c




 




(a) Briefly discuss the theoretical relationships between interest rates and foreign exchange rates
and summarise the empirical evidence relating to these. 


(b) A UK importer has purchased goods from the USA. Payment will be made against shipment
in 6 months time for the amount of US$10,000,000. In order for the transaction to be
profitable, the cost of the imported goods must not exceed £6,400,000.

Given the following information:

Spot £1 = US$ 1.5862 - 1.5866

6 months forward £1 = US$ 1.5520 - 1.5526
6 month £ interest rate 3.5875 ± 3.6500 % pa
6 month US$ interest rate 1.2500 - 1.3125 % pa

Advise the UK importer on how this objective may be achieved. 



(c) Briefly explain the nature of covered interest arbitrage and determine whether such an
opportunity exists given the data presented in (b). If it does, calculate the profit per
£10,000,000 invested. 


? 





r? Vxpect discussion of the Fisher Vffect, International Fisher Vffect, Interest Rate Parity Theory
and possibly Purchasing Power Parity.
r? If a currency offers a higher real rate of interest, then other things being equal, one would expect
currency appreciation. Vg Governments attempt to support their currency by raising short-term
interest rates.
r? 2n the other hand, if a high interest rate merely reflects high inflation, one would expect the
currency to depreciate.
r? Also expect brief discussion of relevant empirical evidence.

  
!

"
!#

r? Buy US$/sell sterling 6 months forward at £1 = US$ 1.5520
r? üost of US$ 10m = 10m/1.5520 = £6,443,299
r? *oes not satisfy criterion

$
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!#

r? üreate *IY forward rate
r? Buy US$ 10m/1.00625 = 9,937,888 spot and sell sterling at 1.5862
r? Sterling cost is 6,265,218
r? *eposit US$ 9,937,888 for 6 months at 1.25% pa
r? †alue of deposit is US$ 10m in 6 months time
r? Sterling cost plus borrowing cost is 6,265,218 * (1 + (6/12 * 1.0365)) = £6,379,558
r? Satisfies criterion

'(

!

  
#
())  %
r? Actual forward rate is £1 = US$ 1.5520 - 1.5526
r? Aoney market forward rate for buying US$/selling £ is £1 = 1.5862 * 1.00625/1.01825 = 1.5675
r? i

  
r? Buy sterling 10m 6 months forward at a cost of 10m *1.5526 = US$ 15,526,000
r? 
 

r? Sell 10m/1.01825 = £ 9,820,771 spot at 1.5862
r? Borrow £ for 6 months at 3.65% pa - loan becomes 10m in 6 mths time
r? US$ cost of purchase is 9,820,771*1.5862 = US$ 15,577,707
r? Place US$ on deposit for 6 months at 1.250% pa
r? *eposit grows to 15,577,707 (1 + (6/12 * 0.0125)) = US$ 15,675,068 
r? ÔÔ   
  
r? c  !!" # $% !


A US exporter has entered into an agreement to supply goods to a UK company at a fixed cost of
£25 per unit. There are to be two consignments; one in 3 months¶ time (1st September 2004) and the
other in 6 months¶ time (1st *ecember 2004). Vach consignment will consist of a minimum of
100,000 units, but the UK company also has the option of purchasing an additional 25,000 units per
consignment at the same price. The policy of the US exporter is to fully hedge future foreign
currency cash flows.

(a) Briefly explain the nature of the exchange rate risk in this situation. 


(b) Given the above and the market information provided below, devise and justify a
suitable hedge strategy: 


Spot rate £1 = $1.9000 ± 1.9005

3 month forward rate £1 = $1.8870 ± 1.8876
6 month forward rate £1 = $1.8775 ± 1.8680

 '
'%

 

*)

3 months 6 months
US *ollar 1.750 ± 1.875% 1.750 ± 1.875%
Sterling 4.000 ± 4.125% 4.125 ± 4.25%


+#) 
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 !++
'
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,
Strike üalls Puts
3-mth 6-mth 3-mth 6-mth
1.9000 2.45 3.22 2.09 2.95

(c) üalculate the profit on the transaction given the following information: -


(i)? The cost of producing the goods was $40 per unit for both consignments
(ii)? The spot rate was £1 = $1.8700 ± 1.8705 on 1st September 2004 and 100,000 units
were sold
(iii)? The spot rate was £1 = $2.0100 ± 2.0105 on 1st *ecember 2004 and 125,000 units
were sold

(d) Briefly discuss the factors affecting the cost of currency options. 


