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Penalties for late lodgement
Go to the Federal Reserve Economic Data (FRED) at the U.S. Federal Reserve Bank – St. Louis and get the daily exchange rates (https://fred.stlouisfed.org/categories/94) for the U.S. dollar against the Australian dollar, the U.K. British pound, and the New Zealand dollar, and answer the following questions. Note that the exchange rates are quoted based on American terms for the U.S.
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- On 20 January 1971, what was the exchange rate between Australian dollar and the U.K. pound, EAU$/£? (round to 3 decimal places) [2 marks]
- The 6-month interest rate in Australia was 2.50% on 20 January 1971. If everybody knew the actual exchange rate of EAU$/£ on 20 July 1971 as of 20 January 1971, what should be the 6-month interest rate in the U.K. according to the uncovered interest parity? [3 marks]
- On 4 January 2016, what was the exchange rate between Australian dollar and the New Zealand dollar, EAU$/NZ$? (round to 3 decimal places) [2 marks]
- On 4 January 2016, the 1- year interest rate in Australia was 2.00%, and the 1-year interest rate in New Zealand was 2.50%. According to the uncovered interest parity, what was the expected exchange rate for 4 January 2017 between the Australian dollar and the New Zealand dollar, EeAU$/NZ$ as of 4 January 2016? (use the exact UIP equation and round to 3 decimal places)

[2 marks] - (i) Assume that today is 6 October 2016. Today, you observe that the exchange rate between AU$ and the US$ is 1.319, EAU$/US$=1.319, the 90-day interest rate in Australia is 0.50%, the 90-day interest rate in the US is 0.22%, and the 90-day forward rate is 1.376, FAU$/US$=1.376. Note that the covered interest parity does not hold here. Explain how you can make risk free profits using spot and forward markets in 90 days, on 4 January 2017, if you can either borrow AU$1.319 million Australian dollars or borrow US$1 million dollars with the interest rates above today. The answer should have the exact amount of profits in Australian dollars. Do not forget to pay the principal and interests on 4 January 2017. [7 marks] (ii) Using diagrams explain what will happen to the current spot exchange rate (increase, decrease, or no change) if the forward rate in (i) and the nominal interest rates in two countries remain the same (the answer should have the change in the demand for or the supply of US$ in the foreign exchange market and also the value of the for new exchange rate). [4 marks]
- Download “Assignment_1_Data.xlsx” on Moodle. The file has the exchange rates for the U.S. dollars against one U.K. pound, the price levels in the U.S. and the U.K. With the data, answer all of the following questions. Note that the exchange rates are in US$1 per £1. Treat the U.S. as the home country Consider 1 March 2018. Assume that the U.S. maintains the inflation rate at 2.00% per year, and the U.K. maintains the inflation rate at 2.25% per year all the time. Note that over 4 years, the overall inflation rates from 1 March 2018 to 1 March 2022 in the U.S. and the U.K. will be 8.00% and 9.00%, respectively.

a. Calculate the real exchange rate between the U.S. and the U.K, q$/£, on 1 March 2018. (round to 3 decimal places) [1 marks]

b. According to the speed of convergence, the deviation from the PPP will shrink by 15% in one year. Calculate expected real exchange rate in 1 year, that is, the expected real exchange rate on 1 March 2018. qe$/£,1-year. (round to 3 decimal places) [3 marks]

c. Based on your answer in (a), (b), the speed of convergence together with the inflation rates in the two countries, calculate the expected exchange rate in 1 year on 1 March 2018, Ee$/£,1-year. (round to 3 decimal places)[3 marks]

d. According to the half-life of the deviation from the PPP, the deviation from the PPP will shrink by 50% in 4 years. Based on the half-life of the deviation from PPP together with the inflation rates in the two countries, calculate expected exchange rate in 4 years, that is, the expected exchange rate on 1 March 2018. Ee$/£,4-year. (round to 3 decimal places) [3 marks]

Sample Solution