Topic 3 Solutions

1. Discuss the implications of interest rate parity for exchange rate determination.

Assuming that the forward rate unbiasedness condition holds, IRP can be written as follows:

1 + i∗
S = * E (S t +1 | I t )
1+ i

In this case, the exchange rate is determined by the two interest rates, and the expected future
spot rate, conditional on information, I, available at time t. Expectations can be self-fulfilling.
Since the information set will be continuously updated as news hits the market, the exchange
rate will exhibit highly dynamic, random behaviour.

2. Explain purchasing power parity, both the absolute and relative version. What
causes deviations from purchasing power parity?

The absolute version of PPP relates the exchange rate to the absolute price levels in two
countries, while relative PPP relates the change in the exchange rate to the change in price
levels in the two countries.

PPP can be violated if there are barriers to trade, transaction costs or if people in different
countries have different tastes.

3. Discuss the implications of the deviations from purchasing power parity for
countries’ competitive positions in the world market.

If the exchange rate changes satisfy PPP, competitive positions of countries will remain
unaffected following exchange rate changes. Otherwise, exchange rate changes will affect the
relative competitiveness of countries. If a currency appreciates (depreciates) by more than what
is warranted by PPP, it will hurt (strengthen) the country’s competitive position.

4. Suppose that the treasurer of IBM has an extra cash reserve of $100 million to invest
for six months. The six-month interest rate is 8 percent per annum in the United
States and 7 percent per annum in Germany. Currently, the spot exchange rate is
€1.01 per dollar and the six-month forward exchange rate is €0.99 per dollar. The

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 treasurer of IBM does not wish to bear any exchange risk. Where should he or she
invest to maximize the return?

i$ = 4%, iDM = 3.5%, S = €1.01/$ and F = €0.99/$

$1,000,000 invested in the US for 6 months will be worth $100,000,000 (1.04) = $104,000,000

If it is invested in €, it will be worth: $100,000,000 * 1.01 * (1.035) * (1/0.99) = $105,590,909

Therefore, it is better to invest in Germany.

5. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange
rate is $1.52/£. The three-month interest rate is 8.0 percent per annum in the U.S.
and 5.8 percent per annum in the U.K. Assume that you can borrow as much as $1.5
million or £1 million.

(a) Determine whether interest rate parity is currently holding.

i$ = 2%, i£ = 1.45%, S = $1.5/£ and F = $1.52/£

(1+ i$) = 1.02 (wealth from investing in the US)

F/S (1+ i£) = 1.0208 (wealth from investing in the UK)

IRP does not hold.

In this question, the pound is overvalued in the forward market.

F 1+ i F − S i − i*
Note: Subtracting 1 from both sides of = gives us =
S 1+ i* S 1+ i*

(b) If IRP is not holding, how would you carry out covered interest arbitrage?
Show all the steps and determine the arbitrage profit.

(1) Borrow $1.5m – will have to repay $1.53m

(2) Buy £1m using $1.5m at the prevailing spot rate

(3) Invest £1m at the pound interest rate of 1.45% and the maturity value will be £1,014,500

(4) Sell £1,014,500 forward for $1,542,040

Arbitrage profit is $12,040

(c) Explain how IRP will be restored as a result of covered arbitrage activities.

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Following the arbitrage transactions described above:

The $ interest rate will rise;

The £ interest rate will fall;

The spot exchange rate will rise;

The forward rate will fall;

The adjustments will continue until IRP holds.

6. The annual inflation of Netherlands is given to be 4.22% and that of the US is 3.8%.
According to purchasing power parity (PPP) will the US dollar appreciate or
depreciate? And by how much?

The expected currency depreciation is the differential of inflation rates between the two
countries: ∆S$/NLG = InfUS – InfNLG measures the US$ depreciation/appreciation. In this case,
it is 3.8% - 4.22% = - 0.42%. Implies US$ appreciation of 0.42% or NLG depreciation of
0.42%.

(Please note: This answer utilizes the approximate version of Relative PPP. The answer will be
slightly different if you use the “proper” formula. In that case the answer is –0.403%).

7. When PPP fails, does it imply the presence of profit making opportunities?

Deviations from PPP that are measured using available data reflect many factors including
transport costs, taxes and customs duties, products sold with financing included with after-sales
service contracts, quality differences, price indices with different mixtures of traded and non-
traded goods etc. Measured deviations from PPP are not necessarily indicative of profit
opportunities through arbitrage.