 



(a)? Transaction risk
Sterling depreciates against the US$
Uncertainty surrounding whether additional units will be purchased

(b) For both consignments, use of either the forward or spot & AA hedge for 100,000 units; use
of options for the potential 25,000 additional units

  '#
 .--/--- 

Forward market Sell £2.5m forward at 1.8870 = $4,717,500
Spot & AA Sell £ spot at $1.90
Borrow £ for 3-months at 4.125% pa
*eposit US$ for 3-months at 1.75% pa
Rate achieved = [1.90 * (1+(0.25*0.0175)]/[(1+(0.25*0.04125]
Rate achieved = 1.88883
Sell £2.5m forward at $4,722,075
Spot & AA provides the best rate

  '#
 .'

/--- 
Buy 3-mth sterling puts at a cost of 25,000* £25*0.0209 = $13,062.50


'!'#
 .--/--- 

Forward market Sell £2.5m forward 1.8775 = $4,693,750
Spot & AA Sell £ spot at $1.90
Borrow £ for 6-months at 4.25% pa
*eposit US$ for 6-months at 1.75% pa
Rate achieved = [1.90 * (1+(0.5*0.0175)]/[(1+(0.5*00.425]
Rate achieved = 1.87674
Sell £2.5m forward at $4,691,850
Forward market provides the best rate


'!'#
 .'

/--- 
Buy 6-mth sterling puts at a cost of 25,000* £25*0.0295 = $18,437.50

(c) 3-mth put expires in the money profit = 625,000*(1.9-0.0209-1.87) = $5,687.50

6-mth put expires worthless loss = $18,437.50

1st consignment 100,000 sold at £25; spot & AA value = $4,722,075

2nd consignment 100,000 sold at £25; forward market value = $4,693,750
25,000 sold at £25; spot value $2.01 = $1,256,250
Net loss on options = $12,750
Total sales revenue $10,659,325
ü2GS 225,000 * $40 $9,000,000
c 0     1/23/4

(d) Strike price, spot rate, interest rates on the two currencies, maturity, American/Vuropean
style and the expected volatility of the exchange rate. †olatility is the most important.
4

The treasury department of a Japanese-based company believes that the US$ is currently
undervalued with respect to all major currencies, including the Yen, based on fundamental
economic indicators. Senior executives in the department also believe that this under-valuation will
correct itself during the next six months. Given Yen 500 million available as surplus cash flow for
the next six months, the treasury department is looking to profit from its view of US$ appreciation,
as well as taking advantage of the increased interest rates available on US$-denominated deposits.

The treasury department's forecast of the exchange rate between the US$ and Yen in six month¶s
time is as follows:

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0.10 US$1 = Yen 105
0.20 US$1 = Yen 110
0.50 US$1 = Yen 120
0.20 US$1 = Yen 125

2ther market-based information available is as follows:

Spot Vxchange Rate US$1 = Yen 107.50 ± 107.80

Six month US$ rates 1.5000 - 1.5125% pa
Six month Yen rates 0.3000 ± 0.3125% pa

5
6
!7

(a)? Given the information provided above, calculate the approximate bid-ask spread of the six-
month forward rate using the interest rate parity relationship. 2


(b)? Assuming the rates quoted above relate to euro-currency money markets, explain why only
uncovered interest arbitrage, rather than covered interest rate arbitrage, would be expected to
generate a profit in this situation. 8


(c) Forecasting exchange rates is extremely difficult. Vxplain two approaches commonly used
and discuss the problems associated with each. -


(d) Assuming the treasury department's forecasts to be accurate, calculate the expected return, as
well as the range of returns, from exploiting uncovered interest arbitrage in this situation.



 
4


(a)
Sell $ spot at 107.50
Borrow $ at 1.5125% pa for 6 months
*eposit Yen at 0.3% pa for 6 months
Rate achieved 107.50 * (1.0015/1.0075625) = 106.85

Buy $ spot at 107.80

*eposit $ at 1.5% pa for 6 months
Borrow Yen at 0.3125% pa for 6 months
Rate achieved 107.80 * (1.0015625/1.0075) = 107.16

) 9$$)+
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(b) Vuro-currency markets are efficient, have low transaction costs and there is no political risk.
The quoted forward rate would be the rate predicted by IRPT ± it merely adjusts for interest
rate differentials, not taking a view of future exchange rate movements as in this case. üIA is
a simple risk free arbitrage, and any temporary mis-pricing would be arbitraged away very
quickly.

