Question 1

The price of a McDonald's Big Mac sandwich

Accepted Answer

The price of a Big Mac sandwich varies considerably across the world in dollar terms, depending on factors such as local input costs and exchange rates. It is not the same in all countries, nor does it necessarily support purchasing power parity (PPP) in those countries.

Question 2

Purchasing Power Parity (PPP)theory states that

Accepted Answer

The Purchasing Power Parity (PPP) theory encompasses both the idea that the exchange rate between two countries' currencies should reflect the ratio of the countries' price levels (A) and that a currency experiencing hyperinflation will depreciate against more stable currencies (B). Therefore, D is the correct choice as it combines both essential aspects of PPP theory.

Question 3

Generally unfavorable evidence on PPP suggests that

Accepted Answer

All of the given options contribute to the unfavorable evidence on PPP. Substantial barriers, tariffs and quotas, and shipping costs can all make it challenging to achieve perfect arbitrage and lead to deviations from the theory of PPP.

Question 4

If a foreign county experiences a hyperinflation,

Accepted Answer

During a hyperinflation, the value of the currency in the affected country decreases rapidly, which means that it will depreciate against stable currencies. This is because the excessive amount of currency in circulation leads to a decrease in demand for that currency, eventually resulting in a drop in its value. As a result, the currency of the affected country may experience a significant depreciation against stable currencies such as the US dollar or the euro.

Question 5

If the annual inflation rate is 2.5 percent in the United States and 4 percent in the U.K.,and the dollar appreciated against the pound by 1.5 percent,then the real exchange rate,assuming that PPP initially held,is ________.

Accepted Answer

The real exchange rate formula is:

Real Exchange Rate = Nominal Exchange Rate * (1 + Domestic Inflation) / (1 + Foreign Inflation)

Given: 
- Domestic inflation (U.S.) = 2.5%
- Foreign inflation (U.K.) = 4%
- Nominal exchange rate (dollars per pound) appreciated by 1.5%

Using the formula:

Real Exchange Rate = (Nominal Exchange Rate * (1 + Domestic Inflation)) / (1 + Foreign Inflation)

Real Exchange Rate = ((1 + 0.015) * 1) * (1 + 0.025) / (1 + 0.04) = 0.9710

Therefore, the real exchange rate is 0.9710, which means that the dollar has depreciated in real terms against the pound.

Question 6

Although IRP tends to hold,it may not hold precisely all the time

Accepted Answer

Both transaction costs and capital controls can affect the ability of investors to take advantage of interest rate differentials between two countries, thereby weakening or even breaking the relationship between the spot exchange rate and the interest rate differential. Therefore, IRP may not hold precisely due to both transaction costs and capital controls.

Question 7

Will an arbitrageur facing the following prices be able to make money? $$\begin{array} { c c c c c } 
& \text { Borrowing } & \text { Lending } & \text { Bid } & \text { Ask } \
€ & 5 \% & 4.5 \% & \text { Spot } \$ 1.00 = € 1.00 & \$ 1.01 = € 1.00 \
€ & 6 \% & 5.5 \% & \text { Forward } \$ 0.99 = € 1.00 & \$ 1.00 = € 1.00
\end{array}$$

Accepted Answer

The arbitrage opportunities are negated by the transaction costs and interest rate differentials, making it unprofitable.

Question 8

Will an arbitrageur facing the following prices be able to make money? $\begin{array}{rcccccc}
\hline & \text { Bid } & \text { Ask } & & \text { Borrowing } & \text { Lending } \
F_{0}(\$ / €) & \$ 1.40-€ 1.00 & \$ 1.43-€ 1.00 & & i \$ 4.20 \% \mathrm{APR} & 4.10 \% \mathrm{APR} \
F_{36}(\$) & \$ 1.44-€ 1.00 & \$ 1.49-€ 1.00 & & i €  3.65 \% \mathrm{APR} & 3.50 \% \mathrm{APR}
\end{array}$

Accepted Answer

The arbitrageur can borrow $1,000,000 at 4.2% and exchange it for €699,300.70 at the spot ask exchange rate of $1.43 = €1.00. They can invest this amount at 3.5% and hedge the investment by going SHORT in a forward contract to sell € at the BID price of $1.44/€. The cash flow in one year will be:

€699,300.70 x (1 + 3.5%) = €723,768.91
Sell €723,768.91 at $1.44/€ = $1,041,439.84
Repay the $1,000,000 loan + interest = $1,000,000 x (1 + 4.2%) = $1,042,000
Cash flow = $1,041,439.84 - $1,042,000 = -$560.16

This gives a negative cash flow of $560.16, which means the arbitrageur would have to pay this amount out of pocket. Therefore, there is no arbitrage opportunity. Option A is incorrect because it suggests borrowing euros at a higher rate than investing dollars, which would result in a negative cash flow. Option C is incorrect because there is no mention of transaction costs. Option D is incorrect because option B provides a specific strategy that can be followed.

