cfa 1 economics-iii

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Economics - III

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Reading 20: International Trade and Capital Flows

Reading 21: Currency Exchange Rates

Expect around 4-5 questions in the exam from todays lecture

Mapping to Curriculum



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Key Concepts

Explain Motivation For And Advantage Of Trading Blocs,Common Market, And Economic Unions

Balance of Payment

Interest Rate Parity

Purchasing Power Parity

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Introduction:

International Trade :

International trade is the exchange of goods and services between countries. This type of trade givesrise to a world economy, in which prices, or supply and demand, affect and are affected by globalevents. Political change in Asia, for example, could result in an increase in the cost of labor, therebyincreasing the manufacturing costs for an American sneaker company

International trade theory is based on the principle of comparative advantage which is in turn basedon the concept of opportunity cost.

Opportunity Cost:

Opportunity cost is the cost of any activity measured in terms of the value of the best alternativethat is not chosen (that is foregone).

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Production Possibility Frontier

A curve depicting all maximum output possibilities for two or more goods given a set of inputs(resources, labor, etc.). The PPF assumes that all inputs are used efficiently.

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Difference Between Domestic Trade And

International Trade

Domestic Trade International Trade

Domestic trade, also known as internal trade or hometrade, is the exchange of domestic goods within theboundaries of a country. This may be sub-divided intotwo categories, wholesale and retail.

International trade is the exchange of capital, goodsand services across international borders orterritories.

Domestic business pertains to a limited territory.Though the firm has many business establishmentsin different locations all the trading activities areinside a single boundary.

Scope of international business is quite wide. Itincludes not only merchandise exports, but also tradein services, licensing and franchising as well asforeign investments

Domestic business is conducted locally so there isno involvement of foreign currency.

International business nations gain by way of earningforeign exchange, more efficient use of domesticresources,

The main difference is that international trade istypically more costly than domestic trade

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Explain Motivation For And Advantage Of Trading Blocs,

Common Market, And Economic Unions

A trade bloc is a type of intergovernmental agreement, often part of a regional inter governmentalorganization, where regional barriers to trade, (tariffs and non-tariff barriers) are reduced or eliminated

among the participating states.

Reduction in Trade restriction have positive effect result from increased trade according tocomparative advantage as well as increase in competition

The negative effect result because some firms, some industries, some group of worker will see their

wealth and income decrease. Worker in affected industries may need to learn new skills to get newjobs.

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Explain Motivation For And Advantage Of Trading Blocs,

Common Market, And Economic Unions

Trade Bloc Motivation

Common Market Remove all barriers to the movement of labor and capital goods among members.

Economic Union Member countries establish common institutions and economic policy for the union.

Monetary Union Member countries also adopt a single currency

Customs Union Member countries adopt a common set of trade restriction with non-member

Free Trade Area All barrier to the import and export of goods and services among member countriesare removed

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Comparative Advantage And Absolute Advantage

Absolute Advantage: A country is said to have an absolute advantage in the production of a good if itcan produce the good at lower cost in terms of resources than that of another country

Comparative Advantage: A country is said to have Comparative advantage in the production of agood if its opportunity cost in terms of other goods that could be produced instead is lower than that ofanother country

Even if a country does not have an absolute advantage in the production of any good, It can gain from

trade by producing and exporting the goods by which it has comparative advantage and importinggoods in which it has comparative disadvantage.

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Comparative Advantage And Absolute Advantage

The law of comparative advantagesays that two countries (or other kinds of parties, such asindividuals or firms there as) will both gain from trade if, in the absence of trade, they have different

relative costs for producing the same goods.

Even if one country is more efficient in the production of all goods (absolute advantage) than theother, both countries will still gain by trading with each other, as long as they have different relativeefficiencies.

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 perhour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour,each country can gain from trade because their internal trade-offs between shoes and shirts aredifferent.

The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produceshirts and trade them to the more-efficient country for shoes.

