Question 1 (10 marks)

For each of the following questions, record the letter for the correct answer on your booklet.

a.   China has been tightening its capital control over the past few years to prevent drawdown on its foreign exchange reserve as the Chinese current account is no longer running on a large surplus, which of the following is true? (2.5 marks)

A)  China is trying to achieve the impossible trinity.

B)   China is trying to give up exchange rate stability to achieve the other two policy goals.

C)   China is trying to give up monetary independence to achieve the other two policy goals.

D)  China is trying to give up full financial integration to achieve to other two policy goals.

Answer: D

(Topic 2 Extension Slides 3-8, Practice Question 1, Week 3)

b.   An Australian bank decides to issue 2-year Euro denominated bonds to take advantage of the low interest  rate in the  Eurozone.  If the  bank  is concerned that the  Euro  might strengthen substantially over the two years  as the  bonds  mature,  how  can  it  protect  itself from  such risk? (2.5 marks)

A)   By buying the Euro forward.

B)   By selling the Australian dollar forward.

C)   By selling the Euro forward.

D)  By buying the Australian dollar forward.

Answer: A

(Topic 4: Forward & Covered Interest Arbitrage + Midsemester Review)

c.   The current market quotes for the GBP against the USD are 1.3208/11. You are the managing director of FX in a major FX dealer, and based on the ongoing inability of the British government to reach a consensus on the Brexit plans and increasing the likelihood of a hard Brexit, you believe that the uncertainty will lead to a depreciation of the GBP. You want to hold less GBP in inventory and accumulate more USD instead, so you are going to quote a different price from the market price, what should you quote? (2.5 marks)

A)  GBP/USD 1.3209/10

B)   GBP/USD 1.3207/10

C)   GBP/USD 1.3209/11

D)  GBP/USD 1.3207/12

Answer: B

You want attract customers to come to you to convert their USD in return to clear your GBP inventory; and you want to hoard USD, so you don’t want to attract customers who wants to convert GBP for USD. To achieve the former, you want to sell GBP for less USD than the rest of the market, so you quote a lower ask price on the GBP/USD quote. To achieve the latter, you want to buy GBP by paying less USD than the rest of the market, so you quote a lower bid price. (Topic 1 Extension Slides 11-12, Practice Question 2, Week 2)

d.   Which of the following statements is correct? (2.5 marks)

A)   All else equal, a country with the free floating regime is less insulated from inflation and unemployment of other countries.

B)  Trade imbalances would self-correct under the gold standard because disequilibrium in price levels in one country will be offset by a counteracting flow of specie that would equalize prices between trading partners and bring balance of trade back to zero.

C)   All else equal, the free floating regime can help to improve conditions for a country that has high inflation or high unemployment.

D)  The Bretton Woods System specifies that each country sets a fixed rate that its currency could be converted to a given weight of gold (e.g., $20/Oz, or £4/Oz), and that the FX rate between any two currencies will be determined by their gold content.

Answer: B                                                                                                                                                  A country with the free floating regime is more insulated from inflation and unemployment of other countries. (slides 43-46 on Topic 2’s class annotated notes)                                            The free floating  regime  can  adversely  affect  a  country that  has  high  inflation  or  high unemployment. (slides 47-50 on Topic 2’s class annotated notes)                                                Each country sets a fixed rate that its currency could be converted to a given weight of gold (e.g., $20/Oz, or £4/Oz), and that the FX rate between any two currencies will be determined by their gold content. The definition is for the gold standard. (slide 20, Topic 2 notes)

(Topic 2: International Monetary System)

Question 2 (26 marks)

a.   An Australian  previously bought  U.S. government  bonds. This year, she  receives  USD500 in coupon payments from her investment. The coupon payment is deposited to her USD bank account in New York. How are these recorded on the Australian balance of payment? (8 marks)

Australian receives coupon payments as a result of her portfolio investment. This is a conceptual inflow of foreign currency (USD) to Australia, increasing the supply of USD in the FX market. (1 mark) This is hence recorded as a credit in the current account.

The coupon is deposited to the Australian’s USD bank account in New York, which increases Australian ownership of foreign assets . (1 mark) This conceptually involves converting AUD for USD  and  hence increasing demand of USD in the  FX  market,  or an outflow of USD from Australia. (1 mark)

(Topic 2 BOP, Practice questions 1 &2; Topic 2 Extensions, Practice question 2; Problem Set #1, Q7)

b.   What is the effect on the Australian balance of payments of the following set of transactions? ANU’s Centre for Arab and Islamic Studies received a $2.5 million donation from the Al-Maktoum Foundation in Dubai in 2000 to fund the centre’s building as well as positions in Arab and Islamic Studies. The donation was paid through the foundation selling Australian government bonds it held. (10 marks)

ANU  receives the  gift from  Dubai. The  Dubai foundation  is  effectively  seeking to  improve relations with Australia, hence seeking for Australia to export goodwill to Dubai. (1 mark) This creates a conceptual supply of foreign exchange (Arab Emirate Dirham, AED) in the FX market, i.e. to pay for the good will, so it’s a conceptual inflow of foreign currency (AED) to Australia. (1 mark) This is hence recorded as a credit in the current account.

The payment is financed by selling Australian bonds held by the Dubai foundation. This payment represents a decrease in foreign ownership of Australian assets. (1 mark) Conceptually, it would involve converting AUD for AED and hence increasing the demand of AED in the FX market, and outflow of AED from Australia. (1 mark) It is therefore recorded as a debit in the capital account.

