Kirt C.

Butler, Solutions for Multinational Finance, 4th edition

Chapter 3 Foreign Exchange and Currency Risk Management

Answers to Conceptual Questions 3.1 3.2 Define liquidity. Liquidity: the ease with which you can exchange an asset for another asset of equal value. What is the difference between a money market and a capital market? Money markets are markets for financial assets and liabilities of short maturity, usually considered to be less than one year. Capital markets are markets for financial assets and liabilities with maturities greater than one year. 3.3 What is the difference between an internal and an external market? Debt placed in an internal market is denominated in the currency of a host country and placed within that country. Debt placed in an external market is placed outside the borders of the country issuing the currency. 3.4 What is the Eurocurrency market and what is its function? The Eurocurrency market is an external credit market in bank deposits and loans. Like a national credit market, the Eurocurrency market permits the transfer of value over time in a given currency. 3.5 In what way is the Eurocurrency market different from an internal credit market? There are typically no reserve requirements, interest rate regulations or caps, withholding taxes, deposit insurance requirements, or regulations influencing credit allocation decisions. There are also less stringent disclosure requirements. 3.6 3.7 What is the London Interbank Offer Rate (LIBOR)? LIBOR is the rate at which a Euromarket bank offers to make a loan to another Euromarket bank. What effect did the Basle Accord have on international banks? The Basle Accord imposed minimum capital adequacy requirements on international banks as a protection against the credit risk of the banks loan portfolios. The Basle Accord also encouraged the use of value-at-risk (VaR) measures to quantify the risk of losses greater than a certain amount over a given time period. 3.8 What is the difference between spot and forward markets for foreign exchange? In the spot market, trades are for immediate delivery. In the forward market, trades are for future delivery according to an agreed-upon delivery date, exchange rate, and amount. 3.9 What is Rule #1 when dealing with foreign exchange? Why is it important? Rule #1 says to Keep track of your currency units. It is important because foreign exchange prices have a currency in both the numerator and the denominator. Most prices (for instance, a $15,000/car price on a new car) have a non-currency asset in the denominator and a currency in the numerator. 3.10 What is Rule #2 when dealing with foreign exchange? Why is it important? Rule #2 says to Always think of buying or selling the currency in the denominator of a foreign exchange quote. The importance of this rule is related to that of Rule #1. Foreign exchange quotes have a currency in both the numerator and the denominator. The rule buy low and sell high only works for the currency in the denominator. 3.11 What are the functions of the foreign exchange market? Currency markets transfer purchasing power from one currency to another, either today (in the spot market) or at a future date (in the forward market). When used with Eurocurrency markets, foreign exchange markets allow investors to move value both across currencies and over time. Foreign 4

Kirt C. Butler, Solutions for Multinational Finance, 4th edition exchange markets also facilitate hedging and speculation. 3.12 Define operational, informational, and allocational efficiency. Operational efficiency refers to how large an influence transactions costs and other market frictions have on a markets operation. Informational efficiency refers to whether or not prices reflect value. Allocational efficiency refers to how efficiently a market channels capital toward its most productive uses. 3.13 What is a forward premium? What is a forward discount? A currency is trading at a forward premium when the nominal value of that currency in the forward market is higher than in the spot market. A currency is trading at a forward discount when the nominal value of that currency in the forward market is lower than in the spot market. 3.14 Describe the empirical behavior of exchange rates. Over daily intervals, spot rate changes are random with a nearly equal probability of rising or falling. As the forecast horizon is lengthened, the correlation between interest and inflation differentials and nominal spot rate changes rises. Eventually, the international parity conditions exert themselves and the forward rate begins to dominate the current spot rate as a predictor of future nominal exchange rates. Finally, exchange rate volatility is not constant. Instead, volatility comes in waves. Problem Solutions 3.1 a. The bid is less than the offer, so Citicorp is quoting the currency in the denominator. Citicorp is buying dollars at the DKr5.62/$ bid rate and selling dollars at the DKr5.87/$ offer rate. b. In American terms, the bid price is $0.1704/DKr and the ask price is $0.1779/DKr. Citicorp is buying and selling the kroner at these quotes. c. In direct terms, the bid quote for the dollar is $0.1779/DKr and the ask price is $0.1704/DKr. Citicorp is buying dollars at $0.1779/DKr (which is equivalent to DKr5.62/$) and selling dollars at $0.1704/DKr (or DKr5.87/$). d. The bank will receive the bid-ask spread on each dollar. When buying one million dollars at DKr5.62/$ and selling one million dollars at DKr5.87/$, the banks profit on the bid-ask spread will be (DKr5.87/$DKr5.62/$)($1,000,000) = DKr250,000. The ask price is higher than the bid, so these are rates at which the bank is willing to buy or sell dollars (in the denominator). Youre selling dollars, so youll get the banks dollar bid price. You need to pay SKr10,000,000/(SKr7.5050/$) $1,332,445. The U.S. dollar (in the denominator) is selling at a forward premium, so the Canadian dollar must be selling at a forward discount. Annualized forward premia on the U.S. dollar are: Six months forward Bid ($) +0.681% Bid (C$) 0.678% Ask ($) +0.761% Ask (C$) 0.758%