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Ricardian And Heckscher- Ohlin Models Of Trade And

Sources Of Comparative Advantage

The Ricardian model assumes that labor is the only primary input to production (labor is consideredto be the ultimate source of value)

The Ricardian model focuses on comparative advantage, perhaps the most important concept ininternational trade theory.

In Ricardian model of trade, comparative advantage and pattern of trade are determined by differencein technology between country. In H - O model of trade, comparative advantage and the pattern of

trade are determined by difference of factor endowment between countries .

In a Ricardian model, countries specialize in producing what they produce best, and trade occurs dueto technological differences between countries. Unlike other models, the Ricardian framework predictsthat countries will fully specialize instead of producing a broad array of goods.

The main advantage of Ricardian model is that it assumes technological differences between

countries. Technological gap is easily included in the Ricardian and Ricardo-Sraffa model.

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The Heckscher-ohlin Model (H-O Model) Makes

The Following Core Assumptions

Assumptions of H-O model:

Labor and capital flow freely between sectors

The amount of labor and capital in two countries differ (difference in endowments)

Free trade

Technology is the same among countries (a long-term assumption)

Taste and preferences are the same.

The problem with the H-O theory is that it excludes the trade of capital goods (including materials andfuels). In the H-O theory, labor and capital are fixed entities endowed to each country. In a modern

economy, capital goods are traded internationally. Gains from trade of intermediate goods areconsiderable, as emphasized by Samuelson .

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Heckscher-ohlin Model And Its Assumption

In the early 1900s an international trade theory called factor proportions theory was developed by twoSwedish economists, Eli Heckscher and Bertil Ohlin. This theory is therefore called the Heckscher-

Ohlin theory (H-O theory).

The H-O theory stresses that countries should produce and export goods that require resources(factors) that are abundant and import goods that require resources in short supply.

It differs from the theories of comparative advantage and absolute advantage since those theories

focus on the productivity of the production process for a particular good. On the contrary, the H- Otheory states that a country should specialize in producing and exporting products that use the factorsthat are most abundant, and thus are the cheapest to produce.

The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basiccomparative advantage. Despite its greater complexity it did not prove much more accurate in itspredictions. However from a theoretical point of view it did provide an elegant method of incorporating

the neoclassical price mechanism into international trade theory.

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Compare Type Of Trade And Capital Restrictions And

Their Economic Implication

A trade restrictionis an artificial restriction on the trade of goods between two countries. It is theresult of protectionism. However, the term is not uncontroversial since what one part may see as a

trade restriction another may see as a way to protect consumers from inferior, harmful or dangerousproducts.

There are many reason why government impose trade restriction. Some have support amongeconomist as conceivably valid in terms of increasing a countrys welfare, while other have little or no

support from economic theory.

Capital Restriction: It is defined as control placed on foreigners ability to own domestic assets and

domestic residents ability to own foreign assets. Thus , in control with trade restriction, which limit theopenness of goods market, capital restriction limit the openness of the financial market.

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Compare Type Of Trade And Capital Restrictions And

Their Economic Implication (Cont..)

Capital Restriction are defined as control placed on foreigners ability to own domestic assets and

domestic residents ability to own foreign assets. In contrast to trade restriction, which limits to

openness of goods markets, capital restriction limit the openness of financial market.

Reasons of Trade Restriction :

Infant Industry

National Security

Protecting domestic jobs

Protecting domestic industries.

Type of Trade Restriction Include:

Tariffs

Quotas

Export subsidies

Minimum domestic content Voluntary export restraint

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Balance Of Payment Account

Balance of payment account (BOP) is the account of a country

It is record of transactions of residents of country with rest of world.

