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# INTERNATIONAL FINANCIAL MANAGEMENT

## SEMESTER JANUARY 2015

CLASS EXAMPLES ON ECU AND GOLD STANDARD
1.

Suppose the central rates within the ERM for the French franc and DM are FF
6.90403: ECU 1 and DM 2.05853: ECU 1, respectively.
a.

What is the cross-exchange rate between the franc and the DM?
Since things equal to the same thing are equal to each other, FF 6.90403
= DM2.05853. Hence, FF1 = DM2.05853/6.90403 = DM0.298164.
Equivalently, DM 1 = F6.90403/2.05853 = FF3.35386.

b. Under the original 2.25% margin on either side of the central rate, what
were the
approximate upper and lower intervention limits for France and
Germany?
Given the answer to part a, the French franc could rise to approximately
DM0.298164 x 1.0225 = DM0.304872 or fall as far as DM0.298164 x
0.9775 = DM0.291455. Similarly, the upper limit for the DM is FF3.42933
and the lower limit is FF3.27840.
a.

Under the revised 15% margin on either side of the central rate, what
are the current approximate upper and lower intervention limits for
France and Germany?
Given the answer to part a, the French franc could rise to approximately
DM0.298164 x 1.15 = DM0.342888 or fall as far as DM2.98164 x 0.85 =
DM 0.253439. Similarly, the upper limit for the DM is FF3.85694 and the
lower limit is FF2.85078.

2.

Suppose that the pound is pegged to gold at 7 pounds per ounce, whereas
the franc is pegged to gold at 14 francs per ounce. This, of course, implies
that the equilibrium exchange rate should be two francs per pound. If the
current market exchange rate is 2.3 francs per pound, how would you take
advantage of this situation? What would be the effect of shipping costs?

## First determine which currency is undervalued and which one is overvalued.

Then use the
undervalued currency to purchase the overvalued currency in
order to be profitable.
1 ounce of gold in U.K. is 7 while 1 ounce of gold in France is Ffr14. Under
the gold standard, the cross rate is Ffr2 = 1 (Ffr14/7). But, the exchange rate is
Ffr2.3 = 1. Meaning the value of
francs has been lowered (devalued) since the
exchange need Ffr2.3 to get 1 instead of Ffr2 as indicated by the gold standard
i.e. more francs is required to acquire 1 by the exchange. So, the
undervalued
currency is the francs and the overvalued currency the . To make the situation
profitable, you can buy gold using francs and sell the gold to get .

If you go to the exchange, you have to pay Ffr2.3 to get your 1. So, buy I
ounce of gold in
France for Ffr14, take it to U.K and sell for 7. By doing this you
pay Ffr2 to get 1 (FFr14/7),
instead of FFr2.3 at the exchange. You save Ffr0.3.
Note, you buy with the undervalued
currency (Ffr) and sell to get the overvalued
currency ()
However, such profit can only be achieved if there is no transportation cost.
The transportation cost cannot be equal or greater than Ffr0.3 to make the effort
profitable. If the transportation cost is Ffr0.3, then there is no difference in the two
options that you have i.e. going to the exchange or buying gold in France and sell in
U.K.
3.

Suppose that Britain pegs the pound to gold at the market price of 6 per
ounce, and the United States pegs the dollar to gold at the market price of
\$36 per ounce. If the official exchange rate between pounds and U.S. dollars
is \$5 = 1. What action should be taken to make the trade profitable?
The same as Q2, first determine which currency is undervalued and which
one is overvalued. Then use the undervalued currency to purchase the
overvalued currency in order to be profitable.
In this case, 1 ounce of gold in U.K. is 6 while 1 ounce of gold in U.S. is \$36. .
Under the gold standard, the cross rate is \$6 = 1 (\$36/6). But, the
exchange rate is \$5 = 1. Meaning the value of pound has been lowered
(devalued) since the exchange need \$5 to get 1 instead of \$6 as indicated
by the gold standard i.e. lower US\$ is required to acquire 1 by the exchange.
So, the undervalued currency is the and the overvalued currency the US\$ To
make the situation profitable, you can buy gold using and sell the gold to
get US\$
At the exchange you get \$5 for 1 (\$5 = 1). So, buy gold with and cost
you 6. Take the gold to the U.S. and sell it for \$36. Now your rate is \$6 for 1
(\$36/6). So, by buying gold using and selling it for US\$, you get US\$1
extra. Note, you buy with the undervalued currency () and sell to get the
overvalued currency (US\$)