ECON 406: Exchange rates and international finance

Coursework Test, Lent 2020

Time allowed: TWO hours

Candidates should answer ALL questions from Section A and TWO from Section B.

Section A accounts for 60 per cent of the available marks Do not spend more than 70
minutes on this section.

Section A:

1. The following quotes from Investing.com for the Mexican Peso (MXN) and the South
African Rand (ZAR) against the Euro (EUR) were provided Investing.com for 25th
February 2020:

Bid Ask

MXN/EUR 20.6902 20.6996

ZAR/EUR 16.4668 16.4774

 What rates would you quote to a Mexican visitor to South Africa (MXN/ZAR)?

(2 marks)

Answer

MXN
MXN MXN EUR EUR BID 20.6902
= = = =1.2557
ZAR BID EUR BID ZAR BID ZAR 16.4774
EUR ASK

MXN 20.6996
Similarly = =1.2571
ZAR ASK 16.4668

2. The following data give spot exchange rate quotes (in RUB per USD) on February 25th
2020 for the Russian Rouble against the US Dollar (USD). One-year interest rates (in per
cent per annum) applying to both currencies are also supplied:

Bid Ask

RUB/USD 66.1990 66.1995

12-month interest rate 1.365% 1.375%

(USD)

12-month interest rate 5.2% 5.35%

(RUB)
  What are the implied quotes for the 12-month forward bid/ask exchange rate
(RUB/USD), and which currency is at a forward premium to the other?

(8 marks)

Answers

( 1+r BID ) 66.199 (1.052 )

F BID =S BID = =68.6968
( 1+r ¿ASK ) (1.01375 )

( 1+r ASK ) 66.1995 ( 1.0535 )

F ASK =S ASK = =68.802
( 1+r ¿BID ) ( 1.01365 )

3. Six months ago, your Colombian firm entered a twelve-month forward contract to buy
USD 100000 at the forward exchange rate COP/USD 3200. With six months of the
contract remaining, the current spot exchange rate is COP/USD 3428. Annual interest
rates in Colombia and the USA are currently 4% and 1.4% respectively:

 What is the present value of your forward contract in Colombian Peso (COP) terms?
Indicate whether this represents a gain or loss to your firm.

(10 marks)

Answer

The contract has 6 months to run, so the current forward rate is:

.04
(1+ )
2
F=3428 =3472.25
.014
(1+ )
2

Our forward contract at 3200 is profitable (COP 272.25 per dollar) yielding COP
27225422 which should be discounted at 2% (0.04/2) to give the present value of the
profit = 26691590 (about 7786USD at the current spot rate).

4. As a Brazil-based arbitrageur you observe the following Brazilian Real (BRL) quotes for
the US Dollar (USD). The relevant one-year interest rates in Brazil and the USA are also
provided:

Bid Ask

BRL/USD spot 3.7147 3.72

BRL/USD forward quote 3.8 3.81

(12 months)

Interest rate (BRL) 4.28% 4.3%

Interest rate (USD) 1.365% 1.375%

 a. Explain your strategy for exploiting any implied arbitrage opportunities in the
quotations.
(4 marks)
Answer

The percentage forward premium on the USD in BRL terms is less than the interest
differential. This suggests that we should borrow in the USA and lend in Brazil

b. What is your USD profit per 1 million USD arbitraged?

(6 marks)

Answer

In BRL terms, the strategy implies that:

S BID (1+r BID )> F ASK (1+r ¿ ASK )

Or, in USD terms:

S BID ( 1+ r BID )
>(1+r ¿ ASK )
F ASK

3.7147(1.0428)
=1.0167>1.01375
3.81

The difference is 0.002966 or about USD2966 per million arbitraged.

