Questions Final Exam

B. As a result of this arbitrage, what is the pressure on the cross-rate between yen and krone. What must the value of the cross-rate be to eliminate the opportunity for triangular arbitrage?

Selling kroner to buy yen puts downward pressure on the cross rate (the yen price of krone). The value of the cross rate must fall to 20 (=0.20/0.010) yen/krone to eliminate the opportunity for triangular arbitrage, assuming that the dollar exchange rates are unchanged.

You have access to the following three spot exchange rates: $0.01/yen $0.20/krone 25 yen/krone You start with dollars and want to end up with dollars. A. How would you engage in arbitrage to profit from these three rates? What is the profit for each dollar used initially?

The cross rate between the yen and the krone is too high relative (the yen value of the krone is too high) to the dollar-foreign currency exchange rates. In a profitable triangular arbitrage, you want to sell kroner at the high cross rate. The arbitrage will be use dollars to buy krone at 0.20/krone, use these kroner to buy yen at 25 yen/krone, and use the yen to buy dollars at $0.01/yen. For each dollar that you sell initially, you can obtain 5 kroner, these 5 kroner can obtain 125 yen, and the 125 yen can obtain $1.25. the arbitrage profit for each dollar is therefore 25 cents

Would the adoption of a new gold standard by industrialized countries result in better achievement of internal balance for these countries?

No, though some individuals believe it would reduce the national and average global rate of inflation by creating a strong discipline on counties ability to expand their money supplies, most international economists oppose a return to the gold standard, as a gold standard is not nearly as stabilizing as its proponents claim it is. Furthermore, stating that the gold standard does not have the advantages of flexible or floating exchange rates, including independence in choosing priorities and using policies.

A trader at a U.S. bank believes that the euro will strengthen substantially in exchange-rate value during the next hour. How would the trader use the interbank market to attempt to profit from her belief?

A trader would enter the interbank market and could either trade directly or use a broker service. The trader could buy a lot of euros and turn around and sell them the best spot rates to trade the euros for dollars in that interbank market and make a profit once the value of the euro strengthens substantially in that hour.

Question (18-4): The current spot exchange rate is $0.010/yen. The current 60-day forward exchange rate is $0.009/yen. How would the U.S. firms and people described in question 3 each use a forward foreign exchange contract to hedge their risk exposure? What are the amounts in each forward contract? A) A small U.S. firm sold experimental computer components to a Japanese firm, and it will receive payment of 1 million yen in 60 days. B) An American college student receives a birthday gift of Japanese government bonds worth 10 million yen, and the bonds mature in 60 days. C) A U.S. firm must repay a yen loan, principle plus interest totaling 100 million yen, coming due in 60 days.

A) The small U.S. firm has an asset position in yen, a long position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 1 million yen and receive $9,000 in 60 days. B) The American college student has an asset position in yen, a long position in yen. To hedge the exposure to exchange rate risk, the student should enter into a forward exchange contract now in which the student commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 10 million yen and receive $90,000 in 60 days. C) The U.S. firm has a liability position in yen, a short position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell dollars and receive yen at the current forward rate. The contract amounts are to sell $900,000 and receive 100 million yen in 60 days.

Show that uncovered interest parity holds at these rates.

Euro appreciation = 1% ((1.005 - 1.000)/1.000) * (360/180) * 100 = 1% annual interest rate on euro-denominated bond + Euro appreciation - U.S. dollar-denominated bonds (3% + 1% - 4% = 0)

The current spot exchange rate is $1.20/euro. The current 90-day forward exchange rate is $1.18/euro. You expect the spot rate to be $1.22/euro in 90 days. How would you speculate using a forward contract? If many people speculate in this way, what pressure is placed on the value of the current forward exchange rate?

Looking at the expected spot value of the euro in 90 days ($1.22/euro), the current forward rate of the euro ($1.18/euro) is low. Using the principle of "buy low, sell high," you can speculate by using a forward contract now to buy euros at $1.18/euro. If that's true, in 90 days you will be able to immediately resell those euros for $1.22/euro, pocketing a profit of $0.04 for each euro that you bought forward. If many people speculate in this way, then massive purchases now of euros forward (increasing the demand for euros forward) will tend to drive up the forward value of the euro, toward a current forward rate of $1.22/euro.

Will the law of one price apply better to gold or to Big Macs? Why?

The law of one price will apply better to gold than to Big Macs. The law of one price says that identical goods should sell for the same price in two separate markets, but the prices of Big Macs are different in different countries. Hence, while gold can be traded on exchange it is not the same for Big Mac. Gold being a commodity which is traded, the law of one price will apply better.

Question and Problem 20-2: What is the difference between an adjustable peg and a crawling peg?

The main difference between an adjustable peg and a crawling peg is the length of time. An adjustable peg is typically for long periods of time while a crawling peg is changed often. When the government knows that a fixed rate may not be fixed forever, they may still try to keep the value fixed for long periods of time. However, when the country faces a substantial disequilibrium in their international position, they may need to change the pegged-rate value, an approach called an adjustable peg. A crawling peg refers to a specific pegged-rate value that cannot be maintained for long and is changed often, such as monthly, according to a certain set of indicators or if the government monetary authority deems it necessary. If a certain set of indicators are used, one choice is to use the difference between the country's inflation rate and the inflation rate of the country whose currency it pegs to.

What is likely to be the effect on the spot exchange rate if the interest rate on 180-day dollar-denominated bonds declines to 3 percent? If the euro interest rate and the expected future spot rate are unchanged, and if uncovered interest parity is reestablished, what will the new current spot exchange rate be? Has the dollar appreciated or depreciated?

The spot exchange rate will increase because the uncovered interest differential would be positive. The current spot rate would change to $1.005/euro to reestablish uncovered interest parity. Therefore, the dollar has depreciated.

CH 18-8

The swiss franc is at premium because it buys 1.01 moving forward They would make a higher investment in the swiss franc denominated bonds because the interest rate is half a percent lower but they gain an percentage on the exchange rates US interest rates go up and Swiss interest rates go down the spot franc appreciate and the forward franc depreciates.

Question 17-2 What results in a supply of foreign currency

Trade is one activity that results in a supply of foreign currency. When's nation's engage in trade, the exporter wants to be paid for goods and services with their home currency. In order for foreign importers to pay the exporter appropriately, foreign curency must be exchanged for the exporter's currency. U.S. = Exporter (Dollars) Brazil = Importer (Real) During the payment process, the Brazilian purchaser will sell Real (to get dollars), and pay the U.S. in dollars (increase foreign currency supply). International financial transactions is another activity that results in a supply of foreign currency. When foreign residents want to purchase financial assets in a home country, the foreign resident must sell their foreign currency. Selling the foreign currency is used to purchase the home country's currency. Brazilian resident wants to invest in General Motors (NYSE:GM). During the payment process, the Brazilian resident will sell Real (to get dollars), and invest in the U.S. financial asset with dollars (increase foreign currency supply).