FINS3616 Tutorials – Week 4

(Parity Conditions, Balance of Payments)

1. Suppose the 1-year nominal interest rate in Zooropa is 9%, and Zooropa’s expected inflation rate is 4%.
What is the real interest rate in Zooropa?

T h e e x p e c t e d r e a l in t e re s t r a t e i s a p p r o x i m at e ly 9 % - 4 % = 5 % . T h e c orr e c t
computation is: (1 + 0.09) / (1 + 0.04) – 1 = 0.0481 or 4.81%.

2. Suppose the 5-year interest rate on a dollar-denominated pure discount bond is 4.5% p.a., whereas in
France, the euro interest rate is 7.5% p.a. on a similar pure discount bond denominated in euros. If the
current spot rate is $1.08/€, what is the value of the 5-year forward exchange rate that prevents covered
interest arbitrage?

3. If the 30-day yen interest rate is 3% p.a., and the 30-day euro interest rate is 5% p.a., is there a forward
premium or discount on the euro in terms of the yen? What is the magnitude of the forward premium or
discount?

4. Suppose the spot rate is CHF1.4706/$ in the spot market, and the 180-day forward rate is CHF1.4295/$. If
the 180-day dollar interest rate is 7% p.a., what is the annualized 180-day interest rate on Swiss francs that
would prevent arbitrage?

5. Carla Heinz is a portfolio manager for Deutsche Bank. She is considering two alternative investments of
EUR10,000,000: 180-day euro deposits or 180-day Swiss francs (CHF) deposits. She has decided not to bear
transaction foreign exchange risk. Suppose she has the following data: 180-day CHF interest rate, 8% p.a.,
180-day EUR interest rate, 10% p.a., spot rate EUR1.1960/CHF, 180-day forward rate, EUR1.2024/CHF.
Which of these deposits provides the higher euro return in 180 days? If these were actually market prices,
what would you expect to happen?
6. In a freely floating exchange rate system, if the current account is running a deficit, what are the
consequences for the nation's balance on capital account and its overall balance of payments?

In a freely floating exchange rate system, the nation’s balance of payments must always be zero.
Consequently, if the current account is running a deficit, the capital account must be running a surplus of
the same size. Overall, international payments will still be in balance.

7. What is likely to happen to the value of the dollar as the U.S. current-account deficit increases? Explain.
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8. China’s overall saving rate is now nearly 50% of GDP, the highest in the world. China’s domestic investment
rate, at 43%, is also high, but not as high as its saving rate. What do these facts imply about China’s current-
account balance?