Deck 15: Exchange Rates, Interest Rates, and Interest Parity

Question 1

The relationship that says that the forward premium or discount is equal to the interest differential is

A) interest rate parity.
B) purchasing power parity.
C) the Fisher equation.
D) the term structure of interest rates.

Answer 1

A

Question 2

The relation indicates that the interest differential between investments in two currencies will equal the forward premium or discount between the currencies.

A) Fisher equation
B) interest rate parity
C) purchasing power parity
D) term structure of interest rates

Answer 2

B

Question 3

If real interest rates are equal in two countries, then the nominal interest differential on their currencies will equal

A) the expected inflation differential.
B) the risk premium.
C) the forward premium or discount.
D) Both A and C.

Answer 3

D

Question 4

The relationship that implies that the nominal interest rate is equal to the real interest rate plus expected inflation is called the

A) exchange rate equation.
B) Fisher equation.
C) interest rate equation.
D) term structure of interest rates.

Question 5

When one country has higher nominal interest rates than another country, the high-interest- rate currency is expected to relative to the low-interest-rate currency.

A) depreciate
B) appreciate
C) stay constant
D) None of the above

Question 6

We can expect very small deviations from interest rate parity in

A) the domestic markets.
B) the Eurocurrency market.
C) the goods market.
D) All of the above.

Question 7

The domestic currency value of the return on a foreign investment when the foreign currency proceeds are sold in the forward market, is defined to be the

A) covered return.
B) uncovered return.
C) forward return.
D) Both B and C.

Question 8

Given that real interest rates are constant, an increase in the expected rate of inflation will tend to

A) decrease the nominal rate of interest.
B) increase the nominal rate of interest.
C) cause lower inflation rates.
D) cause no change in the nominal rate of interest.

Question 9

Differences between the term structure of interest rates in two countries will reflect

A) price levels.
B) GNP differences expected.
C) the absence of covered interest arbitrage.
D) expected exchange rate changes.

Question 10

Careful studies of the data indicate that deviations from interest parity are

A) large.
B) non-existent.
C) small.
D) constant over time.

Question 11

If the 12-month interest rates for the United States and the United Kingdom are 6% and equal, and £1 = $2 in the spot market, then what do you expect the 12-month forward rate to be?

A) 2.10
B) 1.90
C) 2.00
D) 2.11

Question 12

Covered interest arbitrage ensures

A) exchange parity.
B) purchasing power parity.
C) interest parity.
D) All of the above.

Question 13

Deviations from interest rate parity occur due to

A) transaction costs.
B) government controls.
C) political risk.
D) All of the above.

Question 14

Suppose that the effective return to a U.S. investor from buying a U.K. bond is 5.55%. Forward and spot exchange rates ($/£) are 2.10 and 2.00 respectively. The interest rate on the U.K. bond is most likely equal to:

A) 5.45%
B) 5.500%
C) 5.650%
D) 5.60%

Question 15

Nominal interest rates tend to be higher in countries with

A) higher rates of inflation.
B) lower rates of inflation.
C) lower real interest rates.
D) Both B and C.

Question 16

The effective return from a foreign investment is

A) the domestic interest rate plus the forward premium (discount).
B) the foreign interest rate plus the forward premium (discount).
C) the nominal interest rate minus inflation.
D) the real interest rate.

Question 17

Suppose that the 12-month interest rates for the United States and the United Kingdom are 7% and 6% respectively, and E = 2.10 $/£. Given this information, what is the expected exchange rate change over the year?

A) 1%
B) 4.2%
C) 2.1%
D) 2.0%

Question 18

A constant differential between the interest rates of two countries over different terms to maturity implies that future changes in the exchange rate are expected to occur at which rate?

A) constant
B) increasing
C) decreasing
D) None of the above

Question 19

The interest parity condition indicates that the interest differential is equal to the

A) risk premium.
B) forward premium.
C) futures premium.
D) arbitrage premium.

Question 20

Suppose that in the United States and the United Kingdom the real rate of interest is 1 percent and constant. In this case, the nominal interest rates in both countries

A) are equal.
B) differ solely by the expected future spot rate differential.
C) differ solely by the expected inflation differential.
D) differ solely by the forward rate differential.

Question 21

Change in U.S. policy can lead to changes in inflationary expectations, interest rates, and exchange rates simultaneously as they all adjust to new equilibrium levels.

Question 22

One of the negative side effects of financial globalization is that national economic policies lack the discipline that they did in the past.

Question 23

Money is more mobile geographically now than in the past.

Question 24

The higher the expected inflation rate in a country, the lower is the nominal interest rate in that country.

Question 25

The term structure relationships regarding different interest rates approximately reflect expected exchange rate changes.

Question 26

If the real rate of interest is the same internationally, then the nominal interest rates differ solely by the expected inflation differential in two countries.

Question 27

Interest rate parity is more likely to hold in the short run than purchasing power parity.

Question 28

How are interest rates and inflation rates related?

Question 29

Explain briefly PPP and IRP. Why might the latter hold better than the former over time?

Question 30

If the nominal interest rate is 5.6 percent and the rate of inflation is 7.1 percent in a given year, then what is the corresponding real rate of return?

A) 12 .7 percent
B) 1.5 percent
C) -1.5 percent
D) -12.7 percent

Question 31

Arbitrage opportunities exist when uncovered interest rate parity does not hold.

Question 32

Deviations from interest rate parity could be due to transaction costs, differential taxation, government controls, and political risk.

Question 33

Interest differentials cause exchange rate changes.

Question 34

There are several reasons why interest rate parity may not hold exactly and, therefore, we can earn arbitrage profits from this situation.

Question 35

Write down the Fisher equation and IRP relationship for the United States and the United Kingdom. Using these relationships, how can we determine the link between interest, inflation, and exchange rates? How can a change in U.S. policy affect this link?

Question 36

Give 3 reasons for deviations from IRP. Do these deviations indicate unexploited profit opportunities for investors?

Question 37

Suppose that at some point the spot exchange rate is equal to 100 yen per one U.S. dollar, while the interest rate in dollars is 6% and the interest rate in yen is 1%. What is the approximate forward rate that is consistent with this situation?

A) 95.3 yen per dollar
B) 105 yen per dollar
C) 107 yen per dollar
D) 92 yen per dollar

Question 38

Suppose that the forward rate of Mexican pesos per dollar is selling flat, with both the spot and forward rates trading at 15 pesos per dollar. If the relevant interest rates for a foreign exchange speculator are 3 percent on dollars and 13 percent in pesos, a potential arbitrage operation would involve

A) selling pesos in the forward market.
B) buying pesos in the forward market.
C) borrowing pesos now.
D) All of the above.

Question 39

In order to infer expected future exchange rates, we must have a forward exchange market in a currency.

Question 40

Interest rate parity holds well in the Eurocurrency market.

Question 41

How has the globalization of financial markets affected the way in which countries conduct their economic policies?