Suppose the following information is available for the United States and Europe:

	US	Europa
nominal interest rate	4%	6%
expected inflation	2%	5%
spot rate	$1.13
1 year forward rate	$1.10

Is the interest rate parity (IRP) maintained? Show clearly with relevant calculations. [5 MARKS]

Based on purchasing power parity (PPP), what is the expected spot rate of the euro in one year? [5 MARKS]

According to the International Fisher Effect (IFE), what is the expected spot rate of the euro in one year? [5 MARKS]

Reconcile your answers to parts (A) and (C). [5 MARKS]

[TOTAL: 20 BRANDS]

QUESTION TWO

Amco is an American company that does significant import and export business in Japan, so all transactions are billed in dollars. Obtained debt in the United States at an interest rate of 10 percent per year. The long-term risk-free rate in the United States is 8 percent. The return of the stock market in the United States is expected to be 14 percent per year. Amco's beta version is 1.2. Its target capital structure is 30 percent debt and 70 percent equity. Amco is subject to a 25 percent corporate tax rate.

Estimate the cost of capital for Amco. [12 MARKS]

Amco has no subsidiaries in foreign countries, but plans to replace some of its dollar-denominated debt with Japanese yen-denominated debt, as Japanese interest rates are low. You will get yen-denominated debt at an interest rate of 5 percent. It cannot effectively hedge the foreign exchange risk resulting from this debt due to peg conditions that cause the price of derivative contracts to reflect the interest rate differential. How could Amco reduce its exposure to foreign exchange risk from yen-denominated debt without moving its operations? [8 MARKS]

[TOTAL: 20 BRANDS]

QUESTION THREE

The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United States is 2 percent. Suppose there is interest rate parity. The spot exchange rate for the Mexican peso is $.14.

What is the forward rate premium? [4 MARKS]

What is the peso's one-year forward exchange rate? [4 MARKS]

Based on the international Fisher effect, what is the expected change in the spot rate over the next year? [4 MARKS]

If the spot rate changes as expected according to the IFE, what will the spot rate be in one year? [4 MARKS]

Compare your answers to (b) and (d) and explain the relationship.