Homework Assignment - 6 Answers

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Homework Assignment 6

Chapter 15 – Questions

1.

1. When the EurWhen the Euro appreo appreciateciates, are you mors, are you more likee likely to drinkly to drink California or French wine?

California or French wine? Y

You are morou are more likele likely to drink California wine y to drink California wine because thebecause the

euro appreciation makes French wine relatively more

epensive than California wine.

!.

!. ""# country is # country is always worse o$ always worse o$ when its curwhen its currency irency is weak %falls ins weak %falls in value&.' (s the s

value&.' (s the statement true, tatement true, false or uncertain? false or uncertain? Eplain yourEplain your answer.

answer. F

False. #lthou)h a alse. #lthou)h a weak currency has the ne)ative e$ect ofweak currency has the ne)ative e$ect of

makin) it more epensive to buy forei)n )oods or to

makin) it more epensive to buy forei)n )oods or to traveltravel

abroad, it may help domestic industry. *omestic )oods

become cheaper relativ

become cheaper relative to forei)n )oods, and e to forei)n )oods, and the demandthe demand

for domestically produced )oods

for domestically produced )oods increaincreases. +he ses. +he resultinresultin))

hi)her sales of domestic products may lead to

hi)her sales of domestic products may lead to hi)herhi)her

employment, a benecial e$ect on the economy.

-.

-. (n a newspa(n a newspaper, choper, chose one ese one echan)e rchan)e rate frate from each of thom each of thee

re)ions listed in Followin) the Financial ews bo on p-/0. Which re)ions listed in Followin) the Financial ews bo on p-/0. Which of these currencies have appreciated, and which

of these currencies have appreciated, and which havehave depreciated since une !-, !212?

depreciated since une !-, !212? /.

/. (f the apanese (f the apanese price levprice level rises el rises by 34 rby 34 relative to elative to the price the price levellevel in the 5nited 6tates, what

in the 5nited 6tates, what does the theory of purchasin) powerdoes the theory of purchasin) power parity predict will happen to

parity predict will happen to the value of the value of the apanese Ythe apanese Yen inen in terms of 56 dollars?

terms of 56 dollars?

(t predicts that the value of

(t predicts that the value of the yen will fall 34 in the yen will fall 34 in terms ofterms of

dollars.

3.

3. (f the dem(f the demand for a countand for a country7s ery7s eportports falls at the sas falls at the same timme time thate that tari$s on imports are raised, will the country7s currency tend to tari$s on imports are raised, will the country7s currency tend to appreciate or depreciate in the lon)

appreciate or depreciate in the lon) run?run?

(n the lon) run, the fall in the demand for

(n the lon) run, the fall in the demand for a country7sa country7s

eports leads to a depreciation of its currency, but the

hi)her tari$s lead

hi)her tari$s lead to an to an appreciation. +hereappreciation. +herefore, the e$ectfore, the e$ect

on the echan)e rate is uncertain.

8.

8. (n the mid9t(n the mid9to9late 1:o9late 1:027s, the ye027s, the yen appren appreciateciated relad relative to thetive to the dollar even thou)h apan7s in;ation rate was hi)her than dollar even thou)h apan7s in;ation rate was hi)her than #merica7s. <ow can this be eplained by an

#merica7s. <ow can this be eplained by an improveimprovement in thement in the productivit

productivity of y of apanese industry relative to #merican industry?apanese industry relative to #merican industry? Even thou)h the apanese price level rose relative to the

Even thou)h the apanese price level rose relative to the

#merican, the yen appreciated because the

#merican, the yen appreciated because the increase inincrease in

apanese productivi

apanese productivity relativty relative to #merican pre to #merican productivityoductivity

made it possible for the apanese to continue to sell their

)oods at a prot due to the hi)h value of the yen.

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=redictin) the future

0. +he president of the 5nited 6tates announces that he will reduce in;ation with a new anti9in;ation pro)ram. (f the public believes him, predict what will happen to the echan)e rate for the 5.6. dollar vs. other currencies.

+he dollar will appreciate. >ecause epected 5.6. in;ation falls as a result of the announcement, there will be an epected appreciation of the dollar and so the epected return on dollar assets will rise. #s a result, the demand curve will shift to the ri)ht and the euilibrium value of the dollar will rise.

