Business & Finance
Questions:
1-) Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be 2 francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?
2-) There are arguments for and against the alternative exchange rate regimes.
a. List the advantages of the flexible exchange rate regime.
b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime.
c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate regime.
Problems
1-) The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. On the basis of your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/£ in three months. Assume that you would like to buy or sell £1,000,000.
a. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?
b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/£?
2-) Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0 percent per annum in the U.S. and 5.8 percent per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.
a. Determine whether interest rate parity is currently holding.
b. If IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.
c. Explain how IRP will be restored as a result of covered arbitrage activities.
3-) In the October 23, 1999, issue, The Economist reports that the interest rate per annum is 5.93 percent in the United States and 70.0 percent in Turkey. Why do you think the interest rate is so high in Turkey? On the basis of the reported interest rates, how would you predict the change in the exchange rate between the U.S. dollar and the Turkish lira?
4-) Omni Advisors, an international pension fund manager, uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows:
Base price level 100
Current U.S. price level105
Current South African price level111
Base rand spot exchange rate$0.175
Current rand spot exchange rate$0.158
Expected annual U.S. inflation7%
Expected annual South African inflation5%
Expected U.S. one-year interest rate10%
Expected South African one-year interest rate8%
Calculate the following exchange rates (ZAR and USD refer to the South African rand and U.S. dollar, respectively):
a. The current ZAR spot rate in USD that would have been forecast by PPP.
b. Using the IFE, the expected ZAR spot rate in USD one year from now.
c. Using PPP, the expected ZAR spot rate in USD four years from now.
Sample Solution
Question 1
Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be 2 francs per pound. If the current market exchange rate is 2.2 francs per pound, this means that the pound is overvalued relative to the franc.
One way to take advantage of this situation would be to engage in arbitrage. Arbitrage is the practice of buying an asset in one market and selling it in another market for a higher price. In this case, you could buy pounds in the UK and sell them in France for a profit.
Full Answer Section
To do this, you would need to open a bank account in both the UK and France. You would then need to transfer money from your UK account to your French account. Once the money has been transferred, you could use it to buy pounds in the UK. You would then sell the pounds in France for francs. The difference between the exchange rate in the UK and the exchange rate in France would be your profit. However, you would need to factor in the cost of shipping the gold between the two countries. If the cost of shipping is greater than the difference in exchange rates, then arbitrage would not be profitable. Another way to take advantage of this situation would be to invest in French assets. If you believe that the franc is undervalued relative to the pound, then you could invest in French assets, such as French stocks or bonds. As the franc appreciates relative to the pound, the value of your investment will increase. Question 2 Advantages of the flexible exchange rate regime:- Automatic adjustment to changes in economic conditions: Flexible exchange rates can adjust automatically to changes in economic conditions, such as changes in inflation or interest rates. This can help to promote economic stability and growth.
- Increased efficiency of international trade and investment: Flexible exchange rates can help to make international trade and investment more efficient. This is because businesses and investors can use flexible exchange rates to hedge against currency risk.
- Improved international competitiveness: Flexible exchange rates can help to improve a country's international competitiveness. This is because a devaluation of the currency can make a country's exports more affordable for foreign buyers.
- Exchange rate volatility: Flexible exchange rates can be volatile, which can make it difficult for businesses to plan for the future.
- Speculation: Flexible exchange rates can be susceptible to speculation, which can lead to sharp fluctuations in the value of the currency.
- Loss of monetary autonomy: Under a flexible exchange rate regime, the central bank has less control over the value of the currency. This is because the value of the currency is determined by market forces.
- Exchange rate volatility: While flexible exchange rates can be volatile, they can also be managed through monetary policy. For example, the central bank can buy or sell foreign currency to influence the value of the domestic currency.
- Speculation: Speculation can be a problem under a flexible exchange rate regime, but it can also be beneficial. For example, speculators can help to provide liquidity in the foreign exchange market.
- Loss of monetary autonomy: While the central bank has less control over the value of the currency under a flexible exchange rate regime, it still has control over other important economic variables, such as interest rates and inflation.