8. In July, the one-year interest rate is 12% on British pounds and 9% on US dollars

(a) If the current exchange rate is $1.63: 1 GBP. What is the expected future exchange
rate in one year?

E (S t +1 ) − S t i − i*
IFE states that =
St 1+ i*

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 E (S t +1 ) = (0.09 – 0.12)/1.12 * 1.63 + 1.63

= $1.5863

(b) Suppose a change in expectations regarding future US inflation causes the expected
future spot rate to decline to $1.52: GBP 1. What should happen to the U.S. interest
rate?

The US interest rate is unknown. Let us assume that the UK interest rate stayed at 12%
(due to no change in expectations of British inflation), then according to IFE

(1.52 – 1.63)/1.63 = (iUS - 0.12)/1.12

iUS = 4.44%

9. Derive the relative PPP formula using Absolute PPP.

Recall, that Relative PPP links the change in the exchange to the difference in the inflation
rates.

At time t, Absolute PPP is Pt = St Pt*

At t+1, Absolute PPP is Pt+1 = St+1 Pt+1*

Pt +1 S t +1 Pt ∗+1 P P
= ∗
where, t +1 − 1 = inf  t +1 = 1 + inf
Pt S t Pt Pt Pt

Substituting, we get

1 + inf =
St
(
S t +1
1 + inf ∗ )

Subtracting 1 from both sides, we get

1 + inf S
∗
− 1 = t +1 − 1
1 + inf St

inf − inf ∗ S t +1 − S t
=
1 + inf ∗ St

10. Assume the interest rate is 16% on Pounds and 7% on Deutsche marks. At the same
time, inflation is running at an annual rate of 3% in Germany and 9% in England.

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(a) If the Deutsche mark is selling at a one-year forward premium of 10% against the
pound, is there an arbitrage opportunity? Explain.

F −S i − i*
IRP states that =
S 1+ i*

The % forward premium [(F-S)/S] has been given. The DEM is buying 10% more Pounds in a
year’s time than today.

i − 0.07
0.10 =
1.07

i = 17.7%

The £ interest rate should be 17.7% instead of 16%. To take advantage of this arbitrage
opportunity, we borrow at 16% and convert into DEM and invest it at 7%. Then sell forward,
locking the £ return of 17.7%.

(b) What is the real interest rate in Germany? In England?

1 + inom. = (1 + ireal )(1 + inf )

1.07
Germany : − 1 = 3.88%
1.03

1.16
UK: − 1 = 6.42%
1.09

11. If the USD/Yen spot rate is Yen 218/USD and the interest rates in Tokyo and NY are
6% and 12% respectively. What is the expected USD/Yen exchange rate one year
hence?

E (S t +1 ) − S t i − i*
=
St 1+ i*

0.12 − 0.06
E (S t +1 ) = S t × + St
1.06

0.12 − 0.06
E (S t +1 ) = 0.004587 × + 0.004587
1.06

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E (S t +1 ) = USD 0.004847 / Yen (Yen 206.32 / USD )

12. Discuss the impact of transaction costs on the interest rate parity condition.

When transaction costs are present, the Interest Rate Parity condition need no longer hold
exactly. Deviations as large as, but not larger than, transaction costs may exist, forming a
neutral band around the parity line.

13. In France in 1994, short-term interest rates and bond yields remained higher than
in Germany, despite a better outlook for inflation in France. Does this situation
indicate a violation of the Fisher effect? Explain.

No. The Fisher effect is based on Expected Future inflation. Investors are saying that they
believe that Germany would likely to have a lower rate of inflation in the future, despite its
current higher rate of inflation. Hence, investors have accorded a lower interest rates to
Germany than France. (Some background information: Both countries had high unemployment
rates in ’94 and there were calls to ease up on monetary policy to boost economic growth even
if it meant high inflation rates. The market’s expectation was based on the view that the French
central bank is more likely to succumb to the temptation of allowing inflation, to increase
economic growth, than the Bundesbank.)

