The University of the South Pacific

SCHOOL OF ACCOUNTING, FINANCE & ECONOMICS

FM303: INTERNATIONAL FINANCE

MID SEMESTER TEST– SEMESTER 1, 2021
MODE OF STUDY: FACE-TO-FACE & BLENDED

Time allowed: 2 hours

Total Mark on Paper = 60 marks
Weight 25% of coursework

DO NOT OPEN THE QUESTION PAPER UNTIL INSTRUCTED TO DO SO

BY THE CHIEF INVIGILATOR

Number of Pages
Number of Questions
Instructions to Candidates
INSTRUCTIONS
4
5
 This is a closed-book written exam.
 There are FOUR pages including the cover page in
this exam paper, and FIVE questions.
 Answer ALL FIVE questions.
 Use only BLUE or BLACK pen to write your
answers. Do not use pencils to write your answers.
 Present your answers neatly. ONLY legible
answers will be marked.
 Write answers for each Question on a new page.
 All rough workings should be done in the answer
booklet.
 You can only use a non-programmable calculator.
 Some useful formulas are provided on page 4.

1
 Section A: Calculations [15 marks]
Question 1

a) The exchange rate between the British pound and the Australian dollar
(GBP/AUD) rose from 0.3780 to 0.3960 in one week.
i. Calculate the percentage appreciation or depreciation of the
Australian dollar. (Present your answer up to 2 decimal points.)
[3 marks]
ii. Using the result obtained in (i), calculate the percentage
appreciation or depreciation of the pound. (Present your answer
up to 2 decimal points.) [2 marks]

b) You are given the following information:

Quantity 200 units

Foreign currency price of imports AUD20
Exchange rate 1.50 (FJD/AUD)

i. Calculate the foreign currency (AUD) and domestic currency (FJD)

values of imports. [2 marks]
ii. Determine the effect on the domestic and foreign currency values of
imports if the exchange rate falls to 1.20, assuming that the value of the
elasticity of demand for imports is −2.5. [3 marks]

Question 2

Given that 𝑸𝒅 = 𝟏𝟎 − 𝟐. 𝟓𝑺𝒃 and 𝑸𝒔 = 𝟓 + 𝟑. 𝟓𝑺𝒂 , where 𝑄𝑑 and 𝑄𝑠 are

the quantities supplied and demanded by the dealer, respectively; and the
customer’s demand and supply functions are: 𝑸𝒅 = 𝟏𝟐 − 𝟐. 𝟑𝑺𝒂 , 𝑸𝒔 =
𝟐 + 𝟒. 𝟐𝑺𝒃 . Calculate the bid-offer spread in points. [5 marks]

2
 Section B: Short Answers [15 marks]
Question 3

a) Distinguish between direct and indirect quotations of exchange rates. What

happens to the domestic currency as the exchange rate rises if it is measured
in direct quotation? [5 marks]

b) PPP implies that real exchange rate does not change because any change in
prices will be totally offset by changes in the nominal exchange rate. Using
goods market linkage between domestic price and foreign price, and perfect
markets, derive the relationship between the exchange rate and inflation
differentials, 𝑆̇ = 𝑃̇ − 𝑃∗̇ . [5 marks]

𝑀
c) Given the monetary model of exchange rate: 𝑆 = 𝑘𝑃∗𝑌, discuss the plausible
the effect on exchange rate due to changes in the 𝑀, 𝑃∗ and 𝑌. [5 marks]

Section C: Theory [30 marks]

Question 4

Using supply and demand of foreign exchange diagram, discuss the movement of
the exchange rate and the subsequent impact on the domestic resulting from:

(a) A relatively higher domestic inflation rate [8 marks]

(b) A relatively higher domestic interest rate [8 marks]

Question 5

It is often argued that the effect of economic growth on foreign exchange is

ambiguous due to the opposite effects on the components of the balance of payments.
Using the supply of and demand for foreign exchange diagram, clearly explain how
the ambiguity arises. [14 marks]

~END~
3
 Basic Formulas
𝑑
 𝑃 = 𝑆𝑃∗ where 𝑃 is domestic price, 𝑆 is the exchange rate quoted as 𝑆 ( ),
𝑓
where 𝑑 = domestic currency and f = foreign currency, and 𝑃∗ is the foreign
price.

