Tutorial 5 - International Currency and Banking Markets PDF

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Topic 5 tutorial questions and answers...

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TUTORIAL 5 (Week 5 TOPIC 4) Chapter 6: Questions and applications: Q1. a) PPP Explain the theory of purchasing power parity (PPP). The theory of purchasing power parity states that inflation determines, in part, a country’s exchange rate. Where there is inflation in one country, the exchange rate will adjust so that the purchasing power is comparable for the same product in different countries. b) Based on this theory, what is a general forecast of the values of currencies in countries with high inflation such as Iran, Zimbabwe and Argentina relative to Australian dollar? These currencies would have a very high exchange rate (ie very high foreign currency per Aus $). c) Based on inflation forecasts, what is a general forecast of the values of currencies in countries with low inflation such as France, Singapore, and Switzerland relative to Australian dollar? These currencies would have a very low exchange rate (ie 0.8 swiss / Aus $) Hint: You may use a source such as the trading economics shown below to derive inflation forecasts. https://tradingeconomics.com/country-list/inflation-rate d) Knowing the spot rate of currencies such as Brazilian Real, Euro, Singapore dollar and Swiss Franc, forecast the expected currency value one-year from now using the relative version of PPP. Q2. Implications of IFE Assume Australian interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should Australian investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in Australian securities if they believe in the IFE? With a high comparative interest rate, the Australian dollar is expected to weaken over time in comparison to other foreign currency (ie exchange rate will increase). The IFE theory states that this change in exchange rate will balance out any gains/losses that come with a high interest rate. As such, for those who believe in the IFE, they would believe that their earnings would be the same in either their home country and foreign

country (ie the money earned on foreign investments would yield similar results to that at home, in either Australia or another foreign country) Q3. Comparing PPP and IFE How is it possible for PPP to hold if the IFE does not? The IFE is dependent upon: 1. Investors across countries requiring the same real returns 2. The expected inflation rate to be reflected in the nominal interest rate 3. The exchange rate adjusts to the inflation rate differential (under PPP) If investors do not require the same real returns, or the expected inflation rate is not properly reflect in the nominal interest rate, then the IFE would not hold. The PPP, however, would still hold, as this is only dependent upon consumer purchases, which will shift wherever products cost cheaper. Q4. Deriving Forecasts of the Future Spot Rate As of today, assume the following information is available: Australia Switzerland Real rate of interest required by investors

2%

Nominal interest rate

?

Spot rate

2% ? SF $ 0.6467 / AUD

One year forward rate

Bid (bank selling): - 62.05 Ask (bank buying from purchaser): - 60.08 a. Obtain spot and one-year forward rates of Swiss Franc with respect to the Australian dollar from a web source such as au.investing.com/currencies. b. Use the forward rate to forecast the percentage change in Swiss Francs over the next year. One year forward rate = -0.6008 Spot rate = 0.6467 Annualised forward premium =

−0.6008−0.6467 =¿ - 0.6008% decrease in swiss francs 0.6467

c. Use the differential in expected inflation to forecast the percentage change in the Swiss Francs over the next year.

d. Use the spot rate to forecast the percentage change in the Swiss francs over the next year. Q5. IFE, Cross Exchange Rates, and Cash Flows You own a export/import business and are based in the United States. Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Assume that interest rate parity exists. Today, an Australian dollar (A$) is worth US $ 0.68 and HK$5.40. The 1-year interest rate on the Australian dollar is 1.00 percent, while the 1-year interest rate on the U.S. dollar is 2.25 percent. You believe in the international Fisher effect. You will receive A$1 million in 1 year from selling products to Australia, and will convert these proceeds into Hong Kong dollars in the spot market at that time to purchase imports from Hong Kong. Forecast the amount of Hong Kong dollars that you will be able to purchase in the spot market 1 year from now with A$1 million. Show your work. 1+ih −1 1+if 1.0225 1+0.0225 −1= ef = −1 =0.01237=1.237 % expected change in A$ against USD$ 1.01 1+0.01 ef =

Hong Kong is tied to US dollar, so A$ is expected to change 1.237% against HK$ Thus, the exchange rate in one year will be the current exchange + expected change = 5.40 x (1 + 0.01237) = HK $ 5.4668 / AUD$ Thus, in one year, A$1 million would be worth HK $5,466,800 Q6. IFE and Forward Rate The one-year Treasury (risk-free) interest rate in the Australia is presently 1%, while the one-year Treasury interest rate in India is 5.4%. The spot rate of the Indian Rupee is A$0.02. Assume that you believe in the international Fisher effect. You will receive 1 million Indian rupees in one year. a. What is the estimated amount of Australian dollars you will receive when converting the rupees to Australian dollars in one year at the spot rate at that time? 1+ih −1 1+if 1.0 1 1+0.01 −1= −1=− 0.04175=− 4.175 % ef = 1.054 1+0.0 54 ef =

Exchange rate in one year will be 0.02 x (1-0.04175) = A $0.01917 / rupee

Thus, in one year, 1 million rupees will be worth = 1 million x 0.01917 = AUD$19,170 b. Assume that interest rate parity exists. If you hedged your future receivables with a oneyear forward contract, how many dollars will you receive when converting the rupees to Australian dollars in one year? 1+ih −1 1+if 1+0.01 −1=−0.04175=−4.175 % p= 1+0.054 p=

F = spot rate x premium = 0.02 x (1-0.04175) = 0.01917 Forward selling 1 million rupees = 1,000,000 x 0.01917 = AUD$19,170...