Chapter 6 Intervention with Euros Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the U.S. Dollar. Can it apply central bank intervention to achieve this objective? Explain. 1. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some currencies than others? Why would a central bank’s Indirect intervention have a stronger impact than its direct intervention? 2. Intervention Effects on Corporate Performance Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of this materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the U. S dollar as a result. Explain whether these actions would increase, reduce, or have no effect on: a) The volume of your subsidiary's sales in Australia b) The cost of your subsidiary of purchasing materials (measured in A$) c) The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). Briefly explain each answer 4. Intervention Effects on Corporate Performance Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of this materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the U. S dollar as a result. Explain whether these actions would increase, reduce, or have no effect on: a) The volume of your subsidiary's sales in Australia b) The cost of your subsidiary of purchasing materials (measured in A$) c) The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). Briefly explain each answer Chapter 7: 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? ANSWER: Yes, One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401.  With $1 million ...

1. Chapter 6
Intervention with Euros Assume that Belgium, one of the
European countries that uses the euro as its currency, would
prefer that its currency depreciate against the U.S. Dollar. Can
it apply central bank intervention to achieve this objective?
Explain.
1. Indirect Intervention. Why would the Fed’s indirect
intervention have a stronger impact on some currencies than
others? Why would a central bank’s Indirect intervention have a
stronger impact than its direct intervention?
2. Intervention Effects on Corporate Performance
Assume you have a subsidiary in Australia. The subsidiary sells
mobile homes to local consumers in Australia, who buy the
homes using mostly borrowed funds from local banks. Your
subsidiary purchases all of this materials from Hong Kong. The
Hong Kong dollar is tied to the U.S. dollar. Your subsidiary
borrowed funds from the U.S. parent, and must pay the parent
$100,000 in interest each month. Australia has just raised its
interest rate in order to boost the value of its currency
(Australian dollar, A$). The Australian dollar appreciates
against the U. S dollar as a result. Explain whether these actions
would increase, reduce, or have no effect on:
a) The volume of your subsidiary's sales in Australia
b) The cost of your subsidiary of purchasing materials
(measured in A$)
c) The cost to your subsidiary of making the interest payments
to the U.S. parent (measured in A$). Briefly explain each
answer
4. Intervention Effects on Corporate Performance
Assume you have a subsidiary in Australia. The subsidiary sells

2. mobile homes to local consumers in Australia, who buy the
homes using mostly borrowed funds from local banks. Your
subsidiary purchases all of this materials from Hong Kong. The
Hong Kong dollar is tied to the U.S. dollar. Your subsidiary
borrowed funds from the U.S. parent, and must pay the parent
$100,000 in interest each month. Australia has just raised its
interest rate in order to boost the value of its currency
(Australian dollar, A$). The Australian dollar appreciates
against the U. S dollar as a result. Explain whether these actions
would increase, reduce, or have no effect on:
a) The volume of your subsidiary's sales in Australia
b) The cost of your subsidiary of purchasing materials
(measured in A$)
c) The cost to your subsidiary of making the interest payments
to the U.S. parent (measured in A$). Briefly explain each
answer
Chapter 7:
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?
ANSWER: Yes, One could purchase New Zealand dollars
at Yardley Bank for $.40 and sell them to Beal Bank for $.401.
With $1 million available, 2.5 million New Zealand dollars
could be purchased at Yardley Bank. These New Zealand
dollars could then be sold to Beal Bank for $1,002,500, thereby

3. generating a profit of $2,500.
The large demand for New Zealand dollars at Yardley
Bank will force this bank's ask price on New Zealand dollars to
increase. The large sales of New Zealand dollars to Beal Bank
will force its bid price down. Once the ask price of Yardley
Bank is no longer less than the bid price of Beal Bank,
locational arbitrage will no longer be beneficial.
4. Triangular Arbitrage.Assume the following information:
Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars
NZ$3.02
Given this information, is triangular arbitrage possible? If
so, explain the steps that would reflect triangular arbitrage, and
compute the profit from this strategy if you had $1,000,000 to
use. What market forces would occur to eliminate any further
possibilities of triangular arbitrage?
ANSWER: Yes. The appropriate cross exchange rate should be
1 Canadian dollar = 3 New Zealand dollars. Thus, the actual
value of the Canadian dollars in terms of New Zealand dollars is
more than what it should be. One could obtain Canadian dollars
with U.S. dollars, sell the Canadian dollars for New Zealand
dollars and then exchange New Zealand dollars for U.S.
dollars. With $1,000,000, this strategy would generate
$1,006,667 thereby representing a profit of $6,667.
[$1,000,000/$.90 = C$1,111,111 × 3.02 = NZ$3,355,556 ×
$.30 = $1,006,667]
The value of the Canadian dollar with respect to the U.S.
dollar would rise. The value of the Canadian dollar with
respect to the New Zealand dollar would decline. The value of

