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  CHAPTER 4: PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTING

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  1. Inflation is the logical outcome of an expansion of the money supply in excess of real output growth. As the supply of one commodity increases relative to supplies of all other commodities, the price of the first commodity must decline relative to the prices of other commodities. In other words, its value in exchange or exchange rate must decline. Similarly, as the supply of money increases relative to the supply of goods and services, the price of money in terms of goods and services must decline, i.e., the exchange rate between money and goods declines.
  2. The international parallel to inflation is domestic currency depreciation relative to foreign currencies. To maintain the same exchange rate between money and goods both domestically and abroad, the exchange rate must decline by (approximately) the difference between the domestic and foreign rates of inflation. This is purchasing power parity, which is itself based on the law of one price.
  3. Although the nominal or actual money exchange rate may fluctuate all over the place, we would normally expect the real, or inflation-adjusted exchange rate, to remain relatively constant over time. The same is true for nominal versus real rates of interest. However, although the prediction that real interest and exchange rates will remain constant over time is a reasonable one ex ante, ex post we find that these real rates wander all over the place. A changing real exchange rate is the most important source of exchange risk for companies.
  4. Four additional equilibrium economic relationships tend to hold in international financial markets: Purchasing Power Parity (PPP), the Fisher Effect, International Fisher Effect (IFE), Interest Rate Parity (IRP), and the forward rate as an unbiased estimate of the future spot rate.

  1.a.            What is purchasing power parity (PPP)?

  • b. What are some reasons for deviations from purchasing power parity?

  4. Comment on the following statement: “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.”
  5. Which is likely to be higher, a 150% ruble return in Russia or a 15% dollar return in the U.S.?
  6. The interest rate in England is 12%, while in Switzerland it is 5%. What are possible reasons for this interest rate differential? What is the most likely reason?
  7. Over the period 1982-1988, Peru and Chile stand out as countries whose interest rates are not consistent with their inflation experience. Specifically, Peru’s inflation and interest rates averaged about 125% and 8%, respectively, over this period, whereas Chile’s inflation and interest rates averaged about 22% and 38%, respectively.

  7.a.   How would you characterize the real interest rates of Peru and Chile (e.g., close to zero, highly positive, highly negative)?

  Answer.

  7.b.   What might account for Peru’s low interest rate relative to its high inflation rate? What are the likely consequences of this low interest rate?

  7.c.   What might account for Chile’s high interest rate relative to its inflation rate? What are the likely consequences of this high interest rate?

  7.d.   During the same period, Peru had a small interest differential and yet a large average exchange rate change. How would you reconcile this experience with the IFE and with your answer to part b?

  8. Over the period 1982-1988 numerous countries (e.g., Pakistan, Hungary, Venezuela) had a small or negative interest rate differential and a large average annual depreciation against the dollar. How would you explain these data? Can you reconcile these data with the IFE?
  9. What factors might lead to persistent covered interest arbitrage opportunities among countries?
  10. In early 1989, Japanese interest rates were about 4 percentage points below U.S. rates. The wide difference between Japanese and U.S. interest rates prompted some U.S. real estate developers to borrow in yen to finance their projects. Comment on this strategy.
  11. In late December 1990, one‑year German Treasury bills yielded 9.1%, whereas one‑year U.S. Treasury bills yielded 6.9%. At the same time, the inflation rate during 1990 was 6.3% in the U.S., double the German rate of 3.1%.

  12.a.   Are these inflation and interest rates consistent with the Fisher Effect?

  12.b.   What might explain this difference in interest rates between the U.S. and Germany?

  13. The spot rate on the euro is $0.91 and the 180‑day forward rate is $0.93. What are possible reasons for the difference between the two rates?
  14. If the dollar is appreciating against the Polish zloty in nominal terms but depreciating against the zloty in real terms, what do we know about Polish and U.S. inflation rates?
  15. Suppose the nominal peso/dollar exchange rate is fixed. If the inflation rates in Mexico and the U.S. are constant (but not necessarily equal), will the real value of the peso/dollar exchange rate also be constant over time?
  16. If the average rate of inflation in the world rises from 5% to 7%, what will be the likely effect on the U.S. dollar’s forward premium or discount relative to foreign currencies?
  17. Comment on the following quote from the Wall Street Journal (August 27, 1984, p. 6) that discusses the improving outlook for Britain’s economy: “Recovery here will probably last longer than in the U.S. because there isn’t a huge budget deficit to pressure interest rates higher.”
  18. Comment on the following headline that appeared in the Wall Street Journal (December 19, 1990, p. C10): “Dollar Falls Across the Board as Fed Cuts Discount Rate to 6.5% From 7%.” (The discount rate is the interest rate the Fed charges member banks for loans.)
  19. In an integrated world capital market, will higher interest rates in, say Japan, mean higher interest rates in, say, the U.S.?

