Midterm Exam EC 750 2003 Fall

Question 1 (a) BOP<0  outflow of gold  MS BOP>0  inflow of gold  MS (b) President Nixon closed the gold window (1971) (c) UK, Denmark and Sweden

Question 1 (cont’d) (d) (1) Argentine, Hong Kong, Estonia, Lithuania, Ecuador, Panama,… (2) UK, Switzerland, Japan,… (3) Chile, Malaysia,…

Question 1. (cont’d) (e) The country with a currency board still has its currency, while the dollarized country does not. Currency boards: Argentine, Hong Kong Dollarization: Ecuador, Panama

Question 2 (a) Since F$/SF,180 = .6098 > E$/SF = .6049, the the 6-month forward SF is at a premium.

Question 2 (cont’d) (b) (i) (the return on domestic borrowing) (ii) (the return on covered foreign lending) = (1/E$/SF) x (1 + iSF/2 ) X F$/SF,180 = (.6098/.6049) x 1.025 = 1.0333

Question 2 (cont’d) (b) (iii) There is an arbitrage profit opportunity, i.e. you can make positive profits at no cost and with no risk. Borrow $1 from a US bank and convert it into SF1.6533. Deposit this amount with a Swiss bank, which will earn SF1.6946 six months from today. Sell this amount of SF forward at SF1.6400 per dollar, which amounts to $1.0333. Subtracting $1.025, the amount you have to pay back, you end up with $0.0083 per each dollar you borrow.

Question 2 (cont’d) (c) 1.025 = (.6098/.6049) x (1 + iSF/2 ) = 1.0168 1 + iSF/2 = 1.025 x (.6049/.6098) = 1.0168 So, iSF should be 3.4 %.

Question 3 (a) The German firm could borrow in the US$ CP market and swap its dollar obligation into DM, that is by buying US$ forward to match its future CP payments (principal plus interest) and selling US$ spot.

Question 3 (cont’d) (b) The German firm can secure the rate: 1 + iDM/4 = (S/F) x (1 + i$/4). Or, 1 + iDM/4 = (0.60/0.58) x (1 + .08/4), which implies that iDM is 22.07%.