International Economics II1

ANSWERS 12

1. The invester buys £1 in exchange for $2 in New York. Then in London, he

buys ¥410 with this £1. The exchange rate in Tokyo allows him to exchange his
yens for 2,05 dollars. That is, he gains $0,05 per pound.

2. In order to find FP or FD:

(a)  Because the forward rate is for three

months, we multiply it by 4 in order to find yearly forward premium.

(b)

3. The importer who wants to hedge the foreign exchange risk would rather
make a forward transaction over the given forward rate. That is; due to the
forward contract, the importer will be supposed to purchase £10.000 at the
forward rate given today. It needs to be noted that there is no money transfer
until 3-months time = No currencies are paid out at the time the contract is signed.
3 months later, when the contract becomes due, the importer pays 19.600
dollars to buy 10.000 pounds (FR: $1,96/£1  10.000 X 1,96 = 19.600). If he had
bought 10.000 pounds at the time when he signed the contract, it would have
costed him 20.000 dollars instead.
He has to pay 10.000 pounds for his import in 3 months, so he is able to make
a forward contract for 3 months in order to hedge the risk of exchange rate.
This way, he makes the exchange over a rate where dollar appreciates against
pound, i.e £10.000 cost him less.

4. The exporter who wants to hedge the foreign exchange risk would rather
make a forward transaction over the given forward rate. That is; due to the
forward contract, the exporter will be supposed to sell £1 million at the
forward rate given today. It needs to be noted that there is no money transfer
until 3-months time = No currencies are paid out at the time the contract is signed.

1
Yıldız Technical University, Faculty of Economics and Administrative Sciences, Department of
Economics, 2014-2015 Spring Semester, Lecturer: Assistant Prof. Zeynep Kaplan, Research Assistant:
Aslı Özgür Aktay Fidan
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You may also provide the answers in Turkish on my Academia page:
www.yildiz.academia.edu.tr/AsliOzgurAktay

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 3 months later, when the contract becomes due, the exporter pays sells 1
million pounds in exchange for 1,96 million dollars.
The reason why he entered into an agreement where the pound depreciates
against dollar is that the fact that FR has a depreciated pound ($1,96/£1)
implies a depreciation expectation on pound. The exporter wants to avoid a
possible pound depreciation against dollar even more than the forward rate,
so he signs the forward contract.
Let’s assume that the spot rate 3 months later does not change, it is still $2/£1.
In this case, the exporter considers the difference of $40.000 ($2 million - $1,96
million = $0,04 million) as an insurance he needs to face in order to hedge the
foreign exchange risk  the cost of avoiding the risk that the spot rate 3
months later would be $1,9/£1 –for ex.

5. The speculator expects the pound to appreciate against dollar, therefore he

wants to make a forward contract today to purchase -for ex.- 10.000 pounds in
3 months. When it is due time, he buys 10.000 pounds in exchange for 20.000
dollars (FR: $2/£1). If his expectations about the spot rate after 3 months come
true, he makes a profit by exchanging his 10.000 pounds in spot market:
$2,05 = £1  £10.000 = $20.500. Hereby, the speculator makes a profit of 5
cents per pound due to the depreciation of dollar against pound.

6. The speculator expects the dollar to appreciate against pound, therefore he

wants to make a forward contract today to sell -for ex.- 10.000 pounds in 3
months. Whe it is due time, he buys 10.000 pounds in the spot market 3
months later in order to sell it to fulfill the contract. If his expectations are
correct, 10.000 pounds cost him 19.500 dollars (SR: $1,95/£1). Then he sells it
to fulfill the contract at the forward rate he signed for 3 months ago: FR:
$2/£1, so he gets 10.000 x 2,00 = 20.000 dollars. In this way, he gains 20.000 –
19.500 = 500 dollars, i.e 5 cents per pound he sells.
If his expectations happen to be wrong, and 3 months later dollar depreciates
(instead of appreciates) against pound and the spot rate becomes $2,05 = £1,
the speculator then buys 10.000 pounds in exchange for 20.500 dollars in spot
market in order to sell it to fulfill the contract. He will have to sell it for the
forward rate he has agreed: FR: $2/£1. He gets 20.000 dollars fort he 10.000
pounds that costed him 20.500 dollars. So he makes a loss of 5 cents per
pound.

7. If we talk about a “positive interest rate differential in favor of a foreign

monetary center”, it is understood that the the foreign monetary center
(foreign country) has a higher interest rate than home country. The term “in
favor of” is used here because having a higher interest rates means more
investment inflow to that country.
The interest rate for the foreign monetary center = i*
Interest rate differential: i – i* = -4% ,it is minus because i* > i

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 Covered Interest Arbitrage Parity (CIAP)
It shows the relationship “betweeen the interest rate differentials between two
nations and the forward discount or premium on the foreign currency.” (Salvatore
2013, p.447)

 i – i*  FD or FP

i < i*  i – i* = FD
İ > İ*  İ – İ* = FP

The forward discount is given: 2%, that is FD = -0,02

Covered Interest Arbitrage Margin (CIAM): i – i*- FD (or FP)

This gives us the profitability in percentage rising from the covered interest
rate arbitrage.

CIAM: (i - i*) – FD = -0,04 – (-0,02) = -0,02  That is, if one invests in for ex.
treasury bonds in the foreign monetary center, he will gain by 2% per year.
The negative sign for the CIAM, as in this example, refers to a CIA outflow, i.e
investing in the foreign country.

8. Assuming the interest rate differential stays same:

(a) FP = 1% ,then CIAM: -0,04 – 0,01 = 0,05  The profit from an investment in
the foreign monetary center is 5% per year. Forward premium has made
the investment in foreign country more profitable. Because it means that
the foreign currency is going to appreciate against the local currency ( FR >
SR )
(b) FD = 6%, then CIAM: -0,04 – (-0,06) = 0,02  The positive sign for the
CIAM means that the investor is going to invest in his home country. The
spot rate is so higher than the forward rate ( FR << SR ), that the profit that
can be generated due to the appreciation of the local money is more than
the profit that can be generated due to the higher interest rate in the
foreign monetary center. Higher interest rate could not attract the investors
in this case.