3.2

3.3

Percent per annum on the Canadian dollar from the U.S. perspective are as follows: Six months forward

The premiums/discounts on the two currencies are opposite in sign and nearly equal in magnitude. Forward premiums and discounts are of slightly different magnitude because the bases (U$ vs. C$) on which they are calculated are different. Forward premiums/discounts are as stated above regardless of where a trader resides. 3.4 a. The forward premium is equal to (F1$/ S0$/) = ($0.008772945/ $0.009057355/) = $0.000284410/, or 2.8441 basis points. As a percentage over the 90-day period, this is (F1$/ S0$/) / S0$/ = 0.031401, or 3.1401 percent. b. As an annualized forward premium following the U.S. convention, this is equal to 5

Kirt C. Butler, Solutions for Multinational Finance, 4th edition (n)(F1$/S0$/)/S0$/ = (4)(0.031401) = 0.125604, or 12.5604 percent. c. As an APR, the premium is (F1$//S0$/)41 = 0.119811, or 11.9811 percent. 3.5 1984 DM1.80/$ or $0.56/DM 1987 DM2.00/$ or $0.50/DM 1992 DM1.50/$ or $0.67/DM 1997 DM1.80/$ or $0.56/DM a. 1984-87 The dollar appreciated 11.1%; ((DM2.0/$)(DM1.8/$)/(DM1.8/$) = +0.111 1987-92 The dollar depreciated 25%; ((DM1.5/$)(DM2.0/$)/(DM2.0/$) = 0.25 1992-97 The dollar appreciated 20%; ((DM1.8/$)(DM1.5/$)/(DM1.5/$) = +0.20 b. 1984-87 The mark depreciated 10.7%; ($0.50/DM)/($0.56/DM)1= 0.107 1987-92 The mark appreciated 34.0%; ($0.67/DM)/($0.50/DM)1= +0.340 1992-97 The mark depreciated 16.4%; ($0.56/DM)/($0.67/DM)1 = 0.164 a. (PZ5,000,000) / (PZ4.0200/$) = $1,243,781. Warsaws bid price for PZ is their ask price for dollars. So, PZ4.0200/$ is equivalent to $0.2488/PZ. b. (PZ20,000,000) / (PZ3.9690/$) = $5,039,053 PZ3.9690/$ is equivalent to $0.2520/PZ Payment is made on the second business day after the three-month expiration date. You initially receive P0$ = P0/S0/$ = (104,000,000)/(104/$) = $1 million. When you buy back the yen, you pay P1$ = P1/S1/$ = (104,000,000)/(100/$) = $1.04 million. Your loss is $40,000. When buying one currency, you are simultaneously selling another, so a yen bid price is a euro ask price. Yen quotes yield S/ = 1/S/ = 1/(0.007634/) = 130.99/ and S/ = 1/(0.007643/) = 130.84/, so euro quotes (in the denominator) are 130.84/ BID and 130.99/ ASK. a. (1+s/$) = 0.90 = 1/(1+s$/) s$/ = (1/0.90)1 = +0.111, or an 11.1% appreciation. b. (1+sRbl/$) = 11 = 1/(1+s$/Rbl) s$/Rbl = (1/11)1 = 0.909, or a 90.9% depreciation. The 90-day dollar forward price is 33 bps below the spot price: F1SFr/$S0SFr/$ = (SFr0.7432/$ SFr0.7465/$) = SFr0.0033/$. The percentage dollar forward premium is (F1SFr/$S0SFr/$)/S0SFr/$ = (SFr0.7432/$SFr0.7465/$)/(SFr0.7465/$) = 0.442% per 90 days, or (0.442%)*4 = 1.768% on an annualized basis. Banks make a profit on the bid-ask spread. A bank quoting $0.5841/SFr BID and $0.5852/SFr ASK is buying francs (in the denominator) at $0.5841/SFr and selling francs at $0.5852/SFr ASK. A bank quoting $0.5852/SFr BID and $0.5841/SFr ASK is buying dollars (in the numerator) at $0.5852/SFr BID and selling dollars at $0.5841/SFr ASK. Hence, these are equivalent. DKr is at a forward discount 30 day: ($0.18519/DKr$0.18536/DKr)/$0.18536/DKr = 0.092% 90 day: ($0.18500/DKr$0.18536/DKr)/$0.18536/DKr = 0.194% 180 day: ($0.18488/DKr$0.18536/DKr)/$0.18536/DKr = 0.259% a. S1$/ = S0$/ (1+ s$/) = ($0.0100/)(1.2586) = ($0.012586/) b. (1+ s/$) = S1/$/S0/$ = (1/S1$/) / (1/S0$/) = 1 / (S1$//S0$/) = 1 / (1+ s$/) = 1 / (1.2586) = 0.7945, so s$/ = 0.7945 1 = .2055, or = 20.55% (Ftd/fS0d/f)/S0d/f = [(1/Ftf/d)(1/S0f/d)]/(1/S0f/d) = [(S0f/d/Ftf/d)(S0f/d/S0f/d)]/(S0f/d/S0f/d) = [(S0f/d /Ftf/d) 1] = (S0f/d Ftf/d) / Ftf/d. t2 = (0.0034) + (0.40)(0.05)2 + (0.20)(0.10)2 = 0.0064 t = 0.08, or 8%.

