Homework # 3

Econ 316

Miguel Ramirez

1. Suppose that the annual interest rate of U.S. T-bills is 10 %, while that of Canadian T-bills is 5 %. The U.S.-Canadian spot exchange rate is .76 U.S. dollars per Canadian dollar. Assuming that the uncovered interest parity condition holds, what do you think is the market's assessment of the U.S.-Canadian dollar exchange rate six months in the future? What assumptions are implicit in this calculation? Explain.

2. Assume the interest rate on Deutsche mark-denominated assets is .05 and the interest rate on comparable dollar-denominated assets is .10. The forward exchange rate is $1.05/DM1, and the spot rate is $1/DM1.

a. You are the owner of an asset portfolio and are unwilling to bear exchange rate risk; are you satisfied with the current allocation of your portfolio between the two assets? Why or why not?

b. If the forward rate were to fall to $1/DM1 what adjustment, if any, would you make in your portfolio? Explain.

c. What would be the effect of your action (or inaction) in part (b) on the spot exchange rate between dollars and marks?

 

3. The six-month interest rate in the U.S. is 8 percent; in France it is 10 percent. The current spot rate (dollars per franc) is $.42.

a. What do you expect the 6-month forward rate to be?

b. Is the franc selling at a premium of discount? Give an exact value.

c. If the expected spot rate in 6 months is $.40, what is the risk premium? In which country is the rate-of-return larger (to compensate for the added risk)?