Week 2 Solutions

ECN209
PROBLEM SET 2
SUGGESTED SOLUTIONS
Remark: For any of these exercises, unless explicitly specified otherwise, feel free to use
either the exact or the approximate formulae seen in class.
1. Consider two countries with a single good (potatoes) and a single investment asset (risk-free
bank deposits). In Country 1, the interest rate on bank deposits is 5% and the increases of the
price of potatoes is 1%. In Country 2, the interest rate on deposits is 40% and the increase of
the price of potatoes is 36%. Find the real return on bank deposits in either country using
both the approximate and the exact formulae. How can you explain the large discrepancy of
the approximate formula in these two countries?
Answer: Applying the approximate formula, the real return on bank deposits is given by 5%-
1%=4% in country 1 and 40%-36%=4% in country 2.
The exact real return is given by 100·(105/101-1)=3.96% in Country 1 and 100·(140/136-

1)=2.94%. Notice that you can also obtain these numbers by using the formula (r-π)/(1+ π),
that is, (0.05-0.01)/(1+ 0.01)= 3.96% in Country 1 and (0.40-0.36)/(1+ 0.36)= 2.94% in
Country 2.
The approximate formula does simply measure the difference between the nominal interest
rate and the inflation, while the exact formula deflates this difference dividing by the gross
inflation rate 1+ π. When the inflation rate π is small, the approximation is (fairly) good. But
the approximation becomes less good as the inflation grows larger.
2. Suppose the dollar interest rate and the pound sterling interest rate are the same, 3 percent
per year. Suppose that the expected future $/£ exchange rate, $ 1.52 per pound, remains
constant as Britain’s interest rate rises to 8 percent per year. What is the new equilibrium £/$
rate?
Answer: The current equilibrium exchange rate must equal the expected future exchange
rate since, with equality of nominal interest rates, there can be no expected change (increase
or decrease) in the dollar/pound exchange rate in equilibrium. If now Britain’s interest rate
rises to 8 percent and the expected exchange rate remains at 1.52 $/£, then the interest parity
condition holds only if the current exchange rate changes in such a way that the dollar
appreciates by 5%. This happens if the current exchange rate dollar/pound goes at 1.60 $/£
3. Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per
euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on
dollar deposits is 10 percent and on euro it is 4 percent. Under these assumptions, does the
interest parity hold?
Answer: Just apply the interest parity formula and show it applies
4. In Munich a bratwurst costs 5 euros; a hot dog costs $4 at Boston’s Fenway Park. At an
exchange rate of $1.05/per euro what is the price of a bratwurst in terms of a hot dog? All
else equal, how does this relative price change if the dollar depreciates to $1.25 per euro?
Compared with the initial situation, has a hot dog become more or less expensive relative
to a bratwurst?
Answer: At an exchange rate of $1.05 per euro, the price of a bratwurst in terms of hot
dogs is 1.3125 hot dogs per bratwurst. After a dollar depreciation to $1.25 per euro, the
relative price of a bratwurst increases to 1.5625 hot dogs per bratwurst. The hot dog has
become less expensive compared to a bratwurst. Before the depreciation one hot dog could
buy 1/1.3125=0.76 bratwurst. After the depreciation, one hot dog could only buy
1/1.625=0.64 bratwurst.
5. A U.S. dollar costs 7.5 Norwegian kroner, but the same dollar can be purchased for 1.25
Swiss francs. What is the Norwegian krone/Swiss franc exchange rate? Suppose that the
Norwegian kroner, appreciates by 10% against the U.S. dollar, and that the Swiss franc
appreciates by 5% against the U.S. dollar. What is the now the Norwegian krone/Swiss
franc exchange rate? Which one of the two currencies has appreciated against the other?
Answer:The Norwegian krone/Swiss franc cross rate must be 6 Norwegian krone per Swiss
franc. If the Norwegian krone appreciates by 10% against the dollar, it means it needs 6.75
kronas per dollar. If the swiss franc appreciates by 5% it mean it needs 1.1875 francs per
dollar. The new exchange rate is 6.75/1.1875=5.6842.
6. Calculate the dollar rates of return on the following assets:
a) A painting whose price rises from $200,000 to $250,000 in a year.
b) A bottle of a rare wine, whose price rises from $250 to $275 in a year.
c) A £10,000 deposit in a London bank in a year when the interest rate on pounds is 10
percent and the exchange rate moves from $1.50 per pound to $1.38 per pound.
Answer: The dollar rates of return are as follows:
a) ($250,000 - $200,000)/$200,000 = 0.25.
b) ($275 - $250)/$250 = 0.10.
c) There are two parts of this return. One is the loss involved due to the appreciation
of the dollar; the dollar appreciation is ($1.38 - $1.50)/$1.50 = -0.08. The other
part of the return is the interest paid by the London bank on the deposit, 10 percent.
(The size of the deposit is immaterial to the calculation of the rate of return.) Using
the approximate formula, the realized return on the London deposit in terms of
dollars is thus 2 percent per year.
7. Suppose Company A knows that in 2 months it must pay euros to a German supplier for
a shipment of T-shirts. Company A can sell each T-shirt for £10 and must pay its supplier
€8 per T-shirt.
a) What is its profit at a current spot exchange rate of £0.85 per euros?
b) What if the pound depreciates over the next 2 months (€1 =£1.60)?
c) How can Company A avoid this risk?
Answer:
a) £Cost of 1 T-shirt = €8·0.85= £6.8. Hence, £Profit = £10 - £6.8= £3.2.
b) £Cost of 1 T-shirt = €8·1.60= £12.8. Hence, £Profit = £10 - £12.8= -£2.8.
c) To avoid this risk, Company A could make a forward exchange rate transaction (in
2 months) with, say, the Bank of England. The Bank of England may commit to sell
euros at a fixed exchange rate (£0.85/€), while Company A may commit to buy
euros at this rate.

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ECN209

The exact real return is given by 100·(105/101-1)=3.96% in Country 1 and 100·(140/136-

6. Calculate the dollar rates of return on the following assets:

a) A painting whose price rises from $200,000 to $250,000 in a year.

Answer: The dollar rates of return are as follows:

a) ($250,000 - $200,000)/$200,000 = 0.25.

b) ($275 - $250)/$250 = 0.10.

b) £Cost of 1 T-shirt = €8·1.60= £12.8. Hence, £Profit = £10 - £12.8= -£2.8.

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