Problem: The International Financial Environment
Mesa Co. specializes in the production of small fancy picture frames, which are exported from the United States to the United Kingdom. Mesa invoices the exports in pounds and converts the pounds to dollars when they are received. The British demand for these frames is positively related to economic conditions in the United Kingdom. Assume that British inflation and interest rates are similar to the rates in the United States. Mesa believes that the U.S. balance-of-trade deficit from trade between the United States and the United Kingdom will adjust to changing prices between the two countries, while capital flows will adjust to interest rate differentials. Mesa believes that the value of the pound is very sensitive to changing international capital flows and is moderately sensitive to changing international trade flows. Mesa is considering the following information:
¦ The U.K. inflation rate is expected to decline, while the U.S. inflation rate is expected to rise
¦ British interest rates are expected to decline, while U.S. interest rates are expected to increase.
Questions:
1. Explain how the international trade flows should initially adjust in response to the changes in inflation (holding exchange rates constant). Explain how the international capital flows should adjust in response to the changes in interest rates (holding exchange rates constant).
2. Using the information provided, will Mesa expect the pound to appreciate or depreciate in the future? Explain.
3. Mesa believes international capital flows shift in response to changing interest rate differentials. Is there any reason why the changing interest rate differentials in this example will not necessarily cause international capital flows to change significantly? Explain.
4. Based on your answer to question 2, how would Mesa's cash flows be affected by the expected exchange rate movements? Explain.
5. Based on your answer to question 4, should Mesa consider hedging its exchange rate risk? If so, explain how it could hedge using forward contracts, futures contracts, and currency options.