3.6

3.7 3.8

3.9 3.10

3.11

3.12

3.13

3.14 3.15

Kirt C. Butler, Solutions for Multinational Finance, 4th edition

Chapter 4 The International Parity Conditions

Answers to Conceptual Questions 4.1 What is the law of one price? The law of one price states identical assets must have the same price wherever they are bought or sold. The law of one price is enforced by arbitrage activity between identical assets. In a perfect market without transaction costs, the law of one price must hold for there to be no arbitrage opportunities. 4.2 What is an arbitrage profit? Arbitrage profit is a profit obtained through the simultaneous purchase and sale of the same or equivalent securities such that there is no net investment or risk. Arbitrage will drive the prices of identical assets into equilibrium and enforce the law of one price. 4.3 What is the difference between locational, triangular, and covered interest arbitrage? Locational arbitrage is conducted between two physical locations, such as between currency prices at two different banks (such that ASf/d BSd/f 1 for banks A and B and currencies d and f). Triangular arbitrage is conducted across three different cross exchange rates (such that Sd/e Se/f Sf/d 1 for currencies d, e, and f). Covered interest arbitrage takes advantage of a disequilibrium in the interest rate parity condition [(Ftd/ f) / (S0d/ f)] (1+id) / (1+i f)]t between currency and Eurocurrency markets. 4.4 Is interest rate parity a reliable relation in the interbank markets? Interest rate parity is a reliable relation in the interbank markets. Each of the prices in the IRP relation (Ftd/f/S0d/ f) = [(1+id)/(1+i f)]t is a traded contract in the interbank markets, and so covered interest arbitrage is able to enforce the no-arbitrage condition within the bounds of transaction costs (which are small in the interbank market). 4.5 What is relative purchasing power parity? Relative purchasing power parity is a form of the law of one price in which the expected change in the spot exchange rate is influenced by the difference in expected inflation according to E[Std/f]/S0d/f = [(1+E[pd])/(1+E[pf])]t. 4.6 Are forward exchange rates good predictors of future spot rates? Forward rates are poor predictors of future spot rates over short-term forecast horizons, because exchange rate volatility masks the signal from the international parity condition. Over longer forecast horizons, the signal-to-noise ratio improves and the forecast performance of forward rates (as well as inflation differentials from RPPP) improves. 4.7 What does the international Fisher relation say about interest rate and inflation differentials? If real interest rates are constant across currencies, nominal interest rates should reflect inflation differentials according to [(1+id) / (1+if)]t = [(1+E[pd]) / (1+E[pf])]t. 4.8 4.9 What are real changes in exchange rates? Real exchange rate changes reflect changes in currencies relative purchasing power. Are real exchange rates in equilibrium at all times? Real exchange rates show large and persistent deviations from purchasing power parity. These deviations can last for several years. 4.10 What is the effect of a real appreciation of the domestic currency on the purchasing power of domestic residents? A real appreciation of the domestic currency increases the wealth and purchasing power of domestic residents relative to foreign residents. It can also hurt the economy by raising the price of domestic goods relative to foreign goods. 7

