MS&E 247s International Investments Summer 2005

Instructor: Yee-Tien Fu Friday 7/29/05 2:45-4:25pm (100 mins) Midterm Examination

In Class, Closed Book, Closed Notes, Formula-sheet and Calculators OK

Levich: Chapters 16, 3-9 plus Alan Greenspan’s testimonies

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Please attempt the eight questions within the allocated time of 100 minutes. Please
note that each question carries equal weight.

‘QUOTE OF THE DAY’

New York Times
August 15, 2002

A new appearance in financial risk category? --YTF

"I've pretty much used up my advance, and now my editors are hoping that I'll outlive the pope."
ROBERT BLAIR KAISER, who is 71, on a book he will write on Pope John Paul II's successor.
MS&E247s International Investments 7/29/05 Midterm Page 2 of 14

Question 1 (20 points)

Demonstrate with the simultaneous stock and flow approach on exchange rates what happens
between the Dollar and the Sterling Pound when Napa Valley red wine is increasingly ordered by
diners in all major restaurants in London. Show your answer in the Stock and Flow Reactions to
Permanent Increase in the Flow Demand for US Goods and Exchange Rate Response to
Permanent Increase in the Flow Demand for US Goods diagrams.

What happens when you redo the above with the three panel approach (loanable funds market, net
capital outflow, foreign exchange market) used in open economy modeling? To be specific,
answer the following questions in words and using diagrams.
a. What happens to the demand for dollars in the market for foreign-currency exchange?
b. What happens to the value of dollars in the market for foreign-currency exchange?
c. What happens to the quantity of net exports? To make our discussion easier, please
choose Dollar as the domestic currency, and British Pound as the foreign currency.

[Answer to Question 1, 20 points]

Stock and Flow Reactions to Permanent Increase in the Flow Demand for US Goods

Exchange Rate Response to Permanent Increase in the Flow Demand for US Goods
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For Part (a) and (b), please see page 222 in the Levich text.

For Part (c) and in the following diagrams, the demand for US$ will increase at any real
exchange rate. Hence the demand curve will shift outward (rightward). You will see a new
equilibrium point in FX market. You will see no change in the other diagrams in (c).

(a) The Market for Loanable (b) Net Capital

Funds Outflow
Real Real
Interest Supply Interest
Rate Rate

r r

Demand Net Capital

outflow

Quantity of Net Capital

Loanable Funds Outflow

Real
Exchange Supply
Rate

Demand

Quantity of
Dollars

(c) The Market for Foreign-Currency

Exchange
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Question 2 (20 points)

Jason Smith is a foreign exchange trader with Citibank. He notices the following quotes.
Spot exchange rate: SFr 1.6627/$
Six-month forward exchange rate: SFr 1.6558/$
Six-month Euro$ interest rate: 3.5% per year
Six-month EuroSFr interest rate: 3.0% per year

(a) Ignoring transaction costs, is the interest rate parity holding?

(b) Is there an arbitrage possibility? If yes, what steps would be needed to make an arbitrage
profit? Assuming that Jason Smith is authorized to work with $1,000,000 for this purpose,
how much would be the arbitrage profit in dollars?

[Answer to Question 2, 20 points]

(a) For six months, rSFr = 1.50% and r$ = 1.75%. Since the exchange rate is in SFr/$ terms,
F 1 + rSFr
the appropriate expression for the interest rate parity relation is = , or
S 1 + r$
F F 1.6558
(1 + r$ ) = (1 + rSFr ) . The left side of this expression is: (1 + r$ ) = (1 + 0.0175) =
S S 1.6627
1.0133. The right side of the expression is: 1 + rSFr = 1.0150. Since the left and right sides
are not equal, IRP is not holding.

(b) Since IRP is not holding, there is an arbitrage possibility.

As 1.0133 < 1.0150, we can say that the EuroSFr quote is more than what it should be as
per the quotes for the other three variables. Equivalently, we can also say that the Euro$
quote is less than what it should be as per the quotes for the other three variables.
Therefore, the arbitrage strategy should be based on borrowing in the Euro$ market and
lending in the SFr market. The steps would be as follows.
- Borrow $1,000,000 for six-months at 3.5% per year. Need to pay back $1,000,000 × (1
+ 0.0175) = $1,017,500 six months later.
- Convert $1,000,000 to SFr at the spot rate to get SFr1,662,700.
- Lend SFr1,662,700 for six-months at 3% per year. Will get back SFr1,662,700 × (1 +
0.0150) = SFr1,687,641 six months later.
- Sell SFr1,687,641 six months forward. The transaction will be contracted as of the
current date but delivery and settlement will only take place six months later. So, six-
months later, exchange SFr1,687,641 for SFr1,687,641 ⁄ SFr 1.6558/$ = $1,019,230.
The arbitrage profit six months later is 1,019,230 - 1,017,500 = $1,730.
MS&E247s International Investments 7/29/05 Midterm Page 6 of 14