(c)? ühoose between the fundamental, technical and market-based approaches

(d)?
 





     


   
    
        

 
 
      
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The following is an extract from a recent article in the financial press relating to the value of the US
dollar:

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5
6
!7

(a) Given that the US has been running consistent current account deficits, clearly explain the
relationship between the current account and capital accounts, and thus the importance of the
US attracting foreign portfolio inflows in this situation. -


(b) Given your knowledge of the relationships between interest rates and exchange rates, discuss
why sterling might have tested new highs. 


(c) *iscuss the potential basis for the comment that the dollar has been weakened because
investors have hedged their positions. 2


(d) What do you understand by the term ³verbal intervention´, distinguish that with direct
intervention and comment on the likely effectiveness of both. 


 
=


(a)? Vxpect clear description of what items are recorded in the current account and capital
accounts, and that the net between the two represents net outflow/inflows that impacts on
foreign currency reserves.
Vxpect students to be aware that the US has consistently large balance of trade, and therefore
current account, deficits that are not easily sustainable unless it continues to attract investors
in US stocks and bonds.
Link that to the current level of interest rates in the US and the performance of the stock
market.

(b)? Vxpect discussion of the FV and IFV and the distinction between real and nominal rates of
interest, Given domestic concerns, interest rates in the UK are more likely to rise than fall in
the near term, boosting the attractiveness of holding sterling, and thus providing a higher real
rate of return.

(c)? That investors may have been fairly bullish about, eg the performance of the US stock
market, but have hedged their exposure to the US$ exchange rate by selling expected
investment proceeds forward. Through IRPT if the US$ depreciates in the forward market it
will also depreciate in the spot market.

(d)? †erbal intervention ± trying to talk the value of the Vuro down ± as opposed to direct
intervention, whereby the VüB sells Vuros and buys US$ and/or buys £ in the market. We
would not have discussed this specifically during the unit, but hopefully students have been
reading the FT?! Have mentioned the comparative ineffectiveness of large-scale sales of Yen
against the dollar over the last few months and students might mention the arguments about
whether the central bank has a better view of where their currency should trade relative to
the market.

??
?

?


BR†A is a German based company with significant export sales to other Vuropean countries
including the UK. The treasury department of BR†A is considering Vurobond financing options,
wanting to raise the equivalent of Vuro 500 million through the issue of five-year bonds. The
objective is to minimise the cost of financing without exposing the company to undue currency risk.

Two financing options have been selected for consideration:

(i)? The issue of Vuro 500 million nominal 5-year bonds, issued and redeemed at par,
with an annual coupon of 5.05%
(ii)? The issue of GBP 300 million nominal 5-year bonds, issued and redeemed at par,
with an annual coupon of 5.75%.

Although the coupon on GBP-denominated bonds is higher than that on equivalent Vuro-
denominated bonds, the consensus view of the treasury department is that the Vuro will appreciate
against GBP over the next 5 years. Specifically, the following exchange rates have been forecast:


)
! )  >5


+ 1 year 1Vuro = GBP 0.61
+ 2 years 1Vuro = GBP 0.63
+ 3 years 1Vuro = GBP 0.70
+ 4 years 1Vuro = GBP 0.70
+ 5 years 1Vuro = GBP 0.69

This compares to a current spot rate of 1Vuro = GBP 0.6125

5
6
!7

(a)? Briefly explain why the cost of raising funds by BR†A (i.e. the coupon payment) varies
dependent upon the currency of issue 


(b)? Assuming the forecast exchange rates to be accurate, calculate the effective cost of raising
funds in Vuros, versus raising funds in GBP, over the 5-year period. 


(c)? If the GBP-denominated Vurobond option was selected, discuss the likely impact on
BR†A's currency risk exposure. 


 



(a)? üost for BR†A = govt 5-year rate + risk premium

Risk premium depends on the creditworthiness of the issuer, size and likely liquidity of the
issue, marketability of the issue, sentiment in the market at the time, etc.
Aost likely that the cost varies because 5-year Gilts currently offer a higher yield than Vuro-
denominated Treasuries offered by governments such as Germany, France, etc.

