• Southern Methodist University

• FINA 6214

 Unless specified, the quotes are in “trader convention,” i.e. EUR/USD refers to the number of USD per EUR 1. (1) Use the exchange rate table below to answer the questions. All rates are against USD. USD is CCY2 for GBP and EUR but is CCY1 for all other currencies. a. What are the closing bid and offer rates for USD/CHF? ANSWER: Bid _0.9514_ Offer _0.9518_ (in terms of number of CHF per USD 1) b. Does the “% Change” indicate that USD appreciated or depreciated against EUR? ANSWER: Appreciated c. As a customer, which rate would you get if you were to convert CAD to USD? ANSWER: 1.2867 (or, CAD 1 = 1/1.2867 = USD 0.7772) d. What is the amount of USD that you need in order to buy JPY 10,000? ANSWER: USD 93.5541 (calculated by dividing 10,000 by 106.89) (2) Suppose the 6-month (annualized) interest rates are 1.00% for USD and 0.50% for EUR. The current spot rate is USD 1.1000/ EUR. For simplicity, assume that for 6 months, you earn half of the annualized interest rates. a. What is the arbitrage-free 6-month forward EUR/USD? ANSWER: 1.1027 (calculated as 1.1 x (1 + 0.01/2)/(1 + 0.005/2)) FINA 6214 International Financial Markets 2 b. If the 6-month forward rate is 1.1000 as opposed to the rate in (a), describe briefly the four transactions you need to make to earn arbitrage profits? ANSWER: Since EUR is undervalued in the forward market, you want to buy it forward. This means you will need to “buy EUR forward against USD, borrow EUR, sell EUR spot against USD, and lend or deposit USD.” (3) The USD/BRL spot rate is 3.00. The gasoline prices (per gallon) are BRL 10.50 in Brazil and USD 2.50 in the U.S. a. According to PPP, is BRL overvalued or undervalued relative to USD? Recall that the same good is more (less) expensive in the country with overvalued (undervalued) currency. ANSWER: Overvalued. (PPP-implied rate = price in BRL/price in USD = 10.5/2.5 = 4.2. This is greater than the market exchange rate of 3.0.) b. Speculate: Why might this deviation from PPP (based on gasoline prices) persist? ANSWER: The answer can be anything that makes goods market arbitrage difficult or impossible. For example, gasoline is a regulated commodity in Brazil and possibly subject to high (sales) tax rate. ** Please use the data and setups in the excel file: “Problem Set 1.xlsx” to answer questions (4) – (5). Each sheet in the file corresponds to the question of the same number. ** (4) UIRP is overwhelmingly rejected in the data. On average, high-interest rate currencies do not depreciate as much against lower-interest rate currencies as predicted by UIRP. In the long exercise below, we will try to take advantage of this violation. Go to sheet “Question 4”. Here, I am asking you to implement “carry trades”, borrowing low-yielding currencies and depositing high-yielding currencies (uncovered). We are going to use the data for 6 currencies from 5/31/1990 to 6/30/2010. Columns B to D contain the time series of 1-month annualized interest rates, and columns I to N contain the corresponding exchange rates, expressed in terms of USD per 1 unit of foreign currency. In columns P to U, I have calculated for you the currency returns measured against USD. These returns include both the change in exchange rate and the money market return. That is, the return of Currency A from time t to t