Homework Assignment 6Chapter 15 – Questions 1. When the Euro appreciates, are you more likely to drink California or French wine? You are more likely to drink California wine because the euro appreciation makes French wine relatively more expensive than California wine. 2. “A country is always worse off when its currency is weak (falls in value).” Is the statement true, false or uncertain? Explain your answer. False. Although a weak currency has the negative effect of making it more expensive to buy foreign goods or to travel abroad, it may help domestic industry. Domestic goods become cheaper relative to foreign goods, and the demand for domestically produced goods increases. The resulting higher sales of domestic products may lead to higher employment, a beneficial effect on the economy. 3. In a newspaper, chose one exchange rate from each of the regions listed in Following the Financial News box on p347. Which of these currencies have appreciated, and which have depreciated since June 23, 2010? 4. If the Japanese price level rises by 5% relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese Yen in terms of US dollars? It predicts that the value of the yen will fall 5% in terms of dollars. 5. If the demand for a country’s exports falls at the same time that tariffs on imports are raised, will the country’s currency tend to appreciate or depreciate in the long run? In the long run, the fall in the demand for a country’s exports leads to a depreciation of its currency, but the higher tariffs lead to an appreciation. Therefore, the effect on the exchange rate is uncertain. 6. In the mid-to-late 1970’s, the yen appreciated relative to the dollar even though Japan’s inflation rate was higher than America’s. How can this be explained by an improvement in the productivity of Japanese industry relative to American industry? Even though the Japanese price level rose relative to the American, the yen appreciated because the increase in Japanese productivity relative to American productivity made it possible for the Japanese to continue to sell their goods at a profit due to the high value of the yen. If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign goods one year from now. but still remains below its initial level. . The short-run outcome is a lower value of the pound. Both of these changes lower the expected return on pound assets at any given exchange rate. predict what will happen to the exchange rate for the U.Predicting the future 7. The dollar will appreciate. predict what will happen to the US exchange rate. As a result. and the rupee exchange rate therefore rises. In addition. As a result.S. Because expected U. dollar vs. The exchange rate rises to some extent. shifting the demand curve to the left. The announcement of tariffs will raise the expected future exchange rate for the rupee and so increase the expected appreciation of the rupee. and the demand curve shifts back to the right somewhat. in the long run. 9. declining by more in the short run than in the long run. If the Bank of England prints money to reduce unemployment. there will be an expected appreciation of the dollar and so the expected return on dollar assets will rise. the demand curve will shift to the right and the equilibrium value of the dollar will rise. If the public believes him. 8. what will happen to the value of the pound in the short run and the long run? The pound depreciates but overshoots. The dollar will depreciate. the rise in the money supply lowers the domestic interest rate on pound assets. However. what will happen to the value of the Indian rupee today? The Indian rupee will appreciate.S. Consider Britain to be the domestic country. shifting the demand curve to the right. shifting the demand curve to the left and leading to a fall in the exchange rate. If nominal interest rates in the US rise but real interest rates fall. The president of the United States announces that he will reduce inflation with a new anti-inflation program. This means that the demand for rupee-denominated assets will increase. The rise in the money supply leads to a higher domestic price level in the long run. 10. the domestic interest rate returns to its previous value. A rise in nominal interest rates but a decline in the real rate implies a rise in expected inflation that produces an expected depreciation of the dollar that is larger than the increase in the domestic interest rate. other currencies. the expected return on dollar assets falls at any exchange rate. inflation falls as a result of the announcement. which leads to a lower expected future exchange rate. productivity raises the expected future exchange rate and thus raises the expected return on dollar assets at any exchange rate. Consider Mexico to be the domestic country. If there is a strike in France. making it harder to buy French goods. predict what will happen to the exchange rate for the US dollar vs. what will happen to the value of the Euro? Consider France to be the domestic country. If American auto companies make a breakthrough in automobile technology and are able to produce a car that gets 60 miles to the gallon. leads to a decline in the relative expected return on dollar assets. The result of the decline in the relative expected return on dollar assets. Swiss watches and Italian wine. If Mexicans go on a spending spree and buy twice as much French perfume. 