Question 3 (20 points)

(a) What are your three key observations of Federal Reserve Board Chair Alan Greenspan’s July
2005 Testimony? (b) What adjustment in US Monetary Policy may be expected following his 2005
testimony? (c) Peruse the following paragraphs (first paragraph from 2004 and second from 2005
testimony):
If economic developments are such that monetary policy neutrality can be restored at a
measured pace, a relatively smooth adjustment of businesses and households to a more
typical level of interest rates seems likely. Even if economic developments dictate that the
stance of policy must be adjusted in a less gradual manner to ensure price stability, our
economy appears to have prepared itself for a more dynamic adjustment of interest rates.
Of course, considerably more uncertainty and hence risk surrounds the behavior of the
economy with a more rapid tightening of monetary policy than is the case when tightening is
more measured. In either scenario, individual instances of financial strain cannot be ruled
out. - An excerpt from Chair Greenspan’s Testimony (July 2004)
Moreover, core inflation had moved higher again through the first quarter. The rising
prices of energy and other commodities continued to place upward pressures on costs,
and reports of greater pricing power of firms indicated that they might be more able to
pass those higher costs on to their customers. Given these considerations, the
Committee continued the process of gradually removing monetary accommodation in
May.
The data released over the past two months or so accord with the view that the earlier
soft readings on the economy were not presaging a more serious slowdown in the pace
of activity. Employment has remained on an upward trend, retail spending has posted
appreciable gains, inventory levels are modest, and business investment appears to have
firmed. At the same time, low long-term interest rates have continued to provide a lift to
housing activity. Although both overall and core consumer price inflation have eased of
late, the prices of oil and natural gas have moved up again on balance since May and are
likely to place some upward pressure on consumer prices, at least over the near term.
Slack in labor and product markets has continued to decline. In light of these
developments, the FOMC raised the federal funds rate at its June meeting to further
reduce monetary policy accommodation. That action brought the cumulative increase in
the funds rate over the past year to 2-1/4 percentage points
- An excerpt from Chair Greenspan’s Testimony (July 2005)
(C) Now, briefly highlight chair Greenspan’s viewpoint updates on US economy of July 2005 (vs.
July 2004) as indicated in the above paragraphs. Do you think that interest rate might continue to
increase for the rest of 2005? What major changes had occurred in US economy between July
2004 and July 2005?
[Answer to Question 3, 20 points]
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Question 4 (20 points)

Today is March 1, 2004. The day-count basis is actual/365. You have the following contracts on
your FX-book.
CONTRACT A: On March 15, 2004, you will sell 1,000,000 EUR at a price Ft1 dollars per EUR.
CONTRACT B: On April 30, 2004, you will buy 1,000,000 EUR at a price Ft2 dollars per EUR.
(a) Construct one synthetic equivalent of each contract.
(b) Suppose the spot EUR/USD is 1.1500/1.1505. The USD interest rates for loans under 1 year
equal 2.25/2.27, and the German equivalents equal 2.35/2.36. Calculate the Fti numerically.
(c) Suppose the forward points for Ft1 that we observe in the markets is equal to 10/20 (i.e., the
outright forward spot rate is 1.1510/1.1525). How can an arbitrage portfolio be formed?

[Answer to Question 4, 20 points]

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Question 5 (20 points)

Consider the following four different responses to the same news item and try to match each
response with a particular asset model (e.g., monetarist model, overshooting model, etc.) If none of
the existing asset models can explain a particular market response (i.e. there is no appropriate
model), state that there is no applicable model and very briefly explain why.
News announced at t1 : US money supply grew by $3 billion in the most recent week.
Assuming that the consensus market forecast on money supply growth was $2 billion, the realized
money growth is a “positive surprise”.

