Exercise: Exchange rate determination (2)

1. How will the following events affect current exchange rate?

A. A rise in interest rates on domestic bonds

B. A rise in interest rates on foreign bonds
C. A rise in the expected exchange rate
D. An increase in money supply

2. Identify from the above a reason that makes the foreign exchange
market unstable / volatile

3. An Indian Bond offers 18% annual interest rate, while the same for
a Chinese bond is 10%. Rupee is likely to depreciate 10% over next year
vis-à-vis Renminbi. Which bond will you invest in?
Exercise on
interest
parity

1. Smart Bank Corp. (US) can borrow $5 million at 6% annualized rate of interest. It can
invest the proceeds in Canadian $s at 9% annualized over a 6 day period. The Canadian
Dollar is worth US$1.25 and is expected to be worth US$1.10 in 6 days.

a) Should the bank borrow from US and invest in Canadian bonds?

b) What should be the gain or loss in US $?
 Exercise on
interest parity

2. a)Moroccan domestic bonds with 1 year maturity time offer an interest rate of 5%
whereas US bonds offer 2%, say. Risk associated to both are perceived to be equal.
Currently, 1 Moroccan dirham = 0.1 US $. What is the forward market exchange rate such
that covered interest parity hold?

b) Moroccan domestic bonds with 1 year maturity time offer a risk-free interest rate of 6%
whereas US bonds offer 2%, say. Currently, 1 Moroccan dirham = 0.1 US $. The forward
market exchange rate is 9 dirham = 1 US $. If international bond market is in equilibrium,
which bond is perceived to be riskier?
Exercise
on
interest
parity

3. A recent shift in the interest rate differential between US and country A had a large
effect on the value of the currency of A. However, the same shift in the interest
differential between US and country B had practically no effect on the value of
currency of B.

What could be the reason?

Exercise
on
interest
parity

4. ABCD Co. expects that the pound will depreciate from $1.7 to $1.68 in one year. It has no
money to invest. But it could borrow.

A bank allows it to borrow either 1000 Dollars or 1000 Pounds for one year. Dollars are available
at 6% and Pounds are available at 5% for 1 year.
It can invest in a risk free dollar deposit at 5% for 1 year, or a risk free British deposit at 4% for 1
year.

Determine the expected profit or loss if ABCD wants to capitalise on the expected depreciation
of Pound.
Exercise
on
interest
parity

5. A) Imagine everyone in the world has to pay a tax of t% on interest earnings and on capital
gains due to exchange rate changes.

How would such a tax alter the interest parity condition?

B) How does your answer change if the tax rates are unequal in different countries?

C) How does your answer change if the tax applies to interest earnings only and not on capital
gains?
A) R(f) = [i* + (exp e – e)/e](1-t*)
R(D) = i (1- t)
If t* = t then the UIP or CIP does not change

B) If t ≠ t*
Then UIP becomes [i* + (exp e – e)/e](1-t*) = i (1- t)

C) If tax is only on interest earning

Then UIP becomes [i*(1-t*) + (exp e – e)/e] = i (1- t)
Reading

• Class notes for solutions to exercises