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459f09 midterm key-1

# 459f09 midterm key-1 - Brigham Young University Department...

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1 Brigham Young University Department of Economics Economics 459 - International Monetary Theory Dr. Phillips (section 1) Fall Semester 2009 Tuesday & Wednesday, October 27 & 28, 2009 Midterm Exam key 1. Given the following estimated regression of the actual percent change in the spot exchange rate on the forward premium from the previous period, ߝ ൌ .10 െ .33߮ ௧ିଵ ൅ݑ , write down an investment rule that would make money on average. Explain why this strategy would work. Show how to implement this rule on the data provided. Show whether one should take a short or long position. Also show the expected and actual returns from doing so. The return on a short investment is ൌ࢒࢔ࢌ ࢚ି૚ െ࢒࢔࢙ which is the same as ൌ࣐ ࢚ି૚ െࢿ . Note this is also the negative of the return on a long investment. Using the regression equation above this gives, ൌ࣐ ࢚ି૚ െ ሺ. ૚૙െ. ૜૜࣐ ࢚ି૚ ൅࢛ . So the expected value of the return on a short investment is ൌ ૚. ૜૜࣐ ࢚ି૚ െ. ૚૙ . Hence if, ࢚ି૚ .૚૙ ૚.૜૜ a short investment will have a positive expected return. If ࢚ି૚ .૚૙ ૚.૜૜ , it will have a negative expected return, but this means a long investment would have a positive expected return. The rule is: If ࢚ି૚ .૚૙ ૚.૜૜ take a short position, otherwise take a long position. period spot forward φ short or long expected return actual return 1 2.33 2.14 -8.51% long n/a n/a 2 2.15 2.20 2.30% long 21.31% 0.47% 3 2.24 2.35 4.79% long 6.94% 1.80% 4 2.41 2.35 n/a n/a 3.62% 2.52% 2. Explain the difference between covered interest rate parity and uncovered interest rate parity. Which hypothesis is more likely to be true in the real world? Why? Covered interest rate parity (CIRP) says that the expected return on a domestic investment should be the same as the expected return on a covered foreign investment, where “covered” means future exchanges of foreign currency for home currency are done at today’s forward exchange rate

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459f09 midterm key-1 - Brigham Young University Department...

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