Sample/practice exam April 2015, questions and answers PDF

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Monash University Semester One Mid Semester Test 2014 Faculty of Business and Economics TEST CODES:

ECF2721

TITLE OF PAPER:

Trade Finance and Foreign Exchange

TEST DURATION:

90 minutes writing time

READING TIME:

5 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT:( tick where applicable)  Berwick  Clayton  Malaysia  Off Campus Learning  Caulfield  Gippsland  Peninsula  Enhancement Studies  Pharmacy  Other (specify)

 Open Learning  Sth Africa

During a test, you must not have in your possession, a book, notes, paper, calculator, pencil case, mobile phone or other material/item which has not been authorised for the test or specifically permitted as noted below. Any material or item on your desk, chair or person will be deemed to be in your possession. You are reminded that possession of unauthorised materials in a test is a discipline offence under Monash Statute 4.1.

No examination papers are to be removed from the room. AUTHORISED MATERIALS CALCULATORS

 YES

 NO

OPEN BOOK

 YES

 NO

SPECIFICALLY PERMITTED ITEMS if yes, items permitted are:

 YES

 NO

Candidates must complete this section if required to write answers within this paper

STUDENT ID

__ __ __ __ __ __ __ __

DESK NUMBER

__ __ __ __

INSTRUCTIONS TO STUDENTS 1. Candidates should answer ALL questions. 2. This test comprises of two (2) sections, Part A and Part B. In answering the questions in Part B, show all working. Page 1 of 11

Equations that may be helpful. 1. Approximation: For a and b small enough, 

1 + c = (1 + a) × (1 + b) ≈ 1 + a + b.



1 + d = (1 + a) ÷ (1 + b) ≈ 1 + a – b.

2. Growth rate: For Zt = Xt × Yt and Wt = Xt ÷ Yt with Xt >0, Yt > 0, 

(Zt+1 – Zt) / Zt ≈ (Xt+1 – Xt) / Xt + (Yt+1 – Yt) / Yt .



(Wt+1 – Wt) / Wt ≈ (Xt+1 – Xt) / Xt – (Yt+1 – Yt) / Yt .

Page 2 of 11

Part A (45 Marks) Answer all of the following 15 multiple-choice questions in your answer book (not on this paper). Each question is worth 3 marks. Clearly number all the questions and write your answers in CAPITAL LETTERS. For example your answers to this section should look like: 1. A 2. D 3. B And so on.... Note that your answers should consist ONLY of the questions number and the letter of the answer you believe to be correct. NO explanations of answers will be taken into account in marking. 1.

If we compare the exchange rate between two nations, expressed in the domestic currency with the same rate expressed in units of the foreign currency, it will be obvious that: A) B) C) D)

they are both equal to 1. they cancel each other out. one is always the reciprocal of the other. they can never coexist.

Answer: C E$/€ = 1/E$/€

2.

If, in 2012, AU$1.5 = 1 euro, and in 2013, AU$1.2 = 1 euro, which of the following statements would be true? A) B) C) D)

More European tourists will find it cheaper to travel to Australia. More Australians will stay home as visits to Europe become more expensive. Australians will import fewer products from Europe. Europeans will import fewer products from Australia.

Answer: D AU$ appreciated against euros.  Exports of goods and services fall, and imports rise in Australia. 3.

Suppose 20% of Australian trade is with England and the rest is with Japan. If the Australian dollar depreciates by 20% against the pound but appreciates by 20% against the yen, what is the percentage change in the effective exchange rate of Australia? A) B) C) D)

-12% +12% -20% +20%

Answer: A Depreciation rate of the effective E = 0.2x20% + 0.8×(-20%) = 4%-16% = -12%

Page 3 of 11

4.

Suppose $1 = 0.8 euros in London and $1 = 0.7 euros in New York. Which of the following would be the right trade for you to make money? A) B) C) D)

You sell euros in London and buy euros in New York. You sell dollars in New York and buy dollars in London. You sell dollars in London and buy dollars in New York. You sell euros in London and buy dollars in New York.

