UNIVERSITY OF EAST LONDON

Department of Economics

Subject Area: Economics Date: 2 June 2000

Unit Code: ECO 333 Time:

Unit Title: Foreign Exchange Economics Duration: 3hrs 10 mins

Instructions to Candidates:

Answer any FOUR (4) questions.

All questions are equally weighted.

1. "If there were no changes in the data available, and every item of data had been assimilated in the price, and all we experienced was the passage of time, and nothing whatsoever changed, then the current spot rate might well turn out to be the actual spot rate on a specific date in the future. But, as we know, life is not like that …." F. Taylor, Mastering Foreign Exchange & Currency Options, 1997, p. 90

Explain the theoretical basis of the view that the forward exchange rate is an unbiased predictor of the future spot rate of exchange and critically discuss the quotation above.

2. Outline the principal economic theories of the Balance of Payments and discuss their relationship to theories of the determination of exchange rates.

3. "Whether true or not, PPP is an important benchmark for the analysis of exchange rate movements, particularly insofar as they impinge on international competitiveness". (Copeland, Exchange Rates and International Finance, 1994, p. 73).

Outline and discuss the problems associated with discovering whether or not PPP is 'true' and consider why it remains an 'important benchmark'.

4. Explain the basis of Dornbusch's theory of overshooting exchange rates and discuss its significance in the development of exchange rate theory.

5. "It has now been clearly established that forecasting exchange rates on the basis of a view about relative fundamentals such as inflation, external accounts and interest rate differentials is of limited or no value to the hedger, trader or arbitrageur, and is now reserved largely for end of year competitions" (F.Taylor, Mastering Foreign Exchange & Currency Options, 1997, p. 6.)

Critically discuss the above quotation, with reference to the tests that have been used to attempt to establish the usefulness of fundamentals in forecasting exchange rates.

6. Outline the principal arguments in the debate over the choice of fixed or flexible exchange rates and discuss the practical relevance of these arguments.

7. International monetary arrangements have frequently been described in recent years as a 'non-system'. Outline the inadequacies of the arrangements that this description implies and discuss the major proposals for the reform of these arrangements.

8. "The growth of Eurobanking activity has been blamed for many things ranging from the breakdown of the Bretton Woods system, to the rise in worldwide inflation and the Third World debt crisis. In reality, the Eurobanks provide services that are clearly in demand as is verified by their rapid growth." (K. Pilbeam, International Finance, 1998, p. 333)

Outline and discuss the basis of the dangers that critics have identified in the growth of Eurobanking activity and consider why the services of Eurobanks have been so much in demand.

9. Explain the distinctions among the translation, transactions and economic risks faced by firms as the result of changing exchange rates. Consider the extent to which the existence of these risks justifies action by firms to hedge against them.

10. Discuss the relative advantages and disadvantages of forward markets, futures, and options as means of hedging and speculating in foreign exchange markets, paying attention also to the possibility of writing options.

11. Explain each of the following types of the options and consider the circumstances in which they might be used in foreign exchange markets.

(a) straddles and strangles;

(b) butterflies and condors;

(c) barrier options.

Consider the possible impact of the existence of barrier options on the operation of forex markets.

12. Read, explain and discuss the following extract from the Financial Times of the 1/2 April 2000. Pay particular attention to the balance of influence suggested in this article between the economic fundamentals of exchange rates and other factors.

"The yen powered higher across the board yesterday, scoring a lifetime high against the euro and and claiming one of its largest single day rises against the dollar in the past few years. From its opening around Y106 the dollar collapsed to a low of Y101.99, an unusually large move by recent standards.

"But the yen's move was spearheaded by a rise against the euro, which tumbled below technical support at Y100. This barrier had proved hard to breach over the past few sessions, propting talk that several US banks were defending options barriers….

"Analysts said the move reflected rising optimism over the Tankan, the Bank of Japan's quarterly survey of the business climate. A mixed bag of economic indicators yesterday were also given a positive interpretation by yen bulls. Unemployment was up in February to a record 4.9 per cent. 'This was seen primarily as a sign of corporate restructuring', said Tony Norfield, head of foreign exchange research at ABN Amro. And although a sharp rise in consumer spending was largely attributed to leap year effects, the figures were nonetheless considered encouraging.

"Few doubted that yesterday's move was very much driven by the strength of the yen rather than the weakness of the euro. But it did cause analysts to ponder the longer-term implications for Europe's embattled unit.

"There were two schools of thought. The euro fell through technical levels against the yen at Y100 and below £0.60 against sterling. This leaves the position of the euro looking extremely precarious against the dollar as well," said Paul Chertkow, global head of foreign exchange research at Bank of Tokyo-Mitsubishi in London.

