INBU 4200; PROFESSOR MICHAEL PALMER; FALL SEMESTER 2011

EXAM 2 KEY to Sections 3 and 4

Section 3: Lecture Section (lectures 1 – 10). Multiple Choice Questions and Fill in the Blank. Where appropriate, please circle the letter than corresponds to your answer. Each question is worth 2 points, unless otherwise indicated (30 points in total for this section).

47. In the space provided, print the name of the financial institution that accounts for the largest share (by % of market) of the foreign exchange market.

Deutsche Bank

48. List in order of size (by % of total foreign exchange market), the three largest foreign exchange centers as reported in the 2010 BIS survey (3 points for this question).

  1. London
  1. New York
  1. Tokyo

49. List in order of size (by % of average daily turnover) the three largest currencies by trade in the foreign exchange market as reported in the 2010 BIS survey. Indicate each currency by its ISO designation (3 points for this question).

  1. USD
  1. EUR
  1. JPY

51. Assume the following market maker spot quotes for Thursday, October 20, 2011 for the Canadian dollar: 1.0198 1.0200. If on Thursday, October, you negotiated to purchase Canadian dollars from this market maker bank, which of the exchange rates noted above would you use to determine your purchase price in U.S. dollars?

A. 1.0198

B. 1.0200

Note: The Canadian Dollar is quoted on the basis of European Terms, or USD/CAD. Thus the bid price (1.0198) is the price at which the market maker bank will buy U.S. dollars (from you) and sell you Canadian dollars.

52. Assuming you agreed to the deal (in question 51) on Thursday, October 20, 2011, on what date would your clearing bank be credited with the Canadian dollars you purchased? (Fill in the blank).

Friday, October 21, 2011 (Note: Canadian dollars have a 1 business day settlement).

53. Assume the following interbank tick bid ask exchange rate for the New Zealand dollar:

Tick 1: 0.7929 0.7933

Tick 2:0.7930 0.7935

Tick 3: 0.7934 0.7838

Tick 4: 0.7935 0.7939

Assume that at Tick 1 you sold “short” the New Zealand dollar and at Tick 4 you covered your short position. In the space below, indicate your gain or loss in USD for each unit of the New Zealand dollar which you sold short and then covered. You must indicate whether there was a gain or loss and how much.

Sell at .7929 and cover your short sale (i.e., buy back) at .7939; thus a loss of .0010 U.S. cents on each NZD.

54. Using the data in question 53, now assume you went long on the New Zealand dollar at Tick 2 and reversed your long position at Tick 4. In the space below, indicate your gain or loss in USD for each unit of the New Zealand dollar in which you had this long position. You must indicate whether there was a gain or loss and how much.

Buy at .7935 and sell at .7937; thus no gain or loss.

55. Assume the following Bloomberg.com information for October 21, 2011:

  1. 10-year U.S. Government bond rate: 2.20% (p.a.)
  2. 10-year Australian Government bond rate: 4.49% (p.a.)
  3. 10-year United Kingdom Government bond rate: 2.53% (p.a.)
  4. 10-year German Government bond rate: 2.11% (p.a.)
  5. 10-year Japanese Government bond rate: 1.01% (p.a.)

Given the above data, and using only the Fisher Effect and the International Fisher Effect (as appropriate), answer the following questions (each question is worth 2 points).

  1. What is the annual expected rate of inflation differential between the country with the highest expected rate of inflation and that with the lowest rate of inflation? You must give a number (percent) for your answer. You do not have to indicate the countries.

4.49 – 1.01 = 3.48% (Note: Australia – Japan)

  1. Which of the above country’s currencies should show the greatest appreciation against the U.S. dollar over the next 10 years. Name the currency and specify the anticipated annual appreciation in percent.

JPY will appreciate 1.19% against the U.S. dollar (Note: 2.20 – 1.01)

  1. Over the next ten years the annual change in the GBP/AUD exchange should be? Specify the annual change and indicate, given the cross rate as noted, if the GBP/AUD rate will strengthen or weaken by the annual change you have indicated.

GBP/AUD will strengthen by 1.96% (Note: GBP is the base currency, thus 1 GBP will strengthen by 1.96% against the AUD, or 4.49 – 2.53)

56. Assume the following local price information for 1 large Pizza Hut pan crust pizza with pepperoni:

  1. New York:$20.00
  2. London:30.00 Pounds sterling
  3. Sydney:10.00 Australian dollars
  4. Shanghai:100 yuan
  5. Tokyo:2,000 yen

Next assume the following spot exchange rates:

  1. GBP/USD:1.5942
  2. AUD/USD1.0333
  3. USD/CNY6.3838
  4. USD/JPY76.15

Given the above data and using only the Absolute Purchasing Power Parity Model, answer the following questions (each question is worth 2 points).

