International Monetary Relations
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Congratulations, you just won the Irish Lottery! You bought a ticket while you were on vacation in Ireland, and you just won a 1 million Euro jackpot after all taxes were taken out.
If the current exchange rate is US$1 equals 1.25 Euros, how much did you win in US dollars?
Suppose that the interest rate in Irish banks is 5% for a one year CD. In the USA, the rate is 2% for a one year CD. If you left your winnings in Ireland, how many Euros would you have in a year? If you had taken your winnings back to the USA, how many dollars would you have?
Suppose when you cashed in your CD in Ireland a year from now, the exchange rate had changed from US$1 to 1.25 Euro, to US$1 to 1.30 Euro. How much would your Irish bank account be worth in US$ at that point? Did you do better off leaving your winnings in Ireland or bringing them home to the USA?
Explain how banks and individuals can use "covered interest arbitrage" to protect themselves when they make international financial investments.
Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested?
Be sure to show all calculations. 2-3 pages
The media and others suggest that the current account deficit run by the U.S. is a problem for the economy. What do you think? What action(s) would you advise federal government officials to take on this issue?
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Hi there,
Based on an exchange rate indicated in the example, if US$1 = 1.25 Euros, then it would be $750,000 USD. If you left your winnings in Ireland, then you would have 1,050,000 Euros in a year. If you took the winnings back to the US, you would have earned 15K in interest, on the $750,000 USD, for a total of $765,000 USD. If you cashed in the Irish CD a year from now, the 1,050,000 Euros would be worth $735,000 (to arrive at that #, I took 30% off of the USD). If you had taken your $ back to the USA right away, you would have been $30K better off.
Covered Interest Arbitrage:
Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by forward selling the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is a deposit that pays interest once, at the date at which the investor as done the forward sale of foreign currency. Otherwise, some foreign exchange risk remains.
For example consider an investor based in the United States:
Exchange USD 1,350,000 into EUR 1,000,000
Buy EUR 1,000,000 worth of euro-denominated bonds
Forward sell EUR 1,000,000 back into USD 1,400,000, i.e. agree to exchange the euros back into US dollars at a future date at the current forward rate
source: http://en.wikipedia.org/wiki/Covered_interest_arbitrage
Purchasing Power Parity
In economics, purchasing power parity (PPP) is a number used to compare the standard of living of two countries. It is necessary because comparing the gross domestic products in a common currency does not accurately depict differences in material wealth. PPP, by contrast, takes into account both the differences in wages and the differences in cost-of-living. This is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices or in the opposite direction of the difference in entertainment prices. Moreover, purchasing patterns and even the goods ...
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