (an apparently largely nonviolent) war on the Mexican state.
The Zapatistas saw Salinas and his cronies as being out of touch with the will of the people and therefore
an illegitimate power. Having failed earlier to secure a popular uprising, EZLN turned its attentions to
what it considered to be the divisive nature of Mexico’s signing of the NAFTA agreement, which came
into effect on 1st January 1994. The agreement resulted in the removal of Article 27 Section VII of the
Mexican Constitution. This had assured land reparations to Mexico’s indigenous people. The New Year’s
Day revolt lasted just two weeks, but EZLN’s grievances were well-timed to punish the government by
further damaging the country’s risk profile in the eyes of the investment community, putting a higher
premium on Mexican assets. With a sick budget deficit and a current account deficit (now standing at 7%
of GDP) fueled by excessive consumer spending and what was now clearly an over-valued peso, Salinas’
government needed to find funding from somewhere. It issued the tesobono (treasury bill), a debt
instrument denominated in peso but indexed to (and paid out in) US dollars. And then in March 1994, in
the build-up to the election, came the assassination of Salinas’ intended political successor within PRI,
Luis Donaldo Colosio. PRI had been the dominant force in the country for more than 60 years and it
looked very much like Colosio’s election would be a shoo-in. Salinas’ eventual PRI successor, Ernesto

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Zedillo, did win in that August’s election, but just one month later, on 28thSeptember 1994, the party’s
Secretary General (and Salinas’ brother-in-law), José Francisco Ruiz Massieu, was also assassinated. To all
intents and purposes, Mexico looked to be in a state of heightened political instability and funds started
to make a quick exit, further damaging the economy. Ruiz Massieu’s untimely death (untimely in more
ways than one) was later found to be at the hands of Raúl Salinas, the president’s brother, with Ruiz
Massieu’s own brother, Mario Ruiz Massieu, also implicated. The latter’s name was linked to bank
accounts containing some $17m in what appeared to be an attempt at money laundering. Mario Ruiz
Massieu committed suicide in 1999, his suicide note blaming Zedillo for both his own death and the
assassination of his brother. With each successive damaging blow, tesobono investors were offloading
them like they were going out of fashion – and they were. Paying out in dollars further depleted the
already low central bank reserves (these hit a reported record low of $9 billion). In order to maintain the
fixed exchange rate (set at 3.3 pesos per dollar) pushing up interest rates would perhaps have been a
prudent move. But it was election year, and so the central bank, Banco de México, under Salinas’
direction, instead depleted its reserves by getting heavily into Mexican treasury securities. With inflation
having soared to over 50% as his tenure was coming to an end, Salinas knew that the game was up. But
he was absolutely determined not to devalue the peso on his watch. In trying to support the country’s
currency, Mexico deployed yet more of its hard foreign currency holdings, an act which cost it dearly.
Nonetheless, devaluation of the peso was inevitable. When it finally came, on 22nd December 1994, the
loss of face fell to Zedillo’s government which had only assumed power 22 days earlier. Initially, Zedillo
had broken an electoral promise and reversed the Salinas administration’s attempts to keep the fixed
rate peso-dollar rate by allowing an increase of the rate band to 15%. Apart from skating on political thin
ice, economically this was too little, too late. Letting the rate float saw the peso plummet from 4 pesos
per dollar to 7.2 pesos per dollar – within one week. According to the Institute for International
Economics, commenting on the ‘macroeconomic policy mistakes’ that led to Mexico’s crisis, the
announcement of the intended devaluation was unwisely made mid-week, leaving the government
powerless to stop foreign investors abandoning the Mexican market until the following Monday by which
point, of course, the damage had been done. Salinas later blamed Zedillo for the outcome, citing his
successor’s ‘inept’ handling of the situation, referring to it as ‘el Error de Diciembre’ or ‘the December
Mistake’. Just as EZLN’s uprising was short-lived but damaging, so too was the Mexican peso crisis. The
US, under Bill Clinton’s leadership, stepped into the breach almost immediately. It started by buying
pesos in the open market. It then created a package via the US treasury’s Exchange Stabilization Fund (as
opposed to having the US central bank intervene directly, Clinton having failed to get his Mexico
Stabilization Act passed by Congress). The deal also involved the Canadian central bank, the IMF and the
Bank for International Settlements, all guaranteeing Mexico’s loans and reported to be worth in the
region of $50 billion. In less than 18 months, the Mexican economy was on the up. Between 1995 and
2000, the annual rate growth averaged 5.1%, with GDP growth at 5.5% by 2010 (based on figures from
national newspaper, El Economista). According to IMF figures, as of March 2011, foreign reserves were
$128.299 billion and nominal GDP in 2012 stands at $1.231 trillion. The World Bank places Mexico as
nominally the 13th largest economy in the world.

Answer the following questions.

Use the above information to critically analyze the government possible intervention in the
foreign exchange market, highlighting possible rationales of intervention, different types of

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interventions, tools of intervention, and most importantly the potential effect(s) of intervention.
You must relate your answers to the case of the Mexican peso crisis as much as you can.
The Government interventions policies that led to the Mexican peso crisis:
 During the liberalization of the Mexican financial system, the exchange rate system was
fixed as Mexican peso was pegged to the U.S Dollar.
 The Mexican peso strength caused increase the demand for imports result current
account deficit rose to about $29 billion (which represent 8% of Mexican GDP), and the
Mexico’s international reserves declined about two thirds.
 The government of Mexico issued more than $25 billion of peso-denominated short-
term debt whose face value was indexed to the U.S. dollar (it was called tesobonos).