(b)? The costs of raising funds in Vuro would be 5.05%

The equivalent cost in Sterling, assuming the exchange rate forecasts to be accurate, would
be approximately 3.22%
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(c)? Given that BR†A has export sales to the UK, issuing debt in sterling may not increase the
company's exposure to currency risk, and may even reduce it.
If sterling depreciates to the extent expected, there would be a saving in financing costs and
this might offset reduced price competitiveness and its impact on export sales to the UK
(real operating exposure).
If sterling appreciates instead, against the forecast, the cost of raising funds would be higher,
but this might be offset by increased price competitiveness and increased exports to the UK.
Since BR†A exports to the UK, some sales are likely to be invoiced in GBP, and transaction
exposure would be reduced to the extent that the company uses these GBP receivables to
fund the coupon payments.
2

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üritically evaluate this comment 4$




2


Relevant points to mention might include:

Vxtra marks for citing specific examples

r? Transaction exposure is definitely relevant but some argue that translation exposure is not
r? Transaction exposure may not always be hedged however:
|? The size of the exposure may be negligible
|? The company may take a view on the direction of FX movements
|? The company may view FX risk as an integral part of its operations
|? Future inflows and outflows may net off with one another
|? Two foreign currency flows may be highly correlated ± e.g. Vuro & *Kr
r? 2nly some view translation exposure as irrelevant on the basis that:
|? It may not have cash flow implications
|? It is a purely accounting anomaly
|? Investors can hedge the risk for themselves
|? Profits from foreign subsidiaries may not be repatriated
|? FX rates are volatile and do not always reflect economic fundamentals
r? 2ther companies do hedge translation exposure however:
|? It does have cash flow implications because profits are repatriated
|? FX losses might increase the volatility of earnings, thereby increasing the cost of
obtaining and raising finance
r? Hedging translation exposure may create additional risk on the basis that:
|? FX translation losses might be viewed as only ³paper´ profits/losses, but forward
currency hedges create real cash flow losses/profits
|? Profits from overseas subsidiaries may be difficult to forecast accurately; using
forward currency hedges might therefore create additional risk if the actual profit is
very different from that forecasted
8

(a) üompare and contrast the nature of transaction risk and translation risk. -


(b) Both internal and external hedging techniques may be used for the management of
transaction risk. Briefly discuss  examples of each (i.e. two internal techniques and two
external techniques). (
)

(c) *iscuss the arguments both for and against hedging translation risk. 4



8


(a) Vxpect brief definition of each

Vxpect emphasis on the compare & contrast aspect
Vase of measuring/forecasting transaction & translation exposure
Impact on cash flows & the value of the firm

(b) Vxplanation of the distinction between internal and external hedging techniques
Internal ± two from leading & lagging, balance sheet hedging, netting, etc
Vxternal ± two from the use of forwards, futures, options, swaps, etc

(c) For hedging translation exposure:

[? It has cash flow implications if profits are repatriated
[? Poor consolidated results may have an impact on the company¶s share price
[? FX losses might increase the volatility of earnings, thereby increasing the cost of
obtaining and raising finance
Against hedging translation risk:
[? It may not have cash flow implications if profits are not repatriated
[? It is a purely accounting anomaly
[? Investors can hedge the risk for themselves
[? It is difficult to accurately forecast subsidiary earnings & exchange rates
Additional marks if students quote actual examples


(a) If a country¶s currency depreciates, briefly explain why one might expect this to lead to an
improvement in the trade balance (i.e. a reduced trade deficit or an increased trade surplus).
8


(b) üonsidering the situation in the USA, this has not been the case over the last 3+ years.
Suggest possible reasons for this. -


(c) Vxchange rates are affected by many factors.

(i) Briefly describe the impact of  of these. 



(ii) üompare and contrast  different approaches for forecasting exchange rates.
-






(a) Brief definition of the trade balance within the context of B2P generally
üurrency depreciation makes the home country goods cheaper (expected to lead to increased
exports) as well as making imports more expensive (expected to lead to decreased imports)
Vxpect students to provide examples to make the point clear

(b) Points that might be included:

[? J-curve effect
[? Action of international competitors ± e.g. reduce the price in order to maintain
market share
[? Action of foreign governments ± e.g. direct intervention by Japan to keep the value
of the Yen against the US$ ³artificially´ low or by the ühinese authorities to peg the
exchange rate to the US$ at an undervalued rate
[? *iscussion of the capital account ± US continues to attract both portfolio investment
and F*I

(c)(i) *iscussion of inflation, interest rates, income, speculation, etc.

