GBE PS2
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# Problem Set 2 - Global Business Environment
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## Overview
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This problem set covers four main topics in international finance:
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1. **Exchange Rate Risk Analysis** - Understanding currency risk from a portfolio perspective
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2. **Forward Exchange Rates** - Analyzing forward rates and covered interest parity
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3. **Put Options** - Currency option valuation and exercise decisions
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4. **Money Demand and Exchange Rates** - Analyzing the relationship between money markets and forex markets
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## Files in This Problem Set
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### Python Scripts
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| File | Description |
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|------|-------------|
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| `problem1_part1_analysis.py` | Problem 1, Part 1: Exchange rate risk analysis for European resident |
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| `problem1_part2_switzerland.py` | Problem 1, Part 2: Swiss Franc exchange rate data from FRED |
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| `problem2_forward_rate.py` | Problem 2: Forward exchange rate calculations and analysis |
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| `problem3_put_option.py` | Problem 3: Put option analysis with payoff diagrams |
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| `problem4_money_demand.py` | Problem 4: Domestic money demand and exchange rate equilibrium |
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| `run_all_problems.py` | Master script to run all problems sequentially |
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### Generated Outputs
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- `switzerland_exchange_rate.png` - Historical CHF/USD exchange rate chart
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- `problem3_put_option_diagrams.png` - Put option payoff and profit diagrams
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- `problem4_part4_initial.png` - Initial money market and forex market equilibrium
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- `problem4_part4_no_accommodation.png` - Equilibrium after output shock (no accommodation)
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- `problem4_part6_accommodation.png` - Equilibrium with monetary accommodation
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## How to Run
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### Run All Problems
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To run all problems in sequence:
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```bash
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python run_all_problems.py
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```
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### Run Individual Problems
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You can also run each problem separately:
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```bash
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# Problem 1, Part 1: Exchange rate risk analysis
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python problem1_part1_analysis.py
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# Problem 1, Part 2: Swiss exchange rate data
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python problem1_part2_switzerland.py
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# Problem 2: Forward exchange rate
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python problem2_forward_rate.py
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# Problem 3: Put option analysis
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python problem3_put_option.py
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# Problem 4: Money demand
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python problem4_money_demand.py
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```
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## Requirements
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### Python Packages
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The scripts require the following Python packages:
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```bash
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pip install pandas matplotlib requests numpy
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```
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Or install all at once:
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```bash
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pip install pandas matplotlib requests numpy
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```
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### Internet Connection
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Problem 1, Part 2 requires an internet connection to fetch data from FRED (Federal Reserve Economic Data).
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## Problem Summaries
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### Problem 1: Exchange Rate Risk (7 points)
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**Part 1** (Conceptual Analysis)
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- Analyzes which currency (dollar or yen) is riskier for a European resident
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- Considers correlation between currency movements and wealth portfolio
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- Uses modern portfolio theory concepts
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**Part 2** (Empirical Analysis)
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- Fetches historical CHF/USD exchange rate data from FRED
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- Identifies fixed exchange rate periods
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- Analyzes the Bretton Woods system and Euro floor period
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- Generates visualization of exchange rate history
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### Problem 2: Forward Exchange Rate (15 points)
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1. **Calculate forward rate** from spot rate and forward points
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2. **Determine expected currency movement** (appreciation/depreciation)
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3. **Explain intuition** behind the expected movement
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4. **Solve for EUR interest rate** using covered interest parity
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**Key Concepts:**
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- Forward points and forward exchange rates
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- Covered Interest Parity (CIP)
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- Interest rate differentials and currency expectations
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### Problem 3: Put Option (20 points)
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Analyzes a put option to sell 1,000 EUR with:
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- Option fee: 75 CHF
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- 3-month maturity
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- Strike price = expected exchange rate from interest parity
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**Three Parts:**
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1. **Calculate expected exchange rate** using uncovered interest parity
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2. **Scenario 1**: E = 0.93 CHF/EUR at maturity
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- Exercise decision
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- Payoff and profit calculation
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3. **Scenario 2**: E = 0.98 CHF/EUR at maturity
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- Exercise decision
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- Payoff and profit calculation
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**Outputs:**
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- Detailed payoff and profit diagrams
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- Visual representation of both scenarios
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### Problem 4: Domestic Money Demand (50 points)
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Comprehensive analysis of money market equilibrium and exchange rates:
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1. **Find equilibrium Swiss interest rate** (R_CHF)
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2. **Find equilibrium spot exchange rate** (E_CHF/EUR)
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3. **Determine expected currency movement**
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4. **Diagram: Temporary output increase** (no monetary accommodation)
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5. **Solve new equilibrium** with output increase
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6. **Diagram: With monetary accommodation**
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7. **Calculate new money supply** needed for accommodation
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**Key Concepts:**
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- Money market equilibrium
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- Uncovered Interest Parity (UIP)
