Question

1.) Suppose that the US trades goods and services with South Korea. In particular, Jeep produces and sells a Wrangler in South Korea for 30,000 US dollars (USD), and Samsung produces and sells a Galaxy S9 in the US for 960,000 South Korean won (KRW).

(a) Suppose that the exchange rate as is 1,000 won per US dollar.

1.)Obtain the price of a Jeep Wrangler in South Korea in terms of the South Korean won.

2.)Obtain the price of a Samsung Galaxy S9 in the US in terms of the US dollar.

(b) Suppose now that the exchange rate rises to 1,200 won per US dollar.

1.)Obtain the price of a Jeep Wrangler in South Korea in terms of the South Korean won.

2.)Obtain the price of a Samsung Galaxy S9 in the US in terms of the US dollar.

3.)Examine how the increase in the exchange rate affects the price competitive- ness of Jeep in South Korea and of Samsung in the US.

2.)Suppose that you are an investor who is considering investing $10,000 a one-year U.S. government bond that has a 5% interest rate or a one-year Japanese government bond with a 1% interest rate. The exchange rate today is 110 yen per dollar, and you expect the exchange rate to be 105 yen per dollar one year from now.

(a) Which bond would you purchase? Explain detailedly why.

(b) Suppose now that the exchange rate today is 107 yen instead of 110 yen, and you still expect the exchange rate to be 105 yen one year from now. Would you change your decision about which bond to buy? Explain detailedly why.

Answer 1

Ans)

1.a)

1- 30,000 USD *1000 KRW/USD = 30,000,000 KRW

2-960,000 KRW * 1/1000 USD/KRW = 960 USD

1. b)

1- 30,000 USD * 1200 KRW/USD = 36,000,000 KRW

2- 960,000 KRW * 1/1200 USD/KRW = 800 USD.

3 - As exchange rate rises in Korea, or Korean Won appreciates wrt USD, the price of Jeep Wrangler increases in Korea in terms of Korean Won , thereby allowing other Korean based companies to take advantage and sell their comparitively cheaper cars in Korea at a better price.

Similarly, as KRW appreciates wrt USD, USD depreciates wrt KRW. So, the Galaxy S9 becomes cheap in the US market as dollar now is weaker than previously due to exchange rate depreciation of USD wrt KRW. So, other mobile companies would face competitions in US owing to fact that S9 has become relatively more cheaper.

2)Investing in US-

after 1 year, value = $10,000(1+r) = $10,000(1.05) = $10500.

Investing in Japan-

converting dollars to yen at rate of current exchange rate

$10000 = $10000*110 = 1100000 yen

after 1 year, value = 1100000*(1.01) = 1111000 yen = 1111000*(1/105)=$10580.95238 {converted yen to $ at rate of future exchange rate after 1 year}

As it is well evident from the calculations that the difference in exchange rate has created an arbitrage opportunity that can be gained if one invests in one year Japanese government bond and gain a better payoff after 1 year of amount ($10580.9524 - $10500) $80.9524.

b)

If exchange rate today is 107 instead of 110,

the calculations for investing in US remains the same.

Investing in Japan bond,

converting to yen at new exchange rate,

$10,000*107 = 1070000 yen

after 1 year, value = 1070000*(1+0.01) = 1080700 yen

converting back to dollars at exchange rate after 1 year,

1080700 / 105 = 10292.38095 dollars.

So, since now the payoff from investing in Japanese bond has decreased, my decision now changes and I will now invest in US bond as it gives me a better payoff , $10500 , than investing in Japanese bond, $10292.38.