Assignment #1

(Total = 40 marks)

Be sure to **write down all steps for your answer (calculations) to get full marks. **

**Due Date: **Workshop 2 Thursday 16 January 2020 (week 3). To be submitted to the Assignment during the workshop.

**Penalties for late lodgement: **

A late assignment, that is assignments submitted after the due date and where no extension has been granted, will be accepted, but in fairness to students who present their work on time, a penalty will be levied. A penalty of 10% of the total mark allocated to this assessment will be deducted for each day that it is late (**including weekend**). Please note that this policy applies to this unit only; other lecturers may take a different approach.

**Assessment coversheet: **

Work submitted for assessment MUST be accompanied by a completed and signed assignment coversheet, available in Moodle. NO assignment will be accepted or marked if it is not accompanied by a signed Assignment cover sheet.

1. Choose any one country’s currency that you are interested in. Write down how the currency’s exchange rate policy has been changed over the last 5 decades, at least from the mid 1960s. You can find the history of a currency through Google or Wikipedia search. Your answer must not be over 2 pages in length. **[7 marks] **

2. Assume your company has a contract to purchase 100 computers from a Korean company. The payment is due on receipt of the shipment and must be delivered in Korea on 1 December 2016. On 1 July 2016, when you are arranging the contract, the computers are priced at 500,000 won each. On 1 July 2016, the spot exchange rate is AU$1 in exchange for 1,250 won (KRW). Assume that the 6-month interest rate in Korea is 3% and the rate in Australia is 5%. Assume that the covered interest parity holds.

(A) Calculate the Australian dollar price (on 1 July 2016) of one unit of Korean currency (rounding to 4 decimal places). **[1 marks] **

(B) What is the total price of the computers in Australian dollars on 1 July 2016 (rounding to 2 decimal places)? **[1 marks] **

(C) Calculate the 6-month forward exchange rate, *F*KRW/$, under the covered interest parity (rounding to 2 decimal places). Note that the forward rate is defined as the Korean won per AU$1.

**Hint: **Use the CIP equation. **[3 marks]**

(D) What would you advise your firm to do to avoid a loss on the deal if the Korean won costs 5% more compared to the Australian dollar (the expected depreciation rate of Australian dollar

against Korean won is 5%) when payment is due on 1 December 2016? The answer should have the exact numbers (rounding up to 2 decimal places) that you would tell your CEO.

**Hint: **You want to get rid of the exchange rate risks using a forward contract. **[5 marks] **

3. Suppose a basket of goods costs 210,000 Mexican pesos in Mexico, while the same basket costs $16,800 in Australia. The nominal exchange rate is currently at *E*$/Peso = 0.10. Assume that the prices in two countries do not change at all over time (the inflation rates in two countries are always zero). Assume that the uncovered interest parity (UIP) holds.

(A) Calculate the real exchange rate, *q*$/Peso.

**[2 marks] **

(B) Under the purchasing power parity (PPP), what will be the nominal exchange rate in the long run?

**Hint: **Use the real exchange rate definition and apply the PPP. **[2 marks] **

(C) Is the Australian dollar under or overvalued against Mexican pesos at the moment? Calculate the extent and explain what will happen to the value of the dollar in the long run.

**[4 marks]**

(D) The nominal exchange rate in 1 year is expected to become *E**e*$/Peso = 0.097. Using the definition of the real exchange rate with zero inflation rates in two countries, calculate the expected real exchange rate in 1 year, *q**e*$/Peso.

**Hint: **Check the definition of the real exchange rate in growth rates and apply the inflation rates given. **[3 marks] **

(E) The exchange rate in 1 year is expected to be 0.097, *E**e*$/Peso = 0.097 as in (D), the current 1- year interest rate in Australia is 2%, and the 1-year forward rate is *F*$/Peso = 0.10. If you can borrow $1 million from a bank in Australia or 10 million pesos from a bank in Mexico, explain how you can make money without any exchange rate risks. The answer should have the specific amount of profits in Australian dollars in 1 year.

**Hint: **Check the UIP equation and find the interest rate in Mexico. Then, apply the way to make money when the CIP does not hold and outline all the investment steps involved. **[8 marks] **

(F) Using diagrams explain what will happen to the current spot exchange rate (increase decrease, or no change) if the forward rate in (E) and the nominal interest rates in two countries remain the same (the answer should have the change in the demand for or the supply of pesos in the foreign exchange market and also the value of the for new exchange rate, *E*$/Peso. [**4 marks**]