Chapter 4: Exercises

Note: Please do the exercises as I will use turn them to multiple choice questions in
the final exam.
A. Exchange rate determinations

1. If a country experiences high inflation relative to the U.S., its exports to the U.S.
should ____, its imports should ____, and there is ____ pressure on its currency’s value.
a. decrease; increase; upward
b. decrease; decrease; upward
c. increase; decrease; downward
d. decrease; increase; downward
e. increase; decrease; upward

2. If a country experiences an increase in interest rates relative to U.S. interest rates,

the inflow of U.S. funds to purchase its securities should ____, the outflow of its funds to
purchase U.S. securities should ____, and there is ____ pressure on its currency's value.
a. increase; decrease; downward
b. decrease; increase; upward
c. increase; decrease; upward
d. decrease; increase; downward
e. increase; increase; upward

3. Assume that Japan places a strict quota on goods imported from the U.S. and the
U.S. places a strict quota on goods imported from Japan. This event should immediately
cause the U.S. demand for Japanese yen to ____, and the supply of Japanese yen to be
exchanged for U.S. dollars to ____.
a. increase; increase
b. increase; decline
c. decline; decline
d. decline; increase

4. Unemployment?

B. Government influence on exchange rates

1. A weak dollar is normally expected to cause:
a. high unemployment and high inflation in the U.S.
b. high unemployment and low inflation in the U.S.
c. low unemployment and low inflation in the U.S.
d. low unemployment and high inflation in the U.S.

2. Consider two countries that trade with each other, called X and Y. According to the
text, inflation in Country X will have a greater impact on inflation in Country Y under
the ____ system. Now, consider two other countries that trade with each other, called A
and B. Unemployment in Country A will have a greater impact on unemployment in
Country B under the ____ system.
a. floating rate; fixed rate
b. floating rate; floating rate
c. fixed rate; fixed rate
d. fixed rate; floating rate
3. Under a fixed exchange rate system:
a. a foreign exchange market does not exist.
b. central bank intervention in the foreign exchange market is not necessary.
c. central bank intervention in the foreign exchange market is often necessary.
d. central bank intervention in the foreign exchange market is not allowed.

4. Under a managed float exchange rate system, the Fed may attempt to stimulate the
U.S. economy by ____ the dollar. Such an adjustment in the dollar's value should ____ the
U.S. demand for products produced by major foreign countries.
a. weakening; increase
b. weakening; decrease
c. strengthening; increase
d. strengthening; decrease

5. If the Fed desires to weaken the dollar without affecting the dollar money supply, it
should:
a. exchange dollars for foreign currencies, and sell some of its existing Treasury security
holdings for dollars.
b. exchange foreign currencies for dollars, and sell some of its existing Treasury security
holdings for dollars.
c. exchange dollars for foreign currencies, and buy existing Treasury securities with
dollars.
d. exchange foreign currencies for dollars, and buy existing Treasury securities with
dollars.

6. It has been argued that the exchange rate can be used as a policy tool. Assume that the
U.S. government would like to reduce unemployment. Which of the following is an
appropriate action given this scenario?
a. Weaken the dollar
b. Strengthen the dollar
c. Buy dollars with foreign currency in the foreign exchange market
d. Implement a tight monetary policy

7. To strengthen the dollar using sterilized intervention, the Fed would ____ dollars and
simultaneously ____ Treasury securities.
a. buy; sell
b. sell; buy
c. buy; buy
d. sell; sell

8. Which one of the following is a disadvantage of a fixed exchange rate system:

a. Importers are insulated from the risk that the currency will appreciate over time.
b. Management of an MNC is less difficult.
c. The government might change the value of the currency.
d. Exporters are insulated from the risk that the currency will depreciate over time.

True/False Questions
1. Under a fixed exchange rate system, U.S. inflation would have a greater impact on
inflation in other countries than it would under a freely floating exchange rate system.
2. Nonsterilized intervention is intervention by a central bank in the foreign exchange
market without adjusting for the change in money supply
B. International Arbitrage and Interest Rate Parity
1. Locational Arbitrage. Assume the following information:
Beal Bank Yardley Bank

Bid price of New Zealand dollar $.401 $.398

Ask price of New Zealand dollar $.404 $.400

Given this information, is locational arbitrage possible? If so, explain the steps involved
in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000
to use. What market forces would occur to eliminate any further possibilities of
locational arbitrage?

