Please attempt the eight questions within the allocated time of 100 minutes. Please note that each question carries equal weight.

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1 MS&E 247s International Investments Summer 2005 Instructor: Yee-Tien Fu Friday 7/29/05 2:45-4:25pm (100 mins) Midterm Examination In Class, Closed Book, Closed Notes, Formula-sheet and Calculators OK Levich: Chapters 16, 3-9 plus Alan Greenspan s testimonies The Stanford University Honor Code The Honor Code is an undertaking of the students, individually and collectively, that they will not give or receive unpermitted aid in examinations that they will do their share and take an active part in seeing to it that others as well as themselves uphold the spirit and letter of the Honor Code. I acknowledge and accept the Honor Code. Name Solution (Signed) Solution Student ID Major Undergraduate / Graduate Please attempt the eight questions within the allocated time of 100 minutes. Please note that each question carries equal weight. QUOTE OF THE DAY New York Times August 15, 2002 A new appearance in financial risk category? --YTF "I've pretty much used up my advance, and now my editors are hoping that I'll outlive the pope." ROBERT BLAIR KAISER, who is 71, on a book he will write on Pope John Paul II's successor.

2 MS&E247s International Investments 7/29/05 Midterm Page 2 of 14 Question 1 (20 points) Demonstrate with the simultaneous stock and flow approach on exchange rates what happens between the Dollar and the Sterling Pound when Napa Valley red wine is increasingly ordered by diners in all major restaurants in London. Show your answer in the Stock and Flow Reactions to Permanent Increase in the Flow Demand for US Goods and Exchange Rate Response to Permanent Increase in the Flow Demand for US Goods diagrams. What happens when you redo the above with the three panel approach (loanable funds market, net capital outflow, foreign exchange market) used in open economy modeling? To be specific, answer the following questions in words and using diagrams. a. What happens to the demand for dollars in the market for foreign-currency exchange? b. What happens to the value of dollars in the market for foreign-currency exchange? c. What happens to the quantity of net exports? To make our discussion easier, please choose Dollar as the domestic currency, and British Pound as the foreign currency. [Answer to Question 1, 20 points] Stock and Flow Reactions to Permanent Increase in the Flow Demand for US Goods Exchange Rate Response to Permanent Increase in the Flow Demand for US Goods

3 MS&E247s International Investments 7/29/05 Midterm Page 3 of 14 For Part (a) and (b), please see page 222 in the Levich text. For Part (c) and in the following diagrams, the demand for US$ will increase at any real exchange rate. Hence the demand curve will shift outward (rightward). You will see a new equilibrium point in FX market. You will see no change in the other diagrams in (c). Real Interest Rate (a) The Market for Loanable Funds Supply Real Interest Rate (b) Net Capital Outflow r r Demand Quantity of Loanable Funds Net Capital outflow Net Capital Outflow Real Exchange Rate Supply E Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

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5 MS&E247s International Investments 7/29/05 Midterm Page 5 of 14 Question 2 (20 points) Jason Smith is a foreign exchange trader with Citibank. He notices the following quotes. Spot exchange rate: SFr /$ Six-month forward exchange rate: SFr /$ Six-month Euro$ interest rate: 3.5% per year Six-month EuroSFr interest rate: 3.0% per year (a) Ignoring transaction costs, is the interest rate parity holding? (b) Is there an arbitrage possibility? If yes, what steps would be needed to make an arbitrage profit? Assuming that Jason Smith is authorized to work with $1,000,000 for this purpose, how much would be the arbitrage profit in dollars? [Answer to Question 2, 20 points] (a) For six months, r SFr = 1.50% and r $ = 1.75%. Since the exchange rate is in SFr/$ terms, F 1 + rsfr the appropriate expression for the interest rate parity relation is =, or S 1 + r F F (1 + r$ ) = (1 + rsfr ). The left side of this expression is: (1 + r$ ) = ( ) = S S The right side of the expression is: 1 + r SFr = Since the left and right sides are not equal, IRP is not holding. (b) Since IRP is not holding, there is an arbitrage possibility. As < , we can say that the EuroSFr quote is more than what it should be as per the quotes for the other three variables. Equivalently, we can also say that the Euro$ quote is less than what it should be as per the quotes for the other three variables. Therefore, the arbitrage strategy should be based on borrowing in the Euro$ market and lending in the SFr market. The steps would be as follows. - Borrow $1,000,000 for six-months at 3.5% per year. Need to pay back $1,000,000 ( ) = $1,017,500 six months later. - Convert $1,000,000 to SFr at the spot rate to get SFr1,662, Lend SFr1,662,700 for six-months at 3% per year. Will get back SFr1,662,700 ( ) = SFr1,687,641 six months later. - Sell SFr1,687,641 six months forward. The transaction will be contracted as of the current date but delivery and settlement will only take place six months later. So, sixmonths later, exchange SFr1,687,641 for SFr1,687,641 SFr /$ = $1,019,230. The arbitrage profit six months later is 1,019,230-1,017,500 = $1,730. $

