Week 3-4

FM303 Week 3-4: Tutorial Problem Set 3
(Updated) *,
April 13, 2022
PART I: Foreign Exchange Market

(Chapter 2)
1. At 9.30 a.m. Dealer A calls Dealer B and asks for a quote on the AUD/GBP
exchange rate. Dealer B responds by quoting 2.5500 2.5540. Dealer A
decides to buy GBP 200, 000 at the quoted rate. At 3.30 p.m., Dealer B
quotes 5090. Will dealer A make a prot or a loss by selling the pound
at 3.30 p.m.?
Solution: At 9.30 a.m. Dealer B quotes: S(AUD/GBP) = 2.55002.5540.

Dealer B buys GBP at 2.5500 AUD and sells GBP at 2.5540AUD.
• Dealer A buys GBP 200, 000 at the at 2.5540AUD. ⇒ GBP 200, 000 ×
2.5540AUD = 510800AUD (outow of AUD)
At 3.30 p.m., Dealer B quotes 5090 ⇒ S(AUD/GBP) = 2.55502.5590.

Dealer B buys GBP at 2.5550 and sells GBP at 2.5590.
Dealer B sells GBP at 2.5550AUD ⇒ GBP200, 000×2.5550AUD = 511, 000AUD
(inow of AUD).
Therefore, Dealer A has a net ow of 511000 − 510800 = +200 AUD,

Dealer A will make a prot.
2. The exchange rate between the Australian dollar and the euro, expressed
in direct quotation from an Australian perspective, rises from 1.62405 to
1.62808. Calculate:
* Questions compiled from Moosa (2010), International Finance
Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting, Economics
and Finance, The University of the South Pacic.
1
(a) the appreciation or depreciation of the euro in points and pips.
Solution: S1 (AU D/EU R) = 1.62405 and S2 (AU D/EU R) = 1.62808,
which is a direct quote from Australian perspective. Hence:

S2 1.62808−1.62405
Ṡ (AUD/EUR) = S1 − 1 × 100 = 1.62405 × 100 = +0.248%.
Euro has appreciated. In terms of points: 1.62808 − 1.62405 =
0.00403 or 40.3 points, which is equivalent to 403 pips. Note: 1
point = 10 pips.
(b) the appreciation or depreciation of the Australian dollar in points

and pips.
Solution: S1 (EU R/AU D) = 1.62405
1
= 0.6157 and S2 (EU R/AU D) =
1
1.62808 = 0.6142, which is a direct quote from Euro perspective.

S2 0.6142−0.6157
Ṡ (AUD/EUR) = AU D/EU R S1 − 1 ×100 = 0.6157 ×100 =
+ = −0.244%. AUD has depreciated. In terms of points: 0.6142 −
0.6157 = −0.00150 or 15 points, which is equivalent to 150 pips.
Note: 1 point = 10 pips
3. The following exchange rates are quoted:

Currency Pair Quote (Rate)
USD/AUD 0.5674
JPY/AUD 70.43
GBP/AUD 0.3891
EUR/AUD 0.6075
Calculate the following cross rates: JPY/USD, GBP/USD, EUR/USD,
JPY/GBP, JPY/EUR and EUR/GBP.
Solution:
S(JPY/AUD) 70.43
(a) S(JPY/USD) = S(USD/AUD) = 0.5674 = 124.128
S(GBP/AUD) 0.3891
(b) S(GBP/USD) = S(USD/AUD) = 0.5674 = 0.6858
S(EUR/AUD) 0.6075
(c) S(EUR/USD) = S(USD/AUD) = 0.5674 = 1.0707
S(JPY/AUD) 70.43
(d) S(JPY/GBP) = S(GBP/AUD) = 0.3891 = 181.007
S(JPY/AUD) 70.43
(e) S(JPY/EUR) = S(EUR/AUD) = 0.6075 = 115.934
S(EUR/AUD) 0.6075
(f ) S(EUR/GBP) = S(GBP/AUD) = 0.3891 = 1.5613
4. The following exchange rates are quoted:
Currency Pair Quote (Rate)

GBP/AUD 0.382090
AUD/EUR 1.640080
Calculate the bidoer spread (in points) on the exchange rate between
the pound and the euro expressed in direct quotation from a British per-
Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic
spective.
Solution:
Currency Pair Sb Sa
GBP/AUD 0.3820 0.3890
AUD/EUR 1.6400 1.6480
Sb (GBP/EUR) = Sb (GBP/AUD) × Sb (AUD/EUR) = 0.3820 × 1.6400 =
0.6265
Sa (GBP/EUR) = Sa (GBP/AUD) × Sa (AUD/EUR) = 0.3890 × 1.6480 =

00.6411
∴ Spread = Sb − Sa = 0.6411 − 0.6265 = 0.0146 or 146 points
5. On the basis of the following exchange rates, construct a cross exchange

rate matrix that does not include the Australian dollar. All exchange rates
must be expressed in bidoer terms.
Currency Pair Quote
GBP/AUD 0.38200.3900
EUR/AUD 0.60200.6080
CHF/AUD 0.88000.8860
(GPB/AUD)b
(GBP/EUR)b = (EUR/AUD)a = (GPB/AUD)b × (AUD/EUR)b = 0.3820 ×
1
0.6080 = 0.6283
(GPB/AUD)a
(GBP/EUR)a = (EUR/AUD)b = (GPB/AUD)a ×(AUD/EUR)a = 0.3900×
1
0.6020 = 0.6478
1 1
(EUR/GBP)a = (GBP/EUR)b
= 0.6283 = 1.5916
1 1
(EUR/GBP)b = (GBP/EUR)a
= 0.6478 = 1.5437
(GPB/AUD)b 0.3820
(GBP/CHF)b = (CHF/AUD)a = (GPB/AUD)b × (AUD/CHF)b = 0.8860 =
0.4312
(GPB/AUD)a 0.3900
(GBP/CHF)a = (CHF/AUD)b = (GPB/AUD)a ×(AUD/CHF)a = 0.8800 =
0.4432
1 1
(CHF/GBP)a = (GBP/CHF)b
= 0.4312 = 2.3191
1 1
(CHF/GBP)b = (GBP/CHF)a
= 0.4432 = 2.2563

