International Finance
Semester 2, 2024-2025 Assignment 1
Due Week 6
1. (20 marks) Consider a Dutch investor with 1000 euros to place in a bank deposit in either the Netherlands or Great Britain. The (one-year) interest rate is 1% in Britain and 5% in the Netherlands. The (one-year) forward euro-pound exchange rate is 1.65 euros per pound and the spot rate is 1.5 euros per pound.
a. What is the euro-denominated return on Dutch deposits for this investor?
b. What is the (riskless) euro-denominated return on British deposit for this investor using forward cover?
c. Is there an arbitrage opportunity here? Explain why or why not. Is this an equilibrium in the forward exchange rate market?
d. If the spot rate and the interest rates are as stated previously, what is the equilibrium forward rate, according to covered interest parity?
e. If both covered and noncovered interest parity holds, what is the expected depreciation of the euro against the pound over one year?
2. (20 marks) Show how each of the following would affect the U.S. balance of payments. Include a description of the debit and credit items, and in each case identify which specific account and how it is affected.
a. A California computer manufacturer purchases a $50 hard disk from a Malaysian company, paying the funds from a bank account in Malaysia.
b. A U.S. tourist to Japan sells his iPhone to a local resident for yen worth $1000. He carries the money in cash to the U.S. and keeps it at home.
c. The U.S. central bank purchases $500 million worth of U.S. Treasury bonds from a British financial firm and sells pound sterling from its foreign exchange reserves.
d. A U.S. owner of Sony shares receives $10,000 in dividend payments, which are paid into a Tokyo bank.
e. The U.S. government forgives a $50 million debt owed by a developing country.
3. (20 marks) Use the money market and foreign exchange diagrams to answer the following questions. The question considers the relationship between the pound sterling and the U.S. dollar. The exchange rate is in dollar per pound. On all graphs, label the initial equilibrium point A.
a. Illustrate how a permanent decrease in U.K.’s money supply affects the money and foreign exchange markets. Label your short-run equilibrium point B and your long-run equilibrium point C. State how British interest rate, expected exchange rate, and price level change in the short-run and in the long run (increase/ decrease/ no change relative to their initial values at point A).
b. By plotting them on a chart with time on the horizontal axis, illustrate how each of the following variables changes over time for the U.K.: nominal money supply, price level, real money supply, interest rate, and the exchange rate.
4. (20 marks) Use the table below to answer this question. Treat the country listed as the home country, and treat the U.S. as the foreign country Suppose the cost of the market basket in the U.S. is PUS = $190. Determine and explain whether we should expect a real appreciation or real depreciation for each country (relative to the U.S.) in the long run.
|
Country (in FX units)
|
Per USD
EFX/$
|
Price of market basket in FX
|
Price of U.S. Basket in FX
|
FX/ Real exchange rate
|
Does PPP hold? (yes/no)
|
Is FX currency overvalued or undervalued
|
|
Brazil (real)
|
4.07
|
520
|
|
|
|
|
|
India (rupee)
|
68.51
|
12000
|
|
|
|
|
|
Mexico (peso)
|
18.89
|
1800
|
|
|
|
|
|
South Africa (rand)
|
15.78
|
800
|
|
|
|
|
|
Zimbabwe (Z$)
|
101,347
|
4,000,000
|
|
|
|
|
5. (20 marks) Consider two countries: Japan and Korea. Prices are flexible and PPP is assumed to hold. The real money demand function in both countries has the same form. L(R,Y) = aY (a > 0 is a constant and money demand is proportional to the output and independent of the interest rate). Japan experienced relatively slow output growth (1%), While Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed the money supply to grow by 2% each year, while the Bank of Korea chose to maintain relatively high money growth of 15% per year. Use the monetary approach for the analysis of the following problems.
a. What is the inflation rate in South Korea?
b. What is the expected rate of depreciation in the won relative to Japanese yen?
c. Suppose the Bank of Korea decreases the money growth rate from 15% to 12%. What is the new inflation rate in Korea? How will the interest rate difference between Korea and Japan be affected?
d. Draw diagrams to illustrate how the change in c affects the money supply, Korea’s interest rate, prices, real money supply, and the won/yen exchange rate (the won price of a yen) over time.
e. Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What money growth rate would the Bank of Korea have to choose to keep the value of won fixed relative to the yen?