It records payments and receipts from rest of world

Any transaction giving rise to payment is deficit (negative) e.g. purchase of property in USA, imports

Any transaction giving rise to receipt is credit (positive) e.g. exports, gifts from outside

BOP equation must satisfy all the time, which is

Current A/c + Capital A/c + net reserves = 0

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Accounts in BOP

Current account Records trade in goods and services, transfer

payments, profits and interests earned on assetsabroad less profits and interests earned by foreignerson assets in our country

Capital account (financialaccount)

Records transactions in financial assets and land e.g.bond, stocks

Official settlement

account ( Net reserves)

Records changes in official reserves which are gold,

foreign currency


E l i H D i i B C Fi A d


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Explain How Decision By Consumers, Firms, And

Government Influence The Balance Of Payment (Cont.)

Low private saving and high investment trend to produce a current account deficit that must

be financed by net capital imports, high private saving and low investment, however produce a

current account surplus, balanced by net capital exports.

A govt. deficit produce a current account deficit and a govt. surplus lead to current account

surplus.

In equilibrium, we have the relationship :

Export- Import = Private Saving + Govt. SavingDomestic investment

Lower level of private saving, Larger govt. deficit , and high rate of domestic investment all

tend to result in or increase a current account deficit. When total saving is less than domestic

investment, export must be greater than import so that there is a deficit in the current account.

Low private or govt. saving in relation to private investment in domestic capital requires foreigninvestment in domestic capital.

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F ti A d Obj ti Of I t ti l O i ti Th t


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Functions And Objective Of International Organization That

Facilitate Trade, Including The World Bank, IMF, And WTO

The International Monetary Fund(IMF) is an organization of 187 countries, working to foster globalmonetary cooperation, secure financial stability, facilitate international trade, promote high

employment and sustainable economic growth, and reduce poverty around the world

The organization's stated objectives are to promote international economic cooperation, internationaltrade, employment, and exchange rate stability, including by making resources available to membercountries to meet balance of payments needs.

The Main objectives of IMF:

- Assisting in the establishment of a multilateral system of payments

- Promoting international monetary corporation

- balanced growth of international trade

- Facilitating the expansion of the member countries

- Make resources available to members experiencing balance of payment difficulties.

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Describe F nctions And Objecti e Of International


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Describe Functions And Objective Of International

Organization

The World Bankis an international financial institution that provides loans to developingcountries for capital programs. The World Bank's official goal is the reduction of poverty

The International Bank for Reconstruction and Development(IBRD) is one of five institutions thatcompose the World Bank Group. The IBRD is an international organization whose original missionwas to finance the reconstruction of nations devastated by World War II. Now, its mission hasexpanded to fight poverty by means of financing states. Its operation is maintained through paymentsas regulated by member states.

The IBRD provides loans to governments, and public enterprises, always with a government (or"sovereign") guarantee of repayment subject to general conditions. The funds for this lending comeprimarily from the issuing of World Bank bonds on the global capital markets

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Organization

World Trade Organization :

The World Trade Organization (WTO) is an organization that intends to supervise

and liberalize international trade. The organization deals with regulation of trade between participating countries; it provides a

framework for negotiating and formalizing trade agreements, and a dispute resolution process aimedat enforcing participants' adherence to WTO agreements which are signed by representatives ofmember governments and ratified by their parliaments.

Functions of World Trade Organization :

Among the various functions of the WTO, these are regarded by analysts as the most important:

It oversees the implementation, administration and operation of the covered agreements.

It provides a forum for negotiations and for settling disputes.

Additionally, it is the WTO's duty to review and propagate the national trade policies, and to ensurethe coherence and transparency of trade policies through surveillance in global economic policy-

making.