4. the New Zealand dollar with respect to the U.S. dollar would
fall.
17. Covered Interest Arbitrage in Both Directions. The
oneyear interest rate in New Zealand is 6 percent. The oneyear
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? Is it feasible for New Zealand investors? In
each case, explain why covered interest arbitrage is or is not
feasible.
ANSWER:
To determine the yield from covered interest arbitrage by
U.S. investors, start with an assumed initial investment, such as
$1,000,000.
$1,000,000/$.50 = NZ$2,000,000 × (1.06)
= NZ$2,120,000 × $.54 = $1,144,800
Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%
Thus, U.S. investors can benefit from covered interest
arbitrage because this yield exceeds the U.S. interest rate of 10
percent.
To determine the yield from covered interest arbitrage by
New Zealand investors, start with an assumed initial
investment, such as NZ$1,000,000:
NZ$1,000,000 × $.50 = $500,000 × (1.10)
= $550,000/$.54 = NZ$1,018,519
Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 =
1.85%
Thus, New Zealand investors would not benefit from
covered interest arbitrage since the yield of 1.85% is less than

5. the 6% that they could receive from investing their funds in
New Zealand.
35. Assume that the annual U.S. Interest rate is currently 6%
and Germany;s annual interest rate is currently 8%. The spot
rate of the euro is $1.10 and the 1-year forward rate of the euro
is $1.10. Assume that as covered interest arbitrage occurs, the
interest rates are not affected, and the spot rate is not affected.
Explain how the 1-year forward rate of the euro will change in
order to restore interest rate parity, and why it will change.
Your explanation should specify which type of investor
(German or U.S.) would be engaging in covered interest
arbitrage, whether they are buying or selling euros forward, and
how that affects the forward rate of the euro.
36. Assume that interest rate parity exists. As of this morning,
the 1-month interest rate in Canada was lower than the 1-month
interest rate in the United States. Assume that as a result of the
Fed’s monetary policy this afternoon, the 1-month interest rate
in the United States delined this afternoon, but was still higher
than the Canadian 1-month interest rate. The 1-month interest
rate in Canada remained unchanged. Based on the
information,the forward rate of the Canadian dollar exhibited a
____ [discount or premium] this morning that _____[increased
or decreased] this afternoon. Explain.
Chapter 8
1. PPP.Explain the theory of purchasing power parity
(PPP).Based on this theory, what is a general forecast of the
values of currencies in countries with high
inflation?ANSWER:PPPsuggeststhatthepurchasingpowerofacons
umerwillbesimilarwhenpurchasing goods in a foreign country or
in the home country. If inflation in a foreign country differs
from inflation in the home
country,theexchangeratewilladjusttomaintainequalpurchasing
power.Currencies in countries with high inflation will be weak
according to PPP, causing the purchasing power of goods in the
home country versus these countries to be similar.

6. 5. Explain why PPP does not hold.
ANSWER: PPP does not consistently hold because there
are other factors besides inflation that influences exchange
rates. Thus, exchange rates will not move in perfect tandem
with inflation differentials. In addition, there may not be
substitutes for traded goods. Therefore, even when a country’s
inflation increases, the foreign demand for its products will not
necessarily decrease (in the manner suggested by PPP) if
substitutes are not available.
6. Implications of IFE. Explain the international Fisher effect
(IFE). What is the rationale for the existence of the IFE? What
are the implications of the IFE for firms with excess cash that
consistently invest in foreign Treasury bills? Explain why the
IFE may not hold.
ANSWER: The IFE suggests that a currency’s value will
adjust in accordance with the differential in interest rates
between two countries.
The rationale is that if a particular currency exhibits a high
nominal interest rate, this may reflect a high anticipated
inflation. Thus, the inflation will place downward pressure on
the currency’s value if it occurs.
The implications are that a firm that consistently purchases
foreign Treasury bills will on average earn a similar return as
on domestic Treasury bills.
The IFE may not hold because exchange rate movements
react to other factors in addition to interest rate differentials.
Therefore, an exchange rate will not necessarily adjust in
accordance with the nominal interest rate differentials, so that
IFE may not hold.

