"economics"exercise:International Trade and Capital Flows

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Questions 1:

An investor examines the following rate quotes for the Brazilian real (BRL) and the Australian dollar (AUD) and shorts BRL500,000.

● Spot rate BRL/AUD: 2.1128

● BRL 1-year interest rate: 4.1%

● Forward rate BRL/AUD: 2.1388

● AUD 1-year interest rate: 3.1%

The risk-free arbitrage profit that is available is closest to:

A 、–BRL6,327.

B、 BRL1,344.

C、 BRL6,405

Questions 2:

Consider two countries, A and B. Country A, a closed country with a relative abundance of labor, holds a comparative advantage in the production of textiles. Country B has a relative abundance of capital. When the textile trade is opened between the two countries, Country A will most likely experience a favorable impact on:

A、 labor.

B、 both capital and labor.

C、 capital.

View answer resolution

【Answer to question 1】B

【analysis】

B is correct. The equation below is often called the “covered interest arbitrage relationship” because if it is not satisfied, a risk-free arbitrage opportunity exists. It is based on the required equivalence of the two possible investment paths: if the two paths do not produce the same terminal result, an arbitrage profit exists.

A is incorrect. The right side of the equation uses inverted exchange rates in Steps One and Three and 4.1% in Step Two. Step One: BRL500,000 × (2.1128AUD/BRL) = AUD1,056,400 Step Two: AUD1,056,400 × (1.041) = AUD1,099,712 Step Three: AUD1,099,712 × (1/2.1388) = BRL514,173 Arbitrage profit = BRL514,173 (right side above) – BRL520,500 (left side above) = –6,327

C is incorrect. The right side of the equation uses 4.1% and thus 1.041 incorrectly in Step Two. Step One: BRL500,000 × (1/2.1128AUD/BRL) = AUD236,653 Step Two: AUD236,653 × (1.041) = AUD246,355 Step Three: AUD246,355 × 2.1388 = BRL526,905 Arbitrage profit = BRL526,905 (right side above) – BRL520,500 (left side above) = 6,405

【Answer to question 2】A

【analysis】

A is correct. As a country opens up to trade, the benefit accrues to the abundant factor, which is labor in Country A.

B is incorrect. The favorable impact goes to the factor in relative abundance, which includes labor and excludes capital in Country A.

C is incorrect. Country B has an abundance of capital, therefore the favorable benefit to capital lies in Country B, not in Country A

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