International Finance Assignment: Exchange Rates, Risk, and Bonds

This assignment delves into key concepts of international finance, commencing with an analysis of exchange rates, including calculations of new rates with dollar value increases and cross-exchange rate determinations. It further explores triangular arbitrage, comparing direct currency exchange with arbitrage strategies. The assignment then examines purchasing power parity (PPP) and its relationship with inflation, analyzing the impact of inflation rate differences between countries on exchange rates, real exchange rates, and interest rate differentials. The discussion extends to the implications of government bonds and their interest rate stability. Finally, the assignment contrasts country risk analysis with exchange rate volatility, emphasizing the importance of assessing these risks for international investments, with a comparison of economic and political risks. It also provides an overview of the qualitative and quantitative approaches to measuring country risk.

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International finance
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Section A:
1 A). New exchange rate with increase in the dollar value
An increase in the dollar value implies that fewer dollars will be needed to purchase one
Euro. Therefore, the 2% increase in the dollar value will be calculated as follows:
Given the standard rate of EURUSD 1.1, the new exchange will be equal to
If 1EUR = USD 1.1,
Then a 2% increase in dollar value = 1.1- (1.1* 2
100) =1.1-0.022
=1.0780
Therefore, the new exchange EURUSD exchange rate will be 1.0780 dollars per 1 Euro.
B). the exchange rate for the GBPEUR
Given that EURUSD =1.1043 and GBPUSD =1.2970, then the GBPEUR cross exchange
rate will be calculated as below:
GBPEUR = GBPUSD
EURUSD
= 1. 2970
1. 1043 , 1.1745. Therefore, an individual will each pound at 1.1745 Euros.
c). relating the answer to triangular arbitration
By definition, triangular arbitration refers to a mechanism where arbitrager/individual
exchanges currencies for, making profits (Martinez, 2019). It is also notable that arbitration is

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majorly applicable in financial markets without equilibrium. For example, it would be more
profitable for an arbitrager who intends to exchange 10,000 Euros to pounds through triangular
arbitration.
Given that GBPEUR =1.1745 and that EURUSD = 1.1043, the arbitrager has two
options. He can either use a triangular arbitration mode of exchange or directly exchange Euros
to pounds.
i) Exchanging through triangular arbitration
From the rates: 1Euro =1.1043 dollars. Therefore Euros 10,000 = (10,000*1.1043)
=11043dollars.
And that 1GBP = $1.2970. Therefore the arbitrager would get (11,043/1.2970) =GBP 8,
5142637 (Chen,2019).
ii). Direct exchange from Euros to pounds
Given that GBPEUR =1.1745, then the arbitrager would get GBP 8514.2614 from the
transaction. (10,000/1.1745) = 8514.2614 pounds form directly exchanging 10,000 Euros to
pounds. The arbitration exchange is a better option for the arbitrager because it generates a profit
margin for the arbitrager. This is generated by (8514.2637-8514.2614) =0.0023 pounds. This will
be multiplied by the total amount exchanged in the transaction =Euros 23 (0.0023*10,000) (Cui
et al, 2019).
2. Inflation and purchasing power parity
Purchasing power parity can be defined as an economic theory through which currencies
of different countries can be compared either in relative or absolute terms through a “basket of

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goods” ( Chen,2018). In simple terms, this is a situation in which two countries X and Y are in
equilibrium. According to the theory, low inflation rates led to lower interest rates. With low-
interest rates, there is improved consumer power and likewise positive currency value.
Purchasing power parity further holds that inflation reduces the real purchasing power of a
country's currency. The implication here is that if a country has an inflation rate of 10%, then
such a country's currency can purchase 10% less in real goods and services (Amadeo, 2019).
According to the theory, the dollar in December 2017 should have had higher inflationary
tendencies. This is drawn from the assumption one had to pay more dollars for one euro
(EURUSD 1.144). This exchange rate renders the dollar less powerful to the euro as compared
to the January exchange rate.
The percentage increase in the euro-dollar relationship can be calculated by ascertaining
the difference between the two exchange rates of January and December. From the quotation
provided, the difference will be equal to 0.044 obtained as (1.44-1.100). The difference between
the exchange rates will, therefore, represent the percentage increase in the rate of inflation.
Therefore, inflation in December was higher by about 4.4% and it is generated by multiplying
(0.044*100) %.
B). Inflation at 3% higher in the US than in the Euro area
For the case where e inflation is higher by 3% in the United States, the effect would as
well be reflected through the exchange rates between the euro and the dollar. Higher inflation
would imply that the dollar is much less weak on the market. With a depreciated dollar currency
against the euro, the exchange rate between the dollar and euro would be higher (Michail, 2018).