7. 21. Inflation and Interest Rate Effects. The opening of Russia's
market has resulted in a highly volatile Russian currency (the
ruble). Russia's inflation has commonly exceeded 20 percent per
month. Russian interest rates commonly exceed 150 percent, but
this is sometimes less than the annual inflation rate in Russia.
a. Explain why the high Russian inflation has put severe
pressure on the value of the Russian ruble.
ANSWER: As Russian prices were increasing, the
purchasing power of Russian consumers was declining. This
would encourage them to purchase goods in the U.S. and
elsewhere, which results in a large supply of rubles for sale.
Given the high Russian inflation, foreign demand for rubles to
purchase Russian goods would be low. Thus, the ruble’s value
should depreciate against the dollar, and against other
currencies.
b. Does the effect of Russian inflation on the decline in
the ruble’s value support the PPP theory? How might the
relationship be distorted by political conditions in Russia?
ANSWER: The general relationship suggested by
PPP is supported, but the ruble’s value will not normally move
exactly as specified by PPP. The political conditions that could
restrict trade or currency convertibility can prevent Russian
consumers from shifting to foreign goods. Thus, the ruble may
not decline by the full degree to offset the inflation differential
between Russia and the U.S. Furthermore, the government may
not allow the ruble to float freely to its proper equilibrium
level.
c. Does it appear that the prices of Russian goods will
be equal to the prices of U.S. goods from the perspective of
Russian consumers (after considering exchange rates)? Explain.

8. ANSWER: Russian prices might be higher than U.S.
prices, even after considering exchange rates, because the ruble
might not depreciate enough to fully offset the Russian
inflation. The exchange rate cannot fully adjust if there are
barriers on trade or currency convertibility.
d. Will the effects of the high Russian inflation and the
decline in the ruble offset each other for U.S. importers? That
is, how will U.S. importers of Russian goods be affected by the
conditions?
ANSWER: U.S. importers will likely experience higher
prices, because the Russian inflation may not be completely
offset by the decline in the ruble’s value. This may cause a
reduction in the U.S. demand for Russian goods.
26. IRP. The one-year risk-free interest rate in Mexico is 10%.
The one-year risk-free rate in the U.S. is 2%. Assume that
interest rate parity exists. The spot rate of the Mexican peso is
$.14.
a. What is the forward rate premium?
b. What is the one-year forward rate of the peso?
c. Based on the international Fisher effect, what is the expected
change in the spot rate over the next year?
d. If the spot rate changes as expected according to the IFE,
what will be the spot rate in one year?
e. Compare your answers to (b) and (d) and explain the
relationship.
ANSWER:
a. According to interest rate parity, the forward premium is

9. b. The forward rate is $.14 × (1 – .07273) = $.1298.
c. According to the IFE, the expected change in the peso is:
or –7.273%
d. $.14 × (1 – .07273) = $.1298
e. The answers are the same. When IRP holds, the forward
rate premium and the expected percentage change in the spot
rate are derived in the same manner. Thus, the forward premium
serves as the forecasted percentage change in the spot rate
according to IFE.
31. Applying IRP and IFE. Assume that Mexico has a one-year
interest rate that is higher than the U.S. one-year interest rate.
Assume that you believe in the international Fisher effect (IFE),
and interest rate parity. Assume zero transactions costs.
Ed is based in the U.S. and he attempts to speculate by
purchasing Mexican pesos today, investing the pesos in a risk-
free asset for a year, and then converting the pesos to dollars at
the end of one year. Ed did not cover his position in the forward
market.
Maria is based in Mexico and she attempts covered interest
arbitrage by purchasing dollars today and simultaneously selling
dollars one year forward, investing the dollars in a risk-free
asset for a year, and then converting the dollars back to pesos at
the end of one year.
Do you think the rate of return on Ed’s investment will be

10. higher than, lower than, or the same as the rate of return on
Maria’s investment? Explain.
ANSWER: Maria’s rate of return will be higher. Since interest
rate parity exists, she will earn whatever the local risk-free
interest rate is in Mexico. Ed’s expected rate of return is
whatever the risk-free rate is in the U.S. (based on the IFE).
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