𝑑 1
 𝑆̇ ( ) = ( 𝑓 − 1) × 100, where 𝑆̇ = percentage change in exchange rate.
𝑓 1+𝑆̇( )
𝑑

𝑥 𝑥
𝑥 𝑆𝑏 ( ) 𝑥 𝑆𝑎 ( )
 𝑆𝑏 ( ) = 𝑦
𝑧
and 𝑆𝑎 ( ) = 𝑦
𝑧
, where 𝑆𝑏 = bid-rate and 𝑆𝑎 = offer rate,
𝑦 𝑆𝑎 ( 𝑧 ) 𝑦 𝑆𝑏 ( 𝑧 )

and 𝑥, 𝑦 and 𝑧 are currencies of three different countries.

𝑄̇ %Δ𝑄
 𝜖 = = , where 𝜖 is the elasticity, %Δ𝑄 = percentage change in quantity,
𝑃̇ %Δ𝑃
and %Δ𝑃 = percentage change in price.

 𝑆̇ = 𝑃̇ − 𝑃̇∗ , where 𝑆̇, 𝑃̇ and 𝑃̇∗ are percentage change in, the exchange rate
𝑆(𝑑/𝑓), the domestic price, 𝑃 and the foreign price 𝑃∗ , respectively.

 𝑀𝑑 = 𝑘𝑃𝑌 is the demand for money function, where 𝑀𝑑 = quantity of money

demanded, 𝑃 = price level, 𝑌 = real income, and 𝑘 > 0, a positive constant.

Prepared by Ronald R. Kumar

4
5
 The University of the South Pacific
SCHOOL OF ACCOUNTING, FINANCE & ECONOMICS

FM303: INTERNATIONAL FINANCE

MID SEMESTER TEST– SEMESTER 1, 2021

MODE OF STUDY: FACE-TO-FACE & BLENDED
[SOLUTION GUIDE]

Time allowed: 2 hours

Total Mark on Paper = 60 marks

Weight 25% of coursework

DO NOT OPEN THE QUESTION PAPER UNTIL INSTRUCTED TO DO SO BY THE

CHIEF INVIGILATOR

Number of Pages
Number of Questions
Instructions to Candidates
INSTRUCTIONS
3
7
 This is a closed-book written exam.
 There are THREE pages including the cover page in this
exam paper, and SIX questions.
 Answer ALL SIX questions.
 Use only BLUE or BLACK pen to write your answers. Do
not use pencils to write your answers.
 Present your answers neatly. ONLY legible answers will be
marked.
 Write answers for each Question on a new page.
 All rough workings should be done in the answer booklet.
 You can only use a non-programmable calculator.
 Some useful formulas are provided on page 4.

6
 Section A: Calculations

(a) The exchange rate between the British pound and the Australian dollar (GBP/AUD) rose
from 0.3780 to 0.3960 in one week. [10 marks]
i. Calculate the percentage appreciation or depreciation of the Australian dollar.
[3 marks]

𝐺𝐵𝑃 𝐺𝐵𝑃
⇒ Solution: 𝑆1 (𝐴𝑈𝐷) = 0.3780, and 𝑆2 (𝐴𝑈𝐷) = 0.3960. his is a direct quote from UK's
perspective, and hence indirect quote from Australia's perspective. Hence, percentage change of
𝐺𝐵𝑃 𝑆 0.3690
AUD is: 𝑆̇ (𝐴𝑈𝐷) = (𝑆2 − 1) × 100 = (0.3780 − 1) × 100 = 4.76%. ∴ AUD appreciated by
1
4.8%.

ii. Using the result obtained in (a), calculate the percentage appreciation or
depreciation of the pound. [2 marks]

𝐴𝑈𝐷 1 1
⇒ Solution: 𝑆̇ ( 𝐺𝐵𝑃 ) = ( 𝐺𝐵𝑃 − 1) × 100 = (1+0.0476 − 1) × 100 = −4.5437 ≈
1+𝑆̇( )
𝐴𝑈𝐷
−4.54%. ∴ GBP has depreciated by 4.54%.

