Page156-157 Questions: 2. Discuss the implications of the interest rate parity for the exchange rate determination. ns!

er: ssuming that the for!ard exchange rate is roughly an un"iased predictor of the future

spot rate# $%P can "e !ritten as: & ' ()1 * $+,-)1 * $.,/0(&t*1|$t/. 1he exchange rate is thus determined "y the relati2e interest rates# and the expected future spot rate# conditional on all the a2aila"le information# $ t# as of the present time. 3ne thus can say that expectation is self-fulfilling. &ince the information set !ill "e continuously updated as ne!s hit the mar4et# the exchange rate !ill exhi"it a highly dynamic# random "eha2ior. 5. 0xplain the purchasing po!er parity# "oth the a"solute and relati2e 2ersions. 6hat causes the de2iations from the purchasing po!er parity7

ns!er: 1he a"solute 2ersion of purchasing po!er parity )PPP,: & ' P.-P+. 1he relati2e 2ersion is: e ' . - +. PPP can "e 2iolated if there are "arriers to international trade or if people in different countries ha2e different consumption taste. PPP is the la! of one price applied to a standard consumption "as4et. 18. 0xplain the follo!ing three concepts of purchasing po!er parity )PPP,: a. 1he la! of one price. " ns!er: a. 1he la! of one price )93P, refers to the international ar"itrage condition for the standard consumption "as4et. 93P re:uires that the consumption "as4et should "e selling for the same price in a gi2en currency across countries. ". "solute PPP holds that the price le2el in a country is e:ual to the price le2el in another times the exchange rate "et!een the t!o countries. c. %elati2e PPP holds that the rate of exchange rate change "et!een a pair of countries is a"out e:ual to the difference in inflation rates of the t!o countries. ;ote: PPP is not useful for predicting exchange rates on the short-term "asis mainly "ecause international commodity ar"itrage is a time-consuming process. PPP is useful for predicting exchange rates on the long-term "asis. country ". "solute PPP. c. %elati2e PPP.

Pro"lems: P%3<90=& 1. &uppose that the treasurer of $<= has an extra cash reser2e of .188#888#888 to in2est for six months. 1he six-month interest rate is > percent per annum in the ?nited &tates and 6 percent per

annum in @ermany. Aurrently# the spot exchange rate is B1.81 per dollar and the six-month for!ard exchange rate is B8.CC per dollar. 1he treasurer of $<= does not !ish to "ear any exchange ris4. 6here should he-she in2est to maximiDe the return7 1he mar4et conditions are summariDed as follo!s: i. ' 5EF iB ' G.5EF & ' B1.81-.F H ' B8.CC-.. $f .188#888#888 is in2ested in the ?.&.# the maturity 2alue in six months !ill "e .185#888#888 ' .188#888#888 )1 * .85,. lternati2ely# .188#888#888 can "e con2erted into euros and in2ested at the @erman interest rate# !ith the euro maturity 2alue sold for!ard. $n this case the dollar maturity 2alue !ill "e .185#5C8#C8C ' ).188#888#888 x 1.81,)1 * .8G5,)1-8.CC, Alearly# it is "etter to in2est .188#888#888 in @ermany !ith exchange ris4 hedging. 2. 6hile you !ere 2isiting 9ondon# you purchased a Iaguar for +G5#888# paya"le in three months. Jou ha2e enough cash at your "an4 in ;e! Jor4 Aity# !hich pays 8.G5E interest per month# compounding monthly# to pay for the car. Aurrently# the spot exchange rate is .1.55-+ and the three-month for!ard exchange rate is .1.58-+. $n 9ondon# the money mar4et interest rate is 2.8E for a three-month in2estment. 1here are t!o alternati2e !ays of paying for your Iaguar. )a, Keep the funds at your "an4 in the ?.&. and "uy +G5#888 for!ard. )", <uy a certain pound amount spot today and in2est the amount in the ?.K. for three months so that the maturity 2alue "ecomes e:ual to +G5#888. 02aluate each payment method. 6hich method !ould you prefer7 6hy7 &olution: 1he pro"lem situation is summariDed as follo!s: -P ' +G5#888 paya"le in three months i;J ' 8.G5E-month# compounding monthly i9D ' 2.8E for three months & ' .1.55-+F H ' .1.58-+.