Answer: C Buy low and sell high. The euro is cheap in London and it is expensive in NY. Buy euros and sell dollars in London, and sell euros and buy dollars in NY.

5.

If the real exchange rate for a foreign currency rises (a real depreciation), what is the situation? A) B) C) D)

It takes more home goods to purchase the same quantity of foreign goods. It takes fewer home goods to purchase the same quantity of foreign goods. The nominal exchange rate has risen as well. The nominal exchange rate has fallen.

Answer: A qhome/foreign can be interpreted as the units of home baskets that are necessary to get 1 unit of foreign basket. A rise in qhome/foreign means more home baskets are required to get 1 unit of foreign basket. Use the following figure to answer question 6:

Figure 1 Exchange rate ($ per €)

S€

1.4 1.2 1.0

D€ 400

6.

500

600

Euros (billions)

Consider Figure 1. Suppose that the current exchange rate is 1.2 dollars per euro without the Reserve Bank of Australia’s intervention. In order to defend the exchange rate of 1.4 dollars per euro, the Reserve Bank of Australia, monetary authority, must intervene in the foreign exchange market and __________ billion euros. A) B) C) D)

buy 100 sell 100 buy 200 sell 200

Answer: C At E$/€=1.4, private demand = €400, private supply = €600. So, the CB has to demand (buy) €200. ----- End of questions based on Figure 1 ----Page 4 of 11

7.

Which of the following situations would exhibit the relative purchasing power parity? A) Europe’s yearly inflation rate rises from 2% to 4%, all others things being equal, and the depreciation rate for the euro-yen rate, E€/¥, rises by 4 percentage points. B) Europe’s yearly inflation rate rises from 2% to 4%, all others things being equal, and the depreciation rate for the euro-yen rate, E€/¥, falls by 4 percentage points. C) Europe’s yearly inflation rate rises from 2% to 4%, all others things being equal, and the depreciation rate for the euro-yen rate, E€/¥, falls by 2 percentage points. D) Europe’s yearly inflation rate rises from 2% to 4%, all others things being equal, and the depreciation rate for the euro-yen rate, E€/¥, rises by 2 percentage points. Answer: D Relative purchasing power parity: %ΔE€/¥ = π€ – π¥. If π€ goes up by 2% points, %ΔE€/¥ goes up by 2% pointes.

8.

Using the uncovered interest parity equation, what would happen to the spot exchange rate for euros if the interest rate on Australian deposits rises, all others things being equal? A) B) C) D)

the spot rate to purchase euros would rise (dollar depreciation). the spot rate to purchase euros would fall (dollar appreciation). the spot rate to purchase euros would be unchanged. Not enough information is provided.

Answer: B UIP: Ee$/€/E$/€ – 1 = i$ – i€. If i$ rises, (Ee$/€/E$/€ – 1) rises. Thus, E$/€ falls with the same Ee$/€. 9.

Given expectations of future exchange rates, when foreign returns are greater than domestic returns, investors will _____ domestic currency, and ____ foreign currency. A) B) C) D)

sell; sell sell; buy buy; sell buy; buy

Answer: B FR> DR  invest in the foreign country. Buy foreign currencies, and sell home currencies. Use the following to answer questions 10-12: Scenario 1: The price level in Australia is 2, P$=2, the price level in the U.K is 2, P£=2, and the current spot exchange rate for AU$ against the British pounds is 2.0, E$/£=2.0. 10. The Australian dollar is _____ and _______ at the moment. A) B) C) D)

undervalued; strong undervalued; weak overvalued; strong overvalued; weak

Answer: B q$/£= 2 > 1. So, $ is undervalued and weak at the moment.

