Question 1

________ states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.

Accepted Answer

The Fisher-open hypothesis states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. This means that if the interest rates in one country increase, the value of its currency should appreciate relative to the currency of the other country with lower interest rates. Therefore, choice A) is the correct answer.

Question 2

Consider the price elasticity of demand. If a product has price elasticity less than one, it is considered to have relatively elastic demand.

Accepted Answer

If a product has price elasticity less than one, it is considered to have relatively inelastic demand, not relatively elastic demand. Relatively elastic demand refers to a product with a price elasticity greater than one.

Question 3

The forward rate is calculated from all the following observable data items EXCEPT:

Accepted Answer

The forward rate is calculated using the spot exchange rate, the home currency deposit rate, and the foreign currency deposit rate. It does not rely on forecasts of the future spot exchange rate, which are speculative and not directly used in the calculation.

Question 4

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as:

Accepted Answer

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher Effect. It suggests that the real interest rates across countries should be equalized due to the movements in the spot exchange rate. This relationship is used to forecast future spot exchange rates.

Question 5

A ________ is an exchange rate quoted today for settlement at some time in the future.

Accepted Answer

A forward rate is an exchange rate quoted today for settlement at some time in the future. A spot rate, on the other hand, is an exchange rate quoted for immediate settlement. Currency rate and yield curve are not relevant to the context of the question.

Question 6

The Big Mac is considered a good candidate for the application of the law of one price and measurement of under- or overvaluation of a currency. Develop an argument as to why this is a good idea.

Accepted Answer

The answer of The Big Mac is considered a good...

Question 7

The theory of ________ states that the difference in the national interest rates for securities of similar risk and maturity should be equal to but opposite in sign to the forward rate discount or premium for the foreign currency, except for transaction costs.

Accepted Answer

The theory described in the question is known as the interest rate parity. The international Fisher Effect describes the relationship between expected changes in exchange rates and nominal interest rate differentials. Absolute PPP states that the price of a basket of goods should be the same across different countries once adjusted for exchange rates. The law of one price states that identical goods should have the same price in different markets after accounting for transportation and transaction costs.

Question 8

In its approximate form the Fisher effect may be written as ________, where i = the nominal rate of interest, r = the real rate of return and ? = the expected rate of inflation.

Accepted Answer

The Fisher effect in its approximate form is i = r + ?. This equation states that the nominal rate of interest (i) is equal to the real rate of return (r) plus the expected rate of inflation (?). This means that if inflation is expected to be 2%, the nominal rate of interest would need to be at least 2% higher than the real rate of return in order for investors to earn a positive real rate of return. Choice A is incorrect because it only includes the expected rate of inflation without the real rate of return. Choice B is incorrect because it adds the real rate of return twice. Choice D is incorrect because it includes twice the expected rate of inflation.

Question 9

Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.80% and a real rate of interest of 2.00%. Using the Fisher Effect Equation, what is the exact expected rate of inflation in the U.S. over the next year?

Accepted Answer

The Fisher Effect Equation is: (1 + nominal rate) = (1 + real rate) * (1 + inflation rate). Solving for the inflation rate: (1 + 0.038) = (1 + 0.02) * (1 + inflation rate), which gives an inflation rate of approximately 1.76%.

Question 10

The authors state that empirical tests of purchasing power parity "have, for the most part, not proved PPP to be accurate in predicting future exchange rates." The authors then state that PPP does hold up reasonably well in two situations. What are some reasons why PPP does not accurately predict future exchange rates, and under what conditions might we reasonably expect PPP to hold?

Accepted Answer

The answer of The authors state that empirical tests of...

Question 11

Explain the logic behind the application of the PPP theory to explain changes in the spot exchange rate.

Accepted Answer

The answer of Explain the logic behind the application of...

Question 12

The assumptions for relative PPP are more rigid than the assumptions for absolute PPP.

Accepted Answer

Relative PPP has less rigid assumptions than absolute PPP, as it only requires that the rate of change in prices between two countries is reflected in the exchange rate, rather than the absolute price levels.

Question 13

________ states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

Accepted Answer

The statement in the question refers to the Fisher Effect, which explains the relationship between nominal interest rates, real interest rates, and expected inflation. The Fisher Effect states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.

Question 14

According to the international Fisher Effect, if an investor purchases a five-year U.S. bond that has an annual interest rate of 5% rather than a comparable British bond that has an annual interest rate of 6%, then the investor must be expecting the ________ to ________ at a rate of at least 1% per year over the next 5 years.

Accepted Answer

The international Fisher Effect suggests that the currency of the country with the lower interest rate (in this case, the U.S. dollar) is expected to appreciate relative to the currency of the country with the higher interest rate (the British pound) to offset the interest rate differential.

Question 15

Assume the current U.S. dollar-British spot rate is £0.6993/$. If the current nominal one-year interest rate in the U.S. is 5% and the comparable rate in Britain is 6%, what is the approximate forward exchange rate for 360 days?

Accepted Answer

The formula for calculating the approximate forward exchange rate is:

Forward Rate = Spot Rate × (1 + Home Interest Rate) ÷ (1 + Foreign Interest Rate)

In this case, the forward rate would be:

Forward Rate = £0.6993/$ × (1 + 0.05) ÷ (1 + 0.06) = £0.7060/$

Therefore, the answer is D: £0.7060/$.

Question 16

With covered interest arbitrage:

Accepted Answer

Covered interest arbitrage involves a "riskless" profit from discrepancies in interest rates between two currencies, requiring the market to be out of equilibrium. It involves trading in both the spot and future (or forward) currency exchange markets to hedge against exchange rate risk, making all the given statements correct.

Question 17

Empirical tests prove that PPP is an accurate predictor of future exchange rates.

Accepted Answer

Empirical tests have shown that PPP is not always an accurate predictor of future exchange rates. There are several factors that can cause deviations from PPP, such as transaction costs, differences in inflation rates, and political instability, among others. Therefore, investors should not rely solely on PPP to make investment decisions in the foreign exchange market.

Question 18

Assume a nominal interest rate on one-year U.S. Treasury Bills of 2.60% and a real rate of interest of 1.00%. Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the U.S. over the next year?

Accepted Answer

The Fisher Effect Equation is: nominal interest rate ≈ real interest rate + expected inflation rate. Therefore, 2.60% ≈ 1.00% + expected inflation rate, which gives an expected inflation rate of approximately 1.60%.

Question 19

Assume the current U.S. dollar-yen spot rate is ¥90/$. Further, the current nominal 180-day rate of return in Japan is 1% and 2% in the United States. What is the approximate forward exchange rate for 180 days?

Accepted Answer

Using the formula: 
Forward rate = Spot rate × [(1+domestic rate)/(1+foreign rate)]^(time period/360)
We get, 
Forward rate = ¥90/$ × [(1+0.02)/(1+0.01)]^(180/360)
Forward rate = ¥90/$ × 0.994974
Forward rate = ¥ 89.55/$
Therefore, the approximate forward exchange rate for 180 days is ¥89.55/$. Option B is the correct answer.

Question 20

The current U.S. dollar-yen spot rate is ¥125/$. If the 90-day forward exchange rate is ¥127/$ then the yen is selling at a per annum ________ of ________.

Accepted Answer

The yen is selling at a discount because the forward rate (¥127/$) is higher than the spot rate (¥125/$). The annualized discount is calculated as ((127 - 125) / 125) * (360/90) * 100% = 6.30%.

Quiz 6: International Parity Conditions