Midterm Exam Part I: Questions and Instructions

Instructions and Note

•This is Part I of the Midterm Exam, and will be scored out of 50 points. The due date is March 6. Please submit the exam into the appropriate D2L drop box by 11.59 pm on the due date.

•Part II of the Midterm Exam is on MyLab and this too needs to be completed by March 6.

•As a rough rule of thumb, keep your responses to the discussion questions to between 150 and 250 words. However, it is fine if your response is a little shorter or longer. What is important is that your response should be clear and comprehensive, and explain all key points.

•Your primary submission must be in a Word Document or PDF. 

•If you type into this word document, please do NOT use bold font. I have used bold font for the questions so that I can easily distinguish the questions from your answers.

•Please leave enough space between questions for my comments and feedback.

•Please note that you are expected to work on this test entirely on your own. Any collaboration with any other person will be considered academic misconduct and will be dealt with in accordance with university policy.

1.(a) Define interest rate parity. What is the relationship between interest rate parity and forward rates? (5 points)

(b) Explain the difference between Covered Interest Arbitrage and Uncovered Interest Arbitrage. (5 points)

2.What is the Official Reserves Account (ORA) in a country’s Balance of Payments (BOP), and what role does it play when the country follows a fixed exchange rate system? (7 points)

b) Suppose that a certain country has a financial account surplus in its Balance of Payments. Does this mean that the country will necessarily have a current account deficit? Explain why or why not. (8 points)

For the purpose of this question, assume that the financial account includes the capital account, and also ignore net errors and omissions.

3.a) Explain the theory of “the impossible trinity.” (5 points)

b) Suppose that Malaysia wants a stable exchange rate with respect to the dollar, and also wants to retain the ability to have an independent monetary policy. Are these goals consistent? What measures will Malaysia have to take so that it can achieve the above goals? Explain your answer. Hint: Use the theory of the Impossible Trinity. (5 points)

4.a) Explain what an interest rate swap is and how it can be used to manage interest rate risk. (5 points)

b) Explain the difference between a call option and a put option. (5 points)

c) You are expecting the euro to go down in value against the dollar, and would like to make a profit based on this view. You do not wish to take on too much risk, and so you have decided to only buy options, not sell them. Would you buy a call or a put option on the euro? Explain your answer. (5 points)