Question and Applications for Chapter 5

Ex1. (19) Assume that the spot exchange rate of the Singapore dollar is $0.70. The 1-
year interest rate is 11% in the United States and 7% in Singapore. What will the spot
rate be in 1 year according to the IFE? What is the force that causes the spot rate to
change according to the IFE?
Ex2. As of today, assume the following information is available: (20)
U.S Mexico
Real rate of interest 2% 2%
required by investors
Nominal interest rate 11% 15%
Spot rate - $0.20
One-year forward rate - $0.19
a. Use the forward rate to forecast the percentage change in the Mexican peso over the
next year.
b. Use the differential in expected inflation to forecast the percentage change in the
Mexican peso over the next year.
c. Use the spot rate to forecast the percentage change in the Mexican peso over the next
year.
Ex3. (24) Beth Miller does not believe that the international Fisher effect (IFE) holds.
Current 1-year interest rates in Europe are 5%, while 1-year interest rates in the United
States are 3%. Beth converts $100,000 to euros and invests them in Germany. One year
later, she converts the euros back to dollars. The current spot rate of the euro is $1.10.
a. According to the IFE, what should the spot rate of the euro in 1 year be?
b. If the spot rate of the euro in 1 year is $1.00, what is Beth’s percentage return from
her strategy?
c. If the spot rate of the euro in 1 year is $1.08, what is Beth’s percentage return from
her strategy?
d. What must the spot rate of the euro be in 1 year for Beth’s strategy to be successful?
Ex4. (25) Assume the following information is available for the United States and
Europe:
U.S Mexico
Nominal interest rate 4% 6%
Expected inflation 2% 5%
Spot rate - $1.13
One-year forward rate - $1.10
a. Does IRP hold?
b. According to PPP, what is the expected spot rate of the euro in 1 year?
c. According to the IFE, what is the expected spot rate of the euro in 1 year?
d. Reconcile your answers to parts (a) and (c).
Ex5. (26) The 1-year risk-free interest rate in Mexico is 10 %. The 1-year risk-free rate
in the United States is 2 %. Assume that interest rate parity exists. The spot rate of the
Mexican peso is $0.14.
a. What is the forward rate premium?
b. What is the 1-year forward rate of the peso?
c. Based on the international Fisher effect, what is the expected change in the spot rate
over the next year?
d. If the spot rate changes as expected according to the IFE, what will be the spot rate
in 1 year?
e. Compare your answers to (b) and (d) and explain the relationship.
Ex6. (31). Assume that Mexico has a 1-year interest rate that is higher than the U.S. 1-
year interest rate. Assume that you believe in the IFE and IRP. Assume zero transaction
costs. Ed is based in the United States and attempts to speculate by purchasing Mexican
pesos today, investing the pesos in a risk-free asset for a year, and then converting the
pesos to dollars at the end of 1 year. Ed did not cover his position in the forward market.
Maria is based in Mexico and attempts covered interest arbitrage by purchasing dollars
today and simultaneously selling dollars 1 year forward, investing the dollars in a risk-
free asset for a year, and then converting the dollars back to pesos at the end of 1 year.
Do you think the rate of return on Ed’s investment will be higher than, lower than, or
the same as the rate of return on Maria’s investment? Explain
Ex7. (32) Assume that locational arbitrage ensures that spot exchange rates are properly
aligned. Also assume that you believe in PPP. The spot rate of the British pound is
$1.80. The spot rate of the Swiss franc is 0.3 pounds. You expect that the 1-year inflation
rate is 7 % in the United Kingdom, 5 % in Switzerland, and 1 % in the United States.
The 1-year interest rate is 6 % in the United Kingdom, 2 % in Switzerland, and 4 % in
the United States. What is your expected spot rate of the Swiss franc in 1 year with
respect to the U.S. dollar? Show your work
Ex8. (34) The U.S. 3-month interest rate (unannualized) is 1 %. The Canadian 3-month
interest rate (unannualized) is 4 %. IRP exists. The expected inflation over this period
is 5 % in the United States and 2 % in Canada. A call option with a 3-month expiration
date on Canadian dollars is available for a premium of $0.02 and a strike price of $0.64.
The spot rate of the Canadian dollar is $0.65. Assume that you believe in PPP.
a. Determine the dollar amount of your profit or loss from buying a call option contract
specifying C$100,000.
b. Determine the dollar amount of your profit or loss from buying a futures contract
specifying C$100,000.
Ex9. (35) Today’s spot rate of the Mexican peso is $0.10. Assume that PPP holds. The
U.S. inflation rate over this year is expected to be 7 %, while the Mexican inflation over
this year is expected to be 3 %. Wake Forest Co. plans to import from Mexico and will
need 20 million Mexican pesos in 1 year. Determine the expected amount of dollars to
be paid by the Wake Forest Co. for the pesos in 1 year.
Ex10. (38) The United States and the country of Rueland have the same real interest
rate of 3 %. The expected inflation over the next year is 6 % in the United States versus
21 % in Rueland. IRP exists. The 1-year currency futures contract on Rueland’s
currency (called the ru) is priced at $.40/ru. What is the spot rate of the ru?
Ex11. (39) The nominal (quoted) U.S. 1-year interest rate is 6 %, while the
nominal 1-year interest rate in Canada is 5 %. Assume you believe in PPP. You believe
the real 1-year interest rate is 2 % in the United States, and that the real 1-year interest
rate is 3 % in Canada. Today the Canadian dollar spot rate is $0.90. What do you think
the spot rate of the Canadian dollar will be in 1 year?
Ex12. (40) Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and
will remain tied to the U.S. dollar. Assume that IRP exists. Today,
an Australian dollar (A$) is worth $.50 and HK$3.9. The 1-year interest rate on the
Australian dollar is 11 %, while the 1-year interest rate on the U.S. dollar is 7 %. You
believe in the IFE. You will receive A$1 million in 1 year from selling products to
Australia, and will convert these proceeds into Hong Kong dollars in the spot market at
that time to purchase imports from Hong Kong. Forecast the amount of Hong Kong
dollars that you will be able to purchase in the spot market 1 year from now with A$1
million. Show your work.
Ex13. (41) Boston Co. will receive 1 million euros in 1 year from selling exports. It did
not hedge this future transaction. Boston believes that the future value of the euro will
be determined by PPP. It expects that inflation in countries using the euro will be 12 %
next year, while inflation in the United States will be 7 % next year. Today the spot rate
of the euro is $1.46, and the 1-year forward rate is $1.50. Estimate the amount of U.S.
dollars that Boston will receive in 1 year when converting its euro receivables into U.S.
dollars.