Chapter 13: Exchange Rates and the Foreign Exchange Market: An Asset Approach Multiple Choice Questions 1.

How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1. 5 dollars per one British pound! ". 50 dollars B. #0 dollars $. %0 dollars &. # .5 dollars E. '0 British pounds "nswer( & . How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.50 dollars per one British pound! ". 50 dollars B. #0 dollars $. %0 dollars &. )0 dollars E. %5 dollars "nswer( E *. How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds if the exchange rate is 1.)0 dollars per one British pound! ". '0 dollars B. +0 dollars $. 50 dollars &. 100 dollars E. +5 dollars "nswer( B '. ,he -erman currency is called the ". Euro B. &M $. .en &. &ollar E. /ound "nswer( "

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How many British pounds would it cost to buy a pair of "merican designer 0eans costing 1'5 if the exchange rate is 1.50 dollars per British pound! ". 10 British pounds B. 0 British pounds $. *0 British pounds &. *5 British pounds E. 5 British pounds "nswer( $

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How many British pounds would it cost to buy a pair of "merican designer 0eans costing 1'5 if the exchange rate is 1.)0 dollars per British pound! ". 10 British pounds B. 5 British pounds $. 0 British pounds &. *0 British pounds E. '0 British pounds "nswer( B

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How many British pounds would it cost to buy a pair of "merican designer 0eans costing 1'5 if the exchange rate is .00 dollars per British pound! ". .5 British pounds B. * .5 British pounds $. 1 .5 British pounds &. '0 British pounds E. *0 British pounds "nswer( "

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How many British pounds would it cost to buy a pair of "merican designer 0eans costing 1'5 if the exchange rate is 1.#0 dollars per British pound! ". *).1 5 British pounds B. ).1 5 British pounds $. ').1 5 British pounds &. 5).1 5 British pounds E. 1).1 5 British pounds "nswer( B

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What is the exchange rate between the dollar and the British pound if a pair of "merican 0eans costs 50 dollars in 2ew .or3 and 100 pounds in 4ondon! ". 1.5 dollars per British pound B. 0.5 dollars per British pound $. .5 dollars per British pound &. *.5 dollars per British pound E. dollars per British pound "nswer( B

10.

What is the exchange rate between the dollar and the British pound if a pair of "merican 0eans costs #0 dollars in 2ew .or3 and *0 pounds in 4ondon! ". 1.5 dollars per British pound B. 0.5 dollars per British pound $. .5 dollars per British pound &. *.5 dollars per British pound E. dollars per British pound "nswer( E

11.

When a country5s currency depreciates6 ". foreigners find that its exports are more expensi7e6 and domestic residents find that imports from abroad are more expensi7e. B. foreigners find that its exports are more expensi7e6 and domestic residents find that imports from abroad are cheaper. $. foreigners find that its exports are cheaper8 howe7er6 domestic residents are not affected. &. foreigners are not affected6 but domestic residents find that imports from abroad are more expensi7e. E. 2one of the abo7e. "nswer( E

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"n appreciation of a country5s currency ". decreases the relati7e price of its exports and lowers the relati7e price of its imports. B. raises the relati7e price of its exports and raises the relati7e price of its imports. $. lowers the relati7e price of its exports and raises the relati7e price of its imports. &. raises the relati7e price of its exports and lowers the relati7e price of its imports. E. 2one of the abo7e. "nswer( &

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Which one of the following statements is the most accurate! ". " depreciation of a country5s currency ma3es its goods cheaper for foreigners. B. " depreciation of a country5s currency ma3es its goods more expensi7e for foreigners. $. " depreciation of a country5s currency ma3es its goods cheaper for its own residents. &. " depreciation of a country5s currency ma3es its goods cheaper. E. 2one of the abo7e. "nswer( "

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By early 00 6 ". " $anadian dollar was worth only about 15 9nited :tates cents. B. " $anadian dollar was worth only about 0 9nited :tates cents. $. " $anadian dollar was worth only about #5 9nited :tates cents. &. " $anadian dollar was worth only about 100 9nited :tates cents. E. " $anadian dollar was worth only about 5 9nited :tates cents. "nswer( $

