Question 1

The authors describe an application of uncovered interest arbitrage (UIA)known as "yen carry trade." Define UIA and describe the example of yen carry trade. Why would an investor engage in the practice of yen carry trade and is there any risk of loss or lesser profit from this investment strategy?

Accepted Answer

The answer of The authors describe an application of uncovered...

Question 2

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 answer of The current U.S. dollar-yen spot rate is...

Question 3

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 situation where a small change in price leads to a large change in demand.

Question 4

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 of interest rate parity states that the difference between 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. This concept plays a key role in determining exchange rates and can be used for currency trading and risk management.

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 that is quoted today but is settled at a future date. A spot rate, on the other hand, is an exchange rate that is applied immediately upon a transaction. Currency rate is a broad term that refers to any exchange rate between two currencies. The yield curve is the relationship between the interest rates and the maturity dates of a set of bonds.

Question 6

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 in its approximate form is given by i = r + π, which means that the nominal rate of interest (i) equals the real rate of return (r) plus the expected rate of inflation (π). Option C is the only one that matches this equation. Option A is incorrect because it only considers the effect of inflation on the nominal rate of interest, while ignoring the real rate of return. Option B and D are incorrect because they add an extra term of (r)(π), which is not part of the Fisher effect equation in its approximate form.

Question 7

Assume the current U.S. dollar-yen spot rate is 125¥/$. Further, the current nominal 180-day rate of return in Japan is 3% and 4% in the United States. What is the approximate forward exchange rate for 180 days?

Accepted Answer

The formula for the approximate forward exchange rate is:

Forward exchange rate = Spot rate x (1 + foreign interest rate / 1 + domestic interest rate)^time

Plugging in the given values, we get:

Forward exchange rate = 125¥/$ x (1 + 0.03 / 1 + 0.04)^0.5

Forward exchange rate = 124.39¥/$ (rounded to two decimal places)

Therefore, the best choice is C, as it is the closest option to the calculated value.

Question 8

Assume a nominal interest rate on one-year U.S. Treasury Bills of 4.60% and a real rate of interest of 2.50%. 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, expected inflation = nominal rate - real rate = 4.60% - 2.50% = 2.10%.

Question 9

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 10

________ 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 statement given in the question refers to the Fisher-open hypothesis, which states that the spot exchange rate should adjust to reflect the differential in interest rates between two countries. Specifically, if one country has a higher interest rate than another, its currency should depreciate in the spot market to compensate for the higher return available to investors in the other country. This effect is called interest rate parity, which is a fundamental concept in international finance. The Fisher Effect is related to the Fisher-open hypothesis but refers to the relationship between nominal interest rates, expected inflation, and real interest rates. None of the above options are sufficient to answer the question accurately, but the best choice is A.

Question 11

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

Accepted Answer

The answer of The assumptions for relative PPP are more...

Question 12

________ 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 is referring to the Fisher Effect, which states that nominal interest rates are equal to the required real rate of return plus compensation for expected inflation. The other options are not directly related to this concept. Absolute PPP refers to the idea that the same good should cost the same across countries, while relative PPP suggests that changes in exchange rates should reflect differences in inflation rates. The Law of One Price states that identical goods should have the same price in different markets.

Question 13

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 answer of Assume a nominal interest rate on one-year...

Question 14

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

Accepted Answer

Empirical tests have shown that PPP is not a consistently accurate predictor of future exchange rates. While it may hold in the long run, there are many factors that can impact exchange rates in the short term, making it an unreliable predictor.

Question 15

The Fisher Effect is a familiar economic theory in the domestic market. In words, define the Fisher Effect and explain why you think it is also appropriately applied to international markets.

Accepted Answer

The answer of The Fisher Effect is a familiar economic...

Question 16

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 17

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 difference in interest rates between two countries will be offset by an equal but opposite change in their exchange rates.

Question 18

Covered interest arbitrage moves the market ________ equilibrium because ________

Accepted Answer

Covered interest arbitrage involves buying a currency on the spot market and simultaneously selling in the forward market to take advantage of the interest rate differential between two currencies. This activity narrows the differential between the two and thus moves the market towards equilibrium.

Question 19

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 20

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...

Quiz 7: International Parity Conditions