Assignment #4: International Parity Conditions

1. Suppose the 5-year interest rate on a dollar-denominated pure discount bond is 4.5% p.a., whereas
in France, the euro interest rate is 7.5% p.a. on a similar pure discount bond denominated in euros.
If the current spot rate is $1.08/, what is the value of the forward exchange rate that prevents
covered interest arbitrage?

2. Assume that you are an importer of grain into Japan from the United States. You have agreed to
make a payment in dollars, and you are scheduled to pay $377,287 in 90 days after you receive
your grain. You face the following exchange rates and interest rates:

Spot exchange rate:

106.35/$

90-day forward exchange rate: 106.02/$

90-day dollar interest rate:

3.25% p.a.

90-day yen interest rate:

1.9375% p.a.

a. Describe the nature and extent of your transaction foreign exchange risk.
b. Explain two ways to hedge the risk.
c. Which of the alternatives in part b is superior?

3. Suppose the government releases information that causes people to expect that the purchasing
power of a money in the future will be less than they previously had expected. What will happen
to the exchange rate today? Why?

4. Currently, the spot exchange rate is $1.50/ and the three-month forward exchange rate is $1.52/.
The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K.
Assume that you can borrow as much as $1,500,000 or 1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.

5. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$.
The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6%
and 20.0%, respectively. What would you forecast the exchange rate to be at around November 1,
2000?

6. Suppose that you are trying to decide between two job offers. One consulting firm offers you
$150,000 per year to work out of its New York office. A second consulting firm wants you to
work out of its London office and offers you 100,000 per year. The current exchange rate is
$1.65/. Which offer should you take, and why? Assume that the PPP exchange rate is
$1.40/ and that you are indifferent between working in the two cities if the purchasing power of
your salary is the same.

7. Suppose that in 2008, the Japanese rate of inflation is 2%, and the German rate of inflation is 5%.
If the euro weakens relative to the yen by 10% during 2008, what would be the magnitude of the
real depreciation of the euro relative to the yen?