End-of-year Examinations, 2018 ECON344-18S2 (C) Page 3 of 7 SECTION A (5 x 11 = 55 marks) 1. The table below provides data for 3 countries for the Big Mac Index as published by the Economist magazine. Country Price (in Local Currency Units) Exchange Rate (LCU/USD) Price (in USD) United States 4.30 1.00 4.30 Mexico 70 16.97 4.13 Canada 5.90 1.30 4.53 Based on the table, answer the following questions. (a) What is the real exchange rate between Mexican Peso (ARS) and United States Dollar (USD), i.e. qARS/USD? (4 marks) (b) Is the Canadian Dollar over-valued or under-valued with respect to the Mexican Peso? By how much? (4 marks) (c) Does absolute purchasing power parity hold between Mexico and United States? Why or why not? (3 marks) 2. A portfolio manager is considering the benefits of increasing her diversification by investing overseas. She can purchase shares in individual country funds with the following characteristics. NZ Australia Japan Expected return (%) 10 12 15 Standard deviation of return (%) 8 10 12.5 Correlation with NZ 1.0 0.6 0.4 (a) What is the expected return and standard deviation of return of a portfolio with 20% invested in Japan and 80% in New Zealand? (2 + 5 marks) (b) In the context of international portfolio diversification, explain the concept of the investment hurdle rate. (4 marks) 3. As a foreign exchange trader, you see the following quotes for Canadian Dollars (CAD), U.S. Dollars (USD), and Mexican Pesos (MXN): MXN 6.4390/CAD USD 0.7047/CAD MXN 8.7535/USD Is there an arbitrage opportunity? If so, how would you exploit it if you had 1 million USD? (11 marks) End-of-year Examinations, 2018 ECON344-18S2 (C) Page 4 of 7 4. Suppose that you are an investor based in New Zealand, and you expect the U.S. dollar to depreciate by 1.25% over the next year. The interest rate on one-year risk-free bonds is 2.25% in the United States and 3.75% in New Zealand. The current exchange rate is NZD 1.38 per USD. (a) Calculate the foreign currency risk premium from the New Zealand investor’s viewpoint. (3 marks) (b) If the CIP condition holds, is the NZD dollar selling at a premium or discount compared to USD? By how much? (4 marks) (c) What is the domestic currency return (from the New Zealand investor’s viewpoint) on the U.S. bond, assuming that the New Zealand investor’s expectations are met? (4 marks) 5. The first-generation currency crisis models have shown that an exchange rate collapse can be the inevitable result of government policies inconsistent with maintaining a fixed exchange rate permanently. In such cases, simple economic theory may allow us to predict the exact date of a crisis through careful analysis of the government policies and the market’s rational response to them. (a) Describe with the help of an economic model how the exact date of the exchange rate crisis can be determined in such models. Be sure to describe the policy of the government and the reaction of the Central Bank to that policy in your model. (6 marks) (b) Draw separate diagrams to illustrate the path of each of the following variables before and after the crisis: exchange rate, money supply, foreign exchange reserves. (5 marks) SECTION B (3 x 15 = 45 marks) 6. You are a sales manager for IBM and export computers from the USA to other countries. You have just signed a deal to ship computers to an Australian distributor. The deal is denominated in AUD, and you will receive AUD 900,000 when the computers arrive in Sydney in 90 days. Assume that you can borrow and lend at 5% p.a. in USD and at 8% p.a. in AUD. Both interest rate quotes are for a 360-day year. The spot exchange rate is AUD1.4802/USD, and the 90-day forward exchange rate is AUD1.4945/USD. (a) Describe the nature and extent of your transaction foreign exchange risk. (3 marks) (b) Describe two ways of eliminating the transaction foreign exchange risk. Which of the alternatives in part b is superior? (4 marks) (c) Assume that the U.S. interest rate and the exchange rates are correct. Determine what Australian interest rate would make your firm indifferent between the two alternative hedges. (8 marks) End-of-year Examinations, 2018 ECON344-18S2 (C) Page 5 of 7 7. In 2017 the country of Lalaland had a current account deficit of $1 billion and a non-reserve financial account surplus of $750 million. Lalaland’s capital account was in a $100 million surplus. In addition, Lalaland’s factors of production located in foreign countries earn $700 million. Lalaland had a trade deficit of $800 million. Assume Lalaland neither gives nor receives unilateral transfers. Lalaland’s GDP is $9 billion. (a) What happened to Lalaland’s net foreign assets during 2017? Did the country acquire or lose foreign assets during the year? Calculate the changes? (4 marks) (b) Calculate the official settlements balance. Based on this number, what happened to the central bank’s (foreign) exchange reserves? (4 marks) (c) How much income did foreign factors of production earn in Lalaland during 2017? (4 marks) (d) Calculate Lalaland’s Gross National Income (GNI). (3 marks) 8. For each of the following situations, use the IS-LM and FX diagrams to illustrate the effects of the shock. For each case, clearly state the effect of the shock on the following variables (increase, decrease, no change, or ambiguous): output (Y), nominal interest rate (i), exchange rate (S), investment (I), and trade balance (TB). Assume that the government allows the exchange rate to float and makes no other policy intervention. (a) Government spending increases. (5 marks) (b) Money supply decreases. (5 marks) (c) Investors expect a depreciation of the home currency. (5 marks) End-of-year Examinations, 2018 ECON344-18S2 (C) Page 6 of 7 USEFUL FORMULAS (The symbols have their usual meanings and ‘*’ indicates foreign counterpart) 1. Cross exchange rate between 2 currencies: A/B = (A/C)/(B/C) 2. Forward premium or discount (% p.a.): 100 360 NdaysS SF − 3. Forward Market Return: S FSFMR −= 4. Real exchange rate: P SPQ * = 5. Real exchange rate change: ( ) ( ) ( ) 11 11 * − + +×+ = π πsq 6. Conditional expectation of the future exchange rate: ( )( )µ+1tS 7. Conditional volatility of the expected exchange rate: ( )σtS 8. N-period CIP condition: ( ) ( )( ) ( )( )n n ni niSnF *1 1 + + = 9. Present Value: ( ) ( )( ) ( ) ( )( ) ( ) ( )( )nni nC i C i CPV + ++ + + + = 1 .......... 21 2 11 1 2 10. NPV with expropriation risk (2 period): ( ) ( ) ( ) ( )2 2 1 1 1 1 r Cp r CpINPV + − + + − +−= 11. PV with expropriation risk (infinite periods): pr pCPV + − = 1 12. Yield to maturity: ( ) ( )[ ] ( )[ ] ( )[ ] ( )[ ]nn ny M ny C ny C ny CCnB + + + ++ + + + = 11 ..... 11 , 2 13. BOP CA FA KA= + + 14. CANUTNIINX =++ 15. ISCA −= End-of-year Examinations, 2018 ECON344-18S2 (C) Page 7 of 7 16. pg SSS += 17. GNI GDP NFIA= + 18. Simple monetary model: Ygg −= µπ 19. Expected return of a portfolio: ( ) 2211 RwRwRE p += 20. Variance of a portfolio: ( ) 122122222121 2 σσσ wwwwRVar p ++= 21. Correlation between 2 assets: 21 12 12 σσ σ ρ = 22. Hurdle rate: ( ) ( ) ( ) ( ) ** rVol rVol rrE rrE ff − += ρ 23. Foreign Currency Risk Premium: )(]/)[( *001 rrSSSESRP −−−= 24. Risk-pricing for ICAPM: ( ) niniwiwfi SRPSRPRPrRE γγβ ++++= .....11 End of Examination
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