Question: Part 1: 1. Currency Effects on Economy What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal?

2. Pegged Currencies Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg?

Part 2: 1. Limitations of Covered Interest Arbitrage Assume that the 1-year U.S. interest rate is 11 percent, while the 1-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase the currency of that country from you 1 year from now at a discount of 13 percent. Would covered interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest arbitrage in this situation? (Ignore tax effects.)

2. Interpreting Changes in the Forward Premium Assume that interest rate parity holds. At the beginning of the month, the spot rate of the Canadian dollar is $.70, while the 1-year forward rate is $.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the 1-year forward rate is higher than it was at the beginning of the month. Yet, the 1-year forward discount is larger (the 1-year premium is more negative) at the end of the month than it was at the beginning of the month. Explain how the relationship between the U.S. interest rate and the Canadian interest rate changed from the beginning of the month until the end of the month.