 The foreign investment in Mexico were concentrated in instruments with relatively short
maturities and readily transferable. Moreover, by the time the crisis hit, a large
proportion of those instruments were tesobonos and a large number of investors were
caught holding short-term claims on Mexico that could not be serviced without incurring
a massive short-run depreciation of the peso.

 Although the Mexican government has been able to honor its obligations, initially paying
out pesos and meeting the resulting demand for dollars out of its reserves and later
paying off foreign holders of tesobonos directly in dollars, but there was a capital loss.

 To limit the excessive flight of capital, the Central bank of Mexico raised interest rates,
Short-term interest rates rose to 32%, and the resulting higher costs of borrowing which
were a danger to economic stability and decline economic growth.
 In December 1994, The government of Mexico announced the devaluation of its
currency, the devaluation came after three years during which Mexico had followed a
fixed exchange rate policy of maintaining the peso within a well-defined band against
the U.S. dollar.
 Letting the peso exchange rate float rather than fixed rate, increased the peso rate
against dollar from 4 pesos per dollar to 7.2 pesos per dollar within one week.
 The Mexican government allowed the peso to float freely again two days later, but
rather than stabilize, the peso took another sharp hit, depreciating nearly into half of its
value in the months that would follow.

 Since the peso was overvalued, South American countries also suffered rapid currency
depreciation and a loss of reserves because foreign capital not only fled Mexico but the
crisis led to capital flight in emerging markets as well and governments and businesses
in the area had high levels of U.S. dollar-denominated debt, as the devaluation meant
that it would be increasingly difficult to pay back the debts.

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Potential effect of the government intervention:

 The Mexican government was required to implement certain fiscal and monetary
policies controls. They were also careful to maintain their existing commitments to
policies of the North American Free Trade Agreement (NAFTA).
 Mexico received an unprecedented package of external financial support by $50
billion from the International Monetary Fund, the Exchange Stabilization Fund of
the U.S. Department of the Treasury, the Federal Reserve, the Bank of Canada, and
the Bank for International Settlements.
 Mexico suffered through a severe recession and hyperinflation in the years
following the crisis, as the country maintained excessive levels of poverty and
unemployment for several years.

Type of interventions and its tool: (direct and indirect)

Non- Sterilized intervention:
- Fixed exchange rate system: which was pegged with US dollar currency to it was
overvalued caused revaluation, the Mexican central bank intervened in the foreign
exchange markets to maintain the Mexican peso's peg to the U.S. dollar by issuing dollar-
denominated public debt to buy pesos.
- This led to strength in the Mexican peso currency caused increase the demand for
imports resulting a trade deficit and decline the Mexico’s international reserves in
order to maintain the value of its currency.
- Change the exchange rate into free floating system: the central bank of Mexico
decided to devaluation, in order to control the disturbance caused due to its
overvalued currency.

- Increase the interest rates: the central bank of Mexico decided to increase the interest
rates by 32% to stop the massive capital flight, but it’s negatively affected the cost of
borrowing and caused declining to the economic growth.

- Taking external financial loans: from different financial institutions to support the
foreign reserve of the central bank of Mexico and maintain the value of the Mexican
peso and decrease the trade deficit.

The Rationales of intervention: is to increase or decrease in the exports/imports,

decrease/increase in the value of the currency foreign as well as domestic,
increase/decrease debt of a country, increase/decrease a countries foreign currency

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Question Two
You are kindly requested to collect the data of the “Balance of Payments” for the country of
your choice (other than USA & Egypt).

United Kingdom Balance of Payment in 2018 - 2021:

2018 2019 2020 2021
Current account (excludes reserves and - -76,873.7 -69,827.8 -82,534.1
related items) 112,483.9
Goods, credit (exports) 468,242.1 475,008.9 396,779.5 442,352.2
Goods, debit (imports) 657,993.4 651,796.4 564,109.1 656,828.2
Balance on goods - -176,787.5 -167,329.6 -214,476.0
189,751.3
Services, credit (exports) 416,633.0 417,623.3 386,218.4 417,347.4
Services, debit (imports) 264,597.3 267,349.5 211,982.5 242,800.5
Balance on goods and services -37,715.6 -26,513.6 6,906.4 -39,929.0
Primary income, credit 291,901.1 277,874.9 174,534.1 249,561.9
Primary income, debit 332,649.6 294,439.4 214,819.1 266,182.3
Balance on goods, services, and -78,464.1 -43,078.1 -33,378.6 -56,549.4
primary income
Secondary income, credit 25,006.4 24,451.6 26,499.4 23,195.5
Secondary income, debit 59,026.2 58,247.3 62,948.5 49,180.1
Capital account (excludes reserves and -3,585.3 -1,689.2 -3,285.8 -3,700.8
related items)
Capital account, credit 3,092.6 3,260.0 2,886.4 1,223.6
Capital account, debit 6,677.9 4,949.2 6,172.2 4,924.4
Balance on current and capital - -78,562.9 -73,113.6 -86,234.9
account 116,069.2
Financial account (excludes reserves - -87,764.8 -54,371.0 -86,733.5
and related items) 125,781.3
Direct investment, assets -28,632.1 -48,231.9 -53,267.0 101,602.6
Equity and investment fund shares -24,363.9 -32,872.8 -40,275.3 113,919.1
Debt instruments -4,268.2 -15,359.1 -12,991.8 -12,316.5
Direct investment, liabilities -25,055.4 2,236.7 31,058.9 22,604.2
Equity and investment fund shares 82,827.8 21,966.6 33,603.3 61,601.5
Debt instruments - -19,730.0 -2,544.4 -38,997.3
107,883.2
Portfolio investment, assets - 128,741.8 74,720.7 -89,521.3
180,114.9
Equity and investment fund shares - -6,596.0 -50,151.9 -111,398.4
227,997.9
Debt instruments 47,883.1 135,337.8 124,872.6 21,877.1

