International Finance Problem Set on Parity Conditions

1.The price of a tall vanilla latte at Starbucks in New York is $3.25 while in Rome it is 3. The current spot exchange rate is $1.1050/.Assuming the Law of One Price holds, what should be the USD price in Rome for the latte?Which currency is overvalued and by how much?

2.Assume that the export price of a Toyota Corolla from Osaka, Japan is 1,950,000. The exchange rate is 110/$. The forecast rate of inflation in the United States is 2.0% per year and is 0.0% per year in Japan. Use this data to answer the following questions on exchange rate pass-through.

a. What was the export price for the Corolla at the beginning of the year expressed in U.S. dollars?

b. Assuming purchasing power parity holds, what should the exchange rate be at the end of the year?

c. Assuming 100% pass-through of exchange rate, what will be the dollar price of a Corolla at the end of the year?

d. Assuming 75% pass-through, what will be the dollar price of a Corolla at the end of the year?

3.CIASusan Prescott is a foreign exchange trader for a bank in New York. She has $1 million (or its Swiss franc equivalent) for a short term money market investment and wonders if she should invest in U.S. dollars for three months, or make a covered interest arbitrage (CIA) investment in the Swiss franc. She faces the following quotes:

Assumptions

Value

SFr. Equivalent

Arbitrage funds available

$1,000,000

SFr. 994,000

Spot exchange rate (SFr./$)

.9940

3-month forward rate (SFr./$)

.9910

U.S. dollar 3-month interest rate

2.600% pa

Swiss franc3-month interest rate

1.600% pa

What should Susan do?

4.UIA.Susan Prescott, using the same values and assumptions as in the previous question, now decides to seek the full 2.600% return available in US dollars by not covering her forward dollar receipts -- an uncovered interest arbitrage (UIA) transaction. Assess this decision.

Assumptions

Value

SFr. Equivalent

Arbitrage funds available

$1,000,000

SFr.994,000

Spot exchange rate (SFr./$)

.9940

3-month forward rate (SFr./$)

.9910

Expected spot rate in 90 days (SFr./$)

.9940

U.S. dollar 3-month interest rate

2.600% pa

Swiss franc3-month interest rate

1.600% pa