PROBLEMENS ON FOREIGN EXCHANGE MARKET

1. Suppose the president of the United States announces a new set of reforms that includes a
new anti-inflation program. Assuming the announcement is believed by the public, what will
happen to the exchange rate for the U.S. dollar?

2. Through the summer and fall of 2008, as the global financial crisis began to take hold,
international financial institutions and sovereign wealth funds significantly increased their
purchases of U.S. Treasury securities as a safe haven investment. How should this affect
U.S. dollar exchange rates?

3. In March 2009, the Federal Reserve announced a quantitative easing program designed to
lower intermediate and longer-term interest rates. What effect should this have on the
dollar/euro exchange rate?

4. If the price level recently increased by 20% in England while falling by 5% in the United
States, how much must the exchange rate change if PPP holds? Assume that the current
exchange rate is 0.55 pound per dollar.

5. If the European central bank decides to pursue a contractionary monetary policy to fight
inflation, what will happen to the value of the U.S. dollar? Draw a graph to illustrate your
answer.

6. If the spot exchange rate is US$ 1 = S/. 3,35 and the annual effective rate (TEA) for deposits
in US $ and Nuevo soles are 1.2% and 3.4% respectively,
a) If the Nuevo Sol is expected to depreciate against the dollar at an annual rate of 2%,
what would the expected return on dollar deposits in terms of soles be?
b) If the Nuevo Sol is expected to appreciate against the dollar at an annual rate of 3%,
what would the expected return on Soles deposits in terms of Dollars be?
c) If within a year the exchange rate is expected to be S / 3.45, what would the equilibrium
interest rate for deposits in soles be?

7. An investor in England purchased a 91-day T-bill for $987.65. At that time, the exchange rate
was $1.75 per pound. At maturity, the exchange rate was $1.83 per pound. What was the
investor’s holding period return in pounds?

8. The current exchange rate is 0.93 euros per dollar, but you believe the dollar will decline to
0.85 euros per dollar. If a euro-denominated bond is yielding 2%, what return do you expect
in U.S. dollars?

9. The 6-month forward rate between the British pound and the U.S. dollar is $1.75 per pound.
If
6-month rates are 3% in the U.S. and 150 basis points higher in England, what is the current
exchange rate?
10. A one-year CD in Europe is currently paying 5%, and the exchange rate is currently 0.99
euros per dollar. If you believe the exchange rate will be 1.04 euros per dollar one year from
now, what is the expected return in terms of dollars?

11. City Bank issued $200 million of one-year CDs in the U.S. at a rate of 6.50 percent. It
invested part of this money, $100 million, in the purchase of a one-year bond issued by a
U.S. firm at an annual rate of 7 percent. The remaining $100 million was invested in a one-
year Brazilian government bond paying an annual interest rate of 8 percent. The exchange
rate at the time of the transaction was Brazilian real 1/$.

a) What will be the net return on this $200 million investment in bonds if the exchange rate
between the Brazilian real and the U.S. dollar remains the same?

12. North Bank has been borrowing in the U.S. markets and lending abroad, thus
incurring foreign exchange risk. In a recent transaction, it issued a one-year $2
million CD at 6 percent and funded a loan in euros at 8 percent. The spot rate for the
euro was €1.45/$ at the time of the transaction.

Information received immediately after the transaction closing indicated that the euro
will depreciate to €1.47/$ by year-end. If the information is correct, what will be
the realized spread on the loan? What should have been the bank interest rate on
the loan to maintain the 2 percent spread? Assume adjustments in principal value
are included in the spread.

The bank had an opportunity to sell one-year forward marks at €1.46. What would
have been the spread on the loan if the bank had hedged forward its foreign exchange
exposure?

13. Bank USA recently purchased $10 million worth of euro-denominated one-year
CDs that pay 10 percent interest annually. The current spot rate of U.S. dollars for
euros is $1.30/€1.
a) Is Bank USA exposed to an appreciation or depreciation of the dollar relative to
the euro?
b) What will be the return on the one-year CD if the dollar appreciates relative to
the euro such that the spot rate of U.S. dollars for euros at the end of the year is
$1.20/€1?
c) What will be the return on the one-year CD if the dollar depreciates relative to
the euro such that the spot rate of U.S. dollars for euros at the end of the year is
1.40/€1?

14. If a bundle of goods in Japan costs ¥4,000,000 while the same goods and services
cost $40,000 in the United States, what is the current exchange rate of U.S. dollars
for yen? If, over the next year, inflation is 6 percent in Japan and 10 percent in the
United States, what will the goods cost next year? Will the dollar depreciate or
appreciate relative to the yen over this time period?
15. If the interest rate on dollar-denominated assets is 10% and it is 8% on Yens-
denominated assets, then the yen is expected to appreciate at 5% rate,
a) Dollar-denominated assets have a lower expected return than yen-denominated
assets.
b) The expected return on dollar-denominated assets in yen is 2%.
c) The expected return on yen-denominated assets in dollar is 3%.
d) None of the above will occur.

16. If the interest rate on franc-denominated assets is 5% and is 8% on dollar-

denominated assets, then the expected return on dollar assets is higher than that on
franc-denominated assets if the dollar expected to depreciate at a 5% rate.