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International Monetary Relations

Abstract

This paper presents information on international monetary relations and international finance in particular. It focuses on theories such as Purchasing Power Parity and Interest Rate Parity and how exchange rates are perceived using these theories. The paper also shows how an investor can protect himself using Covered Interest Arbitrage. The References page appends four sources in APA format.

International Monetary Relations

Introduction

Issues related to International monetary such as exchange rate adjustments and balance-of-payments have been a major topic of interest in economics at all times. However, in the last couple of years, international finance has been stimulated even more strappingly into the front position of recognition for analysts, practitioners, policy makers, and scholars alike.

Question & Answers

1.                                    If the current exchange rate is US$1 equals 1.25 Euros, how much did you win in US dollars?

Solution:      US$1 = 1.25 Euros

                     1,000,000 Euros = 1,000,000 ÷ 1.25

                     1,000,000 Euros = $ 800,000

2.                                    Suppose that the interest rate in Irish banks is 5% for a one year CD. In the USA, the rate is 2% for a one year CD. If you left your winnings in Ireland, how many Euros would you have in a year? If you had taken your winnings back to the USA,

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how many dollars would you have?

Solution:      If the Winnings are left in Ireland

                     Interest rate in Irish Banks is 5% for a one year CD.

                     1,000,000 Euros × 5% = 50,000

                     An interest of 50,000 Euros can be gained if the winnings are left in Ireland.

The total amount in Euros will be 1,050,000 (1,000,000 + 50,000) after a year if the winnings are left in Ireland.

If the Winnings are taken back to the USA

US$1 = 1.25 Euros

                     1,000,000 Euros = 1,000,000 ÷ 1.25

                     1,000,000 Euros = $ 800,000

$ 800,000 will be taken to the US initially.

Interest rate in USA Banks is 2% for a one year CD

$ 800,000 × 2% = $ 16,000

An interest of $ 16,000 can be gained if the winnings are taken back to USA.

The total amount in US Dollars will be $ 816,000 (800,000 + 16,000) after a year if the winnings are taken back to the USA.

3.                                    Suppose when you cashed in your CD in Ireland a year from now, the exchange rate had changed from US$1 to 1.25 Euro, to US$1 to 1.30 Euro. How much would your Irish bank account be worth in US$ at that point? Did you do better off leaving your winnings in Ireland or bringing them home to the USA?

Solution:      The total amount in Euros will be 1,050,000 after a year if the winnings are left in Ireland.

                     If the exchange rate after a year is US$1 to 1.30:

                     1,050,000 Euros = 1,050,000 ÷ 1.3

                     1,050,000 Euros = $ 807,692.3

Comparing the figure of $ 807,692.3 with the figure of $ 816,000, which would be the worth of the winning money after the year if it would be brought to the USA, it can be concluded that it is better to bring the money back home rather than keeping it in the Irish Bank.

4.                                    Explain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments.

Solution:      Covered interest arbitrage entails investing domestic currency in terms of an overseas currency which pays a higher rate of return with no exchange rate risk. Covered interest arbitrage is put into practice merely at the time when a return in foreign exchange is above that offered by investment opportunities in a domestic currency. Covered interest arbitrage is considered as a risk-free investment as the investors lock the proceeds to be obtained from investing overseas in forward contracts from the time of investment. (Frankel 1979)

5.                                    Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested?

Solution:      According to Purchasing power parity (PPP) the exchange rates between currencies of two countries are stable at the time when the buying power is similar in both of the countries. “PPP states that in competitive market identical goods traded in different countries must sell for the same price when they are expressed in terms of a common currency.” (Dornbusch 1976) The basis for PPP is the “law of one price”. It states that in a free Market with no barriers to trade and no transport or transactions cost, the competitive process will ensure that there will be only one price for any given good. When a country’s domestic price level is increasing (i.e., a country experiences inflation), that country’s exchange rate must depreciated in order to return to PPP. (Eiteman 1982)

During the year in which the lottery winnings were invested the exchange rate had changed from US$1 to 1.25 Euro, to US$1 to 1.30 Euro. This means that EURO depreciated by $ 0.05. Considering this it can be inferred that, according the Purchasing Power Parity, inflation has been higher in the UK during the year.

Conclusion

The beginning of the digital financial system has amplified the competence and competitiveness of financial markets. This experience has encouraged the development of traders in the financial market and stabilized the worth of the monetary goods globally. (Aharoni 1966)

Purchasing Power Parity model is based on the law of one price. However, Covered interest arbitrage infringes this law and represents a market misrepresentation presenting profit opportunities.

In order to recognize the chances of covered interest arbitrage, interest rate parity principle is applied. This principle states that there are benefits from covered interest arbitrage at the time when the interest rate variation between two currencies is different from the discount rate seen in foreign exchange markets. On the other hand, if the degree of difference in interest rate is equal to the forward premium, then interest parity prevails and chances of arbitrage are not present. (Dornbusch 1976)

References

Aharoni Y. The Foreign Investment Decision Process. Boston, MA: Harvard University Press, 1966.

Dornbusch Rudiger. “Expectations and Exchange Rate Dynamics.” Journal of Political Economy 84 ( December 1976):1161-76.

Eiteman D. K., and Arthur Stonehill. Multinational Business Finance. Reading, MA: Addison-Wesley, 1982.

Frankel Jeffery A. “On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials.” American Economic Review 69, no. 4 ( September 1979):610-22.

 

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