Assignment: International Finance
1) Suppose the current dollar-pound exchange rate is $1.35/£, and this is also the price trading in the 1-year forward market (i.e. you can agree today to trade currencies in one year at an agreed upon rate of $1.35/£). U.S. 1-year bond yields are currently 2%, and U.K. 1-year bond yields are currently 3%.
a. In a world without transaction costs or other frictions, describe a strategy for generating arbitrage profits.
b. Suppose every transaction has some percentage cost to enact. For example, if the cost is X%, then converting to pounds will cost $1.35(1+X%) per pound, and that to buy a U.S. bond, the true price is not 100.00/1.02 = 98.04 but 100*(1+X%)/1.02. What is the smallest value of X that eliminates your arbitrage opportunity?
2) Suppose that expected inflation in the U.S. is 1.9% and the expected inflation rate in China is 1.8%. Provide an argument or several arguments to tie this differential to as many of the following as possible (not all are possible, at least as far as I know!):
a. Current Nominal Interest Rate Gaps
b. Current Real Interest Rate Gaps
c. Current Spot Exchange Rates
d. Current Forward Exchange Rates
e. Expected Future Nominal Interest Rate Gaps
f. Expected Future Real Interest Rate Gaps
g. Expected Future Spot Exchange Rates
h. Expected Future Forward Exchange Rates
3) For each of the following, describe any capital or current account debits or credits they create from the perspective of the U.S.
a. A U.S. citizen in Paris buys a ticket to see the Louvre
b. An Egyptian citizen receives a dividend payment from their ownership of GE stock
c. A large Japanese bank buys real estate in Manhattan
d. A European government provides foreign aid to Algeria
4) A protectionist movement in the United States has many proponents in both major political parties. They see as destructive the ability of American firms to outsource components of their business. Among many of the proposals are increasing tariffs on imports and providing incentives to businesses that hire American workers. Briefly, outlines the costs and benefits of either of these policy suggestions.