Page 5 of 11

11. According to the speed of convergence, which predicts that the deviation from the purchasing power parity will be reduced by 15% per year, what will be the real exchange rate for British pounds, q$/£, next year? A) B) C) D)

1.70 1.85 0.65 1.00

Answer: B q$/£= 2.  the deviation from PPP is 1, x = 1. x will shrink by 15%  xnew = 0.85x = 0.85. The real exchange rate in 1 year is q$/£,new = 1 + xnew = 1.85. 12. According to the half-life of deviations from the purchasing power parity, 4 years, what will be the real exchange rate for British pounds, q$/£, in four years? A) B) C) D)

1.00 1.50 0.75 0.25

Answer: B x will shrink by 50% in 4 years  x in 4 years = 0.5x = 0.5. The real exchange rate in 4 years is q$/£,4-year = 1 + (x in 4 years) = 1.5. ----- End of questions based on Scenario 1 ----13. A permanent fall in the rate of money growth in the home country will cause what long-run effects in the home economy? A) B) C) D)

a rise in the nominal rate of interest and a fall in inflation a rise in the nominal rate of interest and a fall in real GDP a fall in the nominal rate of interest and a fall in inflation a fall in the nominal rate of interest and a rise in real GDP

Answer: C Inflation rate falls, and the nominal interest rate falls. 14. When the exchange rate has fallen in the short run and then rises slightly in the long run, it implies that: A) B) C) D)

the domestic money supply has temporarily risen. the domestic money supply has permanently risen. the domestic money supply has temporarily fallen. the domestic money supply has permanently fallen.

Answer: D With a permanent fall in the domestic money supply, the price falls in the long run and the exchange rate also falls in the long run. In the short run, the interest rate rises which causes a further decrease in the exchange rate compared to the long run. After the drop, the exchange rate rises toward the new long-run level over time.

15. If an economy wants to maintain monetary policy autonomy, then: Page 6 of 11

A) B) C) D)

it can maintain a fixed exchange rate and international capital mobility. it can impose strict capital controls and maintain a fixed exchange rate. It can have fixed exchange rates only when it allows free flows of capital. Fixed exchange rates are not possible.

Answer: B Trilemma: A country can have only 2 policies out of following three policies; (i) fixed exchange rate regime, (ii) international capital mobility, and (iii) monetary policy autonomy.

Page 7 of 11

Part B (55 Marks) Answer ALL of the following questions in your answer book (not on this paper). Be sure to label all curves and equilibrium levels in diagrams, and show all working TO GET FULL MARKS.

16. You observe the following current rates:    

the spot exchange rate today : AU$1.0 per €1, the (one-year) nominal interest rate on bank deposits in Australia: i$ = 3%, the expected spot exchange rate in one year: AU$0.98 per €1, the expected annual inflation rate in Australia: πe$ = 1%.

(a) If the uncovered interest parity holds, what is the one-year nominal interest rate on bank deposits in Germany, i€, (using approximation)? (3 marks) Answer: i€ = i$ – (Ee$/€/E$/€ – 1) = 3% - (0.98/1 – 1) = 5%. (b) If the uncovered interest parity and the purchasing power parity hold, what is the real interest rate in Germany, r€? (3 marks) Answer: Real interest parity holds. r€ = r$ = i$ – πe$ = 3% - 1% = 2%. (c) If the covered and uncovered interest parities hold, what is the forward premium (for the 1year forward rate)? (3 marks) Answer: F$/€/E$/€ – 1 = i$ – i€ = 3% - 5% = –2%. Alternatively, with UIP and CIP, F$/€ = Ee$/€ = 0.98. So, F$/€/E$/€ – 1 = 0.98/1 – 1 = –2%. (d) Suppose that the covered interest parity does not hold at the moment with the 1-year forward rate of €1.05 per AU$1, F$/€ = 1/1.05 = 0.952. Assume that you can borrow either AU$1 million in Australia with the annual nominal interest rate of 3% or €1 million in Germany with the nominal interest rate in (a). Explain how you will make risk-free profits using the forward market and the spot markets today in one year (The answer should have the amount of the profit in one year in AU$.). (10 marks) Answer: i$ = 3% > i€ + (F$/€/E$/€ – 1) = 0.2%. Borrow €1 mill. from Germany, convert it to $1 mill., invest in Australia with the interest rate of 3%. At the same time make a forward contract to buy €1.05 mill. at the forward rate of F$/€ = 1/1.05 (€1.05 per AU$1) since you have to payback €1.05 mill. One year later, receive $1.03 mill. from the investment, finalize the forward contract by selling $1 mill. and receive €1.05 mill. Then pay back €1.05 mill. The net profit is $30 thousand.

