Problem 1
In a fixed exchange rate regime (also known as pegged exchange rate), official exchange rate is tied to the exchange rate of another country. In some cases, it can be tied to the prices of gold. Free floating exchange rate changes freely and is determined by the demand and supply of that particular currency relative to other currencies. In the managed floating system, central bank at some frequency often intervenes not to allow the exchange rate getting away to some unexpected level.
The fixed exchange rate system keeps currency value within a narrow range, whereas currency value can be volatile in floating exchange rate system.
In a direct intervention, central use its reserve to buy or sell a particular currency to limit the volatility of the national currency relative to that particular currency. Especially central banks in developing country intervene in the currency market.
Central banks usually intervene to smooth exchange rate movements of its currency in order to build its reserve, stabilize the exchange rate in volatile exchange rate situation and correct any market imperfection from the viewpoint of central bank.
Problem 4
In indirect intervention, exchange rate is affected indirectly by changing the supply of domestic currency and some other tools. It takes sometimes for an indirect method compared to the direct method to have an impact on the exchange market. The most pronounced indirect tool is the money supply. If central bank decreased money supply, value of the currency will increase. On the other hand, value of currency will decrease with the increase in money supply. Capital control is one of the indirect tools. In this process, heavy taxes are levied on transaction, or restrictions on international transactions are imposed in assets. Another tool is the exchange control which imposes restriction on the trade of a particular currency.
Problem 6
Exchange rate of domestic currency has a significant impact on the outside balance sheet of central bank and economy of that particular country. If the home currency is weak compared to other foreign currencies, products and services of the home country will becomes cheaper to the consumers of foreign countries. So export will rise. On the other hand, products of foreign countries will become expensive in home currency terms, so import is likely to go down. So trade balance will be positively affected.
If home currency becomes strong, products and services of foreign countries will become cheap to the home consumers, as a resultant import will go up. However, export will decrease as domestic products and services will become expensive in foreign currency terms. So trade balance will be negatively affected.
Problem 12
Depending on whether currency intervention changes monetary base or not, currency intervention is of two types: sterilized intervention and non-sterilized intervention. In sterilized intervention, central bank purchases (sells) foreign currency bonds by home currency, and then it sells (purchases) domestic currency bonds to neutralize the effects on the monetary base. In this policy, if central bank desires to decrease the value of home currency, it goes for buying foreign currency bonds by home currencies. Then it goes for monetary base neutralizing action by selling domestic currency bonds of equal amount.
In the non-sterilized intervention, central bank intervenes the currency market by buying or selling foreign currency denominated bonds by domestic currency. The action alters monetary-base. In this policy, if central bank desires to decrease the value of home currency, it goes for buying foreign currency bonds by home currencies.
Problem 12
Interest rate parity asserts that difference between spot and exchange rate of two currencies should equal to the interest rate differentials between two countries. If interest rate on Euros in France is lower than the US interest rate and the forward exchange rate of Euros to dollars are not adjusted upward for the interest rate differential, an investor may take the opportunity to invest in the higher US interest rate and at the same time buy forward Euros contract to hedge currency risk.
Problem 13
If interest rate parity exists, an investor will not be able to take advantage of interest rate differential between U.S. and British 1-year Treasury bills. Forward exchange rate is adjusted for the interest rate differential in the marketplace.
Problem 14
It seems that US interest rate is 6% higher than its Japanese counterpart. If US interest rate decreases, then the premium expected to decrease by the equal percentages, otherwise covered interest arbitrager will take the opportunity of market imperfection.
Problem 32
Sell USD for EUR $1000÷0.8=EUR 800
Sell EUR for Pesos EUR 800×13=10400 pesos
Sell pesos for USD 10400 pesos ÷10=USD 1040
Profit equals USD 40.
