File: Chapter 005 International Parity Relationships and Forecasting Foreign Exchange Rates

Multiple Choice

[Question]
1. Interest Rate Parity (IRP) is best defined as:
a. When a government brings its domestic interest rate in line with other major financial markets
b. When the central bank of a country brings its domestic interest rate in line with its major
trading partners
c. A zero arbitrage condition that must hold when international financial markets are in
equilibrium
d. None of these
Answer: c
page: 96
Level: medium

[Question]
2. When Interest Rate Parity (IRP) holds between two different countries X and Y, your decision
to invest your money will:
a. be indifferent between country X and country Y
b. involve forward hedging
c. depend on which country initiated the IRP
d. a and b
Answer: d
page: 97
Level: medium

[Question]
3. When Interest Rate Parity (IRP) does not hold
a. there is a high degree of inflation
b. the financial markets are in equilibrium
c. there are opportunities for covered interest arbitrage
d. b and c
Answer: c
page: 98 - 99
Level: easy

[Question]
4. Covered Interest Arbitrage (CIA) activities will result in
a. unstable international financial markets
b. restoring equilibrium quite quickly
c. disintermediation
d. no changes in the markets
Answer: b
page:98
Level: medium

[Question]
5. Uncovered interest rate parity
a. is an arbitrage condition
b. holds most of the time
c. is based on expectations
d. will provide guaranteed but small profits
Answer: c
page: 101
Level: medium

[Question]
6. Deviations from interest rate parity exist for all of the following reasons except:
a. transaction costs
b. spreads
c. interest rate differentials
d. capital controls
Answer: c
page: 101-102
Level: hard

[Question]
7. Purchasing Power Parity (PPP) theory states that:
a. The exchange rate between currencies of two countries should be equal to the ratio of the
countries’ price levels.
b. As the purchasing power of a currency sharply declines (due to hyperinflation) that currency
will depreciate against stable currencies.
c. The prices of standard commodity baskets in two countries are not related.
d. a and b.
Answer: d
page: 103- 104
Level: medium

[Question]
8. Which statement about real exchange rates is not true?
a. Real exchange rate changes are caused by changes in nominal exchange rates
b. Real exchange rates measure deviations from PPP
c. Real exchange rates are always unity
d. Real exchange rates affect the international competitive positions of countries
Answer: c
page: 106
Level: medium

[Question]
9. Germany has a higher rate of inflation than Japan. The nominal exchange rate is constant.
a. Germany experiences an increase in its real exchange rate
b. Germany experiences a decrease in its real exchange rate
c. Japan experiences an increase in its real exchange rate
d. German goods are cheaper now
Answer: a
page: 108
Level: hard

[Question]
10. The international Fisher effect is the same as the
a. uncovered interest rate parity
b. covered interest rate parity
c. purchasing power parity
d. efficient Fisher effect
Answer: a
page: 112
Level: medium

[Question]
11. According to the fundamental approach, if all of the regression coefficients are already
estimated, all of the following matters in the exchange rate determination EXCEPT
a. The expected rate of grows of domestic money
b. The expected rate of grows of foreign money
c. The historical rate of grows of domestic money
d. The expected rate of real economic growth in the domestic economy
Answer: c
page: 114
Level: medium

[Question]
12. The main approaches to forecasting exchange rates are:
a. Efficient market, Fundamental, and Technical approaches
b. Efficient market and Technical approaches
c. Efficient market and Fundamental approaches
d. Fundamental and Technical approaches
Answer: a
page: 113
Level: easy

[Question]
13. If foreign exchange markets are efficient, all of the following will hold EXCEPT:
a. exchange rates change only when new information arrives
b. exchange rates change randomly
c. incremental changes of exchange rates depend on the current level of the exchange rate
d. the current exchange rate reflects all relevant information
Answer: c
page: 113-114
Level: medium

Reference: 05_14
Suppose that the annual interest rate is 5.0 percent in the United States and 3.5 percent in
Germany, and that the spot exchange rate is $1.12/€ and the forward exchange rate, with one-
year maturity, is $1.16/€. Assume that an arbitrager can borrow up to $1,000,000 or €892,857
(which is the equivalent of $1,000,000 at the spot exchange rate of $1.12/€).

