Question 1

________ 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 refers to the Fisher effect, which states that nominal interest rates are equal to the real rate of return plus expected inflation. Therefore, the answer is D.

Question 2

The final component of the equation for the Fisher Effect, (r)(π), where r = the real rate of return and π = the expected rate of inflation, is often dropped from the equation because the number is simply too large for most Western economies.

Accepted Answer

The final component of the equation, (r)(π), is not dropped from the Fisher Effect equation because it is too large. This component is important in understanding the relationship between interest rates and inflation.

Question 3

Assume the current U.S. dollar-British spot rate is 0.6134£/$. If the current nominal one-year interest rate in the U.S. is 2.5% and the comparable rate in Britain is 3.5%, what is the approximate forward exchange rate for 360 days?

Accepted Answer

Using the interest rate parity formula (1 + Sf/d)/(1+St/d) = (1+rd)/(1+rt), where Sf/d is the forward exchange rate, St/d is the spot exchange rate, rd is the domestic interest rate, and rt is the foreign interest rate:

(1 + Sf/360)/(1 + 0.6134) = (1 + 0.025)/(1 + 0.035)
Solving for Sf, we get:
Sf = 0.6194£/$ (rounded to 4 decimal places)

Therefore, the approximate forward exchange rate for 360 days is 0.6194£/$, which is answer choice D.

Question 4

Incomplete exchange rate pass-through refers to

Accepted Answer

Incomplete exchange rate pass-through refers to the phenomenon where changes in the exchange rate do not lead to proportional changes in the prices of imports and exports. Therefore, option B is the correct choice as it describes this phenomenon accurately. The other options are not reflective of incomplete exchange rate pass-through.

Question 5

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 π = the expected rate of inflation.

Accepted Answer

The Fisher effect can be written as i = r + π, where the nominal rate of interest (i) is equal to the real rate of return (r) plus the expected rate of inflation (π). This is the approximate form of the equation and is the most commonly used version.

Question 6

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 given theory is known as interest rate parity, which states that the difference between the interest rates of two countries should be equal to but opposite in sign to the forward rate premium or discount for the foreign currency. This theory is based on the assumption of no transaction costs.

Question 7

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 8

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. Relatively elastic demand occurs when the price elasticity of demand is greater than one.

Question 9

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 described in the question is known as the International Fisher Effect. This theory suggests that the percentage change in a currency's spot exchange rate over time will be approximately equal to the difference between the national interest rates of two countries. This is based on the idea that investors will seek to earn higher returns on their investments, thus causing a currency with a higher interest rate to appreciate relative to a currency with a lower interest rate.

Question 10

The current U.S. dollar-yen spot rate is 85¥/$. If the 90-day forward exchange rate is 88 ¥/$ then the yen is at a forward premium.

Accepted Answer

A forward premium occurs when the forward exchange rate is higher than the spot rate for the base currency. In this case, the yen is at a forward discount because the forward rate (88 ¥/$) is higher than the spot rate (85 ¥/$), indicating the dollar is expected to strengthen against the yen.

Question 11

Empirical studies show that the Fisher Effect works best for short-term securities.

Accepted Answer

Empirical studies have found that the Fisher Effect, which links inflation and nominal interest rates, tends to hold true for short-term securities but may not apply as well to longer-term investments.

Question 12

The current U.S. dollar-yen spot rate is 85¥/$. If the 90-day forward exchange rate is 88 ¥/$ then the yen is selling at a per annum ________ of ________.

Accepted Answer

The yen is selling at a discount because the forward rate (88 ¥/$) is higher than the spot rate (85 ¥/$). The annualized discount rate is calculated as [(Forward Rate - Spot Rate) / Spot Rate] * (360/90) * 100%, which equals 13.64%.

Question 13

The premium or discount on forward currency exchange rates between any two countries is visually obvious when you plot the interest rates of each country on the same yield curve. The currency of the country with the higher yield curve should be selling at a forward discount.

Accepted Answer

This statement is true. The premium or discount on forward currency exchange rates between two countries is influenced by the difference in interest rates between the two countries. If one country has a higher yield curve, its currency is likely to sell at a forward discount because investors will demand a higher return to compensate for the higher risk associated with that currency. This relationship is visible when you plot the yield curves of each country on the same graph.

Question 14

The government just released international exchange rate statistics and reported that the real effective exchange rate index for the U.S. dollar vs the Japanese yen decreased from 105 last year to 95 currently and is expected to fall still further in the coming year. Other things equal U.S. ________ to/from Japan think this is good news and U.S. ________ to/from Japan think this is bad news.

Accepted Answer

A decrease in the real effective exchange rate index for the U.S. dollar vs. the Japanese yen means that the U.S. dollar has depreciated relative to the yen. This makes U.S. goods cheaper for Japanese consumers and businesses, benefiting U.S. exporters. Conversely, it makes Japanese goods more expensive for U.S. consumers and businesses, which is bad news for U.S. importers.

Question 15

Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.10% 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 states that the nominal interest rate is approximately the sum of the real interest rate and the expected inflation rate. Therefore, the expected inflation rate is approximately 3.10% - 1.00% = 2.10%.

Question 16

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

According to the Fisher Effect Equation: 
Nominal interest rate = Real interest rate + Expected inflation rate

Plugging in the given nominal and real interest rates, we get:
3.80% = 2.00% + Expected inflation rate

Solving for the expected inflation rate, we get:
Expected inflation rate = 3.80% - 2.00% = 1.80%

Therefore, the best choice is B.

Question 17

Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the US for $44,600 which is the UK price multiplied by the current exchange rate of $1.63/£. Jaguar has committed to keeping the US price at $44,600 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $1.75/£, and Jaguar has not hedged against currency changes, what is the amount the company will receive in pounds at the new exchange rate?

Accepted Answer

If the UK pound appreciates against the USD to an exchange rate of $1.75/£, then the US price of $44,600 is equivalent to £25,485.71 (£44,600 / $1.75 per £). This is the amount Jaguar will receive in pounds at the new exchange rate.

Question 18

Exchange rate pass-through may be defined as

Accepted Answer

Exchange rate pass-through refers to the degree to which the prices of imported and exported goods change in response to changes in exchange rates. A refers to bid/ask spread on currency exchange transactions, C refers to purchasing power parity (PPP) of lesser-developed countries and D refers to the currency regime adopted by Great Britain.

Question 19

Phillips NV produces DVD players and exports them to the United States. Last year the exchange rate was $1.25/euro and Phillips charged 120 euro per player in Euroland and $150 per DVD player in the United States. Currently the spot exchange rate is $1.45/euro and Phillips is charging $160 per DVD player. What is the degree of pass through by Phillips NV on their DVD players?

Accepted Answer

The degree of pass through is calculated as the percentage change in the price in the importing country divided by the percentage change in the exchange rate.

Percentage change in price in the importing country = [(new price - old price)/old price] x 100
= [(160-150)/150] x 100
= 6.67%

Percentage change in exchange rate = [(new rate - old rate)/old rate] x 100
= [(1.45-1.25)/1.25] x 100
= 16%

Degree of pass through = [percentage change in price in the importing country / percentage change in exchange rate] x 100
= [6.67 / 16] x 100
= 41.7%

Therefore, the answer is C (41.7%).

Question 20

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 is the exchange rate quoted for immediate settlement. Currency rate is a general term that may refer to either spot or forward exchange rates. Yield curve is a term used in finance to describe the relationship between bond yields and maturities.

Quiz 6: International Parity Conditions