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Portfolio investment, liabilities 181,965.2 84,499.7 91,361.9 258,508.2

Equity and investment fund shares 5,274.3 -6,322.3 65,812.0 63,769.6
Debt instruments 176,690.9 90,822.0 25,549.9 194,738.7
Financial derivatives (other than 12,357.5 9,937.4 38,643.9 -39,669.7
reserves) and employee stock options
Other investment, assets 235,211.5 -290,392.7 514,797.2 419,760.5
Other equity 7.9 45.7 56.5 119.7
Debt instruments 235,203.6 -290,438.3 514,740.8 419,640.8
Other investment, liabilities 7,693.5 -198,916.8 506,845.1 197,793.2
Other equity 0.0 0.0 0.0 0.0
Debt instruments 7,693.5 -198,916.8 506,845.1 197,793.2
Balance on current, capital, and 9,712.1 9,202.0 -18,742.6 498.6
financial account
Net errors and omissions 14,623.1 -10,363.8 14,518.7 22,864.9
Reserves and related items 24,335.2 -1,161.8 -4,223.9 23,363.6
Reserve assets 24,335.2 -1,161.8 -4,223.9 23,363.6
Net credit and loans from the IMF 0.0 0.0 0.0 0.0
(excluding reserve position)
Source: Balance of Payments Analytic Presentation by Country - IMF Data
Answer the following question.
Use the data you collected to analyze how the foreign exchange rate of the currency of your
chosen country is related to the changes in the sub-accounts of the balance of payments. Based
on your answer, is it possible to identify a “J-curve adjustment path” for that economy
Answer:
Introduction

Balance of Payments is a document used to keep track of the transactions between residents
and non-residents. Balance of Payments interacts with nearly all of key macroeconomic
variables in countries such as: GDP, Exchange Rate, Interest Rates, Inflation Rates.
BALANCE OF PAYMENT ACCOUNTS OF UK
As it’s noticed that there’s deficit in current account by around 82.5 billion dollars in 2021
mainly generated from balance of trade deficit by around 214.5 billion dollars in 2021 with
increasing rate by around 28%, so the exports are greater than the imports, and the value of a
UK imports is greater than the value of its exports. Taking into consideration that there’s a
remarkable surplus net exports/ imports of services by around 174.5 billion dollars.
BALANCE OF PAYMENT OF UK AND THE BREXIT EXIT

Prior to the Brexit deadline of 29 March 2019, the UK current account had seen a widening
deficit by around 112.4 billion dollars, after the Brexit had been done, The UK’s current deficit

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had been decreased despite some recent volatility and reached to around 82.5 billion dollars. By
contrast, movements in the primary income deficit had emerged as the main driver in the
current account, the secondary income account had also displayed a constant deficit.
It’s noticed also that there’s a deficit in capital account by around 3.7 billion dollars in 2021 and
total current and capital deficit in 2021 reached to around 86.7 billion dollars which covered by
the financial account with surplus 498 million dollars.
On other hand, it’s noticed that UK had around 22.8 billion dollars as net errors & omissions
taking into consideration that it’s a famous country for Money Laundry, this surplus lead to
increase in UK reserve assets by around 23.3 billion dollars in 2021.
BALANCE OF PAYMENT AND EXCHANGE RATE OF UK

Currency 2018 2019 2020 2021 10/2022

GBP/USD 1.33 1.28 1.29 1.37 1.11
GBP/EUR 1.13 1.14 1.12 1.16 1.14
GBP/AUD 1.78 1.83 1.86 1.84 1.74
Source: https://www.investing.com/currencies

It’s worth mentioning that the GBP against USD was slightly decreased in 2019 compared to
2018, and if we compare it with trade account, we will notice that there was still a deficit in UK
trade account but with declining rate in the mentioned years by around 7%. So, the quantity
demand on UK products had been increased due to the depreciation of the GBP currency which
led to increase in exports revenues, on the other hand, the quantity demand on imported
products inside UK had been decreased due to the depreciation of the GBP and increase its
price which led to decrease cost of imports (Marshall lerner condition)
UK Trade Balance = (PxQx) – (S£/fc PfcM x QM)
- Percentage depreciation in GBP/USD in 2019 = -3.8%
- Percentage increase in exports in 2019 = 1.4%
- Percentage decrease in imports in 2019 = -0.9%
 Therefore, as we’re analyzing the relationship of BoP and exchange rate within 1 year,
the response of change in exports is not so high comparing to the change in foreign
exchange rate of GBP to USD in the short-term.
 So, a fall in the price of exports caused a smaller percentage rise in
quantity demanded which led to small increase in the value exports.
 And a rise in the price imports caused a smaller percentage fall in
demand for imports, which led to small decline in the value of
imports.
 Therefore, the demand of UK products is inelastic.

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Source: www.economicshelp.org

UK devaluation 2007-2009
- There was a sharp devaluation in the value of the sterling from 2007 to 2009, as t he
GBP/USD moved from $1.40 in 2002 right up to $2.10 in October 2007.

- - The pound devaluation in this period was result of the world financial crisis and UK
went to recession period.

- During the depreciation of 2007-2009, there was not

constant improvement in the UK current account as it
was volatile, but remained in deficit.

- At the same time import prices went up by a fairly large amount and export prices rose too.

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- The reason was that the British companies that import goods to use in order produce goods
that they export passed on the cost to foreign buyers, and export prices rose after the
depreciation by more than import prices.