6. A German foreign exchange dealer trading the Australian dollar against
the euro conducts the following transactions over a ve-day period in
November:
Date Exchange Rate (EUR/AUD) Amount (Euro)
14 Nov 0.55630.5613 +5, 000, 000

15 Nov 0.56610.5711 +10, 000, 000
18 Nov 0.55810.5631 −7, 000, 000
19 Nov 0.55660.5616 +8, 000, 000
20 Nov 0.55620.5612 −12, 000, 000
(a) Construct a blotter to show these transactions and the positions in
both currencies.
Solution:
Date Exchange Rate (EUR/AUD) Amount (Euro) Exchange Rate (AUD/EUR)
14 Nov 0.55630.5613 +5, 000, 000 1
0.5613
− 1
0.5563
15 Nov 0.56610.5711 +10, 000, 000 1
0.5711
− 1
0.5661
18 Nov 0.55810.5631 −7, 000, 000 1
0.5631
− 1
0.5581
19 Nov 0.55660.5616 +8, 000, 000 1
0.5616
− 1
0.5566
20 Nov 0.55620.5612 −12, 000, 000 1
0.5612
− 1
0.5562
Amount (Euro) EUR balance S(EUR/AUD) AUD deal amount AUD balance
5, 000, 000EUR
+5, 000, 000 +5, 000, 000 0.5563 −8, 987, 956
× 1 (AUD/EUR) = −8, 987, 956
0.5563
+10, 000, 000 +15, 000, 000 0.5661 −17, 664, 724 −26, 652, 680
−7, 000, 000 +8, 000, 000 0.5631 +12, 431, 185 −14, 221, 495
+8, 000, 000 +16, 000, 000 0.5566 −14, 372, 979 −28, 594, 474
−12, 000, 000 +4, 000, 000 0.5612 +21, 382, 751 −7, 211, 723
(b) Calculate the average exchange rate at which the dealer bought and
sold the Australian dollar.
Solution:
Average exchange rate at which the dealer bought and sold AUD =
4,000,000
7,211,723 = 0.5547
(c) Calculate the unrealized prot/loss on the nal position.
Solution:
Unrealized prot/loss: We note a short position in AUD and the mar-
ket rate (0.5612) is higher than the average rate (0.5547), the position
is unprotable, that is: 7, 211, 723AUD×(0.5547−0.5612)(EUR/AUD) =
−46, 876 (EUR)
(d) What would the dealer do to square the nal position?

To square the position the dealer must buy AUD7, 211, 723 at 0.5612.
7. The spot and forward rates between the Australian dollar and the euro
(AUD/EUR) are as follows:

Type Rate
Spot 1.6030
1-month forward 1.6260
3-month forward 1.5920
Calculate the forward spread in percentage per annum for both maturi-
ties. State whether the Australian dollar sells at a premium or a discount.
Solution:
1.6260 12

(a) 1-month forward: = 1.6030 −1 × 1 = 0.172 ≡ 17.2% ⇒ Euro is
selling at a premium.
1.5920 12

(b) 3-month forward: = 1.6030 −1 × 3 = −0.0274485 ≈ −2.74% ⇒
Euro is selling at a discount.
8. The following are the spot and swap forward values of the EUR/AUD
exchange rate:
Type Rate
Spot 0.60200.6100
1-month forward 2040
Calculate the outright forward rate for each maturity. State whether the
AUD sells at a premium or a discount.
Solution:
Type Sb -rate Sa -rate AUD sells at: EUR sells at:
Spot 0.6020 0.6100

1-month forward 0.6020 + 0.0020 = 0.6040 0.6100 + 0.0040 = 0.6140 premium discount
3-month forward 0.6020 + 0.0040 = 0.6060 0.6100 + 0.0060 = 0.6160 premium discount
6-month forward 0.6020 − 0.0080 = 0.5940. 0.6100 − 0.0040 = 0.6060 discount premium
Part II: Topic: Balance of

Payments - Warm-up Questions (Some
guiding solutions are provided but you may expand as necessary)
1. What are economic transactions? Give some examples of international

economic transactions.
Economic transactions is considered with reference to balance of pay-
ments (BOP). BOP of a country is a systematic record of all economic
transactions between residents of the reporting country and the rest of

the world over a specied period of time. The transactions are 'economic'
in that what is recorded on the BOP are transactions involving exchange
of value such as transfer of ownership of goods, rendering services, and
the transfer of money and other (nancial) assets.
2. Describe a situation in which a transaction that aects Australian balance

of payments is not recorded in it.
3. Here, the term 'resident' which is applied to individuals and institutions,

in the denition of BOP, is debated . For example, overseas students and
temporary workers living in Australia (domestic economy) are not consid-
ered, for the purpose of compiling the Australian BOP statistics, as being
resident in Australia but rather in their country of origin.
This can become more complicated if we consider multinational companies