1. Yes. We can rearrange the information as follows:

Beal Bank NZ$/$ 0.401-0.404

Yardley bank NZ$/$ 0.398-0.400

- Buy $NZ at Yardley Bank for $.400 and sell them to Beal Bank for $.401.
- (1) Use $1m to buy $NZ at $.400: $1m: 0.400 = NZ$2,5m; (2) Sell NZ$2.5m at $0.401:
NZ$2.5m x 0.401 = $1,002,500m => Profit: $2,500
- The large purchase of NZ$ at Yardley Bank will force its ask price up and the large
sale of NZ$ at Beal Bank will force its bid price up, until the locational arbitrage will
no longer be beneficial.

Multiple Choice Question:

Assume the following information:

HSBC: AUD/USD 0.60-0.61
ANZ: AUD/USD 0.62-0.625
Given this information, what would be your gain if you use $1,000,000 and execute
locational arbitrage? That is, how much will you end up with over and above the
$1,000,000 you started with?
a. $10,003
b. $12,063
c. $14,441
d. $16,393
e. $18,219

2. Triangular arbitrage: Assume the following information:

£/$: 1.60-.61
MYR/$: $.200-02
£/MYR: 8.1-8.2

Determine the profit you could generate for Blades Inc, by withdrawing $1000 from Blades’
checking account and engaging in triangular arbitrage before the rates are adjusted.
Step 1: Calculate the ICR:
Implied Cross Rate (you - £/$: 1.62 – 1.66
can choose any pair of - MYR/$: .195 – .199
currencies) - £/MYR: 7.92 – 8.05
Step 2: Compare ICR 1. £/$ RCR: £/$ = 1.60-1.61 => buy £ at 1.61 (and sell $)
and RCR ICR: 1.62 – 1.66

RCR: 1.60 – 1.61

2. MYR/$ RCR: MYR/$ = .200 – .202 => sell MYR at .200 (and buy $)
ICR: .195 – .199

RCR: .200 – .202

3. £/MYR
ICR: 7.92 – 8.05 RCR: £/MYR = 8.1 – 8.2 => Sell £ at 8.1 (and buy MYR)

RCR: 8.1 – 8.2

Step 3: Calculate the 1. For £/$: We know we need to buy £ at 1.61 (and sell $)
profit - $1,000 : 1.61 = £621.12
- £621.12 x 8.1 = MYR 5,031.06
- MYR5,031.06 x 0.200 = 1,006.21
Profit: $6.21

£/$ @ 1.61

MYR £

2. For MYR/$: We know we need to sell MYR at .200 (and buy $)

$
MYR/$ @ .200

MYR £

3. For £/MYR: We know we need sell £ at 8.1 (and buy MYR)

MYR £
 £/MYR @ 8.1
Note: For whatever the pair of currencies we choose, we must have the same
profit.

Multiple Choice Question

Assume the following information:

AUD/USD 0.67-0.69
MXN/USD 0.074-0.077
AUD/MXN 8.2-8.5
Assume you have $100,000 to conduct triangular arbitrage. What will be your profit
from implementing this strategy?
a. $6,133
b. $2,368
c. $6,518
d. $13,711
e. $5,424

Do it yourself:

Assume the following information:

JPY/USD: 0.0085-86
THB/JPY: 2.69-70
THB/USD: 0.0224-27

Determine the profit you could generate for Blades Inc, by withdrawing $1000 from Blades’

Answer: Profit: $726.87

3. Covered Interest Arbitrage in Both Directions. The one-year interest rate in New
Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the
New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is
covered interest arbitrage feasible for U.S. investors? How must S, F, Ih and If change
to restore the IRP?

Multiple choice questions

1. Assume the following information:

Current spot rate of Sudanese dinar (SDD) = $.00570
90-day forward rate of the dinar = $.00569
90-day interest rate in the U.S. = 4.0%
90-day interest rate in Sudan = 4.2%
You have $400,000 to invest. If you conduct covered interest arbitrage, what amount will
you have after 90 days?
a. $416,000.00
b. $416,800.00
c. $424,242.86
d. $416,068.77
e. $415,270.18

2. Assume the following information: U.S. investors have $1,000,000 to invest:

1-year deposit rate offered on U.S. dollars = 12%
1-year deposit rate offered on Singapore dollars = 10%
1-year forward rate of Singapore dollars = $.412
Spot rate of Singapore dollar = $.400

Given this information:

a. interest rate parity exists and covered interest arbitrage by U.S. investors results in
the same yield as investing domestically.
b. interest rate parity doesn't exist and covered interest arbitrage by U.S. investors
results in a yield above what is possible domestically.
c. interest rate parity exists and covered interest arbitrage by U.S. investors results in a
yield above what is possible domestically.
d. interest rate parity doesn't exist and covered interest arbitrage by U.S. investors
results in a yield below what is possible domestically.