Student Name ________________________________________
International Finance 423
Fall 2010- Midterm Test I
Instructions:
There are four sections on this test. Important! : Read the instructions carefully before you start
any section. Marks for each section are in parentheses. Total points: 37
SECTION I: True, False, Uncertain. Explain.
ANSWER any 2 QUESTIONS (3 points each)
Q.1
A decrease in government deficits necessarily decreases the current account deficits by the same
magnitude
(Y- C – T) + (T-G) = (X-N) +I
Sp
+ Sg = CA + I
Uncertain, true only if Sp and I are held constant
Q.2
In the long-run, under the flexible-price monetary approach, a permanent decrease in the future rate of
Canadian nominal money supply growth leads to a decrease in Canadian price levels and interest
rates, and results in a depreciation of the Canadian dollar against the U.S. dollar.
False
In the long-run , under the flexible-price monetary approach, a fall in the future rate of
domestic money supply growth rate would result in an appreciation of domestic
currency
Q.3
The 3-month forward exchange rate is just the market’s expectation of what the spot exchange rate will
be in 3 months from now
False. The forward rate includes expected future spot rate + a risk premium for the
person who offers the forward contract
Q.4
If the interest rate parity holds, other things remaining constant, an increase in the German interest rate
will cause the current value of the Canadian dollar to appreciate against the Euro.
False: If the interest rate parity holds, other things remaining constant, an increase in
the German interest rate will decrease (depreciate) the current value of the Canadian
dollar against the Euro.
SECTION II: Shorter Answers (5 points)
ANSWER ONLY ONE QUESTION: State clearly which question you are answering by circling the
question number
Q.2
The Bank of Canada increases money supply today (t=0), and this change is perceived as permanent.
Furthermore, the US has announced that it will not respond to Canada’s policy. Suppose that prices are
fixed at t=1, what will happen over the short run (t=1) to: (i.) Prices (P1) in Canada (ii.) real interest rates
(r1) in Canada? (iii) The exchange rate CND$/US$?
Canada
Prices
Real interest rate
Exchange rate
P1=P0
r1<r0
Sticky prices
MS increases, MD no change,
r decreases.
Ecan$/us,1 increases,
Canadian dollar
depreciates Ecan$/us,1
>Ecan$/us in LR
(exchange rate
overshooting in the SR)
Q.3
Discuss 2 differences and 2 similarities between the Forward market and the Futures market
Similarities: - (1) Both refer to buying and selling currencies to be delivered in the future (2)
Both can be used to hedge risks
Differences: (1) Only few currencies are traded in the futures market (2) trading occurs in
standardized contracts (3) trading in specific locations
Q.4
Distinguish between foreign exchange swaps and foreign currency options.
A currency option is a contract that provides the right to buy or sell a given amount of currency
at a fixed exchange rate on or before the maturity date. A call option gives the right to buy and
a put option gives the right to sell. Price at which option can be bought or sold is known as the
strike or exercise price.
A currency swap combines two transactions in one. It involves the sale of currency on the spot
market and re-purchase on the forward market. They are efficient ways to meet the firm’s need
for foreign currency because they allow firms to obtain long-term financing at a lower cost than
by borrowing.
SECTION III- Analytical (12)
THIS QUESTION IS MANDATORY: ALL STUDENTS ARE REQUIRED TO ANSWER THIS
QUESTION
Q.1
Imagine a world after automatic teller machines (ATMs) so if you need cash you have to wait in a long
line at the bank for a teller. Consider the model of exchange rate determination with short-run nominal
rigidities and in which money market equilibrium holds every period, Uncovered Interest Rate Parity
holds every period, and PPP holds in the long-run. Assume that the Canadian economy is initially in the
long-run equilibrium.
Now suppose that ATMs are removed permanently from Canada but remain in the United States
Assume that this Canadian action does not change consumer discount rates nor change real output.
Explain what happens to Canadian and US interest rates, Canadian and US prices, and the exchange
rate (measured as units of Canadian dollar per one unit of US dollar) in the short-, and long-run when
ATMs are no longer in existence in Canada. Support your answer with a graph of the Canadian
money market equilibrium and a graph of the foreign exchange market equilibrium.
The rise in home demand for real balances due to the removal of ATMs
leads to excess demand of money in the home country at the initial home
interest rate. The home interest rate then must rise to clear the home
money market. This is an upward shift in the home demand for real
balances curve and a rise in the home interest rate from R1 to R2
.
