1.   If the quote for the AUD in the Interbank market was 0.6892 / 0.6897

a)   What type of quote is this (Direct / Indirect)

Direct (Bid < Ask). As indicated in the lecture notes, all quotations will be presented to you in the form which is Buy then Sell.

b)   What is the size of the spread in points?

6897-6892 = 5 points

c)   Convert this to the other type of quote (Direct or Indirect) on the AUD in the interbank market.

We know it is a direct quotation for the AUD. Direct quotations are quotations of the    dealer’s buy and sell price of the UNIT. Thus, the AUD is the Unit. (The unit is always written first)

AUD / USD 0.6892 / 0.6897 (Direct quote on the AUD)

We need to convert this to an Indirect Quote on the AUD.

USD / AUD (1/.6892) / (1 / .6897)

USD / AUD 1.4510 / 1.4499 (Indirect quote on AUD)

d)   Convert this to a DIRECT quote on the USD.

If we reverse the original quotation, then it becomes an indirect (Bid > Ask) quotation on the USD.

If we reverse the quotation in part (c) then we will find a direct quote on the USD. USD / AUD 1.4499 / 1.4510

That is the Dealer is prepared to buy the USD for 1.4499 AUD, and to sell the USD for 1.4510 AUD.

e)   If I purchased 100 USD worth of goods, what would it cost me in AUD? Assume I can use the interbank rates provided, though I will be charged a retail transaction fee of 1 AUD.

First pick a quotation to use (any will work):

1) AUD / USD 0.6892 / 0.6897

•    This is a dealer quote to buy and sell AUD.

•    I am selling the AUD.

=> Use the dealer’s buy price for the AUD (BID)

Cost     = (100) / 0.6892 + 1 AUD (transaction cost)

=  146.10 AUD

ALTERNATIVELY…

2) AUD / USD 0.6897 / 0.6892

•    In this case the dealer is quoting to buy and sell the USD.

•    I am buying the USD.

=> Use the dealer’s sell price for the USD (ASK).

Cost     = (100) / 0.6892 + 1 AUD (transaction cost)

= 146.10 AUD

ALTERNATIVELY…

3) USD / AUD 1.4499 / 1.4510

•    This is a dealer direct quote to buy and sell USD.

•    I am buying the USD.

=> Use the dealer’s sell price for the USD (ASK)

Cost     = (100) * 1.4510 + 1 AUD (transaction cost)

= 146.10 AUD

ALTERNATIVELY…

4) USD / AUD 1.4510 / 1.4499

•    This is a dealer indirect quote to buy and sell AUD.

•    I am selling AUD.

=> Use the dealer’s buy price for the AUD (BID)

Cost     = (100) * 1.4510 + 1 AUD (transaction cost)

= 146.10 AUD

2.   You are currently offered by an internet broker the following quotations:

•   AUD / USD 0.9321 / 0.9325

•    USD / RUB 35.760 / 35.795

Calculate a cross rate using these quotes in direct terms on the Australian Dollar in terms of Rubles.

AUD / RUB

1 AUD => .9321 USD  => (.9321 * 35.760) RUB          => 33.332 RUB

RUB / AUD

1 RUB               => (1/35.795) USD       => (1 / 35.795)*(1/0.9325) AUD

=> 0.02996 AUD

Goal: Create a Direct Quote on the Australian Dollar

Note: Direct quotes are quotes to buy and sell the unit

   we want to create the AUD / RUB quote.

Note: You can assume the above quotes are Direct or Indirect as they are just alternative ways of stating the same thing. So, let’s assume they are Direct to make life easy:

   both the above quotes are dealer bid quotes (under the assumption they are

DIRECT). If you assume Direct, then as you are selling the units to the dealer, and thus the dealer must be buying the unit => Bid

   We have the direct bid quote already for the AUD/RUB 33.332

Direct ASK Quote: (Selling the AUD is the same transaction as buying the RUB – we already know the buying the RUB price).

AUD / RUBask = 1 / (RUB / AUDbid) = 1 / (0.02996) =  33.379

Answer: AUD / RUB 33.332 / 33.379

Chapter 3

18. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth $.70.      You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for    1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain.

ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged for 1,200 pesos (computed as      200 × 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 1,300 pesos.

23. Interest Rates. Why do interest rates vary among countries?  Why are interest rates normally similar for those European countries that use the euro as their currency? Offer a reason why the government interest rate of one country could be slightly higher than the government interest rate of another         country, even though the euro is the currency used in both countries.

ANSWER:  Interest rates in each country are based on the supply of funds and demand for funds for a given currency.  However, the supply and demand conditions for the euro are dictated by all                participating countries in aggregate, and do not vary among participating countries. Yet, the                government interest rate in one country that uses the euro could be slightly higher than others that use the euro if it is subject to default risk. The higher interest rate would reflect a risk premium.

Chapter 4

2.   Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to      Canadian inflation.  Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

ANSWER:  Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollar’s value should increase.