Another priority of the WTO is the assistance of developing, least-developed and low-incomecountries in transition to adjust to WTO rules and disciplines through technical cooperation andtraining

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Practice - Questions

Q.1 Which among the following most likely contribute to current account deficit?

a) High Taxes

b) Low private Saving

c) Low Private Investment

Q. 2 Which of the following factor best explain why regional trading agreement are more popular than largermultilateral trade agreement?

a) Minimal displacement cost

b) Trade diversion benefit members

c) Quicker and easier policy coordination

Q. 3 Patent fees, Legal services are recorded in which of the following balance of Payment componenet?

a) Capital account

b) Current account

c) Financial account

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Q. 4 In Ricardian trade model, comparative advantage is determined by :

a) Technology

b) The Capital to labor Ratio

c) The level of labor productivity

Q. 5 According to the Hecksher- Ohlin mode, when trade opens:

a) The scare factor gains relative to the abundant factor in each country

b) The abundant factor gains relative to the scare factor in each country

c) Income is redistributed between countries but not within each country

Q. 6 Which of the following is the best describe the benefit of international trade?

a) Countries gain from exchange and specialization

b) Countries receive lower price for their exprots and pay higer prices for improt

c) Absolute advantage is required for a country to benefit from trade in the long term

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Solutions:

1. B

2. C

3. B

4. A

5. B

6. A

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Agenda

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International Trade and Capital Flows

Currency Exchange Rates



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Exchange Rates

Two types of exchange rates

Nominal exchange rate (FX)

Real exchange rate

Nominal exchange rate (FX)

Amount of currency that is required to buy one unit of other currency

Price of one currency in terms of another

Example, Assume nominal exchange rate between Indian rupee and US dollar is 45 Rs per $ (Rs/$)

i.e. to purchase 1 $ we need Rs 45 Exchange rate can be expressed any way i.e. either Rs/$ or $/Rs

Numerator currency expresses the price of one unit of denominator currency

Real Exchange Rate:

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Domestic

Foreign

CPI

CPIrate(d/f)exchangeNominalRate(d/f)ExchangeReal



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Real Exchange Rate

Real exchange rate:

Focus shifts to purchasing power of currency

Quantity of real goods an services that currencies can actually purchase

Real exchange rate (REER) = Nominal exchange rate * ( Price in country A / Price in country B )

Where, Nominal exchange rate = Currency of country B / Currency of country A

It is the ratio of foreign to domestic prices measured in the same currency

Rise in REER (depreciation of domestic currency) implies that foreign goods have become expensivethan domestic goods

REER = 1 implies that a good costs same in both countries taking nominal exchange rate in account Let, Nominal exchange rate (FX) = 45 Rs/$, Price of shirt in USA = 15$, Price of shirt in India = Rs 500

REER = 45 * (15 / 500) = 45 * ( 3/100) = 135/100 = 1.35

It costs 35% more to purchase same shirt in USA than in India

It requires $1.35 to purchase a good in USA that can be purchased for 1$ (in Indian rupees) in India atcurrent nominal exchange rate

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Foreign Exchange Market

Measured by average daily turnover, the foreign exchange market is the largest financial market in theworld.

There is wide diversity of global FX market participants that have a wide variety of motives forentering into foreign exchange transaction.

Individual currencies are usually referred to by standardize three character code. These currencycode can also be used to define exchange rate.

Currencies trade in the foreign exchange market based on nominal exchange rates

Participants in the foreign exchange market : Investment management firms

Non-bank foreign exchange companies

Foreign exchange fixing

Central banks

Retail foreign exchange traders

Hedge funds as speculators Money transfer/remittance companies

Commercial companies

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Spot And Forward Markets For Foreign Exchange

Spot FX markets

It is the currency exchange rate for immediate delivery, which for most currencies means the exchange of

currency takes place two days after the trade. Transactions that had to be settled immediately like trading of equity

Settlement period is two business days after trade

Forward FX markets

Transactions that will be settled in future

Exchange of currencies takes place in future at the exchange rate agreed today

Forward contracts are generally for 30,60,90 and 180 days

Allows the firm to hedge against exchange rate uncertainty or fluctuations

Forward rate can be greater or less than spot exchange rate

Forward exchange rate represents the interest differential between two countries

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Foreign Exchange

Appreciation of currency

When it requires less of domestic currency to purchase 1 unit of foreign currency

