Part 2—Integrative Problem

Exchange Rate Behavior

As an employee of the foreign exchange department for a large company, you have been given the following information.

1. 2.

Beginning of Year Spot rate of £ = $1.596

Spot rate of Australian dollar (A$) = $.70

Cross exchange rate: £1 = A$2.28

One-year forward rate of A$ = $.71

One-year forward rate of £ = $1.58004

One-year U.S. interest rate = 8.00%

One-year British interest rate = 9.09%

One-year Australian interest rate = 7.00%

Determine whether triangular arbitrage is feasible, and if so, how it should be conducted to make a profit.

Using the information in question 1, determine whether covered interest arbitrage is feasible between Pound and US$, and between A$ and US$. Furthermore if so, how you should be conducted to make a profit and how much would you make with one million US dollars?

Based on the information in question 1 for the beginning of the year, use the international Fisher effect (IFE) theory to forecast the annual percentage change in the British pound’s value over the year.

Assume that at the beginning of the year, the pound’s value is in equilibrium. Assume that over the year the British inflation rate is 6 percent while the U.S. inflation rate is 4 percent. Assume that any change in the pound’s value due to the inflation differential has occurred by the end of the year. Using this information and the information provided in question 1, determine how the pound’s value changed over the year.

Assume that the pound’s depreciation over the year was attributed to central bank intervention. Explain the type of direct, indirect, sterilized intervention that would place downward pressure on the value of the pound.