Week 4-5: Tutorial Problem Set 4

( Updated ) * „ ,

April 13, 2022

Warm-up Questions (with guiding answers )

1. Exchange rate follows approximately random walk with little or no drift.
Explain.
• Exchange rates appear to follow a random walk process , which means
that period-to-period changes in the exchange rate are random and unpre-
dictable. That is, the level of exchange rate tomorrow (t + 1) is as likely
to be higher as it is to be lower than its level today (t = 0). Hence, it is
dicult to predict the level of the exchange rate in t + 1 and that the best
forecast for t+1 is the exchange rate at period t.
2. Discuss the factors that cause the demand and supply curves of foreign
exchange to shift, consequently leading to changes in the exchange rate.
• Refer to lecture 7 notes on Moodle ( PowerPoint slides 4-15 )

3. In what sense is PPP relevant to business operations?

• PPP is important for international business rms because the validity or
otherwise, of this theory implies the possibility, or otherwise, of real cur-
rency appreciation and depreciation, and hence the presence of exposure
to economic risk.

4. Explain how PPP can be derived from the supply and demand model of
exchange rate determination, and state the PPP-exchange rate.
• Refer to lecture 8 notes on Moodle (PDF document  Lecture 8 - Ad-
ditional Notes )

5. Derive the monetary model of exchange rates, and explain what happens
to the domestic currency if:

(a) there is a domestic currency expansion (increase in money supply);

* Questions compiled from Moosa (2010), International Finance

„ Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting, Economics
and Finance, The University of the South Pacic.

1
 (b) domestic income falls; and

(c) domestic price level rises.

• Refer to lecture 8 notes on Moodle (PDF document -  Lecture 8
- Additional Notes )

6. The supply and demand model predicts that the domestic currency de-
preciates as domestic income rises. The monetary model predicts that the
domestic currency appreciates as income rises. Why does this contradic-
tion arise?
• The supply and demand model predicts that domestic currency will de-
preciate as income rises because the demand for foreign exchange increases
due to increase in demand for imports. This will result in exchange rate
S(d/f ) rising, resulting in currency depreciation. However, a rise in in-
come, according to the monetary model, leads to a rise in the demand
for money, and given an unchanged supply of money, excess demand for
money will emerge, which has the same eect as a reduction in the nomi-
nal money supply. A reduction in the supply of money reduces price level,
and the exchange rate S(d/f ) decreases , resulting in domestic currency
appreciation. The reasoning can also by discussed in terms of increase in
demand for money, holding supply of money xed, resulting in increase
in domestic interest rates, thus increasing the supply of foreign exchange
and hence domestic currency appreciation.

7. Use supply and demand model and monetary model of exchange rate,
analyze the eects of the following news items on the Australian currency,
that is whether AUD should be bought or sold:

(a) The Reserve Bank of Australia (RBA) announced that the Aus-
tralian money supply increased by 8 per cent in the previous month.
• A monetary expansion causes ination. Both PPP and the mon-
etary model tell us that domestic currency should depreciate. This
also means that AUD should be sold n response to such news. How-
ever, if the RBA reacts by raising interest rates following the an-
nouncement, this leads to currency appreciation, and hence AUD
should be bought.

(b) The Australian short-term interest rate jumped from 6.5 to 7.5 per
cent.
• A higher interest rate depresses economic activity (cost of borrow-
ing increases), hence aecting income, which can have adverse eect
on the domestic currency, hence domestic currency will be sold. How-
ever, higher interest rates attract capital inows, leading to currency
appreciation, hence AUD should be bought.

(c) The federal government predicted that the Australian economy would
grow by 5 per cent in real terms in the coming scal year. Private
sector economists seem to agree with this prediction.
• Growth leads to an increase in imports, which has adverse eects

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic
 on the current account balance and the currency, resulting in selling
AUD. However, growth leads to higher protability and ourishing
nancial markets. The resulting capital inows lead to currency ap-
preciation and hence AUD will be bought.

(d) The federal government announced that public debt as a percentage

of GDP would decline by one percentage point in the coming scal
year.
• When public debt shrinks, less pressure is exerted on domestic
interest rates. Lower interest rates make domestic assets less attrac-
tive and hence leading to currency depreciation, thus AUD should be
sold. On the contrary, as public debt shrinks, foreign investors will
have more condence in the economy. Capital inows will increase,
leading to currency appreciation, hence AUD should be bought.