Kirt C. Butler, Solutions for Multinational Finance, 4th edition 4.11 Will an appreciation of the domestic currency help or hurt a domestic exporter? A nominal appreciation in the domestic currency is likely to have little effect on domestic importers and exporters. A real appreciation of the domestic currency can hurt domestic exporters by raising the price of domestic goods relative to foreign goods. Domestic importers will see their purchasing power increase relative to foreign competitors, and so are likely to be helped by a real appreciation of the domestic currency. 4.12 Describe the behavior of real exchange rates. Although real exchange rates revert to their long run average, in the short run there can be substantial deviations from purchasing power parity and the long run average. 4.13 What methods can be used to forecast future spot rates of exchange? Market-based forecasts are obtained from forward exchange rates or from interest rate parity when forward prices are unavailable. Model-based forecasts can be generated from technical analysis (analyzing patterns in exchange rates) or from fundamental analysis (from a larger set of economic relationships). 4.14 How can the international parity conditions allow you to forecast next years spot rate? In theory, any of the international parity conditions could be used: E[Std/f]/S0d/f = Ftd/f/S0d/f = [(1+id)/(1+if)]t = [(1+E[pd])/(1+E[pf])]t. In practice, forward rates are usually used to predict spot rates. At the least, forwards have the advantage of reflecting the opportunity costs of capital through the interest rate parity relation, Ftd/f/S0d/f = [(1+id)/(1+if)]t. Problem Solutions 4.1 a. SSFr = S/$S$/SFr = (200/$)($0.50/SFr) = 100/SFr b. SSFr = S/$/SSFr/$ =(100/$)/(SFr1.60/$) = 62.5/SFr 4.2 SSFr/$ S$/ S/SFr = 1.0326 > 1. Spot rates are too high relative to the parity condition, so you should sell the currencies in the denominators for the currencies in the numerators at the relatively high prices. This means that you should a) sell dollars for francs, b) sell yen for dollars, and c) sell francs for yen. Alternatively, a) buy francs with dollars, b) buy dollars with yen, and c) buy yen with francs. Triangular arbitrage would yield a profit of 3.26 percent of the starting amount. For triangular arbitrage to be profitable, transactions costs on a round turn cannot be more than this amount. 4.3 Each of these prices is a traded contract in the interbank forex market, and so arbitrage (either bilateral or triangular) will ensure that the relations Ftd/f(Y)/Fd/f(X) = 1 and Ftd/eFte/fFtf/d = 1 hold within the bounds of transaction costs. 4.4 The forward price is at a 9 bp discount over six months, or 18 bps on an annualized basis. The sixmonth percentage premium is (F1/$/S0/$)1 = (0.6352/$)/(0.6361/$)1 = 0.99861 = 0.14%, or a discount of 0.28% on an annualized basis. Because Ft/$ = E[St/$] according to forward parity (the unbiased forward expectations hypothesis), the spot rate is expected to depreciate by 0.14% over the next six months. 4.5 a. The percentage bid-ask spread depends on which currency is in the denominator. Tokyo quote for the peso: (28.77/MXN 28.74/MXN)/(28.74/MXN) = 0.00104, or 0.104%. Mexico City quote for yen: (MXN0.03420/ MXN0.03416/)/(MXN0.03416/) = 0.00117, or 0.117%. b. The Mexican banks yen quote can be converted into a quote for the Mexican peso as follows: S/MXN = 1/(MXN0.03416/) 29.27/MXN bid on the yen and ask on the peso. S/MXN = 1/(MXN0.03420/) 29.24/MXN ask on the yen and bid on the peso. So MXN0.03416/ BID and MXN0.03420/ ASK on the yen is equivalent to 29.24/MXN BID and 29.27/MXN ASK on the Mexican peso. The winning strategy is to buy pesos (and sell yen) from the Tokyo bank at the 28.77/MXN ask 8