with foreign subsidiaries. The company itself is considered s being resident
in the countries in which it is incorporated, but its foreign subsidiaries are
considered to be resident of the countries where they are located.
The term 'residence' follows from the fact that the BOP does not record
transactions between local residents (within provinces or zones) although
such transactions could aect and give rise to transactions that are on
the BOP. Example when the government sells bonds to the citizens, this
transaction will not be recorded on the BOP, although this activity may
lead to an increase in interest rates on the domestic (Australian) dollar
assets which my induce foreign (insurance) companies to buy them. How-
ever, the latter is recorded in the BOP.
4. What is the dierence between stocks and ows? Consider the major
items on the Australian balance of payments and explain why they are
ows, not stocks.
BOP measures ows and not stocks. For example, BOP records ex-
occur over the
ports, imports and transfers which are ows in that they
reporting period (such as a month, a quarter or a year), and changes
in the holdings of assets and liabilities which are ows. This is similar to
the statement of sources and uses of funds for a rm (cash ows). How-
ever, stock would be the cumulative value of exports, imports and other
transactions at a given time. An anology can for stock can be drawn
with balance sheet that records assets and liabilities at a specic point
in time, and can be used to determine the level of indebtedness. Simply
put, ows are records of economic transactions for the reporting period
only, whereas stock is the cumulative value of economic transaction up to
a certain period.

5. Why is it that seasonally unadjusted balance of payments gures may be
misleading? What is the problem with seasonally adjusted gures? Iden-
tify the balance of payments items that may exhibit seasonal behavior.
Seasonally unadjusted gures obscure the true underlying trend. This
means that seasonally adjusted data can be confusing (misleading) in that
the it is not known whether the gures reported are due to seasonal factors
or changes in the trend. The problem with seasonally adjusted gures is
that there can loss of information due to seasonal adjustment, and this
can aect forecast accuracy. In any case, analyst favor seasonally adjusted
data. For example, if we consider receipts from tourism and air travel, they
are likely to rise during holiday seasons and decline in other periods. By
seasonally adjusting the data, we take account of this.
6. What is the balancing item in the balance of payments?

Balance item is also known as errors and omissions, which is added to
ensure that current account matches with capital/nancial account of the
BOP.
7. In 1992 the International Monetary Fund reported 'a signicant deterio-

ration in the coverage and quality of balance of payments data.' Why is
this the case despite the increased sophistication of data collection and
renement methods?
The time period for recording balance of payments ows may be of any
length. However, this aspect is usually dictated by practical considera-
tions, especially the frequency of data collection. Many countries prepare
balance of payments data annually because rm estimates for some balance
of payments transactions are available only once each year. However, since
other data (for example, for exports and imports) are often available quar-
terly and sometimes monthly, some countries prepare quarterly balance
of payments data consistent with quarterly estimates of the national ac-
counts. (https://www.elibrary.imf.org/view/IMF071/15950-9781557758750/15950-
9781557758750/ch03.xml?language=en&redirect=true).
8. In theory, the sum of all countries' capital outows and inows must be
zero. This, however, is not what is implied by the reported balance of
payments statistics. Why is this the case?
This is because of errors and omissions. Also note below:

9. Describe the relationship between the balance of payment and the foreign
exchange market.
The relationship between the BOP and foreign exchange market arises
because transactions involving trade and capital ows (recorded on the
BOP) give rise to demand for and supply of currencies. Transactions in
the market for goods and services (imports and exports) give rise to the
demand for and supply of foreign currencies, respectively. These trans-
actions lead to the supply of and demand for domestic currency, respec-
tively. Moreover, transactions in the nancial markets (recorded in the
nancial/capital account of BOP) also lead to demand for and supply of
currencies. Example is the sale of domestic securities and purchase of
foreign securities, which give rise to demand for foreign currencies (i.e.
supply of domestic currency); purchase of domestic securities and sale of
foreign securities give rise to demand for domestic currency (i.e. supply
of foreign currencies).
10. Why does the demand for foreign exchange rise when the exchange rate
(expressed as domestic/foreign) falls?
Note that we express S(x/y) where x = domestic currency and y =
foreign currency, and S(x/y) is read as the price of one unit of y in terms
of x. Hence, if S(x/y) = a, this means that the price of one unit of y is
a (in domestic currencies). Therefore, a decrease in S(x/y) = a ↓ mean
that domestic currency can buy more foreign currency (foreign currency
is relatively cheaper), hence domestic currency has appreciated. So given
S(x/y) = a ↓, imports become relatively cheaper, and hence demand for