@. (f the >ank of En)land prints money to reduce unemployment, what will happen to the value of the pound in the short run and the lon) run?

+he pound depreciates but overshoots, declinin) by more in the short run than in the lon) run. Consider >ritain to be the domestic country. +he rise in the money supply leads to a hi)her domestic price level in the lon) run, which leads to a lower epected future echan)e rate. (n addition, the rise in the money supply lowers the domestic interest rate on pound assets. >oth of these chan)es lower the epected return on pound assets at any )iven echan)e rate, shiftin) the demand curve to the left. +he short9run outcome is a lower value of the pound. <owever, in the lon) run, the domestic interest rate returns to its previous value, and the demand curve shifts back to the ri)ht somewhat. +he

echan)e rate rises to some etent, but still remains below its initial level.

:. (f the (ndian )overnment unepectedly announces that it will be imposin) hi)her tari$s on forei)n )oods one year from now, what will happen to the value of the (ndian rupee today?

+he (ndian rupee will appreciate. +he announcement of tari$s will raise the epected future echan)e rate for the rupee and so increase the epected appreciation of the rupee. +his means that the demand for rupee9denominated assets will increase, shiftin) the demand curve to the ri)ht, and the rupee echan)e rate therefore rises.

12. (f nominal interest rates in the 56 rise but real interest rates fall, predict what will happen to the 56 echan)e rate.

+he dollar will depreciate. # rise in nominal interest rates but a decline in the real rate implies a rise in epected in;ation that produces an epected depreciation of the dollar that is lar)er than the increase in the domestic interest rate. #s a result, the epected return on dollar assets falls at any echan)e rate, shiftin) the demand curve to the left and leadin) to a fall in the echan)e rate.

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11. (f #merican auto companies make a breakthrou)h in automobile technolo)y and are able to produce a car that )ets 82 miles to the )allon, what will happen to the 56 echan)e rate?

+he dollar will appreciate. +he increase in 5.6. productivity raises the epected future echan)e rate and thus raises the epected return on dollar assets at any echan)e rate. +he resultin) ri)htward shift of the demand curve leads to

a rise in the euilibrium echan)e rate.

1!. (f Aeicans )o on a spendin) spree and buy twice as much French perfume, apanese +Bs, En)lish sweaters, 6wiss watches and (talian wine, what will happen to the value of the Aeican =eso.

+he peso will depreciate. Consider Aeico to be the

domestic country. #n increased demand for imports would lower the epected future echan)e rate and result in a lower epected appreciation of the peso. +he resultin) lower epected return on peso assets at any )iven

echan)e rate would then shift the demand curve to the left, leadin) to a fall in the peso echan)e rate.

1-. (f epected in;ation drops in Europe so that interest rates fall there, predict what will happen to the echan)e rate for the 56 dollar vs. the Euro.

+he dollar will depreciate. +he drop of epected in;ation in Europe, which leads to a decline in the forei)n interest rate %which is smaller than the drop in epected in;ation&, leads to a decline in the relative epected return on dollar assets, because the epected euro appreciation is )reater than the decline in the forei)n interest rate. +he result of the decline in the relative epected return on dollar assets, a leftward shift of the demand curve, and the euilibrium 5.6.

echan)e rate falls.

1/. (f the European Central >ank decides to contract the

money supply to )ht in;ation, what will happen to the value of the 56 dollar vs. the Euro?

+he contraction of the European money supply will

increase European interest rates and raise the future value of the euro, both of which will decrease the relative

epected return on dollar assets. +he demand curve will then shift to the left, and the dollar will depreciate.

13. (f there is a strike in France, makin) it harder to buy French )oods, what will happen to the value of the Euro?

Consider France to be the domestic country. >ecause it is harder to )et French )oods, people will buy more forei)n )oods and the value of the euro in the future will fall. +he epected depreciation of the euro lowers the epected

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return on euro assets at any echan)e rate, so the demand curve shifts to the left and the value of the euro will fall.

