Tutorial Problem Set

(Updated) 1

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 unpredictable.
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 di cult 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
foreignexchange 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 currency
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 ofexchange
rate determination, and state the PPP-exchange rate. • Refer to lecture 8 notes
on Moodle (PDF document Lecture 8 - Additional Notes)

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

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

(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 depreciates
as domestic income rises. The monetary model predicts that the domestic
currency appreciates as income rises. Why does this contradiction arise?

1 Prepared by: Course Coordinator Ronald R. Kumar - Semester 1, 2021-FM303

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 • The supply and demand model predicts that domestic currency will depreciate
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 income, 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 e ect as a reduction in the nominal 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 e ects 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 Australian money
supply increased by 8 per cent in the previous month.
• A monetary expansion causes in ation. Both PPP and the monetary
model tell us that domestic currency should depreciate. This also means
that AUD should be sold n response to such news. However, if the RBA
reacts by raising interest rates following the announcement, 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
borrowing increases), hence a ecting income, which can have adverse e
ect on the domestic currency, hence domestic currency will be sold.
However, higher interest rates attract capital in ows, 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 e ects on
the current account balance and the currency, resulting in selling AUD.
However, growth leads to higher pro tability and ourishing nancial
markets. The resulting capital in ows lead to currency appreciation 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 attractive
and hence leading to currency depreciation, thus AUD should be sold. On

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 the contrary, as public debt shrinks, foreign investors will have more con
dence in the economy. Capital in ows will increase, leading to currency
appreciation, hence AUD should be bought.
(e) The Treasurer announced that the current account de cit as a percent of
GDP would decline.
• One one hand, a smaller current account de cit leads to a smaller
budget de cit, lower interest rates and a weaker currency, hence the
currency should be sold. On the other hand, a smaller current account de
cit 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 updated)

1. Qd = 10 − 2.5Sb, Qs = 5 + 3.5Sa, where Qd and Qsare 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-o er spread.

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

10 − 2.5Sb = 2 + 4.2Sb

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 Similarly, the o er rate is calculated from the customer’s demand function and
the dealer’s supply function. By equating customer’s demand and dealer’s
supply, we obtain:

12 − 2.3Sa = 5 + 3.5Sa

∴ the bid o er 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/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?

• The corresponding initial (spot) AUD/CHF exchange rates are
1− 1 ⇒ 1.1655 1.1765 and projected t + 2, AUD/CHF

, respectively. The specu-

lator buys the Swiss franc at the o er rate of 1.1765 which is the dealer’s
sell rate.

Two days later the speculator can sell at the bid rate of 1.2077. Assuming
that the speculator wants to realize pro t, the Swiss franc will be sold at
1.2077 which is the dealers buy rate,
(b) How much pro t will the speculator make?
• The pro t: BUY CHF:CHF1,000,000×(1.1765) CHFAUD = AUD1,176,500,
SELL CHF: , and Π
= AUD1,207,700 − AUD1,176,500 = AUD31,200

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 (c) Assuming that the speculator could buy and sell at the mid-rates,calculate
the pro t/loss in this case
• The mid-rates for buying is 1
. and selling is 1.
.
• The pro t: BUY CHF:CHF1,000,000×(1.1710) CHFAUD = AUD1,176,500,
SELL CHF:
, and
Π= 1,213,600 − 1,171,000 = 42,600

(d) Comment on your results.

• It is obvious that the pro t realized is lower in the presence of the bid o
er spread.

3. The exchange rate between the Australian dollar and U.S. dollar is (USD/AUD)
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
(USD/AUD) = 0.6526 − 0.6575.

(a) Calculate the mid-rates when the short position is taken and whenit 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).

and t = 2 :
. 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 pro t (in points) realized from this operation if thespeculator
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.
(c) Calculate the pro t (in points) realized from this operation if thebid-o er
spread is taken into account.
• Let’s work this out: Taking a position in Australian dollar means the
speculator is trading AUD. So given the dealer’s quote: S0(USD/AUD) =
0.6925 − 0.6975. So the speculator will sell AUD at 0.6925. At t =
2,S2(USD/AUD) = 0.6526−0.6575 and buy AUD at 0.6575, in

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 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 pro t is lower when the bid o er spread is taken into account because
it represents a transaction cost.

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

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

obtain:

The forward spread is 0.0333 (333 points) or .

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:

Exchange rate
(d/f) Domestic Prices Foreign Prices
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

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 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.

• To calculate PPP exchange rate: , and percentage

deviation of the actual exchange rate from the PPP rate is: D =

• 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 PPPrate.
• Refer to Excel sheet on Moodle - Week 5-Q5 Solution
(d) Calculate the pro t generated by applying a PPP a rule to generatebuy 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

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