Solutions 83 Solutions 1. ecause the interest rate in A is greater than the interest ate in B, ais expected to de- preciate relative to f, and should trade with a forward discount. Accordingly the cor rect answer's ¢) 2, Because the exchange rate is given in $/€ terms, he appropriate expression forthe in terest rate parity relation is B_ltn S 1? % (75382 part of the numerator and isa part of ihe denominator) | AL The oneyear §/€ forward rate is given by 1 Tot = s/€ = 11795 1908 b. The one-month $/€ forward rate given by 0.04 von! $/€ = 1.1795 208) ana 1+ Gow) Of course, these are central rates, and did-ask rates could also be determined on the ba sis of bid-ask rates ‘or the spot exchange and interest rates, bid ¥/€ = (bid ¥/$) « (bid $/€) ask ¥/€ = (ask ¥/8) X (ask $/€) 108.10 1.186 08.20 X 1.1870 2607, 128.4334, Because the exchange ra isin $/€ terms, the appropriate expression for the inter= strate parity relation s S21 + a)/(1 + fe) : 1+ task rs) ag 1+ (0.082514) S/€ Smonth ask = (spot ask8/€)- jpg ey = M870] Sg gaoara L199 Thus, the $/€ $month forward ask exchange rate 1.1929, bid € /$= 1/ask $/€ = 1/1.1929 = 0.8383, Thus, the S month forward bid exchange rate is€/$ = 0.8383, Because the exchange rate ! in ¥/S terms, the appropriate expression forthe inter cst rate parity relation is F Te n/l + oy 14 hid») 1+ @.0135/4) ¥/$ month bid ~ (spot bid ¥/8 = pox 19 1 = 0.012519) $month bid = pot bid ¥/9) ask rey =) TF wk 1+ AIA) og gg EF (:0t50" ¥/$ $month ask = pot ask ¥/8) 1 thid i) 1 «on50aray = 1726 Thus, the ¥/$ 3month forward exchange rate is: 107,03-107.26, Node: The interest rates one uses in all such computations ate those that result in a !ower forward bid (Go, bid interest rates in the numerator and ask rates in the denominator) and a higher forward :sk (So, sk interest rates in the numerator and bid rates in the de- nominator).84 Chapter 2. Foreign Exchange Parity Relations ha, For six months, mo, ~ 1.50 percent and rs ~ 1.75 percent. Because the exchange rate isin SFr/$ terms, the appropriate expression or the interest rate parity relation 1+ 19) = (1+ 9) ‘The left side of this expressions F 1.6558, Fa + my) = PER + 0.0175) = 10198 The right side of the expression i: ! + mg, ~ 1.0150, Because the leftand right sides are not equal, IRPis not holding, Because IRP is not holding, there is an arbitrage posibility: Because 1.0138 < 1.0150, we can say that the SFr interest rate quote is more than what it should be as per the quotes or the other three variables. Equivalently, we can also say that the § interest rate quote is less than what it should he a8 per the quotes for the other three variables. Therefore, the arbitrage strategy should be based on borrowing in the $ market and lending in the SFr market. The steps would be as follows: ‘+ Borrow $1,000,000 for six months at 3.5 percent per year. Need to pay back $1,000,000 X (1+ 0.0175) = $1,017,500 six months later. 1+ Convert $1,000,000 to SFr at the spot rate to get SFr, 662,700. + Lend_SFr1,662,700 for six months at 3 percent per year. Will get back ‘SFr1,662,700 x (1 + 0.0150) = SFrl,687,641 six months later, «Sell SFr,687,641 six months forward, The transaction will be contracted s of the ‘current date but delivery and setement will only take place six months later. 50 six months later, exchange SFr1,687,641 for SFrl,687,641/SFr1.6558/$. = ‘$1,019,330, ‘The arbitrage profit six months later is 1,019,280 ~ 1,017,500 = $1,730. \. For three months, »~ 1.30 percent and ry = 0.30 percent. Because the exchange rate isin ¥/terms, the appropriate expression for the interest rate parity relation # FlI+ S71 A! a 2 orf +) = +m) ‘The left side ofthis expressions £1 + 1) = EE + 0.0130) = 1.0064 ‘The right side ofthis expression is { + ry = 1.0080. Because the lft and right side are not equal, IRPis not holding. Because IRP is not holding, there is an arbitrage possibility. Because {,0004 > #0080, we can say thatthe 8 interest rate quote is more than what ic should be as pet the quotes forthe other three variables, Equivalently, we can also say thatthe ¥ inter {st rate quote is ess than whatit shouldbe as per the quotes forthe other three watt ables. Therefore, the arbitrage strategy should be based on lending in the $ market and borrowingin the ¥ market. The steps would bes follows: 4 Borrow the yen equivalent of $1,000,000. Because the spot rates ¥108/$, borrow $1,000,000 x ¥108/$ = ¥108,000,000. Need to pay back ¥108,000,000 > (1 = 0.0030) ~ ¥108,324,000 three months later + Exchange ¥108,000,000 for $1,000,000 a the spot exchange rate.Solutions 85 + Lend $1,000,000 for three months at 5.20 percent per year; Will get back $1,000,000 x (1 + 3.0130) ~ $1,018,000 three months later, + Buy ¥108,924,000 three months forward. The transaction will be contracted as of the current date, but delivery and settlement will only take place three months later. So, three months later, get ¥108,524,000 for ¥108,824,000/¥107.30/8, 31,009,543, The arbitrage profit three months laters 1,013,000 ~ 1,009,543 = B3,457. 6. Atthe given exchange rate of 5 pesos/$, the cost in Mexico in dollar terms is $16 for 9 shoes, $36 for watches, and §120 for electric motors, Thus, compared with the United States, shoes and watches are cheaper in Mexico, and electric motors are more expen sive in Mexico, Therefore, Mexico will import electric motors from the United states, and the United States will import shoes and watches from Mexico, Accordingly, the cor- rectansweris (4) Consider two countries, and B, Based on relative PPP, Ish 1h where §; and Sy are the expected and the current exchange rates between the curre ies of Aand B, and f, and fy are the inflation ratesin A and B, [FA and B belong to the group of countries that introduces the same currency, then one could think ofboth , and 8, being one. Then, f, and fe should both be equal for relative PPP to hold. Thus, introduction of a common currency by a group of countries would result in the conver: gence ofthe inflation ratesamongthese countries. similar argument could be applied {o inflation among the various states of the United States. Based on relative PPP, where 5; is the expected SFr/$ exchange rate one year from now, Sy is the current Sr/$ exchange rate, and fyinctane aNd fys ate the expected annual inflation rates in Switzerland and the United States, respectively. So, 5) _ 14002 1.60 ~ 1+ 0.05 and S; = 1.60 (1,02/1,08) = Sel 55/8 a. A Japanese consumption basket consists of two-thirds sake and one-third TV sews The price ot sake in yen is rising ata rate ot 10 percent per year. The price of TV sets is constant. The Japanese consumer price index inflation is therefore equal to 210%) + Low) = 667s Rete PPP sats that 51 he 31 ¥ Ine Because the exchange rates given to be constant, we have 5, 5,/So 1.Asa result in aur example, PPP would holif| + fee — Inc). Because the Japanese inflation rate is 5.67 percent and the Ar rate is percent, wedo nothave fe: = Inc, and PPP does not hold, Si, which implies Io: (ie Foe = can inflation86 Chapter 2. Foreign Exchange Parity Relations Joa 1, The law of one price is that, assuming competitive marketsand no transportation costs oF tariffs, the same goods should have the same real prices in all countries after converting prices to 3 common currency fi, Absolute PPP, focusing on baskets of goods and services, states that the samme bas. ket of goods should have the same price in all countries after conversion to a common currency. Under absolute PPP, the equilibrium exchange rate between ‘aco currencies would be the rate that «qualizes the prices ofa basket of goods be- tween the two countries. This rate would correspond to the ratio of average price levels in the countries. Absolute PPP assumes no impediments to trade and iden tical price indexes that do not create measurement problems iii, Relative PPP holds that exchange rate movements reflect differences in price changes (inflation rates) between counties. A countrywith arefatively high infla- tion rate will experience a proportionate depreciation af is urrency’s value vise vis that of a country with a lower rate of inflation, Movements in currencies provide a means for maintaining equivalent purchasing power levelsamong cur- rencies in the presence of differing inflation rates. Relative PPP assumes that prices adjust quickly and price indexes properly measure inflation rates. Because relative PPP focuses 91 changes and not ab- solute levels, relative PPP is more likely to be satisfied than the law of one price of absolute