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FINS3616 Tutorials - Week 4, Questions

This document contains sample questions and explanations about parity conditions, real interest rates, covered interest arbitrage, forward premiums and discounts, and balance of payments concepts. The questions cover topics such as calculating real interest rates given nominal rates and expected inflation, determining forward exchange rates that prevent arbitrage opportunities, and implications of current account balances, capital flows and overall balance of payments positions.

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Lena Zheng
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427 views2 pages

FINS3616 Tutorials - Week 4, Questions

This document contains sample questions and explanations about parity conditions, real interest rates, covered interest arbitrage, forward premiums and discounts, and balance of payments concepts. The questions cover topics such as calculating real interest rates given nominal rates and expected inflation, determining forward exchange rates that prevent arbitrage opportunities, and implications of current account balances, capital flows and overall balance of payments positions.

Uploaded by

Lena Zheng
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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FINS3616 Tutorials – Week 4

(Parity Conditions, Balance of Payments)

1. Suppose the 1-year nominal interest rate in Zooropa is 9%, and Zooropa’s expected inflation rate is 4%.
What is the real interest rate in Zooropa?

T h e e x p e c t e d r e a l in t e re s t r a t e i s a p p r o x i m at e ly 9 % - 4 % = 5 % . T h e c orr e c t
computation is: (1 + 0.09) / (1 + 0.04) – 1 = 0.0481 or 4.81%.

2. Suppose the 5-year interest rate on a dollar-denominated pure discount bond is 4.5% p.a., whereas in
France, the euro interest rate is 7.5% p.a. on a similar pure discount bond denominated in euros. If the
current spot rate is $1.08/€, what is the value of the 5-year forward exchange rate that prevents covered
interest arbitrage?

3. If the 30-day yen interest rate is 3% p.a., and the 30-day euro interest rate is 5% p.a., is there a forward
premium or discount on the euro in terms of the yen? What is the magnitude of the forward premium or
discount?

4. Suppose the spot rate is CHF1.4706/$ in the spot market, and the 180-day forward rate is CHF1.4295/$. If
the 180-day dollar interest rate is 7% p.a., what is the annualized 180-day interest rate on Swiss francs that
would prevent arbitrage?

5. Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two alternative investments of
EUR10,000,000: 180-day euro deposits or 180-day Swiss francs (CHF) deposits. She has decided not to bear
transaction foreign exchange risk. Suppose she has the following data: 180-day CHF interest rate, 8% p.a.,
180-day EUR interest rate, 10% p.a., spot rate EUR1.1960/CHF, 180-day forward rate, EUR1.2024/CHF.
Which of these deposits provides the higher euro return in 180 days? If these were actually market prices,
what would you expect to happen?
6. In a freely floating exchange rate system, if the current account is running a deficit, what are the
consequences for the nation's balance on capital account and its overall balance of payments?

In a freely floating exchange rate system, the nation’s balance of payments must always be zero.
Consequently, if the current account is running a deficit, the capital account must be running a surplus of
the same size. Overall, international payments will still be in balance.

7. What is likely to happen to the value of the dollar as the U.S. current-account deficit increases? Explain.
/

8. China’s overall saving rate is now nearly 50% of GDP, the highest in the world. China’s domestic investment
rate, at 43%, is also high, but not as high as its saving rate. What do these facts imply about China’s current-
account balance?

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