Reading 70: LOS e ～ Q1- 3

1.A U.S. investor purchased a Swiss bond one year ago. At the time of purchase, U.S. inflation and interest rates were 2 percent and 4 percent, respectively, while Swiss rates were 5 percent and 7 percent, respectively. The beginning-of-period exchange rate was 2 ($/SF; SF is the Swiss Franc). The ratio of the price of the U.S. to Swiss consumption baskets at the beginning of the period was also 2. Inflation was exactly as expected during the year. What was the end-of-period real exchange rate?

A)   0.92.

B)   2.10.

C)   1.00.

D)   2.02.

The correct answer was C)

First calculate the expected spot rate using purchasing power parity: E(S₁) = 2 × (1.02/1.05) = 1.9429. If the end-of-period nominal rate is 1.94, then the end-of-period real rate must be 0.999 = X = S (P_F/P_D) = 1.94 ×(1x1.05 / 2x1.02).

2.A U.S. investor purchased a U.K. bond one year ago. The exchange rate at the time was 1.5 to 1 (dollars to pounds) and the beginning-of-period ratio of the price levels of the consumption baskets was 2 ($ to ). During the year, inflation in the U.S. was 5 percent and in the U.K. was 10 percent. Today the exchange rate is 1.6. What is the end-of-period real exchange rate?

A)   0.84.

B)   0.75.

C)   1.64.

D)   1.45.

The correct answer was A)

The end-of-period real exchange rate is calculated as: X = S (P_F/P_D). Here, the new price levels are 1.1 for the U.K. (1 × 1.1 = 1.1) and 2.1 for the U.S. (2 × 1.05 = 2.1). Hence, the end-of-period real rate is 0.838 [= X = S (P_F/P_D) = 1.6 (1.1/2.1)].

3.A U.S. investor purchased a U.K. bond one year ago. The exchange rate at the time was 1.5 to 1 (dollars to pounds) and the beginning-of-period ratio of the price levels of the consumption baskets was 2 ($ to ). Beginning of the year interest rates were 7 percent in the U.S. and 12 percent in the U.K. Inflation during the year was expected to be 5 percent in the U.S. and 10 percent in the U.K. Today the exchange rate is 1.6. What is the ex-post domestic currency return on the U.K. bond to the U.S. investor?

A)   5.33%.

B)   1.64%.

C)   18.67%.

D)   14.67%.

The correct answer was C)     

The dollar was expected to appreciate (lower inflation), but depreciated by 6.67 percent (= 1.6/1.5 = 1.0667 or 6.67%) instead. Hence, the return to U.S. investor is the foreign interest rate plus currency appreciation, or 18.67 percent (= 12% foreign rate + 6.67% appreciation).