Question 9

Some commodities never enter into international trade.Examples include

Accepted Answer

All of the options listed are examples of commodities that do not enter into international trade. Nontradables, by definition, are goods and services that are not traded internationally. Haircuts and housing are also considered nontradables as they are typically produced and consumed locally.

Question 10

Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany,and the one-year forward exchange rate is $1.16/€.What must the spot exchange rate be?

Accepted Answer

To find the spot exchange rate, we need to apply the interest rate parity formula:
(1 + US interest rate) = (1 + German interest rate) x (forward exchange rate / spot exchange rate)
Substituting the given values:
(1.05) = (1.035) x (1.16 / spot exchange rate)
Solving for the spot exchange rate:
spot exchange rate = 1.1434/€ (rounded to four decimal places)

Question 11

A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year.The one-year interest rate in the U.S.is i_$ = 2% and in the euro zone the one-year interest rate is i_€ = 6%.The one-year forward exchange rate is $1.20 = €1.00; what must the spot rate be to eliminate arbitrage opportunities?

Accepted Answer

The correct answer is A because the spot rate must be $1.2471 = €1.00 to eliminate arbitrage opportunities. This is because the currency dealer can borrow $1,000,000 at 2% interest and convert it to €800,000 at the spot rate of $1.2471 = €1.00. The dealer can then invest the €800,000 in the euro zone at 6% interest and earn a profit of €48,000.

Question 12

A higher U.S.interest rate (i_$ ↑)relative to interest rates abroad,ceteris paribus,will result in

Accepted Answer

An increase in the U.S. interest rate relative to interest rates abroad will attract capital flows into the U.S., leading to a higher demand for U.S. dollars and thus a stronger dollar.

Question 13

As of today,the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

Accepted Answer

The formula for calculating the one-year forward rate is:
Forward rate = spot rate x (1 + foreign interest rate) / (1 + domestic interest rate)
Using the information provided in the question, we can calculate the forward rate as:
Forward rate = €1.00 x (1 + 0.03) / (1 + 0.02) = €1.03 / $1.02 = €1.0098 = $0.9903 (rounded to four decimal places)
However, the question asks for the euro to dollar exchange rate, so we need to invert the result to get:
€1.00 = $1.25
€1.0098 = $1.25 * 0.9903 / 1.00 = $1.2379 (rounded to four decimal places) 
Therefore, the correct answer is A.

Question 14

The interest rate at which the arbitrager borrows tends to be higher than the rate at which he lends,reflecting the

Accepted Answer

The bid-ask spread represents the difference between the price at which an asset can be bought and sold. In this case, the arbitrager is borrowing at a higher interest rate than he is lending, which would result in a negative spread, as he would need to make up for the difference in interest rates in order to make a profit. Therefore, the answer is C, the bid-ask spread.

Question 15

Governments sometimes restrict capital flows,inbound and/or outbound.They achieve this objective by means of

Accepted Answer

The answer of Governments sometimes restrict capital flows,inbound and/or outbound.They...

Question 16

In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket,

Accepted Answer

PPP states that the prices of a standard commodity basket should be equalized across countries after converting currencies. This can happen in two ways: either by having identical prices of individual commodities in a common currency or by having different prices in different currencies but with exchange rates adjusted to reflect these differences. Therefore, PPP will hold if the prices of the constituent commodities are equalized across countries in a given currency or if the composition of the consumption basket is the same across countries. Option A and B are incorrect as they only consider one of the two ways PPP can hold.

Question 17

As of today,the spot exchange rate is €1.00 = $1.60 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

Accepted Answer

The answer of As of today,the spot exchange rate is...

Question 18

If the interest rate in the U.S.is i_$ = 5 percent for the next year and interest rate in the U.K.is i_£ = 8 percent for the next year,uncovered IRP suggests that

Accepted Answer

Uncovered Interest Rate Parity (IRP) suggests that the currency in the country with a higher interest rate (in this case, the U.K. with 8%) is expected to depreciate against the currency in the country with a lower interest rate (the U.S. with 5%). This depreciation is expected to be approximately the difference in the interest rates, which is 3%. Therefore, the pound is expected to depreciate against the dollar by about 3%, and conversely, the dollar is expected to appreciate against the pound by about 3%.

