chapter 12 - problems

chapter 12 - problems - QUICK QUIZ 1. The exchange rate is...

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Unformatted text preview: QUICK QUIZ 1. The exchange rate is (a) the relative price at which one good (e.g., wheat) can be exchanged for another good (e.g., corn). (b) the transaction fee that banks charge for exchanging one currency for another. (c) the difference between the money price of a good and the relative price of that same good. (d) the price of one currency expressed in terms of another currency. (e) the difference between the spot price and the forward price of a currency. (f) the difference between interest rates on assets denominated in different currencies. 2. Country A's currency is the alpha; and country B's currency is the beta. Other things being equal, when the alpha price of a beta rises (a) Country A's goods and services become more expensive relative to country B's. (b) Country B 's goods and services become more expensive relative to country A's. (c) buyers shift away from country B's goods toward country A's. (d) buyers shift away from country A's goods toward country B's. (e)(b) and (c). ∙ (f) (a) and (d). 3. Which of the following sets of exchange rates among the dollar, the yen, and the pound, is consistent? ∙ (a) $1/¥1 00; $2/£1; ¥100/£1. (b) $1/¥200; $2/£1; ¥400/£1. (c) $1/¥200; $2/£ I; ¥3 00/£1. (d) $1/¥1 00; $3/£1; ¥200/£1. (e) $1/¥200; $2/£1;¥100/£1. (f) $1/¥200; $2/£1;¥200/£1. 4. Differences between uncovered and covered interest parity include (a) uncovered parity reflects arbitrage activity that uses forward markets to hedge exchange‐rate risk. (b) covered parity reflects arbitrage activity that uses forward markets to hedge exchange‐rate risk. (c) uncovered parity is more easily testable because it includes only observable variables. (d) uncovered parity is an equilibrium condition, while covered parity is not. (e) (a), (c), and (d). (f) none of the above; the two conditions ar~ equivalent. 5. Interest parity coincides with (a) equal expected rates of return on deposits denominated in different currencies. (b) an interest differential between currencies that matches the forward premium. (c) equilibrium in the foreign exchange market. (d) equilibrium in the balance of payments. (e) an interest differential between currencies that matches the expected rate of appreciation or depreciation. (f) all of the above. 6. Which of the following list of events would be expected to increase demand for yen‐denominated deposits? (a) a rise in the interest rate on dollar‐denominated deposits, a fall in the interest rate on yen‐ denominated deposits, a fall in the expected future spot price of yen, a fall in the forward price of yen. (b) a fall in the interest rate on dollar‐denominated deposits, a rise in the interest rate on yen‐ denominated deposits, a fall in the expected future spot price of yen, a fall in the forward price of yen. (c) a rise in the interest rate on dollar‐denominated deposits, a fall in the interest rate on yen‐ denominated deposits, a rise in the expected future spot price of yen, a rise in the forward price of yen. (d) a fall in the interest rate on dollar‐denominated deposits, a fall in the interest rate on yen‐ denominated deposits, a rise in the expected future spot price of yen, a fall in the forward price of yen. (e) a rise in the interest rate on dollar‐denominated deposits, a rise in the interest rate on yen‐ denominated deposits, a fall in the expected future spot price of yen, a rise in the forward price of yen. (f) a fall in the interest rate on dollar‐denominated deposits, a rise in the interest rate on yen‐ denominated deposits, a rise in the expected future spot price ofyen, arise in the forward price of yen. 7. Under a flexible exchange rate regime, an increase in demand for pound‐denominated deposits leads to (a) a depreciation of the pound. (b) an appreciation of the pound. (c) an increase in the supply of pound‐denominated deposits. (d) a decrease in the supply of pound‐denominated deposits. (e) intervention in the foreign exchange market by the central bank. (f) (b) and (c). 8. Under a fixed exchange rate regime, an increase in demand for pound‐denominated deposits leads to (a) a depreciation of the pound. (b) an appreciation of the pound. (c) an increase in the demand for dollar‐denominated deposits. (d) a decrease in the supply of pound‐denominated deposits. (e) intervention in the foreign exchange market by the central bank. (f) (b) and (c). 