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2/13/2016 HW3 Assignment FIN465 - Chapters 6,7,8 Instructor: Dr. Blaise Roncagli You may use your book and notes when working on these problems, and you may work in groups with others, but the final product that you submit for grading must be your own work. Follow the instructions provided in this handout very carefully. Failure to follow instructions may result in loss of points. Chapter 6 Problems 6-1 Assume there is concern that the United States may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might U.S. exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms? To prevent a recession, the Federal Reserve would often implement a loose monetary policy. Through its open market operations, the Federal Reserve would buy treasury bonds, increase the money supply into the economy and cause interest rates to decline. Low interest rates are attractive to borrowers and investors and when the money supply is expended, economic growth is achieved. 6-2 Describe the difference between a sterilized intervention and a non-sterilized intervention by a central bank in the foreign currency markets? What is the central bank trying to accomplish by a sterilized intervention? Please be clear in your explanation. Chapter 7 Problems 7-1 Ferd Rumpledink, a foreign exchange trader at UBS Bank, is exploring covered interest arbit1age opportunities. He has 10,000,000 USD (or the CHF equivalent at the current spot rate) to invest and is considering a 180 day investment. Assume he already has the funds and does not need to borrow them. He has observed the following exchange rate and interest rate quotes (exchange rates are in currency pairs notation): Spot rate (CHF/USD) 180-day forward rate (CHF/USD) (not annualized) 180-day U.S. dollar interest rate (annualized) 180-day Swiss Franc interest rate (annualized) Page 1 of 4 1.1861 1.1812 5.200% 6.100% 2/13/2016 Can Ferd make an arbitrage profit on this situation? If so, should he invest USD or CHF? Show your work on a block diagram like the ones we used in class for covered interest arbitrage. (Remember that interest rates are quoted as annual, but your investment period is 180 days.) 7-2 Ferd Rumpledink at UBS now observes the data below for the USD and the CHF. He still has 10,000,000 USD or the CHF equivalent (at the current spot rate) to invest for 180 days. Can Ferd make an arbitrage profit on this situation? How much and in which currency? Should he invest CHF or USD? Show your work on a block diagram like the ones we used in class for covered interest arbitrage. Spot rate (CHF/USD) 180-day forward rate (CHF/USD) (not annualized) 180-day U.S. dollar interest rate (annualized) 180-day Swiss Franc interest rate (annualized) 1.1861 1.1760 4.900% 5.100% 7-3 Does Interest Rate Parity exist between the two countries for each of the scenarios below? Show your calculations and indicate \"Yes\" or \"No\" in your answer. (a) US annual interest rate 3.50%, UK annual interest rate 2.80%, Spot rate $2.1000, 365 day quoted Forward rate $2.1143. (b) US 6-month interest rate 1.55%, Japan 6-month interest rate 0.52%, Spot rate $0.0098, 6month quoted Forward rate $0.0100. (c) US 90-day interest rate 0.75%, Germany 90-day interest rate 1.05%, Spot rate $1.3305, 90 day quoted Forward rate $1.2777. 7-4 You are given the following information: Spot rate of Canadian dollar 90-day forward rate of Canadian dollar 90-day Canadian interest rate 90-day U.S. interest rate $.80 $.79 4.5% 3.0% Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage? Page 2 of 4 2/13/2016 Chapter 8 Problems 8-1 Money and foreign exchange markets in London and New York are very efficient. The following information is available: Assumptions Spot exchange rate ($/) One-year Treasury bill rate Expected inflation rate London $1.3860 3.800% ? New York $1.3860 4.200% 2.000% a. What do the financial markets suggest for inflation in the UK next year? (Hint: use the equation for the exact Fisher Effect.) b. Estimate today's one-year forward exchange rate between the dollar and the pound, knowing the current spot rate and the current interest rate quotes for the US and the UK. SOLUTION: Assumptions Spot exchange rate ($/) One-year Treasury bill rate Expected inflation rate London $1.3770 3.750% ? New York $1.3770 4.100% 1.800% a. What do the financial markets suggest for inflation in the UK next year? According to the Fisher effect, real interest rates should be the same in both the UK and the U.S. Since the nominal rate = [ (1+real) x (1+expected inflation) ] - 1: 1 + real rate = (1 + nominal) / (1 + expected inflation) 1 + nominal rate 1 + expected inflation So 1 + real = and therefore the real rate in the US is: The expected rate of inflation in the UK is then: 103.750% ? % 104.100% 101.800% % % % b. Estimate today's one-year forward exchange rate between the dollar and the pound, assuming IRP. Spot exchange rate ($/) US dollar one-year Treasury bill rate UK pound one-year Treasury bill rate One year forward rate ($/) 1.3770 4.100% 3.750% Page 3 of 4 2/13/2016 8-2 Answer all parts of this question. (a) Assume that the spot exchange rate of the British pound is $1.6500. How will this spot rate adjust over the next year according to PPP if the United Kingdom experiences an inflation rate of 7.2 percent while the United States experiences an inflation rate of 4.7 percent? (b) Assume that the spot exchange rate of the Australian dollar is $.9011. The one-year interest rate is 6.15 percent in the United States and 4.25 percent in Australia. What will the spot rate be in one year according to the IFE? What is the force that causes the spot rate to change according to the IFE? (c) The one-year risk-free interest rate in Canada is 8.5%. The one-year risk-free rate in the U.S. is 4.9%. Assume that interest rate parity exists. The spot rate of the Canadian dollar is $0.9222. What is the forward rate premium (discount)? What is the one-year forward rate of the Canadian dollar? 8-3 The one-year risk-free interest rate in Mexico is 11%. The one-year risk-free rate in the U.S. is 4%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. a. What is the forward rate premium? b. What is the one-year forward rate of the peso? c. Based on the international Fisher effect, what is the expected change in the spot rate over the next year? d. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year? e. Compare your answers to (b) and (d) and explain the relationship. Final Deliverable - a single file in Microsoft Word format containing your answers to the questions above. You should paste charts or excel spreadsheets into your Word file to support your answers if appropriate. The format for the file name should be \"yourlastname FIN465 HW3.doc\" . Page 4 of 4