1. Assume that interest rate parity holds. The U.S. one-year interest rate is 10

Question

1. Assume that interest rate parity holds. The U.S. one-year interest rate is 10% and the Australian one-year interest rate is 8%. What will the approximate effective yield be for an Australian citizen of a one-year deposit denominated in U.S. dollars? Assume the deposit is covered by a forward sale of dollars.

a. 10%.

b. 8%.

c. 2%.

d. cannot answer without more information

2.

Assume that a U.S. investor invests in a British CD offering a six-month interest rate of 5%. Over this six-month period, the pound depreciates by 9%. The effective yield on the British CD for the U.S. investor is:

a. 14.45%.

b. 4.45%.

c. 14.00%.

d. 4.00%.

3.

Assume that there are several foreign currencies that exhibit a higher interest rate than the U.S. interest rate. The U.S. firm has a higher probability of generating a higher effective yield on a portfolio of currencies (relative to the domestic yield) if:

a. the foreign currency movements against the U.S. dollar are highly correlated.

b. the foreign currency movements against the U.S. dollar are perfectly positively correlated.

c. the foreign currency movements against the U.S. dollar exhibit low correlations.

d. none of the answers above would have any impact on the probability of a foreign cash investment generating a higher effective yield than a U.S. investment.

4.

Which of the following is not a payment method used for international trade?

a. Supplier credit

b. Bill of exchange

c. Bill of lading

d. Letter of credit

e. All of the above are payment methods used.

Explanation / Answer

Part 1)

8% (which is Option B)

___________

Explanation:

If the interest rate parity holds true, the Australian citizen will be able earn a maximum of the one-year interest rate prevailing in the domestic market. Therefore, the approximate effective yield will be 8% in the given case.

___________

Part 2)

4.45% (which is Option B)

___________

Explanation:

The effective yield can be calculated as follows:

Effective Yield on Commerical Deposit = (1+ Six-Month Interest Rate on CD)*(1+(-Depreciation of Pound Percentage)) - 1

Using the values provided in the question, we get,

Effective Yield on Commerical Deposit = (1+5%)*(1+(-9%)) - 1 = -4.45%

___________

Part 3)

The foreign currency movements against the U.S. dollar exhibit low correlations (which is Option C)

___________

Part 4)

All of the above are payment methods used (which is Option D)

___________

Explanation:

In case of international trade, there are four basic methods of payment which include open account (can also be regarded as supplier credit), letter of credit (here, the payment is guaranteed by the L/C issuing bank upon the presentation of relevant documents (which generally includes bill of lading, commerical invoice and a bill of exchange (also known as draft) by the exporter). Therefore, the option b to d get automatically covered under the L/C method of payment.

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