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Given that in January 2017, EURUSD is 1.100; the 3% increase in the inflationary rate
for January would be as follows:
1.100+ ( 3
100* 1.100). This will be equal to 1.1033 dollars per euro for January.
In December however, a euro would cost 1.44 + ( 3
100∗1.44 ¿ = 1.4832 dollars per euro.
Therefore the new exchange rate for December 2017 would be EURUSD 1.4832 and 1.1033 for
January. This is as a result of the increase in inflationary rates in the United States.
Additionally, this change in the exchange rates resulting from the 3% inflation would
consequently lead to reduced exports for the US. Commodities would be rendered expensive
and other euro area countries will not find it attractive to buy expensive products from the US.
Higher inflation rates in the US would as well imply that United States citizens would buy more
of euro area products.
c). Implications in the real exchange rate of a currency
Implications of changes in the real exchange rates look at exchange in real product or
service terms. This, therefore, requires one to ascertain exchange rates in terms of product and
service exchange rates. That is how many units of one us-based product are sufficient enough to
a certain quantity of euro-based products (Beggs, 2018). Therefore real exchange rate value is
computed by dividing units of real foreign products or service by the units of the domestic
product. It looks at the units that can be purchased with the same amount of money at the
prevailing exchange rate between two or more countries.

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Therefore according to prevailing condition and in the United States, the 3% inflationary
increase would render the currency less powerful to the euro. This implies that United States
citizens would buy fewer units of similar products from the European market with the same
amount of money. For example, if 1unit of cheese cost EUR 5 and that the EURUSD is 1.4832,
then a similar quantity of cheese would cost $(5*1.4832) = 7.4160. This means that 1000g of
European cheese are equivalent to 1.4832 units of American cheese.
d). why interest rates would be higher in the US
Interest rates in the United States would be higher simply because the government would
be applying the contractionary monetary tool or policy. Because inflation in the US is high, the
federal government will be interested in reducing the inflationary levels and general price levels
(MacMahon, 2019). By increasing interest rates in the United States, the government will
adequately limit access to the money supply (Muchiri, 2015). With limited money in circulation,
human consumption and expenditure will as well be reduced. Low consumption implies low
demand and this result in lower commodity prices on the market. likewise commodity prices are
reduced inflationary tendencies especially those driven by demand-pull inflation.
Because the US government intends to improve economic growth, setting high-interest
rates is likely to be used as one of the tools. High-interest rates in a county imply that investors
will generate higher returns on capital invested (Pettinger, 2017). Additionally, setting high-
interest rates will also imply that the demand for the dollar will increase in the long run. The
increase in the demand for the dollar will, therefore, lead to an appreciation in terms of the dollar
value on the market. Therefore this is why the United States government is likely to increase
interest rates within the economy.

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E). reasons for no differences in government bonds
Government bonds do not have rampant changes in interest rates for several reasons.
Because these bonds are considered to be risk-free assets, they mostly have lower rates of return.
Risk-averse investors tend to use securities such these government bonds to protect their funds.
This is done in situations when such investor’s projects have unfavorable future macro-economic
trends such as inflation. Therefore, the need to guard against exchange fluctuations drives
investors towards the purchase risk-free government securities (Harper, 2019). When the demand
increases, the government likewise reduces interest. It is this move that results in unchanging
interest rates on government bonds. Therefore for any two euro zone countries would be
pursuing a similar economic policy. For example, the need by countries to undertake an
expansionary monetary policy would call for a similar interest on government bonds.
On the other hand, government bonds can have different interest rates due to changes in
prevailing economic trends. For instance, if a country X in the eurozone is experiencing a boom
and yet another county Y is going through a recession. In county X, investors are reluctant to
purchase government bonds. This is because they can generate better returns from other
securities such shares. This reluctance ultimately results in higher interest rates. In another
country Y however, investors would need to protect themselves from the negative effects of a

