Homework

Assignment 1, FIN 3551

1) On July 6, 2017, Russia announced that June CPI inflation was 4.4% over the year previous. This

was slightly higher than analyst expectations of 4.2%, and was driven by food prices.

a) What effect do you expect that this had on exchange rates?

b) Over what period of time do you expect that this information was incorporated into

exchange rates?

c) What happened to the Ruble/Dollar exchange rate over this period? Is this consistent with

appreciation or depreciation of the Ruble?

d) Does the observed change in exchange rates line up with your intuition? Answer this for

both the direction and magnitude of the change.

2) You observe the exchange rates from the following 4 currencies(US, EU, UK, and Japan):

a. $1.19/€, $1.30/£, $0.0091/¥

b. €0.84/$, €1.09/£, €0.0076/¥

c. £0.77/$, £.91/€, £0.0055/¥

d. ¥110.27/$, ¥130.77/€, ¥183.26/£

Suppose that you incur 2% transaction costs. That is, if you attempt to convert one currency to

another, you only get 98% of the quoted rate. So with €1, you can get .98*$1.19 = $1.17

There is an arbitrage opportunity in this market. Find it and describe each transaction you would

take to exploit it. If a large amount of money went through this process, this would exert

pressure on these exchange rates. For each transaction in your arbitrage strategy, explain how

that transaction would impact currency values.

3) The Trilemma refers to the impossibility of maintaining all of the following:

a. Stable Exchange Rate

b. Independent Monetary Policy

c. Free Flow of Capital

Assume that the following 3 statements are true:

China is currently undergoing an economic transition from an economy based on exports, heavy

industry, and construction to one fueled more by domestic demand and services. Many

observers believe that this change, while necessary, will be accompanied by slower, less

predictable growth.

China, to offset slower growth, is likely to ease monetary policy (lower interest rates), which

may lead to higher inflation in the medium term.

China is continuing capital reforms, allowing Chinese citizens to invest more of their savings

abroad.

a) For each of the three statements, explain their effect on the value of the Yuan.

b) Explain how these statements are related to The Trilemma.

Partially to stabilize their currency vs. the dollar, throughout 2015 and 2016 China sold off

roughly $700 billion of foreign reserves, hitting a recent low of just below $3 trillion.

c) Did China’s policy of selling reserves combat or exacerbate the pressures on the Yuan from

the three factors listed earlier?

d) Despite relatively high pressure on the Yuan, China managed to seemingly solve the

Trilemma: Throughout this period, exchange rates were stable while still allowing some

capital flexibility and a completely independent monetary policy. How is this possible and

why is this not a violation of the premise that all three goals cannot be achieved?