PPP. 1, Relative PPP is not consistently useful in the short run because of the following (1) Relationships between month-to-month movements in market exchange rates and PPP are not consistently strong, according to enapirical research, Deviations Ierween the rates can persist for extended periods. (2) Exchange rates fluctuate minute by minute because they are set in the financial markets. rice levels, in contrast, are sticky and adjust slowly, (3) Many other factors can influence €x: change rate movements rather than justinflation, 4i, Research suggests that over the long term, a tendency exists for marketand PPP. rates to move together, with market rates eventually moving toward levels implied * by PPP. ! 11. a, Ifthe treasureris worried thatthe fran might appreciate in the next three months she could hedge her foreign exchange exposure by trading this risk against the pre» ‘nium included inthe forward exchange rate, She could buy (0 milion Sis francs | fan the three-month forward market atthe rate af F1.5890/€. The transaction wl ‘be contracted as of the current date, but delivery and settlement will only take place three months liter b. Threemonths late, the company received the 10 milion Sis francs the forwar| rate of Fr1.5820/€ agreed a carlicr. Thus, th company needed (Sr10,000,0)/ (SFr1.5320/€), or €6,597,415. If the company had not entered into forward com tray, the company would have received the (0 million Swiss francs atthe spot rate of SFr15101/€. Thus, the company would have needed (SFr10,000,000) / {(SFrl.5101/€), or €6,622,078. Therefore, the company benefited by the treasurer's} ‘uction, because € 6,622,078 — €6,527,415 = €94,663 were saved. 12, The nominal interest rate is approximately the sum of the real interest rate and the 2% pected inflation rate over the term of the interest rate. Even ifthe international ~ _ Ae4, 15, Solutions 37 relation holds, and the real interest rates are equal among countries, the expected infla- tion can be very different from one country to another, Therefore, there is no reason, why nominal interest rates should be equal among countries, Because the Australian dollar is expected to depreciate relative to the dollar, we know from the combination of international Fisher relation and relative PPP that the nominal interest rate in Australia is greater than the nominal interest rate in the United States. Further, the nominal interest rate in the United States is greater than that in Switzerland. Thus, the nominal interest rate in Australia has to be greater than the ‘nominal interest rate in Switzerland, Therefore, we can say from the combination of i- ternational Fisher relation and relative PPP that the Australian dolla is expected to de- preciate relative tothe Swiss franc. According to the approximate version of the international Fisher relation, rw 105 = Kowndon ~ Lis-50,8~ 7 = 8 ~ fess which means that fex = 5 "According to the approximate version of relative PPP, si S Sp wn ~ Hes where, $y and Sy ate in SKr/$ terms, Iowim — fey = 6 ~ 5 = 1%, oF 901. 50, (6~ S,)/5) = 101, Solving for Sp, we pet Sy ~ SKr5.94/3 According to the approximate version af RP, Scien — TUS: F and S), are in Skr/$ terms. ns (P= 5:98)/5.94 ~ 0,01. Solving for F we getF = Skr 6/5, Because we are given the expected exchange rate, we could also have arived at this answer by using the foreign exchange expectations relation. 1%, oF 2.01. So, According to the international Fisher relation, eee T+ hx Therefore, rxistane = 0.0589, oF 5.89%. According to relative PPP, fee ST ha where, $y nd Syare in SFr/£ terms. So, Si_ 1+ 008 371+ 00 Solving for 8), we get Sy = SFr2.8364/8,Chapter 2. Foreign Exchange Parity Relations 16 "7 According to IRR, FB _ 1+ Pests STF x where, Fand Sy are in SFr/£ terms.0, F_ 1+ 00589 37 Toa Solving for Ewe get F = SFr2,8868/S. Thisis the same as the expected exchange rate in ‘one year, with the slight difference due to rounding. During the 1991-1996 period, the cumulative inflation rates were about 25 percent in. Malaysia, 61 percent in the Philippines, and “8 percent in the United States. Over this period, based on relative PPP, one would have expected the Malaysian ringgitto deprec- ate by about 7 percent relative to the United States dollar (the inflation