1. Suppose the value of the Polish zloty moves from Z 1000 = $1 at the start of

Question

1. Suppose the value of the Polish zloty moves from Z 1000 = $1 at the start of the year to Z 1,800 at the end of the year. At the same time, the Polish price level changes from an index of 100 on January 1 to 134 on December 31. U.S. inflation during the year was 4.5%. If the one-year interest rate on the zloty is 44%, what was the real dollar cost of borrowing the zloty during the year?

a) 17.53%

b) 27.81%

c) -23.44%

d) -8.76%

Ans:     c (PLEASE PROVIDE CLEAR STEP-BY-STEP ANSWER ON HOW TO GET THIS FIGURE)

2. Suppose the spot rates for the pound, mark, and Swiss franc prior to 1999 were $1.20, $.32, and $.40, respectively. At the same time, the associated 90day interest rates (annualized) were 16%, 8%, and 4%, while the U.S. 90day interest rate was 12%. What was the 90day forward rate (to the nearest cent) on a TCU (TCU 1 = £1 + DM1 + SFr1) if interest parity were to hold?

a) $1.92

b) $1.98

c) $1.94

d) $1.87

Ans:     a ((PLEASE PROVIDE CLEAR STEP-BY-STEP ANSWER ON HOW TO GET THIS FIGURE))

Explanation / Answer

Answer To Question 1

Polish Inflation could be calculated as change in the price level i.e. from 100 to 134 in one year which means an inflation of 34%

Polish Interest rate = 44%

We know that: (1+nominal rate) = (1+real rate)(1+inflation)

> 1.44= (1+real rate)1.34

> real rate = 7.46%

This is the real cost of borrowing in Polish Zloty

We need to calculate the real cost of borrowing in dollars

According to International Fisher Relation, real interest rates are expected to be the same across various markets.

Nominal Rate of Interest in U.S. = (1 + 7.46%)(1 + 4.5%) – 1 (Simplified from above)

Nominal Rate of Interest in U.S. = 12.29%

So, given polish inflation of 34%, dollar cost of borrowing Zloty is as follows:

Real rate of borrowing Zloty = Nominal rate of interest – Polish Inflation

(Note: Above formula is also an approximation formula of International Fisher Relation)

Hence real rate of borrowing Zloty = -21.71%

Hence the correct answer should be C.

Answer To Question 2

Interest Rate Parity Equation

= Forward rate= [1+ Ra* (days/360)] / [1+ Rb* (days/360)] * Spot Rate

Spot Rate of TCU = 1.20+0.32+0.40 = $1.92

Ra (i.e. TCU interest rate) = average of 3 interest rates = (16+8+4)/3 = 9.33%

Applying this in formula we get:

[1+ 0.0933* (90/360)] / [1+ 0.12* (90/360)] *1.92

= 1.0233/1.03*1.92

= 1.907

Hence the forward rate is TCU/$ = $1.907

So the nearest answer should be A.

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