3.   Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates.  Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b)    supply of pounds for sale, and (c) equilibrium value of the pound?

ANSWER:  Demand for pounds should increase, supply of pounds for sale should decrease, and the pound’s value should increase.

4.   Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate   than does the Canadian income level.  Other things being equal, how should this affect the (a) U.S.    demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

ANSWER:  Assuming no effect on U.S. interest rates, demand for Canadian dollars should increase, supply of Canadian dollars for sale may not be affected, and the Canadian dollar’s value should        increase.

5.   Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its    controls on imports by Japanese companies.  Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen?

ANSWER:  Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease.

7.   Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist about future interest rates could affect the value of the dollar today.  Why do some forecasts by     well-respected economists have no impact on today’s value of the dollar?

ANSWER:  Interest rate movements affect exchange rates.  Speculators can use anticipated interest   rate movements to forecast exchange rate movements.  They may decide to purchase securities in      particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currency’s value.  These purchases of securities require an exchange of        currencies, which can immediately affect the equilibrium value of exchange rates.

If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investors’ original expectations, an announced forecast does not provide new information.  Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected.

13. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations that economic conditions will strengthen.  Yet, this chapter suggests that when other factors are held   constant, increased national income could increase imports and cause the local currency to weaken.    In reality, other factors are not constant.  What other factor is likely to be affected by increased           economic growth and could place upward pressure on the value of the local currency?

ANSWER:  Interest rates tend to rise in response to a stronger economy, and higher interest rates can place upward pressure on the local currency (as long as there is not offsetting pressure by higher        expected inflation).

18. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United       States and also much higher interest rates than the United States.  Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically    more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically   depreciated from one year to the next, but the degree of depreciation has varied substantially. The       bid/ask spread tends to be wider for the peso than for currencies of industrialized countries.

a.   Identify the most obvious economic reason for the persistent depreciation of the peso.

ANSWER:  The high inflation in Mexico places continual downward pressure on the value of the peso.

b.   High interest rates are commonly expected to strengthen a country’s currency because they can    encourage foreign investment in securities in that country, which results in the exchange of other  currencies for that currency.  Yet, the peso’s value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates.  Thus, it      appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s securities.  Why do you think U.S. investors do not try to capitalize on the high interest rates in    Mexico?

ANSWER:  The high interest rates in Mexico result from expectations of high inflation.  That  is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate.  Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate (when they convert the pesos back to           dollars at the end of the investment period).  Therefore, the high Mexican interest rates do not  encourage U.S. investment in Mexican securities, and do not help to strengthen the value of     the peso.

c.   Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries?  How does this affect a U.S. firm that does substantial business in Mexico?

ANSWER:  The bid/ask spread is wider because the banks that provide foreign exchange       services are subject to more risk when they maintain currencies such as the peso that could    decline abruptly at any time.  A wider bid/ask spread adversely affects the U.S. firm that does business in Mexico because it increases the transactions costs associated with conversion of  dollars to pesos, or pesos to dollars.

Practice Solutions

Additional Questions Providedfor Revision Purposes Only (Notfor the tutorial)

1.   The closing quote for the USD in the Australian retail market was 0.8846 / 0.8753

a)   What type of quote is this (Direct / Indirect)

Indirect (Bid > Ask)

b)   What is the size of the spread?

8846-8753 = 93 points

c)   Convert this to the other type of quote (Direct or Indirect) on the USD in the Australian retail market.

AUD / USD 0.8846 / 0.8753 (Indirect quote on the USD)

We need to convert this to a Direct Quote on the USD.

USD / AUD (1/.8846) / (1 / .8753)

USD / AUD 1.1305 / 1.1425 (Direct quote on USD)

d)   If I purchased 100 USD worth of goods, what would it cost me in AUD? The retail transaction charge is 1 AUD.

I am buying 100 USD

=> Dealer is selling 100 USD

=> Ask quote

Cost            = (100)(1. 1425) + 1 AUD (transaction cost)

= 115.25 AUD

2.   If the quote for the AUD in the Interbank market was 1.0192 / 1.0197

a)   What type of quote is this (Direct / Indirect)

Direct (Bid < Ask)

b)   What is the size of the spread in points?

10197- 10192 = 5 points

c)   Convert this to the other type of quote (Direct or Indirect) on the AUD in the interbank market.

We know it is a direct quotation for the AUD. Direct quotations are quotations of the dealer’s buy and sell price of the UNIT. Thus the AUD is the Unit.

AUD / USD 1.0192 / 1.0197 (Direct quote on the AUD)

We need to convert this to an Indirect Quote on the AUD.

USD / AUD (1/1.0192) / (1 / 1.0197)

USD / AUD 0.9812 / 0.9807 (Indirect quote on AUD)

d)   Convert this to a DIRECT quote on the USD.

