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Student’s Name:

Instructor’s Name:

Course:

Date of Submission:

Question 1:

You have €100,000 to invest and you are given the following rates:

Spot exchange rate: SUSD/EUR = 1.28

1-year forward rate: FUSD/EUR = 1.31

1-year interest rate on euros: i€ = 6.5%

1-year interest rate on dollars: i$ = 7.5%

(a) Calculate the forward premium (discount) fEUR/USD from a European investor’s point of view.

Hint: spot and forward rates above are given as indirect quotes.

(7 Marks)

Answer

To calculate the forward premium discount the formula below is applied

Ff/d= Sf/d(1+if)/ (1+id)

Sf/dSf/d = current spot exchange rate

Ff/dFf/d = current forward exchange rate

id = domestic interest rate

if = foreign interest rate

F=1.28 (1+0.0650)/(1+0.075)
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F= 1.28 (1.065/1.075)

F=1.28 (0.9906)

F=1.268

(b) Calculate your financial result (in EUR) after one year if you invest in Euros.

(4 Marks)

Answer:

Y early Financial results=¿

Forward discount / premium=F−S S ×100 Where F is the forward exchange rate quotation ,∧S is the spot exch

(c) Calculate your financial result (in EUR) after one year from covered interest arbitrage, i.e., if

you decide to invest in U.S. dollars.

(9 Marks)

Answer:

Sr=SI PI PI∗Where Sr is the index of the real exchange ra te ; SI is the nominal exchange rate ( foreign currency

105
Sr 2=1.98( )=1.98 ×0.95=1.89
110

(d) Can you make a profit from arbitrage? Fully explain your answer showing what would be

your net result in percentage.

(10 Marks)

Answer:
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Yes one can make profits from an arbitrage, as it enables the traders to enhance their

efficiency in the financial market. When they sell and buy, the differences in prices of similar

or rather identical assets tend to narrow. In this case, the assets with a lower prices are bid up

while those with higher prices tend to be sold off.

Taking for instance from question b and c above;

2.78−1.89
Profit acquired is ( 100 % )=0.3201∗¿100= 32%
2.78

Question 2:

Answer both (a) and (b) below.

(a) For each of the following five scenarios, explain whether the value of the Euro will

appreciate, depreciate, or remain the same relative to the Japanese Yen. Support your answer

with relevant theories. Assume that exchange rates are free to vary and that other factors are

held constant.

i. Inflation is the same in both the Eurozone and in Japan.

Answer:

The value of Euro will remain the same. This is because, there was no significant change in

the value of Euros. According to the purchasing power parity (PPP) theory the currency that

has higher rates of inflation loses value or depreciates while that with lower rates inflates into

the forex market. In this case, they remained the same therefore the value of Euros remained

the same.

ii. Prices in Japan and the Eurozone are rising at different rate.

Answer
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The Euros will depreciate at different rates.

According to the PPP theory, the currency that have high inflation rates, tend to depreciate in

value.

iii. Interest rates are higher in Japan than in the Eurozone.

Answer:

The Euros in Japan will depreciate while that in Eurozone will appreciate.

According to the Purchasing Power Parity, the currency that has higher rates of inflation loses

value or depreciates while that with lower rates inflates into the forex market.

iv. The European Commission imposes new restrictions on the ability of foreigners to invest in

the Eurozone.

Answer:

The value of Euros will appreciate

This is because restrictions put by the European commissions on the economy, tend to control

the inflow and the outflow of the currency. Therefore restrictions that increase the ability of

foreigners to invest on the Euros, increases the vitality of the currency thus making the Euro

to appreciate.

v. The Euro is trading at a discount on the forward market, i.e. F¥/€ < S¥/€

Answer

The value of Euros will depreciate

According to forward discount theory, the forward condition works such that the currency

becomes less compared to the spot price. In this case, the value of the exchange rates

decreases as compared to the rest of the currencies.

(15 Marks)
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(b) One proposal to stabilize the international monetary system involves setting exchange rates at

their purchasing power parity rates. Once exchange rates are correctly aligned (according to

PPP), each nation would adjust its monetary policy so as to maintain them. Explain in detail

the PPP theory and critically discuss what problems might arise from using the PPP as a

guide to the equilibrium exchange rate. (20marks)

Answer:

Discussion on the PPP Theory

Purchasing Power Parity (PPP) refers to an economic theory that is used to make

comparison of different country currencies through an approach referred to as a basket of

goods. According to the PPP theory, when two currencies are said to be at equilibrium, then

the two currencies are said to be at par, that is when the basket of goods tends to be priced at

a similar level for both countries with a close considerations of the exchange rates in

existence. Notably, the PPP theory is one of the most popular metrics that is utilized the

analysts in the micro-economics that is used to make comparison of different countries.

Further, the theory gives an exclusive approach to the economists as they allow the

economists an opportunity to make comparison on the productivity of the economy as well as

the living standards in various countries. In order to make comparisons of currencies of

different countries, then the following formula is useful;

P1
S=
P2

Where S=Exchange rate of thecurrencies ,

P 1is the cost of the good X ∈currencie s∧¿

P 2is the cost of good X ∈currencies

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Problems that may arise from using PPP theory

Purchasing Power Parity Theory is an exclusive and significant theory that is used by the

economist however, the approach may not have a good reflection of reality thus posing a

number of challenges.