15.S. If expected inflation drops in Europe so that interest rates fall there. what will happen to the US exchange rate? The dollar will appreciate. The demand curve will then shift to the left. 13.S. The increase in U. Because it is harder to get French goods. The resulting lower expected return on peso assets at any given exchange rate would then shift the demand curve to the left. because the expected euro appreciation is greater than the decline in the foreign interest rate. The resulting rightward shift of the demand curve leads to a rise in the equilibrium exchange rate. 14. The peso will depreciate. the Euro? The contraction of the European money supply will increase European interest rates and raise the future value of the euro. English sweaters. exchange rate falls. 12. which leads to a decline in the foreign interest rate (which is smaller than the drop in expected inflation). a leftward shift of the demand curve. both of which will decrease the relative expected return on dollar assets. The expected depreciation of the euro lowers the expected . and the dollar will depreciate. what will happen to the value of the Mexican Peso. people will buy more foreign goods and the value of the euro in the future will fall. and the equilibrium U. Japanese TVs. The dollar will depreciate. what will happen to the value of the US dollar vs. If the European Central Bank decides to contract the money supply to fight inflation. An increased demand for imports would lower the expected future exchange rate and result in a lower expected appreciation of the peso. leading to a fall in the peso exchange rate.11. the Euro. The drop of expected inflation in Europe. This gives a value of 114.90 euros) $77. A German sports car is selling for 70. At maturity.S. Chapter 15 – Quantitative Problems 1.67 euro per dollar in 1years time.75 = £564.762/£ 6. the exchange rate was $1. If a euro-denominated bond is yielding 2%. The current exchange rate is 0.000 euros ($1/0.75 per pound.014 − 136.68 per Canadian Dollar on January 1 and $0.014 Canadian dollars The sale price is $100.77.62 GBP/USD.45 − 564.37. If six-month interest rates are 3% in the United States and 150 basis points higher in England.83 per pound.71 = 1.83 = £546.000/$1. what must the Canadian dollar to British Pound exchange rate be? .20 + 1.76 Canadian dollars.76 = 0. The six-month forward rate between the British pound and the US dollar is $1. The holding period return is (546.25/$0. Thus the return in US dollars is 14.67 euro/dollars.777.76)/136.90 euros per dollar? 70.65/$1. At that time. 5. the exchange rate was $1.return on euro assets at any exchange rate.00/$0. If the Canadian dollar to the U.37 = −0. An investor in Canada purchased 100 shares of IBM on January 1 at $93. 2.75 euro per dollar. what is the current exchange rate? Spot rate 1. but you believe that the dollar will decline to 0. so the demand curve shifts to the left and the value of the euro will fall. At maturity.0317.03988 4.71 per Canadian dollar on December 31.000 is worth $1. An investor in England purchased a 91-day T-bill for $987. What is the dollar price in the United States for the German car if the exchange rate is 0.72 on December 31st.20 Canadian dollars The return = (141.45.65. What is the investor’s total return in Canadian dollars? The price of each share is $93. the $1.045/1. dollar exchange rate is 1.72/$0.37)/564. Thus one has 76. IBM paid an annual dividend of $0. One can then exchange this back into US dollars at an exchange rate of 0.5 euros at the end of 1 year. The exchange rate was $0.5 $1.28 CAD/USD and the British Pound to US dollar exchange rate is 0. The stock was sold that day as well for $100. One can then invest this in a euro-denominated bond yielding 2%. 3. The dividend is $0.68 = 136.18%.71 = 141.75 per pound. what return do you expect in US dollars? If one takes 100 dollars and converts it into euros one has 75 euros. What was the investor’s holding period return in pounds? The bond cost $987.25.000 euros.00 per share.75 (1.18.03)^0. what is the percentage change in the Euro’s value? Is this an appreciation or depreciation? % Change = (1.90 per euro. NOTE I REWROTE THIS PROBLEM BECAUSE AS STATED THERE WAS NOT A UNIQUE SOLUTION.5 1.79 ( 0.16 – 0.6664 British pounds.825 r=1. What is the US dollar per real exchange rate? 2. The Brazilian Real is trading at 0. The Mexican peso is trading at 10 pesos per dollar. and the British Pound to US dollar exchange rate is 0. Exchange the 1. If the euro is now trading at $1.825× ( 1+ r )0.62 GBP/USD.825 per pound.00 into 1.36 New Zealand dollars into 0.6664 British pounds into $1. what would you do to earn a riskless profit? Exchange $1. 