"With global fund managers still thought to be holding long euro positions, some analysts have predicted that further weakness would provoke a stampede out of the currency.

"Others were more encouraged by the euro's performance. Despite falls against the yen and sterling, the euro managed to keep its head above water against the dollar."

UNIVERSITY OF EAST LONDON

Department of Economics

Subject Area: Economics Date: 4th September 2000

Unit Code: ECO 333 Time:

Unit Title: Foreign Exchange Economics Duration: 3hrs 10 mins

Instructions to Candidates:

Answer any FOUR (4) questions.

All questions are equally weighted.

1. "It is not surprising that the efficient markets hypothesis does not test well since the proposition used for testing is derived from three separate hypotheses, only one of which tests well".

Outline the three underlying hypotheses mentioned here and critically consider the assumptions on which they depend.

2. Explain and discuss the view that the monetary approach to the balance of payments is a theory of the balance of payments under fixed exchange rates and a theory of the exchange rate under floating exchange rates.

3. Explain and critically discuss the theoretical basis for the belief that exchange rates should move in the long run to preserve Purchasing Power Parity among countries. What factors might interfere with the preservation of PPP?

4. Explain the modifications made to the flexible-price monetary model of exchange rate determination in the Dornbusch sticky-price model and discuss the significance of these changes.

5. Critically discuss the principal reasons put forward for the failure of economic models in the forecasting of exchange rate changes.

6. Explain and critically discuss the arguments for and against the managed floating of the exchange rate.

7. "The present system permits countries to adopt whatever exchange-rate policy they wish providing that they do not peg their currencies to the value of gold."

(K. Pilbeam, International Finance (1998), p. 302.

Discuss the advantages and disadvantages of this system.

 8. "In reality, the Eurobanks provide services that are clearly in demand as is verified by their rapid growth."

(K. Pilbeam, International Finance, 1998, p. 333)

Explain why the services of Eurobanks have been so much in demand. Consider whether the high demand for their services is a sufficient reason to justify the continued growth of offshore financial activity.

9. Explain the nature of foreign exchange risk faced by firms. Outline and discuss the principal external means used by firms to counteract this risk.

10. Discuss the relative advantages and disadvantages of exchange-based and over-the-counter (OTC) derivative products as means of hedging and speculating in foreign exchange markets.

11. Outline and discuss the role in derivatives trading of mixed options strategies and exotic options.

12. Read, explain and discuss the following extract from the Financial Times of the 15/16 July 2000.

"The dollar traded strongly on the foreign exchange markets yesterday after robust US data failed to shake the market’s expectations of a soft landing for the economy. The keenly awaited retail sales data came in ahead of expectations, showing a 0.5 per cent rise in June and an upward revision to the May figure. But analysts said that the data were not strong enough to alarm the Federal Reserve. The dollar held the euro at bay, despite the passage of long-awaited tax reforms in Germany ….

"The euro’s apathetic response to yesterday’s German tax reforms has left some analysts wondering whether anything can boost the currency. Although the reforms had been long in the pipeline, most commentators had assumed that the legislation would be blocked by the Christian Democrat opposition in the Bundesrat, Germany’s upper house. ‘Most expected that the CDU would eventually relent but not for a while,’ said Paul Meggyesi, senior economist at Deutsche Bank in London. ‘This early move was not priced into the market’.

"The reforms have been eagerly awaited by euro bulls. By allowing companies to sell cross shareholdings without capital gains tax, it has been argued, the reforms will speed the process of structural reform. A large reduction in corporate taxation … is also expected to increase the attractions of investing in Germany. Yet the euro failed to mount even the most modest of rallies."

UNIVERSITY OF EAST LONDON

Department of Economics

Subject Area: Economics Date: May 2001

Unit Code: ECO 333 Time:

Unit Title: Foreign Exchange Economics Duration: 3hrs 10 mins

Instructions to Candidates:

Answer QUESTION 1 AND any THREE (3) other questions.

All questions are equally weighted.

"The US dollar is responding to bad news about the US economy in a somewhat perverse fashion. Friday’s warnings from technology bellwethers Motorola and Sun Microsystems initially undermined the dollar. But as expectations mounted that such grim news could prompt an inter-meeting rate cut by the Fed, the dollar revived. Meanwhile reassuring data on results – though thin on the ground – have been taken as a sign that the Fed’s aggressive interest rate cuts in January are already taking effect. ‘The dollar is in a no-lose situation at the moment’, said David Bloom, currency strategist at HSBC in London. ‘Good news is good news and bad news is good news too’. The key ingredient in this happy situation for the dollar is the supreme confidence in the Federal Reserve to revive US growth. This could start to falter, analysts said, if there are few signs of revival in the US economy by the middle of the year. They said consumer confidence holds the key. If this fails to revive then consumers will rebuild their savings rather than resume spending with any extra money from tax cuts or rate cuts."

