Short-Answer and Algebraic Questions: (The numbers in square brackets give the breakdown of the points for various parts of each question. To receive full credit, please explain your answers.)

1. A British money financier is managing 10 million and wants to invest it in safe bonds either in France or United Kingdom for one year. The one-year interest rate on such assets is 0.55% in Britain and 0.1% in France. The one-year forward euro-pound exchange rate is 1.135 / (euros per pound). Assume that the covered interest parity condition (CIP) always holds and to ensure consistency, treat the UK as home country. [18 points total for Question 9]

(a)What is the current euro-pound spot exchange rate? Explain and show your work.[6]

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(b)Suppose the financier believes that the uncovered interest parity (IP) condition also holds and the foreign exchange market participants are acting based on correct expectations about future spot euro-pound exchange rate in the sense that their expectations predict the future rate without bias. Given these assumptions, what is the one-year expected spot euro-pound exchange rate prevailing in the market? Explain and show your work. [6]

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(a)Now suppose that the financier believes that while the uncovered interest parity (IP) condition also holds, the foreign exchange market participants have incorrect expectations about future spot euro-pound exchange rate. She believes that she has a better understanding of the economy and expects the future spot rate to be 1.1 /, on average. Assume that she is risk neutral in the foreign exchange market. Where should she invest the 10 million? Explain and show your work. [6]

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2. In the coming year, as the COVID-19 pandemic eases and the Federal government increases its expenditure, the economic recovery in the US is likely to speed up and inflation may start to take off. Assume that this prospect gives rise to expectations in currency markets that a year from now (early 2022) the Fed will raise the US interest rate and keep it at an elevated level for some years. The following set of questions is about impact of this prospect on the exchange rate and interest rate policies of emerging markets. In answering these questions, assume that the interest parity condition always holds and that the interest rates observed in emerging markets include risk premia. That is, treating the emerging economy as home country and the US as the foreign country, if the nominal domestic and foreign interest rates inclusive of risk premia are i_r and i_r^*, risk free interest rates can be expressed as:

i = i_r- and i^* = i_r^* - ^*,

where and ^* are the risk premia on domestic and foreign bonds, respectively. Since the risk premium for the US assets is practically negligible, assume that ^* = 0 and, therefore, i^* = i_r^*. Then, the IP condition can be written as (1 + i_r - )e^e = (1+ i^*)e. Assume that this condition always holds. [26 points total for Question 10]

(a)Consider an emerging market economy, E, where policymakers need to assess the consequences of a rise in US interest rates next year. For now, suppose that the risk premium and interest rate policies in country E are given (i.e., can be treated as constant as the US interest rate changes). How would the expected rise in the US interest rate affect e^e (which is the expected exchange rate of country E's currency vis--vis the US dollar next year, 2022)? Why? How would this prospect affect the spot exchange rate of country E's currency, e, now? Why? Please remember to explain your answers using concepts covered in this module of the course. [8 points]

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(b)Let's now consider a situation where because of the COVID-19 pandemic the businesses in country E have borrowed heavily in both dollars and domestic currency, while their revenues are stagnant and entirely in local currency. In this situation, a depreciation of the domestic currency or an increase in the domestic interest rate next year could make it difficult for the indebted businesses to pay back their loans and many of them may go bankrupt. Suppose the prospect of such a debt crisis raises the risk premium in E this year. Assume as in part (a), that the central bank plans to keep the domestic interest rate constant this year and beyond. How would this prospect affect the spot exchange rate of country E's currency? Why? Please remember to explain your answers using concepts covered in this module of the course. [6 points]

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(c)Now consider the situation in part (b), but assume the central bank of country E wants to prevent any change in the spot exchange rate of its currency vis--vis the US dollar this year. It plans to return to its past policies next year and let the currency move in whichever way determine by the market at that time. In this situation, what action should Country E's central bank take in regard to the interest rate, i_r, this year? Please remember to explain your answers using concepts covered in this module of the course. [6 points]

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(d)Given the situation described in part (c), could the prospect of interest rate increase in the US and the response of emerging economy's central bank cause a debt crisis in country E this year? Please remember to explain your answers using concepts covered in this module of the course. [6 points]

Answer:

For question 3. the article, "How America's blockbuster stimulus affects the dollar,"

Here is thetale of the dollar so far in 2021. It came into the year on a declining trend. A lot of people were mildly chary of its prospects. The gist was that people had bought a lot of dollars last year. They might wish to sell some. There has since been a dramatic upward revision to forecasts forgdpgrowth in America. This has been mirrored in sharply rising Treasury yields. Growth upgrades; higher interest rates; both are good for currencies. The result has been a stronger dollar.

