MUST SHOW WORK

1. Suppose spot exchange rate E¥/$ = 85. If the price of a music compact disc (CD) is $18 in the U.S. and the same CD costs 1,900 yen in Japan, and if there are no transaction or transportation costs, then what will CD traders do?

a. Nothing, the law of one price is holding.
b. Buy CDs in the U.S. and sell them in Japan.
c. Buy CD's in Japan and sell them in the U.S.

2. Suppose the cost of a market basket of goods in Hong Kong is 1,245 Hong Kong dollars, while the cost of the same market basket in Philippines is 6,500 Philippine peso. Calculate the Philippine peso/ Hong Kong dollar exchange rate if purchasing power parity holds between the two.Now assume that the current exchange rate between Hong Kong dollars (HK$) and U.S. dollars is 7.6923 HK$/$. What then would you expect the rate to be between the Philippine peso and U.S. dollar? This is not a multiple choice question; please show your work to receive full credit.

3. (This problem is worth 4 of the 10 points in this assignment). Assume that a U.S. firm has ordered a major piece of machinery from a Japanese firm for ¥3 million, and that the current exchange rate is 106 ¥/$ (i.e., the current cost of the machinery in dollars is $28,302). The payment for the machinery, to be made in Yen, is due in 6 months and the firm will borrow at its bank at a 6% p.a. rate . The U.S. firm is concerned about appreciation of the Yen, which would lead to a greater cost than planned. Therefore, the firm is considering twopossible transactional hedges: (1) entering into a forward contract, or (2) creating a money market hedge.

REQUIRED:

a. Explain what exact steps the firm should take in each of the possible hedges (i.e., what positions). Assume that 6-month forward contracts are currently available at an exchange rate of 103.5¥/$; the relevant interest rate in Japan is 3% p.a.

b. You learned from week 6 that both the money market hedge and the forward hedge lock in the cost of the machinery. What is that cost to the U.S. firm (in dollars) in 6 months? Show your work.

c. Which hedge would be the best choice? Hint: There is less than $300 difference between the two choices.

d. By what amount would the firm be better or worse off if it simply paid for it today? To be consistent you need to consider the time value of money and we will assume the 6% rate as the opportunity cost of paying today rather than in 6 months.

4. You learned in week 5 about interest rate parity. Let's take the last problem of Problem Set 2 one step further. Recall the problem: Suppose an investor invests in a savings account in England one year ago. At the time of investment, the investor converted $100,000 to pounds at an exchange rate of 1.404$/£. Assume the interest rate in England was 3% and today the investor is converting his/her savings balance (principal plus interest) to dollars when the exchange rate is 1.464$/£. You were asked: How much money will the investor receive? The correct answer was $107,402 (rounded). If we assume that the 1-year forward rate at the time of the investment was 1.464$/£ and interest parity held, then what was the interest rate in the U.S. at the time of investment? Show your work.

5. Now look at the information from the problem above (#5). Assume that today the exchange rate is 1.464$/£ and that the 6-month interest rate in London is 3.2% p.a. while the 6-month interest rate in the U.S. is 2.8% p.a. What would you expect the 6-month forward rate to be at this time?Remember to adjust for the 6-month period. Show your work

6. Again, working with interest rate parity, Let's assume that the spot exchange rate between Mexican pesos (P) and the U.S. dollar is 18.8679 P/$ and the 1-year forward rate is 19.1679 P/$. Also assume that the U.S. interest rates are 2% p.a. and the Mexican interest rates are 1.95% p.a. What actions can an arbitrageur take to profit per $1000 invested from this scenario? Specifically note the actions the arbitrageur would take (1 point) and then report the arbitrage profit available per $1000 because interest rate parity is not holding. Note that an arbitrageur would invest as much money as available (millions) given this scenario so huge arbitrage profits could be made.