14. The Economist constructs the Big Mac index (compares the relative prices of the Big
Mac) on a quarterly basis. This index is used to determine if the Law of One Price
holds across countries in which McDonalds operates. Comment on the usefulness of
the index. Describe the characteristics of an index that will overcome the
shortcomings of the Big Mac index.
The fact that the index is so sensitive to the (potentially very short-term) pricing strategies of
one firm on one product should be of concern! A better RPPP index would be based on:
(i) a basket of goods
(ii) goods who are tradable and do not require non-tradable inputs
(iii) goods that have low transportation costs (i.e. are not perishable)
Moreover, even an ideal RPPP-index is only expected to hold in the long run. Thus, we cannot
expect to be able to understand short-term changes in currency valuations based on any RPPP-
index, let alone based on the Big Mac Index.

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15. Tomoko Matsubara, is a currency arbitrager for Sumitomo in Tokyo. The spot rate
this morning is Yen 120.50/$ and the early indications are that the 90-day interest
rates in the US will rise from their current level of 4.1250% per annum. The US
Federal Reserve is worried about rising inflation and has been considering raising
interest rates by 25 basis points (0.25%). The 90-day forward exchange rate quoted
to Matsubara-san by local banks such as Daichi-Kangyo are all Yen 119.60/$. The
current 90-day Yen interest rate is 0.5% (half of one percent) per annum. Matsubara-
san has Yen 300 million at her disposal. Can Matsubara-san make a profit through
covered interest arbitrage? If so, what is her profit in Yen in 90 days?

In this case, IRP doesn’t hold.

(a) Borrow ¥ 300 million

(b) Convert ¥ into dollars at the current spot rate of ¥120.50/$ and receive $2,489,626

(c) Invest for 90 days in US$ securities yielding 4.1250% per annum (1.03125% for 90
days). Will yield $2,489,626 * 1.0103125 = $2,515,300

(d) Sell $2,515,300 forward 90 days at ¥119.60. Total proceeds ¥300,829,880

(e) Repay ¥300m loan plus the 0.5% (0.1250% for 90 days) - ¥300,375,000

(f) Covered interest arbitrage profits = ¥ 454,880 (300,829,880 – 300,375,000)

16. General Motors exports cars to Korea. Suppose that the Korean Won/US$ exchange
rate changes from Won 172/$ to Won 215/$ over one year. Over the same period the
inflation rate in the US is 4% and the inflation rate in Korea is 30%. Is GM less
competitive at the end of the year assuming that currencies of key competitors remain
unchanged against the Won? Show your workings and briefly explain.

If the Actual exchange rate is different from the Predicted exchange rate, the competitiveness
will be affected. Therefore, need to see if the real exchange rate (E) is 1 or not.

S t +1
E= (Formula is given: 0 marks)
S tPPP
+1

To calculate SPPP need to use the PPP formula (also given)

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 (1 + 0.30) = Won215 / $
+1 = Won172 / $ ×
S tPPP
(1 + 0.04)
215
E= =1
215

Since E = 1, competitiveness is unaffected.

(b) FALSE. The real exchange rate would be one and NOT the nominal exchange rate.

17. (a) If your Swedish customer is considered to be of about the same credit-worthiness
as yourself, what annual rate of interest would he approximately have to pay today for a
three-month credit in Krona?

F ( Kr / $) (1 + i Kr (3 / 12))
= =>
S ( Kr / $) (1 + i $ (3 / 12))
 F ( Kr / $)(1 + i $ (3 / 12))  12 1.67(1 + .06(3 / 12))  12
i Kr =  − 1 ⋅ =  − 1 ⋅ = 0.1092
 S ( Kr / $)  3  1.65  3

Thus, the Swedish customer would pay 10.92% < 14.0%.

(b) Given the circumstances, would you agree to provide the extension of the credit at
the terms offered? Why? Why not?

Yes. The extension is a positive NPV project and should be accepted unless I am totally
cash constrained (cannot borrow). True, I have to acquire Krona at the spot rate
(Krona1.65/$) and sell at the (old) forward rate to the bank at (Krona 1.68/$) which
results in a loss of 1.08% of the Krona receivable. However, that is a “sunk cost.” Ask
yourself if your answer to b) would be different if instead the Krona had depreciated to
Krona 1.70/$. If you think it should be, you are deciding on future NPV projects based
on past “sunk” decisions! Not a good idea!