It is not sufficient for a strong dollar that America does well; others must also be doing badly. "If theuseconomy grows incredibly fast and nowhere else does, the dollar will go up," is how Kit Juckes of Socit Gnrale, a bank, puts it. The question is: can it keep going up and for how long? The dollar usually provokes strong feelings in the currency fraternity. It is either loved or hated. That is not the case now, which is remarkable. There may be a strong-dollar story. But there is no really strong story about the dollar.

To understand why, consider first the important drivers of currency moves: trade flows, relative interest rates and risk appetite. Trade flows track the underlying demand for a currency. If domestic interest rates rise relative to foreign ones, that attracts speculative capital inwards, supporting a currency. Shifts in risk appetite can overwhelm these fundamentals. Indeed that was the story in 2020. Last March, when suddenly the priority was to have cash, the cash that people wanted was dollars. Thedxyindex, a weighted average of the dollar's exchange rate against six other widely traded currencies, rose sharply in mid-March, as covid-19 panicked markets. The Federal Reserve responded by opening swap lines with other central banks to ease the dollar shortage. Then, over the rest of the year, the dollar declined, as risk appetite revived.

The greenback's bounce-back this year is more about interest-rate differentials. Here the story gets a little frayed. The interest rates that you would normally think of as mattering for speculative currency flows are short-term rates. But central banks are not for moving those soon. So bond yields have become a signifier, since they in part reflect the as-yet-distant tremors of moves in future short-term rates. Bond yields in turn are responding to growth expectations. The dollar responds by moving higher.

After all, what currency would you swap it forthe euro? America's economy is roaring back, while much of euro-land remains closed, and the distribution of vaccines has been (how to put it charitably?) sluggish. You can make a case that the Federal Reserve will have to tighten monetary policy sooner than it thinks. But the European Central Bank looks set to keep interest rates near zero indefinitely. The same goes for the Bank of Japan. Britain's vaccination programme has been a success, which helps explain the rising pound. But Britain remains locked down and its economy is still suffering. Rising crude prices have pushed up the currencies of big oil producers, such as Canada and Norway. But beyond these, there are few currencies you might prefer over the greenback.

The dollar seems likely to rise a bit further in the near term. "There are a lot of stale short-dollar positions," says George Papamarkakis of North Asset Management, a hedge fund. Speculators who have a bearish view of the dollar have already sold it short. If the currency keeps rising, they may be forced to buy it back. Another factor in the dollar's favour is that risk appetite is less ravenous than it was. Equity markets are choppy. The dollar might be the least-worst place to sit out the volatility. And if the financial markets suffer a full-scale tantrum, the greenback could benefit from a flight to safety.

Later in the year, though, there is a case for a mildly weaker dollar. A big part of that story is that a booming American economy will lead to a wider trade deficit: strong demand in America will spur activity elsewhere. Asia is already doing well. Europe is lagging but will enjoy an upswing once vaccination rates pick up. Risk-taking would then revive. "When theusis doing well, and also bringing the world with it, there are more interesting places for investors to put their money," says Mr Juckes.

As the days grow longer, 2021 might start to look less like early 2018, when a faster pace of interest-rate increases in America drove up the dollar, and more like 2017, a year of broad global growth and a falling dollar. The story of the greenback in 2021 could yet have a twist.

This article appeared in the Finance & economics section of the print edition under the headline "Winter's tale"

3. This question is based on the article, "How America's blockbuster stimulus affects the dollar," published by The Economist on March 13, 2021. The article discusses the drivers of the past and potential future trends in the value of the dollar in terms of other currencies. Note that the article mentions changes in "risk appetite" as a driver of exchange rates. By "risk appetite" the article means willingness to hold riskier currencies as opposed to the U.S. dollar, which is considered the safest currency. So, when risk appetite declines, people prefer to hold more dollars and demand higher premia for holding risky currencies. [26 points total for Question 11]

(a)According to the article, how did risk appetite change in March 2020 and how did it affect the dollar's value in terms of other currencies? [6]

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(b)According to the article, how did the actions of the Fed help with the situation described in (a)? How did the risk appetite change in the rest of 2020 and how did it affect the dollar's value in terms of other currencies? [6]

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(c)The article claims that "the greenback's bounce-back this year is more about interest-rate differentials." Based on the evidence and arguments presented in the article, does the appreciation of the dollar between mid-December 2020 and mid-March 2021 seem to be due to changes in short-term interest rate differentials that already took place or expected changes to interest rate differentials in the future? [6]

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(d)At the time of its publication in mid-March, the article predicted that the dollar seemed "likely to rise a bit further in the near term." That prediction has not proven quite correct (see https://fred.stlouisfed.org/series/DTWEXBGS, which shows that the dollar has weakened between mid-March and mid-May 2021). However, it points out that "later in the year, though, there is a case for a mildly weaker dollar, which better matches the recent trend in the value of the dollar vis--vis other currencies. What is the article's reasoning for this prediction? [8]

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