Question 19

If IRP fails to hold,

Accepted Answer

All of the options are potential reasons for the failure of the Interest Rate Parity (IRP) to hold. While pressure from arbitrageurs can help to correct deviations from the IRP, there may be cases where large transactions costs prevent this from happening effectively. Additionally, government-imposed capital controls can restrict the movement of capital and disrupt the relationship between exchange rates and interest rates.

Question 20

If the annual inflation rate is 5.5 percent in the United States and 4 percent in the U.K.,and the dollar depreciated against the pound by 3 percent,then the real exchange rate,assuming that PPP initially held,is

Accepted Answer

The formula for calculating the real exchange rate is:

Real exchange rate = (Nominal exchange rate x Domestic price level) / Foreign price level

Assuming PPP initially held, the nominal exchange rate would be equal to the ratio of the U.S. and U.K. price levels:

Nominal exchange rate = U.S. price level / U.K. price level
Nominal exchange rate = (100 + 5.5) / (100 + 4)
Nominal exchange rate = 1.0573

With the dollar depreciating against the pound by 3 percent, the new nominal exchange rate would be:

New nominal exchange rate = 1.0573 x (1 - 0.03)
New nominal exchange rate = 1.0246

Plugging in the numbers, we get:

Real exchange rate = (1.0246 x 100) / (100 + 4)
Real exchange rate = 98.49%

Converting to decimal form, we get:

Real exchange rate = 0.9849

Therefore, the best choice is B.

Quiz 6: International Parity Relationships and Forecasting Foreign Exchange Rates

The price of a McDonald's Big Mac sandwich

Purchasing Power Parity (PPP) theory states that

Generally unfavorable evidence on PPP suggests that

If a foreign county experiences a hyperinflation,

If the annual inflation rate is 2.5 percent in the United States and 4 percent in the U.K.,and the dollar appreciated against the pound by 1.5 percent,then the real exchange rate,assuming that PPP initially held,is ________.

Although IRP tends to hold,it may not hold precisely all the time

Some commodities never enter into international trade.Examples include

Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany,and the one-year forward exchange rate is $1.16/€.What must the spot exchange rate be?

A higher U.S.interest rate (i_$ ↑) relative to interest rates abroad,ceteris paribus,will result in

As of today,the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

The interest rate at which the arbitrager borrows tends to be higher than the rate at which he lends,reflecting the

Governments sometimes restrict capital flows,inbound and/or outbound.They achieve this objective by means of

In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket,

As of today,the spot exchange rate is €1.00 = $1.60 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

If the interest rate in the U.S.is i_$ = 5 percent for the next year and interest rate in the U.K.is i_£ = 8 percent for the next year,uncovered IRP suggests that

If IRP fails to hold,

If the annual inflation rate is 5.5 percent in the United States and 4 percent in the U.K.,and the dollar depreciated against the pound by 3 percent,then the real exchange rate,assuming that PPP initially held,is

Quiz 6: International Parity Relationships and Forecasting Foreign Exchange Rates

The price of a McDonald's Big Mac sandwich

Purchasing Power Parity (PPP) theory states that

Generally unfavorable evidence on PPP suggests that

If a foreign county experiences a hyperinflation,

If the annual inflation rate is 2.5 percent in the United States and 4 percent in the U.K.,and the dollar appreciated against the pound by 1.5 percent,then the real exchange rate,assuming that PPP initially held,is ________.

Although IRP tends to hold,it may not hold precisely all the time

Some commodities never enter into international trade.Examples include

Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany,and the one-year forward exchange rate is $1.16/€.What must the spot exchange rate be?

A higher U.S.interest rate (i$ ↑) relative to interest rates abroad,ceteris paribus,will result in

As of today,the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

The interest rate at which the arbitrager borrows tends to be higher than the rate at which he lends,reflecting the

Governments sometimes restrict capital flows,inbound and/or outbound.They achieve this objective by means of

In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket,

As of today,the spot exchange rate is €1.00 = $1.60 and the rates of inflation expected to prevail for the next year in the U.S.is 2 percent and 3 percent in the euro zone.What is the one-year forward rate that should prevail?

If the interest rate in the U.S.is i$ = 5 percent for the next year and interest rate in the U.K.is i£ = 8 percent for the next year,uncovered IRP suggests that

If IRP fails to hold,

If the annual inflation rate is 5.5 percent in the United States and 4 percent in the U.K.,and the dollar depreciated against the pound by 3 percent,then the real exchange rate,assuming that PPP initially held,is

A higher U.S.interest rate (i_$ ↑) relative to interest rates abroad,ceteris paribus,will result in

If the interest rate in the U.S.is i_$ = 5 percent for the next year and interest rate in the U.K.is i_£ = 8 percent for the next year,uncovered IRP suggests that