Kirt C. Butler, Solutions for Multinational Finance, 4th edition price for pesos and sell pesos (and buy yen) to the Mexican bank at the 29.24/MXN bid price for pesos. Buying pesos in Tokyo yields (1,000,000)/(28.77/MXN) = MXN34,758. Selling pesos in Mexico City yields (MXN34,758)(29.24/MXN) = 1,016,336. Your arbitrage profit is 16,336 yen, or about MXN559 at the Mexican banks 29.24/MXN bid price for pesos. 4.6 In this circumstance, the international parity conditions do not have anything to say about the U.K. inflation rate. Nominal interest rates will adjust to expected inflation according to the Fisher relation; (1+i) = (1+p)(1+). 4.7 a. From interest rate parity, (210/$)/(190/$) = (1+i)/(1.15) i = 27.11%. b. Because the forward rate of 210/$ is greater than the spot rate of 190/$, the dollar is at a forward premium. If forward rates are unbiased predictors of future spot rates, the dollar is likely to appreciate against the yen by (210/$)/(190/$)1 = 10.526%. 4.8 a. In this problem, we know the spot and forward rates and U.S. inflation. The real and nominal interest rates are not needed: F1$//S0$/ = ($1.20/)/($1.25/) = 0.96 = E(1+p$)/E(1+p) = (1.05)/E(1+p) => E(p) = (1.05/0.96)1 = 9.375% b. From the Fisher equation: i = (1+p)(1+)1 = (1.09375)(1.02)1 = 11.56%. 4.9 a. E[P1D] = P0D(1+pD) = D100(1.10) = D110 E[P1F] = P0F(1+pF) = F1(1.21) = F1.21 E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F. b. E[P2D] = P0D(1+pD)2 = D100(1.10)2 = D121 E[P2F] = P0F(1+pF)2 = F1(1.21)2 = F1.4641 E[S2D/F] = E[P2D]/E[P2F] = D121/F1.4641 = S0D/F[(1+pD)/(1+pF)]2 = (D100/F)(1.10/1.21)2 = D82.64/F. 4.10 a. A 7% annualized rate with quarterly compounding is equivalent to 7%/4 = 1.75% per quarter. From interest rate parity, the 3-month MR interest rate is FMR/$/SMR/$ = (MR3.9888/$)/(MR4.0200/$) = (1+iMR)/(1+i$) = (1+iMR)/(1+0.0175) => iMR = 0.009603, or 0.9603% per three months. Annualized, this is equivalent to (0.9603%)*4 = 3.8412% per year with quarterly compounding. Alternatively, the annual percentage rate is (1.009603)41 = 0.03897, or 3.897% per year. b. $10,000,000 invested at the three-month U.S. rate yields $10,175,000. Changed into MR at the forward rate, this is worth ($10,175,000)(MR3.9888/$) = MR40,586,040. You can finance your $10,000,000 by borrowing MR40,200,000. Your obligation on this contract will be (MR40,200,000)(1.009603) MR40,586,040 which is exactly offset by the proceeds from your forward contract. 4.11 a. FtBt/$/S0Bt/$ = (1 + iBt)t/(1 + i$)t = (Bt 25.64/$)/(Bt 24.96/$) = (1 + iBt)/(1.06125) 1.02724 = (1 + iBt)/1.06125 iBt = 9.02% b. F1Bt/$/S0Bt/$ = (Bt25.64/$)/(Bt24.96/$) = 1.027 < (1+iBt)/(1+i$) = (1.1)/(1.06125) = 1.037. So, borrow at i$ and lend at iBt.
+Bt24,960,000 $1,000,000
Invest at the 10% baht interest rate Bt24,960,000

