Problem 7.

6 Argentine Peso and PPP

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/$. During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized. Assumptions Spot exchange rate, fixed peg, early January 2002 (Ps/$) Spot exchange rate, January 29, 2003 (Ps/$) US inflation for year (per annum) Argentine inflation for year (per annum) a. What should have been the exchange rate in January 2003 if PPP held? Beginning spot rate (Ps/$) Argentine inflation US inflation PPP exchange rate b. By what percentage was the Argentine peso undervalued? Actual exchange rate (Ps/$) PPP exchange rate (Ps/$) Percentage overvaluation (positive) or undervaluation (negative) c. What were the probable causes of undervaluation? The rapid decline in the value of the Argentine peso was a result of not only inflation, but also a severe crisis in the balance of payments (see Chapter 4). 3.20 1.17 -63.307% 1.00 20.00% 2.20% 1.17 Value 1.0000 3.2000 2.20% 20.00%

Problem 7.10 XTerra exports and Pass-Through

Assume that the export price of a Nissan XTerra from Osaka, Japan is 3,250,000. The exchange rate is 115.20/$. The forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to answer the following questions on exchange rate pass through. Steps Initial spot exchange rate (/$) Initial price of a Nissan Xterra () Expected US dollar inflation rate for the coming year Expected Japanese yen inflation rate for the coming year Desired rate of pass through by Nissan Value 115.20 3,250,000 2.200% 0.000% 75.000%

a) What is the export price for the XTerra at the beginning of the year expressed in U.S. Dollars? Year-beginning price of an XTerra () 3,250,000 Spot exchange rate (/$) 115.20 Year-beginning price of a XTerra ($) $ 28,211.81 b) Assuming PPP holds, what should the exchange rate be at the end of the year? Initial spot rate (/$) Expected US$ inflation Expected Japanese yen inflation Expected exchange rate at end of year assuming PPP (/$)

115.20 2.20% 0.00% 112.72

c) Assuming 100% pass-through, what should be the dollar price of an Xterra at the end one year? Price of XTerra at beginning of year () 3,250,000 Japanese yen inflation over the year 0.000% Price of XTerra at end of year () 3,250,000 Expected spot rate one year from now assuming PPP (/$) 112.72 Price of XTerra at end of one year in ($) $ 28,832.47 d) Assuming 75% pass-through, what should be the dollar price of an Xterra at the end one year? Price of XTerra at end of year () 3,250,000 Amount of expected exchange rate change, in percent (from PPP) 2.200% Proportion of exchange rate change passed through by Nissan 75.000% Proportional percentage change 1.650% Effective exchange rate used by Nissan to price in US$ for end of year 113.330 Price of XTerra at end of one year in ($) $ 28,677.30

Problem 7.15 Luis Pinzon -- 30 Days Later

One month after the events described in the previous question, Luis Pinzon once again has $1 million (or its Swiss franc equivalent) to invest for three months. He now faces the following rates. Should he again ener into a covered interest arbitrage (CIA) investment? Assumptions Arbitrage funds available Spot exchange rate (SFr./$) 3-month forward rate (SFr./$) U.S. dollar 3-month interest rate Swiss franc3-month interest rate Value $1,000,000 1.3392 1.3286 4.750% 3.625% SFr. Equivalent SFr. 1,339,200

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Difference in interest rates ( i SFr. - i $) Forward premium on the Swiss france CIA profit -1.125% 3.191% 2.066%

This tells Luis Pinzon he should borrow U.S. dollars and invest in the LOWER yielding currency, the Swiss franc, and then sell the Swiss franc principal and interest forward three months locking in a CIA profit.

START $1,000,000 Spot (SFr./$) 1.3392 SFr. 1,339,200.00

U.S. dollar interest rate (3-month) 4.750% 1.011875 $

END 1,011,875.00 1,017,113.13 $ 5,238.13 F-90 (SFr./$) 1.3286 SFr. 1,351,336.50

---------------> 90 days ---------------->

1.0090625

3.625% Swiss franc interest rate (3-month)

Yes, Luis should undertake the covered interest arbitrage transaction, as it would yield a risk-less profit (exchange rate risk is eliminated with the forward contract, but counterparty risk still exists if one of his counterparties failed to actually make good on their contractual commitments to deliver the forward or pay the interest) of $5,238.13 on each $1 million invested.