  1. From base price levels of 100 in 2000, Japanese and U.S. price levels in 2006 stood at 98 and 109, respectively.

  1.a.   If the 2000 $:¥ exchange rate was $0.00928, what should the exchange rate be in 2006?

  1.b.   In fact, the exchange rate in 2006 was ¥1 = $0.00860. What might account for the discrepancy? (Price levels were measured using the consumer price index.)

  2. Two countries, the U.S. and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the U.S. and is £1.35 in England.

  2.a.   According to the law of one price, what should the $:£ spot exchange rate be?

  2.b.   Suppose the price of wheat over the next year is expected to rise to $3.50 in the U.S and to £1.60 in England. What should the one‑year $:£ forward rate be?

  3. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be according to the Fisher Effect? (exact and approximate!)
  4. Suppose the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%.

  4.a.   Based on these figures, what were the real interest rates in France and Germany?

  5. In July, the one‑year interest rate is 12% on British pounds and 9% on U.S. dollars.

  5.a.   If the current exchange rate is $1.63:£1, what is the expected future exchange rate in one year?

  5.b.   Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?

  6. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimate of the one‑year forward exchange premium (discount) at which the pound will be selling relative to the French franc?
  7. Suppose three‑year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12% and 7%, respectively. If the current spot rate for the Swiss franc is $0.3985, what is the spot rate implied by these interest rates for the franc three years from now?
  8. Assume the interest rate is 16% on pounds sterling and 7% on euros. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England.

  10.a.   If the euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain.

  10.b.   What is the real interest rate in Germany? In England?

  13. Suppose that three-month interest rates (annualized) in Japan and the U.S. are 7% and 9%, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1:

  13.a.   Where would you invest?

  13.b.   Where would you borrow?

  13.c.   What arbitrage opportunity do these figures present?

  13.d.   Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?

  15. Suppose today’s exchange rate is $1.35/€. The six-month interest rates on dollars and euros are 6% and 3%, respectively. The six-month forward rate is $1.3672. A foreign exchange advisory service has predicted that the euro will appreciate to $1.375 within six months.

  15.a.   How would you use forward contracts to profit in the above situation?

  15.b.   How would you use money market instruments (borrowing and lending) to profit?

  15.c.   Which alternatives (forward contracts or money market instruments) would you prefer? Why?
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  CHAPTER 4 PROBLEMS

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  1. 1.   From base price levels of 100 in 2000, Japanese and U. price levels in 2003 stood at 102 and 106, respectively.

  1. a.   If the 2000 $:¥ exchange rate was $0.007692, what should the exchange rate be in 2003?

  1. b.   In fact, the exchange rate in 2003 was ¥ 1 = $0.008696. What might account for the discrepancy? (Price levels were measured using the consumer price index.)

  3. 3.   If expected inflation is 100 percent and the real required return is 5 percent, what will the nominal interest rate be according to the Fisher effect?

  4. 4.   In early 1996, the short-term interest rate in France was 3.7%, and forecast French inflation was 8%. At the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%.

  1. a.   Based on these figures, what were the real interest rates in France and Germany?

  1. b.   To what would you attribute any discrepancy in real rates between France and Germany?

  5. 5.   In July, the one-year interest rate is 12% on British pounds and 9% on U. dollars.

  1. a.   If the current exchange rate is $1.63:£1, what is the expected future exchange rate in one year?

  1. b.   Suppose a change in expectations regarding future U. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?

  7. 7.   Chase Econometrics has just published projected inflation rates for the United States and Germany for the next five years. U. inflation is expected to be 10 percent per year, and German inflation is expected to be 4 percent per year.

  1. a.   If the current exchange rate is $0.95/€, what should the exchange rates for the next five years be?

  3. b.   Suppose that U. inflation over the next five years turns out to average 3.2%, German inflation averages 1.5%, and the exchange rate in five years is $0.99/€. What has happened to the real value of the euro over this five- year period?

  8. 8.   During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7.64/U.S.$. At the same time, U. inflation was approximately 3% in contrast to Mexican inflation of about 48.7%.

  1. a.   By how much did the nominal value of the peso change during 1995?