(e) Explain what will happen to the current spot exchange rate, E$/€, (increase, decrease, or no change) if the forward rate in (d) and the nominal interest rates in two countries remain the Page 8 of 11

same (the answer should have the change in the demand for or the supply of euros in the foreign exchange market; the exact number for new exchange rate is not required). (8 marks) Answer: Since many investors will invest in Australia rather than Eurozone area, there will be greater demand for dollars and greater supply of euros in the current spot exchange market. This will decrease the exchange rate E$/€ (price of euros). (The graph and the new exchange rate are not required) E$/€

S1 S

2

A 1.00 0.97

D1 Q1

Q2

Euros

17. Consider two countries, country A and country B. The real output (income) growth rate in country A is 2.0% per year, whereas the growth rate in country B is 5.0% per year. Suppose the central bank of country A allowed the money supply to grow by 6.0% each year, whereas the central bank of country B maintains relatively high money growth of 8.0% per year. For the following questions, use the general monetary model (where L depends on the interest rate of the country) and the purchasing power parity. Treat country A as the home country and country B as the foreign country. In addition, assume that the world interest rate is 2% per year in the long run, r* = 2%. Define the exchange rate as the currency of country A against that of country B, EA/B. (a) What is the growth rate of the real money balance, MA/PA, in country A?

(3 marks)

Answer: %Δ(MA/PA) = gA = 2%. Or, %Δ(MA/PA) = %ΔMA - %ΔPA == µA – πA = µA – (µA – gA)= gA= 2%. (b) What is the expected depreciation/appreciation rate of the currency of country A against that of country B? (3 marks) Answer: πA = µA – gA = 6% – 2% = 4%. πB = µB – gB = 8% – 5% = 3%. %Δ(EA/B) = πA – πB = 4% – 3% = 1% (c) Now, Suppose the central bank of country A decreases the money growth rate from 6% to 3% permanently (at time T). Assume that nothing in country B changes. Page 9 of 11

(i)

What is the new nominal interest rate in country A, iA?

(3 marks)

Answer: πA,new = µA,new – gA = 3% - 2% = 1%. iA,new = πA,new + r* = 1% + 2% = 3% (ii) What is the new expected depreciation/appreciation rate of the currency of country A against that of country B? (3 marks) Answer: %Δ(EA/B)new = πA,new – πB = 1% – 3% = -2% (2% appreciation) (iii) Using time series diagrams below (replicate them in your answer book), illustrate

how this decrease in the money growth rate in country A affects (i) the nominal interest rate in country A, iA; (ii) the price in country A, PA; (iii) the real money supply in country A, MA/PA; and (iv) the exchange rate, EA/B, over time (the answer should have the time paths of variables and their growth rates (slopes) before and after time T). (16 marks) Answer: ln PA

iA

6% 1% 3% 4%

Time

T

Time

T ln EA/B

ln (MA/PA)

2% 1% -2%

2%

T

Time

Time

T

iA,old = πA,old + r* = 4% + 2% = 6%, and iA,new = πA,new + r* = 1% + 2% = 3% So, the interest rate falls from 6% to 3%.

Page 10 of 11

The real money balance growth rate is always equal to the income growth rate as shown in (a), 2%. At time T, the interest rate falls to 3%. This causes the real money balance to rise at time T as the real money balance is given by M/P = L(i)Y with L(i) being negatively related to i. At time T, the money growth rate in country A falls, but MA does not change much at time T. With the increase in the real money balance with almost the same MA at time T, the price, P, should drop at time T, PA = MA/(MA/PA). The growth rate of PA is the inflation rate, 4% before T and 1% after T. The exchange rate with the purchasing power parity is given by EA/B = PA/PB. Since the price of country A falls at time T, the exchange rate falls at time T. The depreciation rate %Δ(EA/B) is given by %Δ(EA/B) = πA – πB, which is 1% before T and -2% after T.

* * * END OF PAPER * * *

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