Due: After Unit 6
Assignment 2 is worth 8% of your final course grade. Each question is worth 10 marks. Answer all parts of each question as completely as possible.
1. Complete all three parts of this question.
a. Suppose KPM Bank has the following balance sheet (in billions of dollars):
Reserves $10 Deposits $80
Loans $95 Capital $25
If net profit of this bank is $2 billion, then what is the return on assets (ROA) and the return on equity (ROE)? Demonstrate that ROE = ROA x EM. (2 marks)
b. A bank has $105 billion of assets with average duration of 5 years and $80 billion of liabilities with average duration of 6 years. Conduct a duration analysis for the bank, and show what will happen to the net worth of the bank if interest rates fall by 1%. What action should the bank take to reduce interest rate risk? (4 marks)
c. A bank has $80 billion of fixed-rate liabilities, $25 billion of rate-sensitive liabilities, $10 billion of fixed-rate assets, and $95 billion of rate-sensitive assets. Conduct a gap analysis for the bank, and show what will happen to the bank profits if interest rates fall by 1%. What action should the bank take to reduce interest rate risk?
2. Describe, and illustrate with balance sheets of both the Bank of Canada and the direct clearers with the Canadian Payments Association, the change in the monetary base in response to the following transactions:
a. A Bank of Canada open market sale to the public of $100 million of Government of Canada securities. (1.5 marks)
b. A redeposit of $200 million worth of Government of Canada deposits.
c. A $300 million advance made by the Bank of Canada to a chartered bank.
d. A $400 million Purchase and Resale Agreement made by the Bank of Canada with the money market jobbers. (1.5 marks)
e. The Bank of Canada intervenes in the foreign exchange market with a $500 million purchase of American currency ($US 1.00 = $Can. 1.55). It uses an open market transaction to sterilize its foreign exchange intervention. (2 marks)
f. Rather than an open market transaction, the Bank of Canada shifts Government of Canada deposits to sterilize its foreign exchange intervention in (e) above.
3. Describe the large value transfer system (LVTS), and list the major reasons for adopting the system. (7 marks)
Discuss how in the LVTS environment, government deposit shifting is affected by auctions of government balances. (3 marks)
4. Suppose the spot foreign exchange rate of the Canadian dollar is $US 1.53, while its 12-month forward rate is $US 1.58. One-year interest rates are 6% in Canada and 10% in the United States. Are there quick profits to be made from foreign currency arbitrage here? If so, show the sequence of purchases and sales, using $Can. 100,000 as your starting point. (10 marks)
5. Describe the major characteristics of the Bretton Woods system and the role of the IMF in this system. Explain why the Bretton Woods system failed. (10 marks)
6. Briefly describe each of the following terms:
a. Eurocurrency markets (2 marks)
b. international debt crises (2 marks)
c. purchasing power parity (2 marks)
d. currency arbitrage (2 marks)
e. interest-rate parity condition (2 marks)
7. Complete all three parts of this question.
a. Why does a lower exercise price mean a call option will have a higher premium and a put option a lower premium? (2 marks)
b. Suppose you buy a put option on a $1 million Canada bond futures contract with an exercise price of 100 and the price of the Canada bond is 110 at expiration.
(i) Is the contract in the money, out of the money, or at the money? (2 marks)
(ii) What is your profit or loss on the contract if the premium was $50,000?
c. Suppose you buy a call option on a $1 million Canada bond futures contract with an exercise price of 150 for a premium of $20,000. If on expiration the futures contract has a price of 155, what is your profit or loss on the contract? (3 marks)
8. Use the information in the table to answer the following questions.
Exchange rates in Year 2 Exchange rates in Year 1
(i.e., exactly one year previously)
Country Currency symbol Per $ Per £ Per € Per $ Per £ Per €
Canada C$ 1.064 2.106 1.428 1.103 2.060 1.414
Denmark DKr 5.551 10.99 7.449 5.819 10.87 7.458
Euro € 0.745 1.475 — 0.780 1.457 —
Japan ¥ 122.0 241.5 163.8 112.4 210.0 144.1
Norway NKr 6.038 11.95 8.101 6.079 11.36 7.792
Sweden SKr 6.945 13.74 9.318 7.220 13.49 9.254
Switzerland SFr 1.231 2.436 1.652 1.218 2.276 1.562
UK £ 0.505 — 0.678 0.535 — 0.686
US $ — 1.979 1.342 — 1.868 1.282
a. Calculate the U.S. dollar-Swiss franc exchange rate (E$/SFr) and the U.S. dollar-British pound exchange rate (E$/£) for Year 1 and Year 2. (2 marks)
b. What happened to the value of the U.S. dollar relative to Swiss franc and the British pound between Year 1 and Year 2? Calculate the percentage change in each currency using the U.S. dollar-foreign currency exchange rates in part (a) above. (5 marks)
c. Using the information in the table for Year 2, calculate the Japanese yen-Norwegian krone exchange rate. (3 marks)
9. Use the information in the table to answer the following questions.
Country Foreign currency units per U.S. dollar
Year 1 Year 2
Brazil (real) 2.379 2.088
China (yuan) 8.277 8.004
Mexico (peso) 9.088 11.393
Venezuela (bolivares) 717.27 2144.60
You and a friend, Ying, are considering a summer vacation to one of the two locales: Mexico or Brazil. Mexico’s currency unit is the peso and Brazil’s currency is the real. You live in the United Sates and Ying lives in China. The cost of the hotel room is denominated in local currency units. You and Ying are trying to find the locale with the lowest hotel expenses. The price of a hotel room is 200 reals per night in Brazil and 800 pesos per night in Mexico. Assume these prices remain unchanged between Year 1 and Year 2.
a. Calculate the U.S. dollar price of a hotel room in Brazil and in Mexico for Year 1. Calculate these prices for Year 2. Based on your answers, where would you spend your vacation in Year 1? And, where would you spend your vacation in Year 2?
b. For Year 1 and Year 2, calculate the Real-Yuan and the Peso-Yuan exchange rates.
c. Using your answer from (b) above and the information in the table, calculate the Chinese yuan price of a hotel room in Brazil and in Mexico for Year 1. Calculate these prices for Year 2. Based on your answers, where would Ying prefer to spend her vacation in Year 1, and in Year 2? (3.5 marks)
10. In June 2013, a Korean investor was considering investing in bank deposits in Korea and Japan. The annual interest rate on Korean deposits is 6.25%, versus 3.75% on deposits in Japan. Suppose the forward rate in June 2013 was equal to Fwon/¥ = 8.2, the expected exchange (rate Korean won per Japanese yen (¥)) was equal to Eewon/¥ = 8.25 won/¥, and the spot exchange rate was equal to Ewon/¥ =8.
a. Does covered interest parity hold in this example? If so, how do you know? Calculate the expected return in Japanese deposits (denominated in Korean won) in this case.
b. Does uncovered interest parity hold in this example? If so, how do you know? If not, what is the implied risk premium? Which deposit pays a higher expected return? Calculate the return on Japanese deposits (denominated in Korean won) in this case.
c. Suppose the exchange rate in June 2014 is equal to 8.528 won/¥. Calculate the Korean investor’s actual return, assuming that she invested in Japanese deposits in June 2013. How do these answers compare with those from part (b)? (2.5 marks)
d. Consider two Korean investors: one uses speculation and another uses hedging. Based on your previous answers, which one would earn a higher return (or a smaller loss) on Japanese assets between June 2013 and June 2014? Briefly explain why.
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