You observe the following spot exchange rates, one-year forward exchange rates, and one-year interest rates.

Spot One Year One Year

Exchange Rate Forward Rate Interest Rate

UK Pound 1.45 USD per GBP 1.51 USD per GBP 1.5%

Mexican peso 17.5 MXN per USD 20.0 MXN per USD 9%

United States 2%

a. Calculate the forward premium for the GBP and the MXN versus the USD, and state whether each is trading at a forward premium or discount. (Note. For consistency, translate the MXN into a direct quote before calculating the forward premium.)

b. Please describe two arbitrage transactions, one for the MXN and one for the GBP, that would provide riskless profits. If no such transaction exists, please say so.

c. Please calculate the one-year forward rates for the GBP and MXN that are consistent with covered interest parity.

d. You observe the following spot exchange rates, 6-month forward exchange rates, and 6-month interest rates.

Spot 6 Month 6 Month

Exchange Rate Forward Rate Interest Rate

UK Pound 1.45 USD per GBP 1.50 USD per GBP 1.5%

United States 2%

Please calculate the 6-month forward rate that is consistent with covered interest parity. (Please use a 30/360 day count convention.)

9. You are a consultant to the country of Atlantis, which is running a sizeable current account surplus of 12% of GDP. The historical average was a small surplus, in the range of 2-4% of GDP.

Due to its large surplus, Atlantis is coming under pressure from its trading partners. The Minister of Finance asks you whether the exchange rate is overvalued or undervalued, and roughly by what percentage. He asks you to remember that, compared to the United States, exports and imports are far more responsive to exchange rate movements.

Please provide an answer to the Minister, and carefully explain your reasoning.