Exercises 6—The floating exchange rate

Haakon O.Aa. Solheim∗

May 7, 2002

Exercises

1. Assuming no transaction costs, suppose GBP=USD 2.4110 in New

York, USD=FRF 3.997 in Paris, and FRF=GBP 0.1088 in London.
How could you take advantage of these rates?
Solution Assume the two dollar rates to be “correct”. Then the
GBP/FRF rate should be
1
GBP/U SD
GBP/F RF = = 2.4110 = 0.10377 6= 0.01088. (1)
F RF/U SD 3.997

⇒ The FRF is expensive in London. Triangular arbitrage does not

hold. Strategy: use FRF 1,000,000 to buy GBP in London.
⇒ obtain GBP 108,800.
sell GBP 108,800 in New York
⇒ obtain USD 262319.
sell USD 262319 in Paris
⇒ obtain FRF 1048480.
⇒ Profit=FRF 48480.

2. The media frequently report that ”the dollar’s value strengthened against
many currencies in response to the Federal Reserve’s plan to increase
interest rates.” Explain why the dollar’s value is expected to appreci-
ate, and why the rate may change even before the Fed affects interest
rates.
Solution Higher interest rates means a monetary contraction. Ac-
cording to the monetary equilibrium model a monetary contraction
should lead to an appreciation of the exchange rate, as money supply,
∗
Norwegian School of Management (BI). email: haakon.o.solheim@bi.no.

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 m, fall. According to the Dornbusch model we should expect a mon-
etary contraction to lead to an immediate appreciation, followed by a
depreciation.
If the Federal Reserve signals a change in interest rates, investors will
update their expectations. As we have seen in the monetary equilib-
rium model, the exchange rate depends on expectations of the future
values of fundamental variables. new information should immediately
be incorporated in the exchange rate, even before the change has come
into effect.
3. The following quotations are available to you. (You may either buy or
sell at the stated rates.)
Hong Kong Shanghai Bank: FRF/USD=4.8600
Dredsner Bank: DEM/USD=1.4200
Banque National de Paris: FRF/DEM=3.4400
Assume that you have an initial USD 1,000,000. Is triangular arbitrage
possible? If so, explain the steps and compute your profit.
Solution The cross rates from Dresdner and BNP implies a FRF/USD
of
F RF/U SD 4.8600
F RF/U SD = = 1 = 4.8848 6= 4.8600. (2)
U SD/DEM 1.4200
You should find that by investing FRF 100 you can make a profit of
FRF 0.51029.
4. You plan to spend one month at the luxurious Nusa Dua Hotel in Bali,
Indonesia, a year from now. The present charge for a suitable suite
plus meals is Rps 28,800 per night or USD 800 at the present exchange
rate of INR/USD 36.
(a) The Nusa Dua Hotel tells you that next year’s charges will increase
with Indonesian inflation, which you expect to be 16 per cent. U.S.
inflation is currently 4 per cent per annum. You believe implicitly
in the theory of purchasing power parity. How many U.S. dollars
will you need one year hence to pay for your 30-day vacation?
Solution

800U SD · (1 + 1.04) · 30 = 24, 960U SD (3)

(b) The forward rate on a one year contract is INR/USD=40. How

many dollars do you need one year hence if you enter into a forward
contract today?

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 Solution In one year you need

28, 800 · (1 + 0.16) · 30 = 1, 002, 240IN R (4)

If the forward contract is at 40 INR= 1 USD, you need

1, 002, 240
= 25, 056U SD (5)
40
in one year.
(c) On a one year instrument, the US rate of interest is 8 per cent.
What is the rate of interest on a similar instrument in Indonesia?
Solution If you use numbers from (b):
1+i 40 · 1 + 0.08
F = ⇒i=1− = 0.2. (6)
1 + i∗ 36
5. The United States and France both produce Cabernet Sauvignon wine.
A bottle of Cabernet Sauvignon sell in the United States for USD 18.
An equivalent bottle sells in France for FRF 100.

(a) According to purchasing power parity, what should be the U.S.

dollar/French franc spot rate of exchange?
Solution
100F RF
= ⇒ 1U SD = 5.5556F RF. (7)
18U SD
(b) Suppose the price of Cabernet Sauvignon in the US is expected to
rise to USD 20 over the next year, while the price of a comparable
bottle of French wine is expected to rise to FRF 118. What should
be the one-year forward U.S. dollar/French franc exchange rate?
Solution
118F RF
F = ⇒ 1U SD = 5.90F RF. (8)
20U SD
(c) Given your answers to (a) and (b) above, and given that the cur-
rent interest rate in the United States is 6 per cent for notes of
one-year maturity, what would you expect current French interest
rates to be?
Solution
1+i
5.90 = 5.5556 ⇒ i = 0.1257. (9)
1 + 0.06

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6. Suppose today’s spot exchange rate is USD/DEM=0.51. The six-
month interest rates on dollars and DM are 13 per cent and 6 per
cent respectively. The six-month forward rate is USD/DEM=0.5273.
A foreign exchange advisory service has predicted that the DEM will
appreciate to USD/DEM=0.54 within six months.
(a) How would you use forward contracts to profit in the above situ-
ation?
Solution A forward contract implies that you get a certain amount
of currency at some time in the future. You will pay the contract
at delivery.
If you buy 100 DEM at the current forward rate, you will have to
have to pay out 100·0.5273 = 52.73 U SD in 6 months. However, if
the advisory is correct, in 6 months 100 DEM will give 54.00 USD.
How to make a profit? Assume that the spot rate in 6 months
really will be 0.54. Contract to sell 52.73 USD in 6 months. You
get 100 DEM. Exchange these back to USD at the spot rate. You
will now hold 54.00 USD. Profit equals 54.00-52.73=1.27 USD.
(b) How would you use borrowing and lending transactions to profit?
Solution Assume the spot rate in 6 moths will actually be 0.54.
Borrow 51 USD at 13 per cent today. In six months you will have
to repay 54.32 USD. Exchange to DEM at current rate, obtain 100
DEM. Invest in Germany at 6 percent for 6 months, in 6 months
you obtain 103. Exchange back at the rate USD/DEM=0.54. You
will get 103∗0.54 = 55.62. Profit will be 55.62−54.32 = 1.30 U SD.
7. In the 1950s and 1960s many influential economists like Milton Fried-
man and Harry Johnson were in favour of floating exchange rates.
Johnson argued that floating exchange rates normally would ”move
only slowly and fairly predictably.”
(a) Explain the reasoning behind such a statement.
Solution The market knows better than governments what is the
true value of the currency. Speculation would be stabilising rather
than destabilising. A speculator who increased the magnitude
of exchange rate fluctuations could only do so by buying high
and selling low, which is a recipe for going out of business rather
quickly.
(b) With the benefit of hindsight we know that exchange rate fluctua-
tions have been anything but slow and predictable, at least in the
short run. Explain.

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Solution Lecture 6 discusses a number of avenues to understand-
ing this “puzzle”. In fact, there is no good answer.