Mensah Co. is a Ghanaian firm based in the US that specializes in the production of small fancy

picture frames, which are exported from the United States to the United Kingdom. Mensah Co.

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 UK. Assume

that British inflation and interest rates are similar to the rates in the United States. Mensah Co.

believes that the US balance of trade deficit from trade between the US and the UK will adjust to

changing prices between the two countries, while capital flows will adjust to interest rate

differentials. Mensah Co. believes that the value of the pound is very sensitive to changing

international capital flows and is moderately sensitive to changing international trade flows.

Mensah Co. is considering the following information:

The UK inflation rate is expected to decline, while the US inflation rate is expected to rise.

British interest rates are expected to decline, while US 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 exchanges rates constant).

2. Using the information provided, will Mensah Co. expect the pound to appreciate or

depreciate in the future? Explain.

3. Mensah Co. 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 Mensah Co.'s cash flows be affected by

the expected exchange rate movements? Explain.

5. Based on your answer to question 4, should Mensah Co. consider hedging its exchange rate

risk? If so, explain how it could hedge using forward contracts, futures contracts, and

currency options.