Chapter 7: Balance of Payments

1. Explain why resident and citizenship may be different.

2. What are the different types of international transactions?
3. What are the international transactions that are recorded in the current accounts, capital
accounts, and financial accounts?
4. Discuss the different between autonomous transactions and accommodating transactions.
5. Theoretically, the sum of the current account balance, the capital account balance and
financial account balance must be zero. Explain this balance of payment identity.
6. Explain why the balance of payment identity does not hold in practice?
7. Is it possible for a country to have a current account deficit, and at the same time it has a
surplus in the balance of payment? Give an example.
8. A deficit in the balance of payments reflects an excess demand for foreign exchange, while a
BOP surplus means an excess supply of foreign exchange. Explain6 this statement.
9. Using the following figures, discuss the trade balances between the US and China and Japan.
US-Japan Trade Balances US-China Trade Balances

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10. The below table gives the US BOP in 2003. Calculate the balance of trade in goods, the
balance of trade in services, the balance of primary incomes, current account balance, the
financial account balance and balance of payment.

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Chapter 8: Foreign Exchange market and exchange rates
1. What are the functions of the foreign exchange market?
2. What are the main actors in the foreign exchange market?
3. The U.S. dollar is often referred to as the dominant vehicle currency. Explain this.
4. How can traders hedge against the foreign exchange risk in the spot market (Credit market)?
What is the major disadvantage of hedging in the spot market?
5. Explain how importers and exporters hedge against the foreign exchange risk in the forward
market? What is the advantage of the hedging in the forward market over the hedging in the spot
market? Give your examples.
6. How can traders hedge against the foreign exchange risk in the option market? What is the
major advantage of the hedging in the option market over the hedging in the forward market?

7. A speculator expects the exchange rate of British pound will rise. He purchases a call
option to buy one million pound with the exercise rate of 1.3 dollars per pound. The option
premium is 0.1 dollars per pound. On the expiration date, the spot rate of the pound reaches
1.42 dollars per pound. Should the speculator exercise the option? Calculate his gain or loss.
Answer:
Cost of purchasing 1 million pounds using the option:
1,000,000*1.3 = 1,300,000 (dollars)
The option fee:
1,000,000*0.1 = 100,000 (dollars)
Total cost of purchasing 1 million pounds using the option:
1,000,000*1.3 + 100,000 = 1,400,000 (dollars)
Receipt of selling pounds in the spot markets (on the expiration date):1,000,000*1.42 =
1,420,000 (dollars)
The speculator would execute the option and earns: 20,000 dollars

8. A speculator expects the exchange rate of British pound would fall. He purchases a put
option to sell one million pound with the exercise rate of 1.3 dollars per pound. The option
premium is 1% of the contract value. On the expiration date, the spot rate of the pound was
1.28 dollars per pound. Should the speculator exercise the option? Calculate his gain or loss.

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Answer:
Receipt from selling 1 million pounds using the option:
1,000,000*1.3 = 1,300,000 (dollars)
The option fee:
1,300,000*0.01 = 13,000 (dollars)
Net receipts from selling 1 million pounds using the option:
1,300,000 – 13,000 = 1,287,000 (dollars)
Cost of purchasing pounds in the spot markets (on the expiration date):1,000,000*1.28 =
1,280,000 (dollars)
The speculator would execute the option and earns: 7,000 dollars

9. Calculate the (annualized) forward discount or premium in the following cases:

a. The 90-day forward rate for the euro is $1.07, while the current spot rate of the euro is
$1.05.
Answer: the forward premium is (1.07-1.05)/1.05*(360/90)*100 = 7.62%
b. The current spot rate of euro is $1.25 and the 180-day forward rate is $1.30.

10. Explain the locational arbitrage and calculate the profits in each of the following cases:

a. Assume that New Zealand dollar is quoted at bank X and bank Y is $.33 and $.32
respectively. Given this information, what would be your gain if you use $1,000,000 and
execute locational arbitrage?
b. The dollar exchange rates quoted at Bank A and Bank B are as follows:
Bank A: 21,030 dongs per dollar – 21,070 dongs per dollar (bid-ask rates)
Bank B: 21,090 dongs per dollar - 21130 dongs per dollar (bid-ask rates)
What would be your profit if you use 1,000,000 dongs and conduct a locational arbitrage?
Answer:
a. Purchasing NZD at bank Y: 1000000/0.32 = 3125000 NZD
Selling NZD at bank X: 3125000*0.33 = 1031250 USD
Profit = 31250
b. Purchasing dollars at bank A and selling dollars at bank B, thus making a profit of 20
dongs per dollars.

11. Suppose the spot exchange rate and the three-month forward rate between dong and dollar
are 20000 dong/dollar and 20500 dong/dollar respectively. The annual interest rates paid on dong
and dollar deposits are 20% and 4% respectively. Suppose you have 20 million dong to invest.

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a. Calculate the profit of investing in dong and dollar deposits.
b. Explain why investing in dong is more profitable than investing in dollars.
Answer:
Convert annual interest rates to three-month interest rates: 5% for dongs and 1% for dollars.
a. Profit of investing in dongs(for three months): 20*1.05 = 21 (million dongs)
Profit of investing in dollars: (i) currently exchange 20 million dongs for dollars at the
rates of 20000 dong/dollars and receives 1000 dollars; ii) The investor deposits 1000 dollars at
a bank and sells this amount of dollars forward (inclusive of interest earning); iii) Three months
later, the investor earns 1000*1.01 = 1010 dollars and implements the forward contract to sell
dollars at the rate of 20500 dongs/dollars. He receives 1010*20500 = 20.705 million dongs.
Investing in dong is more profitable.
b. The forward premium for dollars is: (20500-20000)/20000*(360/90) = 10%. The forward
premium is lower than the interest rate difference between dongs and dollars 20% - 4% = 16%.

12. Suppose the annual interest rates offered on dollar and euro deposits 4% and 3%
respectively. The euro is at the forward premium of 2% per year. Roughly how much would an
interest arbitrageur earn if he invest in one-year euro deposits and cover the foreign exchange
risk in the forward market. Explain why the gain would decline as the interest arbitrage
continues.
Answer: According to the CIAM, the profit of arbitrage is approximately equal to the the
difference between euro and dollar interest rates plus the forward premium on euro: (3% - 4%)
+2% = 1%

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Chapter 9: the international monetary system

1. What are the requirements of a good monetary system?

2. The balance-of-payment adjustment is symmetric under the gold standard. Discuss it.
3. Under the gold standard, the adjustment process of the balance of payments seemed to work
quickly and smoothly with little actual transfers of gold among nation. Discuss this.
4. Discuss the causes of the continuous decline in U.S. gold reserves and the increase in foreign-
held dollar reserves in the late of 1950s and 1960s.
5. What was the U.S. policy response to its persistent and growing balance-of-payment deficits
in the 1960s?
6. The Bretton-Woods system lacked an adequate adjustment mechanism to correct the balance-
of payment deficits. Discuss this argument.
7. What are the problems of the present international exchange rate system?
8. What is the proposal of target zones for exchange rates?
9. The huge international capital flows are the primary cause for exchange rate instability.
Discuss this argument.
11. Discuss the proposal of dual exchange rates advanced by Dornbusch and Frankel (1987).
12. Discuss some proposals for restricting speculative capital inflows.