(c)(ii) *iscussion of fundamental, technical, market based or mixed approaches

Brief explanation of the two approaches
*iscussion of the compare & contrast aspects
*iscussion of the relative effectiveness of the two approaches

?
3

Assume the role of a recent recruit to the treasury department of a UK-based company. The funding
requirement is to raise the equivalent of GBP 250 million through the issue of 5-year bonds in the
Vurobond market. Although your company currently transacts no business with Japanese clients, it
is nevertheless considering the possibility of issuing a Yen-denominated bond in order to take
advantage of reduced funding costs.

Specifically, two funding options highlighted are:

(i)? The issue of GBP 250 million nominal 5-year bonds, issued and redeemed at par,
with an annual coupon of 5.75%
(ii)? The issue of Yen 45,000 million nominal 5-year bonds, issued and redeemed at par,
with an annual coupon of 0.95%.

The exchange rate of the Yen against GBP over the last 5 years has been as follows:

o
 







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The consensus view of the treasury department is that the Yen is unlikely to appreciate significantly
against GBP over the next 5 years. Vven if it did, however, the view is that the worst case scenario
would be an exchange rate of 1GBP = Yen 150, compared to a current exchange rate of 1GBP =
Yen 180.

5
6
!7

(a) Briefly explain the advantages of raising funds through the Vurobond market rather than
using the domestic bond market. -


(b)? üalculate the effective GBP cost of raising funds in Yen, assuming the predicted worst-case
scenario. That is, if immediately after issue, (at a spot rate of 1GBP = Yen 180), the Yen
appreciated such that 1GBP = Yen 150. 


(c) Write a brief report to the treasury department head outlining your recommendation, with
respect to the two identified financing options, including discussion of the impact the
financing decision would have on the company's currency exposure. -

3


(a)? Advantages might include:

- Aore liquid market and cheaper cost of issue as a result
- Aore choice of security type
- Focusing on professional wholesale investors and the speed and efficiency of raising funds
that results from this
- Bearer vs registered security - tax implications
- Listing the Vurobond on an exchange with less onerous regulations

(b)
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(c) To the extent that the view of future exchange rates is correct, the company would benefit
from issuing in Yen rather than sterling (4.80% vs 5.75%).
By issuing in Yen, however, the company would be exposing itself to increased currency
risk, given that it transacts no business with Japanese clients.
No correct answer on the recommended financing option - interested to read students' views
and their justification.
-

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5
6
!7

(a) Briefly outline the origins and development of the Vuromarkets. -


(b) *iscuss the links between less regulation and the competitive rates of interest offered by
Vurobanks. 


(c) Lehman Brothers was allowed by the US Treasury to fail. Was that the right decision?
Justify your answer. -



-


(a) Vxpect discussion to include:

!? The ³cold war´ in the 1950s and 1960s
!? So called ³petro-dollars´ in the 1970s
!? Vuromarkets developing to circumvent seemingly overly restrictive national
markets including Regulation Q and the interest equalisation tax (IVT) in the
US
!? Vurocurrency and Vurobond markets developing in parallel

(b) Vxpect discussion to include:

!? Vurobanks are free from regulatory control with respect to holding reserve
assets
!? Vurobanks do not have to pay deposit insurance
!? Vurobanks avoid many of the costs associated with complying with domestic
banking regulations
!? The Vurobanking business is highly competitive internationally with
relatively low entrance requirements
!? Vurobanks benefit from economies of scale
!? Vurobank lending is almost exclusively to high-quality customers with
negligible default rates

(c) No right answer in my view so will be flexible on awarding marks

|? Vxpect discussion of the consequences of the Lehman Brothers bankruptcy
|? Vxpect discussion of moral hazard
|? Vxpect discussion of contagion
|? Vxpect discussion of both the ³too big to fail´ and ³too connected´ arguments



?
5
6
!7

a)? List the similarities /differences between equity and bonds regarding: objective of their use,
maturity, ownership rights, regularity and method of payment to holders, risk involved,
financial markets where they are issued, financial institutions involved in their issue.
4-

b)? Vxamine the reasons why the supply and offer of bonds may vary over time.
4-

c) Vxplain the differences between the following instruments
! why the variety of
instruments could be useful to international borrowers and international investors: risk-free
/default- free bonds; junk bonds; secured/ asset-backed bonds; unsecured bonds/
debentures. =-


 
.