  1. b.   By how much did the real value of the peso change over this period?

  9. 9.   Suppose three-year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12 percent and 7 percent, respectively. If the current spot rate for the Swiss franc is $0.3985, what is the spot rate implied by these interest rates for the franc three years from now?

  11. 11. Suppose the Eurosterling rate is 15 percent, and the Eurodollar rate is 5 percent. What is the forward premium on the dollar? Explain.

  12. 12. Suppose the spot rates for the euro, pound sterling, and Swiss franc are $1.52, $2.01, and $0.98, respectively.

  The associated 90-day interest rates (annualized) are 8 percent, 16 percent, and 4 percent; the U.S. 90- day rate (annualized) is 12 percent. What is the 90-day forward rate on an ACU (ACU 1 = €1 + £1 + SFr 1) if interest parity holds?

  13. 13. Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectively. If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1:

  1. a.   Where would you invest?

  1. b.   Where would you borrow?

  1. c.   What arbitrage opportunity do these figures present?

  1. d.   Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?

  15. 15. Suppose today’s exchange rate is $1.55/€. The six-month interest rates on dollars and euros are 6 percent and 3 percent, respectively. The six-month forward rate is $1.5478. A foreign exchange advisory service has predicted that the euro will appreciate to $1.5790 within six months.

  1. a.   How would you use forward contracts to profit in the above situation?

  1. b.   How would you use money market instruments (borrowing and lending) to profit?

  1. c.   Which alternatives (forward contracts or money market instruments) would you prefer? Why?
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  ADDITIONAL CHAPTER 4 SOLUTIONS

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  1. 1.   In February 1985, Bolivian inflation reached a monthly peak of 182%. What was the annualized rate of inflation in Bolivia for that month?

  2. 2.   The inflation rate in Great Britain is expected to be 4% per year, and the inflation rate in France is expected to be 6% per year. If the current spot rate is £1 = FF 12.50, what is the expected spot rate in two years?

  3. If the $:¥ spot rate is $1 = ¥218 and interest rates in Tokyo and New York are 6% and 12%, respectively, what is the expected $:¥ exchange rate one year hence?

  4. Suppose that on January 1, the cost of borrowing French francs for the year is 18%. During the year, U.S. inflation is 5%, and French inflation is 9%. At the same time, the exchange rate changes from FF 1 = $0.15 on January 1 to FF 1 = $0.10 on December 31. What was the real U.S. dollar cost of borrowing francs for the year?

  5. 5.   In late 1990, following Britain’s entry into the exchange-rate mechanism of the European Monetary System, 10-year British Treasury bonds yielded 11.5%, and the German equivalent offered a yield of just 9%. Under terms of its entry, Britain established a central rate against the DM of DM 2.95 and pledged to maintain this rate within a band of plus and minus 6%.

  1. By how much would sterling have to fall against the DM over a 10-year period for the German bond to offer a higher overall return than the British one? Assume the Treasuries are zero-coupon bonds with no interest paid until maturity.

  1. How does the exchange rate established in Part a compare to the lower limit that the British government is pledged to maintain for sterling against the DM?

  1. What accounts for the difference between the two rates? Does this difference violate the international Fisher effect?

  6. Assume the interest rate is 11% on pounds sterling and 8% on euros. If the euro is selling at a one-year forward premium of 4% against the pound, is there an arbitrage opportunity? Explain.

  7. If the Swiss franc is $0.68 on the spot market and the 180-day forward rate is $0.70, what is the annualized interest rate in the United States over the next six months? The annualized interest rate in Switzerland is 2%.

  8. 8.   The interest rate in the United States is 8%; in Japan the comparable rate is 2%. The spot rate for the yen is $0.007692. If interest rate parity holds, what is the 90-day forward rate on the Japanese yen?
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  SOLUTIONS TO CHAPTER 4 PROBLEMS

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  1. From base price levels of 100 in 2000, Japanese and S. price levels in 2003 stood at 102 and 106, respectively.

  1. If the 2000 $:¥ exchange rate was $0.007692, what should the exchange rate be in 2003? ANSWER. If e2003 is the dollar value of the yen in 2003, then according to purchasing power parity e2003/0.007692 = 106/102 or e2003 = $0.007994.

  1. b. In fact, the exchange rate in 2003 was ¥ 1 = $0.008696. What might account for the discrepancy? (Price levels were measured using the consumer price in)

  2. Two countries, the United States and England, produce only one good, wheat. Suppose the price of wheat is $3.25 in the United States and is £1.35 in England.