Convert to baht at the spot exchange rate

+Bt27,456,000

Kirt C. Butler, Solutions for Multinational Finance, 4th edition

Borrow at the 6.125% dollar interest rate $1,061,250

+$1,000,000

Cover baht forward

+$1,070,827 Bt27,456,000

This leaves a net gain at time 1 of $1,070,827 $1,061,250 = $9,577, which is worth $9,577/1.06125 = $9,024 in present value. 4.12 F1MXN/$/S0MXN/$=(MXN11/$)/(MXN10/$)=1.1<1.1132=(1.18)/(1.06)=(1+iMXN)/(1+i$). The ratio of interest rates is too high and must fall, so borrow at the relatively low dollar rate and invest at the relatively high peso rate. Similarly, the forward premium is too low and must rise, so buy dollars (and sell pesos) at the relatively low forward rate for the dollar and sell dollars (and buy pesos) at the relatively high dollar spot rate. - Borrow $1 million so that $1,060,000 is due in six months. - Sell $1 million and buy MXN10,000,000 at the relatively high spot price. - Invest MXN10,000,000 at 18% to yield MXN11,800,000 in six months. - Cover by selling MXN11,800,000 at the MXN11/$ forward rate to yield $1,072,727. This leaves a profit of $1,072,727$1,060,000 = $12,727 at time t=1 in six months. 4.13 The Singapore dollar is at a forward premium; F1$/S$/S0$/S$ = ($0.51/S$)/($0.50/S$) = 1.02, or 2% per year. This is less than is warranted by the difference in interest rates (1+i$)/(1+iS$) = (1.06)/(1.04) = 1.019231, so F1$/S$/S0$/S$ > (1+i$)/(1+iS$). The forward/spot ratio is too high and must fall, so sell S$ (and buy dollars) at the relatively high S$ forward rate and buy S$ (and sell dollars) at the relatively low S$ spot rate. Conversely, the ratio of interest rates is too low and must rise, so borrow at the relatively low dollar interest rate and invest at the relatively high S$ rate. (Even though S$ interest rates are lower than dollar interest rates in nominal terms, S$ interest rates are high and dollar interest rates are low relative to the forward/spot ratio.) Suppose you borrow ($1,000,000)/(1+i$) = $1,060,000 at i$ = 6.0%.
+$1,000,000 -$1,060,000

Convert to S$2,000,000 = ($1,000,000)/($0.50/S$) at S0$/S$ = $0.50/S$.

+S$2,000,000 -$1,000,000

Invest S$2,000,000 at the Singapore interest rate of iS$ = 4.0%.

+S$2,080,000 -S$2,000,000

Cover this S$ forward obligation by selling S$ in the forward market.