Financial Times, 27 February 2001

2. It is generally accepted that purchasing power parity helps little in explaining exchange rate changes in the short run and is only mildly helpful in the long run. Discuss the reasons for this apparent failure paying particular attention to the view that the apparent failure of the theory has more to do with the problems of testing PPP than with the inadequacy of the underlying idea.

3. Explain the distinction between uncovered interest rate parity and covered interest rate parity and consider the extent to which each of them is likely to hold in foreign exchange markets.

4. Outline the simple monetary model of exchange rates and explain what the model predicts will happen to the exchange rate of a floating currency in each of the following cases:

the domestic money stock decreases;

foreign national income falls; AND

the foreign price level falls.

5. Explain why exchange rates overshoot and what limits the extent to which they overshoot in the Dornbusch sticky prices model. Consider the advantages of the model in relation to the simple monetary model and the problems that still remain.

6. Outline the portfolio balance model of the exchange rate and discuss its principal conclusions, particularly regarding the linkage between the balance of payments and the exchange rate.

7. "It should be clear … that unbiasedness looks … a completely untenable proposition. As far as rationality and efficiency are concerned, the jury may still be out, but the case for the prosecution certainly looks very strong". L Copeland, Exchange Rates and International Finance p. 317

Explain and discuss Copeland’s conclusion regarding the results of testing for market efficiency in foreign exchange markets.

8. Outline and discuss the principal problems encountered in the econometric modelling of exchange rate theories.

9. Explain and discuss the usefulness of TWO of the following attempts to account for the observed volatility of exchange rates:

rational bubbles;

the peso problem;

‘news’ models of the exchange rate.

10. Explain and critically consider the usefulness of ONE of the following approaches to the explanation of exchange rate behaviour:

chaos models.; OR

crisis models of fixed exchange rate systems.

11. Critically discuss the usefulness of the various methods available to firms wishing to hedge against exchange rate risk.

12. "Once again an elegant theory appears to generate predictions which are flatly contradicted by the data. This time, however, modifications which in any case bring the assumptions closer to reality also serve to make it consistent with the facts." L Copeland, Exchange Rates and International Finance p. 431

Explain and discuss Copeland’s verdict on the target zone model of exchange rates.

UNIVERSITY OF EAST LONDON

Department of Economics

Subject Area: Economics Date: September 2001

Unit Code: ECO 333 Time:

Unit Title: Foreign Exchange Economics Duration: 3hrs 10 mins

Instructions to Candidates:

Answer QUESTION 1 AND any THREE (3) other questions.

All questions are equally weighted.

______________________________________________________________________________

SECTION A

1. Explain and discuss the passage below, paying particular attention to the role of interest rate changes in the foreign exchange market and the problems in interpreting news.

"It seemed like an odd day to be considering the prospect of the week dollar yesterday. Once again the market shrugged off worrying US data while punishing poor euro-zone data.

"But there were some in the markets who saw potential rain clouds on the horizon for the dollar. The most immediate source of concern for the greenback, said Alan Ruskin, director of research at 4Cast in New York, was the weight of speculative long positions. ‘There has been an accumulation of long positions in the dollar which may start to become a problem if it continues,’ he said.

"The main long-term risk for the dollar, however, came from fading confidence in the Federal Reserve, he added. ‘The dollar’s resilience to bad news is premised on expectations that the Federal Reserve will succeed in kick-starting the economy and if this confidence ebbs the dollar is in trouble’, said Mr Ruskin. This could come about in several ways, according to 4Cast. First, the Fed could be boxed in by higher inflation figures. … A more likely scenario … is that the Federal Reserve could run out of bullets.

Answer any THREE questions from this section.

2. Explain the notion of purchasing power parity and discuss its usefulness in the development of theories of the determination of the foreign exchange rate.

3. Explain the notion of interest rate arbitrage and consider the likely impact on spot and forward exchange rates of a ceteris paribus increase in domestic interest rates.

4. Outline the simple monetary model of exchange rates, paying particular attention to the assumptions of the model. Consider the extent to which the nature of the assumptions reduces the usefulness of the model.

5. Compare and contrast Dornbusch’s overshooting exchange rate model of the exchange rate with the simple monetary and portfolio models of the exchange rate.