6 MS&E247s International Investments 7/29/05 Midterm Page 6 of 14 Question 3 (20 points) (a) What are your three key observations of Federal Reserve Board Chair Alan Greenspan s July 2005 Testimony? (b) What adjustment in US Monetary Policy may be expected following his 2005 testimony? (c) Peruse the following paragraphs (first paragraph from 2004 and second from 2005 testimony): If economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely. Even if economic developments dictate that the stance of policy must be adjusted in a less gradual manner to ensure price stability, our economy appears to have prepared itself for a more dynamic adjustment of interest rates. Of course, considerably more uncertainty and hence risk surrounds the behavior of the economy with a more rapid tightening of monetary policy than is the case when tightening is more measured. In either scenario, individual instances of financial strain cannot be ruled out. - An excerpt from Chair Greenspan s Testimony (July 2004) Moreover, core inflation had moved higher again through the first quarter. The rising prices of energy and other commodities continued to place upward pressures on costs, and reports of greater pricing power of firms indicated that they might be more able to pass those higher costs on to their customers. Given these considerations, the Committee continued the process of gradually removing monetary accommodation in May. The data released over the past two months or so accord with the view that the earlier soft readings on the economy were not presaging a more serious slowdown in the pace of activity. Employment has remained on an upward trend, retail spending has posted appreciable gains, inventory levels are modest, and business investment appears to have firmed. At the same time, low long-term interest rates have continued to provide a lift to housing activity. Although both overall and core consumer price inflation have eased of late, the prices of oil and natural gas have moved up again on balance since May and are likely to place some upward pressure on consumer prices, at least over the near term. Slack in labor and product markets has continued to decline. In light of these developments, the FOMC raised the federal funds rate at its June meeting to further reduce monetary policy accommodation. That action brought the cumulative increase in the funds rate over the past year to 2-1/4 percentage points - An excerpt from Chair Greenspan s Testimony (July 2005) (C) Now, briefly highlight chair Greenspan s viewpoint updates on US economy of July 2005 (vs. July 2004) as indicated in the above paragraphs. Do you think that interest rate might continue to increase for the rest of 2005? What major changes had occurred in US economy between July 2004 and July 2005? [Answer to Question 3, 20 points]

7 MS&E247s International Investments 7/29/05 Midterm Page 7 of 14 Question 4 (20 points) Today is March 1, The day-count basis is actual/365. You have the following contracts on your FX-book. CONTRACT A: On March 15, 2004, you will sell 1,000,000 EUR at a price F 1 t dollars per EUR. CONTRACT B: On April 30, 2004, you will buy 1,000,000 EUR at a price F 2 t dollars per EUR. (a) Construct one synthetic equivalent of each contract. (b) Suppose the spot EUR/USD is / The USD interest rates for loans under 1 year equal 2.25/2.27, and the German equivalents equal 2.35/2.36. Calculate the F i t numerically. (c) Suppose the forward points for F 1 t that we observe in the markets is equal to 10/20 (i.e., the outright forward spot rate is /1.1525). How can an arbitrage portfolio be formed? [Answer to Question 4, 20 points]