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recession (Moffatt,2019). This leads to high demand for government bonds hence leading to low-
interest rates on such bonds. Therefore the outcome of such different prevailing economic
situations means that interest rates on government bonds will be different for the two countries.
PART B
3. Compare and contrast country risk analysis with exchange rate volatility
Investing in a country like United States is not the same as investing in a country like
Bahrain. The reason behind this is that every country has a risk profile different from others.
Country risk means risk involved while investing in another country (Trinh & Nguyen, 2019).
The major risk examples are economic risk and political risk. On the other side, an exchange rate
risk refers to that risk which affects returns of any company brought about by exchange rate
volatility and fluctuations (Côté, 2010). All these risks mentioned above influence the returns of
people who invest in foreign countries and therefore should be addressed as soon as possible. It
is very essential for investors to take a keep look at these risks and find possible solutions to
resolve the situation. It is therefore recommended that the investor should make a thorough
analysis on country risk before carrying out any business in foreign countries.
In country risk, economic risk refers to the potential of a country to service all its debts.
Countries that are able and can easily pay their debts, have a stable financial stand and a strong
economy having favorable investment climate well as a political risk refers to the decisions of a
country based on politics that can easily influence the profits of an investor in that country. No
potential investor would wish to invest in a politically stable country. On the other hand,
exchange rate volatility shows the level to which exchange rate of a country varies with other

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currencies over a given period. Volatile exchange rates raise the exchange risk (Côté, 2010). This
makes it hard and risky for the foreign country to invest in the economy. Investors therefore
monitor. Investors follow up their businesses effectively so that they can find out the level of
exchange rate risks and country risks that their companies face. It I thus the responsibility of
financial managers to be able to measure the exposure of their companies to the above risks and
thereafter find ways of defending their investments. It is difficult to measure the behavior of the
country risk. Various tools that investors may have at a moment right from sovereign ratings
coefficients to betas can be employed to analyze a country’s risk. The country risk can therefore
be measured by using two approaches which include qualitative approach and quantitative
approach. With qualitative approach, risks are determined by use of statistics several ratios and
indices such as the GDP ratio debt, the beta coefficient and MSCI index which are used to
measure the country risk (Daniel et al, 2015).. This information can easily be accessed by
investors from different online sources publications provided by rating agencies. Quantitative
approach involves subjective analysis to investigate the risks such as using political polls or
news on political issues of a country.
Different political and economic factors are rated differently (Ochieng, 2012). The
ratings attached are combined into a singular unit with an intention of obtaining an overall
evaluation index of a country risk (Berka & Suleman, 2017).. This data can easily be got from
sources like economic publications, global news or eve other sources. In contrast, foreign
exchange volatility can be known by measuring the rate of exposure exchange rate changes that
can be grouped into three kinds that is; economic, translation and transaction exposure
(Ramautarsing, 2016). For the transaction, methods like ‘Value – at - Risk’ that uses volatility

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and currency correlations to find out the day’s optimum potential loss on the MNCs value to the
exchange rate volatility (Daniel et al, 2015).
The economic exposure can be obtained by applying the sensitivity of earnings to the
rates of exchange (Trinh & Nguyen, 2019). It needs comparing the changes in earnings to
fluctuations of currency which is done by creating a subjective forecasting of costs and revenues
of the firm’s ‘income statement’. Finally, translation exposure is based on factors like proportion
of the firm’s business that is carried out by foreign auxiliary, site for the foreign auxiliary and
also the methods of accounting used.
Both country risk and foreign exchange volatility can be solved by application of several
methods (Ramautarsing, 2016). For instance, MNCs may base on particular supplies or
technology and if its not treated well at any time, it can reduce or even stop supplies. It can also
decide to keep technology within its process of production, borrow local currency in case the
government has taken over the MNCs. This does create losses to subsidiaries and the home
country gets creditors. MNCs can chose to buy insurance so as to cover up several risks and
other political risks (Ochieng, 2012). On the other side, foreign exchange volatility can be done
away with by buying derivatives for example forwards, futures and options, increasing or
reducing the speed of payment of currencies anticipated to appreciate or depreciate respectively
and also increasing or reducing currencies anticipated to depreciate or appreciate respectively,
promoting invoicing in local currency among others (Berka & Suleman, 2017).
Conclusion
Conclusively, country risk and exchange rate volatility are related both positively and
negatively. They majorly affect foreign investors and MNCs and thus better methods should be