  1. According to the law of one price, what should the $:£ spot exchange rate be?

  3. Suppose the price of wheat over the next year is expected to rise to $3.50 in the United States and to £1.60 in England. What should the one-year $:£ forward rate be?

  1. If the U.S. government imposes a tariff of $0.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur?

  3. 3.   If expected inflation is 100 percent and the real required return is 5 percent, what will the nominal interest rate be according to the Fisher effect?

  4. 4.   In early 1996, the short-term interest rate in France was 7%, and forecast French inflation was 1.8%. At the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%.

  1. Based on these figures, what were the real interest rates in France and Germany?

  1. To what would you attribute any discrepancy in real rates between France and Germany?

  5. 5.   In July, the one-year interest rate is 12% on British pounds and 9% on U.S. do

  1. If the current exchange rate is $1.63:£1, what is the expected future exchange rate in one year?

  1. Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?

  6. 6.   Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is 14%. To the nearest whole number, what is the best estimate of the one-year forward exchange premium (discount) at which the pound will be selling relative to the French franc?

  7. 7.   Chase Econometrics has just published projected inflation rates for the United States and Germany for the next five yea U.S. inflation is expected to be 10 percent per year, and German inflation is expected to be 4 percent per year.

  1. If the current exchange rate is $0.95/€, what should the exchange rates for the next five years be?

  3. Suppose that U.S. inflation over the next five years turns out to average 3.2%, German inflation averages 1.5%, and the exchange rate in five years is $0.99/€. What has happened to the real value of the euro over this five- year period?

  8. 8. During 1995, the Mexican peso exchange rate rose from Mex$5.33/U.S.$ to Mex$7.64/U.S.$. At the same time, U.S. inflation was approximately 3% in contrast to Mexican inflation of about 48.7%.

  1. By how much did the nominal value of the peso change during 1995?

  1. By how much did the real value of the peso change over this period?

  9. Suppose three-year deposit rates on Eurodollars and Eurofrancs (Swiss) are 12 percent and 7 percent, respectively. If the current spot rate for the Swiss franc is $0.3985, what is the spot rate implied by these interest rates for the franc three years from now?

  10. 10. Assume the interest rate is 16 percent on pounds sterling and 7 percent on euros. At the same time, inflation is running at an annual rate of 3 percent in Germany and 9 percent in England.

  1. If the euro is selling at a one-year forward premium of 10 percent against the pound, is there an arbitrage opportunity? Explain.

  1. b.   What is the real interest rate in Germany? in England?

  1. Suppose that during the year the exchange rate changes from €1.8/£1 to €1.77/£1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real cost of borrowing euros.

  1. d.   What are the real costs to a British firm of borrowing euros? Contrast this cost to its real cost of borrowing pounds.

  11. 11. Suppose the Eurosterling rate is 15 percent, and the Eurodollar rate is 11.5 p What is the forward premium on the dollar? Explain.

  12. 12. Suppose the spot rates for the euro, pound sterling, and Swiss franc are $1.52, $2.01, and $0.98, respectively. The associated 90-day interest rates (annualized) are 8 percent, 16 percent, and 4 percent; the U.S. 90- day rate (annualized) is 12 percent. What is the 90-day forward rate on an ACU (ACU 1 = €1 + £1 + SFr 1) if interest parity holds?

  13. 13. Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent and 9 percent, respectiv If the spot rate is ¥142:$1 and the 90-day forward rate is ¥139:$1:

  1. Where would you invest?

  1. b. Where would you borrow?

  1. What arbitrage opportunity do these figures present?
  2. d.   Assuming no transaction costs, what would be your arbitrage profit per dollar or dollar-equivalent borrowed?

  14. 14. Here are some prices in the international money markets:

  Spot rate

  Forward rate (one year) Interest rate (€)

  Interest rate ($)

  = $1.46/€

  = $1.49/€

  = 7% per year

  = 9% per year

  1. Assuming no transaction costs or taxes exist, do covered arbitrage profits exist in the above situation? Describe the flows.

  1. Suppose now that transaction costs in the foreign exchange market equal 0.25% per transaction. Do unexploited covered arbitrage profit opportunities still exist?

  1. Suppose no transaction costs exist. Let the capital gains tax on currency profits equal 25%, and the ordinary income tax on interest income equal 50%. In this situation, do covered arbitrage profits exist? How large are they? Describe the transactions required to exploit these profits.

