FIN30013 Final Assessment PDF

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Question 1 a) Premium = (Spot rate - Forward rate)/Forward rate x (12/No. of Months Forward) x100 = (1.2810 – 1.2740)/ 1.2740 x (12/3) x 100 = 2.2% Spot:

1$ = 1.2810 SFr, $100,000 = 128,100 SFr

Forward: 1$ = 1.2740SFr $100,000 = 127,400 SFr Covered Interest Arbitrage Rate per Year 4.8%

Rate per 3 Months 1.2%

interest rates Swiss Franc nominal

3.2%

0.8%

interest rates Uncovered interest rate

1.6%

0.4%

U.S dollar nominal

differential favouring the Swiss Forward premium on the

2.2%

3-month Swiss Franc Covered interest rate

2.6%

differential favouring the Swiss I (differential) < Premium, borrow in the higher interest rate country and invest in the lower interest rate country. Swiss Franc nominal interest rate is 3.20% per annum. (0.8% for 3months) 128,100SFr x 1.008 = 129124.80SFr Convert back to US dollar at the forward rate: 129124.80SFr ÷ 1.2740SFr/1$ = $ 101353.85

Pay back USD interest: U.S dollar nominal interest rates is 4.80% per annum. (1.2% for 3months) $100,000 x 1.012 = $ 101200 Profit = $ 101353.85- $ 101200 = $ 153.85 Ans: Desmond can invest in 90 days as he can get the profit of $153.85.

b)

U.S dollar nominal interest rates Swiss Franc nominal interest rates

Rate per Year 4.8%

Rate per 3 Months 1.2%

3.2%

0.8%

Uncovered interest rate

1.6%

0.4%

differential favouring the Swiss Extra Return: 1.2% - 0.8% + 0.4% = 0.8%

Uncovered Interest Arbitrage: $100,000 x (1 + （0.008）) = $100,800 Profit = $100,800 - $100,000 = $800 Ans: If Desmond is considering engaging in uncovered interest arbitrage, according to above calculation, I will advise to Desmond to go for this investment, as in a result, it will be having a profit of $800.

Question 2

Trilemma is often related with the "impossible trinity," also known as the Mundell-Fleming trilemma. This theory emphasizes the dangers of choosing one of the three primary options available to a country when it comes to setting and maintaining international monetary policy agreements. When it comes to basic issues on international monetary policy management, a trilemma means that states have three options. The Mundell-Fleming trilemma model suggests three options: fixing a currency exchange rate, permitting capital to move freely without a fixed currency exchange rate agreement, and autonomous monetary policy. Because of reciprocal exclusivity, the mechanics of each choice clash. As a result of mutual exclusivity, only one side of the trilemma triangle may be reached at any one moment. (Majaski, 2020).

Side A: A country can opt to set exchange rates with one or more nations while allowing capital to flow freely in and out of the nation. If it adopts this option, autonomous monetary policy will be impossible to achieve because interest rate swings would promote currency arbitrage, putting currency pegs under stress and driving them to fail (Majaski, 2020). If the UK government wished to keep the Pound stable versus the Euro, it would have to modify interest rates in the same way that the ECB does. If the market believes the Pound is overpriced, capital will flow out of the UK and into the Europe, depreciating the Pound. As a result, to sustain the value of the Pound and the fixed exchange rate peg, the UK government would need to raise interest rates (and attract hot money flows). It means that in the event of a recession, the UK would be unable to decrease interest rates because the Pound would depreciate. (Pettinger, 2019)

Side B: A country can opt for unfettered capital mobility among overseas nations and its own monetary policies. The free transfer of capital and the fixed exchange rates of all nations are incompatible. Like a result, only one can be chosen at a time. As a result, fixed exchange rates are impossible to achieve when money flows liberally between all nations (Majaski, 2020). Since this government is worried about inflation, interest rates may be raised. Because of growing interest rates, the exchange rate will rise. Countries that seek to promote growth may lower interest rates, but this may cause foreign capital to flee the country, resulting in a drop in the currency value. (Pettinger, 2019) Side C: A country can't have a free flow of money if it opts for fixed exchange rates and autonomous monetary policies. Set exchange rates and unfettered capital mobility are incompatible in this case, yet again (Majaski, 2020). Let's say China wanted to keep its currency stable but cut interest rates to boost growth. The Yuan is being pushed lower in this case. Investors want to get rid of their Chinese currency and replace it with US dollars. The scenario will grow more difficult when China's government enforces capital controls. This could intentionally maintain the Yuan's value by prohibiting Chinese individuals from purchasing dollars and transferring funds out of the country. (Pettinger, 2019) Selecting which of these options to pursue and how to manipulate them is the difficult task for a government's international monetary policy. Most countries prefer the triangle's side B because it allows them to have independent monetary policy that could be used to guilt capital flows. (Majaski, 2020)

Fiscal policy and monetary policy are two of macroeconomic policy's most important tools. To keep a country’s internal and external equilibrium, these tools are used. There are three major economic sectors in a country to keep it equilibrium: Goods market, Money market, Balance of payments equilibrium.

