# Homework 8 Answer - ECON 460 Homework 8(Final HW 1 a Draw a...

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ECON 460 – Homework 8 (Final HW) 1. a. Draw a graph to show the CIP condition. In the graph, plot the following and indicate whether there will be capital inflow or outflow: (10 points) (i) I NY = 0.02; I Germany = 0.02; Spot rate: € 1 = \$1.35; Forward rate: € 1 = \$1.30. Assume transaction cost of 0.25 I NY D- I Germany = 0.02 – 0.02 = 0 p, forward premium = (1.30-1.35)/1.30 = 0.03/1.30 = -0.037 INFLOWS (ii) I NY = 0.02; I Germany = 0.03; Spot rate: € 1 = \$1.35; Forward rate: € 1 = \$1.33. Assume transaction cost of 0.25% I NY D- I Germany = 0.02 – 0.04 = -0.01 p, forward premium = (1.33-1.35)/1.35 = 0.02/1.35 = 0.-0148 INFLOWS (iii) I NY = 0.04; I Germany = 0.02; Spot rate: € 1 = \$1.35; Forward rate: € 1 = \$1.3635. Assume transaction cost of 0.25% I NY D- I Germany = 0.04 – 0.02 = 0.02 p, forward premium = (1.3635-1.35)/1.35 = 0.0135/1.35 = 0.01 INFLOWS NOTES ON GRAPH: i-i* is measured on vertical axis p, forward premium, is measured on x axis Draw a band for transaction cost. b. What is the effect of each of the above on domestic interest rate, foreign interest rate, spot rate and forward rate? Use the money market graph and foreign exchange graph to explain this. 1

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(10 points) Capital Inflows: S 0 S 1 S 1 S 0 i NY i GER 0.02 0.02 D D Domestic money market Foreign money market S 0 S 1 S 0 e D €1 D D €0 Spot market Forward market 2. Given the following exchange rates, how will arbitrageurs behave? Calculate profit/loss. a. € 1 = \$1.35 in New York € 1 = \$1.36 in Paris What will happen to the Euro in the two markets? Depreciate or appreciate? (5 points) 2
Buy Euros in New York and sell Euros in Paris. The Euro will appreciate in New York and depreciate in Paris. Profit made is \$0.01 per \$1.35. b.

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Homework 8 Answer - ECON 460 Homework 8(Final HW 1 a Draw a...

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