bapswarrior

A Korean investor (currency = won) is considering the purchase of a U.S. bond. The current exchange rate is 100 (won to $). Korean inflation is 1% and U.S. inflation is 5%. Interest rates in Korea are 4% and in the U.S. are 8%. Assuming that the real rate remains constant, what is the domestic currency return from the purchase of the U.S. bond?

A) 3%.

B) 12%.

C) 4%.

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The domestic currency return on the U.S. bond is equal to the foreign interest rate plus the currency appreciation. Since the inflation differential favors Korea and the real rate is assumed to be constant, the dollar will appreciate by –4%. Hence, the domestic currency return is 4% [= 8% foreign rate + (–4%) currency appreciation].

bapswarrior

A U.K. investor is considering the purchase of a Japanese bond. The current exchange rate is 150 (yen to pounds). The real rate is assumed to be constant. Inflation in Japan is 0% and interest rates are 2%. U.K. inflation is 3% and interest rates are 5%. What is the domestic currency return to the purchase of the Japanese bond?

A) 3%.

B) 5%.

C) 2%.

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The domestic currency return on the Japanese bond is equal to the foreign interest rate plus the currency appreciation. Since the inflation differential favors the Japanese bond and the real rate is assumed to be constant, the yen will appreciate by 3%. Hence, the domestic currency return is 5% (= 2% foreign rate + 3% currency appreciation).

bapswarrior

A U.S. investor purchased a U.K. bond one year ago. The exchange rate at the time was 1.6 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 6% and in the U.K. was 11%. Today the exchange rate is 1.7. Which of the following is closest to the end-of-period real exchange rate?

A) 0.890.

B) 1.123.

C) 1.005.

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The end-of-period real exchange rate is calculated as: X = S (PF/PD). Here, the new price levels are 1.11 for the U.K. (1 × 1.11 = 1.11) and 2.12 for the U.S. (2 × 1.06 = 2.12). Hence, the end-of-period real rate is 0.890 [= X = S (PF/PD) = 1.7 (1.11 / 2.12)].

bapswarrior

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 1 (dollars to pounds). Beginning of the year interest rates were 7% in the U.S. and 12% in the U.K. Inflation during the year was expected to be 5% in the U.S. and 10% 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) 18.67%.

B) 14.67%.

C) 5.33%.

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The dollar was expected to appreciate (lower inflation), but depreciated by 6.67% (= 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% (= 12% foreign rate + 6.67% appreciation).

bapswarrior

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% and in the U.K. was 10%. Today the exchange rate is 1.6. What is the end-of-period real exchange rate?

A) 0.84.

B) 1.64.

C) 1.45.

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The end-of-period real exchange rate is calculated as: X = S (PF/PD). 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 (PF / PD) = 1.6 (1.1 / 2.1)].

bapswarrior

A U.S. investor purchased a Swiss bond one year ago. At the time of purchase, U.S. inflation and interest rates were 2% and 4%, respectively, while Swiss rates were 5% and 7%, 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) 2.02.

B) 1.00.

C) 0.92.

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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 0.9985 = X = S (PF / PD) = 1.94[(1 × 1.05) / (2 × 1.02)].

bapswarrior

Steven Retting lives in Canada and is considering investing in a Canadian bond yielding 6% or a U.S. bond yielding 5%. Retting expects the Canadian dollar to appreciate by 3% over the next year.What is the foreign currency risk premium on the U.S. dollar?

A) 2%.

B) −4%.

C) −1%.

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The interest rate differential is 1% (Canada – U.S.). We expect the Canadian dollar to appreciate by 3% relative to the U.S. dollar therefore the U.S. dollar will depreciate by 3%. The foreign currency risk premium (FCRP) is the expected exchange rate movement minus the interest rate differential between the domestic currency and the foreign currency. FCRP = −3% − 1% = −4%.

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What will be the Canadian currency returns on the U.S. bond?

A) 8%.

B) 6%.

C) 2%.

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Since Retting lives in Canada, the Canadian rate is the domestic rate. The interest rate differential is 1% (Canada − U.S.). The foreign currency risk premium (FCRP) is −3% − 1% = −4%. The domestic currency return on the foreign U.S. bond can be calculated as the domestic Canadian interest rate plus the FCRP: 6% − 4% = 2%. Alternatively, the domestic currency return can be calculated as the U.S. interest rate plus the expected currency depreciation: 5% − 3% = 2%

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According to the traditional model, if the Canadian currency appreciates, then Canadian industries in the long run should become:

A) less competitive, and there will be an economic slowdown in Canada.

B) more competitive, and there will be an economic slowdown in Canada.

C) more competitive, and there will be an economic expansion in Canada.

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In the long run, an increase in the value of a country’s currency decreases national competitiveness. Likewise, a decrease in the value of a country’s currency increases national competitiveness in the long run. However, in the short run a decrease in the national currency causes a widening gap in the trade balance and an increase in domestic inflation. Therefore, short-run and long-run reactions to changes in currency differ.

bapswarrior

Which of the following is the formula for the foreign currency risk premium (FCRP)? The FCRP equals:

A) E[(S1 − S0) / S0] − (rFC − rDC).

B) E[(S0 − S1) / S0] − (rDC − rFC).

C) [E(S1) − F] / S0.

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The formula for the foreign currency risk premium is: FCRP = [E(S1) – F] / S0. Both remaining formulas are incorrect in the algebra or the subscripts.

bapswarrior

Which of the following describes the foreign currency risk premium (FCRP)? FCRP equals:

A) expected exchange rate movement minus the ratio of the spot to the forward rate.

B) forward rate minus the spot rate.

C) expected exchange rate movement minus the interest rate differential.

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The FCRP is defined as the expected exchange rate movement minus the interest rate differential. The FCRP will be zero if the expected exchange rate change is purely a function of the relative interest rates.

bapswarrior

A Canadian investor has a domestic currency risk-free rate of 4%. The risk free rate in the U.S. is 5%. The investor expects the Canadian currency (Can$) to appreciate by 1% against the U.S. dollar ($). What is the foreign currency risk premium (FCRP)?

A) 1%.

B) -1%.

C) 0%.

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The FCRP is the expected appreciation of the foreign currency minus the interest rate differential (domestic − foreign). Hence, the FCRP is 0% (= –1% appreciation of U.S. dollar minus –1% interest rate differential (i.e., rDC – rFC = 4% – 5% = –1%).