TOPIC: International Parity Relationships and Forecasting Foreign Investment

Provide substantial information for your reasoning. Include the solutions for calculation.

Problem 1: For the last seven months, $=1.77% and =0.75%. What would be the appropriate expression for the interest rate parity relationship?

Problem 2: Suppose that the current spot exchange rate is 1.50/ and the one-year forward exchange rate is 1.60/. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most 1,000,000 or the equivalent pound amount, i.e., 666,667, at the current spot exchange rate. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.

Problem 3: Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 7 percent per annum in Germany. Currently, the spot exchange rate is 1.01 per dollar and the six-month forward exchange rate is 0.99 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?

Problem 4: Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.

Problem 5: Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity? Problem 6: In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollar and the Turkish lira?