Problem Set 1 of EF 4331 (49 pts)

Instructor: Dr. Du Du

Select the best answers for questions (2 points each for questions 1-10)
1. Which of the following services is not provided by a typical bank?
A) Accept deposits
B) Make loans to a firm
C) Manufacture products from raw materials
D) Carry out payments for goods on behalf of customers
Answer: C
2. A WSJ (wall street journal) article reports that:
the euro was at $1.3674 up from $1.3653 at Mondays close, while the dollar was at
115.09 yen from 116.08 yen
That means the dollar_________against euro, and the yen_____________against dollar
A) appreciated; appreciated
B) appreciated; depreciated
C) depreciated; appreciated
D) depreciated; depreciated
Answer: C

3. Of the following exchange rates, which are quoted in European terms?

i)

2 USD for one British pound;

ii)

0.75 euro for one USD;

iii)

7.8 HKD for one USD;

iv)

100 yen for one USD

A) only i)
B) only ii)
C) iii) and iv)
D) ii), iii) and iv)

Answer: D

4. The AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ exchange rate is
SF1.25/$. The AUD/SF cross exchange rate is thus:
A) 0.7813
B) 2.0000
C) 1.2800
D) 0.3500
Answer: C
5. Which of the following statements about forward rate/forward contract is
FALSE?
A) the forward rate is determined when both the long side and the short side enter
into the forward contract
B) The forward rate will not be executed until the forward contract expires
C) The forward rate represents the market prediction of the future spot rate
D) The forward rate is determined when the forward contract is about to expire

Answer: D
6. Suppose the current exchange rate is $1.6 for 1, and the expected inflation rate in
the U.S. and in the U.K. are 2% and 4%, respectively, in the coming year.
According to the relative PPP,
A) $ is expected to appreciate against in one year
B) $ is expected to depreciate against in one year
C) the $/ exchange rate is expected to remain unchanged in the coming year
D) none of the above
Answer: A

7. Consider the two quotations about Japanese yen against the U.S. dollar: The
spot rate is 108/$; whereas the 90 day forward rate is 110/$. Applying what
youve learned from interest rate parity (IRP), which of the following is
correct?
A) Yen is expected to depreciate against dollar, and according to IRP, interest rate

prevailing in Japan should be higher than that prevailing in the U.S.

B) Yen is expected to appreciate against dollar, and according to IRP, interest rate
prevailing in Japan should be higher than that prevailing in the U.S.
C) Yen is expected to depreciate against dollar, and according to IRP, interest rate
prevailing in Japan should be lower than that prevailing in the U.S.
D) Yen is expected to appreciate against dollar, and according to IRP, interest rate
prevailing in Japan should be lower than that prevailing in the U.S.

Answer: A
8. Assume that the balance-of-payments accounts for a country are recorded as
follows.
balance on the current account = BCA = $130 billion
balance on the capital account = BKA = -$86 billion
Then, under the fixed exchange rate regime, the balance on the reserves account (BRA)
should be (ignore statistical discrepancies)
A) $44 billion
B) $44 billion
C) $216 billion
D) none of the above
Answer: A
9. Consider the supply-demand framework for the British pound relative to the
U.S. dollar shown in the following chart. The current demand and supply
curve is D and S, hence equilibrium exchange rate is $1.90 = 1.00. Which of
the following statements is correct?