- Moreover, the British companies selling on the domestic market after the sharp fall in wages in
this period to absorb the higher costs, they didn’t have to raise prices and could thus maintain
market share, at the same time as firms saw their import prices increase they saw their wage
bills fall dramatically. So, they didn’t have to increase prices too much because they just passed
through the savings, they were making on wage costs.

- On the long-run, after the depreciation, the trade deficit remained volatile and then the deficit
increased worsened.

- In this case, the J-Curve effect couldn’t be proven. Because there are many factors can
influence the current account balance of payments other than the exchange rate includes:
the state of the economy (in a recession, demand for import spending falls), consumer
demand in other countries (Eurozone recession hit demand for UK exports), competitive
advantage of manufacturing UK industries relative to its main competitors.

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Question Three
Read the following case and answer the question that follows.
Welles Fargo Bank, based in Los Angeles, California, can borrow 30 million U.S. dollars (USD) at
5% annualized. It can then invest in either the euro (EUR), the Australian dollar (AUD), or the
Canadian dollar (CAD). For simplicity, suppose that the lending rate of all of the euro, the
Australian dollar, and the Canadian dollar is 3% annualized over a 5-day time period. The spot
rates and the expected rates of the euro, Australian dollar and the Canadian dollar are given in
the table below.

Spot Rate Expected Spot Rate

(15/9/2022, 9:00 PM) After 5 days
EUR-USD 0.9997 1.0197
1 EUR in USD
AUD-USD 0.6699 0.7369
1 AUD in USD
CAD – USD 0.7559 0.7786
1 CAD in USD
Answer the following questions.
Based on the information given above, determine in which currency should Welles Fargo Bank
invest: EUR, AUD or CAD? Justify your answer. Calculate the potential profit in U.S. dollars.
Calculate the effective rate of return on investment.
Answer:

Invested
Expected Repayment Profit after Effective
Converted Amount after Convert back
Currency Spot Rate Spot Amount repayment Rate of
amount adding to USD
Rate (principle+interest) Loan Return
interest (3%)

EUR-USD 0.9997 1.0197 30,009,002.70 30,021,506.45 30,612,930.13 30,020,833.33 592,096.80 2.04%

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AUD-USD 0.6699 0.7369 44,782,803.40 44,801,462.90 33,014,198.01 30,020,833.33 2,993,364.68 10.05%

CAD – USD 0.7559 0.7786 39,687,789.39 39,704,325.97 30,913,788.20 30,020,833.33 892,954.87 3.05%

- I will borrow $30 Million and I will repay them $30,020,833.3 Million after paying the principle and
interests.
= (30,000,000 x (1+5%x 5/360) = 30,020,833.3)
- I will convert USD to EUR, AUD, CAD dividing $30 million by spot rate of each currency.

Currency Spot Rate Converted amount

EUR-USD 0.9997 30,009,002.70
AUD-USD 0.6699 44,782,803.40
CAD – USD 0.7559 39,687,789.39
- I will invest the EUR, AUD, CAD converted amount at an annualized rate (3%) over five days, as
follows:
 EUR 30,009,002.70 x [1+3% (5/360)] = EUR 30,021,506.45
 AUD 44,782,803.40 x [1+3% (5/360)] = AUD 44,801,462.90
 CAD 39,687,789.39 x [1+3% (5/360)] = CAD 39,704,325.97

- I will convert EUR, AUD, CAD amounts back to USD multiplying by Expected Spot Rate of each
currency

Invested Amount after Convert back to

Currency Expected Spot Rate
adding interest (3%) USD
EUR-USD 1.0197 30,021,506.45 30,612,930.13
AUD-USD 0.7369 44,801,462.90 33,014,198.01
CAD – USD 0.7786 39,704,325.97 30,913,788.20

- I will subtract the converted Dollars amount with the repayment amount to figure out the profit as
follows:
 EUR: $30,612,930.13 - $30,020,833.3 = 592,096.80
 AUD: $33,014,198.01 - $30,020,833.3 = 2,993,364.68
 CAD: $30,913,788.20 - $30,020,833.3 = 892,954.87

Convert back Repayment Amount Profit after

Currency
to USD (principle+interest) repayment Loan
EUR-USD 30,612,930.13 30,020,833.33 592,096.80
AUD-USD 33,014,198.01 30,020,833.33 2,993,364.68
CAD – USD 30,913,788.20 30,020,833.33 892,954.87

- Finally, I will calculate the effective rate of return by divide the converted back to USD amount of each
currency by $30 million and subtract it by 1, as follows:

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 EUR: ($30,612,930.13 / $30,000,000 -1) *100 = 2.04%

 AUD: ($33,014,198.01 / $30,000,000 -1) *100 = 10.05%
 CAD: ($30,913,788.20 / $30,000,000 -1) *100 = 3.05%

We can conclude that the highest profit of the investment of USD will be from AUD currency, as it’s
effective rate of return and it appreciated by 10.05%.

Question Four
As of Thursday, September 15th, 2022, 09:30 pm (GMT) the following quotes apply.

Currency Quote
Value of GBP in USD 1.1468
Value of NZD in USD 0.5968
Value of GBP in NZD 1.8395
Answer the following questions.
Given the information above, is “triangular arbitrage” possible? Why? Or why not? If it is
possible, explain the steps that would reflect the “triangular arbitrage” process and compute
the potential profit from this strategy if you had 1,000,000 USD at your disposal to use for this
purpose.

