PART A (the 8 questions in this part are worth 8 marks each)

Question 1

Show how increased government borrowing can cause the exchange rate to appreciate.
Give a historical example if possible.
[8 marks]

Question 2

What is the likely change in the real exchange rate after a 5% increase in productivity in
the non-tradable sector when that sector is 75% of the economy.
[8 marks]

Question 3

What is relative PPP? Does it hold in practice?

[8 marks]

Question 4

What are FX swaps? Give an example and describe why you might enter such a trade.
[8 marks]

Question 5

What are covered interest parity and the cross currency basis? Describe how you could
make a riskless profit if covered interest parity did not hold.
[8 marks]

Question 6

Hong Kong 1-year outright forward rates are currently at about 7.75 despite the fact the
Hong Kong Dollar is pegged at 7.80 to the US dollar. If this difference is pricing in the
possibility that the Hong Kong Dollar will soon move to a 1 to 1 peg with the Chinese Yuan
at 7.60 to the dollar, what probability are the markets assigning to such an event?
[8 marks]
Page 2 ECOM035 (2017)

Question 7

What is the Dutch Disease? Describe its key causes and consequences.
[8 marks]

Question 8

What are the terms of trade? What is the likely impact on the real exchange of declining
terms of trade? Why?
[8 marks]

Part B (the 2 questions is this part are worth 18 marks each)

Question 9

You are about to enter the following three trades. Short USDCNY, Long EURUSD and
Short EURMAD all with a value date 2 months from today. Calculate the outright forward
for each trade.

Spot rates (bid & ask):

USDCNY: 7.7937 & 7.7967, EURUSD: 1.2919 & 1.2921, USDMAD: 8.5768 &
8.5918.

2-month forwards (bid & ask):

USDCNY -453 & -433 EURUSD: 33.93 & 34.16, USDMAD: -322 & -176.
[18 marks]

Question 10

Describe how FX options are traded and priced. In particular, describe how a risk reversal
is constructed, identify what we can learn from them and how they relate to carry trades
[18 marks]

End of Paper
ECOM035 (2017) Page 3

SOLUTIONS

Q1

More borrowing -> need for more foreign borrowing -> need for current account deficit -> stronger ex rate
(diagram good). Reaganomics a good example

Q2

3.75% decline (5*.75)

Q3

Real exchange rate fixed (or at least stationary). Evidence mixed but some for very long run
stationarity. 4 year half life for developed countries

Q4

agreement to buy and sell currency pair at specified dates at current forward rates (i.e. no
currency exposure). Mainly used to ‘roll’ trades or for relative interest rate speculation

Q5

forward rates determined by interest rate differentials, cross currency basis is the implicit
difference in interest rate beween those implied by forward rates and those implied by interest
rates . To arbitrage buy/sell spot, borrow and invest at quoted interest rates simulatanously enter
an outright forward to convert currency back in future.

Q6

25%

Q7

Real exchange rate appreciation due to natural resource. Crowds out other export industries.

Q8

Price of exports divided by price of imports, low terms of trade reduce incomes in tradable thus
non-tradable sector -> lower price for non-tradables -> weaker real exchange rate (could also
argue a balance of payments story)

Q9

7.7484, 1.2955, 11.0678

Q10

Options priced in terms of implied vol (from Garman-Kohlhagen model), mainly an OTC
market with some exchange traded

Turn Over
Page 4 ECOM035 (2017)

Risk reversal is combination of selling an out of the money put and buying an equally out
of the money call. Seen as an approaximate measure of risk neutral expected skew. Clear
evidence that there is a link between interest rate differentials and expected skew from
risk reversals. Predicts carry trades have a risk of ‘crash’.