If we reverse the original quotation it becomes an indirect (Bid > Ask) quotation on the USD.

If we reverse the quotation in part (c) then we will find a direct quote on the USD. USD / AUD 0.9807 / 0.9812

That is the Dealer is prepared to buy the USD for 0.9807 AUD, and to sell the USD for 0.9812 AUD.

e)   If I purchased 100 USD worth of goods, what would it cost me in AUD? Assume I can use the interbank rates provided, though I will be charged a retail transaction fee of 1 AUD.

First pick a quotation to use (any will work):

1) AUD / USD 1.0192 / 1.0197

•    This is a dealer quote to buy and sell AUD.

•    I am selling the AUD.

=> Use the dealer’s buy price for the AUD (BID)

Cost     = (100) / 1.0192 + 1 AUD (transaction cost)

=  99.12 AUD

ALTERNATIVELY…

2) AUD / USD 1.0197 / 1.0192

•    In this case the dealer is quoting to buy and sell the USD.

•    I am buying the USD.

=> Use the dealer’s sell price for the USD (ASK).

Cost     = (100) / (1.0192) + 1 AUD (transaction cost)

= 99.12 AUD

ALTERNATIVELY…

3) USD / AUD 0.9807 / 0.9812

•    This is a dealer quote to buy and sell USD.

•    I am buying the USD.

=> Use the dealer’s sell price for the USD (ASK)

Cost     = (100) * (0.9812) + 1 AUD (transaction cost)

= 99.12 AUD

3.   On Thursday an internet broker offers you the following quotes:

•   AUD / USD 0.8787 / 0.8790

•    EUR / USD 1.3769 / 1.3771

Calculate a cross rate using these quotes in direct terms on the Euro.

AUD / EURbid

1 AUD => .8787 USD  => (.8787 / 1.3771) EUR

=> 0.6381 EUR

EUR / AUDbid

1 EUR               => 1.3769 USD

=> (1.3769 / .8790) AUD

=> 1.5664 AUD

Goal: Direct Quote on the Euro => EUR / AUD

EUR / AUDask = 1 / (AUD / EURbid) = 1 / (.6381) = 1.5672 AUD

Answer

EUR / AUD 1.5664 / 1.5672

4.   Imagine that, after a fall below parity for the Australian Dollar, an internet broker offered you the following quotes:

•   AUD / USD 0.8973 / 0.8978

•    GBP / USD 1.5474 / 1.5479

Calculate a cross rate using these quotes in direct terms on the Pound.

AUD / GBP

1 AUD => .8973 USD  => (.8973 / 1.5479) GBP           => 0.5797 GBP

GBP / AUD 1 GBP

=> 1.5474 USD

=> (1.5474 / .8978) AUD

=> 1.7235 AUD

Goal: Create a Direct Quote on the Pound

Direct quotes are quotes to buy and sell the unit

   both the above quotes are dealer bid quotes (under the assumption they are

DIRECT – you can assume either as they are just alternative ways of stating the same thing) As you are selling the unit to the dealer, the dealer must be buying  the unit)

   we want to create a GBP / AUD quote. (we already have the bid)

GBP / AUDask = 1 / (AUD / GBPbid) = 1 / (.5797) =  1.7250 AUD

Answer: GBP / AUD 1.7235 / 1.7250

Chapter 3

24. Interpreting Exchange Rate Quotations.

•    Today you notice the following exchange rate quotations:

•    $1 is equal to 3.00 Argentine pesos

•    1 Argentine peso =  0.50 Canadian dollars

You need to purchase 100,000 Canadian dollars with U.S. dollars. How many U.S. dollars will you need for your purchase?

ANSWER: Value of AP = $.333

Value of C$ in AP = 2

Value of C$ in $ = $.666

So you need $66,666 to purchase C$100,000.

26. Explaining Variation in Bid/Ask Spreads. (Using online resources) Determine the bid/ask spread for the euro. Then determine the bid/ask spread for a currency in a less developed country. Why do  you think is the main reason for the difference in the bid/ask spreads between these two currencies?

ANSWER: The percentage spread is estimated as:

(Ask quote – Bid quote)/Ask quote.

A key part of this question is to ensure that students can obtain bid and ask quotations.

Thus, foreign exchange dealers are more willing to hold an inventory in the euro, because they do more business in euros. Also, there is less chance for a major loss from holding an inventory of euros versus  currencies of less developed countries because there the euro is less likely to experience an abrupt         decline in the value of the euro than to a decline in the value of a currency in a less developed country.

27. Direct Versus Indirect Exchange Rates. Assume that during this semester, the euro appreciated against the dollar. Did the direct exchange rate of the euro increase or decrease? Did the indirect  exchange rate of the euro increase or decrease?

ANSWER: The indirect exchange rate is the reciprocal of the direct exchange rate. Thus, as the euro appreciates against the U.S. dollar over time, this means that the direct rate of the euro increases       while the indirect rate of the euro decreases.