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1. From base price levels of 100 in 1987, West German and U.S. price levels in 1988 stood at 102 and 106, respectively. If the 1987 $/DM exchange rate was $0.54, what should the exchange rate be in 1988? In fact, the exchange rate in 1988 was DM 1 = $0.56. What might account for the discrepancy? (Price levels were measured using the consumer price index.)

3. In early 1996, 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%.

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?

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

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

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?

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

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?

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

10. 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?

12. 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?

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

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

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

2. Suppose that during the year the exchange rate changes from Euro2.7/£1 to Euro2.65/£1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real cost of borrowing Euro

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

15. Suppose today’s exchange rate is $0.62/Euro. The 6-month interest rates on dollars and Euro are 6% and 3%, respectively. The 6-month forward rate is $0.6185. A foreign exchange advisory service has predicted that the Euro will appreciate to $0.64 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?