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Exercises on RER

These two exercises are from: Feensta, Robert C. and Alan M. Taylor (2017). International Economics,
Macmillan Learning, chapter 14.

1. In recent years China has been routinely accused of currency manipulation. Use The Economists Big
Mac Index to investigate these claims. Go to http://www.economist.com/content/big-mac-index to
access the full dataset.
a. What is the most recent price of a Big Mac in China? What is the implied yuan/dollar
exchange rate from this price?
Answer: If we take the price of a Big Mac in China measured in dollar and the price measured
in yuan, we can compute the exchange rate that was used for the conversion:

The July 2017 price in yuan is 19.80, and in dollars it is $2.92. The exchange rate implied by this
price is 6.78 yuan per dollar, computed by the following expression:


19.80
= = = 6.78.
2.92

The price of a Big Mac in the US is $5.30. The exchange rate that would equalize the price in
China to the price in the US is:


19.80
= = 3.74,
5.30


where is the exchange rate yuan/dollar compatible with purchasing power parity
of Big Mac
b. Does this measure suggest that the Chinese yuan is overvalued or undervalued relative to
the dollar? Why might this be beneficial to the Chinese economy?
Answer: This suggests that the Chinese yuan is undervalued relative to the dollar by


= 44.8%. This would make Chinese goods relatively cheap on

international markets and boost their exports.
c. The fundamental assumption of this index is that the cost of producing a Big Mac is identical
across countries. Why might this assumption be violated? How might this violation affect your
answer in part (b)?
Answer: There may be a number of factors of production that differ in price across countries.
Even if the cost of the materials (two all-beef patties, special sauce, lettuce, cheese, pickles,
onions on a sesame seed bun) are identical, the price could differ if the price of labor or rent
is different from one country to another. If labor and land are significantly cheaper in China, it
may cause the price in China to be lower and as a result their exchange rate may seem more
undervalued than it actually is.
d. Which three countries are most undervalued relative to the U.S. dollar in the most recent
year? Which three are most overvalued?

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Answer: In July 2017, there are only 3 countries with overvalued currencies with respect to the
US dollar: Switzerland, Norway and Sweden. The 3 most undervalued are: Malaysia, Egypt and
Ukraine.

2. Suppose that two countries, Vietnam and Cte dIvoire, produce coffee. The currency unit used in
Vietnam is the dong (VND). Cte dIvoire is a member of Communaut Financire Africaine (CFA), a
currency union of West African countries that use the CFA franc (XOF). In Vietnam, coffee sells for
4,500 dong (VND) per pound. The exchange rate is 40 VND per 1 CFA franc, EVND/XOF = 30.
a. If the law of one price holds, what is the price of coffee in Cte dIvoire, measured in CFA
francs?
Answer: According to LOOP, the price of coffee should be the same in both markets:

b. Assume the price of coffee in Cte dIvoire is actually 160 CFA francs per pound of coffee.
Compute the relative price of coffee in Cte dIvoire versus Vietnam. Where will coffee traders
buy coffee? Where will they sell coffee in this case? How will these transactions affect the price
of coffee in Vietnam? In Cte dIvoire?
Answer: With an exchange rate of 30 VND per 1 CFA franc, the price of coffee in Vietnam
measured in CFA francs will be 150 as calculated in part (a). Traders will therefore buy coffee
in Vietnam because buying coffee is cheaper there while selling coffee in Cte dIvoire because
selling coffee is cheaper there. This will lead to an increase in the price of coffee in Vietnam
and a decrease in the price in Cte dIvoire.

Exercises on IP conditions
These exercises are from chapter 3 of my book.

Exercise 1
Suppose the nominal interest rate on a one-year United States bond is 5% and the nominal interest
rate in Mexico for a bond of the same maturity is 10%. The current exchange rate in the spot exchange
rate market is 2.5 peso$/US$.
(a) If the uncovered interest rate parity is valid and the expected exchange rate for the
next year is 2.4 peso$/US$, which of the two investments is more interesting to an
American investor?
Answer: Uncovered return for an American bond, measured in pesos:

(S+1 ) 2.4
(1 + i
)= (1.05)
S 2.5

Return of a Mexican bond with 1 + i


= 1.10.
2.4
Clearly, we have that: 2.5 (1.05) < 1.10

=> the Mexican bond is more interesting for all investors

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(b) If the covered interest rate parity is valid, what should be the nominal exchange rate
on the future dollar contract with a one-year term?
Answer: Covered interest parity:
+1 1 + i
=
S 1 + i

