Instructions: There are 5 questions on this exam. Please be explicit in your answers and provide as many details as possible. For parts that require calculations, please show your work clearly as I will be giving partial credit.
1) What do you understand from the phrase “Impossible Trinity”? Why is it impossible to have exchange rate stability, independence in monetary policy, and free flow of capital simultaneously for a country? Please explain. Give examples from today’s world of countries that selected different options among the choices offered by the Impossible Trinity. For a small emerging economy with a focus and potential to grow, which choice would you offer? Would your answer change if it was a developed large economy? Please provide details.
2) According to the fundamentals of Balance of Payments (BOP), the sum of its sub accounts must always add up to zero. Usually for most economies, a deficit in the current account is offset by a surplus in the financial/capital account, or vice versa. However, China has been running a huge surplus in both of its current account and financial/capital account in the last 15 years. How is this possible? Does that mean the BOP is in surplus for China? Explain in detail.
3) Most of the open economies that run current account deficits must either increase the interest rates to entice capital inflows so that the surplus in the financial/capital account finances the current account deficit, or must let their currency depreciate to improve the current account deficit. However, the US has been able to finance its huge current account deficit with a big surplus in its financial/capital account since the world financial crisis of 2008 despite maintaining an almost zero-interest rate policy (at least up until now). Moreover, the trade-weighted USD index has been on an upward trend from 2011 to 2020. How do you reconcile the ability of the US to finance its current account deficit with a rising USD and a zero-interest rate policy? What are the threats to the US economy going forward analyzing the US BOP fundamentals from this perspective?
4) The following spot exchange rates are provided to you in your trading platform on your computer screen (assume you can buy or sell at the stated rates without paying for a bid-ask spread). Imagine you have an initial SF12,000,000. Can you make a profit via triangular arbitrage? If so, show the steps and calculate the amount of profit you would make in Swiss francs (Swissies).
|Mt. Fuji Bank||¥92.00/$|
|Mt. Rushmore Bank||SF1.02/$|
|Mt Blanc Bank||¥90.00/SF|
5) You are working in the arbitrage division of a large international bank. This morning you noticed in your Bloomberg currency page that USD/JPY is trading at 112.00 and the 3-month forward rate on USD/JPY is at 111.65. You also discovered that the dollar interest rate for 3-month maturity is at 2.50% per annum, while the yen interest rate for the same 3-month term is at 0.50% per annum. According to the Covered Interest Arbitrage (CIA) theory, do you see an arbitrage opportunity? What does the Covered Interest Arbitrage Theory say? If you do see an opportunity, how should you act? You can either borrow $1,000,000 from a US bank or ¥100,000,000 from a Japanese bank to start the execution of your trades. If you do act and borrow, you need to return both the principal and the interest at the end of 3-months. Please list all the transactions you need to execute and indicate how much profit you would make in JPY (or in USD) form and in percentage terms at the end of 3 months. If you think the USD/JPY forward rate and the interest rates in the US and Japan are out of balance, explain the mechanism how the markets would move back to equilibrium.
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