(e) The Treasurer announced that the current account decit as a per-
cent of GDP would decline.
• One one hand, a smaller current account decit leads to a smaller
budget decit, lower interest rates and a weaker currency, hence the
currency should be sold. On the other hand, a smaller current ac-
count decit is good for the currency, which implies greater supply of
foreign exchange (more exports relative to imports), hence domestic
currency appreciates, and the currency should be bought.

Application Questions (With Solutions - to be up-

dated )
1. Qd = 10 − 2.5Sb , Qs = 5 + 3.5Sa ,
where Qd and Qs are the quantities supplied and demanded by dealers.

The customer's demand and supply functions are:

Qd = 12 − 2.3Sa , Qs = 2 + 4.2Sb . Calculate the bid-oer spread.

• Solution: The bid rate is calculated from the dealer's demand func-
tion and the customer's supply function. Hence, equating dealers demand
and customers supply, we obtain:

QD C
d = Qs

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic
 ⇒

10 − 2.5Sb = 2 + 4.2Sb

⇒
8
Sb = = 1.1940
6.7

Similarly, the oer rate is calculated from the customer's demand func-
tion and the dealer's supply function. By equating customer's demand
and dealer's supply, we obtain:

QC D
d = Qs

12 − 2.3Sa = 5 + 3.5Sa

⇒
7
Sa = = 1.2069
5.8

∴ the bidoer spread is: 1.2069 − 1.1940 = 0.0129 or 129 points

2. The spot exchange rate between the Australian dollar and the Swiss franc
(CHF/AU D ) is 0.8500 − 0.8580. A speculator believes that the Swiss
franc will appreciate, and so buys CHF 1, 000, 000. Two days later, the
exchange rate turns out to be 0.8200 − 0.8280. Ignoring the interest rate
factor, answer the following questions:

(a) What will the speculator do?

• The corresponding initial (spot) AU D/CHF exchange rates are
1 1
0.8580 − 0.8500 ⇒ 1.16551.1765 and projected t + 2, AU D/CHF
1 1
rates are
0.8280 − 0.8200 ⇒ 1.20771.2195, respectively. The specu-
lator buys the Swiss franc at the oer rate of 1.1765 which is the
dealer's sell rate.

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic
 Two days later the speculator can sell at the bid rate of 1.2077. As-
suming that the speculator wants to realize prot, the Swiss franc
will be sold at 1.2077 which is the dealers buy rate,

(b) How much prot will the speculator make?

AU D
• The prot: BUY CHF:CHF 1, 000, 000×(1.1765) = AU D1, 176, 500,
CHF
AU D
SELL CHF: CHF 1, 000, 000 × (1.2077) = AU D1, 207, 700,
CHF
and Π = AU D1, 207, 700 − AU D1, 176, 500 = AU D31, 200

(c) Assuming that the speculator could buy and sell at the mid-rates,
calculate the prot/loss in this case
1.1655+1.1765
• The mid-rates for buying is
2 = 1.1710 and selling is
1.2077+1.2195
2 = 1.2136.
AU D
• The prot: BUY CHF:CHF 1, 000, 000×(1.1710) CHF = AU D1, 176, 500,
AU D
SELL CHF: CHF 1, 000, 000 × (1.2136) = AU D1, 207, 700, and
CHF
Π = AU D1, 213, 600 − AU D1, 171, 000 = AU D42, 600

(d) Comment on your results.

• It is obvious that the prot realized is lower in the presence of the
bidoer spread.

3. The exchange rate between the Australian dollar and U.S. dollar is (U SD/AU D)
currently 0.6925 − 0.6975. A speculator takes a short position on the Aus-
tralian dollar, and this position is squared two months later when the
exchange rate is (U SD/AU D) = 0.6526 − 0.6575.

(a) Calculate the mid-rates when the short position is taken and when
it is squared.
Note that taking a short position means to borrow and sell at t=0
and buy and return at t = 2. This is when the speculator believes
that the currency (AUD) will depreciate in the future (sell high, buy
cheap).

