Question Details

The International Financial Environment 


The International Financial Environment 
Mesa Company specializes in the production of small fancy picture frames, which are exported from
the U.S. 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 U.S. Mesa believes that the U.S. balance-of-trade deficit from trade between the U.S. 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 international trade flows. Mesa is
considering the following information:
• The U.K. inflation rate is expected to decline, while U.S. inflation rate is expected to rise.
• British interest rates are expected to decline, while U.S. interest rates are expected to increase.
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- 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.




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