[Question]
14. The above mentioned scenario
a. is an example of covered interest arbitrage (CIA), and interest rate parity (IRP) holds
b. is an example of covered interest arbitrage (CIA), and interest rate parity (IRP) does NOT hold
c. is an example of Purchasing Power Parity (PPP), and hyperinflation
d. none of these
Answer: b
page: 98, Equation (5.3)
Level: medium
Refer To: 05_14

[Question]
15. The net cash flow in one year is
a. $10,690
b. $15,000
c. $46,207
d. $22,000
Answer: d
page: 99, Exhibit 5.2
Level: hard
Refer To: 05_14

[Question]
16. Covered interest rate arbitrage would not be possible if the forward rate would be:
a. $1.10/€
b. $1.12/€
c. $1.14/€
d. $1.16/€
Answer: c
page: 100
Level: hard
Refer To: 05_14

[Question]
17. 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. 0.07
b. 0.98
c. 1.05
d. 7.3
Answer: b
page: 106, Equation 5.13
Level: hard

[Question]
18. Canada’s competitive position will
a. strengthen when the dollar appreciates more than is warranted by PPP
b. improve when the dollar appreciates more than is warranted by PPP
c. weaken when the dollar appreciates more than is warranted by PPP
d. weaken when the dollar depreciates more than is warranted by PPP
Answer: c
page: 106-107
Level: medium

[Question]
19. PPP does not hold well because of the following except
a. barriers to international commodity arbitrage
b. the existence of non-tradables
c. commodity prices are different in different countries
d. the CPI index is calculated using the same basket of goods
Answer: d
page: 110-111
Level: hard

[Question]
20. The forward expectations parity states that
a. any forward premium or discount is equal to the expected change in the exchange rate
b. any forward rate is equal to the expected change in the exchange rate
c. the forward premium or discount is equal to the expected change in the real exchange rates
d. the forward premium or discount is equal to the expected change in purchasing power parity
Answer: a
page: 112
Level: medium

Essay

[Question]
1. Suppose that the two-months interest rate is 6.0 percent per annum in the United States and 7.0
percent per annum in Germany, and that the spot exchange rate is $1.12/€ and the forward
exchange rate, with two-months maturity, is $1.10/€. Assume that an arbitrager can borrow up to
$1,000,000 or €892,857.

a) What kind of arbitrage is possible?

b) Determine the arbitrage profit that can be made.
c) What would the forward rate have to be so that there would be no arbitrage opportunity?
Answer:
a) Covered interest rate arbitrage
b) Borrow Euro 892,857
Exchange spot at $1.12/euro to get $999,999.84
Invest at 1 percent to get 1,009,999.84
Exchange forward at $1.10/euro
To get Euro 918,181.67
Repay loan 903,273.67
Profit: 14,908.01

c) F = 1.12(1.01/1.01167) = $1.1182/euro

[Question]
2. The 9-months inflation rate in Great Britain is expected to be 4% p.a., and the 9-months
inflation rate in Switzerland is predicted to be 6% p.a. Assume that the parity conditions hold.
a) By what percentage rate do you expect the Swiss franc to appreciate (depreciate) with respect
to the British pound over the next nine months, based on purchasing power parity?
b) If the spot rate is pound 0.5/SF, what is the expected spot exchange rate between the Swiss
franc and the British pound in nine months?
Answer:
a) ef = (1.03/1.045) - 1 = - 0.014 or a 1.4% depreciation of the Swiss franc
b) St + 1 = 0.5(1.03/1.045) = pound 0.4928/SF

[Question]
3. The 9-months inflation rate in Great Britain is expected to be 4% p.a., and the 9-months
inflation rate in Switzerland is predicted to be 6% p.a. The real interest rate is 3% in Great
Britain. Assume that the parity conditions hold.
a) What is the nominal interest rate in Switzerland?
b) What is the nine-month forward rate of the Swiss franc with respect to the British pound?
c) If the inflation rates are expected to stay unchanged over the next two years, what is the
expected spot exchange rate between the British pound and the Swiss franc in two years?
Answer:
a) (1.03)(1.06) - 1 = 0.0918 or 9.18% p.a.
b) 1/0.4928 = SF 2.0292/pound
c) 0.5(1.04/1.06)2 = pound 0.4813/ SF