Answer:
1. In order to identify arbitrage opportunity, I will get USD/GBP, USD/NZD as follows:

Currency Quote
Value of USD/GBP 0.8719916288
Value of USD/NZD 1.67560321715
Value of GBP/ NZD 1.8395

- The implicit cross-rate between GBP and NZD is calculated as follows:

 Cross Rate GBP/NZD =
Value of New Zealand dollar in U.S. dollar / value of GBP in U.S. dollar
= 1.6756 / 0.87199 = NZD/GBP = 1.92158
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Thus, the implicit cross rate is NZD/GBP = 1.92158, however, the quoted cross rate is
GBP/NZD = 1.8395 which is higher than the implicit cross rate. Thus, triangular arbitrage
exists.
2. If I had $1 million, I will do triangular arbitrage to invest the $1 million as follows:
 I will buy GBP at exchange rate 0.87199 = 1,000,000/ 0.87199 = 1,146,802.14 £
 Then, I will convert GBP into NZD at exchange rate 1.8395
= 1,146,802.14 / 1.8395 = 623,431.44
 Finally I will convert the NZD into USD at exchange rate of 1.67560
= 623,431.44 x 1.67560 = 1,044,621.72

 Then, the profit of triangular arbitrage is:

= 1,000,000 – 1,044,621.72 = $ 44,621.72.

Question Five
Many arguments call for the independence of central banks’ conduct of monetary policy,
where others call for some degree of "centralization" of monetary policy actions.
Answer the following question.
In the light of the "Impossible Trinity" concept and the attributes of "Ideal Currency", compare
and contrast centralization versus decentralization of central banks from the government.
Highlight the pros and cons of each. Support your answer with relevant examples.
Answer:
Impossible trinity also called as the trilemma refers to such a condition in an economy which
states that it is impossible to have all the three factors of foreign exchange, free capital
movement and an independent monetary policy at the same time.
Thus, it can be seen that a Central bank can pursue only two of the above these factors at the
same time in an economy. If the domestic interest rate is set at a lower value than the interest
in the international economy, this would set a depreciation pressure on the inherent domestic
currency and thus it cannot be pursued. The bank may opt to sell foreign currency reserves, but
as they are also limited, they might exhaust and reintroduce the issue.
Thus, an attempt to maintain all the three at the same time will lead to imbalances and
destruction of the economy.

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International Finance – Final Take home Exam
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The following may be considered as the pros of centralization of the central banks in an
economy:
 It would help in a centralized management and control of the economy which would
help in overcoming the issues associated with varying demand of the states.
 It would help in easier organization and the management of an economy.
 It would help in reducing the uncertainty in an economy as there would be a centralized
planning in such an economy.
 It can help in reducing the cost of regional planning as the centralized planning would
give them a base above which they can plan the regional economic measures.
 It would help in meeting the liquidity requirements of the domestic economy on a better
scale.

The following may be considered as the cons of centralization of the central banks in an
economy:

 In case of any financial risk, the risk can rapidly spread to all central banks. This is
because all central banks are networked and operate as a single system.
 The process of making decisions is time-consuming under centralization system because
of bureaucratic process. This can delay the effectiveness of a given policy that could have
helped the economy to solve a certain economic problem.
 It can ensure that the customers can access financial products and services they require
in one place. As centralized central banks ensure that the customers receive high-quality
services within one location.
 It makes it easier for the government to regulate and control the operations of
banks. This is important for the good performance of the economy as this system
ensures that policies made are prudent and won`t have negative effects on the
economy.

The following maybe considered as the pros of decentralization of the central banks in an
economy:
 It would help in taking more timely decisions at the root level as the centralization
process would involve sanctions on certain implementations which have to get the
approval which would consume a lot of time in implementation process.
 It empowers the central banks to be innovative as they carry out their operations.
Whenever faced with a difficult situation they can devise ways of overcoming the
challenge independently and this leads to growth of the central banks.

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International Finance – Final Take home Exam
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 It would help in lowering the burden of a top management on a day-to-day basis.

 It would induce a regional freedom approach which can bring in many economic
measures on a regional scale which might not be applicable to the whole nation and
may be misrepresented in a centralized planning.

 It would insulate the member banks from bank failures as decisions can be made very
fast. It does not require the financial institutions or governmental officials to authorize
certain decisions and this ensures that the decisions are made very fast.

The following maybe considered as the cons of decentralization in an economy:

 It may lead to inefficiency in decision making as some banks may make decisions that do
not align with the goals of the economy.
 It may result in redundancy as some tasks may be repeated and this can lead to wasting
of resources.

The following are the various examples to centralization and decentralization of central
banks:
The central bank of India
 It has a wider power of decentralization as the whole economy is based on the concept
of decentralization of wealth in the domestic economy.
 There is a centralized planning, but it is being followed by a planning at all the three
levels of an economy like center, state and regional levels. This makes sure that regional
economic measures are not disrupted due to any inefficiencies in the central planning.
The Federal Reserve of America
 The Fed is called a decentralized central bank. However, The Fed was designed as a
decentralized independent agency to ensure that monetary policy decisions would be
representative of all regions of the country and free from political influence.
 The Fed’s monetary policy decisions don’t have to be approved by the President, the
executive branch of the government, or Congress. However, the Fed is subject to
oversight by Congress and is required to conduct monetary policy to promote maximum
employment, stable prices, and moderate long-term interest rates. In order to operate
independently of the government, the Fed finances its own operations.
 Its unique public-private organization includes, the Board of Governors (an independent
federal agency); 12 regional Reserve Banks (private corporations acting as fiscal agents
of the government); the FOMC (a committee comprising Reserve Bank presidents and
members of the Board of Governors).