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,he largest trading of foreign exchange occurs in ". 2ew .or3. B. 4ondon. $. ,o3yo. &. ;ran3furt. E. :ingapore. "nswer( B

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<n 0016 ". 0 percent of foreign exchange transactions in7ol7ed exchanges of foreign currencies for 9.:. dollars. B. 10 percent of foreign exchange transactions in7ol7ed exchanges of foreign currencies for 9.:. dollars. $. *0 percent of foreign exchange transactions in7ol7ed exchanges of foreign currencies for 9.:. dollars. &. '0 percent of foreign exchange transactions in7ol7ed exchanges of foreign currencies for 9.:. dollars. E. +0 percent of foreign exchange transactions in7ol7ed exchanges of foreign currencies for 9.:. dollars. "nswer( E

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Which one of the following statements is the most accurate! ,he term spot exchange rate is ". misleading because e7en spot exchanges usually become effecti7e only three days after a deal is struc3. B. misleading because e7en spot exchanges usually become effecti7e only four days after a deal is struc3. $. misleading because e7en spot exchanges usually become effecti7e only fi7e days after a deal is struc3. &. misleading because e7en spot exchanges usually become effecti7e only six days after a deal is struc3. E. misleading because e7en spot exchanges usually become effecti7e only two days after a deal is struc3. "nswer( E

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Which one of the following statements is the most accurate! ,rades of 9.:. dollars for $anadian dollars in 2ew .or3 are executed with ". a one=day lag. B. a two=day lag. $. a three=day lag. &. a four=day lag. E. a >ero=day lag. "nswer( "

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;orward and spot exchange rates ". are necessarily e?ual B. do not mo7e closely together $. ,he forward exchange rate is always abo7e the spot exchange rate. &. while not necessarily e?ual6 do mo7e closely together. E. 2one of the abo7e. "nswer( &

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" foreign exchange swap ". is a spot sale of a currency. B. is a forward repurchase of the currency. $. is a spot sale of a currency combined with a forward repurchase of the currency. &. is a spot sale of a currency combined with a forward sale of the currency. E. 2one of the abo7e. "nswer( $

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"n "merican put option on foreign exchange ". gi7es the buyer the right to sell the foreign currency at a 3nown exchange rate at any time during the period of the option. B. gi7es the seller the right to sell the foreign currency at a 3nown exchange rate at any time during the period of the option. $. gi7es the buyer the right to sell the foreign currency at a 3nown exchange rate at a specific time in the future. &. obligates the buyer to sell the foreign currency at a 3nown exchange rate at any time during the period of the option. E. 2one of the abo7e. "nswer( "

"n "merican call option on foreign exchange ". obligates you to buy foreign currency at a 3nown price at any time during the period of the option. B. gi7es you the right to buy foreign currency at a 3nown price at any time during the period of the option. $. gi7es you the right to buy foreign currency at a 3nown price at a specific day in the future. &. gi7es you the right to sell foreign currency at a 3nown price at any time during the period of the option. E. 2one of the abo7e. "nswer( B

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,he exchange rate between currencies depends on ". the interest rate that can be earned on deposits of those currencies. B. the expected future exchange rate. $. the interest rate that can be earned on deposits of those currencies and the expected future exchange rate. &. national output. E. 2one of the abo7e. "nswer( B

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Which one of the following statements is the most accurate! $ountries in the euro >one include ". "ustria6 "ustralia6 and Belgium. B. "ustria6 Belgium6 and ;inland. $. "ustria and ;inland. &. "ustria6 Belgium6 ;inland6 and ;rance. E. "ustria6 Belgium6 ;inland6 ;rance6 and -ermany. "nswer( E

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5.

