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to Answers Assignment# 3 Chapter 6 14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages? View Full Document

freely floating currency may allow the exchange rate to adjust to market conditions, which can stabilize flows of funds between countries. If there is a larger amount of funds going out versus coming in, the exchange rate will weaken due to the forces and the flows may change because the currency has become cheaper; this discourages further outflows. Yet, a disadvantage is that speculators may take positions that force a freely floating currency to deviate far from what is perceived to be a desirable exchange rate. Chapter 7 2. Locational Arbitrage. Assume the following information: Bid price of New Zealand dollar Ask price of New Zealand dollar Beal Bank $.401 $.404 Yardley Bank $.398 $.400 Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of locational arbitrage? ANSWER: Yes! One could purchase New Zealand dollars at Yardley Bank for $.400 and sell them to Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby generating a profit of $2,500. The large demand for New Zealand dollars at Yardley Bank will force this banks ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial. 4. Triangular Arbitrage. Assume the following information: Value of Canadian dollar in U.S. dollars Value of New Zealand dollar in U.S. dollars Value of Canadian dollar in New Zealand dollars Quoted Price $.90 $.30 NZ$3.02 Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage? ANSWER: Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand dollars. Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what it should be. One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this strategy would generate $1,006,667 thereby representing a profit of $6,667. [$1,000,000/$.90 = C$1,111,111 3.02 = NZ$3,355,556 $.30 = $1,006,667] The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the Canadian dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the U.S. dollar would fall. 6. Covered Interest Arbitrage. Assume the following information: Spot rate of Canadian dollar 90day forward rate of Canadian dollar 90day Canadian interest rate 90day U.S. interest rate Quoted Price $.80 $.79 4% 2.5% Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage? ANSWER: $1,000,000/$.80 = C$1,250,000 (1.04) = C$1,300,000 $.79 = $1,027,000 Yield = ($1,027,000 $1,000,000)/$1,000,000 = 2.7%, which exceeds the yield in the U.S. over the 90day period. The Canadian dollars spot rate should rise, and its forward rate should fall; in addition, the Canadian interest rate may fall and the U.S. interest rate may Covered rise. 22. Interest Arbitrage in Both Directions. The following information is available: You have $500,000 to invest The current spot rate of the Moroccan dirham is $.110. The 60-day forward rate of the Moroccan dirham is $.108. The 60-day interest rate in the U.S. is 1 percent. The 60-day interest rate in Morocco is 2 percent. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest arbitrage work for the investor in this case? a. Would covered interest arbitrage be possible for a Moroccan investor in this case? b. Covered interest arbitrage would involve the following steps: 1. Convert dollars to Moroccan dirham: $500,000/$.110 = MD4,545,454.55 2. Deposit the dirham in a Moroccan bank for 60 days. You will have MD4,545,454.55 (1.02) = MD4,636,363.64 in 60 days. 3. In 60 days, convert the dirham back to dollars at the forward rate and receive MD4,636,363.64 $.108 = $500,727.27 The yield to the U.S. investor is $500,727.27/$500,000 1 = .15%. Covered interest arbitrage did not work for the investor in this case. The lower Moroccan forward rate more than offsets the higher interest rate in Morocco. b. Yes, covered interest arbitrage would be possible for a Moroccan investor. The investor would convert dirham to dollars, invest the dollars at a 1 percent interest rate in the U.S., and sell the dollars forward 60 days. Even though the Moroccan investor would earn an interest rate that is 1 percent lower in the U.S., the forward rate discount of the dirham more than offsets that differential. Chapter 8 2. Rationale of PPP. Explain the rationale of the PPP theory. ANSWER: When inflation is high in a particular country, foreign demand for goods in that country will decrease. In addition, that countrys demand for foreign goods should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that a foreign countrys goods are no more attractive than the home countrys goods. Inflation differentials are offset by exchange rate changes. 14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for oneyear securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. ANSWER: If investors from the U.S. and Mexico required the same real (inflationadjusted) return, then any difference in nominal interest rates is due to differences in expected inflation. Thus, the inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate. According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact formula, since the concept is stressed here more than precision.) 16. Changes in Inflation. Assume that the inflation rate in Brazil is expected to increase substantially. How will this affect Brazils nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the higher inflation in Brazil? Explain. ANSWER: Brazils nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. If the IFE holds, the return to U.S. investors who invest in Brazil would not be affected. Even though they now earn a higher nominal interest rate, the expected decline in the Brazilian real offsets the additional interest to be earned. ********** ...