9. A rise in e = $/£ is referred to as (a) an appreciation of the dollar under a flexible rate regime or a revaluation of the dollar under a fixed rate regime. (b) a depreciation of the dollar under a flexible rate regime or a devaluation of the dollar under a fixed rate regime. (c) an appreciation of the dollar under a fixed rate regime or a revaluation ofthe dollar under a flexible rate regime. (d) a depreciation of the dollar under a fixed rate regime or a devaluation of the dollar under a flexible rate regime. (e) a depreciation of the pound under a flexible rate regime or a devaluation of the pound under a fixed rate regime. (f) a depreciation of the pound under a fixed rate regime or a devaluation of the pound under a flexible rate regime. 10. Other things being equal, under a fixed exchange rate, persistent expectations that a currency will be devalued are likely to lead to (a) a revaluation of that currency. (b) no change in the exchange rate. (c) an appreciation of that currency. (d) a devaluation of that currency. (e) a depreciation of that currency. (f) an increase in demand for that currency. ANSWERS TO QUICK QUIZ 1. d. 2. e. 3. b. 4. b. 5. f. 6. f. 7. b. 8. e. 9. b. 10. d. PROBLEMS AND QUESTIONS FOR REVIEW 1. Assume that interest rates on 30‐day assets denominated in dollars (i$) and in yen (i¥) are the same and that the spot and 30‐day forward exchange rates are equal at $1/¥130. Now suppose that the interest rate on one of the two types of assets rises. After a few hours, the spot exchange rate has moved to $1/¥120 and the 30‐day forward rate has moved to $1/¥140. Assume that the differential between the spot and forward rates is due solely to interest arbitrage. (a) Did the interest rate rise on dollar‐denominated assets or on yen‐denominated assets? (b) Explain your answer to (a). 2. Prior to introduction of the euro, assume that you faced the following spot exchange rates: $1/4 French francs (FF), $1/3 Deutsche marks (DM), and DM1/FF2. (a) Starting with dollars, describe the trades you would have undertaken as an arbitrageur. (b) How much profit would you have made on the first $1 of arbitrage (ignoring transaction costs)? (c) When all the gains from arbitrage had been exhausted, would the dollar price of DM have been higher or lower? Would the dollar price of francs have been higher or lower? Would the franc price of DM have been higher or lower? Why? (d) What condition in foreign exchange markets is guaranteed by this triangular arbitrage? 3. Suppose that you manage an asset portfolio and are currently satisfied with the portfolio's composition. (a) What changes might you make in the portfolio if the forward dollar price of the pound were to fall? Why? (b) What would happen to the spot exchange rate between dollars and pounds as a result of your action? Why? (c) What relationship between interest rates and exchange rates is enforced by this type of arbitrage? 4. Suppose you work for the International Monetary Fund and are responsible for monitoring the policies of a small country that has borrowed from the Fund because of serious debt problems. The Fund's recommendation to the small country is to peg its exchange rate at the equilibrium level. You observe that the foreign exchange reserves of the country's central bank are falling rapidly. What might you conclude about the extent to which the country is following the Fund's recommendation? Why? 5. How might the degree of flexibility of a country's exchange rate affect the amount of foreign exchange reserves the country would choose to hold? Why? 6. Distinguish between the terms in each pair: (a) Bilateral exchange rate and effective exchange rate (b) Appreciation and revaluation (c) Depreciation and devaluation (d) Flexible exchange rate regime and fixed exchange rate regime 7. As a central bank intervening in the foreign exchange market, which would you expect to be able to maintain longer: (1) intervention to support an exchange rate above equilibrium (the exchange rate is the price of foreign exchange in terms of your domestic currency), or (2) intervention to support an exchange rate below equilibrium? Why? 8. A leather briefcase costs $100 in New York, while a comparable briefcase costs £50 in London. Which briefcase would you buy if the exchange rate were $1.90/£1? If the exchange rate were $2.00/£1? If the exchange rate were $2.10/£1? In each case, what effect would your action have on the demand for briefcases in New York and London? On the price of briefcases in New York and London? 