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(1) Forward Interest Parity. Suppose that today (t=0), the rate of interest earned on a 3 month
eurodollar deposit (R(0,3)) is 1.00% and the rate earned on a 6 month eurodollar deposit (R(0,6)) is 3.00%.
a. What is the implied forward rate on a 3 month eurodollar deposit with a settlement date 3 months
from now? (i.e., what is the implied value of F(3,6)?)
b. Suppose that, for some reason, the actual forward rate (F(3,6)) was 1.75%. If you are a eurodollar
bank, how could you make a risk-free profit?
c. Is the situation described in part (b) (where the actual forward rate differs from the implied forward
rate) likely to occur in reality? Why or why not?
(2) Burgernomics. In 1986, The Economist magazine introduced the “Big Mac Index” in an effort to
“make exchange-rate theory a bit more digestible.” Since a Big Mac R
is identical in every country, the
theory of purchasing power parity (PPP) would suggest that the relative prices of Big Macs could be used
to determine whether the exchange rate between currencies are at their “correct” level. You can find the
updated Big Mac Index and more information at the following:
http://www.economist.com/content/big-mac-index
a. Using your knowledge of PPP and the exchange rates given in Table 1, construct the Big Mac Index
by filling in the values in Table 2.
Table 1: Exchange Rates
Country Currency Quote
U.K. Pound (GBP) GBP/USD = 1.31
Japan Yen (JPY) USD/JPY = 112.43
China Renminbi (CNY) USD/CNY = 6.68
India Rupee (INR) USD/INR = 65.98
Switzerland Franc (CHF) USD/CHF = 0.98
Table 2 can interpreted as follows
i. Column (i) of Table 2 gives the price of a Big Mac in each country (in the local currency); in
other words, this is the price that you would see on the menu in the respective countries.
ii. To complete column (ii), enter the exchange rate for each country’s currency in terms of dollars
(i.e., the number of dollars that it takes to purchase one unit of the country’s currency).
iii. To complete column (iii), find the local price of a Big Mac in U.S. dollars (use columns (i) and
(ii)).
iv. Column (iv) will give the “Big Mac Index,” using U.S. dollars as the base currency. For each
country, calculate the exchange rate implied by PPP (the foreign price [in U.S. $s] divided by the
domestic (U.S.) price); this gives you the Big Mac Index.
v. In column (v), state whether the currency is undervalued or overvalued (Hint: compare your
results from column (iv) with what the theory of PPP says the real exchange rate should be).
vi. In column (vi) determine by what percent the currency is overvalued or undervalued (again,
compare your results in column (iv) with what PPP says it should be).
1
Table 2: The Big Mac Index
(i) (ii) (iii) (iv) (v) (vi)
Country Price in local
currency
Exchange
rate (in $s)
Price of Big
Mac (in $s)
Big Mac
Index
Overvalued/
Undervalued
% Over/ Undervalued
U.S. $ 4.85 1 $ 4.85 1 N/A N/A
U.K. £ 2.99
Japan Y 385
China RMB 17.99
India Rupee 129.00
Switzerland SFr 6.49
b. Based on your results in part (a), which currency listed in Table 2 is the most undervalued? Which is
the most overvalued?
c. Briefly explain the theory of Purchasing Power Parity to someone with no training in economics. In
your answer, identify some of the reasons that PPP might fail and briefly comment on the validity of
using hamburgers (or any comparable good) to determine the relative price of currencies.
(3) International Monetary Regimes. For the past six years, Greece has faced double-digit
unemployment rates with few signs of any meaningful improvement (Greece is a Eurozone member country,
meaning they share the euro currency). Suppose that a newly elected prime minister of Greece has
suggested that Greece abandon the Euro, issue their own currency (the Drachma), and use independent
monetary policy to stabilize the economy and restore employment. However, since Greece wants to
maintain stable exchange rates, they would peg the value of the drachma to the U.S. dollar.1 Additionally,
the Greek government is committed to a policy of free capital movement into and out of the Greek
financial markets. Is this proposal reasonable? Explain why/why not and suggest any changes that you
would make (be sure to consider whether all of the proposed policies can be in effect simultaneously).
(4) Cross-Currency Swaps. Suppose an international bank commits to making a 1-year loan of
pounds (£) to a firm in London. The bank currently has no pounds available to lend, so they must decide
how to fund this loan. The bank has two options:
a. Directly borrow a 1-year Europound deposit.2
b. Borrow a 1-year Eurodollar deposit and swap the dollars to pounds; that is, borrow U.S. dollars for 1
year, exchange the dollars to pounds to fund the loan, then swap pounds back to dollars at the end of
1 year.
The spot rate between pounds and dollars is GBP/USD=1.31085, the 1-year forward exchange rate is
quoted at 1.31607 and a 1-year Eurodollar deposit can be obtained at a rate of 1.20%. Additionally, the
rate charged on a 1-year Europound deposit is 1.10%.
Based on the information provided above, which option is the least expensive way to fund the loan?

 

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