ECON40915 INTERNATIONAL FINANCE 2020
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ECON40915
INTERNATIONAL FINANCE
2020
1 a) “The honeymoon effect basically means that a perfectly credible target zone is inherently
stabilizing.” Using the Krugman (1991) model explain the significance of this statement. (60 marks)
b) Explain why the purchasing power parity condition may not necessarily hold in the presence of nontraded goods.
(40 marks)
2 a) An econometrician tests the foreign exchange market efficiency as follows. She simply runs a regression: + - = a + b ( - ) where is the log of the spot exchange rate and is the log of the forward rate, and then tests whether a=0 and b=1. Explain why
this test strategy may not necessarily reveal the efficiency of the foreign exchange market. (50 marks)
b) The currency risk premium drives a wedge between the forward rate () and the expected spot rate ((+). Using a simple consumption CAPM model explain how this risk premium is related to investor’s degree of risk aversion and the covariance between future spot rate (+) and consumption (+ )
(50 marks)
3 a) Consider the following loglinear Cagan money demand function:
mt st [Etst1 st]
where mt = natural log of money stock at date t and st = natural log of the spot exchange rate (home currency/foreign currency), and η>0. Let money supply follow the process:
Etmt1 mt where 0<<1. Derive the rational expectations equilibrium solution
for the spot rate, st . Interpret your results.
(50 marks)
b) Using the same Cagan money demand equation, illustrate the distinction between exchange rate fundamental and bubble and comment on the frequently held belief that a bubble necessarily reflects irrational exuberance of investors.
(50 marks)
4 Examine whether the following statements are true or false. Support your reasoning using a relevant model.
a) If the unbiased forward rate hypothesis holds, a currency bought at a premium is expected to depreciate in value. (33 marks)
b) If a country’s national saving exceeds its physical investment, it (33 marks) runs a current account deficit.
c) The law of one price means that the absolute purchasing power condition necessarily holds.
(34 marks)
2022-05-06