Chapter67Homework

#6)Currency Effects on Economy What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal?

A weak home currency would have many impacts on the economy, as imports would decrease because of decreased purchasing power abroad and exports would increase because foreigners can get more for their money. This would shift the balance of trade. This would also increase demand for labor, lowering unemployment. However, things like inflation would increase and prices would subsequently go up. A strong currency, on the other hand, would increase demand for imports and reduce exports while minimizing inflation.

#10)Intervention Effects on Bond Prices U.S. bond prices are normally inversely related to U.S. inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected?

If the Fed used intervention to weaken the dollar, bond prices could be affected by the expected rate of inflation. Because there would be downward pressure on the dollar, inflation would increase and prices would go up. This would in turn increase interest rates, causing bond prices to go down.

#11.)Direct Intervention in Europe If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth?

The European Central Bank could use intervention to stimulate the economy by selling euros against other currencies to force euro depreciation. This would lead to greater exports and demand for euros, which would help stimulate the economy.

#19.)Pegged Currencies Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg?

I think a country would peg its currency to reduce instability in its own exchange rate. This way, it would help create more consistency and allow individuals and businesses to have more security regarding the future value changes. It can be broken if something happens in the country that makes it incapable of keeping it tied to the other currency, such as significant political instability or investors who believe that it will not be maintainable. If many investors move away from domestic investments in large amounts, this will hurt the value and cause it to break even if it has not broken away yet.

Ch.7

#5)Covered Interest Arbitrage: Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible.

Covered interest arbitrage is when investors try to protect themselves from exchange rate risk using forward contracts on investments in foreign currency, where they are able to gain from interest differentials. For it to be plausible, it would require the cost of hedging in regards to the exchange risk is below the gained return from investment in a currency with a higher yield, which is uncommon because investors will immediately take advantage of such situation, which causes the imbalance to shift as demand increases.

#18.)Limitations of Covered Interest Arbitrage Assume that the 1-year U.S. interest rate is 11 percent, while the 1-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase the currency of that country from you 1 year from now at a discount of 13 percent. Would covered interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest arbitrage in this situation? (Ignore tax effects.)

In this case, covered interest arbitrage would be a good strategy to employ if possible because the return would be higher than the interest rate in the U.S. However, it would have to be converted back to US dollars, and this could be complicated by other factors in Malaysia.

27.)Interpreting Changes in the Forward Premium Assume that interest rate parity holds. At the beginning of the month, the spot rate of the Canadian dollar is $.70, while the 1-year forward rate is $.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the 1-year forward rate is higher than it was at the beginning of the month. Yet, the 1-year forward discount is larger (the 1-year premium is more negative) at the end of the month than it was at the beginning of the month. Explain how the relationship between the U.S. interest rate and the Canadian interest rate changed from the beginning of the month until the end of the month.

Here, we can see that the spot rate for the U.S. interest rate must be lower than Canada’s because of the forward discount at the beginning of the month. What likely happened is that the interest rates in Canada could have gone up at a faster rate than the rates in the U.S. so that over the course of the month, the difference between the two was greater than at the beginning.

30.)Testing IRP The 1-year interest rate in Singapore is 11 percent. The 1-year interest rate in the United States is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46. Assume zero transaction costs.

a. Does interest rate parity exist?

Interest rate parity does not exist because the interest rate differential is less than the discount.

b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage?

A U.S. firm would not benefit from such an investment because the interest rate benefits from a Singapore investment would be less than the discount on a forward sale.