∗
foreign for foreign exchange (Df = Pm Qm ) will rise due to increase in the
demand for imports (Qm ), that is import expenditure increases, holding
foreign price P ∗ constant.
11. 'The eect of a rise in the exchange rate in the supply of foreign exchange
is ambiguous.' Explain.
Note that we express S(x/y) ↑, this implies that domestic currency is
depreciating, hence this creates lower demand for imports and increase the
demand for exports. We can expect more demand for domestic and supply
of foreign currency, because price of exports in foreign currency terms are
relatively cheaper than the price of imports in domestic currency terms. If
the elasticities of demand for exports and imports are suciently high,
then the demand for imports falls and the demand for exports rises, lead-
ing to improvement in the current account. However, what happens to
the current account position depends on the elasticity of demand for
exports and imports, i.e. the responsiveness of the quantities of exports
and imports to changes in prices.
12. Why do countries that have higher growth rates than their trading part-
ners experience deteriorating current accounts?
Since imports are positively related to domestic income whereas ex-
ports are not (necessarily, because demand for exports depend on foreign
income), if a country has higher growth rate that its trading partners, its
demand for goods and services including imported goods and services, will
rise faster than the demand of its trading partners for its goods and ser-
vices. Assuming other factors unchanged, it follows that the country with
higher growth rate will experience a deterioration it its current account.
13. It is sometimes stated that one of the most important consequences of in-
ation is its adverse eect on the current account. How does this adverse
eect develop?
A country that has higher ination rate than its trading partners suf-
fers from deterioration of the current account, because ination erodes
the competitive position of the economy by making domestic goods more
expensive and hence less competitive in foreign markets. If the domestic
ination rate is higher than the foreign ination rate, then Px rises faster
∗
that Pm . This leads to a decline in exports, and increase in imports and
hence deterioration in the current account. Also, elasticities do matter,
and if the demand for imports is inelastic (relatively insensitive to price
changes) while the demand for exports is elastic (relatively sensitive to
price changes), then the current account will deteriorate.
14. Capital controls are typically imposed to protect the balance of payments.
Can we then say that the abolition of capital controls in Australia in the
early 1980s has led to deterioration of the Australian balance of payments?

Not necessarily, since the abolition of capital controls in Australia pro-
moted trade and greater nancial activity. On one hand there has been
a decline in the current account balance, which improved somewhat since
2008, nancial activity has increased. The objective of abolishing capital
controls was to promote liberalization and deregulation of nancial system.
15. Why do countries normally worry more about the eective exchange rate
rather than the bilateral exchange rates of their currencies? Why do they
also worry more about real rather than nominal exchange rates?
Changes in the exchange rate aect the price of imports in domes-

tic currency terms and the price of exports in foreign currency terms.
Changes in the domestic and foreign prices aect the competitiveness of
exports and imports and hence the current account. Because trade is nor-
mally conducted on a multilateral (rather than bilateral) basis, it is more
appropriate to consider the multilateral exchange rate, which is the eect
exchange rate. Note that multilateral (eective) exchange rate is an in-
dex measured relative to a base period of a weighted average of nominal
exchange rates against the currencies of major trading partners. Eec-
tive exchange rate reect the geographical distribution of trade and hence
is calculated as a weighted average of the bilateral exchange rates. The
Pm
eective exchange rate is computed as: Et = i=1 ωi Vi,t where ωi is the
weight assigned to currency i and Vi,t is the exchange rate relative of cur-
Si,t
rency i at time t such that Vi,t = Si,0 .
Real exchange rate is the nominal exchange rate adjusted for dierences
in prices or ination; it is a measure of the purchasing power of currencies
in foreign markets, and hence the relevant rate for measuring the compet-
h i
Py
itiveness of the economy. This is given by: Q(x, y) = S(x/y) Px , where
Py andPx are the price levels of the countries whose currencies are y and x,
respectively. Q ↑ ⇒ real appreciation of y which can be due to S ↑ (nom-
inal appreciation of y ) and/or Py ↑ (increase in the price level in country
y ). Both a higher S and P level erode the competitiveness of the economy.
16. Why did the Reserve Bank of Australia decide in 1988 to calculate the
TWI of the Australian dollar as a geometric average rather than an arith-
metic average?
Trade weighted index (TWI) of AUD uses geometric average because
geometric average (mean) has better mathematical properties than arith-
metic average, particularly in representing rates of change. The eective
exchange rate and real eective exchange rate using geometric average is
ωi
ωi Qi,t
given by: Et = Πm
i=0 (Vi,t ) and Qt = Πm
i=1 Qi,0 , respectively.

Part III: Applicationss (Worked-out the
solutions )
1. The demand for imports function is: Qm = 40 − 1.5Pm . Calculate the

quantity of imports if the foreign price of imports is 10 and the exchange
rate (domestic/foreign = d/f ) is 1.20. Also calculate the demand for for-
eign exchange at this rate.
Solution: Note that we are given:
∗
S = 1.20,and Pm = 10. Now, it re-
∗
mains to determine the price of imports in domestic terms: Pm = SPm
⇒1.20 × 10 = 12. Then Qm = 40 − 1.5Pm = 40 − 1.5(12) = 22. Therefore,
the demand for foreign exchange is the price in foreign terms times the
∗
volume of imports, that is: Pm Qm = 10(22) = 220.
2. Using the same demand function as in (1) above, calculate the quantity of
foreign exchange demanded at the following values of the exchange rate:
1.30, 1.40, 1.50, 1.60, 1.70,and 1.80. Plot the demand for foreign exchange
curve. [You may work this out in Excel if necessary]
Solution: The quantity of foreign exchange demanded is equal to import
expenditure.
∗ ∗
S = 1.30, Pm = 13 since Pm = SPm , Pm = 10,and Qm = 40 − 1.5Pm =
∗
40 − 1.5(13) = 20.5 ⇒ Pm Qm = (10)(20.5) = 205.
∗
S = 1.40, Pm = 14 since and Qm = 40 − 1.5(14) = 19 ⇒ Pm Qm =
(10)(19) = 190.
∗
S = 1.50, Pm = 15 since and Qm = 40 − 1.5(15) = 17.5 ⇒ Pm Qm =
(10)(17.5) = 175.
∗
(10)(16) = 160.
∗
S = 1.70, Pm = 17 since and Qm = 40 − 1.5(17) = 14.5 ⇒ Pm Qm =
(10)(14.5) = 145.
∗
(10)(13) = 130
∗ ∗
S(d/f ) P m = S × Pm Qm = 40 − 1.5Pm Pm × Qm
1.8 18 13.0 130
1.7 17 14.5 145
1.6 16 16.0 160
1.5 15 17.5 175
1.4 14 19.0 190
1.3 13 20.5 205
1.2 12 22.0 220
1.1 11 23.5 235

