1.  You are trying to imitate the famous currency speculator (and now philanthropist) George Soros, by undertaking a bet against the British pound. You borrow 10 billion pounds for one year from British banks at an annual rate of 8%. You convert this into dollars and buy US bonds earning an annual interest rate of 4%. British banks charge an interest rate equal to the rate of return on British Treasury securities plus 2 percentage points. Management fees for this transaction are $650 million. (i) How much does the "market" expect the pound to depreciate by in a year's time? (ii) How much you need the pound to depreciate in order to make money? (ii) If the pound depreciates by 7 percent, how much money do you make? (iv) What makes you think you are smarter than the market?

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(i) Let i denote the US interest rate, and let i* denote the British interest rate. Interest parity requires that i=i*+D, where D denotes the expectede depreciation of the dollar. As i=4% and i* = 6% (equal tot interest rate charged by the banks minus their 2% premium), D=-2%. Thus, the dollar is expected to appreciate by 2% against the pound or, equivalently, the pound is expected to depreciate by 2%.

(ii) If I borrow at 8%, and can earn 4% in dollars, I need the pound to depreciate by at least 4% in order to cover my costs.

(iii) If the pound depreciates by 7%, I can calculate how much money I make as follows. I borrow 10 billion pounds, and convert it to $10E billion. After a year of earning 4% interest, this turns into $10.4E billion. I then convert enough of these dollars back into pounds at the new exchange rate E/1.07 to repay principal plus interest equal to 10.8 billion pounds. Let y be the number of dollars I need to repay. Then y/(E/1.07)=10.8 billion, implying that y=$10.093E billion. Subtracting the dollars I must repay from what I earn gives a net profit of $0.3065E billion. Thus, if the exchange rate is, say $1.80 per pound, I make $551 million.

(iv) Because I've taken intermediate macroeconomics.

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