  1. What is the Absolute Purchasing Power Parity Exchange Rate for GBP/USD (show formula and calculate the Absolute PPP exchange rate) and note if the pound is currently overvalued or undervalued based on this model (you don’t have to indicate the amount of over or under value)?

PPP Absolute Term Exchange Rate = PriceUSD/PriceForeign Currency = 20/30 = .6666. With an actual exchange rate of 1.5942 the pound is overvalued.

  1. What is the Absolute Purchasing Power Parity Exchange Rate for USD/CNY (show formula and calculate the Absolute PPP exchange rate) and note if the yuan is currently overvalued or undervalued (you don’t have to indicate the amount of over or under value)?

PPP European Terms Exchange Rate = PriceForeign Currency/Price USD = 100/20 = 5.0000. With an actual exchange rate of 6.3838, the yuan is undervalued.

  1. In the space below indicate the major problem using the above data in combination with the Absolute Purchasing Power Parity model to assess the Absolute Purchasing Power Exchange Rate for the two currencies in question.

Pizzas are not tradable cross border (Note: You needed this for full credit). Other answers would get you partial credit.

Section 4: Lecture Section (lectures 1 – 10). Working with Data (18 points for this section)

57. Given the data below and using only the Interest Rate Parity Model, answer the questions which follow (each question is worth 2 points).

  1. EuroDollar 1 year deposit rates in London:1.10%
  2. EuroDollar 6 month deposit rates in London:0.75% (p.a.)
  3. EuroSwiss franc 1 year deposit rates in London:0.50%
  4. EuroSwiss franc 6 month deposit rates in London:0.25% (p.a.)
  5. EuroPound 1 year deposit rates in London:1.50%
  6. EuroPound 6 month deposit rates in London:1.00% (p.a.)
  7. Current USD/CHF spot exchange rate:0.8822
  8. Current GBP/USD spot exchange rate:1.5900
  1. Set up the appropriate formula for calculating the 1 year forward rate for USD/CHF

FTet = Set x [(1+ interest foreign)/(1+ interest US)]

  1. Using the data given, insert the data into the appropriate formula (do not solve).

= 0.8822 x (1 + .005)/(1 + .011) Note: You needed to insert data correctly for full credit.

  1. Set up the appropriate formula for calculating the 6 month forward rate of GBP/USD.

FTat = Sat = [(1+ (interest US x n/360)/(1+interest foreign x n/360)]

  1. Using the data given, insert the data into the appropriate formula (do not solve).

= 1.5900 x ((1 + (.0075 x 180/360))/((1 + (.01 x 180/360)) Note: You needed to insert data correctly for full credit.

  1. In the space below, explain the rational for the discount or the premium which the Interest Rate Parity Model formula calculates? Specifically, why is this a parity rate?

Rational is based on the Interest Rate Parity Model. The forward rate must be set at a rate which will offset the interest rate differential between to two currencies. This is the equilibrium forward rate which will prevent covered interest arbitrage.

58. Given the data below and using either the Relative Purchasing Power Parity Model or the International Fisher Effect, answer the questions which follow (each question is worth 3 points).

  1. Expected annual rate of inflation for the U.S. over the next 5 years: 2.15%
  2. Expected annual rate of inflation for the Eurozone over the next five years:2.30%
  3. Current interest rate (p.a.) on 10 year U.S. Government bonds: 1.07%
  4. Current interest rate (p.a.) on 10 year Brazilian Government bonds: 11.62%
  5. Current EUR/USD spot exchange rate: 1.3896
  6. Current USD/BRL spot exchange rate*:1.7755

*Note: BRL is the ISO designation for the Brazilian real.

  1. Set up the appropriate Relative Purchasing Power Parity Model formula for forecasting the EUR/USD exchange rate 5 years from now:

PPP American Terms Spot = Current spot x [(1 = inflation US)n/ (1+ inflation foreign)n]

  1. Using the data given, insert the data into the appropriate formula (do not solve).

= 1.3896 x (1 +.0215)5/(1+.0230)5 Note: You needed to insert data correctly for full credit.

  1. Set up the appropriate International Fisher Effect Model formula for calculating the USD/BRL spot exchange rate 10 years from now.

IFE European Terms Spot = Current spot x [(1+interest rate foreign)n/(1+interest rate US)n

  1. Using the data given, insert the data into the appropriate formula (do not solve).

= 1.7755 x (1+1162)10/(1+0107)10 Note: You needed to insert data correctly for full credit.

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