A) Demand for British pounds

exceeds the supply of
pounds at the exchange rate
of $1.80 = 1.00.
B) Supply for British pounds
exceeds the demand of
pounds at the exchange rate
of $1.80 = 1.00
C) Suppose the demand curve
shifts from D to D. Under
a floating exchange rate
regime, the equilibrium
pound exchange rate will
depreciate from $1.90 =
1.00 to $1.80 = 1.00
D) Both A) and C) are correct
Answer: D
10. The U.S. Trade Deficit
A) is a capital account surplus
B) is a current account deficit
C) has to be financed by capital account surplus assuming the US government maintains a zero
official reserve account.
D) both B) and C)

Answer: D
11. From the 1944 to 1971, the international monetary system is under the so
called Bretton Woods System, in which U.S. dollar is pegged to gold at
$35/oz and all other currencies are pegged to dollar. As a result, gold and
dollar are the two most important reserve assets for the central banks. Since
gold has a natural scarcity, to satisfy the growing need for reserves, central
banks from around the world have the incentive to accumulate dollars. The
measures these foreign countries can take to attract dollars include stimulating
_____ and _____ interest rates.
A) imports from the US , raising
B) imports from the US, decreasing

C) exports to the US, raising

D) exports to the US, decreasing
Answer: C
Reasoning: when foreign countries want dollar, they can either try to export more
to the US or raise the interest rate to attract the US investors. In the former case,
the US pays dollar for its imports, i.e., supplies dollar (which satisfies the demand
of dollar from the foreign countries). In the latter case, US investors have to
convert dollar into the foreign currencies to finish the foreign investment which
again raises the supply of dollar.

12. Under the currency board arrangement, HK has achieved

i) full financial integration
ii) exchange rate stability
iii) monetary independence
A) i) and ii)
B) i) and iii)
C) ii) and iii)
D) i), ii), and iii)
Answer: A
Questions 13-17 are quantitative calculation problems: you need to show both the final results
and the procedure with which you obtain the final results.

13. (5pts) Suppose a U.S. investor bought 100 shares of Toyota Corporation in
year 2001. At that time each share of Toyota Corporation cost 10,000 yen, and
the prevailing spot exchange rate was 120/$. Suppose one year later, the
price of Toyota Corporation increased to 11,000 yen share.
a) (1pt) Compute the investors one year net return (in percentage) from this investment
in terms of
b) (1.5pt) if the spot exchange rate one year later was 110/$, compute the investors net
return (in percentage) in terms of dollar

c) (1pt) if the spot exchange rate one year later was instead 140/$, repeat the
computation in b)
d) (1.5pt) what do you learn from the computation a)c)?
Answer:
a) One year net return in terms of is:
(11,000*10-10,000*10)/(10,000*10)*100%=10% (1pt)
b) The initial dollar investment is 10,000*100/120=$8333.33 (0.5pt)
Dollar payoff one year later at 110/$ is 11,000*100/110=$10,000 (0.5pt)
Hence, one year net return in terms of dollar is: (10,000-8333.33)/8333.33*100%=20%
(0.5pt)
c) Dollar payoff one year later at 140/$ is 11,000*100/140=$7857.14 (0.5pt)
Hence, one year net return in dollar is: (7857.14-8333.33)/8333.33*100%=-5.7% (0.5pt)
d) For a U.S. investor who considers doing international investment, he faces the so
called foreign exchange risk. That is, even though he earns profits in a foreign currency
(such as in this question), it is not necessary that the same investment will bring him
profits in $ terms. (0.5pt)
In particular, foreign currency profits may evaporate due to the depreciation of the
foreign currency, and the investor may even lose money in dollar terms, as the
computation in c) shows. (0.5pt)
On the other hand, the investor may earn higher profits in dollar terms than in the foreign
currency if the U.S. dollar appreciates against the foreign currency, as the computation in
b) shows. (0.5pt)
14. (7pts) Assume you are a trader with Deutsche Bank. From the quote screen on
your computer terminal, you notice that Dresdner Bank is quoting
0.7627/$1.00 and Credit Suisse is offering SF1.1806/$1.00. suppose you also
learn that UBS is making a direct market between the Swiss franc and the
euro, with a current quote of 1 = SF1.5637.
a) (1.5pts) Compute the implied cross rate between and SF, and identify the
arbitrage opportunity