Plot of the demand of FX curve
(See Excel le TUT_SOL Sheet Q2 on Moodle)
3. The demand for exports function is: Qx = 40 − 2Px∗ . Calculate the quan-
tity of exports if the domestic price of export is 10 and the exchange rate
(domestic/foreign = d/f ) is 1.20. Also calculate the supply of foreign ex-
change at this rate.
Solution:
Px
The demand for export function is: Qx = 40 − 2Px∗ . Px∗ = S = 10
1.20 =
8.33.
Qx = 40 − 2(8.33) = 23.34 and expenditure is: Px∗ Qx = 8.33 × 23.34 =
194.42
4. Using the same supply function as in (3) above, calculate the quantity of
foreign exchange supplied at the following values of the exchange rate:
1.30, 1.40, 1.50, 1.60, 1.70,and 1.80. Plot the supply of foreign exchange
curve and comment on its shape. [You may work this out in Excel if
necessary]
S = 1.30 ⇒ Px∗ = PSx = 1.30 10
= 7.69;Qx = 40 − 2(7.69) = 24.62;
∗
Px Qx = 7.69 × 24.62 = 189.29
S = 1.40 ⇒ Px∗ = PSx = 1.40 10
= 7.14;Qx = 40 − 2(7.14) = 25.71;
∗
Px Qx = 7.14 × 25.71 = 183.57
S = 1.50 ⇒ Px∗ = PSx = 1.50 10
= 6.67;Qx = 40 − 2(6.67) = 26.66;
∗
Px Qx = 6.67 × 26.66 = 177.82
S = 1.60 ⇒ Px∗ = PSx = 1.60 10
= 6.25;Qx = 40 − 2(6.25) = 27.50;
∗
Px Qx = 6.25 × 27.50 = 171.88

S = 1.70 ⇒ Px∗ = PSx = 1.70 10
= 5.88;Qx = 40 − 2(5.88) = 28.24;
∗
Px Qx = 5.88 × 28.24 = 166.05
S = 1.80 ⇒ Px∗ = PSx = 1.80 10
= 5.56;Qx = 40 − 2(5.56) = 28.88;
∗
Px Qx = 5.56 × 28.88 = 160.57
Px
S(d/f ) Px∗ = S Qx = 40 − 2Px∗ Px∗ × Qx
1.8 5.56 28.89 160.49
1.7 5.88 28.24 166.09
1.6 6.25 27.50 171.88
1.5 6.67 26.67 177.78
1.4 7.14 25.71 183.67
1.3 7.69 24.62 189.35
1.2 8.33 23.33 194.44
1.1 9.09 21.82 198.35
See Excel le TUT_SOL, Sheet Q4 on Moodle
5. Use the demand and supply functions specied in Problems (1) and (3)
above to demonstrate the eect of ination on the current account, starting
∗
from a situation in which Pm = Px = 10 and S = 1.20. Plot the path of
the current account over several periods of time when:

(a) The domestic and foreign ination rates are 0 and 5 per cent,
respectively.
∗ ∗ = Px Qm = Qx ∗Q ∗ Q B∗ =
time Pm Px S Pm Px ∗ Px x Pm m ∗Q − P ∗ Q
S 40 − 1.5Pm = 40 − 2Px Px x m m
1 10.0 10 1.2 12.0 8.33 22.0 23.3 194.4 220.0 -25.6

2 10.5 10 1.2 12.6 8.33 21.1 23.3 194.4 221.6 -27.1
3 11.0 10 1.2 13.2 8.33 20.2 23.3 194.4 222.2 -27.8
4 11.6 10 1.2 13.9 8.33 19.2 23.3 194.4 221.8 -27.4
5 12.2 10 1.2 14.6 8.33 18.1 23.3 194.4 220.3 -25.8
6 12.8 10 1.2 15.3 8.33 17.0 23.3 194.4 217.3 -22.9
7 13.4 10 1.2 16.1 8.33 15.9 23.3 194.4 212.8 -18.3
8 14.1 10 1.2 16.9 8.33 14.7 23.3 194.4 206.5 -12.0
9 14.8 10 1.2 17.7 8.33 13.4 23.3 194.4 198.1 -3.6
10 15.5 10 1.2 18.6 8.33 12.1 23.3 194.4 187.3 7.1
Refer to Excel TUT_SOL Sheet Q5(a)
(b) The domestic and foreign ination rates are 5 and 0 per cent,
respectively.