(Topic 2 BOP, Practice questions 1 &2; Topic 2 Extensions, Practice question 2; Problem Set #1, Q7)

c.   The US current account has been consistently in deficit since 1982 to be the largest in the world and stands at $124 billion in the third quarter of 2018. The fact that the U.S. holds a current account deficit with many of its trading partners have been considered to be “unfair” by some U.S. policy makers advocating for trade wars; according to them, the size of the current account deficit is harmful to the U.S. economy. Discuss whether you consider a large current account deficit such as the case of the U.S. to be harmful, be sure to include arguments discussed in class.

(8 marks)

The context of  how the deficit  is  built  up  matters  in the discussion.  It  involves a trade-off between whether the deficit arises from 1) a country living beyond its means, such that national consumption  exceeds  national  savings,  where  the  excess  consumption  is  based  on  debt borrowed from the rest of the world, or 2) a country attracts abundant capital investments from the rest of the world because the economy offers many profitable investment opportunities and higher risk-adjusted returns from the rest of the world. (2 marks)

Borrowing from the rest of the world to invest can boost national economy if there are good positive NPV investment that generate sufficient profits after interest and debt repayment. It would be harmful to the national economy, if the sum of expected future returns is not sufficient to cover interest and principal payments on the debts (i.e ., not enough positive NPV project around). (2 marks)

In the U.S. case, many consider that the deficit reflects a vote of confidence from the rest of the world, in its highly productive economy to make good use of capital. The USD is also widely used to settle trade, so the demand for USD denominated assets will remain strong . Additionally, most debt that the U.S. holds is denominated in USD, so the U.S. is not exposed to FX exposure on repaying their debts. (2 marks)

However, this is not to say that the U.S. is immune to loss of confidence, in which case, foreign investors may reduce their demand of U.S. assets, leading to a fall in international capital inflow

that cutting financing to positive NPV projects, in this case the deficit will be a problem.(2 marks) Overall, a current account deficit may not be all about underlying economic difficulties.

(Topic 2 BOP, Practice questions 1 &2; Topic 2 Extensions, Practice question 2; Problem Set #1, Q7)

Question 3 (10 marks)

Most luxury cars sold in Australia are not made locally. If you wanted a Porsche 992 Carrera S in April 2019, the price per vehicle is €120,125. At the same time, the spot market rate is AUD/EUR 0.63.

a. If PPP holds, what should have been the price of the Porsche 992 in Australian dollars in April 2019? (2 marks)

Answer:

€120,125 x (A$/€0.63) = A$190674.6032 (2 marks)

b.   In reality, if you were to buy the Porsche 992 in Australia in April 2019, you would have needed to pay A$265,000. Explain why the PPP, in other words, the law of one price, did not hold in this case and discuss situations in general where PPP does and does not hold. (8 marks)

Answer:

The PPP assumes all goods are traded internationally at negligible transaction costs. Typically, any mispricing would be driven away by arbitrage activities.

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However, PPP doesn’t hold in many cases when goods and services do not move at zero costs between countries, due to shipping costs, tariffs, quotas, etc. (2 marks)

Also,  many services are  not tradeable, such as  haircuts that differ from  one  hairdresser to another. (1 mark)

Additionally, many goods and services are not of the same quality across countries, and there are  differences  in  the  tastes  and  resources  of  the  countries  of  their  manufacture  and consumption. (1 mark)

The above cause arbitrage strategies to be difficult to carry out.

PPP holds well over the very long run but poorly over shorter time periods. (1 mark) PPP holds better for countries with relatively high rates of inflation and underdeveloped capital markets. (1 mark) (Also see “About PPP” post on April 1 on the course forum)

In this case, luxury cars are sold in a NON-COMPETITIVE market (imperfect competition) and it is not easily substituted given it’s not a standardized good (e.g., owning a Porsche vs. a Toyota Corolla may not be seen as the same thing). Luxury car manufacturers wish to limit sales so ownership of the car will be seen as a status symbol. Additionally, importing tariffs on luxury items may be significant. As a result, you cannot easily exploit arbitrage strategies to drive away

the mispricing (2 mark) and PPP fails.

(Topic 4, PPP.)

Question 4 (10 marks)

You find the following rates quoted by FINM Bank, and observe the following prices, find the corresponding cross rate of MYR/GBP. Be sure to show all your steps for the full mark.

Answer:

The implied cross rate should be:

⇒ ÷ ⇒ × ⇒ ÷

MYR/GBP bid: the price in GBP the dealer is willing to buy one MYR

o MYR -> USD -> GBP

0.2245⁄ ( . ) ÷ 1.3172⁄( . ) = /0.1704 Or:  0.2245⁄ × 0.7590⁄ = /0.1704

Or:  0.7590⁄÷ 4.4543⁄ = /0.1704

MYR/GBP ask: the price in GBP the dealer is willing to sell one MYR

o GBP -> USD -> MYR

0.2247⁄ ( . ) ÷ 1.3172⁄( . ) = /0.1706

Or:  0.2247⁄ × 0.7592⁄ = /0.1706

Or:  0.7592⁄÷ 4.4504⁄ = /0.1706

So the implied cross rate should be MYR/GBP 0.1704/06 . (1 mark)

(Topic 1 Extension, Practice Question 1, cross rates with bid-ask spread. Problem Set #1, Q3)