• t = 0 : S0 (U SD/AU D) = 0.6925+0.6975
2 = 0.6950 and t = 2 :
S2 (U SD/AU D) = 0.6526+0.6575
2 = 0.6551. We can see that USD
has appreciation S ↑, and hence AUD has depreciation. So there will
be some gains from short-selling.

(b) Calculate the prot (in points) realized from this operation if the
speculator buys and sells at the mid-rates.
• Note that taking a short position means to borrow and sell at t = 0
and buy and return at t = 2. Therefore Π = 0.6950 − 0.6551 =
0.0399 or 399 points.

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic
 (c) Calculate the prot (in points) realized from this operation if the
bid-oer spread is taken into account.
• Let's work this out: Taking a position in Australian dollar means
S0 (U SD/AU D) =
the speculator is trading AUD. So given the dealer's quote:
0.6925 − 0.6975. So the speculator will sell AUD at 0.6925. At
t = 2, S2 (U SD/AU D) = 0.6526 − 0.6575 and buy AUD at 0.6575, in
which case, the speculate makes a gain of: Π = 0.6925 − 0.6575 =
0.0350 or 350 points, which is slightly lower than when mid-point is
considered.

(d) Comment on your results.

• The prot is lower when the bidoer spread is taken into account
because it represents a transaction cost.

4. The demand and supply functions in the spot and forward markets are as
follows:

Spot Forward

Qd = 100 − 20S 115 − 20F

Qs = 50 + 10S Qs = 64 + 10F
Calculate the forward spread in points and as a percentage of the spot
rate.
• The spot exchange rate is calculated by equating supply and demand to
obtain:

100 − 2S = 50 + 10S
50
S= ≈ 1.6667
30

• The forward exchange rate is calculated by equating supply and demand

to obtain:

115 − 20F = 64 + 10F

51
F = ≈ 1.7000
30

1.7000


The forward spread is 0.0333 (333 points) or = 1.6667 − 1 × 100 ≈ 2%.

5. The following table contains data on the exchange rate (expressed as do-
mestic/foreign) as well as domestic and foreign price levels over 22 time
periods. You are required to do the following:

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic
 Time (t)
Exchange rate
Domestic Prices Foreign Prices
(d/f )
0 2.8397 100.00 100.00
1 2.6871 106.04 106.70
2 1.9171 115.28 110.75
3 2.3774 123.55 114.41
4 1.7725 132.70 120.68
5 3.2643 139.55 127.34
6 1.8685 150.40 132.31
7 4.0757 158.96 137.36
8 3.5116 169.15 144.78
9 2.0286 178.01 149.88
10 3.4712 188.55 157.72
11 3.3230 200.71 164.20
12 4.0433 210.85 169.58
13 1.7364 222.29 175.83
14 2.9546 235.77 182.33
15 3.1847 251.21 191.61
16 1.6524 264.02 200.58
17 4.2821 280.99 209.35
18 3.9053 295.15 218.99
19 2.3159 313.24 226.37
20 3.5607 331.33 235.85
21 3.9437 348.15 245.77

(a) Calculate the PPP exchange rate for each time period.
 
Pt /P0
• To calculate PPP exchange rate: S̄t = S0 Pt∗ /P0∗ , and percentage

deviation of the actual exchange rate from the PPP rate is:
  D =
100 × S− S̄
S̄

• Refer to Excel sheet on Moodle - Week 5-Q5 Solution

(b) Plot the actual exchange rate against the PPP rate.
• Refer to Excel sheet on Moodle - Week 5-Q5 Solution

(c) Calculate the percentage deviation of the actual rate from the PPP
rate.
• Refer to Excel sheet on Moodle - Week 5-Q5 Solution

(d) Calculate the prot generated by applying a PPP a rule to generate

buy and sell signals. Construct the rule such that a buy signal is
generated when the foreign currency is 5 per cent undervalued and a
sell signal is generated when it is 5 per cent overvalued.
• Refer to Excel sheet on Moodle -Week 5-Q5 Solution

~END~

Compiled by Dr. Ronald R. Kumar, Semester 1, 2022, School of Accounting,

Economics and Finance, The University of the South Pacic