∗ ∗ = Px Qm = Qx = ∗ ∗ B∗ =
time Pm Px S Pm Px ∗ Qx Px Qm Pm ∗Q − P ∗ Q
S 40 − 1.5Pm 40 − 2Px Px x m m
1 10.0 10 1.2 12.0 8.33 22.0 23.3 194.4 220.0 -25.6

2 10.0 10.5 1.2 12.0 8.33 22.0 22.5 196.9 220.0 -23.1
3 10.0 11.0 1.2 12.0 8.33 22.0 21.6 198.7 220.0 -21.3
4 10.0 11.6 1.2 12.0 8.33 22.0 20.7 199.8 220.0 -20.2
5 10.0 12.2 1.2 12.0 8.33 22.0 19.7 200.0 220.0 -20.0
6 10.0 12.8 1.2 12.0 8.33 22.0 18.7 199.2 220.0 -20.8
7 10.0 13.4 1.2 12.0 8.33 22.0 17.7 197.3 220.0 -22.7
8 10.0 14.1 1.2 12.0 8.33 22.0 16.5 194.0 220.0 -26.0
9 10.0 14.8 1.2 12.0 8.33 22.0 15.4 189.3 220.0 -30.7
10 10.0 15.5 1.2 12.0 8.33 22.0 14.1 182.9 220.0 -37.1
Refer to Excel TUT_SOL Sheet Q5(b)
6. You are given the following information:
Quantity 200
Foreign currency price of imports 20
Exchange rate (d/f ) 1.50
(a) Calculate the foreign currency and domestic currency values of im-
ports.
Solution: Qm = 200, Pm ∗
= 20, S = 1.50. The foreign currency value
∗
of imports is calculated as: = Pm Qm = 20 × 200 = 4000. The
domestic currency value of imports is obtained by converting the for-
∗
eign currency value at the current exchange rate: = S(Pm Qm ) =
1.50(d/f ) × 4000(f ) = 6000(d)
(b) What will happen if the exchange rate falls to 1.20, assuming that
the value of the elasticity of demand for imports is −0.5?
Solution: At an exchange rate of 1.50,the domestic currencySee
∗
Excel le, TUT_SOL, Sheet Q4 price of imports is Pm = SPm =
1.50 × 20 = 30. When S = 1.20,Pm = 1.20 × 20 = 24. Hence, the

percentage change in the domestic currency price of imports result-
24

ing from the change in the exchange rate is:
30 − 1 × 100 = −20%.
Given that elasticity of demand, = −0.5, the percentage change in
quantity demanded can be calculated as:
= PQ̇˙ = %∆Q ˙
m %∆P ⇒ Q̇ = %∆Qm = Pm × = %∆P × . ∴
%∆Qm = (−20%) × −0.5 = +10% . So the quantity of imports
rises by 10% to 200(1 + 0.10) = 220,and the foreign value of im-
ports is: 220 × 20 = 4400(f ) and the domestic value of imports is:
220 × (1.10 × 20) = 220 × 24 = 5280(d).
(c) What will happen if the exchange rate falls to 1.20, assuming that
1.50,the domestic currency price of imports is
At an exchange rate of
∗
Pm = SPm = 1.50 × 20 = 30. When S = 1.20,Pm = 1.20 × 20 = 24.
Hence, the percentage change in the domestic currency price of im-
24

ports resulting from the change in the exchange rate is:
30 − 1 ×
100 = −20%. Given that elasticity of demand, = −0.5, the percent-
age change in quantity demanded can be calculated as:
= PQ̇˙ = %∆Q ˙
m %∆P ⇒ Q̇ = %∆Qm = Pm × = %∆P × .
∴ %∆Qm = (−20%) × −2.5 = +50% .
So the quantity of imports rises by 50% to 200(1 + 0.50) = 300,and
the foreign value of imports is: 300 × 20 = 6000(f ) and the domestic
value of imports is: 300 × (1.20 × 20) = 300 × 24 = 7200(d).
7. You are given the following information:

Quantity 500
Domestic currency price of exports 10
Exchange rate 1.20
(a) Calculate the foreign currency and domestic currency values of ex-
ports.
Qx = 500, Px = 10, Px∗ = PSx since P = SP ∗ ,and S(d/f ) = 1.20.
⇒ Domestic currency value of export: Qx Px = 500 × 10 = 5000 (d)
⇒ Foreign currency value of exports: Qx Px∗ = 500 × 1.2
10
= 4166.67 ≈
4167(f )
(b) What will happen if the exchange rate falls to 0.90, assuming that
At an exchange rate of S0 = 1.20, the foreign currency price of ex-
ports is P0∗ = 8.33 . At an exchange rate of S1 = 0.90, the foreign
currency price of exports rises to P1∗ = 10
0.9 = 11.11 .
The percentage change in the foreign currency price of imports result-

P1∗

ing from the change in the exchange rat: %∆Px∗ = P0∗ − 1 × 100 =
11.11

8.33 − 1 × 100 = 33.37%. If the elasticity of demand is: = 0.2,

the percentage change in the quantity of exports demanded can be
%∆Qx
calculated from equation as: = %∆Px∗ ⇒ %∆Qx = × %∆Px∗ =
−0.2 × 33.37 = −6.67%. Therefore, initial quantity decreases by
6.67%.
Hence the new quantity is:Q1 = Q0 ×(1−0.0667) = 500×0.93326 =
466.63 ≈ 467. Therefore:
10
= 5188.89 ≈
5189(f )
0.90, assuming that
(c) What will happen if the exchange rate falls to
−1.8?
the value of the elasticity of demand for imports is
= %∆Q x
%∆Px∗ ⇒ %∆Qx = × %∆Px∗ = −1.8 × 33.37 = −60.066% ≈
60.07%
Hence the new quantity is: Q1 = Q0 × (1 − 0.6007) = 500 × 0.393 =
169.65 ≈ 170. Therefore:
10
= 1889(f )
8. Assume that Australia trades mostly with two countries only, the United
States and the United Kingdom, such that 70% of the trade is conducted
with the the United States, 25% is conducted with the United Kingdom,
and 5% with the rest of the world. The exchange rates of the Australian
dollar at two points in time 0 and 1, are as follows:
Time =0 Time =1
AUD/USD 1.3541 1.7724
AUD/GBP 2.1533 2.5692
(a) Calculate exchange rates in indirect quotation from an Australian

perspective.
Time =0 Time =1
1 1
USD/AUD
1.3541 = 0.7385 1.7724 = 0.5642
1 1
GBP/AUD
2.1533 = 0.4644 2.5692 = 0.3892
(b) Calculate the percentage rates of depreciation or appreciation of the
Australian dollar against the two currencies . Comment on your re-
sults.
• Percentage change of USD/AUD: Ṡ(U SD/AU D) = 0.5642

