Mock Test Answers

1. Calculate the direct rate if the indirect rate is $1.75 : £1

ANS: 0.57

2. Assume the Australian dollar to Euro rate is AUD $1.53: €1 and the US dollar is US $1.39:€1. What
is the AUD $ to USD $ rate?

ANS: AUD $1.10: USD$1 or USD$0.91: AUD$1

3. According to the International Fisher Effect, if U.S. investors expect a 7.5% rate of domestic
inflation over one year, and a 2.5% rate of inflation in European countries that use the euro, and
require a 4% real return on investments over one year, the nominal interest rate on one year U.S.
Treasury securities would be:

ANS: 11.5%

4. Assume that the inflation rate in the UK is 4%, while the inflation rate in the U.S. is 3%. According
to PPP, what will happen to the UK £ and by what amount?

ANS: UK £ will depreciate by 0.96% [using the formula (1+π / 1+π*)]

5. Assume covered interest parity holds. What is the forward rate if the U.S. interest rate is 10% and
the British interest rate is 20%, while the spot rate 0.5/$1?

ANS: f = 0.55 [using formula (s(1+r / 1+r*))]

6. Compute the bid-ask spread percentage rate for the Euro versus the US $, when the bid rate is
€0.82 and the ask rate is €0.85

ANS: 3.53

7. You have £1,000,000 to invest for 3 months – take 3 months to be exactly 0.25 of a year.

Current spot rate of pound = $1.50

90 day forward rate of pound = $1.45

3 month deposit rate in U.S. = 12% pa

3 month deposit rate in UK = 20% pa

If you utilise the spot and forward markets to invest in the USA, what will be your US return
compared to your UK return?

ANS: UK ret: 1,050,000; US ret: 1,065,517

(UK: £1m(1+0.2/4); US: $1.5(1+0.12/4)/1.45)

8. What happens to the value of the UK £ versus the Australian dollar (AUD) if UK interest rates are
higher than Australian interest rates

ANS: Cash inflow equals appreciation (UIP would say depreciation)

9. Assume a two country world: Country A and Country B. Which of the following is correct about
purchasing power parity (PPP) as related to these two countries?

A) If Country A’s inflation rate exceeds Country B’s inflation rate, Country A’s currency will weaken.

B) If Country A’s interest rate exceeds Country B’s inflation rate, Country A’s currency will weaken.

C) If Country A’s interest rate exceeds Country B’s inflation rate, Country A’s currency will
strengthen.

D) If Country B’s inflation rate exceeds Country A’s inflation rate, Country A’s currency will weaken.

E) None of the above

ANS: A

10. What happens to prices, interest rates and exchange rates in the Dornbusch model of exchange
rates when the money supply is increased?

ANS: in short-run prices do not changes, interest rates fall and the exchange rate overshoots its PPP
position. In the long-run prices increase, interest rates return to previous level and exchange rate
moves to its PPP level.