Answers to End of Chapter 8s Questions

1. PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar.

5. PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. hus, exchange rates will not move in perfect tandem with inflation differentials. In addition, there may not be substitutes for traded goods. herefore, even when a country!s inflation increases, the foreign demand for its products will not necessarily decrease "in the manner suggested by PPP# if substitutes are not available.

6.

he I$% suggests that a currency!s value will adjust in accordance with the differential in interest rates between two countries. he rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. hus, the inflation will place downward pressure on the currency!s value if it occurs. he implications are that a firm that consistently purchases foreign reasury bills will on average earn a similar return as on domestic reasury bills. he I$% may not hold because exchange rate movements react to other factors in addition to interest rate differentials. herefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that I$% may not hold.

7.

he I$% would suggest that the &.'. dollar will depreciate over time if &.'. interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased &.'. securities would on average receive a similar yield as what they receive in their own country, and &.'. investors that purchased foreign securities would on average receive a yield similar to &.'. rates.

'P()*+,- .ultinational /usiness $inance

8. Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium "or discount#. PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. I$% suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. I$% is based on nominal interest rate differentials, which are influenced by expected inflation. hus, the I$% is closely related to PPP.

11. he high %uropean inflation overall would reduce the &.'. demand for %uropean products, increase the %uropean demand for &.'. products, and cause the euro to depreciate against the dollar. 1ccording to the PPP theory, the euro2s value would adjust in response to the weighted inflation rates of the %uropean countries that are represented by the euro relative to the inflation in the &.'. If the %uropean inflation rises, while the &.'. inflation remains low, there would be downward pressure on the euro.

14. If investors from the &.'. and .exico required the same real "inflation3adjusted# return, then any difference in nominal interest rates is due to differences in expected inflation. hus, the inflation rate in .exico is expected to be about )+ percent above the &.'. inflation rate. 1ccording to PPP, the .exican peso should depreciate by the amount of the differential between &.'. and .exican inflation rates. &sing a )+ percent differential, the .exican peso should depreciate by about )+ percent. 4iven a )5 percent nominal interest rate in .exico and expected depreciation of the peso of )+ percent, &.'. investors will earn about 5 percent. " his answer used the inexact formula, since the concept is stressed here more than precision.#

15. 1ccording to the I$%, higher foreign interest rates should not attract investors because these rates imply high expected inflation rates, which in turn imply potential depreciation of these currencies. 6et, some investors still invest in foreign countries where nominal interest rates are high. his may suggest that some investors believe that "0# the anticipated inflation rate embedded in a high nominal interest rate is overestimated, or "*# the potentially high inflation will not cause substantial depreciation of the foreign currency "which could occur if adequate substitute products were not available elsewhere#, or "7# there are other factors that can offset the possible impact of inflation on the foreign currency!s value.

'P()*+,- .ultinational /usiness $inance

20. a. "8.09 : 8.*+#;8.*+ < :.+,, or :,= b. "0.+9#;"0.07# : 0 < 3.+7,7 or 37.,7=> the negative sign represents depreciation of the peso. c. ?ero percent change

21. a. 1s @ussian prices were increasing, the purchasing power of @ussian consumers was declining. his would encourage them to purchase goods in the &.'. and elsewhere, which results in a large supply of rubles for sale. 4iven the high @ussian inflation, foreign demand for rubles to purchase @ussian goods would be low. hus, the ruble!s value should depreciate against the dollar, and against other currencies.

b.

he general relationship suggested by PPP is supported, but the ruble!s value will not normally move exactly as specified by PPP. he political conditions that could restrict trade or currency convertibility can prevent @ussian consumers from shifting to foreign goods. hus, the ruble may not decline by the full degree to offset the inflation differential between @ussia and the &.'. $urthermore, the government may not allow the ruble to float freely to its proper equilibrium level.

c. @ussian prices might be higher than &.'. prices, even after considering exchange rates, because the ruble might not depreciate enough to fully offset the @ussian inflation. he exchange rate cannot fully adjust if there are barriers on trade or currency convertibility.

d. &.'. importers will likely experience higher prices, because the @ussian inflation may not be completely offset by the decline in the ruble!s value. his may cause a reduction in the &.'. demand for @ussian goods.

22. he investors2 behavior suggests that they did not expect the international $isher effect "I$%# to hold. 'ince central banks of some 1sian countries were maintaining their currencies within narrow bands, they were effectively preventing the exchange rate from depreciating in a manner that would offset the interest rate differential. Consequently, superior profits from investing in the foreign countries were possible. If investors believed in the I$%, the 1sian countries would not attract a high level of foreign investment because of exchange rate expectations. 'pecifically, the high nominal interest rate should reflect a high level of expected inflation. 1ccording to purchasing power parity "PPP#, the higher interest rate should result in a weaker currency because of the implied market expectations of high inflation.

'P()*+,- .ultinational /usiness $inance

26. a. 1ccording to interest rate parity, the forward premium is

"0 + .+*# 0 = .+A*A7 "0 + .0+#

b.

he forward rate is 8.0) B "0 : .+A*A7# < 8.0*95.

c. 1ccording to the I$%, the expected change in the peso is"0 + .+*# 0 = .+A*A7 "0 + .0+#

or :A.*A7=

d. 8.0) B "0 : .+A*A7# < 8.0*95 e. he answers are the same. Chen I@P holds, the forward rate premium and the expected percentage change in the spot rate are derived in the same manner. hus, the forward premium serves as the forecasted percentage change in the spot rate according to I$%.

32. '$ spot rate in 8 < 0.5+ B .7 < 8.,). %xpected = change in '$ in one year < "0.+0#;"0.+,# : 0 < :7.5= %xpected spot rate of '$ in one year < 8.,) B "0 : .+75# < 8,0.9)

40. %xpected change in 18 against &' 8 <"0.+A#;0.00 : 0 < 37.D= he EF 8 is tied to &.'. 8 so 18 should depreciate by 7.D= against EF 8. In one year, 18< EF87.9 x "0 3 .+7D# < EF87.A,9, 'o in 0 year, 180 million < EF87,A,9,,++.

'P()*+,- .ultinational /usiness $inance