6. Outline and discuss the short-run and long-run effects of a reduction in domestic interest rates within the portfolio model of exchange rates.

7. Explain and discuss the proposition that the forward exchange rate should be an unbiased predictor of the future spot rate of exchange.

8. Consider the performance of the fundamentalist exchange rate models in the forecasting of foreign exchange rates.

9. Critically consider the explanations put forward by economists for the existence of bubbles in the foreign exchange market.

10. What are ‘news models’ of the determination of the exchange rate? Consider the extent to which they are an improvement on portfolio and monetary models.

11. Outline the types of exposure to foreign exchange risk faced by firms engaged in international trade and consider the usefulness of derivatives markets in the protection against forex risk.

12. Outline and critically discuss the arguments for attempting to limit the exchange-rate swings between the major currencies. Consider the relative merits of the proposals of Williamson, McKinnon and Tobin for bringing this about.

UNIVERSITY OF EAST LONDON

Department of Economics

Subject Area: Economics Date: May 2002

Unit Code: ECO 333 Time:

Unit Title: Foreign Exchange Economics Duration: 3hrs 10 mins

Instructions to Candidates:

Answer QUESTION 1 AND any THREE (3) other questions.

All questions are equally weighted.

___________________________________________________________________________

SECTION A

You must answer this question.

"The euro fell to a three-week low against the dollar yeaterday despite an unexpectedly sharp fall in a survey of US consumer confidence and a comparatively strong result from a similar German survey. The US Conference Board’s confidence index fell to 94.1 in February from 97.3 last month. Economists had expected a broadly unchanged figure. The euro had spiked higher earlier in the day after Germany’s Ifo Institute released a stronger-than-expected business sentiment survey. But it fell back, as analysts reflected that most of the gains were in the future expectations component and that confidence surrounding current conditions had in fact deteriorated….The Euro spiked to $0.8710 on the US data but tumbled to a three-week low of $0.862 by midsession in New York after breaking support at $0.8675." Financial Times, February 27 2002.

"Once again the failure of robust economic figures to stimulate the dollar was the main talking point….one explanation is that growth is becoming less important than valuations. ‘This year will not be about relative economic strength but rather how much value is offered in financial markets,’ said Adrian Schmidt, chief currency strategist at Royal Bank of Scotland Financial Markets. ‘In this rerspect the eurozone wins because equities in particular offer much more attractive valuations’…. The dollar also faces greater headwind than the euro because of its bloated current account deficit." Financial Times, March 6 2002.

Outline and discuss the factors mentioned in these two extracts as having an impact on short-term variations in exchange rates.

SECTION B

Answer any THREE questions from this section.

2. Explain what is meant by relative purchasing power parity (PPP). Consider why PPP has been such a powerful idea in the explanation of changes in exchange rates AND the extent to which it appears to be supported by evidence.

3. Discuss the difficulties involved in testing uncovered interest rate parity. Consider, in particular, why the testing of covered interest rate parity is less of a problem.

4. Explain and discuss the view that the monetary approach to the balance of payments is a theory of the balance of payments under fixed exchange rates and a theory of the exchange rate under floating exchange rates.

5. Consider the assumptions underlying the Mundell-Fleming model and contrast these with the assumptions of the simple monetary model. Discuss the impact of an expansionary monetary policy in each model.

7. According to Copeland (Exchange Rates and International Finance p. 223), the portfolio balance model of exchange rate determination is richer in insights and more plausible than other standard models. Outline and discuss the elements of the model that ensure this.

8. "It has now been clearly established that forecasting exchange rates on the basis of a view about relative fundamentals …. is of limited or no value to the hedger, trader or arbitrageur, and is now reserved largely for end of year competitions" (F.Taylor, Mastering Foreign Exchange & Currency Options, 1997, p. 6.)

Explain and discuss the above quotation.

9. What is ‘currency substitution’? Outline the currency substitution hypothesis and consider the extent to which available evidence appears to support it.

10. "The theoretical implication is clear: there is money to be made in the forward market." (Copeland, Exchange Rates and International Finance, 2000, p. 317).

Copeland draws this conclusion from his discussion of the available evidence concerning the existence of ‘unbiasedness’ and ‘rationality and efficiency’ in the foreign exchange market. Explain these hypotheses and discuss the available evidence concerning them.

11. Outline the ‘news’ approach to the modelling of exchange rates and discuss the extent to which it succeeds in explaining the volatility of exchange rate movements.

12. International monetary arrangements have frequently been described in recent years as a 'non-system'. Outline the inadequacies of the arrangements that this description implies and discuss the major proposals for their reform.