Merrill Lynch Investment Banking Institute

August 2006

International Finance Sessions

Professor Gordon Bodnar

Problem Set #1

Some of the problems require that you obtain the data file: ps1data.xls from my program web page at The data file is an MS Excel file and contains nominal exchange rates (all in USD/FC), and various price indexes for several countries over the period January 1973 – May 2006. Download the file by clicking on it and following the prompts.

  1. Exchange Rate Games
  1. The following is a table of spot exchange rates. Based upon the provided information fill in the missing values.

Express rates as S(Currency in Top Row/ Currency in First Column)

S(top row/first col) / USD / EUR / JPY / GBP / CAD
USD / 1.00 / 107.25 / 0.5383
EUR / 1.2575
JPY
GBP
CAD / 0.9018
  1. You are told that the rates for exchanging currencies are:

JPY 107.25 = USD1 USD 1.2575 = EUR 1 USD 1.8575 = GBP 1

Please state the following relative prices as S(·/·):

  1. the price of yen in terms of dollars
  2. the dollar price of euros
  3. the number of pounds per dollar
  1. Suppose the USD strengthened relative to the JPY but weakened relative to the EUR and GBP. Which way would the following exchange rates move (up or down)?

i. S(JPY/USD) ii. S(USD/EUR)iii. S(GBP/USD)

  1. You see the following info in the Financial Times (these are interbank market quotes)

Currencymidpointbid – ask90 day swap points

Swiss Franc (CHF) 1.2511505 – 51630/20

Canadian Dollar(CAD) 1.1065060 – 069 15/25

Australian Dollar (AUD) 0.7753748 – 75840/50

i. At what price could you …

a. Buy CHF with USD b. Sell CAD for USD c. Sell USD for AUD

  1. How many AUD would you get if you started with CHF1,000 and transacted today?
  2. What is the 90-day forward rate at which you can sell CHF for USD?
  3. How many CAD could you assure yourself of receiving in 90 days if you were to have access to USD15,000 in 90 days?

For the next three questions and attach a graph and a small table of the relevant numbers to support your answers.

  1. Effective XR Index

Consider a US firm with operations in the UK, Mexico, and Brazil. Ps1data.xls contains monthly data on exchange rates for these three countries.

  1. Suppose the firm has 50% of its foreign sales in the UK, 35% in Mexico, and 15% in Brazil. Determine the effective exchange rate index for the firm for the period January 2000 – December 2005. Choose January 2000 as the base year for the index.
  2. Determine whether the effective FC value of the US dollar for the firm has appreciated or depreciated between January 2000 and December 2005. Determine the percentage change in the USD value of this weighted foreign currency index.
  1. British Pound Real Exchange Rates

Calculate and graph a real exchange rate index (with a base period of June 1973 = 1.00) based upon consumer prices (CPI), for the USD/GBP exchange rate over the period 1973:6 – 2006:2.

  1. In September 1992, the GBP left the exchange rate mechanism of the European Monetary System and depreciated sharply. Discuss the size of this devaluation (by February 1993) in terms of PPP for the GBP versus the USD.
  2. Based upon APPP, is the USD expected to appreciate or depreciate in real terms against the GBP in the future? For February 2006, determine the percentage under/overvaluation of the USD against the GBP. (Be careful about the size and sign)
  1. Mexican Peso Inflation Adjusted Exchange Rates

Mexico last devalued their currency in December of 1987. Assume that the exchange rate at the end of January 1988 is a good approximation of an equilibrium rate (benchmark for APPP).

  1. Using both the CPI and WPI data, plot the inflation-adjusted exchange rates for the MXP/ USD exchange rate and the actual nominal exchange rates from January 1988 onward.
  2. Using the plot, discuss the size of the nominal peso devaluation in mid December 1994 (between Nov and Dec 1994 data) in terms the inflation-adjusted exchange rates. How did the devaluation size compare with the predictions of APPP? (approximately)
  3. Identify the inflation adjusted exchange rate levels using WPI for February 2006. Compare this with the nominal rate at this time. Determine the % over or under valuation for the nominal exchange rate. (% overvaluation of MXP = [NXR(USD/MXP) – IAXR(USD/MXP))/IAXR(USD/MXP)]. Compare this to the extent of overvaluation in November 1994 just prior to the devaluation. Do you see evidence to be concerned about another possible devaluation of the MXP?
  1. Parity Conditions

The following table shows some interest rates and exchange rates for the Australian dollar (AUD) and the Danish Krone (DKR). The current spot exchange rate for AUD in terms of DKR is 4.3835 (DKR/AUD).

  1. Complete the missing entries using the exact formulas (ratios) for the parity calculations. Determine short term interests rates (1 YR and less) to the closest 32nd of a percent and other entries to the same precision as given. (annualization factor is 360 days)

Horizon 3 Months6 Months1 Year5 year

k = 90 k = 182 k = 365 n = 5

AUD interest rate (annual) 5 1/16%5 3/16% v.6.25%

DKR interest rate (annual) 2 11/16% iii.3 1/4%3.58%

Forward rate (DKR/AUD) i. iv.4.2886 vii.

Forward premium on DKR, (annual %/yr) ii.2.279% vi. viii.

  1. If you expect Australian inflation for the next year to be 3.5% and we assume the Fisher Effect holds internationally, what it is the expected global real rate of interest for one year and what is inflation expected to be in Denmark over the coming year? (use exact formulas)
  2. If inflation in Australia is expected to average 3.5% per year over the next 5 years and inflation in Denmark is expected to average the rate in part b per year over the next 5 years, determine the expected exchange rate Et(S(DKR/AUD)t+5Y) based upon Relative Purchasing Power Parity.
  3. Given the 5 year interest rates for these currencies, use the linear form of long horizon Interest Rate Parity (or International Fisher Effect) to determine a set of annual exchange rate forecasts for years 1 – 5. (Hint: use the implied annualized forward premium from these rates to project out the spot rate into years 1 – 5.)
  1. Exchange Rate Behavior

On June 30, 2004 the FED raised US interest rates by 25 basis points. Simple economic reasoning would suggest that the higher US interest rates should attract foreign capital into the US and raise the FC value of the USD. However, in response to the rate increase, the value of the dollar fell slightly against all major currencies. Foreign central banks did not alter their interest rates on that day. Offer a rational economic explanation for this apparently illogical behavior of the exchange rate in response to the US interest rate increase.

ML Investment Banking Institute: August 2006 Problem Set #1 p. 1