Question 1

Consider a bank dealer who faces the following spot rates and interest rates. What should he set his 1-year forward ask price at?

Accepted Answer

The answer of Consider a bank dealer who faces the...

Question 2

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

To find the real exchange rate, we need to use the formula:

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

Assuming that PPP initially held, the exchange rate would be 1 dollar = 1 pound.

Using the formula, we get:

Real exchange rate = 1 x (1.025 / 1.04) / (1 + 0.015)
Real exchange rate = 0.9710

Therefore, the real exchange rate is 0.9710.

Question 3

Consider a bank dealer who faces the following spot rates and interest rates. What should he set his 1-year forward bid price at?

Accepted Answer

The answer of Consider a bank dealer who faces the...

Question 4

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

The answer of If the interest rate in the U.S....

Question 5

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. He can then invest the €800,000 at 6% interest and convert it back to $1,024,710 at the forward rate. This would give him a profit of $24,710. However, if the spot rate is not $1.2471 = €1.00, then the currency dealer will not be able to make a profit from this arbitrage opportunity.

Question 6

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

Using the interest rate parity formula: Spot Rate = Forward Rate * (1 + Domestic Interest Rate) / (1 + Foreign Interest Rate). Plugging in the values: Spot Rate = 1.16 * (1 + 0.05) / (1 + 0.035) = 1.1434.

Question 7

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% and 3% in the euro zone. What is the one-year forward rate that should prevail?

Accepted Answer

We can use the formula for calculating the forward rate:
Forward rate = Spot rate x (1 + domestic interest rate) / (1 + foreign interest rate)
Here, domestic interest rate (in the euro zone) = 3% and foreign interest rate (in the U.S.) = 2%
Forward rate = €1.00 x (1 + 0.03) / (1 + 0.02) = €1.00 x 1.03 / 1.02 = €1.0303 / 1.02 = €1.0098
Converting this to dollars using the spot exchange rate:
Forward rate = €1.00 = $1.5845 (rounded to four decimal places)

Therefore, the best choice is C.

Question 8

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

Accepted Answer

Both options (a) and (c) are potential reasons why the interest rate parity (IRP) may not hold precisely all the time. Transaction costs, such as bid-ask spreads, can impact exchange rates and interest rates and create discrepancies from IRP. Capital controls imposed by governments can limit or restrict the movement of capital across borders, which can also create deviations from IRP. Asymmetric information is also a potential factor that can impact exchange rates and interest rates, but it is not directly related to IRP. Therefore, option D is the best choice.

Question 9

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

Real exchange rate = Nominal exchange rate x (1 + inflation rate of domestic country) / (1 + inflation rate of foreign country)

Initially, assuming PPP held, the nominal exchange rate would be 1.

Real exchange rate = 1 x (1 + 0.055) / (1 + 0.04) = 0.9849

With the depreciation of the dollar against the pound by 3 percent, the new nominal exchange rate would be 1 / 0.97 = 1.0309.

Real exchange rate = 1.0309 x (1 + 0.055) / (1 + 0.04) = 1.007

The change in real exchange rate would be 1.007 - 0.9849 = 0.0221 or 2.21%. However, since the dollar has depreciated, the answer would be negative, giving us a real exchange rate change of -2.21% or -0.0221.

Question 10

Purchasing Power Parity (PPP) theory states that

Accepted Answer

PPP theory suggests that exchange rates should adjust to equalize the price of identical goods and services in different countries (A). It also implies that currencies experiencing high inflation will depreciate against more stable currencies (B).

Question 11

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% and 3% in the euro zone. What is the one-year forward rate that should prevail?

Accepted Answer

The forward rate can be calculated using the formula: Forward Rate = Spot Rate * (1 + Inflation Rate of Domestic Currency) / (1 + Inflation Rate of Foreign Currency). Here, the domestic currency is the euro, and the foreign currency is the dollar. So, Forward Rate = 1.25 * (1 + 0.02) / (1 + 0.03) = 1.2379.

Question 12

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. The Big Mac Index, which is published by The Economist, tracks the average price of a Big Mac in different countries and uses it to measure currency exchange rates and purchasing power parity (PPP). While the price of a Big Mac may give some indication of PPP, it is not exactly the same across all the countries that McDonald's does business in.

Question 13

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 (Purchasing Power Parity) holds when the prices of a standard basket of goods are equalized across countries in a common currency, and this requires both the prices of individual commodities to be equalized and the composition of the basket to be the same across countries.

Question 14

Will an arbitrageur facing the following prices be able to make money?

Accepted Answer

The answer of Will an arbitrageur facing the following prices...

Question 15

Some commodities never enter into international trade. Examples include

Accepted Answer

All of the above - Nontradables, such as haircuts and housing, do not enter into international trade as they are only consumed locally and cannot be transported easily.

Question 16

Will an arbitrageur facing the following prices be able to make money?

Accepted Answer

Option B involves borrowing USD at a rate of 4.2% and exchanging it for EUR at an ask rate of $1.43/€. The EUR can then be invested at a rate of 3.5%. The investor can hedge against currency risk by entering into a SHORT position in a forward contract to sell EUR for USD at a rate of $1.44/€ in one year. This strategy results in a small profit of approximately $237.76 after one year. Option A involves borrowing EUR at a rate of 3.65%, but the bid spot exchange rate for EUR/USD is used, resulting in a lower exchange rate of $1.40/€. Option C's intimation of high transaction costs is not relevant to the information provided. Therefore, the best choice is option B.

Question 17

Generally unfavorable evidence on PPP suggests that

Accepted Answer

Substantial barriers to international commodity arbitrage, tariffs and quotas imposed on international trade, and shipping costs can all contribute to the unfavorable evidence on PPP.

Question 18

If a foreign county experiences a hyperinflation,

Accepted Answer

Hyperinflation is often accompanied by a loss of confidence in the currency and a decrease in its value. As a result, the currency is likely to depreciate against stable currencies.

Question 19

If IRP fails to hold

Accepted Answer

Pressure from arbitrageurs can bring exchange rates and interest rates back into line if IRP fails to hold due to market inefficiencies, but it may fail to hold due to transactions costs or government-imposed capital controls. Therefore, all the options given are correct.

Question 20

A higher U.S. interest rate (i_$ ↑) will result in

Accepted Answer

A higher U.S. interest rate will attract more foreign investment, which in turn increases demand for U.S. dollars, leading to a stronger dollar.

Quiz 6: International Parity Relationships and Forecasting Foreign Exchange Rates

Consider a bank dealer who faces the following spot rates and interest rates. What should he set his 1-year forward ask price at?

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 _____.

Consider a bank dealer who faces the following spot rates and interest rates. What should he set his 1-year forward bid price at?

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

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?

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% and 3% in the euro zone. What is the one-year forward rate that should prevail?

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

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

Purchasing Power Parity (PPP) theory states that

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% and 3% in the euro zone. What is the one-year forward rate that should prevail?

The price of a McDonald's Big Mac sandwich

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

Will an arbitrageur facing the following prices be able to make money?

Some commodities never enter into international trade. Examples include

Will an arbitrageur facing the following prices be able to make money?

Generally unfavorable evidence on PPP suggests that

If a foreign county experiences a hyperinflation,

If IRP fails to hold

A higher U.S. interest rate (i$ ↑) 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

A higher U.S. interest rate (i_$ ↑) will result in