8 MS&E247s International Investments 7/29/05 Midterm Page 8 of 14

9 MS&E247s International Investments 7/29/05 Midterm Page 9 of 14 Question 5 (20 points) Consider the following four different responses to the same news item and try to match each response with a particular asset model (e.g., monetarist model, overshooting model, etc.) If none of the existing asset models can explain a particular market response (i.e. there is no appropriate model), state that there is no applicable model and very briefly explain why. News announced at t 1 : US money supply grew by $3 billion in the most recent week. Assuming that the consensus market forecast on money supply growth was $2 billion, the realized money growth is a positive surprise. [Answer to Question 5, 20 points] Response (a) Response (b) Nominal exchange rate ($/FC) (2) Nominal exchange rate ($/FC) (3) U.S. price level (3) U.S. price level (4) $ interest rate (4) $ interest rate (2) U.S. money supply (1) U.S. money supply (1) t 1 t 2 Time t 1 t 2 Time Monetarist Model (completely flexible commodity prices) 1. Realized money growth is a positive surprise ; the market feels that the higher money supply will be maintained. 2. If both prices and exchange rates are perfectly flexible, then the US$ will weaken immediately. 3. At the same time, with national output constant, a larger money supply leads to a higher price level. 4. The interest rate does not change since the price level is constant after the monetary shock. No Applicable Model 1. Assume that market participants believe that the Federal Reserve will drain reserves from the banking sector in the coming weeks. 2. Market projects a low growth in the money supply and interest rates are projected to rise; interest rates rise immediately in anticipation. 3. Higher US$ interest rates attract capital, and the US$ rises. 4. Since market believes excessive money creation will be corrected soon, U.S. price level does not change.

10 MS&E247s International Investments 7/29/05 Midterm Page 10 of 14 Response (c) Response (d) Nominal exchange rate ($/FC) (4) Nominal exchange rate ($/FC) (3) U.S. price level (2) U.S. price level (2) $ interest rate (3) $ interest rate (2) U.S. money supply (1) U.S. money supply (1) t 1 t 2 Time t 1 t 2 Time Monetarist Model (completely flexible commodity prices) 1. Assume a permanent change in the rate of growth of the money supply is expected. 2. Then, inflation turns positive after t 1 (prices rise when the government prints too much money). 3. And the interest rate jumps (Fisher Closed). 4. At the same time, the US$ steadily depreciates (relative PPP). Overshooting Model (sticky commodity prices) 1. The US money supply rises unexpectedly. 2. The surplus of money leads $ interest rates to fall, but goods prices are sticky. 3. As a result, capital flows out of US toward foreign investments, and $ depreciates. To get investors to willingly hold US$ assets, the US$ depreciates immediately by too much (overshoots). Then in the medium run, the US$ can appreciate, and compensate investors for the low $ interest rate.

11 MS&E247s International Investments 7/29/05 Midterm Page 11 of 14 Question 6 (20 points) Please read the following portion of the testimony on China s Trade and Exchange Rate Regime, followed by the testimony on Federal Reserve's Monetary Policy, delivered by Federal Reserve Board Chair Alan Greenspan on June 23, 2005 and July 20, 2005, respectively. Underline three key points that you believe worth serious discussion. What was Chair Alan Greenspan s stance on Chinese Yuan s revaluation. Testimony of Chairman Alan Greenspan on China's Trade and Exchange Rate Regime June 23, 2005 Some observers mistakenly believe that a marked increase in the exchange value of the Chinese renminbi (RMB) relative to the U.S. dollar would significantly increase manufacturing activity and jobs in the United States. I am aware of no credible evidence that supports such a conclusion. The enhanced integration of China into the world trading system is having a notable effect on Asia's trade with the rest of the world and on trade within Asia. After having risen rapidly through the 1990s, U.S. imports from Asia excluding China have flattened since This has occurred as production within Asia has evolved, with the final stages of assembly and exporting to the United States and elsewhere becoming increasingly concentrated in China. As a consequence, because exports by country are recorded on a gross basis rather than as value added, the widening of the United States' bilateral trade deficit with China, measured gross, has largely been in lieu of wider deficits with other Asian economies, including Japan. Measured by value added, our bilateral deficits with China would have been far less, and our bilateral deficits with other Asian exporters would have been far more. Accordingly, an increase in the exchange rate of the RMB, relative to the dollar, would likely redirect trade within Asia, reversing to some extent the patterns that have emerged during the past half decade. However, a revaluation of the RMB would have limited consequences for overall U.S. imports as well as for U.S. exports that compete with Chinese products in third markets. Such a revaluation would affect Chinese value added but not the dollar cost of intermediate goods imported into China from the rest of Asia, which represents a significant share of the gross value of Chinese exports to the United States and elsewhere. (To the extent that exporters to China revalued as well, of course, the impact on overall Asian exports would be somewhat greater.) Testimony of Chair Alan Greenspan on Federal Reserve's Monetary Policy July 20, 2005 Should the prices of crude oil and natural gas flatten out after their recent run-up--the forecast currently embedded in futures markets--the prospects for aggregate demand appear favorable. Household spending-- buoyed by past gains in wealth, ongoing increases in employment and income, and relatively low interest rates--is likely to continue to expand. Business investment in equipment and software seems to be on a solid upward trajectory in response to supportive conditions in financial markets and the ongoing need to replace or upgrade aging high-tech and other equipment. Moreover, some recovery in nonresidential construction appears in the offing, spurred partly by lower vacancy rates and rising prices for commercial properties. However, given the comparatively less buoyant growth of many foreign economies and the recent increase in the foreign exchange value of the dollar, our external sector does not yet seem poised to contribute steadily to U.S. growth. A flattening out of the prices of crude oil and natural gas, were it to materialize, would also lessen upward pressures on inflation. Overall inflation would probably drop back noticeably from the rates experienced in 2004 and early 2005, and core inflation could hold steady or edge lower. Prices of crude materials and intermediate goods have softened of late, and the slower rise in import prices that should result from the recent strength in the foreign exchange value of the dollar could also relieve some pressure on inflation.