Which one of the following statements is the most accurate! ". Because dollar and &M interest rates are measured in comparable terms6 they can mo7e ?uite differently o7er time. B. Because dollar and &M interest rates are not measured in comparable terms6 they can mo7e ?uite differently o7er time. $. Because dollar and &M interest rates are measured in comparable terms6 they mo7e ?uite the same o7er time. &. Because dollar and &M interest rates are measured in comparable terms6 they still mo7e ?uite differently o7er time. E. 2one of the abo7e. "nswer( B

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Which one of the following statements is the most accurate! $ountries in the euro >one include ". "ustria6 Belgium6 ;inland6 ;rance6 and -ermany. B. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 and -reece. $. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 and <reland. &. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 and <taly. E. "ll of the abo7e statements are correct. "nswer( E

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Which one of the following statements is the most accurate! $ountries in the euro >one include ". "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 and -reece. B. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 and 4uxembourg. $. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 /ortugal6 and <reland. &. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 :pain6 and <taly. E. "ll of the abo7e statements are correct. "nswer( E

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Which one of the following statements is the most accurate! $ountries in the euro >one include ". "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 -reece6 4uxemburg6 and <reland. B. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 4uxembourg6 /ortugal6 and /oland. $. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 /ortugal6 <reland6 and the $>ec3 @epublic. &. "ustria6 Belgium6 ;inland6 ;rance6 -ermany6 :pain6 <taly6 and 93raine. E. "ll of the abo7e statements are correct. "nswer( "

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Which one of the following statements is the most accurate! ". ,he dollar rate of return on euro deposits is the euro interest rate plus the rate of depreciation of the dollar against the euro. B. ,he dollar rate of return on euro deposits is approximately the euro interest rate minus the rate of depreciation of the dollar against the euro. $. ,he dollar rate of return on euro deposits is the euro interest rate minus the rate of depreciation of the dollar against the euro. &. ,he dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of appreciation of the dollar against the euro. E. ,he dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro. "nswer( E

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<f the dollar interest rate is 10 percent and the euro interest rate is # percent6 then ". an in7estor should in7est only in dollars. B. an in7estor should in7est only in euros. $. an in7estor should be indifferent between dollars and euros. &. it is impossible to tell gi7en the information. E. "ll of the abo7e. "nswer( &

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<f the dollar interest rate is 10 percent6 the euro interest rate is # percent6 and the expected return on dollar depreciation against the euro is >ero percent6 then ". an in7estor should in7est only in dollars. B. an in7estor should in7est only in euros. $. an in7estor should be indifferent between dollars and euros. &. <t is impossible to tell gi7en the information. E. "ll of the abo7e. "nswer( "

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<f the dollar interest rate is 10 percent6 the euro interest rate is # percent6 and the expected return on dollar depreciation against the euro is ' percent6 then ". an in7estor should in7est only in dollars. B. an in7estor should in7est only in euros. $. an in7estor should be indifferent between dollars and euros. &. <t is impossible to tell gi7en the information. E. "ll of the abo7e. "nswer( $

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<f the dollar interest rate is 10 percent and the euro interest rate is # percent6 and the

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expected return on dollar depreciation against the euro is ) percent6 then ". an in7estor should in7est only in dollars. B. an in7estor should in7est only in euros. $. an in7estor should be indifferent between dollars and euros. &. <t is impossible to tell gi7en the information. E. "ll of the abo7e. "nswer( B *'. <f the dollar interest rate is 10 percent6 the euro interest rate is 1 percent6 and the expected return on dollar depreciation against the euro is negati7e ' percent6 then ". an in7estor should in7est only in dollars. B. an in7estor should in7est only in euros. $. an in7estor should be indifferent between dollars and euros. &. <t is impossible to tell gi7en the information. E. "ll of the abo7e. "nswer( " *5. Which of the following statements is the most accurate! ". " rise in the interest rate offered by dollar deposits causes the dollar to appreciate. B. " rise in the interest rate offered by dollar deposits causes the dollar to depreciate. $. " rise in the interest rate offered by dollar deposits does not affect the 9.:. dollar. &. ;or a gi7en euro interest rate and constant expected exchange rate6 a rise in the interest rate offered by dollar deposits causes the dollar to appreciate. E. 2one of the abo7e. "nswer( & *#. Which of the following statements is the most accurate! ". ;or a gi7en 9.:. interest rate and a gi7en expectation with regard to the future exchange rate6 a rise in the interest rate paid by euro deposits causes the dollar to depreciate. B. ;or a gi7en 9.:. interest rate and a gi7en expectation with regard to the future exchange rate6 a rise in the interest rate paid by euro deposits causes the dollar to appreciate. $. " rise in the interest rate paid by euro deposits does not affect the 7alue of the dollar. &. " rise in the interest rate paid by euro deposits causes the dollar to depreciate. E. 2one of the abo7e. "nswer( "