  15. 15. Suppose today’s exchange rate is $1.55/€. The six-month interest rates on dollars and euros are 6 percent and 3 percent, respectively. The six-month forward rate is $1.547 A foreign exchange advisory service has predicted that the euro will appreciate to $1.5790 within six months.

  1. How would you use forward contracts to profit in the above situation?

  1. How would you use money market instruments (borrowing and lending) to profit?

  1. Which alternatives (forward contracts or money market instruments) would you prefer? Why?
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  ADDITIONAL CHAPTER 4 ANSWERS

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  1. 1. If the dollar is appreciating against the Polish zloty in nominal terms but depreciating against the zloty in real terms, what do we know about Polish and U.S. inflation rates?

  2. 2. Suppose the nominal peso/dollar exchange rate is fixed. If the inflation rates in the Mexico and the United States are constant (but not necessarily equal in both countries), will the real value of the peso/dollar exchange rate also be constant over time?

  3. 3. If the average rate of inflation in the world rises from 5% to 7%, what will be the likely effect on the S. dollar’s forward premium or discount relative to foreign currencies?

  4. Comment on the following statement. “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.”

  5. The empirical evidence shows that there is no consistent relationship between the spot exchange rate and the nominal interest rate differential. Why might this be?

  6. During 1988, the U.S. prime rate–the rate of interest banks charge on loans to their best customers–stood at 9.5%. Japan’s prime rate, meanwhile, was about 3.5%. Pointing to that discrepancy, a number of commentators argued that the cost of capital must come down for U.S. business to remain competitive with Japanese companies. What additional information would you need to properly assess this claim? Why might interest rates be lower in Japan than in the U.S.?

  7. In the late 1960s, Firestone Tire decided that Swiss francs at 2% were cheaper than U.S. dollars at 8% and borrowed about SFr 500 million. Comment on this choice.

  8. Comment on the following quote from a story in the Wall Street Journal (August 27, 1984, p. 6) that discusses the improving outlook for Britain’s economy: “Recovery here will probably last longer than in the U.S. because there isn’t a huge budget deficit to pressure interest rates higher.”

  9. Comment on the following headline that appeared in the Wall Street Journal (December 19, 1990, p. C10): “Dollar Falls Across the Board as Fed Cuts Discount Rate to 6.5% From 7%.” The discount rate is the interest rate the Fed charges member banks for loans.

  10. 10. In late 1990, the U.S. government announced that it might try to reduce the budget deficit by imposing a 0.5% transfer tax on all sales and purchases of securities in the United States, with the exception of Treasury securities. It projected the tax would raise $10 billion in federal revenues–an amount arrived at by multiplying 0.5% by the value of the $2 trillion trading on the New York Stock Exchange each year.

  1. What are the likely consequences of this tax? Consider its effects on trading volume in the United States and stock and bond prices.

  1. b. Why does the S. government plan to exclude its securities from this tax?

  1. Critically assess the government’s estimates of the revenue it will raise from this tax.
  2. 11. It has been argued that the S. government’s economic policies, particularly as they affect the U.S. budget deficit, are severely constrained by the world’s financial markets. Do you agree or disagree? Discuss.

  12. 12. In 1991, the U. government imposed a stiff import tariff on the active-matrix LCD screens that now appear in next-generation laptop computers.

  1. Assess the likely consequences of the import duty for U.S. laptop computer manufacturers.

  1. How are these manufacturers likely to react to this import duty?

  13. “High real interest rates can be a cause for celebration, not alarm.” Discuss.

  14. 14. In an integrated world capital market, will higher interest rates in, say Japan, mean higher interest rates in, say, the United States?

  15. 15. In France in 1994, short-term interest rates and bond yields remained higher than in Germany, despite a better outlook for inflation in Fran Does this situation indicate a violation of the Fisher effect? Explain.

  16. 16. On February 15, 1993, President Clinton previewed his State of the Union message to Congress in a toughly- worded talk on television about how the growing federal budget deficit made tax increases necessa Financial markets reacted by pushing bond prices up and pummeling stock prices. President Clinton said that the rise in Treasury bond prices was a “very positive” response to his televised speech the night before. How would you interpret the reaction of the financial markets to President Clinton’s speech?

  17. 17. At the same time that it was talking down the dollar, the Clinton Administration was talking about the need for low interest rates to stimulate economic growth. Comment.

  18. 18. One idea to curb potentially destabilizing international movements of capital has been devised by James Tobin, a Nobel Prize-winning He proposes putting a small tax on foreign exchange transactions. He claims that his “Tobin tax” would make short-term speculation more costly while having little effect on long-term investment.

