460SP2010midterm - Economics 460 Suggested Answers Midterm...

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Unformatted text preview: Economics 460 Suggested Answers Midterm 1. Definitions: Define in no more than two sentences [our of the following concepts. (28 points) 1. Official reserves are stocks of foreign currencies held by the central bank. They are used for interventions in the foreign exchange market designed to influence the value of the spot exchange rate. 2. The cross rate is the exchange rate implicit in two exchange rates including a common currency. For example, if the Euro exchange rate with Swiss Francs is 0.5, and the Euro exchange rate with US dollars is 0.7, then the Swiss cross exchange rate with US dollars is (0.7/0.5) = 1.4. 3. The par value of a currency is the price of that currency in terms of a second currency or of gold. It is set by the central bank, and is one of the “rules of the game” for a fixed exchange rate regime. 4. Autonomous expenditures are expenditures that do not vary as national income varies. In our derivation of the IS curve, we considered investment, exports and government expenditures as autonomous expenditures. 5. Purchasing power parity exists between two countries when a given market basket of goods and services has the same exchange-rate adjusted price in both countries. This is a property of the exchange rate that is typically only observed in the long run (if at all). 11. Short answers. Answer two of the following questions. using references to readings where appropriate and diagrams where helpful. (72 points) I. You were free to agree, or not, with the CFO. His options contract strategy is a combination of hedging and speculation. Hedging is the use of transactions in financial markets to eliminate the risk due to future exchange-rate movements. The options contract eliminates the possibility of downside risk (lowered profits in the instance of Euro appreciation relative to the US dollar). Speculation is the activity of buying and selling financial contracts to earn a risky profit. With an option contract, Michelin is keeping the upside profit opportunity (increased profits in the instance of Euro depreciation). With an options contract, Michelin has the right not to complete the transaction should it be more profitable not to do so. In the case of substantial Euro depreciation it will choose not to do so. Any options contract is more expensive than a forward contract at the same exchange rate, because with an options contract the seller (in this case) bears all the downside risk while gaining nothing on the upside. This options contract is especially expensive because the CFO has locked in a European exchange rate strongly depreciated relative to today’s. (Remember, the CEO was worried about an appreciated European exchange rate.) There is in effect more than 3 percent profit built in to the exercise price relative to today’s rate. The seller seems to have Midterm: Economics 460 - 2 recouped that profit in the fee. You could come up with many alternatives. One would be an options contract with 1.4 exercise price - that should have a lower fee, because less profit is built into it for Michelin. Another would be a forward contract. These are less expensive, because the contract is always honored — there is no transfer of risk disproportionately to the seller. You could also suggest pure speculation: do nothing, and wait to see what the future exchange rate will be. That has no cost, but the most risk. 2. The nominal interest rates cited are not equal, but they do not need to be to satisfy covered interest parity. Covered interest parity is the condition on interest rates, spot and forward exchange rate that precludes arbitrage profits: (1+iU) = (1+i ;)(e1r/eo), with iU the US interest rate, i 1 the Japanese interest rate, eo the spot exchange rate for yen and elrthe (10-year) forward rate for yen. Even if the interest rates are not equal, the ratio of forward to spot rate can exactly offset the difference to assure covered interest parity. The forward rate is a crucial part of covered interest parity, in what it eliminates risk and makes arbitrage possible. You could also respond to the question by indicating that 10-year forward exchange rates are not generally available, and certainly not in Ghanaian currency (the cedi). If Ghana introduces a fixed exchange rate, its central bank must do two things. First, it must choose a par value of cedis for US dollars. Second, it must stand ready to buy and sell US dollars without limit from sellers and to purchasers at that par value. If the Ghanaian central bank is successful, investors will infer from the fixed exchange rate that the exchange rate ratio in the covered interest parity equation is equal to one. Thus, the Ghanaian and US interest rates will become equal. Given the relative sizes of the countries, it is likely that the US interest rate will stay the same and the Ghanaian interest rate will fall until it is equal to the US interest rate. 3. Krugman’s thesis can be translated as follows: the elimination of capital inflow caused a deficit in the official reserves transaction balance. Since Spain is a member of the Euro zone, it has a fixed rate with other European countries. This led to reduction in Euros in circulation in Spain and contraction in production. (This occurred, in his analysis, because of the high consumer prices supported during the housing bubble by the capital inflows to purchase vacation homes.) Unfortunately, the automatic adjustment necessary here is the price reduction forecast by the price-specie flow for deficitary countries — and that can take years to occur. illidlerm: Economics 460 - 3 IMP/m? 7:. Krugman thought that Spain would be much better off with a flexible exchange rate, since depreciation of that rate would solve its problems with internal balance. (He also said, though, that he thought that leaving the Euro at this time would be impractical.) If it remains in the Eurozone, its only policy option to re-establish internal balance is expansionary fiscal policy. This will raise employment through autonomous spending. It will also put upward pressure on bond interest rates, thus attracting capital flows from the rest of the Eurozone to invest in those higher-return bonds. Those flows will increase the “money supply” in circulation in Spain in a way analogous to the monetary effect under a fixed exchange rate. Grade Distribution 96 - loo 0 91 — 95 4 86 — 90 8 Mean: 80 81 - 85 11 Median: 82 76 — 80 0 71 - 75 4 61 — 70 5 0 — 60 2 Missed the exam 6 Total 40 ...
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This note was uploaded on 05/01/2010 for the course ECON 460 taught by Professor Staff during the Spring '08 term at UNC.

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460SP2010midterm - Economics 460 Suggested Answers Midterm...

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