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1. (5 points) The table below gives information on foreign trade for a country.
a. Using the initial information, what is the country’s trade deficit?
b. If the government undertakes policies to depreciate the currency 18%, what will be the immediate effect on the trade balance?
c. After the pass-through period (when the quantity has fully adjusted to the new numbers given below and the exchange rates are still at the new rate), what will the trade balance be?
2. (5 points) You observe the following three exchange rates at which you can buy or sell (borrow or lend). Calculate your total profit from triangular arbitrage, reporting your total profit in $ (by first calculating the profit in British pounds and then converting).
3. (5 points) You are working as a corporate treasurer and observe the following two exchange rates. Calculate, using $1 million how you could make an arbitrage (risk-free) profit.
4. (10 points) A foreign exchange dealer has $1 million for a short-term money market investment. That is, he wants minimal risk in his investment, but he still wants to maximize the available return. Given the following market rates in the U.S. and London, what would you recommend? Why? And what is the annualized rate of return for your recommended investment?
5. (5 points) As of today, the exchange rate between the Brazilian real and U.S. dollar is R$1.45/$. The consensus forecast for the U.S. and Brazilian inflation rates for the next one-year period is 3.6% and 16%, respectively. What would you forecast the exchange rate to be one year in the future?
6. (10 points) Consider a spot exchange rate of $1.40/£ and a 3-month forward exchange rate of $1.43/£. Assume a 3-month interest rate of 7.6% p.a. in the U.S. and 4.8% p.a. in the U.K. Assume that you can borrow as much as $1,000,000.
a. Determine whether interest rate parity is holding. (Answer yes or no and show why.)
b. If IRP does not hold, calculate your profit.
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7. (10 points) Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate of 2.5% on their lending. There is consensus in capital markets that the annual inflation rate is likely to be 1.5% in the U.S. and 2.5% in the U.K. for the next three years. The spot exchange rate is currently $1.34/£.
a. Compute the nominal interest rate p.a. in both the U.S. and U.K., assuming that the simplified version of the Fisher effect holds.
b. What is your expected future spot dollar-pound exchange rate three years from now?
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