Real Life Economic Problems

Scenario 1

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Exchange rate

Dollars to Euro
0.7

1 million Euros equals
1.428571
Million dollars

Irish Bank @ 2%
1.02
million euro

US Bank @ 4%
1.485714
million dollars

US Bank in euros
1.04
million euro

The exchange rate in the US is big enough to translate a savings amount of 1.04 million Euro in total after the dollar has been converted back into Euro. It is advisable then to take the cash to US to earn interest rather than let it earn interest in an Irish bank. The initial situation where the exchange rate is 0.7 euro to 1 dollar, the resulting dollar taken home would be \$1.42 million dollars. It is a good idea to let the winnings stay in Ireland if you happen to believe that the dollar would depreciate even more after one year.

Scenario 2

Exchange rate

Dollars to Euro
0.65

1 million Euros equals
1.538462
Million dollars

At the end of the year after the exchange rate has changed to 0.65, it would be a better decision to take the winnings back home to the US because the resulting dollar amount is bigger than before. The winnings would now be valued at \$1.54 million dollars. In the second situation, it is a better idea to take all of the money back to the US to take advantage of the bigger dollar amount gained. The only there could still be some foreign exchange rate risk is when the interest paid for the financial instrument occurs more than once (Revsine, 2004). The company then eliminates the risk of foreign exchange by selling the income derived from forward contracts. The company has to do this carefully because they might end up with more risks if not executed properly.

Inflation means the amount of value lost by a currency by the amount of price increases of goods and services over a period of time. The salary and income of employees stay the same but the prices of the goods they buy are steadily increasing. In effect, they are actually losing money. The theory of purchasing power parity explains the capacity of a nation’s currency to buy a comparable basket of goods from another country. The amount of purchase an average consumer can buy with a fixed amount of money is the purchasing power parity. The rate of changes in the price of goods that exist between different countries is PPP (Bodie, 1999). The inflation rate naturally impacts the PPP because the inflation rate is not equal among different countries. The price of goods in one country increases and decreases differently from another country and PPP reflects that rate of changes. Based on the theory of PPP, the inflation between Ireland and USA is not equal.

The USA displays a higher interest rate for its cash bonds because investors think it is the fair rate at which they should be compensated in order to profit. All savvy investors factor in inflation when calculating for their investments. We can infer therefore that the bigger the interest rate an investment has to pay an investor, the bigger the inflation rate that country is experiencing. In this case, The US appears to have a bigger inflation rate if we are to base our analysis from the theory of PPP. The prices of all goods and services are the same. The only difference is the currency in which it is expressed. The PPP therefore is in indication of the inflation of countries as well because of the close relationship between the two index rates.
It is not totally accurate to analyze the situation based on PPP alone. If we are to exclude PPP in our analysis, the individual who won the lottery should invest it in the USA simply because they have a higher interest rate offered. Even if we are to factor in the exchange rate difference, the interest rate would still provide a bigger return for the investor. The inflation rates as well as the interest rate on the investment should be considered well by the investor to determine the best possible option (Bruner, 1998). The interest rate should be bigger than the inflation rate of a given country in order for the investor to make money. The second thing an investor has to consider is the implied interest rate of return after it has been deducted with inflation. The investor can now compare the adjusted interest rate on the investment with other adjusted rates of investment from other countries. The one with the bigger remaining interest rate naturally is the one profitable for the investor.

The individual that won the lottery will be assured of getting the most out of his money if he is to invest it in a financial instrument that outpaces inflation. It does not matter what currency he chooses to deal with as long as rate of returns on the investment is the biggest he can possibly find. It is assumed that there are no taxes to be paid as well as well as other custom duties regarding the lottery win. The investment vehicle is also assumed to be safe from potential default. The resulting investment returns can then be analyzed for its worth after it has already been adjusted for inflation. The exchange rate is a simple matter of translating the currency to the next currency the investor intends to use for personal usage. All of this should be done in order to paint a complete picture of the situation. It is necessary for the investor to see all the angles regarding the lottery winnings to ensure he arrives at the best possible decision when handling it.

References:

Revsine, (2004), “Financial Analysis and Reporting”,

New York, Pearson Hall

Bodie et al (1999), “Investments”,

New York: Irwin-McGraw-Hill.

Bruner, Robert F. (1998). Case Studies in Finance: Managing for Corporate Value Creation, New York: Irwin McGraw-Hill