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Suppose that the price of a dollar in Moscow is 32 rubles, but that rubles can be purchased in New York for $0.
1.Suppose that the price of a dollar in Moscow is 32 rubles, but that rubles can be purchased in New York for $0.030. Use demand and supply curves for each foreign exchange market to illustrate these equilibrium exchange rates, assuming that the markets were separate. Then assume that the markets are not separate and that arbitrage occurs in order to equalize prices. Illustrate the effects that arbitrage has on the exchange rate by making appropriate shifts in demand and supply.2. Suppose that the ruble costs 0.025 pound in London, 30 rubles can be purchased for one euro in Moscow, and that the euro/pound exchange rate in Frankfurt is 1.5. Explain how you would profit from triangular arbitrage starting with one million rubles, ignoring transaction costs. Give an example of a feasible set of consistent exchange rates that could result from this arbitrage.3. Suppose that you have $2,000 and face the following situation. The current 180-day interest rate on a dollar denominated deposit is 2% and the rate on a pound denominated deposit is 5%. The current spot exchange rate is $2 per pound. You are interested in maximizing your dollar earnings over the next 180 days given these limited choices.a. Based on your knowledge of foreign exchange markets, what are your three basic choices of investment strategies?b. If you and everyone else were certain that the exchange rate between dollars and pounds would not change over the next 180 days, what would you do? What would you have at the end of 180 days?c. Assume that you do not mind bearing foreign exchange risk. You expect that the spot rate in 180 days will be $1.95 per pound. What strategy would you follow and why? After 180 days, the actual spot rate turns out to be $1.90 per pound. Are you pleased with your decision? Explain why.d. Now assume that you are highly risk averse. The dollar interest rate is 4% and the pound interest rate is 3%. The 180-day forward rate is $2.04 per pound. What strategy do you follow? Explain the results.2.Suppose that the market expects that next year the exchange rate between Mexican pesos and U.S. dollars will be equal to et+1 = US$0.12 next year. The current return on high-quality Mexican financial assets is 10 percent while the interest rate in the U.S. for comparable assets is 20 percent. Given this information, calculate what the spot exchange rate e must be. 3.Suppose that the spot exchange rate between Japanese yen and U.S. dollars is equal to e = US$0.01. The current return on high-quality Japanese financial assets is 1 percent while the interest rate in the U.S. for comparable assets is 7 percent. Given this information, calculate what the 360¬day forward exchange rate must be. 4.Explain precisely why, under the assumption that the interest parity condition holds and people set their expectations rationally, it is impossible to accurately predict changes in the exchange rate.
