HW 4 Solutions
2.
a. Percentage change of exchange rate from 2009-2010: Canada=(0.9643-0.9225)/0.9225=4.53% Mexico=(0.0788-0.0756)/0.0756=4.23% China=(0.1473-0.1454)/0.1454=1.31% Japan=(0.0112-0.0105)/0.0105=6.67%

b. Percentage change in the nominal effective exchange rate for the United States between 2009 and 2010: =(4.53%*36%)+(4.23%*28%)+(1.31%*20%)+(6.67%*16%)=(+)4.14% United States' effective exchange rate has depreciated by 4.14%.

c. The value of U.S. dollar has depreciated by 4.14% against the basket. Compared with the change in the value of the U.S. dollar relative to the Mexican Peso, where U.S. dollar depreciated 4.23% against Peso, the 4.14% depreciation of the U.S. dollar against FX basket is smaller. The reason is that Mexico only take 28% of trade share of United States, there are also other trade partners whose currency also could affect the nominal exchange rate for U.S. For this question, U.S. dollar only depreciated 1.31% against Chinese yuan, which bring down the number of overall depreciation of U.S. dollar against foreign currency basket.

6.
a. The investor's return on euro-denominated Dutch deposits is €1,000*(1+4.04%)=€1,040.4
b. Using forward cover, the euro-denominated return on British deposits is €1,000*(1.575/1.5)*(1+2%)=€1,071
c. Yes, there is an arbitrage opportunity because the euro-dominated return on British deposits is higher than that on Dutch deposits. The net return on euro deposit on a British deposit=(1.575/1.5)*(1+2%)=71/1,000=7.1% The net return on euro deposit in a Dutch bank=4.04%, which is less than 7.1%.
d. According to CIP: F(€/£)=E(€/£)*(1+i€)/(1+i£)=1.5*1.0404/1.02=€1.53/£
e. Forward premium is (F€/£/ E€/£)-1=(1.53/1.5)-1=1.03-1=0.03=3% This shows the forward premium is positive. The investors require this premium because the