5. The following UNSD data refer to the exchange rate of the Argentine Peso (ARS) against
the USD in 2010 and 2018:

2018 2019

ARS/USD 27.4 41

Price deflator Argentina 2000 3000

(2004=100)

Price deflator USA 110 112.2

(2009=100)

1-year interest rate 40%

Argentina

1-year interest rate USA 1.5%

 Which currency appreciated between the two years, and by what percentage?
 (2 marks)

Answer

(41−27.4)
The USD appreciated against the ARS in nominal terms by ≈ 50 %
27.4

 What was the percentage change in Argentina’s real bilateral exchange rate against
the USD? Was this a real appreciation or depreciation of the ARS?

(5 marks)

Answer

The real exchange rate index (SP*/P) calculated for 2018 is 27.4(110)/2000 = 1.507 and
the index for 2019 is 41(112.2)/3000 = 1.5334. These figures show that the nominal
exchange rate for the ARS depreciated roughly in line with the differential rate of price
increase between the two countries. There has been a negligible 1.75% real appreciation
in ARS terms of the USD.

 What was the real interest rate in Argentina and what would have been the real
interest rate for an Argentine firm that chose in 2018 to borrow unhedged for one year
in the USA?

(8 marks)

Answer

Using the Fisher closed condition, (1+r )=(1+ i)(1+ ṗ) we find that the real interest rate
(i) is minus 6.67% when borrowing in Argentina. The real ARS cost of borrowing in the
S
( 1+ r ¿ ) 2019
USA will be S 2018 1.015 ( 1.4964 ) . In this case, the nominal ARS
= =1.01 256
(1+ ṗ) (1.5)
depreciation (which increases the nominal ARS cost of repaying the US loan) has been
almost offset by the rise in ARS prices at home in Argentina. It leaves us with a positive
effective real interest cost of 1.256% - low, but not as low in real terms as borrowing at
home.

6. Although Wrightbus produces buses mainly for its home (UK) market, it sources chassis,
engines and gearboxes from Volvo in Sweden. Wrightbus is considering the possible
implications of ‘Brexit’ for the depreciation of the British pound. The firm estimates that
its net revenues in 2020 at the current exchange rate of GBP 0.079/SEK (Swedish
Kroner) will be approximately £20 million. If the exchange rate were to change to GBP
0.1/SKR, it estimates that its revenues would fall to around £18 million.

 In what sense could Wrightbus be interpreted as a portfolio of the two currencies?

You should specify the amounts of the currencies in the portfolio.

(10 marks)

Answer

If profits (π) were regressed on the GBP/SKR exchange rate we would have:
 π=α + βS

We have two ‘observations’ of this relationship:

20=α + β ( 0. 079 ) and:18=α + β (0.1)

By subtracting the second from the first, we can find β = -95.24. As it is importing bus
components, the firm is ‘short’ (minus) SKR 95 million. This solution for β can be
substituted into either equation to find that α = 27.5238. This is effectively a ‘long’
position in GBP.

 Show how a forward exchange contract might be used to hedge the exchange rate risk
faced by Wrightbus in 2020.

(5 marks)

Answer

Since Wrightbus is ‘short’ the SKR, they would buy SKRβ forward: Their hedged position
at the end of the year will be:

π=α + β S T −β ( S T −Ft 0 T ) =α + β Ft 0 T

The bracketed term after the first equality is the loss (or gain) on the ‘long’ forward
(purchase) contract.

Section B: Answer any TWO questions (20 marks each)

7. Representative annual interest rates in Brazil and Japan are currently 4.25 per cent and
(minus) 0.1 per cent respectively. With reference to the familiar interest parity conditions,
evaluate the case for borrowing in Japan and lending in Brazil.

8. What are the main sources of foreign exchange risk to business firms? Why might firms
with foreign exchange exposure choose not to hedge these risks?

9. Depreciation of a floating exchange rate, or devaluation in the case of a pegged currency,

is commonly thought to improve a country’s balance of trade. Discuss two alternative
mechanisms by which this improvement may occur.

10. Under what circumstances would the forward exchange rate and the expected exchange
rate be the same?

End of paper