Example, FX decreasing from 46 Rs/$ to 40 Rs/$ Reduces the demand of domestic currency

Increases supply of domestic currency

Increases imports as foreign products become cheaper in international market

Domestic consumers demand more of foreign products

Depreciation of currency

When it requires more of domestic currency to purchase 1 unit of foreign currency

Example, FX increasing from 46 Rs/$ to 50 Rs/$

It raises the demand of domestic currency

Decreases supply of domestic currency

Increases exports as domestic products become cheaper in international market

Foreigners demand more of domestic currency

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Exchange Rate Quotes

Two kind of quotes

Direct quoteA foreign exchange rate quoted as the domestic currency per unit of the foreign currency. In other words,it involves quoting in fixed units of foreign currency against variable amounts of the domestic currency.

Price of one unit of foreign currency in terms of domestic currency

Exchange rate of 46 Rs/$ is a direct quote for Indian citizen

It tells the value of 1 unit of foreign currency in terms of domestic currency to domestic resident

Value of foreign currency is fixed at 1 and value of domestic currency is variable Domestic currency per unit of foreign currency

For example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1. Conversely,in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.

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Exchange Rate Quotes

Indirect quote

A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. In an indirectquote, the foreign currency is a variable amount and the domestic currency is fixed at one unit.

Price of one unit of domestic currency in terms of foreign currency

Exchange rate of 46 Rs/$ is a indirect quote for US citizen

It tells the value of 1 unit of domestic currency in terms of foreign currency to domestic resident

Value of domestic currency is fixed at 1 and value of foreign currency is variable

Foreign currency per unit of domestic currency

For example, in the U.S., an indirect quote for the Canadian dollar would be C$1.17 = US$1.Conversely, in Canada an indirect quote for U.S. dollars would be US$0.85 = C$1

To convert an indirect quote to direct quote

Take the reciprocal of exchange rate

Example Indirect quote 46 Rs/$ for US citizen

Direct quote 1/46 $/Rs = 0.0217 $/Rs for US citizen

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The Percentage Change In A Currency Relative


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To Another Currency

For a change in an exchange rate, we can calculate the percentage appreciation (price goes down) ordepreciation (price goes up) as the percentage change in the price currency.

For example, a decrease in the USD/ EUR exchange rate from 1.44 to 1.42 represents anappreciation of the USD relative to the EUR of 1.39% (1.42 / 1.441 = - .0139)

To calculate the appreciation or depreciation of the base currency, we first invert the quotes and thenproceed as the above example.

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Currency Cross Rates

Cross rates

Exchange rates between two currencies derived from exchange rate with a common third currency

Example, let Rs/$ = 46 and $/GBP = 1.67then Rs/GBP = ( Rs/$ ) * ( $/GBP) = 46 * 1.67 = 76.82

Hence, Rupee - Pound cross rate is 76.82 Rs/GBP

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F d Di t A d P i


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Forward Discount And Premium

A forward premium or discount is calculated

Forward discount Assume INR/$

If forward price of INR/$ is greater than spot price of INR/$

Then, INR is quoted as forward discount

INR (domestic currency) is cheaper today than future

Forward premium Assume INR

If forward price of INR/$ is lesser than spot price of INR/$

Then, INR is quoted as forward premium

INR (domestic currency) is expensive today than future

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F d Di t A d P i


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Forward Discount And Premium

Annualized forward percentage premium/discount (AF)

If one currency is in premium then other is in discount

Use mid points of bid ask to calculate annualized forward premium/discount if bid ask spot andforward quotes are given in exam

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nRateSpot

RateSpotRateForward

AF

n 360

*


I t t R t P it


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Interest Rate Parity

Interest rate parity

Expected returns on deposit of two currencies should be equal when measured in same currency

Forward premiums and discounts wipe out the differences in interest rates between two countries If interest rates are higher in country A compared to country B, then currency of country A will depreciate

thus equating returns in both countries

Mathematically,

where F = forward rate; S = Spot rate; R = risk free interest in both countries

Forward and spot quotes are direct quotes to investor of country A i.e. B : A

Alternate mathematical representation

When interest rate parity holds

Higher (lower) nominal interest rate in country will lead to currency selling at forward discount (premium)

Simply put, IRP implies that interest rate differentials is equal to forward rate differential.