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International Finance – Final Take home Exam
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 The Fed is divided into 12 districts, with each district served by a regional Reserve Bank.
Reserve Banks are the operating arms of the Fed. They: distribute currency and coins,
provide short-term loans to banks, supervise banks, provide educational information on
consumer protection rights and laws.
 Reserve Banks aren’t federal agencies—they’re individually incorporated. Each has a board
of directors and stockholders from commercial banks operating within their district. In
most cases, each regional Reserve Bank also operates one or more branch offices.
Central Bank of Egypt:
 It’s a centralized central bank located in Cairo, it regulates the banking system in the
economy and implements the monetary policy, credit policy and the banking policy of
Egypt. In this clause, it maintains a better degree of independency.
 It issues banknotes and helps in maintaining the gold and foreign exchange reserves for
which it has the most independent operation as it does not have a direct influence on
the regional economy as such.
 It manages the foreign exchange market and supervises the national payment system.
 It helps in managing the private and public debt of the nation in which it has a higher
level of freedom.
Conclusion:

Under the decentralization of central banks from the government, banks are free to make own
independent decisions. In the decentralized system, each single bank is allowed to make its own
decision. The governmental authorities of the financial institutions do not interfere with
decision-making process of the banks. Therefore, decentralization system has no central point
of control.

In contrast, under the centralization of the central banks, the different central banks do not
make their own independent decisions. The financial institutions or governmental authorities
always chip in decision-making process of the different central banks. Therefore, it is easier to
control the operations of the central banks under the centralized banking system as compared
to the decentralized system.

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International Finance – Final Take home Exam
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Question Six
You are kindly requested to collect the foreign exchange rates for the EUR, GBP, NZD and AUD
on monthly average bases, for the time period 1 January 2017 till 31 August 2022. Answer the
following questions.
Analyze the volatility of the four currencies over the time horizon identified and determine
which currency has witnessed the highest volatility. Provide a plausible justification at the best
of your ability.

Value of Value of Value of Value of Monthly Monthly Monthly Monthly

Date Change change change change
EUR GBP NZD AUD
EUR GBP NZD AUD
31-Jan-17 0.94088 0.80997 1.40532 1.34212 -- -- --- --
28-Feb-17 0.93911 0.80103 1.38373 1.30407 -0.19% -1.10% -1.54% -2.84%
31-Mar-17 0.9351 0.8103 1.42777 1.31228 -0.43% 1.16% 3.18% 0.63%
30-Apr-17 0.93391 0.79123 1.43542 1.32732 -0.13% -2.35% 0.54% 1.15%
31-May-17 0.90419 0.77398 1.43876 1.3455 -3.18% -2.18% 0.23% 1.37%
30-Jun-17 0.89053 0.78129 1.38352 1.32369 -1.51% 0.94% -3.84% -1.62%
31-Jul-17 0.86753 0.76896 1.35788 1.28253 -2.58% -1.58% -1.85% -3.11%
31-Aug-17 0.84634 0.77187 1.36873 1.26334 -2.44% 0.38% 0.80% -1.50%
30-Sep-17 0.83949 0.75113 1.37874 1.25372 -0.81% -2.69% 0.73% -0.76%
31-Oct-17 0.85114 0.75782 1.42112 1.28449 1.39% 0.89% 3.07% 2.45%
30-Nov-17 0.85149 0.75672 1.45224 1.31207 0.04% -0.15% 2.19% 2.15%
31-Dec-17 0.84425 0.74606 1.43456 1.30603 -0.85% -1.41% -1.22% -0.46%
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31-Jan-18 0.8199 0.72408 1.37819 1.25742 -2.88% -2.95% -3.93% -3.72%

28-Feb-18 0.81002 0.7159 1.36839 1.27076 -1.20% -1.13% -0.71% 1.06%
31-Mar-18 0.81105 0.71614 1.37876 1.28906 0.13% 0.03% 0.76% 1.44%
30-Apr-18 0.81455 0.71111 1.38139 1.30191 0.43% -0.70% 0.19% 1.00%
31-May-18 0.84565 0.74276 1.43812 1.32797 3.82% 4.45% 4.11% 2.00%
30-Jun-18 0.85618 0.75218 1.44089 1.33423 1.25% 1.27% 0.19% 0.47%
31-Jul-18 0.85528 0.75931 1.47294 1.3505 -0.11% 0.95% 2.22% 1.22%
31-Aug-18 0.86669 0.77729 1.50033 1.36474 1.33% 2.37% 1.86% 1.05%
30-Sep-18 0.85797 0.76676 1.51553 1.38889 -1.01% -1.35% 1.01% 1.77%
31-Oct-18 0.87008 0.76806 1.5322 1.4077 1.41% 0.17% 1.10% 1.35%
30-Nov-18 0.87991 0.77519 1.47642 1.37995 1.13% 0.93% -3.64% -1.97%
31-Dec-18 0.879 0.78875 1.46903 1.39689 -0.10% 1.75% -0.50% 1.23%
31-Jan-19 0.87563 0.77548 1.47502 1.39809 -0.38% -1.68% 0.41% 0.09%
28-Feb-19 0.88096 0.76883 1.46361 1.40017 0.61% -0.86% -0.77% 0.15%
31-Mar-19 0.88515 0.75974 1.46417 1.4127 0.48% -1.18% 0.04% 0.89%
30-Apr-19 0.89013 0.76782 1.48987 1.40585 0.56% 1.06% 1.75% -0.48%
31-May-19 0.89352 0.77781 1.52322 1.43967 0.38% 1.30% 2.24% 2.41%
30-Jun-19 0.88495 0.78887 1.51508 1.43935 -0.96% 1.42% -0.53% -0.02%
31-Jul-19 0.8915 0.80178 1.49733 1.43223 0.74% 1.64% -1.17% -0.49%
31-Aug-19 0.89751 0.82251 1.554 1.47619 0.67% 2.59% 3.79% 3.07%
30-Sep-19 0.9072 0.80942 1.57717 1.46883 1.08% -1.59% 1.49% -0.50%
31-Oct-19 0.90382 0.78973 1.57805 1.47062 -0.37% -2.43% 0.06% 0.12%
30-Nov-19 0.90481 0.77648 1.5635 1.46469 0.11% -1.68% -0.92% -0.40%
31-Dec-19 0.90007 0.76332 1.51628 1.45204 -0.52% -1.69% -3.02% -0.86%
31-Jan-20 0.90105 0.76484 1.51257 1.45647 0.11% 0.20% -0.24% 0.30%
29-Feb-20 0.91606 0.77109 1.5644 1.50063 1.67% 0.82% 3.43% 3.03%
31-Mar-20 0.90486 0.80971 1.6539 1.61132 -1.22% 5.01% 5.72% 7.38%
30-Apr-20 0.92022 0.80507 1.66323 1.58553 1.70% -0.57% 0.56% -1.60%
31-May-20 0.9146 0.81236 1.64091 1.5334 -0.61% 0.91% -1.34% -3.29%
30-Jun-20 0.88859 0.79939 1.55103 1.45056 -2.84% -1.60% -5.48% -5.40%
31-Jul-20 0.87302 0.78946 1.51834 1.42385 -1.75% -1.24% -2.11% -1.84%
31-Aug-20 0.8453 0.76127 1.51447 1.38871 -3.18% -3.57% -0.25% -2.47%
30-Sep-20 0.84838 0.77238 1.50004 1.3842 0.36% 1.46% -0.95% -0.32%
31-Oct-20 0.84958 0.7702 1.50577 1.4022 0.14% -0.28% 0.38% 1.30%
30-Nov-20 0.84459 0.75717 1.45627 1.37433 -0.59% -1.69% -3.29% -1.99%
31-Dec-20 0.82131 0.74475 1.4093 1.32664 -2.76% -1.64% -3.23% -3.47%
31-Jan-21 0.82215 0.73313 1.3983 1.29615 0.10% -1.56% -0.78% -2.30%