  1. Why would the Tobin tax have a disproportionate impact on short-term investments?

  1. Is the Tobin tax likely to accomplish its objective? Explain.
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  ANSWERS TO CHAPTER 4 QUESTIONS

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  1. a.   What is purchasing power parity?

  1. What are some reasons for deviations from purchasing power parity?

  1. Under what circumstances can purchasing power parity be applied?

  2. 2.   One proposal to stabilize the international monetary system involves setting exchange rates at their purchasing power parity Once exchange rates are correctly aligned (according to PPP), each nation would adjust its monetary policy so as to maintain them. What problems might arise from using the PPP rate as a guide to the equilibrium exchange rate?

  3. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S. prices. Is the Indonesian rupiah appreciating or depreciating in real terms

  4. Comment on the following statement. “It makes sense to borrow during times of high inflation because you can repay the loan in cheaper dollars.”

  5. 5.   Which is likely to be higher, a 150% ruble return in Russia or a 15% dollar return in the United States?

  6. 6.   The interest rate in England is 12%, while in Switzerland it is 5%. What are possible reasons for this interest rate differential? What is the most likely reason?

  7. From 1982 to 1988, Peru and Chile stand out as countries whose interest rates are not consistent with their inflation experience. Specifically, Peru’s inflation and interest rates averaged about 125% and 8%, respectively, over this period, whereas Chile’s inflation and interest rates averaged about 22% and 38%, respectively.

  1. How would you characterize the real interest rates of Peru and Chile (e.g., close to zero, highly positive, highly negative)?

  1. What might account for Peru’s low interest rate relative to its high inflation rate? What are the likely consequences of this low interest rate?

  1. What might account for Chile’s high interest rate relative to its inflation rate? What are the likely consequences of this high interest rate?

  1. During the same period, Peru had a small interest differential and yet a large average exchange rate change. How would you reconcile this experience with the international Fisher effect and with your answer to part b?

  8. From 1982 to 1988 a number of countries (e.g., Pakistan, Hungary, and Venezuela) had a small or negative interest rate differential and a large average annual depreciation against the dollar. How would you explain these data? Can you reconcile these data with the international Fisher effect?

  9. What factors might lead to persistent covered interest arbitrage opportunities among countries?

  10. 10. In early 1989, Japanese interest rates were about 4 percentage points below S. rates. The wide difference between Japanese and U.S. interest rates prompted some U.S. real estate developers to borrow in yen to finance their projects. Comment on this strategy.

  11. 11. In early 1990, Japanese and German interest rates rose while S. rates fell. At the same time, the yen and DM fell against the U.S. dollar. What might explain the divergent trends in interest rates?

  12. In late December 1990, one-year German Treasury bills yielded 9.1%, whereas one-year U.S. Treasury bills yielded 6.9%. At the same time, the inflation rate during 1990 was 6.3% in the United States, double the German rate of 3.1%.

  1. Are these inflation and interest rates consistent with the Fisher effect?

  1. What might explain this difference in interest rates between the United States and Germany?

  13. 13. The spot rate on the euro is $1.39, and the 180-day forward rate is $41. What are possible reasons for the difference between the two rates?

  14. 14. German government bonds, or Bunds, currently are paying higher interest rates than comparable U.S. Treasury bond Suppose the Bundesbank eases the money supply to drive down interest rates. How is an American investor in Bunds likely to fare?

  15. 15. In 1993 and early 1994, Turkish banks borrowed abroad at relatively low interest rates to fund their lending at hom The banks earned high profits because rampant inflation in Turkey forced up domestic interest rates. At the same time, Turkey’s central bank was intervening in the foreign exchange market to maintain the value of the Turkish lira. Comment on the Turkish banks’ funding strategy.
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  INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGN EXCHANGE RATES 2

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  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 7 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. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar.

  (a) Keep the funds at your bank in the U.S. and buy £35,000 forward.

  (b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to £35,000.

  Evaluate each payment method. Which method would you prefer? Why?

  3. 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% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.
  4. Determine whether the interest rate parity is currently holding.

  1. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.
  2. Explain how the IRP will be restored as a result of covered arbitrage activities.

  4. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is €0.7813/$. The three-month interest rate is 5.6 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or €800,000.

  1. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.
  2. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros.

  5. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollar and the Turkish lira?

  6. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, respectively. How would you forecast the exchange rate to be at around November 1, 2000?

