1. Suppose the Swiss franc revalues from $0.40 at the beginning of the year to $

Question

1.  Suppose the Swiss franc revalues from $0.40 at the beginning of the year to $0.44 at the end of the year. U.S.inflation is 5% and Swiss inflation is 3% during the year. What is the real devaluation (-) or real revaluation (+) ofthe Swiss franc during the year?

2.  The spot and 30-day forward rates for the Dutch euro are $1.4757 and $1.48, respectively. The guilder is saidto be selling at

a forwarda) premium of 1.2%   b) premium of 3.5%  c) discount of 3.5% d) discount of 1.2%

3. If the direct price of the dollar is DM2.5 in 1990 Frankfurt and transaction costs were .4% of the amounttransacted, then the minimum-maximum direct quotes for the DM in New York were?

4.Suppose one observed the following direct spot quotations in New York and London, respectively:$1.2500-60 and £.8000-50. Arbitrage profits per $1 million equal how much?

Explanation / Answer

1) According to the Purchasing Power Parity theory the forward exchange rate S1 is given by the formula

S1 = S0(1+ih)/(1+if) = 0.40*1.05/1.03 = 0.4078. The SF should appreciate to $0.4078 due to inflation. The appreciation due to inflation should be in % terms (1.05/1.03) - 1 = 1.95%

Therefore, real appreciation in absolute terms = 0.44 - 0.4078 = 0.0322. This is equivalent to 0.0322/0.40 = 8.05%

Alternatively, the appreciation that occured = (0.44/0.40) - 1 = 0.10 =10%

Real appreciation as a % = Nominal appreciaton (10%) - Appreciation mandated by PPT (1.95) = 8.05%

2) The guilder is at a premium, the premium is (1.48/1.4757) - 1 = 0.00291387

Annual rate = 0.00291387*12 = 0.034966 = 3.50%

Answer: Option (b) Premium of 3.5%

3) The maximum price = (1/2.5)*1.008 = 0.4032

    The minimum price = (1/2.5)*0.992 = 0.3968

4) There is no arbitrage possibilities as reasoned below:

The quote for GBP in NY = $1.2500/$1.2560

and the quote for $ in London = GBP0.8000/GBP0.8050

Converting the first quote to indirect quote, the quote for $ in NY becomes 0.7962/0.8000

Purchasing Dollar in London or NY and selling it in NY or Londone will not yield profit as in either case the Ask rate is not less than the bid rate.

For purchasing $ in London the ask rate = 0.8050, which is greater that the bid rate of $ in NY of 0.7962

For purchasing $ in NY the ask rate = 0.8000 which is equal to the bid rate for $ in London

In either of the above cases there is no arbitrage opportunity as the Ask rate for $ > Bid rate for $

Similar is the case with the purhase and sale of GBP.

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