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Problem Set #1 Solutions

The solutions for the first homework assignment is available on my I-drive.

For the record, given my tardiness on getting this posted and grading, I was very liberal with the credit.

Preparation for Test #1 (updated)

Here is the answer key to the study problems. (I did this quickly so if you think some are wrong let's talk about it. jjulian@iup.edu)

1-D, 2-C, 3-B, 4-C, 5-D, 6-C, 7-C, 8-A, 9-D, 10-D,
11-C, 12-C, 13-D, 14-A, 15-D, 16-F, 17-C, 18-D,
19-A, 20-A, 21-A, 22-D, 23-D.

***Comments Updated****

Material from problems 19, 21-23 weren't really discussed in class yet. So you won't be required to know those for the test.

For 19 you should try the following: change the phrase "inflation were expected to be" to "short term interest rates are". Then you can use the interest parity condition to solve for the "unknown"... in this case the forward exchange rate. (Soon in class we will show that when considering real vs. nominal interest rates, the real interest rate differential will equal not only the forward premium (discount) but the inflation differential as well.)

And be careful (19 and 20): Interest rates are quoted in ANNUALIZED rates, but in 19, the forward rate is 180 days (half a year). You will need to convert to "annual" or "half year" to get consistent rates. (I don't mean to confuse you, but this is done by convention. Interest rates are almost always posted as annualized rates.)

Relevant readings for chapter 12:

pp. 357-368. Then in the section "Forwards and Futures", you only need to worry about Forward markets. Futures will be discussed later, as will be options. A more thorough treatment of the forward market comes later in the chapter.

Continue readings on p. 372-375 with "Exchange-rate determination"
Skip "Indexes of the fx value of the dollar: nominal and real exchange rates"

Continue readings on p. 377 with "Arbitrage". The section on Forward Markets follows. When the discussion turns to explaining the differences between forward and spot rates because of interest rates, you can stop reading. This leads to covered interest arbitrage which we have also discussed. (This part changed from initial post. YOU WILL BE TESTED ON THIS.)

The section on Speculation (p. 185 to the end of the chapter) is NOT on this test either.

I hope this is clear enough.

Comments on study problems:

A comment on #12 & 13: We infer there is a BoP deficit or surplus if there is any official intervention. There is evidence of official intervention in that table of numbers. A BoP deficit or surplus arises when counting all items except the official transactions by governments. So if there is said to be a BoP deficit, the sum of the current accounts and financial accounts would be less than zero. This is offset by an official transaction requiring a "credit" to offset the deficit.

Comment on #11: "capital account" should be interpreted as "financial account". (Recall the discussion of the "old school" name: capital account, and the "new school" name: financial account.)

Suggested study questions from Carbaugh, Ch. 12 (pp. 391-392): 1-5, 9-11, 14, 16.