Workshop Exercises

1. If the spot exchange rate of the yen relative to the dollar is ¥105.75, and the 90-day
forward rate is ¥103.25/$, is the dollar at a forward premium or discount? Express the
premium or discount as a percentage per annum for a 360-day year?

Answer: When the forward rate of yen per dollar is less than the spot rate of yen per dollar,
the dollar is said to be at a discount in the forward market. The magnitude of the discount is
expressed in percentage per annum by dividing the difference between the forward rate and
the spot rate by the spot rate and multiplying by reciprocal of the fraction of the year
corresponding to the maturity of the forward contract (360/N days) and by 100. Thus, the
annualized forward discount is 9.46% because (¥103.25/$ - ¥105.75 / $/¥105.75/$ ) 360/90
100 = -9.46% .
Notice that the word “discount” implies that the forward rate is less than the spot rate.

2. Toward the end of 1999, the central bank (Reserve Bank) in Zimbabwe stabilized the
Zimbabwe dollar, the Zim for short, at Z$38/USD and privately instructed the banks
to maintain that rate. In response, at the end of 1999, an illegal market developed
wherein the Zim traded at Z$44/USD. Are you surprised at rumors that claim
corporations in Zimbabwe were “hoarding” USD200 million? Explain.

Answer: The existence of an illegal exchange market indicates that the Zim is incorrectly
valued at Z$38/USD. Clearly, the Zim is over-valued at the official rate (See Exhibit 5.10 for
an example of such a situation). At this “artificial” exchange rate everybody wants to turn in
Zim to the central bank, receive foreign currency and invest them abroad. To maintain the
overvalued rate without losing all its international reserves, the government must control the
use of foreign exchange (impose exchange controls). It likely forces exporters to convert their
foreign exchange at the official rate, which is too low. Given this situation, hoarding foreign
exchange is a rational response. Anyone who earns foreign exchange has an incentive to hold
on to the foreign exchange until the Zim is valued correctly, i.e. after it is devalued.
Moreover, given high inflation in Zimbabwe and a highly unstable political regime, U.S.
dollars are a better store of value than Zimbabwe dollars. The situation in Zimbabwe
subsequently deteriorated into hyperinflation, and the abandonment of the Zim.

3. Describe how you would calculate a 5-year forward exchange rate of yen per dollar if
you knew the current spot exchange rate and the prices of 5-year pure discount bonds
denominated in yen and dollars. Explain why this has to be the market price.
Answer: The 5-year forward rate would be equal to the spot rate of yen per dollar times the
ratio of the future value in 5 years of one yen to the future value in 5 years of one dollar. The
logic is the following. If you can invest directly in yen for 5 years, you can convert one yen
into the future value of one yen in 5 years. Alternatively, you can convert the one yen into
dollars in the spot foreign exchange market, invest that dollar principal for 5 years to get the
future value of dollars, and contract today to sell those dollars in the forward market to get
back to future yen in 5 years. If the two amounts of future yen differ, there would be an
arbitrage available in which you would borrow future yen where they are cheap and invest in
future yen where they are expensive. Hence, the 5 year forward rate should satisfy:
 4. If interest rate parity is satisfied, there are no opportunities for covered interest
arbitrage. What does this imply about the relationship between spot and forward
exchange rates when the foreign currency money market investment offers a higher
return than the domestic money market investment?
Answer: If the foreign currency money market investment offers a higher return (in the
foreign currency) than the domestic money market investment, the foreign currency must be
at a discount in terms of the domestic currency in the forward market. The forward discount
locks in a capital loss when the transaction exchange risk is offset, which reduces the higher
return of the foreign currency back to the lower return offered in the domestic money market.

5. Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two
alternative investments of EUR10,000,000: 180-day euro deposits or 180-day Swiss
francs (CHF) deposits. She has decided not to bear transaction foreign exchange risk.
Suppose she has the following data: 180-day CHF interest rate, 8% p.a., 180-day EUR
interest rate, 10% p.a., spot rate EUR1.1960/CHF, 180-day forward rate,
EUR1.2024/CHF. Which of these deposits provides the higher euro return in 180
days? If these were actually market prices, what would you expect to happen?
Answer:

If these were the actual market prices, you should expect investors to do covered interest
arbitrages. Investors would borrow Swiss francs, which would tend to drive the CHF interest
rate up; they would sell the Swiss francs for euros in the spot foreign exchange market, which
would tend to lower the spot rate of EUR/CHF; they would deposit euros, which would tend
to drive the EUR interest rate down; and they would contract to buy CHF with EUR in the
180-day forward market, which would put upward pressure on the forward rate of EUR/CHF.
Each of these actions would help bring the market back to equilibrium.

6. What do economists mean by the law of one price? Why might the law of one price
be violated?
Answer: The law of one price says that the price of a good, when denominated in a particular
currency, is the same wherever in the world the good is being sold. The law of one price
relies on arbitrage in the goods market. If the good is being sold in one place at a low price
and is being sold in a different place at a high price, people have an incentive to arbitrage the
two markets. Therefore, anything that makes it difficult or costly to arbitrage in the goods
market can create a deviation from the law of one price. Clearly, transaction costs, such as the
costs of shipping, generate deviations from the law of one price that cannot be arbitraged.
Tariffs and quotas on imports and exports also create deviations. If markets are not
competitive and firms have some monopoly power, the corporation may decide to charge
different prices in different countries, but it must be able to segment the markets to prevent
arbitrage. If arbitrage cannot be done instantaneously, there will be a speculative element that
enters the calculations and the speculator may have to be compensated for the risk of loss
with an expected profit from buying in one market and selling in another market at a later
point in time. Finally, various goods markets are subject to a certain amount of price
stickiness because of the costs of changing prices. Because exchange rates are asset prices
and freely flexible, unanticipated changes in exchange rates will create deviations from the
law of one price if goods prices are sticky.