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selected to analyze and measure for their exposure. This will help companies come up with the
suitable solutions to the risks.
4. MNCs promote globalization. Is this a force for good or bad? Discuss
Globalization refers to the strong relationship and interdependence of countries all over
the globe. Multinational Corporations to a greater extent are seen promoting globalization and
therefore the force is a good one (Haller, 2016). The activities performed by multinational
companies indicate a positive impact on globalization and this paper provides some of the facts
that can back up this statement are indicated below;
MNCs do integrate markets. This is seen through the competition of these multinational
corporations with the local industries. However much the MNCs are operated from distant places
from the main company, they still produce similar quality or higher quality products as the local
producers (Irarrazaba et al, 2013). The operation of MNCs leads to exchange of commodities and
investments that encourages intergration among countries (Strielkowski et al, 2017). Also,
MNCs have led to the presence of commodities all over the world from any country. For
instance, corporations such as Hyundai and Ford in China which avail cars in the world, Apple
and Dell that avail computers, phones, laptops and many more to the entire world (Lee et al,
2013).
In addition, all countries all over the world are given a change to trade with others. In this
situation, developing countries such as those in parts of Asia, Africa and in South America
(Haller, 2016). Companies from these countries are allowed to establish their branches and
export their products to developed countries. Furthermore, labour movement has increased
globally where different workers of MNCs are seen moving from their home countries to operate

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in other countries where the company exists. This labour movement has brought about
improvement in both quality and quantity of commodities (Sophie & Dimitri, 2012). An example
is the movement of laborers from Indian Software Company to United States. In most cases,
MNCs target areas where there are ready markets and those with skilled or semi-skilled labour
with minimal costs according to their wish. Other factors essential for the growth of their
businesses are majorly considered too.
Foreign capital among countries has risen drastically due to establishment of
multinational corporations. This has promoted globalization in such a way that even developing
countries are able to develop due to the presence of capital from foreign countries. An example is
the General electric invest in India from abroad (Haller, 2016). This brings in capital for Indians
and its also a source of revenue to the Indian government. In addition, technological transfer is
observed among countries. Developed countries like Japan and United States are known for their
high-standardized technology (Whitaker et al, 2017). This technology has moved from these
economies down to the developing world hence globalization. For instance companies like
Samsung, TECNO, Dell, Apple and so on are seen in countries like India, Uganda, Kenya, South
Africa among others (Whitaker et al, 2017).
Products are developed wherever production facilities are set up in several countries.
MNCs link the local industries to larger markets. Some multinational corporations interact with
the local companies to achieve the best in the country (Sophie & Dimitri, 2012). Theses MNCs
favor local companies to sell their products all other the world through using their brand names.
Employment opportunities are generated for the people within the country leading to increased
standards of living and per capita income, relationships between the foreigners and the
inhabitants increases and this curbs segregation and many more.

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However, MNCs may promote globalization for the bad as discussed. Globalization may
be brought about with an intention of taking away the market from local industries (Irarrazaba et
al, 2013). This is very dangerous to the local country since it will remain backward well as the
foreign industries become known. The government may end up earning less revenue more so for
developing economies. Also, profit repatriation is likely to take place (Lee et al, 2013). This is
observed when all the workers employed by an MNC are foreigners and so whatever income the
company obtains is sent to the home country leaving the local country to suffer from a ‘capital
surge’.
In addition, MNCs may bring about machinery which do not favor social benefit to the
community where they are established or even over concentration of industries in a particular
area (Strielkowski et al, 2017). This in turn causes misunderstandings and wrangles between
MNCs owners and the local people. Pollution of the environment which may spark off several
diseases like cancer, heart diseases among others. Therefore, instead of creating globalization,
MNCs may cause ‘ bad relationships’ with countries they operate from (Sophie & Dimitri,
2012).
Conclusion
To wrap it all, Multinational Corporation splay an essential role to promote globalization
all over the world. This is done mainly through investments, labour movements and
technological movements. Large investments and increased research by MNCs brings about
globalization. In some instances, MNCs are doors to globalization of a country. The existence of
foreign companies in an economy gives a chance to local companies to interact with these MNCs
so that they are linked to the international market. Therefore, to some extent multinational

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corporations promote globalization especially for developing countries. On the other hand,
MNCs may have negative intention of creating globalization and this harms the economies
where they are established.
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