EF4331 Case Study 1

Name: Lam Chung Hon

SID: 56201357

1. The unit is quoted in USD/JPY, that the base currency is USD, and the quoted
currency is JPY.

2. The quarterly forward exchange rate premium is shown in Column I. The data
table shows that the mean is negative (-0.6712%), while the standard deviation is
0.6961%. On average, the forward rate was lower than the spot exchange rate.
This suggests that the average forward premium was negative. Future appreciation
of the JPY versus the USD is predicted because of the anticipated decline in the
local JPY to USD exchange rate. JPY depreciation against USD was only
expected between 1976 and 1977 and 1990 and 1994.
 ¿ F
3. Under CIP , R−R =ln( )=ln ( F)−ln(E)
E
As shown by the columns K, L, and M, the mean real 90-day Euro-Yen rate
(0.4405%) is less than the Euro-dollar rate (0.5200%). The average difference
between these real rate projections is negative (-0.0794%), indicating that JPY
appreciation is anticipated.
The purchasing power is impacted by real interest rates. Compared to the
domestic interest rate R, the international interest rate R* is higher. This suggests
that to make a short-term arbitrage, and we need borrow USD and lend JPY.
When the JPY appreciates, the purchasing power of the Japanese people rises. The
same amount of money can buy more things in Japan. Hence, the spot foreign
exchange rate will return to its previous equilibrium level.

4. The relationship between inflation and interest rates can be explained by fisher
effect. Fisher effect imply that:
Nominal interest rate=real interest rate+inflation
Nominal interest rate−real interest rate=inflation
R−R∗¿ π e −π e ,∗¿ ¿
This indicate that the interest rate differential must be equal to the inflation
differential. They have positive correlated relationship. When there is inflation,
money supply will decrease. Government will issue more bonds to increase the
supply of bond. Interest rate will then increase. People are unwilling to deposit the
money in bank. Vice versa, interest rate will decrease when there is deflation. 

5. The natural logarithm of the spot exchange rate and the natural logarithm of the 3-
month forward exchange rate are positive and continue to decrease after
computing columns N and O. The mean difference after that is 0.0028, and the
standard deviation after that is 0.0627. The difference is very slight which is
almost zero.
It shows that the price of the spot and forward contracts in 3 months will be stable
and will not have significant float. This demonstrates the market's inefficiency,
which implies that expectations might not come true. The monetary differences
are negligibly minor. When they invest through currency exchange, they take a
significant currency risk.
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6. Under Covered Interest Parity , R−R =ln ( FE )=ln ( F )−ln ( E )
Therefore , R−R¿ −ln ( FE )=0 when no arbitrage
The mean of different of column Q and R are -0.0069 and -0.0002 respectively.
The standard deviation of different of column Q and R are 0.0062 and 0.0026
respectively.
Therefore, it indicates there are arbitrage opportunity exists. We should invest in
USD and sell JPY to make arbitrage.

7. The calculation shows the relative purchasing power parity's deviance (PPP).
(Inflation rate of JPY-Inflation rate of USD) - ¿(E t +3)−ln(Et )) has a mean and
standard deviation of 0.3367% and 6.2662%, respectively. The amount of the
negative difference between them (215) is typically bigger than those of the
positive balance after computing the difference between (Inflation rate of JPY-
Inflation rate of USD) and (ln(Et+3) - ln(Et)) in column S. (209). The quarterly
CPI inflation rate for the yen is generally lower than that for the dollar. Moreover,
the calculated difference of (ln(Et+3) - ln(Et)) is close to 0. Given the high
standard deviation and positive mean rate, the data is unstable and the real spot
exchange rate is not equal to the expected spot exchange rate in the future period.
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8. Under UIP ( R=R + ln (Et +3 / Et )¿, the change in nominal interest rate led to
the change in expected rate of a currency’s appreciation or depreciation.
¿
Arbitrage take place when R ≠ R +ln ( Et +3 / Et ). From the data, the mean is
0.0025 and standard deviation is 0.0625. It implies
(1+ R)>(1+ R¿¿ ¿)(ln (Et +3 / Et ))¿ . The expected rate different from the
realized 3-month spot exchange rate. We should long JPY interest rate and
short USD interest rate to make risk-less profit from arbitrage.

9. BID can analyze the effective borrowing cost by calculating the total finance
cost over the total loan principle. BID should consider factors like the nation's
high inflation rate and whether the currency is experiencing an appreciation
or depreciation trend when deciding whether to borrow in one currency
versus another. For instance, BID must be cautious of the exchange rate risk
when borrowing money.
When the domestic currency rate (Yen) is lower than the foreign currency
rate (USD), BID should borrow in Yen; when the domestic currency rate (Yen)
is higher than the foreign currency rate, BID should borrow in USD (USD).
If we only consider the data from the most recent quarter (Jun, Jul), we can
expect the USD to decline against the Yen.