Tutorial Problem Set 4
Topic:
Exchange Rate Determination
FM303: International Finance
Week 5, Sem. 1, 2019
ANSWER ALL QUESTIONS
#1. The dealer’s demand and supply functions are:
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. 2 Sb
Calculate the bid–offer spread.
#2. The spot exchange rate between the Australian dollar and the Swiss franc (CHF/AUD) is
0.8500–0.8580. A speculator believes that the Swiss franc will appreciate, and so buys CHF1
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?
(b) How much profit will the speculator make?
(c) Assuming that the speculator could buy and sell at the mid-rates, calculate the
profit/loss in this case. Comment on your results.
#3. The exchange rate between the Australian dollar and US dollar is currently 0.6925–0.6975.
A speculator takes a short position on the Australian dollar, and this position is squared two
months later when the exchange rate is 0.6526–0.6575.
(a) Calculate the mid-rates when the short position is taken and when it is squared.
(b) Calculate the profit (in points) realised from this operation if the speculator buys and sells
at the mid-rates.
(c) Calculate the profit (in points) realised from this operation if the bid–offer spread is taken
into account.
(d) Comment on your results.
#4. The demand and supply functions in the spot and forward markets are as follows:
Spot
Qd 100 20S
Qs 50 10S
Forward
Qd 115 20 F
Qs 64 10 F
Calculate the forward spread in points and as a percentage of the spot rate.
1
#5. The following table contains data on the exchange rate (expressed as domestic/foreign) as
well as domestic and foreign price levels over 22 time periods. You are required to do the
following:
(a) Calculate the PPP exchange rate for each time period.
(b) Plot the actual exchange rate against the PPP rate.
(c) Calculate the percentage deviation of the actual rate from the PPP rate.
(d) Calculate the profit generated by applying a PPP rule to generate buy and sell signals.
Construct the rule so that a buy signal is generated when the foreign currency is 5%
undervalued and a sell signal is generated when it is 5% overvalued.
Exchange rate
(domestic/foreign) Domestic prices Foreign prices
2.8397 100.00 100.00
2.6871 106.04 106.70
1.9171 115.28 110.75
2.3774 123.55 114.41
1.7725 132.70 120.68
3.2643 139.55 127.34
1.8685 150.40 132.31
4.0757 158.96 137.36
3.5116 169.15 144.78
2.0286 178.01 149.88
3.4712 188.55 157.72
3.3230 200.71 164.20
4.0433 210.85 169.58
1.7364 222.29 175.83
2.9546 235.77 182.33
3.1847 251.21 191.61
1.6524 264.02 200.58
4.2821 280.99 209.35
3.9053 295.15 218.99
2.3159 313.24 226.37
3.5607 331.33 235.85
3.9437 348.15 245.77
~The End~
RRK/SI/2019/FM303/W5TUT
2
Tutorial Problem Set 4
Topic: Exchange Rate Determination
FM303: International Finance
Week 5, Sem. 1, 2019
Solution Guide
#1. Solution
The bid rate is calculated from the dealer’s demand function and the customer’s supply
function. By equating supply and demand we obtain:
10 2.5S b 2 4.2S b
which can be solved to obtain:
8
Sb 1.1940
6.7
Similarly, the offer rate is calculated from the customer’s demand function and the dealer’s
supply function. By equating supply and demand we obtain:
12 2.3S a 5 3.5S a
which can be solved to obtain:
7
Sa 1.2069
5.8
Therefore, the bid–offer spread is:
1.2069 1.1940 0.0129 or 129 points
#2. Solution
(a) The corresponding AUD/CHF exchange rates are 1.1655–1.1765 and 1.2077–1.2195,
respectively. The speculator buys the Swiss franc at the offer rate of 1.1765. Two days later
the speculator can sell at the bid rate of 1.2077. Assuming that the speculator wants to realise
profit, the franc will be sold at 1.2077.
(b) The profit realised by buying and selling CHF1 000 000 is:
1000 000 (1.2077 1.1765) AUD31200
(c) The mid-rates for buying and selling are 1.1710 and 1.2136. If the speculator can act on
these rates, the profit realised will be:
1000 000 (1.2136 1.1710) AUD42 600
It is obvious that the profit realised is lower in the presence of the bid–offer spread.
3. Solution
(a) The mid-rates when the position is taken and squared (selling and buying rates, respectively)
are:
3
0.6925 0.6975
0.6950
2
0.6526 0.6575
0.6551
2
(b) If the speculator buys and sells the AUD at the mid-rates, the profit will be:
0.6950 0.6551 0.0399
which means that the speculator makes a profit of 399 points. This is because when a currency
depreciates, a short position on that currency becomes profitable.
(c) The speculator sells the Australian dollar at 0.6925 and buys it at 0.6575, earning a profit of
0.035, or 350 points.
(d) The loss is greater when the bid–offer spread is taken into account because it represents a
transaction cost.
4. Solution
The spot exchange rate is calculated by equating supply and demand to obtain
100 20S 50 10S
which gives:
50
S 1.6667
30
The forward exchange rate is calculated by equating supply and demand to obtain:
115 20F 64 10F
which gives:
51
F 1.70000
30
The forward spread is 0.0333 (333 points) or 2%.
5. Solution
The PPP exchange rate is calculated by multiplying the value of the exchange rate in the first
period by the ratio of domestic to foreign prices in the current period. The following table
shows the calculations. Three buy and loss signals are generated. The rate of return on a buy/sell
transaction is the percentage difference between the sell and buy rates.
Time Actual PPP Deviation (%) Signal Return (%)
0 2.8397 2.8397 0.00
1 2.6871 2.8221 -4.78
2 1.9171 2.9559 -35.14 Buy
3 2.3774 3.0666 -22.47
4 1.7725 3.1225 -43.24
5 3.2643 3.1120 4.89
6 1.8685 3.2280 -42.12
7 4.0757 3.2862 24.02 Sell 112.60
8 3.5116 3.3177 5.84
9 2.0286 3.3727 -39.85 Buy
4
10 3.4712 3.3948 2.25
11 3.323 3.4711 -4.27
12 4.0433 3.5308 14.52 Sell 99.31
13 1.7364 3.5900 -51.63 Buy
14 2.9546 3.6720 -19.54
15 3.1847 3.7230 -14.46
16 1.6524 3.7378 -55.79
17 4.2821 3.8115 12.35 Sell 146.61
18 3.9053 3.8273 2.04
19 2.3159 3.9294 -41.06
20 3.5607 3.9893 -10.74
21 3.9437 4.0226 -1.96
Actual and PPP exchange rates
Percentage deviation of actual from PPP rate
