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136 Ps2 Solutions Essay

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Econ 136: Financial Economics
Problem Set #2
Due Date: September 25, 2013

(1 + r$)

$1

S£/$

£ S£/$

$ (1 + r$)

F£/$

(1 + r£)

£ F£/$ (1 + r$)
£ S£/$ (1 + r£)

Figure 1: The Covered-Interest Parity diagram from Lecture 3. 1. Define each element of Figure (1) listed below:
(a) S£/$ . The spot foreign-exchange rate quoted in £ per $ . (b) (1 + r£ ). The number of pounds that will be in your UK account in one year per pound invested for a year in a UK bank today.
(c) S£/$ (1 + r£ ). The number of pounds that will be in your UK account in one year per dollar converted into pounds today and invested for a year in an UK bank. (d) (1 + r$ ). The number of dollars that will be in your US account in one year per dollar invested in a US bank today.

(e) F£/$ . The forward foreign-exchange rate quoted in £ per $ . (f) (1 + r$ ) F£/$ . The number of dollars that will be in your US account in one year per dollar invested today.

1

2. Explain why S£/$ (1 + r£ ) and (1 + r$ ) F£/$ in Figure (1) should be equal? Both result in the same number of pounds in a year. If two portfolios have the same payoff at the same time in the future then they must have the same price today. 3. If you saw that

(1 + rf ) >

Ff/d (1 + rd )
,
Sf/d

describe the transactions that you could undertake to lock in a profit. If this condition holds then your money has a greater growth rate in a foreign bank account on a c...

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