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B

A

R

R

S

F

1

1

B

BA

R

RR

S

SF

1




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Same good should cost equal in different countries considering the nominal exchange rate

REER should be equal to 1

Example, FX = 45 Rs/$, Price of shirt in USA = $15

then, in India Price of shirt should be = 15 * 45 = Rs 675

But the shirt in India is for Rs 500

This is due to many factors like taxes, subsidies, transportation costs etc

Nominal exchange rate (FX) should change such that REER becomes equal to 1

Therefore, FX * (15/500) = 1FX = 500/15 = 33.33 Rs/$

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Exchange Rate Regimes


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Exchange Rate Regimes

Each country, through varying mechanisms, manages the value of its currency. As part of thisfunction, it determines the exchange rate regime that will apply to its currency. For example, the

currency may be free-floating, pegged or fixed, or a hybrid.

If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and isdetermined by the market forces of supply and demand. Exchange rates for such currencies are likelyto change almost constantly as quoted on financial markets, mainly by banks, around the world.

A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the

devaluation of a currency. For example, between 1994 and 2005, the Chinese yuan renminbi (RMB)was pegged to the United States dollar at RMB 8.2768 to $1.

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Impact Of Exchange Rate On Countries International

Trade And Capital Flows Imp


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Trade And Capital Flows.

Elasticity of export and import demand must meet the Marshall-Lener condition for a depreciation ofthe domestic currency to reduce an existing trade deficit.

Export - Import = (Private Saving - Investment in physical capital) + (Tax revenue - Govt. Spending)

The J curve :

Import and Export quantities may be relatively insensitive to currency depreciation in the short run.

Currency depreciation may worsen a trade deficit.

The short term increase in the deficit followed by a decrease when the Marshall- Lerner condition ismet is referred to as the J- curve.

Under the absorption approach, national income must increase

relative to national expenditure in order to decrease a trade deficit.

This can also be viewed as a requirement that national saving must

increase relative to domestic investment in order to decrease a trade deficit.

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1. Assuming annual interest rate is 8% in India and 1.5% in USA. Let spot exchange rate is 47.10 Rsper $. What is the forward rate.

a. For 3 monthsb. For 6 months

c. For 1 year

d. Let the forward rate in market for 1 year is 48 Rs per $. Is there any opportunity for arbitrage.

2. Assuming the 180 days forward rate for GBP:USD is 1.65 and the spot rate is GBP:USD is 1.60. IsUSD trading at forward premium or forward discount to GBP. Calculate the annualized premium or

discount and whether the USD is strong or weak.

3. Let the exchange rate for USD and GBP is 1.65$ per GBP and forward rate is 1.60 $ per GBP.Assuming Interest rate parity holds then in which country will be the interest rate higher.

4. The bid ask quote for GBP in India is 78.2078.50 (GBP:INR) . In New York the bid ask quote for

Indian Rupee is 4646.30 (USD:INR). What is the USD: GBP ask as a cross rate.

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Practice Questions

5. The following quotes are available at GNB

USD:INR = 45.13

GBP:USD = 1.5424GBP:INR = 70.02

Compute any arbitrage opportunity that may be available in the above case. Calculate the arbitrageprofit from $1,000.

6. Given the $:won rates of 1,146.251,148.35

One year interest rate $ = 4.24.8%

One year interest rate won = 2.32.7%

Calculate the one year forward rate for $:won and also specify which of the two is the strongercurrency.