differential). In reality; the Malaysian ringgit appreciated by about 8 percent. Similarly, in view of the very high inflation differential between the Philippines and the United States, one would have expected the Philippine peso to depreciate considerably relative to the dollar, But it did not. Thus, according to PPP, both currencies ad become strongly overvalued, a. Acordingto PPP the current exchange rate should be Puneet! PPR were subscript I refesto the value now, subscript refers tothe vale 20 years ago, Prefers to price index, and § is the pi/$ exchange rat. Thus, the current fx = 92000100, change ated on PPP Sb =2(2D) = b. Asper PPP, the pi wervalued at the prevailing exchange rate of pif 0.9/5. Exports equal 10 million pifs and imports equal §7 million (6.3 million pits) Accordingly the trade balances (0 ~ 68 = 3.7 million pif. + Balance of services includes the $05 millon spent by tourists (0.45 million pis). + Nevincome includes 80.1 million or 0.09 million pifs received by Pa investors | dividends, minus | million pfs paid aut by Paf 2 interest on Paf bonds (-091 million + Unrequited transfers include 80.8 million (0.27 millon pits) received by Paf as foreign aid + Fortolio investment includes the $3 million or 2.7 milion pifs spent by Pat in vestors to buy foreign firms. So, portfolio investment = ~2.7 million pif. Based on the preceding, ‘« Currentaccount = 3.24 Capital account = 0.27 + Financial account = The sum of current account, capital account, and financial account is 0.81. By defn‘ tion of balance of payments, the sum of the current account, the capital account, the nancial account, and the chatigein offical reserves must be equal to 2-1 Therefore, official reserve account = ~0.81 =3.70+ 9.45 0.91) | |Bibliography 89 ‘The following summarizes the effect of the transactions on the balance of payments Current account 3.24 Trade balance 30 Balance of services 0.45 Net income -091 Capital account 027 Unrequited transfers oar Financial account -270 Portfolio investment ~2.70 Official reserve account -0st 19, a. A traditional flow market approach would suggest that the home currency should ‘depreciate because of increased inflation. An inerease in domestic consumpti could also ead to increased imports and a deficit in the balance of trade. This deficit, should lead toa weakening ofthe home currency'in the short ran, ’b. The asset market approach claims that this scenario is good for the home currency Foreign capital investment is attracted by the high returns caused by economic growth and high interest rates. This capital inflow leads to an appreciation of the home currency. 20. a. i, The immediate effect of reducing the budget defictis to reduce the demand for loanable funds because the government needs to borrow less 1o bridge the gap between spending and taxes. fi, The reduced publicsector demand forloanable funds has the sleet effect of lower ing nominal interest rates, because lower demand leads to lower cost af borrowing. ii, The direct effect ofthe budget deficit reduction isa depreciation ofthe domestic currency and the exchange rate. As investors sell lower yielding Countzy M secu rities to buy the securities of other countries, Country M's currency will come un- dder pressure and Country M's currency will depreciate b. i, In the case of a credible, sustainable, and large reduction in the budget deficit, reduced inflationary expectations ate likely because the central bank is less likely to monetize the debt by increasing the money supply. Purchasing power parity and international Fisher relationships suggest that 4 currency should strengthen against other currencies when expected inflation declines. ii, A reduction in government spending would tend to shift resources into private- sector investments, in which productivity is higher. The effect would be to in crease the expected return on domestic securities Bibliography Annaert, J and De Ceustes, M. “The Big Mac: More Than a Junk Asset Allocator? TInteruatonal Review of nancial Anais 5(3), 1997, pp. 179-19. Amott, R, “Tactical Currency Allocation,” in Managing Currency Risks in fnvestment Portfolios, AIMR Proceedings, 1999. Cassel, G, “The Present Situation on the Foreign Exchanges,” Ezonomic Journal, 1916, pp. 6265,