1. Foreign exchange market (4 marks)

If the Australian dollar-British pound exchange rate is A$1.80 per pound, and the Australian dollar-euro rate is A$1.53 per euro:

(a) What is the pound-per-euro rate? (2 marks)

(b) How could you profit if the pound-per-euro rate were above the rate you calculated in part a? What if it were lower? (2 marks)

2. Interest rate parity conditions (5 marks)

(a) It is often said that interest rate parity is satisfied when the differential between the   interest rates denominated in two currencies equals the forward premium or discount between the two currencies. Explain why this is an imprecise statement when the      interest rates are not continuously compounded. (3 marks)

(b) Suppose you are the German representative of a company selling washing machines in South Africa. Describe your foreign exchange risk and how you might hedge it    with a money market hedge. (2 marks)

3. Purchasing power parity and real exchange rates (10 marks)

(a) Suppose the Australian dollar-United States dollar exchange rate moves from AUD1.28/USD to AUD1.42/USD. At the same time, the prices of United States-made goods and services rise 8.3 per cent, while prices of Australian-made goods and services rise 5. 1 per cent. What has happened to the real exchange rate between the Australian dollar and the United States dollar? (2 marks)

(b) The same television set costs A$750 in Australia, US$500 in the United States, €450   in France, £300 in the United Kingdom, and ¥100,000 in Japan. If the law of one price holds, what are the AUD/USD, AUD/EUR, AUD/GBP, and AUD/JPY exchange rates? (2 marks)

(c)  Why might the law of one price fail? (2 marks)

(d) Can purchasing power parity help predict short-term movements in exchange rates? Why or why not? (2 marks)

(e) If the price (measured in a common currency) of a particular basket of goods is 10 per cent higher in the United Kingdom than it is in Australia, which country’s currency is undervalued, according to the theory of purchasing power parity? Why? (2 marks)

4. Foreign currency swaps (5 marks)

The swap desk at Macquarie Bank is quoting the following rates on 5-year swaps versus 6-month Australian dollar BBSW:

Australian dollars: 6.85% bid and 6.95% offered

Swiss francs: 4.25% bid and 4.35% offered

You would like to swap out of Swiss franc debt with a principal of CHF50,000,000 and into fixed-rate Australian dollar debt.

(a) At what rates will Macquarie Bank handle the transaction? (2 marks)

(b)  If the current exchange rate is AUD1.46/CHF, what would the cash flows be? (3 marks)

5. A monopolist with imported costs (8 marks)

Suppose you are a monopolist who faces a domestic demand curve given by Q = 1,000 – 2P. Your domestic cost of production involves domestic costs per unit of 300 and a         foreign cost per unit produced of 150.

(a) If the real exchange rate is 1. 1, what would be the price you would charge and the quantity you would sell? (4 marks)

(b)  How does the price you would charge and the quantity you would sell change when the real exchange rate increases by 10%? (4 marks)

6. International debt financing (6 marks)

(a) What is the difference between a foreign bond and a Eurobond? (2 marks)

(b) Why are Eurocredits not extended by one bank but by a large syndicate of banks? (2 marks)

(c)  Should corporations issue bonds in countries where they face the lowest credit spreads? Be specific about the concept of credit spread you use. (2 marks)

7. Risk and return of international investments (12 marks)

Suppose a Singaporean investor wishes to invest in a British firm currently selling for £80 per share. The investor has S$20,000 to invest, and the current exchange rate is S$2/£ .

(a) How many shares can the investor purchase? (2 marks)

(b) Fill in the table below for rates of return after one year in each of the nine scenarios (three possible share prices denominated in pounds times three possible exchange   rates). (3 marks)

(c) If each of the nine outcomes is equally likely, find the standard deviation of both the pound-denominated and Singaporean dollar-denominated rates of return. (2 marks)

(d) Now suppose the investor also sells forward £10,000 at the forward exchange rate of S$2. 10/£ . Recalculate the dollar-denominated returns for each scenario. (3 marks)