1) What is meant by the asset market approach to exchange rate determination? According to this approach what is the relative importance of stock adjustments in financial assets as compared with adjustments in trade flows for the determination of exchange rates?
2) Explain the difference between "covered interest arbitrage" and "uncovered interest arbitrage". How are these concepts related to efficiency in foreign exchange markets? 2) Explain the difference between "absolute" and "relative" purchasing power parity. In practice would these concepts be more relevant to the long-run or to the short-run in explaining foreign exchange markets, why?
3) Using the concept of trade elasticities and the effects of exchange rate changes on domestic import and export prices, explain what is meant by the "J-Curve effect".
4) Say that the U.S. federal reserve's "bank lending rate" is currently at 4.5% annual interest and the Bank of Canada's "bank lending rate" is currently at 3.5% annual interest. a) If the spot exchange rate between Canadian and US dollars (R=$CAN/$US) is 1.1395, what 12-month forward exchange rate (R for 12 ) would be consistent with a zero covered interest arbitrage margin?
b) If the actual 12-month forward rate was R for 12 = 1.13. How might you explain the differences that appear between this number and the answer which you calculated in part a) above? Are these results consistent with exchange markets being efficient? Explain.
5) The European Monetary Authority is considering issuing a new 3-month bond denominated in "Euros" which will pay a 4% annual interest rate. The current issue of 3-month Canada Savings Bonds pays 3.6% annually.
a) If the current exchange rate is 2.5 Canadian Dollars per Euro and the 3-month forward exchange rate is 2.48 Canadian Dollars per Euro, should a resident of Canada invest in the Canada Savings Bond or in the Euro-bond? Explain.
b) Assuming that the new Euro-bond is issued with a 4% annual interest rate, in which direction would you expect Canadian interest rates and the Canadian Dollar-Euro spot exchange rate to change? Explain.
c) Again, assuming that the new Euro-bond is issued with the 4% annual interest rate, what value for the 3-month forward exchange rate would be consistent with a zero Covered Interest Arbitrage Margin? Explain.