11. A Mexican firm owes $1 million to a U.S. firm for imported goods. The bill must be paid in dollars within 60 days. What are the various methods facing the Mexican firm for obtaining the dollars? How would the firm make its decision concerning which to use? In what sense does this international trade transaction involve an asset decision? 12. Assume the interest rate on euro‐denominated assets is .05 and the interest rate on comparable dollar denominated assets is .10. The forward exchange rate is $1.05/euro1, and the spot exchange rate is $1/euro1. (a) You are the owner of an asset portfolio and are unwilling to bear exchange rate risk; are you satisfied with the current allocation of your portfolio between dollar‐denominated and euro‐denominated assets? . Why, or why not? (b) If the forward rate were to fall to $1/eurol, what adjustment, if any, would you make in your portfolio? Why? (c) What would be the effect of your action (or inaction) in part (b) on the spot exchange rate between dollars and euros? 13. Assume the interest rate on US$‐denominated assets maturing in five years is 30% for the entire period and the interest rate on comparable Canadian dollar (Can$) denominated assets is 5%. The spot exchange rate between the US$ and the Can$ is 0.8, defined as the US$ price of a Can$. (a) You are the owner of a portfolio, and you never use forward contracts to cover foreign exchange risk. You expect that five years from today, the spot exchange rate will be US$1 /Can$ 1 . Are you satisfied with the current allocation of your portfolio between US$‐denominated and Can$‐denominated assets? Why, or why not? (b) If your expectation today (ee) of the spot exchange rate in five years were to change from US$1/Can$1 to US$0.90/Can$1, what adjustment, if any, would you make in your portfolio? Why? (c) Assume that everyone shared your change in expectations. What would be the effect of your answer to part (b) on the spot exchange rate? Why? 14. Triangular arbitrage in foreign exchange markets produces consistent cross exchange rates. Suppose the exchange rate between pounds and euros is £1/euro1, the exchange rate between euros and dollars is $1/euro1, and the exchange rate between pounds and dollars is $2/£1. (a) Are these rates consistent? Why, or why not? (b) If you had $ 100 to use in arbitraging these markets, could you make a profit (ignoring transaction costs)? If so, how, and how much? (c) What would be the direction of the effect of your actions in part (b) on each of the three exchange rates? Why? ANSWERS TO PROBLEMS AND QUESTIONS FOR REVIEW 1. (a) The interest rate on yen‐denominated assets rose. (b) The dollar price of yen (e) rises from $1/¥130 to $1/¥120. Using the expression for covered interest parity in Equation 6, this would be consistent with a move to purchase yen‐denominated assets; therefore, the interest rate on yen‐denominated assets rose. 2. (a) Use $1 to buy DM3, then buy F6, then buy $1.50. (b) Profit would be 50%, or $0.50 on a $1 transaction. (c) The dollar price of DM will be higher, the dollar price of francs lower, and the franc price of DM lower. These changes in the exchange rates result from the arbitrage transactions outlined in (a). (d) $/DM = $1¥ ∙ F/DM. 3. (a) Using the covered interest parity condition, you would shift funds toward dollar‐denominated assets. The fall in the forward exchange rate implies that fewer dollars could b({ obtained with the future proceeds of any pound‐denominated asset. Therefore, dollar‐denominated assets become relatively more attractive. (b) The spot dollar price of pounds would fall due to the arbitrage described in (a). (c) Covered interest parity (Equation 6) is enforced by this type of arbitrage. 4. The rapid loss of foreign exchange reserves suggests that the central bank of the country is engaging in large sales of foreign currency. The country's domestic currency price of foreign currency is below equilibrium, creating a shortage of foreign exchange that is being satisfied through the sale of reserves. The country is, therefore, not following the Fund's recommendation to peg the exchange rate at the equilibrium level. 