Question

Citibank gives you the following information:

Spot exchange rate (AUD/EUR) = 1.42

One-month forward exchange rate (AUD/EUR) = 1.45

One-month domestic interest rate (in Australia) = 6.5% p.a.

One-month foreign interest rate (in Germany) = 4.5% p.a.

(a) Is there any violation of the CIP? Why or why not?

(b) Is the AUD selling at a premium or discount against the EUR? By how much?

(c) Suggest a value for the forward rate which is consistent with CIP.

(d) Based on the given information, due to expect the EUR to appreciate or depreciate against the AUD over the next month? Why?

2. ANZ bank is quoting the following exchange rates against the New Zealand dollar (NZD) for the Danish Krone (DKK) and the South African Rand (ZAR):

DKK/NZD = 4.23 - 42

ZAR/NZD = 9.60 - 95

A South African firm asks the ANZ bank for a ZAR/DKK quote. What rates (bid and ask) would the bank quote? Explain how you arrive at your answer.

3. Suppose that the Reserve Bank of India suddenly increases the domestic money supply. This policy change is expected to be permanent by the market. Assume the Indian rupee (INR) to be the home currency and the USD to be the foreign currency.

(a) Explain with the help of the money market and FOREX market diagrams, what happens to the interest rate and exchange rate in the short-run? In your graphs, clearly label the axes, curves and equilibrium points.

(b) Explain what happens to the interest rate and exchange rate in the long-run. In your graphs, clearly label the axes, curves and equilibrium points.

(c) Explain how the economy transitions from the short-run equilibrium to the long-run equilibrium.

4. As of November 1, 2017, the nominal exchange rate between the Brazilian real and the U.S. dollar is BRL1.95/USD. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, respectively. Assume UIP and relative PPP holds.

(a) What would you forecast the nominal exchange rate to be at around November 1, 2018?

(b) If the U.S. interest rate on bonds with one-year to maturity is 4%, what would you expect the interest rate for a Brazilian bond with one-year to maturity to be?

Answer 1

You have asked multiple unrelated questions in the same post. Further, the questions have multiple sub parts. Hence, I will address all the sub parts of the first question. Please post the balance questions one by one separately.

Citibank gives you the following information:

Spot exchange rate (AUD/EUR) = 1.42

One-month forward exchange rate (AUD/EUR) = 1.45

One-month domestic interest rate (in Australia) = 6.5% p.a.

One-month foreign interest rate (in Germany) = 4.5% p.a.

(a) Is there any violation of the CIP? Why or why not?

Forward premium = (F - S) / S = (1.45 - 1.42) / 1.42 = 2.11%

Interest rate differential = i_Aus - i_Ger = 8.5% - 6.5% = 2%

Since forward premium is not same as interest rate differential, but both bear the same sign, hence there is indeed a violation of CIP and the violation is quantitative in nature.

Actual 1 month forward rate (AUD / EUR) = 1.45

Hence, there is a violation of the CIP. And the violation is quantitative in nature.

(b) Is the AUD selling at a premium or discount against the EUR? By how much?

Spot (AUD/EUR) = 1.42 Hence, Spot (EUR / AUD) = 1/1.42 = 0.7042

Forward (AUD / EUR) = 1.45. Hence, forward (EUR / AUD) = 1/1.45 = 0.6897

Since forward is lower than spot, AUD is selling at a discount and the discount is equal to = (0.7042 - 0.6897) / 0.7042 = 2.07%

(c) Suggest a value for the forward rate which is consistent with CIP.

The forward rate consistent with CIP = CIP consistent forward rate (AUD / EUR) = S x (1 + i_Aus x t) / (1 + i_Ger x t) = 1.42 x (1 + 6.5% x 1/12) / (1 + 4.5% x 1/12) =  1.4224

(d) Based on the given information, due to expect the EUR to appreciate or depreciate against the AUD over the next month? Why?

Forward (AUD / EUR) > Spot (AUD / EUR)

Hence, this implies EUR becomes expensive and hence we expect EUR to appreciate against the AUD over the next month.