12 MS&E247s International Investments 7/29/05 Midterm Page 12 of 14 [Answer to Question 6, 20 points]

13 MS&E247s International Investments 7/29/05 Midterm Page 13 of 14 Question 7 (20 points) (a) Assume that the one-year interest rate is 12% in the U.K. The expected annual rate of inflation for the coming year is 10% for the U.K. and 4% for Switzerland. The current spot exchange rate is SFr 3/. Using the precise form of the international parity relations, compute the one-year interest rate in Switzerland, the expected Swiss franc to pound exchange rate in one year, and the one-year forward exchange rate. (b) Think about the recent revalue of Chinese Yuan. How does the revaluation of Chinese Yuan benefit Hong Kong economy? Please note that the exchange rates prior to the RMB revaluation were: 8.28 RMB/$ and 7.77 HKD/$ (as of June 28, 2005), and are 8.11 RMB/$ and 7.77 HKD/$ (as of July 26, 2005) after the 2% revaluation of RBM. [Answer to Question 7, 20 points] (a) According to the international Fisher relation, 1 + r 1 + r Switzerland UK 1 + I = 1 + I Switzerland UK. So, 1 + rswitzerland =. Therefore, r Switzerland = , or 5.89% S 1 + ISwitzerland According to relative PPP, =, where, S 1 and S 0 are in SFr/ terms. So, 0 S 1 + I S =. Solving for S 1, we get S 1 = SFr / F 1 + rswitzerland According to IRP, =, where, F and S 0 are in SFr/ terms. So, 0 S 1 + ruk F =. Solving for F, we get F = SFr / UK

14 MS&E247s International Investments 7/29/05 Midterm Page 14 of 14 Question 8 (20 points) You are given the following quotes. Spot exchange rates: $/ /$ Three-month interest rates (percent per year): Euro$ Euro Euro What should the quotes be for the: (a) / spot exchange rate (b) $/ 3-month forward exchange rate (c) /$ 3-month forward exchange rate (d) /$ 3-month forward exchange rate? (e) / 3-month forward exchange rate? (was not on the exam) [Answer to Question 8, 20 points] (a) / bid = = / ask = = ( 5.00 / 4) % (b) $/ 3-month bid = = x / = / 4 % (c) (d) (e) ( ) ( 5.25 / 4) ( 3.25 / 4) 1 + % $/ 3-month ask = = x / = % The $/ 3-month forward exchange rate is : ( ) ( ) ( 3.50 / 4) ( 5.00 / 4) 3.25/ 4 % /$ 3-month bid = = / 4 % % /$ 3-month ask = = % The /$ 3-month forward exchange rate is : ( ) ( ) ( 1.50 / 4) ( 5.00 / 4) / 4 % /$ 3-month bid = = / 4 % 1 + % /$ 3-month ask = = % The /$ 3-month forward exchange rate is : ( ) ( ) ( 1.50 / 4) ( 3.25/ 4) 1.25/ 4 % / 3-month bid = = / 4 % % / 3-month ask = = % The / 3-month forward exchange rate is :

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