Figure 1 The macroeconomic equilibrium is represented by a graph that summarizes market equilibrium. The IS-LM-BP diagram is shown in Figure 1. In the three markets studied, this graph depicts different pairings of domestic interest rate I with domestic national income (Y) that produce equilibrium. Curves that denotes I, Y configurations produce balance in products market while all other variables (such as price level) stay constant is IS curve. Y stands for the economy's overall income. Equilibrium is established when the number of products and services requested equals the number of goods and services produced. In floating exchange rates and free capital mobility. Under floating rates, federal reserve is not obligated cooperating in forex market to sustain certain exchange rate. Without action, official settlements with a zero balance. Furthermore, because the central bank doesn’t act

keeping the exchange rate, the supply of money might vary to any rate liked by the monetary authorities. One benefit of flexible exchange rates is the independence of monetary policy.

Because domestic interest rate is less than iF, the rate of interest and revenue at point e0 will bring the capital and products markets to a state of equilibrium but might result in a bigger capital account deficit. Official settlements deficit has prevented in this flexible exchange rate system by making the exchange rate toward a point where balance is restored. Due to pressure of the official settlement deficit, local currency would decline. Devaluation is followed by a shift to the right change in the IS curve as domestic exports increase. New equilibrium is obtained at ev when the IS curve shifts to IS0. At ev, revenue rises, and the domestic interest rate has reached parity with the foreign rate. If there had been a monetary contraction rather than an expansion, scenario might have been different. Capital account deficit might be reduced by a temporary increase in the interest rate, putting upward stress on the domestic currency. As domestic net exports fall, IS curve moves to left till a stable point is attained at such a lower amount of pay, and original I = iF is restored. In contrast to fixed exchange rates, floating exchange rates allow monetary policy to change the level of income. Because the exchange rate adjusts to provide balance of payments equilibrium, the central bank may determine its monetary policy irrespective of other nations' actions. The Mundell Fleming open economy concept is noted for its free capital mobility and flexible exchange rates.

The IS curve will be shifted to the right by an expansionary fiscal policy, such as tax cut or more government spending. It was previously demonstrated that a policy based on fixed exchange, a higher amount of domestic revenue would arise. We shall see that the story changes dramatically with variable exchange rates. The IS curve swings right in Figure 13.10, from IS to IS0, as a result of the expansionary fiscal policy. This change would lead to a point e0, which would be an intermediate equilibrium. At e0, the commodities and financial markets are in balance, but due to the decreased capital account deficit induced by higher interest, there is an official settlement surplus. Because the exchange rate is allowed to fluctuate for erase the balance of payments surplus, the junction of the IS and LM curves cannot persist above the BP curve. Native currency appreciates as a result of the official settlements surplus. This rise in imports will offset the decrease in domestic exports. The IS curve swings left when net exports decline. Equilibrium is restored in all markets after IS curve has reverted to its original balance point that goes through point e. The eventual equilibrium is achieved at the original I, Y levels. When exchange rates are floating, fiscal policy is ineffectual in moving income levels. When a stimulus package has no effect on income, it is called complete crowding out. The crowding-out effect occurs when exchange rate caused by expansionary fiscal policy decreases net exports toward point that balances fiscal policy's income effects. Variations in exchange rates and net exports caused by monetary policy has been reduced if central banks synchronize their actions such that iF adjusts with i. There are already periods when a group of financial institutions worked together to adopt policies targeted at depreciating or appreciating the dollars. Such coordinated actions try to bring domestic monetary policies closer together while reaching a specific dollar value. In compared with

Japan, if the US pursues an expansionary monetary policy, US interest rates will drop below those of the countries, resulting in a bigger capital account deficit and push for the currency to depreciate. The Japanese might purchase dollars on the foreign exchange market using home currencies if central banks agree - cooperate to stem the currency's devaluation, while the Central Bank will have to offer foreign exchange to purchase dollars. As a consequence, Japan's supply of money will grow, while the United States' would shrink. The coordinated intervention aims for monetary policy convergence in each country. The majority of exchange rate movements are due to actual economic shocks and must be regarded irreversible.

Reference: Pettinger, 2021, ‘Policy trilemma – the impossible trinity’, viewed 25 May 2021, https://www.economicshelp.org/blog/glossary/policy-trilemma-the-impossible-trinity/ Majaski, C 2020, ‘Trilemma Definition’ , viewed 25 May 2021, https://www.investopedia.com/terms/t/trilemma.asp#:~:text=Trilemma%20often%20is %20synonymous%20with,its%20international%20monetary%20policy%20agreements. Warwick.ac.uk. N.d. The IS-LM-BP Approach, viewed 26 May 2021 https://warwick.ac.uk/study/summer-with-warwick/warwick-summerschool/courses/macroeconomics/carlinsoskice_ch13.pdf...