International Finance

1 Suppose that you are a foreign exchange trader for a bank based in New York. You are faced with the following market rates:

Spot exchange rate: $1.1500/

1 year dollar interest rate = 2.50%

1 year pound interest rate = 1.75%

1 year forward exchange rate: = $1.1625/

a) Is there a Covered Interest Arbitrage (CIA) opportunity here? Explain why or why not with calculations. (5 points)

b) Given the data in part (a), spell out the actions you would take to profit from this situation: Which currency would you borrow and which currency would you lend (invest)? What is the forward transaction you would engage in? Note that you do not have to solve the problem or provide any detailed calculations of arbitrage profits. (5 points)

2. Explain the difference between a Balance of Payments (BOP) deficit and surplus. If a country were on a pure floating exchange rate system, would it be possible for the country to have either a BOP deficit or surplus? Explain your answer. (10 points)

3. Explain how the BOP can affect exchange rates both under a fixed exchange rate system and under a flexible exchange rate system. (10 points)

4. For over 30 years, the Hong Kong has pegged its currency, the Hong Kong dollar, to the US dollar. At the same time, Hong Kong places hardly any restrictions on capital flows into or out of Hong Kong. From time to time, the question comes up whether Hong Kong should continue to peg its currency to the US dollar or switch to something else such as peg its currency to a basket of currencies rather than just the dollar, or peg its currency to the Chinese renminbi, or perhaps just switch to a floating exchange rate system. Discuss the pros and cons of continuing with the current policy of a peg to the US dollar. Your answer must include implications of the theory of the impossible trinity. (10 points)

5. Briefly explain any two important differences between a call option and a put option. (10 points)