3ption a: 6hen you "uy +G5#888 for!ard# you !ill need .5C#888 in three months to fulfill the for!ard contract. 1he present 2alue of .5C#888 is computed as follo!s: .5C#888-)1.88G5,G ' .5>#5>C. 1hus# the cost of Iaguar as of today is .5>#5>C. 3ption ": 1he present 2alue of +G5#888 is +G5#G15 ' +G5#888-)1.82,. 1o "uy +G5#G15 today# it !ill cost .5C#755 ' G5#G15x1.55. 1hus the cost of Iaguar as of today is .5C#755. Jou should definitely choose to use Loption aM# and sa2e .1#266# !hich is the difference "et!een .5C#755 and .5>5>C. G. Aurrently# the spot exchange rate is .1.58-+ and the three-month for!ard exchange rate is .1.52-+. 1he three-month interest rate is >.8E per annum in the ?.&. and 5.>E per annum in the ?.K. ssume that you can "orro! as much as .1#588#888 or +1#888#888. a. Determine !hether the interest rate parity is currently holding. ". $f the $%P is not holding# ho! !ould you carry out co2ered interest ar"itrage7 &ho! all the steps and determine the ar"itrage profit. c. 0xplain ho! the $%P !ill "e restored as a result of co2ered ar"itrage acti2ities. &olution: 9etNs summariDe the gi2en data first: & ' .1.5-+F H ' .1.52-+F i. ' 2.8EF i+ ' 1.55E Aredit ' .1#588#888 or +1#888#888. a. )1*i., ' 1.82 )1*i+,)H-&, ' )1.8155,)1.52-1.58, ' 1.82>8 1hus# $%P is not holding exactly. ". )1, <orro! .1#588#888F repayment !ill "e .1#5G8#888. )2, <uy +1#888#888 spot using .1#588#888. )G, $n2est +1#888#888 at the pound interest rate of 1.55EF maturity 2alue !ill "e +1#815#588. )5, &ell +1#815#588 for!ard for .1#552#858 r"itrage profit !ill "e .12#858

c. Hollo!ing the ar"itrage transactions descri"ed a"o2e# 1he dollar interest rate !ill riseF 1he pound interest rate !ill fallF 1he spot exchange rate !ill riseF 1he for!ard exchange rate !ill fall. 1hese adOustments !ill continue until $%P holds. 5. &uppose that the current spot exchange rate is B8.>8-. and the three-month for!ard exchange rate is B8.7>1G-.. 1he three-month interest rate is 5.6 percent per annum in the ?nited &tates and 5.58 percent per annum in Hrance. ssume that you can "orro! up to .1#888#888 or B>88#888. a. &ho! ho! to realiDe a certain profit 2ia co2ered interest ar"itrage# assuming that you !ant to realiDe profit in terms of ?.&. dollars. lso determine the siDe of your ar"itrage profit. ". ssume that you !ant to realiDe profit in terms of euros. &ho! the co2ered ar"itrage process and determine the ar"itrage profit in euros. &olution: i.'1.5E# iB'1.G5E# &).-B,'1-8.>'1.25# H).-B,'1-8.7>1G'1.27CC a. )1* i ., ' 1.815 P )H-&, )1* i B , ' 1.8G77575>. 1hus# one has to "orro! dollars and in2est in euros to ma4e ar"itrage profit. 1, <orro! .1#888#888 and repay .1#815#888 in three months. 2, &ell .1#888#888 spot for B>88#888. G, $n2est B>88#888 at the euro interest rate of 1.G5 E for three months and recei2e B>18#>88 at maturity. 5, &ell B>18#>88 for!ard for .1#8G7#75>. r"itrage profit ' .1#8G7#75> - .1#815#888 ' .2G#75>. ". Hollo! the first three steps a"o2e. <ut the last step# in2ol2ing exchange ris4 hedging# !ill "e different. 5, <uy .1#815#888 for!ard for B7C2#2G>.

r"itrage profit ' B>18#>88 - B7C2#2G> ' B1>#562 6. s of ;o2em"er 1# 1CCC# the exchange rate "et!een the <raDilian real and ?.&. dollar is

%.1.C5-.. 1he consensus forecast for the ?.&. and <raDil inflation rates for the next 1-year period is 2.6E and 28.8E# respecti2ely. Qo! !ould you forecast the exchange rate to "e at around ;o2em"er 1# 28887

&olution: &ince the inflation rate is :uite high in <raDil# !e may use the purchasing po!er parity to forecast the exchange rate. 0)e, ' 0)., - 0)%., ' 2.6E - 28.8E ' -17.5E &8).-%.,'1-1.C5'8.512> 0)&1, ' &o)1 * 0)e,, ' ).8.512>-%., )1 - 8.175, ' .8.52G6-%.