Question

1. Assume that annual interest rates in the U.S. are 3 percent, while interest rates in Japan are 6 percent. Assume that the current spot rate is ¥100/$.

Suppose the U.S. risk-free interest rate has been steadily rising from 2% 3 years ago to 5% currently. The Euro interest rate has remained constant over the same time period at 6%, what should be happening to the Euro’s forward premium/discount?

What is the impact of an appreciation of the USD on

    U.S. exports

    U.S. imports

    The dollar value of U.S. investments in the foreign country (and denominated in the foreign currency)

    The foreign currency value of foreign investments in the U.S. (and denominated in dollars)

Answer all of the above with a simple ↑ or ↓

2. Suppose there is a large increase in the income level in Mexico and a much smaller increase in the U.S. income level. Everything else equal, what is likely to happen to value of the MXN?

3. The INR appreciates 4% versus the USD. The EUR depreciates 10% versus the USD. What’s the approximate appreciation or depreciation we might see in the EUR/INR exchange rate?

4. Based on interest rate parity, the larger the degree by which the U.S. interest rate exceeds the foreign interest rate, then?

5. If the spot rate is C$1.12/$ and the forward rate is C$1.02/$, which currency exhibits a forward discount?

6. Bank believes the New Zealand dollar will appreciate over the next 6 months from $.41/NZ$ to $.43/NZ$. The following 6-month interest rates apply: (the rates are periodic rates so you do not need to adjust them at all – we do not need to multiply by 180/360 or anything like that)

       Currency                    Lending Rate               Borrowing Rate

       Dollars    3.5% 4.25%

       New Zealand dollar (NZ$)    2.6% 3.05%

Bank has the capacity to borrow either NZ$10 million or $5 million. If Bank’s forecast if correct, what will its U.S. dollar profit be from speculation over the 6-month period?

7. Interest rates are 6.5% in the U.S. and 4% in Canada. Jacque carry trader borrows C$10,000,000 to execute a carry trade. At the start, the exchange rate is C$1.1325/$. After one year, the exchange rate is C$1.1175/$.

8. If the C$ had not appreciated or depreciated over the year (stayed at C$1.1325/$) verify that Jacque would have made C$250,000. What’s special about C$250,000? You’ll see if you take the interest rate differential and multiply that percentage profit by the amount of Canadian dollars Jacque borrowed.

9. A U.S. firm with net cash inflows denominated in euros could partially offset this exposure by issuing bonds denominated in euros. T/F

10. Assume that the U.S. and Japan nominal interest rates are equal. Then, the U.S. nominal interest rate decreases while the Japan nominal interest rate stable. According to the international Fisher effect, this implies expectations of ____ than before, and that the Japan yen should ____ over time against the dollar.

Answer 1

1.

Generally, with all other factors remaining constant, higher interest rates in a country increasee the value of that country's currency against the currencies of countries where interest rates have remained the same or have been lowered.  

Keeping in mind the interest parity concept, since the Euro linked interest rate continues to be higher, the Euro will trade at a forward premium against the $. However, when the USD linked interest rate goes from 2% to 5%, the Euro premium will decline or shrink.  

Example:

1Euro = 1.2$

at 2%

Forward Rate =1.2*(1+0.06)/(1+0.02) = 1.247$

at 5%

Forward Rate =1.2*(1+0.06)/(1+0.05) = 1.211$

Due to an appreciation of the USD:

- USD is costlier in relative terms to other currencies, hence, exports will reduce

- 1USD can buy more of 1 unit of another currency due to appreciation, i.e. buying power has increased. Hence, 1 USD can buy more. Hence, imports will increase.  

- The dollar value of U.S. investments in the foreign country which are denominated in the foreign currency will show a higher valuation. Since 1 $ can buy more of 1 unit of the other currency, the entire investment value in the foreign denomination will increase accordingly.  

- The foreign currency value of foreign investments in the U.S. and denominated in dollars will lose value. Since the $ appreciates, the value of the other currency decreases relatively. Although the USD investment amount remains the same, when converted at the appreciated USD rate, the amount in the other currency is lower.  

2.

If there is a large increase in the income level in Mexico and a much smaller increase in the U.S. income level, assuing no other external measures are taken, the mexican currency, MXN will appreciate against the USD. This implies that 1 USD will but less MXN than before the income level rise.  

3.

The INR appreciates 4% versus the USD. The EUR depreciates 10% versus the USD. What’s the approximate appreciation or depreciation we might see in the EUR/INR exchange rate?

Let us say 1$ = INR 60

After appreciation of 4%, 1$ = INR (60 - 60x0.04) = INR 57.60

At the same time, 1 Euro = 1.2 $

If the Euro depreciates 10%, 1.1 Euro = 1.2$ or 1Euro = 1.091$

Today, 1Euro = 1.2 x 60 = INR72

Later, 1 Euro = 1.091 x 57.60 = INR62.836

Hence, we see there is a depreciation of about 12.7% in the Euro against the INR.

4.

Based on interest rate parity, the larger the degree by which the U.S. interest rate exceeds the foreign interest rate:

- The higher the premium on the USD future rate will be against the other currency

- This implies the USD will appreciate against the other currency at a higher rate

Example:

1 $ = INR 60

Interest (USD) = 8%; Interest(INR) = 5%

Forward = Spot x (1+Interest of Domestic Currency) / (1+Interest of Domestic Currency) = 60 x (1+0.08) / (1+0.05) = 61.714

If Interest (USD) = 8%; Interest(INR) = 5%

Forward = 60 x (1+0.10) / (1+0.05) = 62.857

5.

If the spot rate is C$1.12/$ and the forward rate is C$1.02/$, the $ exhibits a forward discount. This is because in the forward rate 1$ only gets you 1.02C$ while today 1S can get you C$1.12.