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INTERNATIONAL FINANCE
Assignment Problems (5) Name: Student#:
I. Choose the correct answer for the following questions (only correct answer) (3 credits for each question, total credits 3 x 20 = 60)
1. When the supply of and demand for a foreign exchange in the foreign exchange market are exactly the same, the exchange rate is the __________. A. real exchange rate B. effective exchange rate C. equilibrium exchange rate D. cross exchange rate
2. An increase in the demand for French goods and services will __________. A. induce a rightward shift in the demand for euro B. induce a leftward shift in the demand for euro
C. result in a rightward movement along the demand curve for euro D. result in a leftward movement along the demand curve for euro
3. If U.S. demand for Japanese goods increases and Japan’s demand for U.S. products also rises at the same time, which of the following can you conclude in this situation? A. The U.S. dollar will appreciate against the yen. B. The U.S. dollar will depreciate against the yen. C. The U.S. dollar will not change relative to the yen.
D. The U.S. dollar may appreciate, depreciate, or remain unchanged against the yen.
4. If the price of a pair of Nike sneakers costs $85 in U.S, and the price of the same sneakers is �80 in Paris, the spot rate is $1.35 per euro, the euro __________. A. is correctly valued according to PPP
B. is correctly valued according to relative PPP C. is undervalued according to PPP D. is overvalued according to PPP
5. If the expected exchange rate E (SB/A) according to the relative purchasing power parity is lower than the spot exchange rate (SB/A), we may conclude that __________.
A. country B is expected to run huge BOP surplus with country A
B. country A’s interest rate is going to be lower than that of country B’s
C. the expected inflation rate in country A is higher than the expected inflation rate in country B
D. the expected inflation rate in country A is lower than the expected inflation rate in country B
6. Assume that PPP holds in the long run. If the price of a tradable good is $20 in the
U.S. and 100 pesos in Mexico; and the exchange rate is 7 pesos/$ right now, which of the following changes might we expect in the future? A. an increase in the price of the good in the U.S B. a decrease in the price of the good in Mexico C. an appreciation of the peso in nominal terms D. a depreciation of the peso in nominal terms
7. Which basket of goods would be most likely to exhibit absolute purchasing power parity?
A. Highly tradable commodities, such as wheat B. The goods in the Consumer Price index
C. Specialized luxury goods, which are subject to different tax rates across countries D. Locally produced goods, such as transportation services, which are not easily traded
8. The absolute purchasing power parity says that the exchange rate between the two currencies should be determined by the __________ . A. relative inflation rate of the two currencies B. relative price level of the two countries C. relative interest rate of the two currencies D. relative money supply of the two countries
9. According to the relative PPP, if country A’s inflation rate is higher than country B’s inflation rate by 3%, __________.
A. country A’s currency should depreciate against country B’s currency by 3% B. country A’s currency should appreciate against country B’s currency by 3%
C. it is hard to say whether country A’s currency should appreciate or depreciate against country B’s currency. The exchange rate is influenced by many factors D. none of the above is true
10. If the law of one price holds for a particular good, we may conclude that __________.
A. there is no trade barriers for the good among the different nations B. the price of the good is the same ignoring the other expenses C. arbitrage for the good does not exist D. all of the above are true
11. An investor borrows money in one market, sells the borrowed money on the spot market, invests the proceeds of the sale in another place and simultaneously buys back the borrowed currency on the forward market. This is called __________. A. uncovered interest arbitrage B. covered interest arbitrage C. triangular arbitrage D. spatial arbitrage
12. Real return equalization across countries on similar financial instruments is called __________.
A. interest rate parity
B. uncovered interest parity C. forward parity D. real interest parity
13. In which of the following situations would a speculator wish to sell foreign currency on the forward market?
14. According to IRP, if the interest rate in country A is higher than that in country B, the forward exchange rate, defined as F1A/B is expected to be __________. A. lower than the spot rate S0A/B B. the same as the spot rate S0A/B C. higher than the spot rate S0A/B
D. necessary the same as the future spot rate S1A/B
15. For arbitrage opportunities to be practicable, __________. A. arbitragers must have instant access to quotes B. arbitragers must have instant access to executions
C. arbitragers must be able to execute the transactions without an initial sum of money relying on their bank’s credit standing D. All of the above must be true.
16. The __________ states that the forward exchange rate quoted at time 0 for delivery at time t is equal to what the spot rate is expected to be at time t. A. interest rate parity
B. uncovered interest parity C. forward parity D. real interest parity
17. Assume expected value of the U.S. dollar in the future is lower than that now compared to the value of the Japanese yen. The U.S. inflation rate must be higher than Japan’s inflation rate according to __________. A. relative PPP B. Fisher equation
C. International Fisher relation D. IRP
18. According to covered interest arbitrage if an investor purchases a five-year U.S. bond that has an annual interest rate of 5% rather than a comparable British bond that has an annual interest rate of 6%, then the investor must be expecting the __________ to __________ at a rate at least of 1% per year over the next 5 years. A. British pound; appreciate B. British pound; revalue C. U.S. dollar; appreciate D. U.S. dollar; depreciate
19. Covered interest arbitrage moves the market __________ equilibrium because __________.
A. toward; investors are now more willing to invest in risky securities
B. toward; purchasing a currency on the spot market and selling in the forward market narrows the differential between the two
C. away from; purchasing a currency on the spot market and selling in the forward market increases the differential between the two
D. away from; demand for the stronger currency forces up the interest rates on the weaker security
20. If the forward exchange rate is an unbiased predictor of the expected future spot rate, which of the following is NOT true?
A. The future spot rate will actually be equal to what the forward rate predicts
B. The forward premium or discount reflects the expected change in the spot exchange rate.
C. Speculative activity ensures that the forward rate does not diverge too far from the market’s consensus expectation. D. All of the above are true.
II. Problems (40 credits)
1. The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002 the Argentine peso was floated. On January 29, 2003, it was trading at Ps3.20/$. During that one year period Argentina’s inflation rate was 20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized. (10 credits)
a. What should have been the exchange rate in January 2003 if purchasing power parity held?
b. By what percentage was the Argentine peso undervalued on an annualized basis?
2. Assume that the interest rate paid by an American borrower on a ten-year foreign bond is 10% if the bond is sold in Denmark and 7% if the bond is sold in the Netherland. Will the expected inflation rate in the Netherlands likely be higher than the expected inflation rate in Denmark? Will the Danish kroner be expected to increase in value against the Dutch guilder? Explain your answer. (5 credits)
3. Suppose S = $1.25/? and the 1-year forward rate is F = $1.20/?. The real interest rate on a riskless government security is 2 percent in both England and the United States. The U.S. inflation rate is 5 percent. (5 credits)
a. What is England’s nominal required rate of return on riskless government securities?
b. What is England’s inflation rate if the equilibrium relationships hold?
4. Akira Numata, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars and Japanese yen. He faced the following exchange rate and interest rate quotes: (12 credits)