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Unformatted text preview: 1 Brigham Young University Department of Economics Economics 459 - International Monetary Theory Dr. Phillips (section 1) Winter Semester 2012 Monday, February 13, 2012 Midterm Exam #1 key 1. Explain the difference between an ask price and bid price for foreign currency. How large are foreign currency bid/ask spreads in percent terms? A bid price is the price a bank is willing to pay for a unit of foreign currency. An ask price is the price the bank charges if it sells a unit of foreign currency. The percent difference is less than 1/10 th of 1 percent. 2. Briefly explain the notion of spatial arbitrage. If arbitrage of this sort is able to be exploited whenever it occurs what does it imply about the relationship between the $/€ rate in New York and the $/€ rate in London? Spatial arbitrage is buying at a relatively low price in one location and selling at a higher price in another market. If it can always be exploited when the opportunity arises, the prices in the two locations will almost always be the same, or at least differ by no more than the transport/transactions cost of arbitrage. Since these costs are almost zero for foreign currencies, the exchange rates in New York and London should be almost identical. 3. Write down the three equations used to derive the forward bias regression. Name each equation properly and explain what all variables and parameters stand for. Covered Interest Rate Parity െ ∗ ൌ Uncovered Interest Rate Parity െ ∗ ൌ ሼࢿ′ሽ Rational Expectations ሼࢿ ᇱ ሽ ൌ ࢿ ᇱ is the home country interest rate ∗ is the foreign country interest rate is the forward premium ࢿ′ is the percent change in the spot exchange rate between now and next period is a mean-zero random variable ሼሽ denotes expectation of variable x today 4. Use the equations above to find the null-hypothesis that is tested with the typical forward bias regression. CIRP & UIRP imply ൌ ሼࢿ′ሽ Using RE gives ൌ ࢿ ᇱ Rearranging terms gives ࢿ ᇱ ൌ െ Hence we can test these three hypotheses with the following regression: ࢿ ൌ ࢻ ࢼ ି where we test the null hypothesis that ࢻ ൌ & ࢼ ൌ . 2 5. Given the following estimated regression of the actual percent change in the spot exchange rate on...
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