7. Suppose that you are trying to decide between two job offers. One consulting firm
offers you $150,000 per year to work out of its New York office. A second consulting
firm wants you to work out of its London office and offers you £100,000 per year.
The current exchange rate is $1.65/£. Which offer should you take, and why? Assume
that the PPP exchange rate is $1.40/£ and that you are indifferent between working in
the two cities if the purchasing power of your salary is the same.

Answer: We know from the extensive discussion in Question 8 that we should use the PPP
exchange rate to compare the pound salary to the dollar salary. If we do so, we find $1.40/£
£100,000 = $140,000. This is less than the $150,000 that you are being offered in New York.
The fact that the dollar is undervalued on the foreign exchange markets makes the perceived
salary of $1.65/£ £100,000 = $165,000, calculated with the spot exchange rate, seem more
attractive. But, the key point is that to achieve $165,000 of spending in the United States, you
would have to work in London and consume in New York.

8. If there is 10% inflation in Brazil, 15% inflation in Argentina, and the Argentine peso
weakens by 21% relative to the Brazilian real, by how much has the peso
strengthened or weakened in real terms. What effect do you expect that this change in
the real exchange rate would have on trade between the two countries?

Answer: If s denotes the rate of change of the nominal exchange rate measured as Brazilian
real per Argentine peso, π(A) denotes the rate of Argentine inflation, and π(B) denotes the
rate of Brazilian inflation, the percentage change in the real exchange rate measured as
Brazilian real per Argentine peso is
 9. Suppose a multinational corporation is particularly worried about ethnic warfare in a
few countries in which it is considering investing. Do country risk ratings have
information on this particular risk?

Answer: Yes, some rating services, such as the PRS Group’s ICRG (International Country
Risk Guide) system have subcomponents within their overall political risk rating. It so
happens that “ethnic tensions” is one such subcomponent, providing assessment of
disagreements and tensions between various ethnic groups that may lead to political unrest or
civil war. Other subcomponents that may also be worthwhile investigating are “internal
conflicts” (an assessment of internal political violence in the country) and “religious
tensions” (an assessment of the activities of religious groups and their potential to evoke civil
dissent or war).

10. Considering the simple monetary model of a fixed exchange rate, discuss the impact
of devaluation on the domestic economy, and explain whether PPP holds or not after
devaluation takes place.

Answer: The economy starts off in equilibrium with an exchange rate of S 0, a price level that
ensures PPP, and a money supply of M0 that made up of domestic credit in the quantity
DC0 and reserves of FX0.

The home country then devalues, raising the price of foreign currency to S1. With a given
foreign price level and, as yet, with no time for domestic prices to change the home country is
now over competitive.

Therefore PPP does not hold under these conditions. With both domestic and foreign prices
unchanged, it is the real as well as the nominal exchange rate that has been devalued. Foreign
goods now cost more, while domestic goods are unchanged in price. The result must be a
tendency for home country consumers to buy more domestically produced output than
previously and fewer imports.

Conversely, foreigners find the home country’s products more attractively priced, on average,
than prior to the devaluation. With its balance of payments in surplus, the country must be
accumulating reserves.

Since the volume of domestic credit is unchanged, the money supply will grow, and shift the
aggregate demand schedule upwards. With real income and output constant, price level will
rise as agents will buy additional goods. As the price level rises, the competitive advantage
and consequent external surplus is eroded. In terms of the goods market, if output is fixed at a
level, the increased demand by both domestic residents and by foreigners cannot be satisfied.
Therefore this conditions must simply generate an inflation.

Ultimately, after a temporary improvement in the competitiveness of the home country, the
economy ends up at where it started, with a higher price level, greater reserves and a larger
nominal money stock, but the same real money supply, with PPP restored and the real
exchange rate back where it was before, thanks to domestic inflation.

11. When autocorrelation is present, which assumption of the linear regression model is
violated?
Ans. When autocorrelation exists, the assumption of zero covariance between non-
contemporaneous error terms is violated. Formally: cov(et, es) ≠ 0, for all t≠s Estimation
with Newey-West heteroscedasticity and autocorrelation consistent (HAC) standard errors
allows for valid inference - provided that the time-series is stationary.

12. What are the benefits and costs of including lagged value(s) of the dependent in a
distributed lag model that suffers from autocorrelation?

Ans. Including lagged value(s) of the dependent variable may help eliminating
autocorrelation. However, this implies relaxing the assumption of no correlation between the
error term and the covariates. Specifically, it requires assuming that the error term is not
correlated with the present and past values of the dependent variable but it is correlated with
future values. Under autocorrelation, coefficient estimates are unbiased, but they are not
BLUE – i.e., they do not have minimum variance. When lagged value(s) of the dependent
variable are included to eliminate autocorrelation, the coefficient estimates are biased but
consistent.