5. Other things equal, the greater the degree of exchange rate flexibility, the smaller the stocks of foreign exchange reserves that must be held. The primary motivation for holding reserves is to intervene in foreign exchange markets when the exchange rate is pegged at a level away from equilibrium. The more closely the forces of supply and demand are allowed to determine the exchange rate, the more infrequent and small‐scale will be any intervention. 6. (a) A bilateral exchange rate measures the value of one currency against a single other currency (for example, the euro relative to the yen). An effective exchange rate measures the value of one currency against a basket of the currencies of trading‐partner countries (for example, the euro a composite of dollars, pounds, yen, and Swiss francs). (b) A currency appreciates when the price of foreign exchange expressed in terms of that currency falls under a flexible exchange rate regime (or, equivalently, when the price of the currency expressed in terms of foreign exchange rises). A revaluation is a cut in the pegged domestic currency price of foreign currency under a fixed exchange rate regime. (c) A currency depreciates when the price of foreign exchange expressed in terms of that currency rises under a flexible exchange rate regime. A devaluation is an increase in the pegged domestic currency price of foreign currency under a fixed exchange rate regime. (d) A flexible exchange rate regime relies on the forces of supply and demand in foreign exchange markets to determine the exchange rates among currencies. A fixed exchange rate regime relies on central bank intervention to hold the exchange rate at a predetermined level. 7. An exchange rate above equilibrium implies an excess supply of foreign exchange that must be purchased and placed into reserves; this presents no threat of running out of reserves. An exchange rate below equilibrium implies an excess demand for foreign exchange that must be covered using foreign exchange reserves; this does present the threat of running out of reserves. An above‐equilibrium exchange rate can, other things being equal, be sustained longer than a below‐equilibrium exchange rate of the same magnitude. 8. At $1.90/£1, buy in London for $95 (rather than New York for $1 00). This raises the demand for briefcases and their price in London relative to that in New York. At $2.00/£1, buy in either New York or London for $100. At $2.10/£1, buy in New York for$100 (rather than London for $105). This raises the demand for briefcases and their price in New York relative to that in London. 11. The firm could buy dollars now in the spot foreign exchange market, buy dollars now in the 60‐day forward market, or wait to buy the dollars in 60 days. The choice will depend on interest rates on peso‐ and dollar denominated assets, the spot and forward exchange rates, and the firm's expected future spot rate. The transaction involves an asset decision because the firm is deciding what asset to hold for 60 days. 12. (a) Yes, because the interest differential in favor of dollar‐denominated assets (0.10 ‐ 0.05 = 0.05) is equal to the 5 percent forward discount on dollars against the euro; therefore, covered interest parity is satisfied. (b) A lower forward rate (reflecting the filet that the dollar no longer is expected to depreciate against the euro) would stimulate a move to purchase more dollar‐denominated assets. Graphically, the demand for dollars would shift right (or, equivalently, the demand for euros would shift left). (c) The move toward dollar‐denominated assets would cause a depreciation of the euro against the dollar (or an appreciation of the dollar against the euro). 13. (a) Yes, because the 25 percent interest differential in favor of U.S. dollar‐denominated assets just matches the expected 25 percent depreciation of the U.S. dollar. (b) Purchase U.S. dollar‐denominated assets; the interest differential exceeds the expected depreciation. (c) The U.S. dollar would appreciate relative to the Canadian dollar. 14. (a) No, the rates are inconsistent because $2/£1 x £1/euro1 > $1/euro1. (b) Yes, a profit can be made by exploiting the inconsistent rates: use $100 to buy el 00, then buy £100, then buy $200, for a profit of$100. (c) Arbitrage would raise the dollar price of euros, raise the euro price of pounds, and raise the pound price of dollars until $/£ x £/€ = $/€. ...
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