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28-Feb-21 0.82685 0.72094 1.38108 1.28987 0.57% -1.66% -1.23% -0.48%

31-Mar-21 0.84016 0.72155 1.40213 1.2973 1.61% 0.08% 1.52% 0.58%
30-Apr-21 0.83578 0.72289 1.40403 1.29914 -0.52% 0.19% 0.14% 0.14%
31-May-21 0.82331 0.71102 1.3838 1.28883 -1.49% -1.64% -1.44% -0.79%
30-Jun-21 0.83071 0.71358 1.40878 1.30942 0.90% 0.36% 1.81% 1.60%
31-Jul-21 0.84565 0.72404 1.43146 1.34708 1.80% 1.47% 1.61% 2.88%
31-Aug-21 0.84962 0.72486 1.4336 1.36955 0.47% 0.11% 0.15% 1.67%
30-Sep-21 0.8494 0.72747 1.41601 1.36582 -0.03% 0.36% -1.23% -0.27%
31-Oct-21 0.86231 0.73086 1.41756 1.35091 1.52% 0.47% 0.11% -1.09%
30-Nov-21 0.87763 0.74387 1.42742 1.3708 1.78% 1.78% 0.70% 1.47%
31-Dec-21 0.88465 0.75145 1.47373 1.39793 0.80% 1.02% 3.24% 1.98%
31-Jan-22 0.88328 0.73771 1.48358 1.39382 -0.16% -1.83% 0.67% -0.29%
28-Feb-22 0.88125 0.73871 1.49688 1.39585 -0.23% 0.14% 0.90% 0.15%
31-Mar-22 0.90856 0.75968 1.45554 1.35539 3.10% 2.84% -2.76% -2.90%
30-Apr-22 0.92538 0.77324 1.48193 1.35966 1.85% 1.79% 1.81% 0.32%
31-May-22 0.94597 0.80364 1.56284 1.41878 2.23% 3.93% 5.46% 4.35%
30-Jun-22 0.94641 0.81189 1.57301 1.42363 0.05% 1.03% 0.65% 0.34%
31-Jul-22 0.98132 0.83331 1.61537 1.45802 3.69% 2.64% 2.69% 2.42%
31-Aug-22 0.98845 0.83543 1.59786 1.4377 0.73% 0.25% -1.08% -1.39%
Standard
1.51% 1.78% 2.20% 2.08%
Deviation
Source: https://www.ofx.com

It’s noticed that the New Zealand Dollar (NZD) is has the highest volatility during the period
from 1st January 2017 till 31 August 2022, because the standard deviation for the foreign
exchange rate change is 2.2% which is the highest among other currencies (EUR, GBP, AUD),
and in the second place of volatility come Australian Dollar (AUD) with standard deviation
equal 2.08%, the third and fourth place are Pound sterling (GBP), Euro (EUR) with standard
deviation 1.78%, 1.51% respectively.

