6. Challenge Problem: The beautiful, mythical country of Coloradial uses the teo as its currency, and the gritty, post-industrial country of Oheo uses the eren. Exactly 1 year ago, you could get 100 teos in exchange for 5 erens in the foreign exchange market. Since then, though, the real interest rate in Coloradial has increased, while staying constant in Oheo.

a. All other things being equal, would you expect the eren to have appreciated or depreciated with respect to the teo? In other words, what would you expect to happen to the exchange rate of teo per eren? Explain your reasoning.

b. Assume that the change in the value of the eren with respect to the teo (appreciation or depreciation, depending on your previous answer) was 50 percent.

What is the current nominal exchange rate expressed in teo per eren?

c. One year ago, you borrowed 100,000 teos from a Coloradial bank at a rate of 3 percent per year.

You then traded the 100,000 teos for erens at the nominal exchange rate that prevailed at the time

(100 teos = 5 erens), and invested those erens in Oheo at 5 percent interest. After the year was over, your intention was to exchange the erens back for teos, repay the loan to the Coloradial bank, and make a tidy profit. (This strategy is called a “carry trade” and is often popular with foreign exchange traders.)

i. How much would you have made on this strategy if the interest rates did not change and if the exchange rate had not changed from 100 teos =

5 erens?

ii. What will be your profit (or loss) on the trade given the changes in the exchange rate you found in parts

(a) and (b)? (Assume the interest rate you paid to the Coloradial bank was fixed in your loan agreement, and so did not change.)