Transportation Costs; while using PPP theory to evaluate the currencies comparison of

different countries, transport costs might be incurred due to the importation of the

goods that are not available locally. These costs include importation duties. In this

case therefore, the imported goods further are sold at higher prices compared to

similar goods that are found locally.

Differences in Taxes; the government imposed taxes that include the value-added tases

(VAT) may spike in one country and remain constant in the other country of

comparison.

Intervention of Government; the intervention of government through tariffs may lead to

dramatic augmentation of the imported goods prices such that the price of a similar

good in another country of comparison may be sold at a cheaper price.

Competition in the market; the use of Purchasing Power Parity theory may lead to the

prices of some goods being deliberately higher in a country. In other cases, the prices

of these goods may hike as some companies tend to have a greater advantage over

their buyers.

The Purchasing Power Parity (PPP) theory is not a proven perfect evaluation metric as

it does not allow a pricing comparison between the countries that use different types

of currencies. This therefore cannot be used in establishing the equilibrium exchange

rates.

Question 3:
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In an integrated world financial market, a financial crisis in a country can be quickly transmitted to

other countries, causing a global crisis.

(a) What was the primary disequilibrium at work in Asia in 1997 that likely caused the Asian

financial crisis? Fully explain your answer.

(15 Marks)

Answer:

The Financial crisis in Asia were initiated by the fundamental variances in the region

economics as well as the numerous transformations of a number of countries from being an

exporter nation and to being an importer nation. The Asian financial crisis were preceded by

a series of asset bubbles with the growth of the exportation regions leading to increased levels

of direct investments by the foreign. This further led to soaring values of the real estate,

increased spending of the bolder companies and even huge projects of public infrastructure.

Heavy borrowings especially from the banks led to increased chances of financial crisis in the

country.

Due to the increased levels of borrowings in the country, there was reduced quality of

investments and excess capacity in these economies. Further, the United States Federal

Reserve, also took advantage of the Asia’s situation and raised the rated of interests during

this period as a way of counteracting the inflation, thus leading to reduced attractive exports

as well as reduced investments by the foreigners.

Increased rate of devaluation of Asian currency including the Singapore dollar,

Indonesian rupiah and the Malaysian ringgit lowered sharply. In this case, due to the

increased rate of devaluation, there were high levels of inflation as well as host problems that

even spread to Japan as well as South Korea.

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(b) What kind of measures would you propose to prevent the recurrence of an Asian-type crisis?

(10 Marks)

Answer

During the early 1990;s the economies of the East Countries were described by an

initiation of more levels of importation compared to their levels of exportation therefore they

ended up requiring high amount of capital that was required to support their home currencies.

Therefore in order to stop similar crises from happening it is important to ensure maintenance

of the rates of exchange through constant inflow of the capital so that they may be able to

utilize projects of the capital infrastructure. As well as development of dams and

manufacturing plants and the real state initiatives. In this case therefore, with the seize in the

flow of capital then it was impossible to stop the crisis.

Further, it is also essential that countries stop to peg the rates of their currencies at a

young state in order to give a chance to the economies to be able to adjust to minimal of no

flow of capital.

Further in order to prevent such crisis from happening, it is important to adhere to

some of the strategies that the IMF put into place including the inclusion of high taxes,

minimal public spending, privatization of the state own corporates and increase in the rates of

interest as an approach of cooling down the over-heated economies.

(c) In your opinion, was globalization responsible for the slowdown of MNC business during the

financial crisis of 2008? Explain carefully.

(10 Marks)

Answer:

It would not be correct to implicate that globalization played a role on the 2008

financial crisis. This line of thinking in this case holds a place of review that despite the fact
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that there is an integration of global economy, there is a mixture of policies that have been

designed in order to keep the flow of capital as a way of ensuring that there is effective

regulation. These policies would have gone a long way of insulating the economies of the

universe from the frustrations accompanied by various global crisis in economy.

Additionally, the governments also had a role to play in the 2008 economic crisis. They

should have seen the crisis coming as signs had built up since 2007. In this case therefore,

instead of placing all the blame to globalization, individual culpability as well as the

governments could carry the blames as well.

On another perspective, the increase in tendencies of protectionists in various

countries has however pointed out that globalization played some aspects of the crisis. Taking

for instance the trading of the derivatives that have been modelled towards the risks and the

algorithms of returns have been coupled with risk taking and greed in excess indicating that

countries that gave a chance to financial flows were greatly affected as soon as there was a

collapse of the derivative market. In this aspect therefore, it is a definite drawback to indicate

that the global financial system is the way it is today due to its near connections between the

world economies that has caused disturbance in one part of the globalized economy which

spreads faster to the rest parts of the system.

In conclusion, while it can be concluded that globalization had a significant role in

spreading the impacts of world crisis in economy, it could also be the case that as soon as

some steps were taken in order to prevent acceleration, the world economy was seen to pull

back. In this case therefore, it would be unfair to entirely place the blame on globalization as

individuals and government also had the role of preventing the acceleration of financial crisis

in 2008.