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:uppose that the one=year forward price of euros in terms of dollars is e?ual to 11.11* per euro. ;urther6 assume that the spot exchange rate is 11.05 per euro6 and the interest rate on dollar deposits is 10 percent and on euros it is ' percent. What is the rate of return on a co7ered euro deposit! ". 0.10 B. 0.101 $. 0.10 &. 0.10* E. 0.10' "nswer( &

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:uppose that the one=year forward price of euros in terms of dollars is e?ual to 11.11* per euro. ;urther6 assume that the spot exchange rate is 11.05 per euro6 and the interest rate on dollar deposits is 10 percent and on euros it is ' percent. 9nder these assumptions6 ". co7ered interest parity does hold. B. co7ered interest parity does not hold. $. <t is hard to tell whether co7ered interest parity does or does not hold. &. 2ot enough information is gi7en to answer the ?uestion. E. 2one of the abo7e. "nswer( B

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Essay Questions 1. <n the year 0006 "mericans floc3ed to /aris. What economic forces made ;rench goods appear so cheap to residents of the 9nited :tates!

"nswer( Ane ma0or factor was a sharp fall in the dollar price of ;rance5s currency. . Who are the ma0or participants in the foreign exchange mar3et! 1. . *. '. *. $ommercial ban3s $orporations 2onblan3 financial institutions $entral ban3s

"nswer(

Based on the case study6 B" ,ale of ,wo &ollars6C explain why errors in the currency mar3et can be more costly to the ,oronto Blue Days baseball team than errors in the field.

"nswer( :ee page * +. ,he ,oronto team has )0 percent of its re7enue paid in $anadian dollars and )0 percent of its expenses set in 9.:. dollars. :ince the $anadian dollar has depreciated substantially6 it causes big losses for the team by raising its expenses relati7e to its receipts. ,o protect itself from the 7agaries of the exchange rate6 the team tries to predict its need for 9.:. dollars ahead of time so that it can sell $anadian dollars and purchase the "merican currency in ad7ance to loc3 in the exchange rate. Errors in the currency mar3et can thus be more costly to the team than on the field. '. Explain what a B7ehicle currencyC is. Why is the 9.:. dollar considered a 7ehicle currency!

"nswer( " 7ehicle currency is one that is widely used to denominate international contracts made by parties who do not reside in the country that issues the 7ehicle currency. :ince 0016 ninety percent of foreign exchange transactions in7ol7e exchanges of foreign currencies for 9.:. dollars8 therefore6 the dollar is considered a 7ehicle currency. 5. What are the factors affecting the demand for foreign currency!

"nswer( ,hree factors affect the demand for foreign currency. ,hey are expected return6 ris36 and li?uidity.

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What is the interest parity condition!

"nswer( ,he condition that the expected returns on deposits of any two currencies are e?ual when measured in the same currency is called the interest parity condition. <t implies that potential holders of foreign currency deposits 7iew them as e?ually desirable assets6 i.e. ris3 is assumed away. <n notational forms( @1 E @E F GEe1HE I E1HEJ H E1HE. %. &iscusses the effects of a rise in the dollar interest rate on the exchanger rate.

"nswer( ;or a gi7en euro interest rate and constant expected exchange rate6 a rise in the interest rate offered by dollar deposits causes the dollar to appreciate.

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). &iscusses the effects of a rise in the interest rate paid by euro deposits on the exchanger rate. "nswer( ;or a gi7en 9.:. interest rate and a gi7en expectation with regard to the future exchange rate6 a rise in the interest rate paid by euro deposits causes the dollar to depreciate.

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+. Explain the purpose of the following figure. :how the effects of -erman unification on -ermany5s interest rate.