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- Relationship between money market and forex market
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- Monetary policy accommodation
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- Short-run vs. long-run adjustments
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**Outputs:**
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- Three detailed diagrams showing:
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- Initial equilibrium
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- Effect of output shock without accommodation
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- Effect with monetary accommodation
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## Key Economic Concepts
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### Exchange Rate Notation
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- **E_CHF/EUR**: Swiss Francs per Euro (direct quote from Swiss perspective)
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- **E_USD/EUR**: US Dollars per Euro
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### Interest Parity Conditions
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**Covered Interest Parity (CIP):**
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```
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F/E = (1 + R_domestic)/(1 + R_foreign)
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```
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**Uncovered Interest Parity (UIP):**
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```
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E_expected/E = (1 + R_domestic)/(1 + R_foreign)
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```
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### Money Market Equilibrium
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```
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M^s / P = L(R, Y)
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```
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Where:
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- M^s = Nominal money supply
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- P = Price level
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- L(R, Y) = Real money demand function
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- R = Interest rate
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- Y = Output/Income
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### Put Option Payoff
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For a put option to sell foreign currency:
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```
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Payoff = Amount × max(Strike - Spot, 0)
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Profit = Payoff - Future Value of Premium
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```
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## Understanding the Results
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### Problem 1: Key Insight
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The **yen is riskier** than the dollar for a European resident because:
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- Dollar provides a **hedge** (appreciates when wealth does well)
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- Yen **amplifies risk** (dollar depreciates vs yen when wealth does poorly)
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- Portfolio risk depends on **covariance**, not just variance
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### Problem 2: Key Insight
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Forward rate > Spot rate implies:
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- **Dollar expected to depreciate** vs Euro
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- Reflects **higher US interest rates** than Eurozone
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- Covered interest parity ensures no arbitrage
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### Problem 3: Key Insight
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Put option provides **downside protection**:
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- Exercise when CHF strengthens (E falls below strike)
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- Let expire when CHF weakens (E rises above strike)
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- Maximum loss = option premium (with interest)
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### Problem 4: Key Insight
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**Without accommodation:**
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- Output increase → Money demand increases → Interest rate rises → Currency appreciates
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**With accommodation:**
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- Central bank increases money supply → Interest rate stays constant → Exchange rate unchanged
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## Troubleshooting
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### FRED Data Access
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If you get an error accessing FRED data:
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1. Check your internet connection
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2. Verify the FRED website is accessible: https://fred.stlouisfed.org/
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3. The script will print diagnostic information if data fetch fails
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### Graphics Display
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If graphs don't display:
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- They are automatically saved as PNG files in the same directory
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- You can view them manually even if the display window doesn't open
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### Missing Packages
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If you get import errors:
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```bash
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pip install pandas matplotlib requests numpy
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```
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## Mathematical Formulas
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### Forward Points
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```
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F = E_spot + (Forward Points / 10,000)
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```
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### Expected Return from Currency
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```
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Expected Return = (E_expected - E_spot) / E_spot
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```
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### Money Demand Function (Problem 4)
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```
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L(R_CHF, Y_CHF) = 100 + 1.5 × Y_CHF - 5000 × R_CHF
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```
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## Interpreting Diagrams
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### Money Market Diagram (Bottom Panel)
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- **X-axis**: Real money balances (M/P)
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- **Y-axis**: Interest rate (R)
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- **Vertical line**: Money supply (M^s/P)
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- **Downward-sloping curve**: Money demand (M^d/P)
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- **Intersection**: Equilibrium interest rate
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### Forex Market Diagram (Top Panel)
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- **X-axis**: Domestic interest rate (R_CHF)
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- **Y-axis**: Exchange rate (E_CHF/EUR)
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- **Downward-sloping curve**: Foreign return curve (FR)
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- Reflects UIP condition
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## Additional Notes
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### Rounding
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All numerical results are rounded to 3 decimal places as specified in Problem 4.
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### Assumptions
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- Perfect capital mobility
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- Rational expectations
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- No transaction costs
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- Prices are sticky in the short run (Problem 4)
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## Contact and Support
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For questions about the economic concepts or interpretation of results, please refer to:
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- Course materials on exchange rate determination
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- Textbook chapters on international finance
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- Lecture notes on forward markets and options
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## License
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This problem set is for educational purposes as part of the Global Business Environment course.
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