  7. (CFA question) 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 level	105
  Current South African price level	111
  Base rand spot exchange rate	$0.175
  Current rand spot exchange rate	$0.158
  Expected annual U.S. inflation	7%
  Expected annual South African inflation	5%
  Expected U.S. one-year interest rate	10%
  Expected South African one-year interest rate	8%

  Calculate the following exchange rates (ZAR and USD refer to the South African and U.S. dollar, respectively).

  1. 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.
  2. Using PPP, the expected ZAR spot rate in USD four years from now.

  8. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.

  1. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.
  2. b. Discuss how the interest rate parity may be restored as a result of the above transactions

  1. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.

  9. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently $1.50/£.

  1. Compute the nominal interest rate per annum in both the U.S. and U.K., assuming that the Fisher effect holds.
  2. b. What is your expected future spot dollar-pound exchange rate in three years from now?

  1. Can you infer the forward dollar-pound exchange rate for one-year maturity?

  10. After studying Iris Hamson’s credit analysis, George Davies is considering whether he can increase the holding period return on Yucatan Resort’s excess cash holdings (which are held in pesos) by investing those cash holdings in the Mexican bond market. Although Davies would be investing in a peso- denominated bond, the investment goal is to achieve the highest holding period return, measured in U.S. dollars, on the investment. Davies finds the higher yield on the Mexican one-year bond, which is considered to be free of credit risk, to be attractive but he is concerned that depreciation of the peso will reduce the holding period return, measured in U.S. dollars. Hamson has prepared selected economic and financial data, given in Exhibit 3-1, to help Davies make the decision.

  Selected Economic and Financial Data for U.S. and Mexico Expected U.S. Inflation Rate                                                         2.0% per year Expected Mexican Inflation Rate                                                 6.0% per year U.S. One-year Treasury Bond Yield                                             2.5%

  Mexican One-year Bond Yield                                                     6.5%

                                                               Nominal Exchange Rates                                                      

  Spot                                                                                   9.5000 Pesos = U.S. $ 1.00

  One-year Forward                                                             9.8707 Pesos = U.S. $ 1.00

  Hamson recommends buying the Mexican one-year bond and hedging the foreign currency exposure using the one-year forward exchange rate. She concludes: “This transaction will result in a U.S. dollar holding period return that is equal to the holding period return of the U.S. one-year bond.”

  1. Calculate the U.S. dollar holding period return that would result from the transaction recommended by Hamson. Show your calculations. State whether Hamson’s conclusion about the U.S. dollar holding period return resulting from the transaction is correct or incorrect

  After conducting his own analysis of the U.S. and Mexican economies, Davies expects that both the U.S. inflation rate and the real exchange rate will remain constant over the coming year. Because of favorable political developments in Mexico, however, he expects that the Mexican inflation rate (in annual terms) will fall from 6.0 percent to 3.0 percent before the end of the year. As a result, Davies decides to invest Yucatan Resorts’ cash holdings in the Mexican one-year bond but not to hedge the currency exposure.

  1. b. Calculate the expected exchange rate (pesos per dollar) one year from Show your calculations.

  Note: Your calculations should assume that Davies is correct in his expectations about the real exchange rate and the Mexican and U.S. inflation rates.

  1. Calculate the expected U.S. dollar holding period return on the Mexican one-year bond. Show your calculations. Note: Your calculations should assume that Davies is correct in his expectations about the real exchange rate and the Mexican and U.S. inflation rates.

  11. Jason Smith is a foreign exchange trader with Citibank. He notices the following quotes.

  Spot exchange rate                                                           SFr1.6627/$ Six-month forward exchange rate                                   SFr1.6558/$ Six-month $ interest rate                                                 3.5% per year

  Six-month SFr interest rate                                               3.0% per year

  1. Ignoring transaction costs, is the interest rate parity holding?

  1. b. Is there an arbitrage possibility? If yes, what steps would be needed to make an arbitrage profit?

  Assuming that Jason Smith is authorized to work with $1,000,000 for this purpose, how much would the arbitrage profit be in dollars?