Chapter 15 – Quantitative Problems

1. # erman sports car is sellin) for 02,222 euros. What is the dollar price in the 5nited 6tates for the erman car if the echan)e rate is 2.:2 euros per dollar?

02,222 euros × %D12.:2 euros& = D00,000.00.

!. #n investor in En)land purchased a :19day +9bill for D:@0.83. #t that time, the echan)e rate was D1.03 per pound. #t maturity, the echan)e rate was D1.@- per pound. What was the

investor7s holdin) period return in pounds? +he bond cost D:@0.83D1.03  G38/.-0.

#t maturity, the D1,222 is worth D1,222D1.@-  G3/8./3. +he holdin) period return is %3/8./3 H 38/.-0&38/.-0 

H2.2-10.

-. #n investor in Canada purchased 122 shares of (>A on anuary 1 at D:-.22 per share. (>A paid an annual dividend of D2.0! on *ecember -1st_{. +he stock was sold that day as well for D122.!3.}

+he echan)e rate was D2.8@ per Canadian *ollar on anuary 1 and D2.01 per Canadian dollar on *ecember -1. What is the investor7s total return in Canadian dollars?

+he price of each share is D:-.22D2.8@  1-8.08 Canadian dollars.

+he dividend is D2.0!D2.01  1.21/ Canadian dollars

+he sale price is D122.!3D2.01  1/1.!2 Canadian dollars +he return  %1/1.!2 I 1.21/ H 1-8.08&1-8.08  2.2-:@@ /. +he current echan)e rate is 2.03 euro per dollar, but you

believe that the dollar will decline to 2.80 euro per dollar in 19 years time. (f a euro9denominated bond is yieldin) !4, what return do you epect in 56 dollars?

(f one takes 122 dollars and converts it into euros one has 03 euros. Jne can then invest this in a euro9denominated bond yieldin) !4. +hus one has 08.3 euros at the end of 1 year. Jne can then echan)e this back into 56 dollars at an echan)e rate of 2.80 eurodollars. +his )ives a value of 11/.1@. +hus the return in 56 dollars is 1/.1@4.

3. +he si9month forward rate between the >ritish pound and the 56 dollar is D1.03 per pound. (f si9month interest rates are -4 in the 5nited 6tates and 132 basis points hi)her in En)land, what is the current echan)e rate?

6pot rate = 1.03 × %1.2/31.2-&K2.3 = D1.08!G

8. (f the Canadian dollar to the 5.6. dollar echan)e rate is 1.!@ C#*56* and the >ritish =ound to 56 dollar echan)e rate is 2.8! >=56*, what must the Canadian dollar to >ritish =ound echan)e rate be?

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6pot rate = 1.!@ × %12.8!& = !.28/3 Canadian

dollarspound

0. +he L dollar to 56 dollar echan)e rate is 1.-8 L*56*, and the >ritish =ound to 56 dollar echan)e rate is 2.8! >=56*. (f you nd that the >ritish =ound to ew Lealand dollar echan)e rate is 2./: >=L*, what would you do to earn a riskless prot?

Echan)e D1.22 into 1.-8 ew Lealand dollars.

Echan)e the 1.-8 ew Lealand dollars into 2.888/ >ritish pounds.

Echan)e the 2.888/ >ritish pounds into D1.20/@.

@. (n 1:::, the Euro was tradin) at D2.:2 per euro. (f the euro is now tradin) at D1.18 per euro, what is the percenta)e chan)e in the Euro7s value? (s this an appreciation or depreciation?

4 Chan)e  %1.18 M 2.:2&2.:2  !@.@@4 +he dollar has depreciated by !@.@@4

:. +he >raNilian Oeal is tradin) at 2.-03 real per 56 dollar. What is the 56 dollar per real echan)e rate?

!.8880 56* per real

12. +he Aeican peso is tradin) at 12 pesos per dollar. (f the epected 56 in;ation rate is !4 while the epected Aeican in;ation rate is !-4 over the net year, what is the epected echan)e rate in one year?

Epected rate  12 P %1.!-1.2!&  1!.23: pesos per dollar

11. +he current echan)e rate between the 56 and >ritain is D1.@!3 per pound. +he si9month forward rate between the >ritish =ound and the 56 dollar is D1.0:. (f >ritish interest rates are 34 then what are 56 interest rates? #ssume interest rates are of the form

(

1+r

)

t .