[Answer to Question 5, 20 points]

Response (a) Response (b)

Nominal
Nominal exchange rate
exchange rate
($/FC) (2) ($/FC) (3)

U.S. price level U.S. price level

(3) (4)

$ interest rate (4)

$ interest rate
(2)

U.S. U.S.
money supply (1) money supply (1)

t1 t2 Time t1 t2 Time

Monetarist Model
No Applicable Model
(completely flexible commodity prices)
1. Realized money growth is a “positive 1. Assume that market participants believe
surprise”; the market feels that the higher that the Federal Reserve will drain reserves
money supply will be maintained. from the banking sector in the coming
2. If both prices and exchange rates are weeks.
perfectly flexible, then the US$ will weaken 2. Market projects a low growth in the money
immediately. supply and interest rates are projected to
3. At the same time, with national output rise; interest rates rise immediately in
constant, a larger money supply leads to a anticipation.
higher price level. 3. Higher US$ interest rates attract capital,
4. The interest rate does not change since the and the US$ rises.
price level is constant after the monetary 4. Since market believes excessive money
shock. creation will be corrected soon, U.S. price
level does not change.
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Response (c) Response (d)

Nominal
exchange rate Nominal
($/FC) (4) exchange rate (3)
($/FC)

U.S. price level U.S. price level

(2) (2)

$ interest rate $ interest rate

(3) (2)

U.S. U.S.
money supply (1) money supply (1)

t1 t2 Time t1 t2 Time

Monetarist Model Overshooting Model

(completely flexible commodity prices) (sticky commodity prices)
1. Assume a permanent change in the rate of 1. The US money supply rises unexpectedly.
growth of the money supply is expected. 2. The surplus of money leads $ interest rates
2. Then, inflation turns positive after t1 (prices to fall, but goods prices are sticky.
rise when the government prints too much 3. As a result, capital flows out of US toward
money). foreign investments, and $ depreciates. To
3. And the interest rate jumps (Fisher Closed). get investors to willingly hold US$ assets,
4. At the same time, the US$ steadily the US$ depreciates immediately by “too
depreciates (relative PPP). much” (overshoots). Then in the medium
run, the US$ can appreciate, and
compensate investors for the low $ interest
rate.
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Question 6 (20 points)

Please read the following portion of the testimony on China’s Trade and Exchange Rate Regime,
followed by the testimony on Federal Reserve's Monetary Policy, delivered by Federal Reserve
Board Chair Alan Greenspan on June 23, 2005 and July 20, 2005, respectively. Underline three
key points that you believe worth serious discussion. What was Chair Alan Greenspan’s stance on
Chinese Yuan’s revaluation.
Testimony of Chairman Alan Greenspan on China's Trade and Exchange Rate Regime
June 23, 2005

Some observers mistakenly believe that a marked increase in the exchange value of the Chinese renminbi
(RMB) relative to the U.S. dollar would significantly increase manufacturing activity and jobs in the United
States. I am aware of no credible evidence that supports such a conclusion.

The enhanced integration of China into the world trading system is having a notable effect on Asia's trade
with the rest of the world and on trade within Asia. After having risen rapidly through the 1990s, U.S. imports
from Asia excluding China have flattened since 2000. This has occurred as production within Asia has
evolved, with the final stages of assembly and exporting to the United States and elsewhere becoming
increasingly concentrated in China. As a consequence, because exports by country are recorded on a gross
basis rather than as value added, the widening of the United States' bilateral trade deficit with China,
measured gross, has largely been in lieu of wider deficits with other Asian economies, including Japan.
Measured by value added, our bilateral deficits with China would have been far less, and our bilateral deficits
with other Asian exporters would have been far more.

Accordingly, an increase in the exchange rate of the RMB, relative to the dollar, would likely redirect trade
within Asia, reversing to some extent the patterns that have emerged during the past half decade. However,
a revaluation of the RMB would have limited consequences for overall U.S. imports as well as for U.S.
exports that compete with Chinese products in third markets. Such a revaluation would affect Chinese value
added but not the dollar cost of intermediate goods imported into China from the rest of Asia, which
represents a significant share of the gross value of Chinese exports to the United States and elsewhere. (To
the extent that exporters to China revalued as well, of course, the impact on overall Asian exports would be
somewhat greater.)

Testimony of Chair Alan Greenspan on Federal Reserve's Monetary Policy

July 20, 2005

Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast currently
embedded in futures markets--the prospects for aggregate demand appear favorable. Household spending--
buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest
rates--is likely to continue to expand. Business investment in equipment and software seems to be on a solid
upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace
or upgrade aging high-tech and other equipment. Moreover, some recovery in nonresidential construction
appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties.
However, given the comparatively less buoyant growth of many foreign economies and the recent increase
in the foreign exchange value of the dollar, our external sector does not yet seem poised to contribute
steadily to U.S. growth.