8.5 1.0645 Canadian dollars/pound 7. In 1999.825 USD 1× ( 1+ 5 )0.059 pesos per dollar 11.16 per euro.5= ( 1+5 )0. what is the expected exchange rate in one year? Expected rate = 10 × (1.5 1GBP=1.23/1. The NZ dollar to US dollar exchange rate is 1.825 × USD=1.02) = 12. The current exchange rate between the US and Britain is $1.88% The dollar has depreciated by 28.28 (1/0.90)/0. The current exchange rate between the Japanese yen and the US dollar is 120 yen per dollar. If British interest rates are 5% then what are US interest rates? Assume interest rates are of the form ( 1+r )t . The six-month forward rate between the British Pound and the US dollar is $1.79USD ( 1+ 5 )0. the Euro was trading at $0.5 USD (1+ r )0.6667 USD per real 10. You need to use the relationship between spot and forward rates 1GBP=1.5 GBP=1.88% 9. If the expected US inflation rate is 2% while the expected Mexican inflation rate is 23% over the next year.62) 2.36 New Zealand dollars. Exchange the 0. If you find that the British Pound to New Zealand dollar exchange rate is 0.79.01 ( ) 12.49 GBP/NZD.825 2 1. If the dollar is expected to .0748.90 = 28.375 real per US dollar.79 ( 1+r )0.Spot rate 1.36 NZD/USD.5 r= 1+5 ) −1 1. what is the new expected exchange rate? 120*.9995=-0. If you believe that the exchange rate will be 1. The interest rate in the United States is 4% and the Euro is trading at 1 euro per dollar. At maturity this yields 1. If you start with no money then you need to borrow 1 dollar at 4% exchange them into 120 yen and invest the yen at 2%. 16.69 yen/dollar.0395 euros. and the exchange rate is 0.99 euros per dollar.04 = 117. This will yield 1. The yen will grow to be 120*1. If the price level recently increased by 20% in England while falling by 5% in the United States. Go back 3 months from today and find: . You then invest the euros in the one-year CD. Thus you want to exchange yen for dollars at 115 rather than the implied 117.55*1.04 euros per dollar one year from now.04 dollars.024 dollars.1 dollar ( 1+r USD ) dollar r euro =1.1 euros per dollar in one-years time. You then turn this back into dollars which yields 0.02 = 122.69. A one-year CD in Europe is currently paying 5%. 0.6875 pounds per dollar. Choose an exchange rate that you looked at in problem 3. The current exchange rate is 120 yen per dollar.55 pounds per dollar. The correct formula to use is euro ( 1+r euro ) euro 1 × =1.25 =0.4 yen into dollars at an exchange rate of 115.depreciate by 10% relative to the yen. Thus you make a risk-less profit of 0. what is the expected return in terms of dollars? If you start with 1 dollar. 14. how can you arbitrage the situation? The first thing to do is figure out what the correct forward rate should be. This turns into 0. One-year interest rates are 2% in Japan and 4% in the United States.9995 dollars.0005 dollars.064 dollars.99 euros. If you can enter into a one forward exchange contract of 115 yen per dollar.02/1.4 so you enter into a forward exchange agreement to exchange 122.04 ) −1=14.1× ( 1. The 1-year expected return is thus 1-0. The euro is expected to depreciate to 1. 15. how much must the exchange rate change if PPP holds? Assume that the current exchange rate is 0. The forward rate should be 120*1.9=108 yen per dollar 13.4 Chapter 15 – Additional Problems 1. You need to repay your dollar borrowing which will cost 1. Calculate the interest rate in Europe. 5 c. a. The exchange rate that was valid for that date. What actually happened? There will be lots of answers for this question 2.a. The spot rate for British Pounds (GBP) into Swiss Francs (CHF) is 1. The spot rate for British Pound (GBP) into South African Rand (ZAR) is 14. Assume rates are of the form ( 1+r )t a.75% and 6-month interest rates in South Africa are 5.4966 CHF/GBP. Would you expect that the forward FX rate to be higher or lower than today? Higher than today b.4936 b.0075 0.5%. Are interest rates higher in the UK or Switzerland? UK interest rates are higher. The 3-month forward point is quoted as -28. d.055 0.4936 ( 0. Given all of this information would you have expected that the foreign currency would have strengthened versus the dollar over the past three months or weakened? Explain your answer.005 ) −1=¿ -. The relevant 3-month T-bill rate from 3 months ago. What is the 6-month forward FX rate? ZAR 1.25 CHF ( 1+r CHF ) CHF 1. What is the quote for the 6-month forward point? 3276 .4936 0.4966 ( ) 3. c.06 ZAR/GBP.4966 × =1. The exchange rate valid for today. What is the 3-month forward rate? 1.5% then what are interest rates in Switzerland? Assume rates are of the form ( 1+r )t We use the relationship 0. c. If interest rates in the UK are 0. 6-month interest rates in the UK are 0.5 14. b.06 =14.7498% 1.25 GBP ( 1+ r GBP ) GBP 4 1.25 r CHF = × 1. A measure of government 3-month interest rates in that country from 3 months ago.3876 GBP 1.