(b) The following exchange rates are quoted:

Currency Pair Quote (Rate)

GBP/AUD 0.3820–90
AUD/EUR 1.6400–80

Calculate the bid–offer spread (in points) on the exchange rate between the pound and the euro
expressed in direct quotation from a British perspective. [5 marks]

⇒ Solution:

Currency Pair 𝑺𝒃 𝑺𝒂
GBP/AUD 0.3820 0.3890
AUD/EUR 1.6400 1.6480
EUR/AUD 1 1
= 0.60796 = 0.60975
1.6480 1.6400

𝐺𝐵𝑃
𝐺𝐵𝑃 𝑆𝑏 ( ) 0.3820 0.3820
𝐴𝑈𝐷
⇒ 𝑆𝑏 (𝐸𝑈𝑅) = 𝐸𝑈𝑅 = 1 = 0.60975 = 0.6265
𝑆𝑎 ( ) ( )
𝐴𝑈𝐷 1.6400

7
 𝐺𝐵𝑃
𝐺𝐵𝑃 𝑆𝑎 (𝐴𝑈𝐷) 0.3890 0.3890
⇒ 𝑆𝑎 ( ) = = = = 0.6411
𝐸𝑈𝑅 𝐸𝑈𝑅 1 0.60796
𝑆𝑏 (𝐴𝑈𝐷) (1.6480)

∴ Spread = 𝑺𝒃 − 𝑺𝒂 = 𝟎. 𝟔𝟒𝟏𝟏 − 𝟎. 𝟔𝟐𝟔𝟓 = 𝟎. 𝟎𝟏𝟒𝟔 or 146 points

b) You are given the following information:

Quantity 200 units

Foreign currency price of imports AUD20
Exchange rate 1.50(FJD/AUD)

b) Calculate the foreign currency (AUD) and domestic currency (FJD) values of
imports. [3 marks]
c) Determine the effect on the domestic and foreign currency values of imports if the
exchange rate falls to 1.20, assuming that the value of the elasticity of demand for
imports is −2.5. [7 marks]

i. Foreign currency value of imports = 𝑸𝒎 × 𝑷∗𝒎 = 𝟐𝟎𝟎 × 𝑨𝑼𝑫 𝟐𝟎 = 𝑨𝑼𝑫 𝟒𝟎𝟎𝟎.

Domestic currency value of imports = 𝑄𝑚 × 𝑃𝑚
𝐹𝐽𝐷
Since, 𝑃𝑚 = 𝑆 × 𝑃𝑚∗ ⇒ 𝑃𝑚 = 1.50 (𝐴𝑈𝐷) × 𝐴𝑈𝐷20 = 𝐹𝐽𝐷 30, and domestic currency
value of imports 200 𝑢𝑛𝑖𝑡𝑠 × 𝐹𝐽𝐷 30 = 𝐹𝐽𝐷 6000

ii. ⇒ Solution: At an exchange rate of 1.50, the domestic currency price of imports is
𝐹𝐽𝐷 𝐹𝐽𝐷
𝑃𝑚 = 𝑆 × 𝑃𝑚∗ = 1.50 (𝐴𝑈𝐷) × 𝐴𝑈𝐷 20 = 𝐹𝐽𝐷 30 . When 𝑆 = 1.20 (𝐴𝑈𝐷), 𝑃𝑚 =
𝐹𝐽𝐷
1.20 (𝐴𝑈𝐷) × 𝐴𝑈𝐷 20 = 𝐹𝐽𝐷 24. Hence, the percentage change in the domestic
currency price of imports resulting from the change in the exchange rate is:
𝐹𝐽𝐷 24
(𝐹𝐽𝐷 30 − 1 ) × 100 = −20%. Given that elasticity of demand, 𝜖 = −0.5 , the
percentage change in quantity demanded can be calculated as:

𝑄̇
𝜖 = ⇒ 𝑃𝑚̇ = %Δ𝑃,
𝑃𝑚̇

𝑄̇ = %Δ𝑄

%Δ𝑄
⇒𝜖=
%Δ𝑃

⇒ %Δ𝑄 = 𝜖 × %Δ𝑃

⇒ %Δ𝑄 = −2.5 × (−20%) = +50%

8
So the quantity of imports increases by 50% to 200( 1 + 0.50 ) = 300 units.

⇒ Foreign value of imports is: 300 𝑢𝑛𝑖𝑡𝑠 × 𝐴𝑈𝐷 20 = 𝐴𝑈𝐷 6000

𝐹𝐽𝐷
⇒ Domestic value of imports is: 300 𝑢𝑛𝑖𝑡𝑠 × (1.20 (𝐴𝑈𝐷) × 𝐴𝑈𝐷 20) = 300 × 𝐹𝐽𝐷 24 =
𝐹𝐽𝐷 7200 .