"nswer( ,he main purpose is to show that different interest rates exist for different assets since foreign currencies are different assets. ;rom 1++0 to 1++56 the &M interest rate is higher than that of the 9nited :tates. Excluding this period6 the dollar rates are higher reflecting higher inflation in the 9nited :tates and depreciating of the dollar 7ersus the -erman currency.

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Explain the purpose of the following figure.

"nswer( ,o show that spot and forward exchange rates are in general close to each other.

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Quantitative/ raphing !ro"le#s 1. $ompute how many dollars it would cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds for the following exchange rates(
Exchange Rate Price of a sweater in British pounds Price in dollars Number of dollars per one British pound 1 1.1 1.2 1.25 1. 1.! 1.5 1." 1.# 1.#5 1.$ 1.% 2 50 50 50 50 50 50 50 50 50 50 50 50 50

"nswer(

Exchange Rate Price of a sweater in British pounds Price in dollars Number of dollars per one British pound 1 1.1 1.2 1.25 1. 1.! 1.5 1." 1.# 1.#5 1.$ 1.% 2 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50 & 50.00 55.00 "0.00 "2.50 "5.00 #0.00 #5.00 $0.00 $5.00 $#.50 %0.00 %5.00 100.00

$ompute how many British pounds it would cost to buy a pair of "merican designer 1%+

0eans costing 1'5( /rice of a pair of "merican designer 0eans Price in British pounds
!5 !5 !5 !5 !5 !5 !5 !5 !5 !5 !5 !5 !5

Exchange Rate Number of dollars per one British pound

1 1.1 1.2 1.25 1. 1.! 1.5 1." 1.# 1.#5 1.$ 1.% 2

"nswer( /rice of a pair of "merican designer 0eans

Exchange Rate Number of dollars per one British pound 1 1.1 1.2 1.25 1. 1.! 1.5 1." 1.# 1.#5 1.$ 1.% 2

Price in British pounds

!5 !5 !5 !5 !5 !5 !5 !5 !5 !5 !5 !5 !5

!5 !0.%0%0%0%1 #.5 " !."15 $!"2 2.1!2$5#1! 0 2$.125 2".!#05$$2! 25.#1!2$5#1 25 2 ."$!2105 22.5

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;ind the exchange rate between the dollar and the British pound for the following cases(

/rice of a pair of "merican designer 0eans

Price in British pounds Exchange Rate Number of dollars per one British pound !5 10 !5 20 !5 0 !5 !0 !5 50 !5 "0 !5 #0 !5 $0 !5 %0 !5 100 !5 110 !5 120 !5 1 0 !5 1!0

"nswer( /rice of a pair of "merican designer 0eans

Price in British pounds Exchange Rate Number of dollars per one British pound !5 10 !.5 !5 20 2.25 !5 0 1.5 !5 !0 1.125 !5 50 0.% !5 "0 0.#5 !5 #0 0."!2$5#1! !5 $0 0.5"25 !5 %0 0.5 !5 100 0.!5 !5 110 0.!0%0%0%0% !5 120 0. #5 !5 1 0 0. !"15 $!" !5 1!0 0. 21!2$5#1

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;or the following 15 cases6 compare the dollar rates of return on dollar and euro deposits(
Rate of Return (ifference Expected between Rate of (ollar and (ollar Euro (ollar Euro )nterest )nterest (epreciation (eposits Rate* R& Rate* RE against Euro 1 0.1 0.0" 0 2 0.1 0.0" 0.0! 0.1 0.0" 0.0$ ! 0.1 0.12 +0.0! 5 0.1 0.1$ 0 " 0.15 0.0" 0 # 0.15 0.0" 0.0! $ 0.15 0.0" 0.0$ % 0.15 0.12 +0.0! 10 0.15 0.1$ 0 11 0.2 0.0" 0 12 0.2 0.0" 0.0! 1 0.2 0.0" 0.0$ 1! 0.2 0.12 +0.0! 15 0.2 0.1$ 0 Rate of Return (ifference Expected between Rate of (ollar and (ollar Euro (ollar Euro )nterest )nterest (epreciation (eposits Rate* R& Rate* RE against Euro 1 0.1 0.0" 0 0.0! 2 0.1 0.0" 0.0! 0 0.1 0.0" 0.0$ +0.0! ! 0.1 0.12 +0.0! 0.02 5 0.1 0.1$ 0 +0.0$ " 0.15 0.0" 0 0.0% # 0.15 0.0" 0.0! 0.05 $ 0.15 0.0" 0.0$ 0.01 % 0.15 0.12 +0.0! 0.0# 10 0.15 0.1$ 0 +0.0 11 0.2 0.0" 0 0.1! 12 0.2 0.0" 0.0! 0.1 1 0.2 0.0" 0.0$ 0.0" 1! 0.2 0.12 +0.0! 0.12 15 0.2 0.1$ 0 0.02