10

Kirt C. Butler, Solutions for Multinational Finance, 4th edition

+$1,060,800 -S$2,080,000

The result is a dollar profit of $1,060,800$1,060,000 = $800. These transactions are worth undertaking only if the costs of executing the four transactions is less than $800. 4.14 a. E[P1F] = P0F(1+pF) = 1.21 E[P1D] = P0D(1+pD) = 110 E[S1D/F] = (S0D/F)(1+pD)/(1+pF) = (D100/F)(1.10/1.21) D90.91/F. b. Because nominal exchange rates should adjust to reflect changes in relative purchasing power, the expected real exchange rate is 100% of the beginning rate: E[X1D/F] = (E[S1D/F]/S0D/F)((1+pF)/(1+pD)) = ((D90.91/F)/(D100/F))(1.21/1.10) = 1.00, or 100%. c. E[P2F]) = P0F(1+pF)2 = F1.4641 E[P2D]) = P0D(1+pD)2 = D121 E[P2F]) = P0F(1+pF)2 = F1.4641 E[P2D]) = P0D(1+pD)2 = D121 E[S2D/F] = S0D/F((1+pD)/(1+pF))2 = (D100/F)(1.10/1.21)2 D82.64/F The real exchange rate is not expected to change: E[X2D/F] = (E[S2D/F]/E[S0D/F]) [(1+pF)/(1+pD)]2 = ((D82.64/F)(D100/F)) / (1.21/1.10)2 = 1.00, or 100%. 4.15 a. s/SFr = (S0/SFr)/(S1/SFr) 1 = (155/SFr)/(160/SFr) 1 = 3.125%. b. From relative purchasing power parity, the spot rate should have been: E[S0/SFr] = (S1/SFr) [(1+p)/(1+pSFr)] = (160/SFr) [(1.02)/(1.03)] = 158.45. c. As a difference from the expectation, the real change in the spot rate is: x/SFr = (Actual-Expected)/(Expected) = (S0/SFr E[S0/SFr])/E[S0/SFr]) = (155/SFr158.45/SFr)/158.45/SFr = 2.18%. Alternatively, change in the real exchange rate is equal to: x/SFr = ((S0/SFr)/(S1/SFr)) ((1+pSFr)/(1+p)) 1 = ((155/SFr)/(160/SFr)) ((1.03)/(1.02)) 1 = 2.18%. d. The franc depreciated by 2.18% in purchasing power. e. In real terms, the yen rose by xSFr/ = ((S0SFr/) / (S1SFr/)) ((1+p) / (1+pSFr)) 1 = ((S0/SFr)1 / (S1/SFr)1) ((1+p) / (1+pSFr)) 1 = ((155/SFr)1 / (160/SFr)1 ) ((1.02)/(1.03)) 1 = +2.23% = ((SFr.0064516/)/(SFr.00625000/)) ((1.02)/(1.03)) 1 = +2.23%. Because the SFr fell by 2.18% in real terms, the yen rose by 1/(10.0218) 2.23%. 4.16 a. b. c. d. e. technical analysis technical analysis fundamental analysis fundamental analysis technical analysis

Appendix 4-A Continuous Time Finance 4A.1 Total two-period return is [V2/V0]1 = [(1+i1)(1+i2)]1. Mean geometric return is iavg = [(1+i1)(1+i2)]1/21. Total wealth after two periods is the same as beginning wealth; $100(1+1)(10.5) = $100. Notice that the order of the rates of return does not matter. A loss of 50% followed by a gain of 100% leaves your initial value unchanged. For the pair of returns (100%,50%), the average period return is iavg = [(1+1)(10.5)]1/21 = 0. With continuously compounded returns, periodic rates are given by i1 = ln(1+i1) = ln(2) = +0.69315 and i2 = ln(1+i2) = ln(0.5) = 0.69315. The (arithmetic) average return using continuously compounded rates is (i1+ i2)/2 = (+0.693150.69315)/2 = 0. Either way, your ending value is the same as your beginning value. These methods are equivalent. 11

Kirt C. Butler, Solutions for Multinational Finance, 4th edition 4A.2 Inflation rates are pD = ln(1+pD) = ln(1.10) = 9.531% and pF = ln(1+pF) = ln(1.21) = 19.062% in continuously compounded returns. Expected price levels and spot rates are: E[P1D] = P0D e(0.09531) = (D100)(1.10) = D110 E[P2D] = P0D e(2)(0.09531) = (D100)(1.21) = D121 E[P1F] = P0F e(0.19062) = (F1)(1.21) = F1.21 E[P2F] = P0F e(2)(0.19062) = (F1)(1.4641) = F1.4641 E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F E[S2D/F] = E[P2D] / E[P2F] = D121 / F1.4641 = D82.64/F

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