Question 1. (36 points) Multiple choice: For each of questions 1.1 through 1.9 below, please pick and write in the answer template sheet one and only one letter (among A,B,C,D) associated with the most correct answer (no explanation is needed for your answers):

1.1 (4 points): Concerning the slope coefficient b (in Famas regression of the % change in the exchange rate on the forward premium), which of the following statements is TRUE:

1. When b > 0, you should borrow high-interest-rate currencies and lend low-interest-rate currencies.

2. When b 1, you should borrow low-interest-rate currencies and lend high-interest-rate currencies.

3. When b = 1, you should do nothing.

4. For all values of b, you should never borrow high-interest-rate currencies and lend low-

   interest-rate currencies

1.2 (4 points): Concerning the Covered Interest Rate Parity (CIP), Uncovered Interest Rate Parity (UIP), and Currency Carry Trade, which of the following statements is TRUE:

1. The violation of UIP implies the violation of CIP.

2. The violation of CIP implies the violation of UIP.

3. The holding of CIP and the violation UIP imply a currency carry trade strategy.

4. If traders they do not believe in UIP, they should stay out of currency markets.

1.3 (4 points): When should a company issue a floating-rate bond?

1. The company expects that its credit rating will deteriorate in the future.

2. The company expects that interest rates are going to increase in the future.

3. The company believes in the expectation hypothesis.

4. The company expects that interest rates are going to decrease in the future.

1.4 (4 points): Concerning the nominal and real interest rates, which of the following statements is FALSE:

1. Real interest rate is not known for sure beforehand.

2. Nominal interest rate is not known for sure beforehand.

3. Inflation is not known for sure beforehand.

4. We only know the total of real interest rate and inflation for sure beforehand.

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1.5 (4 points): Concerning the Covered Interest Rate Parity (CIP), which of the following statements is TRUE:

1. The violation of CIP implies arbitrage opportunities for individual investors if there are no bid/ask spreads.

2. The violation of CIP implies the existence of bid/ask spreads.

3. The violation of CIP implies arbitrage opportunities for individual investors.

4. The violation of CIP implies arbitrage opportunities for market makers.

1.6 (4 points): Concerning the Purchasing Power Parities (PPP), which of the following statements is FALSE:

1. The purchasing power of a currency reflects the inflation of that country.

2. The exchange rate in FX markets between two currencies is computed from the

   purchasing power parity of these two currencies.

3. PPP is violated because the consumption tastes in different countries are different.

4. The movement of the price level in a country characterizes the inflation of that country

   over time.

1.7 (4 points): Concerning the Uncovered Interest Rate Parity (UIP), which of the following statements is TRUE:

1. The violation of UIP implies that opportunities exist for currency traders.

2. The violation of UIP implies that no opportunities exist for currency traders.

3. The violation of UIP implies the existence of bid/ask spreads.

4. The violation of UIP implies arbitrage opportunities for individual investors if there are

   no bid ask spread.

1.8 (4 points): Concerning the PPP-implied exchange rate, which of the following statements is FALSE:

1. When two countries have identical consumption baskets, and there are neither frictions nor arbitrages in the market, the PPP-implied exchange rate equals one.

2. When the foreign country experiences a deflation (and everything else stays the same), then the PPP-implied exchange rate of the foreign currency (in the numeraire of USD) increases.

3. The PPP-implied exchange rate has nothing to do with the spot exchange rate.

4. Investors may formulate some currency trading strategies based on PPP-implied and spot

   exchange rates.

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1.9 (4 points): Concerning the forward FX markets, and assume that there are no arbitrage opportunities, which of the following statements is TRUE:

1. Borrowing a currency traded at a forward premium and lending a currency traded at a forward discount will surely generate profits.

2. A currency traded at a forward discount will surely depreciate in the future.

3. A currency traded at a forward premium will surely appreciate in the future.

4. A currency with lower interest rate than the U.S. interest rate is surely traded at a forward

   premium against USD in the forward FX market.

Question 2 (30 points): Bid/Ask spreads in FX markets

The following data are posted by market makers concerning USD and GBP: Bid spot exchange rate 1GBP=1.3USD; Ask spot exchange rates 1GBP=1.4USD; Bid 6-mon forward exchange rate 1GBP=1.18USD; Ask 6-mon forward exchange rates 1GBP=1.32USD; Bid US annualized interest rate 4%; Ask US annualized interest rate 8%; Bid UK annualized interest rate 2%; Ask UK annualized interest rate 6%; In this question, we take the perspective of an UK investor, Jennifer, who does not want to have any uncertainty what-so-ever in her investments. Let Jennifer start out with a notional value of 1000 GBP (her own money).

First, Jennifer considers staying within the UK market only.

2.1 (5 points): How much money (in GBP) she will have in 6 months?

Alternatively, Jennifer now considers investing in FX markets. To do so, she will need to buy USD in the spot market and deposit USD to a US bank, and in 6 months, convert all proceeds back to GBP.

2.2 (10 points): Which forward contract (sell or buy GBP?) Jennifer needs to enter now? Specify 2 key characteristics: (i) the delivery time, and (ii) the forward exchange rate, of that forward contract?

2.3 (10 points): How much money (in GBP) Jennifer will have in 6 months by investing in FX markets?

2.4 (5 points): Should Jennifer stay in UK market or invest FX market? Do arbitrage opportunities exist for Jennifer?

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Question 3 (20 points): Parities

Assume that all parities (CIP, UIP, PPP) hold in international financial markets.

This year (currently): the consumption basket in the U.S. costs 100 USD, the consumption basket in Australia costs 160 AUD, the nominal interest rate in Australia is 6%.

Next year: the inflation in the U.S. is expected to be 5%, the inflation in Australia is expected to be 10%.

3.1 (5 points): What is the current (this years) nominal exchange rate between AUD and USD (in the numeraire of USD)? What is the current (this years) real exchange rate between the two countries (in the numeraire of the U.S. basket)?

3.2 (5 points): What is the expected nominal exchange rate between AUD and USD (in the numeraire of USD) next year? What is the expected real exchange rate between the two countries (in the numeraire of the U.S. basket) next year?

3.3 (5 points): What is the one-year forward exchange rate between AUD and USD (in the numeraire of USD)? What is current interest rate in the U.S.?

3.4 (5 points): Should currency speculators borrow USD and lend AUD, or they should not? Question 4 (14 points): BigMac as a currency

Currently, the spot exchange rate between USD and GBP is 1 GBP = 1.8 USD. A BigMac burger costs 6.30 USD in the U.S., and 4 GBP in U.K.

4.1 (4 points): What is BigMac-PPP-implied exchange rate between GBP and USD (in the numeraire of USD)?

4.2 (5 points): Ignore the transportation cost and all other costs, how much (in USD) would you (as an American investor) make per 1000 USD notional value by trading BigMac?

4.3 (5 points): If you believe in PPP, do you expect that USD will appreciate or depreciate next year (with respect to GBP, in the currency market)? By how many percent?