1+i 1.10
+1 = S (
1+i
) = 2.5 (
1.05
) 2.62

Exercise 2
Suppose that the three-month interest rate on English bonds is 10%. The rate of return for United
States bonds of the same maturity is 6%. The spot exchange rate between the dollar and pound is
2US$/pound.
(a) With free financial capital mobility between the two countries, and the bonds from
the two countries being perfect substitutes, what should be the expected depreciation
for the dollar? Explain the economic intuition for your answer.
Answer: Free capital mobility + bonds are perfect substitutes => Uncovered IP is valid
(S+1 ) 1 + i 1 + i

= (S +1 ) = S ( )
S 1 + i 1 + i
1.06
(S+1 ) = 2 ( ) 1.93
1.10

(S+1 )S
Percentage exchange rate change: S
= 3.5%

There should be an expected appreciation of the exchange rate of 3,5%


Intuition: the nominal interest rate is higher in England than in the US. To increase the
attractiveness of US bonds, there should be an expected appreciation of the USD, so that
the return of US bonds rise when measured in euros.

(b) Suppose the exchange rate for the future pound contract is 1.99 US$/pound. Is it
possible for a North American investor to exploit an arbitrage opportunity?
Answer: Return of English bond, covered to the exchange rate risk:
+1 1.99
(1 + i ) = 1.10 1.09
S 2
Return of US bond: 1 + i
= 1.06
There is an arbitrage opportunity: one could borrow in the US to lend in England. The
debt service payment will be lower than the interests received on the loans, so that
this operation would be profitable to the investor.

Exercise 3
Suppose the Mexican government imposes a tax rate of t% on the profitability of Mexican bonds as
well as on gains received from exchange rate operations. How will this situation affect the uncovered
interest rate parity equation?
Answer:

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(S+1 ) 1+i
Uncovered exchange parity: =
S 1+i
S
Returns for a foreign investor, investing in Mexican bonds: (1 + i ) (S
+1 )
If the government imposes a t% tax on the return, the net return on Mexican assets will become:
S
[(1 + i ) ] (1 %)
(S+1 )
New uncovered interest parity condition:
S
[(1 + i ) ] (1 %) = 1 + i
(S+1 )

(S+1 ) 1 + i
=( ) (1 %)
S 1 + i

Exercise 5
Consider two bonds, one of them Spanish, denominated in euros (), and the other denominated in
Chilean pesos ($), a Chilean bond. Assume both bonds have a one-year maturity and that they are
negotiated with discount, in other words, they pay a determined value per maturity and have a current
price equal to a fraction of the amount paid at maturity. The current exchange rate is S=2.5 $/. The
face value of the Chilean bond is $1,000.00, while the face value of the Spanish bond is 1,000.00. The
market price for the Chilean bond on date t is $956.00 and the market price for the Spanish bond is
945.00.
(a) What is the nominal interest rate for each of the bonds?
Answer:
1000 956
i = 4.6%
956
1000 945
i = 5.8%
945

(b) Find the expected exchange rate at bond maturity that is compatible with the
uncovered interest rate parity.
(S+1 ) 1+i

Answer: Uncovered exchange parity: = =>
S 1+i
1.046
(S+1 ) = 2.5 = 2.47
1.058

(c) If you expect there will be a short-term appreciation of the Chilean peso against the
euro, which of the bonds should you buy?
(S+1 )S 2.472.5
Answer: S
= 2.5
= 1.2%

If the expected appreciation of the Chilean peso is larger than 1.2%, I should buy the Chilean
bond.
For smaller expected appreciation or for an expected depreciation of the Chilean peso, I
should buy the Spanish bond.

(d) Suppose you are a Chilean investor who is considering exchanging pesos for euros to
purchase the Spanish bond. One year later the exchange rate will be S=2.3$/. What is

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the rate of return measured in pesos? Compare to the rate of return you would have
received by investing in Chilean bonds.
Answer: Rate of return of Spanish bonds measured in pesos:
S+1 2.3
(1 + i ) = 1.058 0.97
S 2.5

Rate of return: 0.97 1 = 2.7%


Rate of return in Chilean bond @ +4,6%
(e) Are the differences in returns obtained in the previous question compatible with the
uncovered interest rate parity? Explain your answer.
Answer: No, unless there is an error in expectations.