Question 2:

a) Given that 𝑄𝑑 = 10 − 2.5𝑆𝑏 and 𝑄𝑠 = 5 + 3.5𝑆𝑎 , where 𝑄𝑑 and 𝑄𝑠 are the quantities
supplied and demanded by dealers, respectively. The customer's demand and supply
functions are: 𝑄𝑑 = 12 − 2.3𝑆𝑎 , 𝑄𝑠 = 2 + 4.2𝑆𝑏 . Calculate the bid-offer spread. [5
marks]

⇒ Solution: The bid rate is calculated from the dealer’s demand function and the
customer’s supply function. Hence, equating dealers demand and customers supply, we
obtain:

𝑄𝑑𝐷 = 𝑄𝑆𝐶

10 − 2.5𝑆𝑏 = 2 + 4.2𝑆𝑏

8
⇒ 𝑆𝑏 = = 1.1940
6.7

Similarly, the offer rate is calculated from the customer’s demand function and the dealer’s
supply function. By equating customer's demand and dealer's supply, we obtain:

𝑄𝑑𝐶 = 𝑄𝑆𝐷

12 − 2.3𝑆𝑎 = 5 + 3.5𝑆𝑎

7
⇒ 𝑆𝑎 = = 1.2069
5.8

∴ the bid-offer spread is: 1.2069 − 1.1940 = 0.0129 or 129 points.

Section B: Short Answers

9
 Question 3

d) Distinguish between direct and indirect quotations of exchange rates.

What happens to the domestic currency as the exchange rate rises if it is
measured in direct quotation? [3 marks]

Solution:

Direct quotation can be of the form: 𝑆( 𝑑/𝑓 ) where d refers domestic currency and 𝑓 refers to
foreign currency, and 𝑆( 𝑑/𝑓 ) is therefore priced in domestic terms and the currency traded is
𝑓. The exchange rate 𝑆( 𝑑/𝑓 ) is a direct quote from domestic perspective, and indirect quote
from foreign perspective. A rise in 𝑆( 𝑑/𝑓 ) implies price for foreign currency in domestic terms
has increased, and therefore domestic currency depreciation (or foreign currency appreciation).

e) PPP implies that real exchange rate does not change because any change in
prices will be totally offset by changes in the nominal exchange rate. Using
goods market linkage between domestic price and foreign price, and perfect
markets, derive the relationship between the exchange rate and inflation
differentials. [5 marks]

Solution: PPP implies that real exchange rate does not change because any change in prices
will be totally offset by changes in the nominal exchange rate.

In goods market, the linkage between domestic price and foreign price is denoted by 𝑃 = 𝑆 −
𝑃∗ , which can be expressed as: 𝑃 = 𝑆𝑃 ∗ (perfect markets). 𝑃0 = 𝑆0 𝑃0∗ (at t=0 ) and 𝑃1 =
𝑆1 𝑃1∗ (at t=1 )

𝑃 𝑆1 𝑃1∗
The price ratio is given by: 𝑃1 =
0 𝑆0 𝑃0∗

𝑃 𝑆1 𝑃1∗
Next, given price ratio: 𝑃1 = , show that 𝑆̇ = 𝑃̇ − 𝑃∗̇
0 𝑆0 𝑃0∗

𝑃1 𝑃1∗
Since %Δ𝑃 = 𝑃̇, ⇒ 1 + 𝑃̇ = , %Δ𝑃∗ = 𝑃∗̇ , ⇒ 1 + 𝑃∗̇ = and %Δ𝑆 = 𝑆̇, ⇒ 1 + 𝑆̇ =
𝑃0 𝑃0∗
𝑆1
, then:
𝑆0

𝑃1 𝑆1 𝑃1∗
= ⇒ (1 + 𝑃̇ ) = (1 + 𝑆̇)(1 + 𝑃∗̇ ) ⇒ (1 + 𝑃̇) = 1 + 𝑆̇ + 𝑃∗̇ + 𝑆̇𝑃∗̇ , and since 𝑆̇𝑃∗̇ ≈
𝑃0 𝑆0 𝑃0∗
0 ⇒ Rearranging the equation gives us 𝑆̇ = 𝑃̇ − 𝑃 ∗̇ , which represents the relationship
between the exchange rate and inflation differentials. This mean that rate of change of
exchange rate equals the inflation differential.

