Part 1: Form A: a d c b e, b b a b, c a d e a a, e
Form
B: b d e b a, c c b a b, d e a a e, a
Part 2: Answer both questions.
1. Given the following exchange quotations for the US dollar and the British pound
Spot: £1 = $1.42
Forward £1 = $1.47
The $ is the domestic currency, and the forward rate is the price of the pound for delivery in 90 days
a. Which currency is selling at a premium and why?
The pound, because the forward
price of the pound is greater than the spot price
b. In which country would you expect to find the higher interest rates? Why?
The US. Not only do investors earn interest in the UK, but they also gain because for every £ they buy at $1.42 they get $1.47 in 90 days time. The US interest rate has to compensate for that.
c. State the covered interest parity condition. If the covered interest parity condition holds, and the interest rate in the U.S. is 8%, what is the interest rate in Britain? (Assume no risk differential or transactions costs)
iUS – iUK
= p, The forward premium is eFWD/e – 1 = 3.5%, which implies the
equilibrium interest rate in the UK is 4.5%
d. Suppose you expect the spot rate in 90 days to be: £1 = $1.40. What type of speculation would you undertake in the forward markets? Use $1000 to illustrate how you would complete the transaction. If you are correct how much profit would you make?
Sell Pounds forward and in 90 days time buy
pounds on the spot market for $1.40 each, fulfill your contract to sell for
$1.47 a profit of 7 cents per pound. If you plan to buy $1000 worth of pounds
you expect to get £714. So contract to sell £714, which will get you $1,050, or
a profit of $50.
e. If there is a general expectation that the expected exchange rate in 90 days is £1 = $1.40, what will happen to the forward rate, and the forward premium?
If many other speculators also expect the spot rate will fall to $1.40, they will also be selling pounds forward. That will lead to a fall in the forward rate, until the forward rate is equal to the expected future spot rate. The forward premium will fall until it equals the expected appreciation of the pound (In this case the forward discount will equal the expected depreciation of the pound)
2. What does the monetary approach predict would happen to the balance of payments as a result of
a. In increase in the money supply
Starting from money market
equilibrium, this leads to an excess supply of money. As
Md = kPY, to increase money
demand, domestic prices rise. This leads to a loss of competitiveness and a
trade (and B of P) deficit develops. The country loses foreign reserves. Ms =
a(DR + FR) . This continues until money supply is restored to its former level.
Prices are also restored to their old level, at PPP. Domestic reserves have
been swapped for foreign reserves, nothing real has changed, and the B of P is
back in balance.
b. A rise in real incomes.
This causes a rise in money demand, and therefore an excess demand for money. At the original money supply prices fall to equate Ms = Md. Domestic goods and services are more competitive, and therefore a B of P surplus results. Foreign reserves increase, adding to the money supply. This continues until money supply equals the new money demand. Prices return to their former levels. The money supply now contains more foreign reserves, and B of P equilibrium is restored.
Explain your answers. In both cases explain how any payments imbalances are self-correcting.