Sample questions

Sample questions

Question I.

This question relates to material in chapter 13:

Suppose that a one-year bond denominated in dollars pays an interest rate of 6%. A bond that is denominated in lira, with similar characteristics in risk and liquidity pays 4%, and the spot rate between the two currencies is e($/IL)=0.0006, where IL stands for Italian lira.

1. 
   How does the market expect the dollar's value to change against the lira over the next year?
   
2. 
   Suppose you want to invest your $1000 on a dollar or a lira-denominated asset and you are not risk averse. (A) Which investment strategy would you choose? (B) What would be your return in one year? (Hint: find the expected exchange rate from your answer to (1) and do not round up your result).
   
3. 
   Suppose now that from some banks you calculate that one-year forward premium on lira is negative and it is equal to 5%. (A) What is F($/IL), the dollar lira forward rate? (B) What would be your covered return in lira-denominated bond? Would you change your investment strategy in (2)?
   

Question II.

This is the overshooting topic in chapter 14 and directly relates to course material:

You are examining the economic conditions of Xoria that is a small open economy with flexible exchange rates and perfect capital mobility. A new government is elected and it announces that it will combat inflation by contractionary monetary policy once it is inaugurated.

1. 
   What will be the immediate effect of this announcement on interest rate, output and exchange rate if public believes that this is a temporary policy?
   
2. 
   How does your answer to 1. change if the government announces that it will reduce the money supply permanently?
   

Question III. Problem #10, page 386 (392 5^th edition).
Question IV.

Others possible question topics will be related to: NIA, BOP identities, forward vs. futures, term structure of interest rates. Know the answer to: what is the term structure of interest rates, how is the yield curve obtained and how you interpret its slope; what is the forward rate, the difference between forward contract and futures contract, the difference between uncovered and covered interest rate parities.

These are sample questions only. Our coverage is more extensive than the book and these questions so make sure that you read and understand your lecture notes thoroughly.
Answer to sample question No. 1
1. x=i-i*=6-4=2% => expected depreciation of the dollar by 2% against the IL.
(e^e-e)/e=0.02 => e^e($/IL) = (0.02+1)e =1.02*0.0006 = 0.000612.
2. You are not risk averse, then you will invest uncovered:

R_us = 1000*1.06=$1060=return from investing in US$.

R^e_IL = (1000/E)*(1.04)*(e^e) = (1000/0.0006)*1.04*0.000612=$1060.8=expected return in one year from investing in IL.
Invest in IL uncovered or indifferent between the two investments.

Or:

R^e_IL =1000*(1+0.04+0.02(1+0.04))=$1060.8.
3. Negative forward premium on Lira=positive forward discount on the dollar

f($/IL) = [F($/IL)-e($/IL)]/e($/IL) = 0.05

A) F($/IL) = (1+0.05)*0.0006 = 0.00063
B) R^F_IL =($1000/0.0006)*1.04*0.00063=$1092=Expected return in one year from investing covered in IL.

Or:

R^F_IL = $1000*(1+0.04+0.05(1+0.04))=$1092.
Yes, I would invest covered rather than uncovered because the return is higher.