a) The answer to this question should depict a respectable understanding of these two
instruments and how they are traded in the financial markets.
Among others, you may emphasize the following:
Vquity (including common and preferential stock), implies a long-term financing. It confers
ownership rights to the holder, and claims in the net profits and the assets of the business.
Periodic payments (dividends) tend to be annual or semi-annual. However, dividends are not
guaranteed. Neither is guaranteed the original capital invested by the shareholder. Therefore,
the risk level is higher than in the case of bondholders. Shareholders are ³residual
claimants´. You may consider giving some details about the LSV, and refer how financial
intermediaries (i.e., investment banks and dealers) help the borrowing firms with advice, the
issuance of the different securities (including underwriting and placements), and creating a
market for these securities.
Bonds: Long-term financing for both corporations and governments, represent debt that
obligate the borrower to pay at a given date, capital and interest (coupon). They can be sold
at a discount (Zero-coupon) or at face value (par). Interest payments are usually fixed and
involve periodic payments to lender. The bondholder has a claim on the issuers¶ assets if
there is default. *omestic bonds are registered. They can be secured or unsecured,
depending on the collateral attached and level of priority of their claim in case of default.
Bonds have priority of claim over shareholders.

b) Increases in demand usually obey to variations in wealth and business cycle; expected return
on bonds versus alternative assets (i, shares, etc.), relative risk level versus risk of alternative
assets; Liquidity of bonds versus alternative assets.
ühanges in the supply of bonds: Vxpected profitability of investment opportunities to be
carried out by borrower and positive expectations about business cycle (+); expected
inflation (+), government deficit and level of expenditure (+).

c) Vxplain the differences between:

!? risk-free /default- free bonds
No default risk, usually because they are issued by the üentral government. This is a
theoretical assumption.
!? junk bonds
†ery high default risk, speculative-grade bonds (under S&P¶s BBB rating). *ifficult to sell
since generally unsecured (üase: Aichael Ailken- *rexel Burnham Lambert 1977). Bonds
are usually downgraded to (rather that issued such as) speculative-grade.
!? secured/ asset-backed bonds
Have specific collateral attached. In case of default, claims are made against these particular
assets. Therefore, they may carry a lower interest rate than unsecured bonds.
!? unsecured bonds/ debentures
2nly guaranteed by the general creditworthiness of the borrower and the assets that are not
promised to other bondholders. Subordinated debentures have a lower priority claim than
debentures, therefore carry a higher default risk and receive higher interest rates.
Students should talk about the alternatives risk/return investors may receive when they
invest in these instruments, and how they could be useful to the different type of borrowers.


?
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 i  +9
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US Vurope (VU) UK
Vnd of 2008 Inflation Rates (annual) 2% 5% 6%
üurrent spot rate $1.54 per euro
üurrent spot rate $2.00 per pound

5
6
!7

a) Using the information in the table:

i) üalculate the percentage appreciation/ depreciation of the VUR against the US*
and of the GBP against the dollar that according to the PPP should take place by the
end of the year. -


ii) üalculate the expected spot rate of the VUR and the GBP against the US* at the
end of 2008 if the PPP holds. -


b) üonsider and explain why currency prices may not reflect the inflation rates and trade
imbalances between countries, as expected by the Purchasing Power Parity (PPP).
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c) What are the possible damages that persistent deviations observed in the value of the US
dollar have caused or may cause to the US economy and its business sector?
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a)
i) Against the Vuro: (1.02/ 1.05) ± 1 = - 0.02857 : the VUR should depreciate against the US*
by 2.857 %
Against the Pound: (1.02/1.06) ± 1 = -0.03774 : the Pound should depreciate against the
US* by 3.774 %

ii) Against the Vuro: (US*1.54/VUR) * 0.97143= the US* should appreciate to US* 1.496 per
VUR.
Against the Pound: (US*2.0/GBP) * 0.9623 = The US* should appreciate to US* 1.9245
per GBP.

b) The evident short-term imbalances in the prediction of the theory are a consequence of other
factors not considered by the PPP: government intervention and interest rates are two of the
most important in current times. These imbalances can continue over longer periods of time.
It is expected that students should quote the case of ühina and Japan capital flows, among
others, to justify the present imbalances. Factors to consider: government intervention and
high saving rates from these countries that create outflows of currency invested in US
markets.

c) A clear understanding of the PPP theory is expected, showing that imbalances in the
equilibrium as in the case of the US generate increasing imports and loss of competitiveness.
According to the theory this disequilibria must be restored via adjustments in the exchange
rate. However, in contrast to the theory, the adjustment to the deficit in the BoP of the US
does not seem to work in the short-term, particularly due to inflows of capital from the rest
of the world. Better marks will be awarded to those answers explaining the differences
between the absolute and relative versions of PPP, and why the adjustment tends to occur
only in the long-term.