'ase

"nswer(

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;or the table below6 calculate the EK"$, relationship.

Expected Rate of Rate of Return (ollar (ifference (epreciation between against Euro (ollar and Euro Exact E (eposits formula 0.0" 0 0.0! 0.0" 0.0! 0 0.0" 0.0$ +0.0! 0.12 +0.0! 0.02 0.1$ 0 +0.0$ 0.0" 0 0.0% 0.0" 0.0! 0.05 0.0" 0.0$ 0.01 0.12 +0.0! 0.0# 0.1$ 0 +0.0 0.0" 0 0.1! 0.0" 0.0! 0.1 0.0" 0.0$ 0.0" 0.12 +0.0! 0.12 0.1$ 0 0.02

'ase

R& 1 2 ! 5 " # $ % 10 11 12 1 1! 15

RE 0.1 0.1 0.1 0.1 0.1 0.15 0.15 0.15 0.15 0.15 0.2 0.2 0.2 0.2 0.2

"nswer(
Expected Rate of Rate of Return (ollar (ifference (epreciation between against Euro (ollar and Euro Exact E (eposits formula 0.0" 0 0.0! 0.0! 0.0" 0.0! 0 +0.002! 0.0" 0.0$ +0.0! +0.0!!$ 0.12 +0.0! 0.02 0.02!$ 0.1$ 0 +0.0$ +0.0$ 0.0" 0 0.0% 0.0% 0.0" 0.0! 0.05 0.0!#" 0.0" 0.0$ 0.01 0.0052 0.12 +0.0! 0.0# 0.0#!$ 0.1$ 0 +0.0 +0.0 0.0" 0 0.1! 0.1! 0.0" 0.0! 0.1 0.0%#" 0.0" 0.0$ 0.0" 0.0552 0.12 +0.0! 0.12 0.12!$ 0.1$ 0 0.02 0.02

'ase

R& 1 2 ! 5 " # $ % 10 11 12 1 1! 15

RE 0.1 0.1 0.1 0.1 0.1 0.15 0.15 0.15 0.15 0.15 0.2 0.2 0.2 0.2 0.2

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$alculate the interest rate in the 9nited :tates6 if interest parity condition holds6 for the following 15 cases(

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Expected Rate of (ollar (epreciation against Euro 'ase RE 1 2 ! 5 " # $ % 10 11 12 1 1! 15 E 0.0" 0.0" 0.0" 0.12 0.1$ 0.0" 0.0" 0.0" 0.12 0.1$ 0.0" 0.0" 0.0" 0.12 0.1$ R& 0 0.0! 0.0$ +0.0! 0 0 0.0! 0.0$ +0.0! 0 0 0.0! 0.0$ +0.0! 0

"nswer(
Expected Rate of (ollar (epreciation against Euro E R& 0.0" 0 0.0" 0.0! 0.0" 0.0$ 0.12 +0.0! 0.1$ 0 0.0" 0 0.0" 0.0! 0.0" 0.0$ 0.12 +0.0! 0.1$ 0 0.0" 0 0.0" 0.0! 0.0" 0.0$ 0.12 +0.0! 0.1$ 0

'ase

RE 1 2 ! 5 " # $ % 10 11 12 1 1! 15

0.0" 0.1 0.1! 0.0$ 0.1$ 0.0" 0.1 0.1! 0.0$ 0.1$ 0.0" 0.1 0.1! 0.0$ 0.1$

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$alculate the interest rate in the euro >one if interest parity condition holds6 for the following 15 cases(
Expected Rate of (ollar (epreciation against Euro E R& 0 0.0! 0.0$ +0.0! 0 0 0.0! 0.0$ +0.0! 0 0 0.0! 0.0$ +0.0! 0

