Suppose The CFO Of An American Corporation With Surplus Cash

Suppose The Cfo Of An American Corporation With Surplus Cash Flow H

Suppose the CFO of an American corporation with surplus cash flow had $50 million to invest on March 20, 2015, and the corporation did not believe it would need to utilize these funds to retool or expand production capacity for one year. The interest rate on one-year CD deposits in US banks was 1%, while the rate on one-year CD deposits in England (denominated in British Pounds) was 2%. The exchange rate at that time was $1.55 per British Pound. A year later, the exchange rate was $1.42 per British Pound. What rate of return did the CFO earn on the investment in the British CD? What must the CFO have expected about the value of the British Pound in dollars today to believe that investing in one-year British CDs was more profitable than US CDs?

Between February 2008 and Summer 2009, the Federal Reserve expanded its open market operations with direct lending to various financial institutions, broader collateral acceptance, and a program to buy commercial paper. Explain why the Fed created these extraordinary lending facilities instead of relying solely on traditional open market purchases of Treasury securities from commercial banks.

From 2009 onward, the Fed increased purchases of long-term mortgage-backed securities and Treasury notes, resulting in a substantial accumulation of excess reserves in commercial banks. As the Fed begins to raise the federal funds rate, what potential problems could the backlog of excess reserves cause, and what relatively untested policy tools might help the Fed address these issues?

In early 2016, signs of global economic slowdown and low-interest rates in other countries led to policies that reduced interest rates outside the US. The US economy, however, showed resilience, prompting the Fed to consider raising interest rates. What impact would a planned increase in the Federal Funds Rate have on the USD exchange rate? Should US policymakers favor a stronger or weaker dollar at this point? Discuss the advantages and disadvantages of each scenario considering the US economic conditions.

According to the Federal Reserve's recent statement, the FOMC considers a wide range of economic indicators to decide on the timing of rate increases, especially given the inflation shortfall from 2%. Why are indicators such as labor market conditions, inflation expectations, and international developments important in this decision-making process? How do market expectations of inflation influence the timing of rate hikes?

Since 2010, Republican policymakers have argued for rapid fiscal tightening through tax cuts and spending reductions to balance the budget. Why is it problematic to attempt balancing the federal budget immediately via these measures at present? Does the argument against quick balancing imply that budget deficits are benign over the long term? Why or why not?

Paper For Above instruction

The scenario involving the CFO's investment in UK and US CDs highlights the importance of understanding not only nominal interest rates but also the effects of exchange rate fluctuations on international investments. This case exemplifies the concept of foreign exchange risk and the need for foreign exchange expectations in investment decisions. In March 2015, the US interest rate was 1%, while the UK rate was 2%, with an initial exchange rate of $1.55/£. A year later, the exchange rate depreciated to $1.42/£, affecting the investment return.

To calculate the rate of return in foreign currency terms, the CFO must account for both interest earned and changes in exchange rate. The initial amount invested in the UK was equivalent to $50 million / $1.55/£ ≈ 32.26 million GBP. After one year, the amount in GBP grew by 2%, so the gross interest earnings in GBP were 32.26 million × 2% ≈ 0.645 million GBP, totaling about 32.905 million GBP. Converting back at the new exchange rate of $1.42/£, the final USD value is 32.905 million × $1.42 ≈ $46.74 million. Therefore, the overall return is ($46.74 million - $50 million) / $50 million ≈ -6.52%. The negative return indicates a loss when considering both interest earnings and exchange rate depreciation.

The expected future value of the British pound in USD that would make the UK investment more attractive than US options depends on the initial interest rate differential and currency expectations. Typically, this involves the concept of covered interest parity, which states that the forward exchange rate should reflect the interest rate differential between two currencies. For the UK investment to be preferred, the expected future exchange rate must be higher than the forward rate implied by interest rates, indicating that the market anticipates the GBP to appreciate or at least depreciate less than the interest rate differential would suggest. Formally, the expected future exchange rate (E[S]) would need to satisfy the inequality where the risk-adjusted return on UK CDs exceeds US CDs, factoring in possible currency appreciation.

During the financial crisis (2008-2009), the Fed employed unconventional tools like direct lending facilities because traditional open market operations—purchasing Treasury securities—were insufficient to address the liquidity shortages and to stabilize financial institutions. The crisis exposed the vulnerabilities of the banking system, with many banks hesitant to lend, creating a credit crunch. By providing direct loans to banks, brokerages, and other financial intermediaries, the Fed aimed to restore confidence, address short-term liquidity needs, and prevent a collapse of the financial system. These measures served as emergency liquidity facilities to bridge the gap created by the disruption of normal market functioning, which traditional open market operations could not fully remedy.

From 2009 onward, the Fed's quantitative easing (QE) policies significantly increased the monetary base, leading to a buildup of excess reserves in banks. As the Fed decided to normalize monetary policy by raising interest rates, these large reserves posed potential challenges, such as the risk of inflationary pressures if banks begin lending aggressively or the difficulty in managing the transition from an accommodative to a restrictive policy stance. The excess reserves got stuck in the banking system, reducing the effectiveness of traditional policy tools and complicating the control of short-term interest rates. To manage this issue, the Fed can utilize relatively untested tools such as paying interest on excess reserves (IOER) at the policy rate, implementing overnight reverse repurchase agreements (ON RRP), and gradually reducing the size of its balance sheet—a process known as balance sheet normalization. These tools help keep the short-term interest rates aligned with the target rate and control liquidity in the system without injecting excessive reserves into banks.

The expected impact of raising the Federal Funds Rate on the USD exchange rate depends on market perceptions of monetary policy and economic outlook. An increase in US interest rates tends to attract foreign capital seeking higher returns, leading to an appreciation of the USD. This potentially reduces US exports and makes imports cheaper, influencing the trade balance. Given the US's improving economic fundamentals—such as employment and housing recovery—policy makers might prefer a stronger dollar to control inflation and support the Fed's inflation target. However, a too-strong dollar could harm export competitiveness and exacerbate trade deficits. Conversely, a weaker dollar could boost exports, support US manufacturing, and help close the output gap. Therefore, policymakers must weigh inflation concerns against growth objectives when considering currency strength.

The Fed’s consideration of indicators like labor market conditions, inflation expectations, and international developments stems from their critical influence on inflation and economic growth forecasts. Labor market tightness affects wage pressures, which can influence inflation. Inflation expectations help determine whether actual inflation will accelerate or decelerate, impacting the appropriate timing of rate hikes. International developments, such as global economic slowdown and currency policies, influence US trade, capital flows, and financial stability. Market expectations of inflation act as a self-fulfilling prophecy; if markets expect higher future inflation, they may demand higher interest rates today, prompting the Fed to act preemptively. Thus, assessing both current and expected conditions ensures monetary policy maintains its credibility and effectiveness without provoking unnecessary market volatility.

The debate over immediate fiscal tightening reflects a trade-off between short-term stabilization and long-term sustainability. Rapidly balancing the budget via large tax cuts or austerity may hinder economic growth, especially during a recovery phase, by reducing aggregate demand (AD). Cuts in government spending or increases in taxes can dampen economic activity, leading to higher unemployment and lower output. On the other hand, proponents argue that future fiscal discipline prevents deficits from spiraling out of control. While the Republican argument emphasizes long-term sustainability, executing swift fiscal consolidation in a fragile recovery could stifle growth, increase debt burdens, and lead to social and political instability. Therefore, a balanced approach that promotes sustainable growth while gradually addressing deficits is essential.

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