Question

2A. Suppose that the return on U.S. dollar deposits is greater than the dollar rate of return on euro deposits (which you calculated). Which of the following statements is most likely to be true? a. Investors will get out of dollar deposits, and move into euro deposits. b. Investors will get out of euro deposits, and move into dollar deposits. c. The U.S. dollar will appreciate in value. d. The U.S. dollar will depreciate in value. e. Both a and d are true. f. Both b and care true. 2B. Which of the following is more likely to explain day-to-day changes in the value of the U.S. dollar? a. Changes in world interest rates b. The state of the Chinese economy. c. Change in investors' expectation of the future value of the U.S. dollar. d. None of the factors above have much influence on the value of the U.S. dollar. 20. In which case will locational arbitrage most likely be feasible? a. One bank's ask price for a currency is greater than another bank's bid price for the currency b. One bank's bid price for a currency is greater than another bank's ask price for the currency. c. One bank's ask price for a currency is less than another bank's ask price for the currency. d. One bank's bid price for a currency is less than another bank's bid price for the currency

Answer 1

2A

Answer: f

Solution :

Key Fact : Rate of return is simply the interest rate

The rate of return on US dollar deposit is greater, lets assume the interest rate on a dollar deposit is 4%

The dollar rate of return on euro deposit is lesser, lets assume the interest rate on a euro deposit is 2%

Suppose today the exchange rate is $1/1Euro, and expected rate 1 year in the future is 0.97$/1Euro

These 100 Euros will be yield to 102 Euros after 1 year

102 Euros are worth $0.97/Euro 1 * Euro 102 = $98.94.

Rate of return in terms of dollars from investing in Euro deposits = ( $98.94-$100)/$100 = -1.06 %

Rate of return from a dollar deposit is as follows:

• After 1 year, $100 will yield $104

which is ( $104-$100)/$100 = 4%

Hence, the euro deposit has a lower expected rate of return which means that "All investors will prefer dollar deposits and none are willing to hold Euro deposits" i.e. option b

Also, the expected rate of appreciation of Euro is ($0.97-$1)/$1 = -0.03 = -3%

which is equal to 2% (as supposed above) + (-3%) = -1 % ~ -1.06% (calculated above)

Hence, euro is expected to depreciate and U.S. dollar is expected to appreciate in value as people will buy more dollars to invest in dollar deposits (option c)

Answer : Hence, both 'b' and 'c' are correct i.e. Option 'f'

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2BOne bank's bid price frir

Solution for 2B :

The answer for this is :

• Supply and demand factors for exchange rates : The increase in demand of the US dollars may increase the price and vice -versa. When the U.S. exports products or services, it creates a demand for dollars because customers need to pay for goods and services in dollars.
• Sentiment and market psychology : In U.S. case, economy goes down and consumption slows due to increasing unemployment, for example, the U.S. is confronted with the possibility of a sell-off, which could come in the form of returning the cash from the sale of bonds or stocks in order to return to their local currency. When foreign investors buy back their local currency, it has a dampening effect on the dollar.
• Technical Factors : Traders have to gauge whether the supply of dollars will be greater or less than the demand for dollars. News like government statistics, payroll data and GDP data etc determines if the currency strengthens or weakens.

Hence, the answer that best suits the factors mentioned above is 'c' i.e. "Change in Investors expectation of future value of the U.S. dollar" as it is a part of market psychology mentioned in point no 2 above.

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2C

Answer : C

Solution for 2C:

Locational arbitrage : An act of buying a currency where it is priced low and selling it where the currency is priced higher to capitalize on difference in exchange rate at two different locations.

Example : The exchange rates of the European euro quoted by 2 banks differ. The ask quote is higher than the bid quote to reflect the transaction costs charged by each bank. Because Santander bank is asking (ask price) $1.046 for euros and Citi Bank is willing to pay (bid) $1.05 for euros, this is a situation of a locational arbitrage. This achieves a risk-free return without typing up funds for any length of time by buying euros at one location (Santander Bank) and selling parallely at other location (Citi Bank). Hence this forms a perfect example of locational arbitrage. Hence, 'b' option is an answer.

In all other cases, the risk -free return is not a possible chemistry to work-out.