A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward
pressures on inflation. Overall inflation would probably drop back noticeably from the rates experienced in
2004 and early 2005, and core inflation could hold steady or edge lower. Prices of crude materials and
intermediate goods have softened of late, and the slower rise in import prices that should result from the
recent strength in the foreign exchange value of the dollar could also relieve some pressure on inflation.
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[Answer to Question 6, 20 points]

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Question 7 (20 points)

(a) Assume that the one-year interest rate is 12% in the U.K. The expected annual rate of
inflation for the coming year is 10% for the U.K. and 4% for Switzerland. The current spot
exchange rate is SFr 3/£. Using the precise form of the international parity relations,
compute the one-year interest rate in Switzerland, the expected Swiss franc to pound
exchange rate in one year, and the one-year forward exchange rate.
(b) Think about the recent revalue of Chinese Yuan. How does the revaluation of Chinese
Yuan benefit Hong Kong economy? Please note that the exchange rates prior to the RMB
revaluation were: 8.28 RMB/$ and 7.77 HKD/$ (as of June 28, 2005), and are 8.11 RMB/$
and 7.77 HKD/$ (as of July 26, 2005) after the 2% revaluation of RBM.
[Answer to Question 7, 20 points]

1 + rSwitzerland 1 + I Switzerland
(a) According to the international Fisher relation, = . So,
1 + rUK 1 + I UK
1 + rSwitzerland 1 + 0.04
= . Therefore, rSwitzerland = 0.0589, or 5.89%.
1 + 0.12 1 + 0.10
S1 1 + I Switzerland
According to relative PPP, 0 = , where, S1 and S0 are in SFr/£ terms. So,
S 1 + I UK
S1 1 + 0.04
= . Solving for S1, we get S1 = SFr 2.8364/£.
3 1 + 0.10
F 1 + rSwitzerland
According to IRP, 0 = , where, F and S0 are in SFr/£ terms. So,
S 1 + rUK
F 1 + 0.0589
= . Solving for F, we get F = SFr 2.8363/£.
3 1 + 0.12
MS&E247s International Investments 7/29/05 Midterm Page 14 of 14

Question 8 (20 points)

You are given the following quotes.
Spot exchange rates:
$/€ 1.1865–1.1870
¥/$ 108.10–108.20
Three-month interest rates (percent per year):
Euro$ 5–51⁄4
Euro€ 31⁄4–31⁄2
Euro¥ 11⁄4–11⁄2
What should the quotes be for the:
(a) ¥/€ spot exchange rate
(b) $/€ 3-month forward exchange rate
(c) €/$ 3-month forward exchange rate
(d) ¥/$ 3-month forward exchange rate?
(e) ¥/€ 3-month forward exchange rate? (was not on the exam)

[Answer to Question 8, 20 points]

(a) ¥/€ bid = 108.10×1.1865 = 128.2606
¥/€ ask = 108.20×1.1870 = 128.4334
1 + (5.00 / 4 )%
(b) $/€ 3-month bid = 1.1865 = 1.1865 x 1.0125 / 1.00875 = 1.1909
1 + (3.50 / 4 )%
1 + (5.25 / 4 )%
$/€ 3-month ask = 1.1870 = 1.1870 x 1.013125 / 1.008125 = 1.1929
1 + (3.25 / 4 )%
The $/€ 3-month forward exchange rate is : 1.1909 – 1.1929.
1 + (3.25 / 4 )%
(c) €/$ 3-month bid = 0.8425 = 0.8383
1 + (5.25 / 4 )%
1 + (3.50 / 4 )%
€/$ 3-month ask = 0.8428 = 0.8397
1 + (5.00 / 4 )%
The €/$ 3-month forward exchange rate is : 0.8383 - 0.8397.
1 + (1.25 / 4 )%
(d) ¥/$ 3-month bid = 108.10 = 107.0330
1 + (5.25 / 4)%
1 + (1.50 / 4)%
¥/$ 3-month ask = 108.20 = 107.2649
1 + (5.00 / 4 )%
The ¥/$ 3-month forward exchange rate is : 107.0330 - 107.2649.
1 + (1.25 / 4 )%
(e) ¥/€ 3-month bid = 128.2606 = 127.5454
1 + (3.50 / 4 )%
1 + (1.50 / 4 )%
¥/€ 3-month ask = 128.4334 = 127.8760
1 + (3.25 / 4 )%
The ¥/€ 3-month forward exchange rate is : 127.5454 - 127.8760.