Essay Fx Currency

771 Words Dec 4th, 2014 4 Pages
INTERNATIONAL FINANCE ASSIGNMENT 2 _ Answer Key PROBLEM I (30 points) Suppose the quarterly (90-day) interest rate in the US is 2.5% and it is 4% in Canada. If the $/CD spot exchange rate is $0.80/CD and the 90-day forward exchange rate between US and Canadian dollars is $0.79/CD , does the interest rate parity (IRP) hold? Why or why not? If it does not hold, what is the direction of the capital flow?

1.025 0.79  1.04 0.80 0.9856 ≠ 0.9875 IRP does not hold. 2.5< (4-1.25=2.75) Therefore, funds flow from US to Canada.

If an arbitrageur can borrow up to $1,000,000 (or CD1,250,000), formulate a covered interest arbitrage. Make sure to explain your steps in detail (just writing out three random calculations does not count). Determine the
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If the expected inflation rate in Canada is 4% , what should the expected inflation rate be in the US? __________________________

1   $ 0.80 (0.80)(1.04)   1 $   0.9788 1.04 0.85 0.85  $  0.021 = 2.1% deflation

PROBLEM IV: (10 points) The Australian dollar spot exchange rate is $0.90/AUD. If the semi-annual interest rates in Australia and the U.S. are 5% and 3%, respectively, what should the $/AUD exchange rate be in six months? ___________________________

S 1.03 (1.03)(0.90)  1  S1   $0.8829 / AUD 1.05 0.90 1.05

PROBLEM V: (15 points)
If the annual inflation rate is 3.5 percent in the United States and 2 percent in the U.K., and the dollar depreciated against the pound by 2.5 percent, then the real exchange rate, assuming that PPP initially held, is:

______________0.9899__________________

q

1.035  0.9899 (1.02)(1.025)

What can you conclude about the competitiveness of the US economy after this depreciation in dollars? (Did competitiveness improve, deteriorate or remain unchanged?) Why?

q<1 dollar depreciated more than necessary to cover up for the inflation differential between US and

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