Steps Value

Initial spot exchange rate (/$) 110.60

Initial price oI a Nissan Xterra () 2,800,000
Expected US dollar inIlation rate Ior the coming year 2.000
Expected Japanese yen inIlation rate Ior the coming year 0.000
Desired rate oI pass through by Nissan 70.000
a. What was the export price for the XTerra at the beginning of the year?
Year-beginning price oI an XTerra () 2,800,000
Spot exchange rate (/$) 110.60
Year-beginning price oI a XTerra ($) 25,316.46 $
b. What is the expected spot rate at the end of the year assuming PPP?
Initial spot rate (/$) 110.60
Expected US$ inIlation 2.00
Expected Japanese yen inIlation 0.00
Expected spot rate at end oI year assuming PPP (/$) 108.43
c. Assuming complete pass through, what will the price be in US$ in one year?
Price oI XTerra at beginning oI year () 2,800,000
Japanese yen inIlation over the year 0.000
Price oI XTerra at end oI year () 2,800,000
Expected spot rate one year Irom now assuming PPP (/$) 108.43
Price oI XTerra at end oI year in ($) 25,822.78 $
d. Assuming partial pass through, what will the price be in US$ in one year?
Price oI XTerra at end oI year () 2,800,000
Amount oI expected exchange rate change, in percent (Irom PPP) 2.000
Proportion oI exchange rate change passed through by Nissan 70.000
Proportional percentage change 1.400
EIIective exchange rate used by Nissan to price in US$ Ior end oI year 109.073
Price oI XTerra at end oI year ($) 25,671 $
Problem 4.2 XTerra exports and pass through
Assume that the export price oI a Nissan XTerra Irom Osaka, Japan is 2,800,000. The exchange rate is
110.60/$. The Iorecast rate oI inIlation in the United States is 2 per year and is 0 per year in Japan. Use this
data to answer the Iollowing questions on exchange rate pass through.
Assumptions Value
Spot exchange rate, Iixed peg, early January 2002 (Ps/$) 1.0000
Spot exchange rate, January 29, 2003 (Ps/$) 3.2000
US inIlation Ior year (per annum) 2.20
Argentine inIlation Ior year (per annum) 20.00
a. What should have been the exchange rate in 1anuary 2003 if PPP held?
Beginning spot rate (Ps/$) 1.00
Argentine inIlation 20.00
US inIlation 2.20
PPP exchange rate 1.17
b. By what percentage was the peso overvalued?
Actual exchange rate (Ps/$) 3.20
PPP exchange rate (Ps/$) 1.17
Percentage overvaluation (positive) or undervaluation (negative) -63.307
c. What were the probable causes of undervaluation?
The rapid decline in the value oI the Argentine peso was a result oI not only inIlation,
but also a severe crisis in the balance oI payments (see Chapter 3).
Problem 4.3 Argentine peso and PPP
The Argentine peso was Iixed through a currency board at Ps1.00/$ throughout the 1990s. In
January 2002 the Argentine peso was Iloated. On January 29, 2003 it was trading at Ps3.20/$.
During that one year period Argentina's inIlation rate was 20 on an annualized basis. InIlation
in the United States during that same period was 2.2 annualized.
Assumptions Value
Forecast annual rate oI inIlation Ior Japan 1.000
Forecast annual rate oI inIlation Ior United States 5.000
One-year interest rate Ior Japan 4.000
One-year interest rate Ior United States 8.000
Spot exchange rate (/$) 104.00
One-year Iorward exchange rate (/$) 100.00
Forecast change in
Forward rate as spot exchange rate Purchasing
an unbaised 4.0000 5ower
5redictor (E) ollar expected to weaken) 5arity (A)

Forward premium Forecast difference

on foreign currency nternational in rates of inflation
4.0000 Fisher Effect (C) -4.0000
apanese yen at a premium) &$ higher than apan)

nterest rate ifference in nominal Fisher

5arity (D) interest rates effect (B)
-4.0000
higher in &nited $tates)
Problem 4.9 apanese -- &nited $tates parity conditions
Approximate Form
Use the Iollowing data to diagram and calculate whether international parity conditions hold between Japan and the United States. What
is the Iorecasted change in the Japanese yen/US dollar (/$) exchange rate one year hence?
As is the always the case with parity conditions, the Iuture spot rate is implicitly Iorecast to be equal to the Iorward rate, the implied rate
Irom the international Fisher eIIect, and the rate implied by purchasing power parity. In this case, 100/$.
Value SFr. Equivalent
Arbitrage funds available $1,000,000 SFr. 1,281,000
Spot exchange rate (SFr./$) 1.2810
3-month forward rate (SFr./$) 1.2740
U.S. dollar 3-month interest rate 4.800
Swiss franc3-month interest rate 3.200
Difference in interest rates ( i SFr. - i $) -1.600
Forward premium on the Swiss franc 2.198
CIA profit potential 0.598
U.S. dollar interest rate (3-month)
START 4.800 END
1,000,000.00 $ 1.0120 1,012,000.00 $
1,013,538.46
1,538.46 $



Spot (SFr./$) ---------------> 90 days ----------------> Forward-90 (SFr./$)
1.2810 1.2740



SFr. 1,281,000.00 1.0080 SFr. 1,291,248.00
3.200
Swiss franc interest rate (3-month)
a) Kavita Raman makes a CIA proIit oI $1,538.46 on each million she invests.
0.62
Problem 4.10 Kavita Raman -- CIA
Assumptions
-) Assuming a $1 million investment Ior the 90-day period, the annual rate oI return
on this near risk-less investment is:
Kavita Raman is a Ioreign exchange trader Ior a -ank in New York. She has $1 million (or its Swiss Iranc
equivalent) at her disposal Ior a short term money market investment. Kavita wonders iI she should invest in U.S.
dollars Ior three months, or make a covered interest ar-itrage (CIA) investment in the Swiss Iranc Ior three
months. She Iaces the Iollowing quotes:
This tells Kavita Raman she should -orrow U.S. dollars and invest in the LOWER yielding currency, the Swiss
Iranc, in order to earn covered interest ar-itrage (CIA) proIits.
Arbitrage Rule of Thumb. If the difference in interest rates is greater than the forward premium/discount, or
expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in
interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding
currency.