The rise in the home interest rate increases the return on the home asset.
For investors to continue to invest in the home asset, they must have to
give up less home currency to acquire foreign currency in the spot market
for foreign investment, thereby increasing the return to the foreign
investment. That is, the home currency must experience
a current appreciation (a fall in the spot rate).
Furthermore, since the demand for money has increased permanently, we
expect the long-run price of money to rise. That is, we expect the price of
home goods to fall in the long-run. Since PPP holds in the long-run, this
implies that investors expect that the long run nominal exchange rate will
be lower because it will equal the ratio of the home price to the foreign
price. Thus, investors’ expectations of the future nominal exchange rate
are lower than they were before the removal of ATMs. Through UIRP this
causes the current spot rate to decrease and a home currency
appreciation.
The effect of the two forces described in the previous two paragraphs on
the asset market equilibrium can be shown as (1) a rightward shift in the
home asset return schedule and (2) an downward shift in the foreign asset
return schedule. Both
of these effects cause the current spot rate to fall much larger
(overshooting)
In the medium-run, the home price slowly begins to decrease for the
reasons described above. As the home price decrease, the home real
money supply begins to rise, creating excess supply for real balances in
the home market. Thus, the home interest rate begins to fall to bring about
home money market equilibrium. This fall in home interest rates in the
medium-run causes the exchange rate to rise (depreciate) to satisfy UIRP.
In the long-run, the home price will have fallen in the right amount so that
the home money market clears at the long-run interest (that is, at the
interest rate that prevailed before the removal of ATMs). The long-run spot
rate settles to an equilibrium level below the initial spot rate but above the
short-run spot rate.
Thus, to summarize, the removal of ATMs causes a situation of exchange
rate overshooting. The home currency initially experiences a large
appreciation (a large fall in the spot rate) followed by a series of
depreciations in the medium run until the spot rate settles at its long-run
level below the initial level. Therefore, the home country experiences a
long-run appreciation of its currency.
There are no effects on foreign interest rates or the foreign money market
equilibrium.
SECTION IV: Problem Solving
ANSWER ALL QUESTIONS
Q.1
The annualized interest rate on deposits in Canada is 5%. For yen deposits in Japan, it is 3.75%. The
spot rate of the Yen is 70 Yen/$.
a.
If the covered interest parity condition holds, what is the one year forward Yen/$
exchange rate? (2)
ryen = rc + [(FEy/$ - EY/$)/ EY/$)]
0.0375) = (0.05)+ (F-70/70)
F = 69.125
b.
A Canadian importer plans to pay 1.5 million yen one year from now. He buys a forward
contract and places $x in a Canadian bank deposit so that the proceeds will be used to
pay for the forward yen later. Calculate x (3)
x = 1.5m /(1.05)(69.125)
Q.2
Suppose consumers in Canada and Germany only consume velvet shirts (which are traded) and legal
services (which are not traded). The prices of those goods in each country for two years are given in
the table below. All prices are quoted in the currency of the relevant country.
Year
2008
2009
Shirts in
Canada (CDN
$)
50
60
Legal services
in Canada (CDN
$)
15
18
Shirts in
Germany
(Euros)
40
43
Legal services in CPI
CPI
Germany (Euros) (CAN) (GER)
14
14.34
36
43.2
32.2
34.4
The weights in the price indexes are given by the share of each good in the consumers’ consumption
baskets. Assume that Canadians spend 60% of their consumption expenditures on shirts while
Germans spend 70% of their consumption expenditures on shirts. Assume that the nominal exchange
rate is such that the Law of One Price holds for traded goods in every year.
a. Fill in the box below by determine the nominal exchange rate (CDN$ per Euros) in each year.
(3) and 2008 = 50/40 = 1.25
2009 = 60/43 = 1.395
b. By determine the real exchange rate in each year. (3)
q=E*Pg/Pc
2008 = 1.25*(32.2/36) = 1.118
2009 = 1.395*(34.4/43.2)=1.115
Year
2008
Nominal
Exchange rate
(Ecdn$/euro)
1.25
Real
Exchange rate
(qcdn$/euro)
1.118
2009
1.395
1.115
c.
Determine if absolute purchasing power parity holds and justify your answer. If it does not hold,
give one reason why it does not hold. (3)
If absolute PPP holds then (qcdn$/euro) should be equal to 1. It’s not so absolute PPP
does not hold. One possible reason could be the different weights or using just
the tradeable goods in LOP