Chapter 6

    1. Multiple Choice Quiz

    (1) Suppose interest rates in the U.S. are 5% when the spot exchange rate is $0.75 = ?1 and the interest rate in France is 8% per year. What must the one-year forward

    exchange rate be?

    A) $0.7292 = ?1

    B) $0.75 = ?1

    C) $0.81 = ?1

    D) $0.7714 = ?1

    E) $1.2963 = ?1

     (2) Purchasing power parity states that:

    A) The cost of a haircut in Columbia Missouri should be exactly the same as the cost in Hong Kong.

    B) Rates of inflation must be the same everywhere.

    C) Spot exchange rates are the best predictor of expected inflation rates.

    D) The cost of a Big Mac sandwich should be reflected in the cost of two all-beef patties, special sauce, lettuce, cheese, pickles, onions and a sesame seed bun.

    E) None of the above.

    (3) Suppose that the spot exchange rate for Japanese yen is ?122/$ and that the one year forward exchange rate for Japanese yen is ?130/$. The one-year interest rate is 5% in the U.S. What's the interest rate in Japan?

    A) 11.89%

    B) 6.56%

    C) 3.28%

    D) 1.67%

    E) None of the above.

    (4) Suppose you observe the following exchange rates: S($/?) = 0.85 (i.e. ?1 = $.85) The one-year forward rate is F($/?) = 0.935 (i.e. ?1 = $.935) The risk-free interest 1

    rate in the U.S. is 5% and in Germany it is 2%. How can a dollar-based investor make money?

    A) Borrow dollars in the U.S., exchange for euros, invest in Germany, enter into a on-year forward contract; in one year, translate the euros back into dollars at the forward rate.

    B) Borrow euros, translate into dollars at the spot, invest in the U.S. at 5% for one year. At the end of the year, translate part of your dollar investment back into euros at the forward rate to repay your euro debt.

    C) There is no profitable arbitrage opportunities.

     (5) Consider the following exchange rate quotation from Wall Street Journal

    U.S.$ equiv. Currency per U.S. $ Friday Thursday Friday Thursday

Britain (Pound) 1.5760 1.5720 0.6345 0.6361

    1 Month Forward 1.5726 1.5686 0.6359 0.6375

    3 Months 1.5661 1.5621 0.6385 0.6402 Forward

    6 Months 1.5564 1.5523 0.6425 0.6442 Forward

    Judging by the exchange rates quoted above, which country has the higher rate of inflation?

    A) Britain

    B) The United States

    C) There is not enough information to say.

    D) All of the above

    E) None of the above

    2. Calculation and analysis

    (1) Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 6 percent per annum in Germany. Currently, the spot exchange rate is ?1.01

    per dollar and the six-month forward exchange rate is ?0.99 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?

     (2) Due to the integrated nature of their capital markets, investor in both the U.S. and Great Britain require the same expected real interest rate of 3 percent. The expected annual inflation in the U.S. is 2 percent and in the U.K. expected annual inflation is 5%. The spot exchange rate is currently ?1.00 = $1.80. Calculate the nominal interest rates in Britain and the U.S. assuming the Fisher effect holds.