MGEC61 2013 fall Assignment 1 Solution.docx

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Economics for Management Studies
Iris Au

Answer for Question 1 Part a (Submit this page with your answers in your assignment for grading) A B C National Output, Y 4800 6000 5400 Consumption, C 2880 3600 3240 Investment, I 1000 900 0 Government spending, G 1280 1500 1800 Taxes, T 920 1270 1450 P Private saving, S 1000 1130 710 Public saving, S -360 -230 -350 National saving, S 640 900 360 Net unilateral transfer 0 0 0 Current Account, CA -360 0 360 Non-reserve portion of financial accountnon-res 200 180 -380 Official reserve transactions, ORT 0 190 -190 Capital account 160 -370 210 Answer for Question 1 Part b BOP = CA + KA non-resCapital Account ORT BOP Country A. -360 + 200 + 160 = 0 0 0 Country B. 0 + 180 – 370 = - 190 190 -190 Country C. 360 – 380 + 210 = 190 -190 190  For Country C o BOP>0 in other words, Country C has BOP surplus, in the absence of central bank’s international transactions o Exports of goods, services and assets > Import of goods, services and assets o (private) demand of Country C currency > (private) supply of Country C currency o Because of the excess demand of Country C currency, so there is pressure for Country C Currency to appreciate Answer for Question 2 Part a  In theory, Carry on Trade should NOT work due to interest rate parity o If the foreign exchange market is in equilibrium, then interest rate parity holds o Which means return on domestic assets = return on foreign assets o Due to interest rate parity, carry on trade should Not work because the return on domestic assets need equals to the return on foreign assets, if there is a difference in interest rates this difference is EXACTLY offset by the forward exchange rate such that the returns on both domestic and foreign assets are equivalent; covered interest rate parity always holds, therefore carry on trade should NOT work  Eg. Assume the domestic currency has a higher nominal interest rate than the foreign currency, then the investors will invest in domestic currency deposits, this will cause net capital inflows, which creates upward pressure for the domestic currency to APPRECIATE, that push back exchange back to the point where Interest Rate Parity holds, where the return on the DC = the return on the FC Answer for Question 2 Part b  If a country has persistent current account deficits o Exports of goods and services < Import of goods and services o Which country experiences net capital outflows o Downward pressure on domestic currency lead to currency depreciate o There is a RISK investing in the country, because a high probability of domestic currency depreciate, which means if the country’s currency is expected to depreciate in the future, there will be more RISKY to invest because it decreases the arbitrage profit margin for investors it can leads to the loss o To attract investment into the country, the country MUST pay a higher interest otherwise investors will be unwilling to invest in a country whose currency is expected to depreciate in the future. o Due to the RISK associated in investing in a country whose currency is expected to depreciate in the future due to current account deficits, the country MUST pay a higher interest rate to attract investment into the country Answer for Question 2 Part c  Carry on Trade only works when the uncovered interest rate parity DOES NOT HOLD\ o the covered interest rate parity (CIRP) will always hold, because the forward exchange rate reflects the difference in the foreign and domestic interest rates such that there is no arbitrage opportunity o however, in the uncovered interest rate parity scenario, the expected exchange rate is unknown, due to the uncertainty, if the return of domestic asset does not equal to the return on foreign asset under uncovered interest rate parity, then there is a opportunity for Carry on Trade (arbitrage profit) o which means it’s a working method because there is an opportunity for Carry on Trade/ arbitrage profit Answer for Question 3  given by question o spot exchange market E ¥/A$= 100.6 o given by question that Australian dollar is traded at a forward premium of 1.1% against the Japanese yen, in other word we can also understand that Japanese yen is traded at a forward discount of 1.1% against Australian dollar (F¥/A$- E¥/A) = 0.011  F ¥/A$= 0.011* E¥/A$ E¥/A$ F ¥/A$= 0.011*100.6+100.6 = 101.7066 E¥/A$ o so that F¥/A$ 101.7066 o R ¥= 0.0280 o R A$= 0.0372 Answer for Question 3 part a  to check it’s there an arbitrage opportunity o Return on ¥ denominated corporate bonds: R ¥= 0.0280(2.28%) o Covered ¥ return on A$ denominated corporate bonds: RA$ + (F ¥/A$- ¥/A$) = 0.0372 + (101.7066 – 100.6) = 0.0482 E¥/A$ 100.6 o Since R ¥
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