10
 𝑀
f) Given the monetary model of exchange rate: 𝑆 = ∗ , and discuss the
𝑘𝑃 𝑌
plausible the effect on exchange rate due to changes in the 𝑀, 𝑃 ∗ and 𝑌. [5
marks]

Solution:

⇒ a rise in the money supply (𝑀0 → 𝑀1 ) causes a proportional increase in the price level
(𝑃0 → 𝑃1 ), a prediction of quantity theory of money. Monetary expansion 𝑀 leads to a
proportional rise in 𝑆 . i.e. depreciation of domestic currency, because rise in M gives rise to
domestic inflation, hence increasing the price of exports, and makes imports relatively cheaper,
hence greater demand for foreign exchange and lower supply of foreign exchange.

⇒ a rise in income 𝑌 leads to a fall in 𝑆 , i.e. appreciation of the domestic currency, because of
capital inflow as rising economies attract greater foreign investments, and increase in supply of
foreign exchange and relatively lower demand for foreign exchange.

⇒ a rise in foreign price 𝑃∗ level leads to a fall in 𝑆, i.e. appreciation of domestic currency,
because demand for foreign currency decreases due to decrease in demand for imports. Exports
become relatively cheaper (assuming similar goods are available in both economies), increasing
the supply of foreign exchange, resulting in domestic currency appreciation.

Section C: Theory

Question 5: Discuss the direction of movement in the exchange rate and the impact on domestic
and foreign currency due to:

i. A relatively higher domestic inflation rate [8 marks]

Solution: A country that has a higher inflation rate than its trading partners will experience a
depreciating currency.

Channel: Price of domestic commodities increase relative to foreign commodities. The demand
for foreign goods increase, as they become relatively cheaper. This increases the demand for
foreign currency, and decrease in the supply of foreign currency, because exports become
relatively expensive.

11
 𝑺𝒇 ↓ 𝒂𝒏𝒅 𝑫𝒇 ↑ ⇒ 𝑺𝟎 → 𝑺𝟏 ⇒ "𝑫𝒐𝒎𝒆𝒔𝒕𝒊𝒄 𝒄𝒖𝒓𝒓𝒆𝒏𝒄𝒚 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏"

ii. A relatively higher domestic interest rate [8 marks]

Channel: ↑ domestic interest rate relative to foreign interest rates → domestic financial assets
become more attractive than foreign financial assets, and this results in restructuring of
portfolios  capital outflows out of foreign assets into domestic assets. In foreign exchange
market → decrease in the demand for foreign exchange (currency) and an increase in the supply
of foreign exchange (currency). Higher interest rates lead to currency appreciation.

𝑺𝒇 ↑ & 𝑫𝒇 ↓ ⇒ 𝑺𝟎 → 𝑺𝟏 ⇒ 𝑺 ↓ … “Domestic currency appreciates”

12
Question 6: It is often argued that the effect of economic growth on foreign exchange is ambiguous
due to the opposite effects on the components of the balance of payments. Using the supply of and
demand for foreign exchange diagram, clearly explain how the ambiguity arises. [14 marks]

⇒ Solution: The effect of growth is ambiguous, since it affects the current account and financial
account in different directions. Economic growth is the rise in income level or gross domestic
product (per capita). An increase in growth increases demand for imports and exports, even with
no change in prices. If the demand for imports is relatively stronger than the demand for exports,
the former implying demand for foreign currency while the latter implying supply of foreign
currency, then net effect is exchange rate moving up. The effect is explained from current
account balance. 𝑆𝑓 ↓ & 𝐷𝑓 ↑ ⇒ 𝑆0 → 𝑆1 ⇒ 𝑆 ↑ ⇒ Domestic currency depreciates. This is noted
in the figure below.

However, economic growth can affect capital account. Faster (GDP) growth in domestic country
can lead to booming financial markets, where domestic assets are more attractive for foreign
investors.

Effects: ↑ in capital inflow in domestic economy, i.e. increase in the supply of foreign currency
increases, and supply of foreign currency increases relatively more than the demand for foreign
currency. Demand increases on the assumption that there is a growth in foreign economy, but
relatively lower. The net effect is explained from capital/finance account balance where S↓⇒
currency appreciation. See figure below.

13
14