  12. Mini Case: Turkish Lira and the Purchasing Power Parity

  Veritas Emerging Market Fund specializes in investing in emerging stock markets of the world. Mr. Henry Mobaus, an experienced hand in international investment and your boss, is currently interested in Turkish stock markets. He thinks that Turkey will eventually be invited to negotiate its membership in the European Union. If this happens, it will boost the stock prices in Turkey. But, at the same time, he is quite concerned with the volatile exchange rates of the Turkish currency. He would like to understand what drives the Turkish exchange rates. Since the inflation rate is much higher in Turkey than in the U.S., he thinks that the purchasing power parity may be holding at least to some extent. As a research assistant for him, you were assigned to check this out. In other words, you have to study and prepare a report on the following question: Does the purchasing power parity hold for the Turkish lira-U.S. dollar exchange rate? Among other things, Mr. Mobaus would like you to do the following:

  1. Plot the past exchange rate changes against the differential inflation rates between Turkey and the U.S. for the last four years.

  1. b. Regress the rate of exchange rate changes on the inflation rate differential to estimate the intercept and the slope coefficient, and interpret the regression

  Data source: You may download the consumer price index data for the U.S. and Turkey from the following website: http://www.oecd.org/pages/0,3417,en_33816563_33816769_1_1_1_1_1,00.html, “hot file” (Excel format) . You may download the exchange rate data from the website: http://pacific.commerce.ubc.ca/xr/data.html.
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  INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGN EXCHANGE RATES 1

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  1. Give a full definition of arbitrage.

  2. Discuss the implications of the interest rate parity for the exchange rate determination.

  3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.

  4. Explain the purchasing power parity, both the absolute and relative versions. What causes   the deviations from the purchasing power parity?

  5. Discuss the implications of the deviations from the purchasing power parity for countries’ competitive positions in the world market.

  6. Explain and derive the international Fisher effect.

  7. Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding

  8. Explain the random walk model for exchange rate forecasting. Can it be consistent with the technical analysis?

  *9. Derive and explain the monetary approach to exchange rate determination.

  10. Explain the following three concepts of purchasing power parity (PPP):

  1. The law of one price. b. Absolute PPP.
  2. Relative PPP.

  11.  Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on:

  1. Short-term basis (for example, three months)

  1. b. Long-term basis (for example, six years)
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  International Finance: SOLUTIONS TO Chapter 11(b) PROBLEMS

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  3. Gizmo, U.S.A. is investigating medium‑term financing of $10 million in order to build an addition to its factory in Toledo, Ohio. Gizmo’s bank has suggested the following alternatives:

  Type of loan	Rate
  3-year U.S. dollar loan 3-year Euro loan 3-year Swiss franc loan	14 8 4

  1. What information does Gizmo require to decide among the three alternatives?

  1. Suppose the factory will be built in Geneva, Switzerland, rather than Toledo. How does this affect your answer in part a?

  5. In September 1992, Dow Chemical reacted to the currency chaos in Europe by switching to Euro pricing for all its products in Europe. The purpose, said a Dow executive, was to shift currency risk from Dow to its European customers. Moreover, said the Dow executive, the policy was fairer: By setting the same DM price throughout Europe, Dow’s new policy would nullify any advantage that a Dow customer in one company might have over competitors in another country based on currency swings.

  1. What is Dow really trying to accomplish with its new pricing policy?

  1. What is the likelihood that this new policy will reduce Dow’s currency risk?

  1. How are Dow’s customers likely to respond to this new policy?

  8. Cost Plus Imports is a West Coast chain specializing in low‑cost imported goods, principally from Japan. It has to put out its semiannual catalogue with prices that are good for six months. Advise Cost Plus Imports on how it can protect itself against currency risk.

  11. Lyle Shipping, a British company, has chartered out ships at fixed‑U.S.‑dollar freight rates. How can Lyle use financing to hedge against its exposure? How will your recommendation affect Lyle’s translation exposure? Lyle uses the current rate method to translate foreign currency assets and liabilities. However, the charters are off‑balance‑sheet items.

  13. In 1985, Japan Airlines (JAL) bought $3 billion of foreign exchange contracts at ¥180/$1 over 11 years to hedge its purchases of U.S. aircraft. By 1994, with the yen at about ¥100/$1, JAL had incurred more than $1 billion in cumulative foreign exchange losses on that deal.

  1. What was the economic rationale behind JAL’s hedges?

  1. Did JAL’s forward contracts constitute an economic hedge? That is, is it likely that JAL’s losses on its forward contracts were offset by currency gains on its operations?

  16. In 1990, a Japanese investor paid $100 million for an office building in downtown Los Angeles. At the time, the exchange rate was ¥145/$1. When the investor went to sell the building five years later, in early 1995, the exchange rate was ¥85/$1 and the building’s value had collapsed to $50 million.

  1. What exchange risk did the Japanese investor face at the time of his purchase?

  1. How could the investor have hedged his risk?