b) (4.5pts) Compute the arbitrage profits that you can obtain. Suppose you start
with 1,000,000, and please show all relevant steps.
Answer:
a) The implied cross exchange rate between and SF is 1.1806/0.7627=SF1.5479/ (1pt)
Since the cross rate is different than the direct quotation of SF1.5637/, there is the
triangular arbitrage opportunity (0.5pt)
b) Since under direct quotation is over-priced relative to the implied cross rate, you
should sell to UBS for SF at the higher price of SF1.5637/ (0.5pt)
Selling 1,000,000 to UBS at SF1.5637/ yields SF1, 563,700. (1pt)
Selling SF1,563,700 to Credit Suisse at SF1.1806/$1.00 yields $1,324,496 (1pt)
Selling $1,324,496 to Dresdner at 0.7627/$1.00 yields 1,010,193 (1pt)
The arbitrage profit is thus 1,010,193-1,000,000=10,193 (1pt)
15. (3pts) Suppose the exchange rate between dollar and euro at the end of 2014 is
$1.16/. According to World Bank, inflation rates over 2015 are expected to
be 5.0 percent in the United States and 3.5 percent in Germany. If relative PPP
holds, then what is the expected exchange rate between dollar and euro at the
end of 2015?
Answer:

St 1 ($ / ) 1 $

S
($
/
)
1 ,
t
In the formula for relative PPP,

$ 5% , 3.5%, and St ($ / ) $1.16/ (1pt)

We thus have

St 1 ($ / )

1 $
1.05
St ($ / )
1.16
1
1.035
(1pt)

The final result is: St 1 ($ / ) 1.1768$ / (1pt)

16. (3pt) Suppose that the one-year interest rate is 5.0 percent in the United States
and 3.5 percent in Germany. In addition, assume the one-year forward

exchange rate is $1.16/. What is the implied spot exchange rate according to
the IRP?
Answer:

F ($ / ) 1 i$

S
($
/
)
1 i ,
In the formula for IRP,
i$ 5% , i 3.5%, and F ($ / ) $1.16/ (1pt)
S ($ / )

We thus have

1 i
1.035
F ($ / )
1.16
1 i$
1.05
(1pt)

The final result is: S ($ / ) 1.1434$ / (1pt)

17. (7pts) Currently, the spot exchange rate is $1.50/ and the one-year forward
exchange rate is $1.6/. You also observe that one-year interest rate prevailing
in the U.S. and Germany. are 8.0% and 5.8%, respectively. Assume the
maximum that you can borrow is $1,500,000 or 1,000,000.
a) (3pts) compute the synthesized dollar interest rate from the German market and
identify the arbitrage opportunity.
b) (4pts) Compute the maximum arbitrage profit that you can obtain.

Answer:
a) In the formula for the synthesized dollar interest rate implied from the German market,
F ($ / )
1 i 1 i 8% i 5.8%,
S ($ / ) $1.5/ , and F ($ / ) $1.6/ (1pt)
S ($ / )
, $
,
The synthesized dollar interest rate is thus
F ($ / )
1.6
1 i$ 1
1.058 1 12.85%

S ($ / )
1.5
(1.5pt)
Since this rate is different than i$ , there is covered interest arbitrage opportunity
(0.5pt)

b) Since the synthesized dollar interest rate implied from the German market is higher
dollar rate prevailing in the U.S., you should borrow from the U.S. money market and
lend out in the Germany money market (0.5pt)
Borrowing the maximum of $1,500,000 and convert it into 1,000,000 in the spot market.
(1pt)
Invest 1,000,000 in the Germany money market at the rate of 5.8%. The maturity value
in one year will be 1,058,000. (1pt)
Sell 1,058,000 forward at F ($ / ) $1.6/ to yield for $1,692,800 (1pt)
The maximum arbitrage profit is thus 1,692,800-1,500,000= $192,800 (0.5pt)
Given we should payback the borrowing cost of initial $1,500,000, i.e., 120,000, thus
finally get 72,800.