0.7385 − 1 ×
100 = −23.60% ⇒ Australian dollar has depreciated by 23.6% against
USD.
0.3892

• Percentage change of GBP/AUD: Ṡ(GBP/AU D) = 0.4644 −1 ×
100 = −16.19% ⇒ Australian dollar has depreciated by 16.2% against
GBP.

It can be said that the Australian dollar has depreciated more pro-
portionately against the USD (than GBP).
(c) Calculate exchange rate relatives, using Time =0 as a base period.

Exchange rate relative (dierence from base)
USD/AUD = 100 + (−23.60) = 76.40 = VU S

GBP/AUD = 100 + (−16.19) = 83.81 = VU K
(d) Calculate an unweighted eective exchange rate index, using Time

=0 as a base period in which the index assumes the value of 100.
• The unweighted eective exchange rate is the equally weighted
rate: ( 12 × 76.4 + 1
2 × 83.81) = 80.11
(e) Calculate the normalized trade weights
• Normalized trade weights for the US and the UK are:
0.70 0.25
wU S = 0.70+0.25 = 0.74 and wU K = 0.70+0.25 = 0.26 such that
wU SA + wU K = 1
(f ) Calculate the trade-weighted eective exchange rate index.

What is the rate of appreciation or depreciation of the Australian
dollar in eective terms? Compare this result with that obtained in
(b) and (d) above. Comment on your results.
Arithmetic approach
Trade-weighted Eect Exchange Rate: E = wU S × VU S + wU K +
VU K = 0.74 × 76.4 + 0.26 × 83.8 = 78.3. Since E < 0,AUD has
depreciated by (100 − 78.3 =) 21.7%.
(g) Recalculate the eective exchange rate as weighted geometric aver-

age. Compare the results with the previous ones.
Geometric approach
w w
Trade-weighted Eect Exchange Rate: E = (VU S ) U S (VU K ) U K =
0.74 0.26
(76.4) (83.8) = 78.3. Since E < 0,AUD has depreciated by
(100 − 78.3 =) 21.7%.
9. Using the information given in problem 8, calculate the nominal eective
exchange rate, using the bilateral exchange rates expressed in direct quo-
tation. Compare the results with those obtained by solving problem 8.
Calculate the percentage rates of depreciation or appreciation of the Aus-
tralian dollar against the two currencies . Comment on your results.
1.7724

• Percentage change of USD/AUD: Ṡ(AU D/U SD) =
1.6541 − 1 ×
100 = 30.89% ⇒ USD has appreciated by 30.9% against AUD.
2.5692

• Percentage change of GBP/AUD: Ṡ(AU D/GBP ) =
2.1533 − 1 ×
100 = 19.31% ⇒ GBP has appreciated by 19.3% against AUD.
Calculate exchange rate relatives, using Time =0 as a base period.

Exchange rate relative (dierence from base)
USD/AUD = 100 + (30.89) = 130.9 = VU S

GBP/AUD = 100 + (19.31) = 119.3 = VU K
Calculate an unweighted eective exchange rate index, using Time = 0
as a base period in which the index assumes the value of 100.
• The unweighted eective exchange rate is the equally weighted
rate: ( 12 × 130.9 + 1
2 × 119.3) = 125.1
Calculate the normalized trade weights

• Normalized trade weights for the US and the UK are:
0.70 0.25
wU S = 0.70+0.25 = 0.74 and wU K = 0.70+0.25 = 0.26 such that wU SA +
wU K = 1
Calculate the trade-weighted eective exchange rate index. What

is the rate of appreciation or depreciation of the Australian dollar in eec-
tive terms? Compare this result with that obtained in (b) and (d) above.
Comment on your results.
Arithmetic approach
Trade-weighted Eect Exchange Rate: E = wU S × VU S + wU K + VU K =
0.74 × 130.9 + 0.26 × 119.3 = 127.88. Since E > 100,trading partners
currency has appreciated by (127.88 − 100 =) 27.9%.
Recalculate the eective exchange rate as weighted geometric average.
Compare the results with the previous ones.
Geometric approach
wU S wU K 0.74 0.26
Trade-weighted Eect Exchange Rate: E = (VU S ) (VU K )
= (130.9) (119.3) =
127.8. Since E > 100,trading partners currency has appreciated by (127.81−
100 =) 27.8%.
10. Using the information given in (8) above, calculate the nominal eective
exchange rate, using the bilateral exchange rates expressed in direct quo-
tation. Compare the results with those obtained by solving (8).
Time =0 Time =1
AUD/USD 1.3541 1.7724
AUD/GBP 2.1533 2.5692
Use the information in (8) above, and assume that the price levels at
two points in Time =0 and Time =1 are as follows:
Times =0 Time =1
Australia 100 110
United Kingdom 100 105
United States 100 104
Calculate the real bilateral exchange rates

