Question 1

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 $55,000 which is the UK price multiplied by the current exchange rate of $2.01/£. Jaguar has committed to keeping the US price at $55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $2.15/£, 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 to a rate of $2.15/£, the value of the £27,363 price in USD will be $58,879.45 ($27,363 x 2.15). However, Jaguar has committed to keeping the US price at $55,000, which means they will receive fewer USD for each sale. To calculate the new pound amount received, we need to divide $55,000 by the new exchange rate of $2.15/£, which gives us £25,581.40 (rounded to the nearest penny). Therefore, the correct answer is B.

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

Comment: 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 relatively insignificant for most Western economies.

Question 3

Exchange rate pass-through may be defined as:

Accepted Answer

Exchange rate pass-through refers to the extent to which changes in the exchange rate of a currency affect the prices of goods and services in the trading partners of that currency. It is the degree to which the prices of imported and exported goods change as a result of exchange rate changes. Therefore, option B is the correct choice. Option A is incorrect because it refers to bid/ask spread, which is the difference between the buy and sell price in a currency exchange transaction. Option C is incorrect because PPP stands for Purchasing Power Parity, which is a theory that explains how exchange rates between currencies are determined by their relative purchasing power. Option D is incorrect because it refers to the practice of the UK government, which is not related to exchange rate pass-through.

Question 4

Phillips NV produces DVD players and exports them to the United States. Last year the exchange rate was $1.25/euro and Plillips 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 answer of Phillips NV produces DVD players and exports...

Question 5

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 is known as the International Fisher Effect, where changes in the spot exchange rate reflect differences in the nominal interest rates between two countries. This diffusion occurs due to similar inflationary conditions in different markets. The International Fisher Effect thus describes the relationship between the nominal interest rate, inflation expectations, and the spot exchange rate.

Question 6

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 $55,000 which is the UK price multiplied by the current exchange rate of $2.01/£. Jaguar has committed to keeping the US price at $55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $2.15/£, and Jaguar has not hedged against currency changes, what is the percentage margin the company will realize given the new exchange rate?

Accepted Answer

With the new exchange rate of $2.15/£, the UK price in pounds becomes $55,000 / 2.15 = £25,581.40. The margin is calculated as (Selling Price - Cost) / Selling Price = (£25,581.40 - £22,803) / £25,581.40 = 10.9%.

Question 7

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 interest rate parity theory states that the forward exchange rate should incorporate the difference in interest rates between two countries. Therefore, the currency of the country with higher interest rates should be selling at a forward discount to compensate for the higher interest rate. This relationship can be seen on a yield curve, where the country with a higher interest rate will have a higher yield, and the currency should be selling at a forward discount.

Question 8

Both covered and uncovered interest arbitrage are risky operations in the sense that even without default in the securities, the returns are unknown until all transactions are complete.

Accepted Answer

Comment: Only UIA is risky.

Question 9

________ 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 is known as the Fisher-open hypothesis, which 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. The Fisher Effect refers to the relationship between nominal interest rates, real interest rates, and inflation, while Fisher-closed is not a recognized term.

Question 10

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

Accepted Answer

Comment: The current U.S. dollar-yen spot rate is ¥125/$. If the 90-day forward exchange rate is ¥127/$ then the yen is at a forward discount.

Question 11

All that is required for a covered interest arbitrage profit is for interest rate parity to not hold.

Accepted Answer

Covered interest arbitrage involves exploiting differences in interest rates between two countries while covering the exchange rate risk. For this to be profitable, interest rate parity must not hold, meaning there is a difference between the implied forward exchange rate and the actual forward exchange rate.

Question 12

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 13

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 14

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 approximate form of the Fisher effect is i = r + π, which means that the nominal rate of interest (i) is equal to the real rate of return (r) plus the expected rate of inflation (π). This equation suggests that if the expected rate of inflation increases, then the nominal interest rate will increase by the same amount while the real rate of return remains constant. Choice C, which is i = r + π, is the only option that correctly represents the approximate form of the Fisher effect.

Question 15

Use interest rate parity to answer this question. A U.S. investor has a choice between a risk-free one-year U.S. security with an annual return of 4%, and a comparable British security with a return of 5%. If the spot rate is $1.43/£, the forward rate is $1.44/£, and there are no transaction costs, the investor should invest in the U.S. security.

Accepted Answer

According to interest rate parity, the expected return on a foreign security should equal the return on a domestic security after adjusting for exchange rate changes. In this case, the forward rate implies an expected depreciation of the pound, which would lower the return on the British security for the U.S. investor. Therefore, the investor should instead invest in the British security to take advantage of the higher return and potential exchange rate gains.

Question 16

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

Question 17

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 18

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 19

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

Accepted Answer

The Fisher Effect, which states that nominal interest rates adjust to changes in expected inflation, has been found to be more accurate in predicting short-term interest rates rather than long-term rates. This is because long-term rates are subject to other factors such as changes in economic growth, monetary policy, and global events.

Question 20

The price elasticity of demand for DVD players manufactured by Sony of Japan is greater than one. If the Japanese yen appreciates against the U.S. dollar by 10% and the price of the Sony DVD players in the U.S also rises by 10%, then other things equal, the total dollar sales revenues of Sony DVDs would:

Accepted Answer

The price elasticity of demand for Sony DVD players is greater than one, which means that a change in price will have a greater impact on the quantity demanded. If the price of the DVDs rises by 10% due to the appreciation of the Japanese yen, demand for the product in the US will decrease. As a result, the total dollar sales revenues of Sony DVDs will decline.

Quiz 7: International Parity Conditions