FNCE 423 – International Finance
Problem Set 2
1. Use the asset approach to exchange rate determination discussed in class to answer the
following questions. The interest rate on US dollar denominated assets maturing in one year is
10% and the interest rate on comparable Canadian dollar denominated assets is 8%.
a. Consider two possible expectations for the direct spot exchange rate between the Canadian
dollar and the U.S. dollar (Canadian dollars per one U.S. dollar) in one year: (1) the spot rate
will fall by 5 Canadian cents or (2) the spot rate will rise by 3 Canadian cents (note that these
changes are in absolute levels, not in percentage terms). Determine the current equilibrium
spot rate under each scenario. Explain which expectation for the future spot rate makes
sense, justify your answer, and provide economic intuition for your result.
b. Suppose interest rates are as given initially (10% and 8%) and the current spot rate equals 2
Canadian dollars per U.S. dollar. Calculate the forward discount or forward premium
2.
The annualized interest rate on deposits in Canada is 10%. In yen deposits in Japan, it is
7.5%. The spot rate of the dollar is 130 Yen/$.
a.
Which currency is expected to depreciate in six months and by how much?
b.
If the covered interest parity condition holds, what is the six-month forward
$/yen exchange rate?
c.
A Canadian importer plans to pay 1 million yen six months 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. Go to the Financial Times website (www.ft.com). Hover over the tab “Markets” then
click on “Markets Data” in the drop down menu. Once there, hover over the
“Markets Data” tab then click on “Currencies” in the drop down menu. Finally, click
on “Currencies macromap” (next to “Highlights” near the top left corner of the
webpage). Using the options “Global currencies” and Currency Performance in the
last 1 month,
figure out how you can use this tool to assess the relative strength of each of the
currencies listed in the drop down menu on the right bottom corner. Which currency
or currencies appear to be the strongest in the last month? Which currency or
currencies appear to be the weakest in the last month? Explain how you arrived at
your answer in detail.
True, False, Uncertain. Explain. 2 lines maximum
1. If the dollar interest rate is 10 percent, the euro interest rate is 16 percent, then an
investor should invest only in euros.
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2. If the interest rate parity holds, an increase in the German interest rate will increase the
current value of the Euro against the dollar. [Diagrams Required].
Short Answers: 5 lines maximum
1. Discuss the effects of a rise in the dollar interest rate on the exchange rate.
2. Why might you prefer an option over a futures or forward contract?
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