T = 1
Price Ratio Exchange Exchange
T = 0
(PAU D /Pi ) Rate (T=0) Rate (T=1)
Australia 100 110
EER= 1.7724
1 × 1.05769 = 0.5642 × 1.05769
110 = 0.5968
United States 100 104 104 USD/AUD = 1 = 0.7385
(b)

= 1.05769 1.3541 %∆ = 0.5968 − 1
0.7385
= −19.19%
EER = 2.5692
1 × 1.04762 = 0.3892 × 1.04762
110 = 0.40776
United Kingdom 100 105 105 GBP/AUD = 1 = 0.4644
(b) %∆ = 0.40776

= 1.04762 2.1533 −1
0.4644
= −12.20%
Exchange rate relatives are: VU S = 100 + (−19.19) = 80.81, and VU K =

100 + (−12.20) = 87.80
(c)
Arithmetic Approach: Real eective exchange rates of Australian dollar:
E = wU S × VU S + wU K + VU K = 0.74 × 80.81 + 0.26 × 87.80 = 82.63
w w
Geometric Approach: Trade-weighted Eect Exchange Rate: E = (VU S ) U S (VU K ) U K =
0.74 0.26
(80.81) (87.80) = 82.57. Since E < 100,AUD has depreciated by
(100 − 82.6 =) 17.4%.
~END~


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FM303 Week 3-4: Tutorial Problem Set 3

April 13, 2022

PART I: Foreign Exchange Market

Solution: At 9.30 a.m. Dealer B quotes: S(AUD/GBP) = 2.55002.5540.

At 3.30 p.m., Dealer B quotes 5090 ⇒ S(AUD/GBP) = 2.55502.5590.

Therefore, Dealer A has a net ow of 511000 − 510800 = +200 AUD,

(b) the appreciation or depreciation of the Australian dollar in points

3. The following exchange rates are quoted:

4. The following exchange rates are quoted:

Currency Pair Quote (Rate)

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Sa (GBP/EUR) = Sa (GBP/AUD) × Sa (AUD/EUR) = 0.3890 × 1.6480 =

∴ Spread = Sb − Sa = 0.6411 − 0.6265 = 0.0146 or 146 points

5. On the basis of the following exchange rates, construct a cross exchange

Currency Pair Quote

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Date Exchange Rate (EUR/AUD) Amount (Euro)

14 Nov 0.55630.5613 +5, 000, 000

(d) What would the dealer do to square the nal position?

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Spot 0.6020 0.6100

Part II: Topic: Balance of

guiding solutions are provided but you may expand as necessary)

1. What are economic transactions? Give some examples of international

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

2. Describe a situation in which a transaction that aects Australian balance

3.  Here, the term 'resident' which is applied to individuals and institutions,

This can become more complicated if we consider multinational companies

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

6. What is the balancing item in the balance of payments?

7. In 1992 the International Monetary Fund reported 'a signicant deterio-

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

 Changes in the exchange rate aect the price of imports in domes-

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

1. The demand for imports function is: Qm = 40 − 1.5Pm . Calculate the

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

(See Excel le TUT_SOL Sheet Q2 on Moodle)

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

See Excel le TUT_SOL, Sheet Q4 on Moodle

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

1 10.0 10 1.2 12.0 8.33 22.0 23.3 194.4 220.0 -25.6

Refer to Excel TUT_SOL Sheet Q5(a)

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

1 10.0 10 1.2 12.0 8.33 22.0 23.3 194.4 220.0 -25.6

Refer to Excel TUT_SOL Sheet Q5(b)

6. You are given the following information:

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

7. You are given the following information:

The percentage change in the foreign currency price of imports result-

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

(a) Calculate exchange rates in indirect quotation from an Australian

• Percentage change of USD/AUD: Ṡ(U SD/AU D) = 0.5642

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

(c) Calculate exchange rate relatives, using Time =0 as a base period.

USD/AUD = 100 + (−23.60) = 76.40 = VU S

(d) Calculate an unweighted eective exchange rate index, using Time

(f ) Calculate the trade-weighted eective exchange rate index.

(g) Recalculate the eective exchange rate as weighted geometric aver-

Calculate exchange rate relatives, using Time =0 as a base period.

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

USD/AUD = 100 + (30.89) = 130.9 = VU S

Solution: At 9.30 a.m. Dealer B quotes: S(AUD/GBP) = 2.55002.5540.

At 3.30 p.m., Dealer B quotes 5090 ⇒ S(AUD/GBP) = 2.55502.5590.

Therefore, Dealer A has a net ow of 511000 − 510800 = +200 AUD,

14 Nov 0.55630.5613 +5, 000, 000

(d) What would the dealer do to square the nal position?

2. Describe a situation in which a transaction that aects Australian balance

3. Here, the term 'resident' which is applied to individuals and institutions,

7. In 1992 the International Monetary Fund reported 'a signicant deterio-

Changes in the exchange rate aect the price of imports in domes-

(See Excel le TUT_SOL Sheet Q2 on Moodle)

See Excel le TUT_SOL, Sheet Q4 on Moodle

Refer to Excel TUT_SOL Sheet Q5(a)

Refer to Excel TUT_SOL Sheet Q5(b)

(d) Calculate an unweighted eective exchange rate index, using Time

(f ) Calculate the trade-weighted eective exchange rate index.

(g) Recalculate the eective exchange rate as weighted geometric aver-

Calculate the trade-weighted eective exchange rate index. What