[Question]
4. You have the following information:

You are asked to forecast the spot exchange rate between the Canadian dollar and the U.S. dollar
in six months.

a) What is your forecast based on purchasing power parity?

b) What is your forecast based on the forward expectations parity?
c) Based on the Fisher effect, what should be the real interest rate in Canada?
d) Why are the two forecasts in a and b different?
Answer:
a) 0.685(1.02/1.01) = $0.6918/C$

b) $0.7100/C$

c) 1.06/1.04 -
1 = 0.01923 or 1.923%

d) The parity conditions do not hold.

[Question]
5. Suppose that the two-months interest rate is 8.0 percent per annum in the Canada and 7.0
percent per annum in France, and that the spot exchange rate is $1.50/€ and the forward
exchange rate, with one-year maturity, is $1.50/€. Assume that an arbitrager can borrow up to
$1,000,000 or €666,666.

a) What kind of arbitrage is possible?

b) Determine the arbitrage profit that can be made.
c) What would the French interest rate have to be so that there would be no arbitrage
opportunity?
Answer:
a) Covered interest rate arbitrage
b)
Borrow Euro 666,666
Exchange spot at $1.50/euro to get $1,000,000
Invest at 8 percent to get 1,080,000
Exchange forward at $1.5/euro
To get Euro 720,000
Repay loan 666,666 + 46,667 = 713,333
Profit: euro 6,667

c. 8% p.a.
[Question]
6. Assume the current $/£ exchange rate is 1.7 $/£ and 1-year forward exchange rate is 1.68$/£.
The risk-free interest rates in US and UK are 4% and 6% respectively. Is there an arbitrage
opportunity?
Answer: Direct investment of $s gives you 4%
Indirect investment gives (1/1.7)*1.06*1.68 - 1 = 0.0475 or 4.75%

Thus, arbitrage is possible. Strategy:

Today: Borrow $1, buy 1/1.7 = £0.5882, invest it at 6% (so that you expect to receive
1.06*(1/1.7) = £0.6235 one year from now) and sell forward contract for £0.6235

1-year from now: Collect £0.6235 from your investment, sell £0.6235 trough previously sold
forward contract, receive 0.6235*1.68 = $1.0475, repay your debt of 1*1.04 = $1.04. Profit =
1.0475 - 1.04 = $0.0075

[Question]
7. Assume the current $/£ exchange rate is 1.7 $/£ and 1-year forward exchange rate is 1.68$/£.
The risk-free interest rates at which you can invest in US and UK are 4% and 6% respectively.
However, since you do not have a very good credit rating, you can borrow funds only at higher
rates. Namely, you can borrow $s at 5% and you can borrow £s at 7%. Is there an arbitrage
opportunity?
Answer:
Try both directions:

Direction 1: (borrow $s, invest £s)

Today: Borrow $1, buy 1/1.7 = £0.5882, invest it at 6% (so that you expect to receive
1.06*(1/1.7) = £0.6235 one year from now) and sell forward contract for £0.6235
1-year from now: Collect £0.6235 from your investment, sell £0.6235 trough previously sold
forward contract, receive 0.6235*1.68 = $1.0475, repay your debt of 1*1.04 = $1.04. Profit =
1.0475 - 1.05 = - $0.0025 < 0. No arbitrage this way

Direction 2: (borrow £s, invest $s)

Today: Buy $1 for £ (1/1.7) and invest this $1 at 4%. Borrow, £ (1/1.7) at 7% and buy £
(1/1.7)*1.07 = £0.6294 forward.
1-year from now: Collect $1.04 from your investment, buy £0.6294 trough previously bought
forward contract to repay your debt. Profit = 1.04 - (1/1.7)*1.07*1.68 = 1.04 - 1.0574 = -
$0.0174 < 0. No arbitrage this way as well

Therefore, there is no arbitrage.