Exchange Rates - (A) While traveling abroad in Japan, you notice that an Acura c

Question

Exchange Rates -

(A) While traveling abroad in Japan, you notice that an Acura costs 1.2 million yen. Curious about what that would be in dollars, you check the exchange rate and see that its $0.011/yen. What would that Acura be worth in the U.S. if you could ship it home at no cost? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

Inflation and Exchange Rates -

(B) Suppose gold sells for $1,000 per ounce in the U.S. and it sells for 1,000 Canadian dollars per ounce in Canada. Suppose further, the exchange rate is $1 per Canadian dollar. If U.S. inflation is 6 percent next year, Canadian inflation is 2 percent, and exchange rates do not change, how could you make an arbitrage profit in the gold market? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

(C) Suppose U.S. interest rates on a risk-free, one-year bond are 4 percent and European interest rates on a risk-free, one-year bond are 6 percent. Suppose further than inflation is 2 percent in the U.S. and 4 percent in Europe. Assume it takes one year for the exchange rate to adjust to inflation differences. What is the predicted change in the $/euro exchange rate for the next year? Given that, what would the dollar return on a European bond be for this year? (PLEASE INCLUDE FORMULAS USED TO SOLVE PROBLEM).

Explanation / Answer

A)Exchange rate = $0.011/yen

Cost of Acura in yen terms=yen 1.2 million

Cost of Acura in $ terms = 1.2 million × 0.011=$0.0132 million

B)As per Interest rate parity:

F/S=(1+ia)/(1+ib)

F/1=1.06/1.02

F=3.92 i.e $3.92/Canadian dollar

But actual forward rate $1/Canadian dollar

This shows that arbitrage exists if Canadian dollar is borrowed.

Borrow 1000 Canadian dollar .Outflow after year=1000×1.02=1020

Convert spot 1000 Canadian dollar giving $1000

Invest $1000 giving inflow of 1000×1.06=$1060

Sell forward $1060 giving 1060÷1= Canadian dollar 1060

Hence, profit =1060-1020=Canadian dollar 40

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