ch04

Chapter 4:

V. Answers to End of Chapter Questions

1. Given that the exchange rate is expressed as dollars to euros, we treat the dollar as the domestic currency. Note also that interest rates are quoted on an annual basis even

though the maturity period is only one month. In this problem we divide the interest rates by 12 to put them on a one-month basis.

a. The interest rate differential, therefore, is (1.75%/12 - 3.25%/12) = -0.125%. The

forward premium/discount, expressed as a percentage, is calculated as:

((F-S)/S)?100 = ((1.089 – 1.072)/1.072)?100=1.5858%

(F-S)/S

450

1.5858 -1.00 -0.125 1.00 R – R*

b. Transaction costs are shown in the figure above by the dashed lines that interest the horizontal axis at values of -1.00 and 1.00.

c. The positive value indicates that the euro is selling at a premium. In addition, the interest rate differential favors the euro-denominated instrument. Hence, a saver shift funds to euro-denominated instruments.

2. Using the provided information:

(1.75/12) – (3.25/12) < [(1.089 - 1.072/1.072)]?100

-0.125% < 1.5858%.

3. The four markets are graphed below. An explanation follows.

Graph 1, the spot market for the euro.

S0 $/

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