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Module 7 –The foreign exchange market1© University of Southern Queensland Module 7 –The foreign exchange market Self-assessment questions 7.1 Questions 9, 11, 14 & 15; Quantitative problems 1, 2, 5, 10 & 15 from Mishkin & Eakins, chapter 15. Answers to end-of-chapter questions Mishkin & Eakins, chapter 15 9. The Indian rupee will appreciate. The announcement of tariffs will raise the expected future exchange rate for the rupee and so increase the expected appreciation of the rupee. This means that the demand for rupee-denominated assets will increase, shifting the demand curve to the right, and the rupee exchange rate therefore rises. 11. The dollar will appreciate. The increase in US productivity raises the expected future exchange rate and thus raises the expected return on dollar assets at any exchange rate. The resulting rightward shift of the demand curve leads to a rise in the equilibrium exchange rate. 14. The contraction of the European money supply will increase European interest rates and raise the future value of the Euro, both of which will decrease the relative expected return on dollar assets. The demand curve will then shift to the left, and the dollar will depreciate. 15. Consider France to be the domestic country. Because it is harder to get French goods, people will buy more foreign goods and the value of the Euro in the future will fall. The expected depreciation of the Euro lowers the expected return on Euro assets at any exchange rate, so the demand curve shifts to the left and the value of the Euro will fall. Quantitative problems 1. A German sports car is selling for 70,000 euros. What is the dollar price in the United States for the German car if the exchange rate is 0.90 euros per dollar? Solution: 70,000 euros × ($1/0.90 euros) = $77,777.77. 2. An investor in England purchased a 91-day T-bill for $987.65. At that time, the exchange rate was $1.75 per pound. At maturity, the exchange rate was $1.83 per pound. What was the investor’s holding period return in pounds?Solution: The bond cost $987.65/$1.75 = £564.37. At maturity, the $1,000 is worth $1,000/$1.83 = £546.45.
2FIN8202 –Financial markets and instruments© University of Southern Queensland The holding period return is (546.45 –564.37)/564.37 = –0.0317. 5. The 6-month forward rate between the British pound and the U.S. dollar is $1.75 per pound. If 6-month rates are 3% in the United States and 150 basis points higher in England, what is the current exchange rate? Solution: Spot rate = 1.75 × (1.045/1.03) = $1.775/£ 10. The Mexican peso is trading at 10 pesos per dollar. If the expected US inflation rate is 2% while the Mexican inflation rate is 23% over the next year, what is the expected exchange rate in one year? Solution: Expected rate = 10 × (1.23/1.02) = 12.059 pesos per dollar. 15. Short-term rates are 2% in Japan and 4% in the United States. The current exchange rates is 120 yen per dollar. What is the expected forward exchange rate? Solution: 0.04 = 0.02 –(X–120)/120 X= 117.6