1. Challenge Problem: The beautiful, mythical country of Color dial uses the toe as its currency, and the gritty, postindustrial country of Ohio uses the erne. Exactly 1 year ago, you could get 100 toes in exchange for 5 ernes in the foreign exchange market. Since then, though, the real interest rate in Color dial has increased, while staying constant in Ohio.
a. All other things being equal, would you expect the erne to have appreciated or depreciated with respect to the toe? Explain your reasoning.
b. Assume that the change in the value of the erne with respect to the toe (appreciation or depreciation depending on your previous answer) was 50 percent. What is the current nominal exchange rate expressed in toes/erne?
c. One year ago, you borrowed 100,000 toes from a Color dial bank at a rate of 3 percent per year. You then traded the 100,000 toes for ernes at the nominal exchange rate that prevailed at the time (100 toes = 5 ernes), and invested those ernes in Ohio at 5 percent interest. After the year was over, your intention was to exchange the ernes back for toes, repay the loan to the Color dial bank, and keep a tidy profit. (This strategy is called a “carry trade” and at various times has been popular with foreign exchange traders.)
i. How much would you have made on this strategy if the interest rates did not change and if the exchange rate had not changed from 100 toes = 5 ernes?
ii. What will be your profit (or loss) on the trade given the changes in the exchange rate you found in parts (a) and (b)? (Assume the interest rate you paid to the Color dial bank was fixed in your loan agreement, and so did not change.)