A. 1,200-1,210 , won is stronger

B. 1,200-1,210, dollar is stronger

C. 1,200-1,210, dollar is stronger

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Practice Question


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Practice Question

7 A shirt costs 15 $ in USA and 9 GBP in Great Britain. Assuming the exchange rate of 1.6 $ per GBP.In which country is the shirt more expensive?

8 Let the interest rates in USA are 2% higher than the interest rates in Great Britain and the exchangerate is 1.6 $ per GBP. Assuming that the interest rate parity holds, then what will be the expectedfuture exchange rate.

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Practice - Solutions


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Practice Solutions

1. a. For 3 months

F3-months= S*(1.08/1.015)0.25 = 47.84

b. For 6 monthsF6-months= S*(1.08/1.015)

0.5 = 48.58

c. For 1 year

F12-months= S*(1.08/1.015)= 50.12

d. Let the forward rate in market for 1 year is 48 Rs per $. Yes there any arbitrage opportunity

2. Since the forward rate is trading at $1.65/GBP therefore the USD is trading at a forward discount tothe GBP. The annualized discount is 6.25%. Since the USD is trading at a forward discount it is theweaker currency in the exchange pair.

3. Since the USD is trading at a premium to the GBP in the forward market. The GBP risk-free rate isgreater than the USD risk-free rate

4. Given the bid-ask rates the USD:GBP cross rates are (USD:GBP)ask= 78.2/46.3 = 1.6890

(USD:GBP)bid = 78.5/46 = 1.7065

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5. The following quotes are available at GNB

USD:INR = 45.13

GBP:USD = 1.5424GBP:INR = 70.02

Compute any arbitrage opportunity that may be available in the above case. Calculate the arbitrageprofit from $1,000

The cross rate for GBP:INR = 45.13*1.5424 = 69.61. Since the GBP:INR rate provided by GNB ishigher a triangular arbitrage is possible. Given 1,000 USD. A triangular arbitrage is possible throughthe following series of transactions

a. Convert USD to GBP

1,000 USD /1.5424 = 648.34 GBP

b. Convert GBP to INR

648.34 * 70.02 = 45,396.78 INR

c. Convert INR to USD

45,396.78/45.13 = 1,005.9 USD

Thus a profit of 5.9 USD is possible through a triangular arbitrage.

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6.

The forward is selling at a discount to the spot therefore the won is the weaker currency.

46

82.131,1042.1

027.1*35.148,1

($)

)(*):($):($

bid

askaskask

r

wonrwonSwonF

91.118,1048.1

023.1*25.146,1

($)

)(*):($):($

ask

bidbidbid

r

wonrwonSwonF


PracticeSolutions


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7. The cost of the shirt in Great Britain in USD = 9*1.6 = 14.4 USD

The shirt is cheaper in Great Britain than in the USA

8 Through Interest Rate Parity

Therefore E(S) = S*(1.02) = 1.6*1.02 = 1.632

47

iu RS

SSER

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Five Minute Recap


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www.edupristine.com Neev Knowledge Management Pristine 48

Production Possibility Frontier

Videogames(units)

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3

40 50

103

A

B

Books(Units)

Annualized forward percentage

premium/discount (AF):

nRateSpot

RateSpotRateForwardAF n

360*

Common strategies ExchangeRate Policies: Flexible exchange rate Fixed exchange rate Crawling exchange rate policy

Export - Import = (Private Saving- Investment in physical capital) + (Tax revenue - Govt. Spending)

Forward and spot quotes

B

BA

R

RR

S

SF

1B

A

R

R

S

F

1

1

Interest Rate Parity:

Terms to Remember:

Appreciation of currency Depreciation of currency Currency Cross Rates

Spot FX Markets Forward FX Markets Law of Comparative Advantage Trade Restriction Capital Restriction Purchasing Power Parity

Balance Of Payments:Current A/c + Capital A/c + Net Reserves = 0

Domestic

Foreign

CPI

CPIrate(d/f)exchangeNominal

Real Exchange Rate:

Economic

Welfare

Time

J Curve


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