Econ 4401 – International Economics – Spring 2014
Homework #3
Suggested Solution
**********
1) [10 Points]
a) Go on http://www.fxstreet.com/rates-charts/currency-rates/ and report in a table the
exchange rate for USD and Euro, GBP, JPY, CHF, AUD (use the ``Last”)
EUR/USD
GBP/USD
USD/JPY
USD/CHF
AUD/USD
1.378
1.675
102.007
.8838
.9369
b)
A rifle manufactured in the United States cost $1200. Using the exchange rate from the
table in part (a), what would the rifle cost in France, Italy, Great Britain, Japan, Switzerland
and Australia (in their local currency)?
The only thing we need to be careful about here is to interpret the numbers correctly.
For example: EUR/USD=1.378 means that it takes $1.378 to make 1 Euro. Consequently, I can buy the
rifle
in
any
country
that
adopts
the
Euro
for
1200/1.378=Euro
870.82
On the other hand, when the exchange rate is quoted as USD/Other currency=k, we have to interpret it
as: “it takes k units of Other currency to make $1”. So, for example, we read USD/JPY=102.007 as: it
takes JPY 102.007 to make $1. The cost of the rifle in Japan will be JPY 1200*102.007
France and Italy
Great Britain
Japan
Switzerland
Australia
EUR/USD =1.378
GBP/USD =1.675
USD/JPY =102.007
USD/CHF=.8838
AUD/USD=.9369
Rifle Cost
Eur 1200/1.378=870.82
GBP 1200/1.675=716.41
JPY 1200*102.007=122408.4
CHF 1200*.8838=1060.56
AUD 1200/.9369=1280.81
2) [20 Points]
a)
The Forward Exchange Rate between Euros and USD at 3 months is 1. The risk free interest
rate in the Euro Area is 3%; in the US the risk free interest rate is 4%. The spot exchange
rate is $1.4. Is this situation possible in equilibrium? Is there any arbitrage opportunity
here? If so, make an example of an arbitrage for this world.
We can use the covered interest rate parity, which gives us the formula for the forward exchange rate:
i$=ieur+(F-E)/E. If this does not hold with equality, then we can come up with some arbitrage strategy.
Plugging in the numbers we obtain:
i$=.04
ieur+(F-E)/E=.03 + (1 -1.4)/1.4 = .03 + (-.4)/1.4 = .03 – 0.28 =- 0.2557
Clearly i$>ieur+(F-E)/E !
The forward rate is (way) lower than it should be. This situation won’t last forever! Either the interest
rate in Europe will shoot up, or the forward rate will. This is a good moment to borrow in Euro,
purchasing the forward rate at 1, and invest in dollars. Each Euro you borrow today would cost you $1.4
if you had to pay back immediately; however, the forward contract allows you to fix a lower rate of
conversion in the future, when you will have to pay back the money: $1. In a situation like this (Forward
discount), the interest rate in the Euro area should be much higher than the interest rate in the US.
However, on the euros you borrow, according to our data, you owe 3%; you can take your loan, convert
it today in dollars at the spot rate (each Euro buys you $1.4) and invest at 4%. You are bringing home a
positive interest rate differential (4% - 3%) and with the forward contract, you have secured a lower rate
of conversion of $ in Euros in the future: this is a (large) free meal (or arbitrage).
b) You are a Swiss exporter of the finest Swiss Chocolate. A big chain of supermarkets in the
United States has just offered to buy 2000000 pounds of Chocolate bars from you, for $2
each. They will pay you in dollars at delivery, in 6 months. Today the spot exchange rate is
CHF .90
What should you be worried about? Explain. Which financial contract should you write to
hedge against risk? Why? (multiple financial instruments work; pick one!)
As a Swiss exporter, your consumption is priced in Swiss Francs (CHF). However, you are
getting paid in $. The exchange rate is the price of $, or, in other words, how many CHF it
takes to make one $. If this price goes down (less CHF for 1$), for each $ you get paid, you
will obtain less CHF in exchange. This is situation is an appreciation of the Swiss Franc, and
this is what should be concerned about.
One financial contract that works is a Future: you can fix today the rate of conversion of $
into CHF in 6 months and forget about the risk that the spot exchange rate will fall below
the Future.
Another instrument that works is a PUT option on CHF/$. This instrument gives you the right
to sell $ for CHF at a given “strike price”. If in the future the CHF appreciates above the
strike price (i.e. it takes less CHF than the strike to make a $), then you will exercise your put
option and sell $ at the established strike price.
3) [10 Points]
Use the table in the following page on Frances’s international transactions to answer the
following questions (amounts are in millions of Euro)
a) What is France’s balance of trade?
It’s Merchandise Exports - Merchandise Imports : -1000
b) What is France’s current account balance?
It’s (Merchandise Exports – Merchandise Imports) + (Service Exports – Service Imports) +
(Inv. Income Receipts – Inv. Income Payments) + Net Unilateral Transfers =
( -1000 ) + (+5000) + (+18000) + (-1000) = 21000
Transaction
Merchandise Imports
Merchandise Exports
Service Imports
Service Exports
Investment Income Receipts
Investment Income Payments
Gifts (Net Unilateral Transfers)
Amount
93000
92000
15000
20000
43000
25000
-1000
4) [10 Points]
This part of the homework requires you to use FRED.
http://research.stlouisfed.org/fred2/categories/32951
a) Create ONE picture with Current Account (Excludes Exceptional Financing) for China,
USA and Germany (they have to be all on the same graph). [5 points]
(See next page)
600000000000
USA
400000000000
China
Germany
200000000000
0
-200000000000
-400000000000
-600000000000
-800000000000
-1000000000000
b) Many economic commentators think that Germany and China should engage in
expansionary policies (either through monetary or fiscal policy), to solve the problem of
“Global Imbalances” (i.e. the US current account balance being very negative and
Germany and China’s C.A.B. being very positive). Looking at the graph you created, do
you think that would help? Explain. [5 points]
Not necessarily: Germany and China’s current accounts (the overall sum of the past current
account balances), according to the graph, have been almost flat from the beginning of
the 80s to the beginning of 2000. This means that their CAB was basically 0 during that
period of time. Notice how that didn’t stop the US from accumulating big CAB deficits:
from 1983 to 1989 and after 1993. The graph doesn’t seem to imply that a CAD surplus
in China or Germany implies a CAB deficit in the US and viceversa!