'ase

RE 1 2 ! 5 " # $ % 10 11 12 1 1! 15

0.0" 0.11 0.1" 0.05 0.1 0.11 0.1" 0.21 0.1 0.15 0.1" 0.21 0.2" 0.15 0.2

"nswer(
'ase RE 1 2 ! 5 " # $ % 10 11 12 1 1! 15 E 0.0" 0.0# 0.0$ 0.0% 0.1 0.11 0.12 0.1 0.1! 0.15 0.1" 0.1# 0.1$ 0.1% 0.2 R& 0 0.0! 0.0$ +0.0! 0 0 0.0! 0.0$ +0.0! 0 0 0.0! 0.0$ +0.0! 0 0.0" 0.11 0.1" 0.05 0.1 0.11 0.1" 0.21 0.1 0.15 0.1" 0.21 0.2" 0.15 0.2

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"ssume that the euro interest rate is constant at 5 percent6 and that the expected exchange rate is 1.05 dollars per one euro. ;ind the expected dollar return on euro deposits for the following cases(
Expected (ollar ,oda-.s )nterest (epreciation Expected (ollar (ollar/Euro Rate on Rate 0gainst Return on Euro Exchange Euro Euro (eposits Rate (eposits 11.05 + E2/E Re 3 11.05 + E2/E 1 1.0# 2 1.0" 1.05 ! 1.0! 5 1.0 " 1.02 # 1.01 $ 1 % 0.%% 10 0.%$

'ase

"nswer(
Expected (ollar ,oda-.s )nterest (epreciation Expected (ollar (ollar/Euro Rate on Rate 0gainst Return on Euro Exchange Euro Euro (eposits Rate (eposits 11.05 + E2/E Re 3 11.05 + E2/E 1 1.0# 0.05 +0.01$"%1" 0.0 1 0$!11 2 1.0" 0.05 +0.00%! ! 0.0!05""0 $ 1.05 0.05 0 0.05 ! 1.0! 0.05 0.00%"15! 0.05%"15 $5 5 1.0 0.05 0.01%!1#5 0.0"%!1#!#" " 1.02 0.05 0.02%!11$ 0.0#%!11#"5 # 1.01 0.05 0.0 %"0! 0.0$%"0 %" $ 1 0.05 0.05 0.1 % 0.%% 0.05 0.0"0"0"1 0.110"0"0"1 10 0.%$ 0.05 0.0#1!2$" 0.121!2$5#1

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;or the data in Luestion )6 plot today5s dollarHeuro exchange rate against the expected dollar return on euro deposits.

1)#

"nswer(
1.0$ 1.0" 1.0! 1.02 1 0.%$ 0.%" 0 0.02 0.0! 0.0" 0.0$ 0.1 0.12 0.1!

10.

9sing the data from Luestion ) and the plot in Luestion +6 show that if the interest rate in the 9nited :tates is 10 percent6 the exchange rate will be 16 and if the interest rate in the 9nited :tates is 1 percent6 the exchange rate will be 0.+) dollars per euro. in the figure below correspond to these two e?uilibrium points.

"nswer( /oints 1 and

1.0$ 1.0" 1.0! 1.02 1 0.%$ 0.%" 0 0.02

1 2

0.0!

0.0"

0.0$

0.1

0.12

0.1!

11.
,oda-.s

"ssume the 9.:. interest rate is 10 percent6 and the interest rate on euro deposits is 5 percent. ;or the following exchange rates6 find the forward exchange rates.
4orward

1)%

(ollar/Euro Exchange Rate Exchange Rate E&/E 4&/E 1 1.05 1.1 1.2 1.

"nswer( 9sing the co7ered interest rate parity will yield the second column in the table(
4&/E ,oda-.s (ollar/Euro Exchange 4orward Rate Exchange Rate E&/E 4&/E 1 1.05 1.05 1.1025 1.1 1.155 1.2 1.2" 1. 1. "5

E G@1 = @EJ E1HE F E1HE

1))