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International Finance – Final Take home Exam
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Question Seven
Read the hypothetical case below and answer the questions that follow.
Lexington Corp., a U.S. firm, currently has no existing business in New Zealand but is
considering establishing a subsidiary there to serve the local market there. The following
information has been gathered to assess this project.
• The initial investment required is 25 million New Zealand dollars (NZ$).
• The project will be terminated at the end of year 5, when the subsidiary will be sold.
• The current spot rate of the New Zealand dollar is quoted as: NZD-USD = 0.5968 and for now
it is assumed to remain constant until the end of the project.
• The after-tax earnings of the subsidiary are estimated to be NZ$1,500,000; NZ$2,750,000;
NZ$3,900,000; NZ$5,000,000 and NZ$6,250,000 at the end of years one, two, three, four, and
five respectively.
• The New Zealand government will impose a withholding tax of 20 percent on remitted
earnings by the subsidiary.
• All cash flows received by the subsidiary are to be sent to the parent at the end of each year.
The salvage value to be received is NZ$9 million.
• Lexington requires an 16% rate of return on this project.
Answer the following questions:
1) Calculate the net present value of this project. Should Lexington accept this project?
 Calculating straight line depreciation
= (initial investment – salvage value) / life time of the project
= (25,000,000 – 9,000,000) /5 = 3,200,000

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 International Finance – Final Take home Exam
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 I will add back the salvage value in the last year of the project (year 5)
Cashflow
Cash flow
Cashflow Exchange remitted
after withholdi
Cash salvage remitted After Rate After
Year adding ng tax
flows value withholding (USD/NZ withholding
depreciati (20%)
tax D) tax (in USD
on
Dollar)
Year 0 (25,000,000) 0.5968 (14,920,000)
1,500,0 0.5968
Year 1 00 4,700,000 940,000 3,760,000 2,243,968
2,750,0 0.5968
Year 2 00 5,950,000 1,190,000 4,760,000 2,840,768
3,900,0 0.5968
Year 3 00 7,100,000 1,420,000 5,680,000 3,389,824
5,000,0 0.5968
Year 4 00 8,200,000 1,640,000 6,560,000 3,915,008
6,250,0 9,000,0 0.5968
Year 5 00 9,450,000 1,890,000 00 16,560,000 9,883,008
Cumulati
ve NPV
($2,650,663) ($1,581,915)

Then,
The net present value of the project (NPV) = ($1,581,915)
- Since the NPV is negative, so Lexington should reject this project.

2) Suppose that the New Zealand dollar depreciated continuously against the U.S. dollar by
1.5% annually until the end of year 5. What will be the effect on Lexington project’s
NPV? Comment on your results. What could be done to face this possible scenario?

Cashflow
Cash flow Cashflow
Exchang remitted
after withhol remitted
Cash salvage e Rate After
Year adding ding tax After
flows value (USD/NZ withholding
deprecia (20%) withholding
D) tax (in USD
tion tax
Dollar)
Year 0 (25,000,000) 0.5968 (14,920,000)
1,500,0 0.5878
Year 1 00 4,700,000 940,000 3,760,000 2,210,308
2,750,0 1,190,00 0.5790
Year 2 00 5,950,000 0 4,760,000 2,756,184
3,900,0 1,420,00 0.5703
Year 3 00 7,100,000 0 5,680,000 3,239,559
5,000,0 1,640,00 0.5618
Year 4 00 8,200,000 0 6,560,000 3,685,340

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 International Finance – Final Take home Exam
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6,250,0 1,890,00 9,000,0 0.5534

Year 5 00 9,450,000 0 00 16,560,000 9,163,688
Cumulati
ve NPV
($2,650,663) ($2,148,697)

Answer:
- If New Zealand dollar depreciated continuously against US Dollar by 1.5% annually
- We will recalculate the exchange rate of USD/NZD by multiplying each year by 98.5%,
to find the variable exchange rate.
- Since the value of currency is depreciated, the NPV will be worse than the fixed
exchange rate.
- The Net present value (NPV) of Lexington’s project will be = ($2,148,697)

The results:
- The project’s NPV will be negative and will get worse than the constant USD/NZD
exchange rate by ($566,781)

 So, Lexington should also reject this project, and should invest in a country with
strong currency.

Solution:
 Making hedging against the exchange rate risk (NZD depreciation) through making
forward contract of total cash flow remitted after withholding tax with fixed
exchange rate. (0.5968)
3) Go back to the original scenario again, but now assume that funds are blocked until the
subsidiary is sold and funds are reinvested at a rate of 3% annually until they are
remitted by the end of Year 5. Show how the project’s NPV is affected. Comment on your
answer.

Accumulat Net FCF

Cash flow
ed cash Exchange (in USD
after withholdi
Cash salvage flow by Rate Dollar)
Year adding ng tax
flows value reinvesting (USD/NZ After
depreciati (20%) funds to be D) withholdi
on remitted ng tax
(25,000,00 0.5968 (14,920,00
Year 0 0) 0)
1,500,00 0.5968
Year 1 0 4,700,000 940,000 5,289,891 3,157,007
2,750,00 0.5968
Year 2 0 5,950,000 1,190,000 6,501,726 3,880,230
3,900,00 0.5968
Year 3 0 7,100,000 1,420,000 7,532,390 4,495,330
Year 4 5,000,00 8,200,000 1,640,000 8,446,000 0.5968 5,040,573

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 International Finance – Final Take home Exam
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0
6,250,00 9,000,00 0.5968
Year 5 0 9,450,000 1,890,000 0 16,560,000 9,883,008
Cumulative NPV $1,523,154 $909,018

Answer:
- We will recalculate the cashflow remitted after reinvesting funds to be remitted as follow:
 Year 1 : 4,700,000 x (1+0.03)4 = 5,289,891
 Year 2: 5,950,000 x (1+0.03)3 = 6,501,726
 Year 3: 7,100,000 x (1+0.03)2 = 7,532,390
 Year 4 : 8,200,000 x (1+0.03) = 8,446,000

- The new NPV after reinvesting funds remitted will be equal = 909,018
 So, the net present value (NPV) of the project will be positive after investing funds
to be remitted by the end of Year 5 and assuming that the exchange rate is fixed
through forward contract.
 Then, in this case Lexington should accept the project.

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