2 −1 r=1.01

1!. +he current echan)e rate between the apanese yen and the 56 dollar is 1!2 yen per dollar. (f the dollar is epected to

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depreciate by 124 relative to the yen, what is the new epected echan)e rate?

1!2S.:12@ yen per dollar

1-. (f the price level recently increased by !24 in En)land while fallin) by 34 in the 5nited 6tates, how much must the echan)e rate chan)e if === holds? #ssume that the current echan)e rate is 2.33 pounds per dollar.

2.33S1.!3 2.8@03 pounds per dollar.

1/. # one9year C* in Europe is currently payin) 34, and the echan)e rate is 2.:: euros per dollar. (f you believe that the echan)e rate will be 1.2/ euros per dollar one year from now, what is the epected return in terms of dollars?

(f you start with 1 dollar. +his turns into 2.:: euros. You then invest the euros in the one9year C*. #t maturity this yields 1.2-:3 euros. You then turn this back into dollars which yields 2.:::3 dollars. +he 19year epected return is thus 192.:::392.2223 dollars.

13. Jne9year interest rates are !4 in apan and /4 in the 5nited 6tates. +he current echan)e rate is 1!2 yen per dollar. (f you can enter into a one forward echan)e contract of 113 yen per dollar, how can you arbitra)e the situation?

+he rst thin) to do is )ure out what the correct forward rate should be. +he forward rate should be 1!2S1.2!1.2/  110.8: yendollar. +hus you want to echan)e yen for dollars at 113 rather than the implied 110.8:. (f you start with no money then you need to borrow 1 dollar at /4

echan)e them into 1!2 yen and invest the yen at !4. +he yen will )row to be 1!2S1.2!  1!!./ so you enter into a forward echan)e a)reement to echan)e 1!!./ yen into dollars at an echan)e rate of 113. +his will yield 1.28/ dollars. You need to repay your dollar borrowin) which will cost 1.2/ dollars. +hus you make a risk9less prot of 2.2!/ dollars.

18. +he interest rate in the 5nited 6tates is /4 and the Euro is tradin) at 1 euro per dollar. +he euro is epected to depreciate to 1.1 euros per dollar in one9years time. Calculate the interest rate in Europe.

+he correct formula to use is 1 euro dollar ×

(

1+r_euro

)

(

1+r_USD

)

=1.1 euro dollar r_euro₌1.1×

(

1.04

)

₋1₌14.4

Chapter 15 – Additional Problems

1. Choose an echan)e rate that you looked at in problem -. o back - months from today and ndT

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a. +he echan)e rate that was valid for that date. b. +he echan)e rate valid for today.

c. # measure of )overnment -9month interest rates in that country from - months a)o.

d. +he relevant -9month +9bill rate from - months a)o.

iven all of this information would you have epected that the forei)n currency would have stren)thened versus the dollar over the past three months or weakened? Eplain your answer. What actually happened?

+here will be lots of answers for this uestion

!. +he spot rate for >ritish =ounds %>=& into 6wiss Francs %C<F& is 1./:88 C<F>=. +he -9month forward point is uoted as 9!@.

a. What is the -9month forward rate? 1./:-8

b. #re interest rates hi)her in the 5U or 6witNerland? 5U interest rates are hi)her.

c. (f interest rates in the 5U are 2.34 then what are interest rates in 6witNerland? #ssume rates are of the form

(

1₊r

)

t

4 −1=¿ _9.0/:@4

-. +he spot rate for >ritish =ound %>=& into 6outh #frican Oand %L#O& is 1/.28 L#O>=. 89month interest rates in the 5U are 2.034 and 89month interest rates in 6outh #frica are 3.34. #ssume rates are of the form

₍

1₊r

)

t

a. Would you epect that the forward FV rate to be hi)her or lower than today?

<i)her than today

b. What is the 89month forward FV rate? 14.06 ZAR

GBP

1.0550.5 1.00750.5

=14.3876

c. What is the uote for the 89month forward point? -!08