Question

Consider the prices of a U.S. dollar in the following currencies in a foreign-exchange

market: Australian dollar (A$) = 1.35 and Swiss franc (CHF) = 0.90.

i) What characteristics does a foreign-exchange market possess? Name any two.

ii) What is the price of a Swiss franc in Australian dollars?

iii) Consider an Australian investor who is deciding between investing domestically (i.e.

within Australia) or in Switzerland. The investor is only interested in the return his

investment will yield in 12-months. If the domestic interest rate (iA$) is 0.08 and the

interest rate in Switzerland (iCHF ) is 0.12, what is the value of a 12-month forward

rate that will make the covered interest parity condition hold?

iv) Now suppose that the spot rate is as you calculated in part (ii) and the 12-month

forward rate is as you calculated in part (iii). However, the interest rates in the two

countries are now as follows: iA$ = 0.21 and iCHF = 0.30. In which country must

the investor invest her money?

v) Australia maintains a flexible exchange rate policy. Suppose that the supply of Swiss

franc on the foreign exchange market in Australia goes down. What impact does this

change have on each of the following, holding everything else constant?

a) The price of a Swiss franc in Australian dollars.

b) The ability of Australian residents to invest in Switzerland.

c) The international reserves of the Australian central bank.

Answer 1

1. Characteristics of foreign exchange market are:

a. Most dynamic market: This market is one of the most active markets in the world with currencies fluctuating in value every seconds and twenty four hours a day. Due to this high volume it is the most liquid market in the world.

b. International network of dealers: There are a lot of  market participants trading, carrying out exchange activities across globe. These players provide adequate liquidity and volume in market and helps in making transactions.

2. Price of CHF/AUD => 0.9/1.35 => 0.66 CHF per AUD.

3. Forward price = Spot price * (1+interest rate foreign currency) / (1+ interest rate domestic currency)

=> 0.66 *(1.12)/(1.08) => 0.6914 CHF per AUD.

4. If exchange rate turns out to be 21% for AUD and 30% CHF, then exchange rate will be:

=> 0.66 *(1.3)/(1.21) => 0.7163 CHF per AUD.

Therefore it can be seen actually AUD appreciated more than earlier estimated in part 3. Therefore investor must invest money in Australia to get high returns.

5.

Effect of drop in supply of CHF:

a. As there is shortage of CHF in Austarlian market, this will lead to increase in prices of CHF and therefore CHF will appreciate with respect to to AUD in Australian market. Therefore price of CHF will increase.

b. Because of reduced supply of CHF in Australian market, Australian residents will be able to invest less in Switzerland because they need to pay more in order to buy CHF (which are short in market), therefore their demand will decrease due to high price of CHF relative to AUD.

c. As there is shortage of CHF in Australian market, central bank of Australia will intervene in foreign exchange market to stop sudden decline in value of AUD against CHF. To control this adversity it needs to supply CHF in Australian foreign exchange market to fight reduced supply. Therefore this will cause a drag on central bank's international reserves hence international reserves will fall at Australian central bank.

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