Chapter 8 Inter Finance

Assume that the U.S. one-year interest rate is 3 percent and the one-year interest rate on Australian dollars is 6 percent. The U.S. expected annual inflation is 5 percent, while the Australian inflation is expected to be 7 percent. You have $100,000 to invest for one year and you believe that PPP holds. The spot exchange rate of an Australian dollar is $0.689. What will be the yield on your investment if you invest in the Australian market?

4 percent

Assume that the international Fisher effect (IFE) holds between the United States and the United Kingdom. The U.S. inflation is expected to be 5 percent, while British inflation is expected to be 3 percent. The interest rate offered on pounds is 7 percent, and the U.S. interest rate is 7 percent. What does this say about real interest rates expected by British investors?

Real interest rates expected by British investors are 2 percentage points above the real interest rates expected by U.S. investors.

Research indicates that deviations from purchasing power parity (PPP) are less pronounced over the long run.

True

The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.

True

Among the reasons that purchasing power parity (PPP) does not consistently occur are

all of the above are reasons that PPP does not consistently occur.

Assume that the one-year interest rate in the United States is 7 percent and in the United Kingdom is 5 percent. According to the international Fisher effect, the British pound's spot exchange rate should ____ by about ____ over the year.

appreciate; 1.9 percent (1 + .07)/(1 + .05) 1 = 1.9%

Assume U.S. and Swiss investors require a real rate of return of 3 percent. Assume the nominal U.S. interest rate is 6 percent and the nominal Swiss rate is 4 percent. According to the international Fisher effect, the franc will ____ by about ____.

appreciate; 2 percent

If nominal British interest rates are 3 percent and nominal U.S. interest rates are 6 percent, then the British pound (£) is expected to ____ by about ____percent, according to the international Fisher effect (IFE).

appreciate; 2.9

If interest rate parity holds, then the one-year forward rate of a currency will be ____ the predicted spot rate of the currency in one year according to the international Fisher effect.

equal to

Which of the following theories suggests the percentage change in spot exchange rate of a currency should be equal to the interest rate differential between two countries?

international Fisher effect (IFE)

Because there are a variety of factors in addition to inflation that affect exchange rates, this will:

reduce the probability that PPP will hold.

Assume that the New Zealand inflation rate is higher than the U.S. inflation rate. This will cause U.S. consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States. According to purchasing power parity (PPP), this will result in a(n) ____ of the New Zealand dollar (NZ$).

reduce; increase; depreciation

The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

False

The international Fisher effect (IFE) suggests that the currencies with relatively high interest rates will appreciate because those high rates will attract investment and increase the demand for that currency.

False

The nominal interest rate can be measured as the real interest rate minus the expected inflation rate.

False

Which of the following is not true regarding IRP, PPP, and the IFE?

IRP suggests that a currency's spot rate will change according to interest rate differentials.

Given a home country and a foreign country, purchasing power parity suggests that:

none of the above

Given a home country and a foreign country, the international Fisher effect (IFE) suggests that:

none of the above

The Fisher effect is used to determine the:

real interest rate.

According to the international Fisher effect, if Venezuela has a much higher nominal interest rate than other countries, its inflation rate will likely be ____ than other countries, and its currency will ____.

higher; weaken

Assume that the U.S. inflation rate is higher than the New Zealand inflation rate. This will cause U.S. consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States. According to purchasing power parity (PPP), this will result in a(n) ____ of the New Zealand dollar (NZ$).

increase; reduce; appreciation

Which of the following theories can be assessed using data that exists at one specific point in time?

interest rate parity (IRP)

Which of the following theories suggests that the percentage difference between the forward rate and the spot rate depends on the interest rate differential between two countries?

interest rate parity (IRP)

According to the IFE, if British interest rates exceed U.S. interest rates:

the British pound will depreciate against the dollar.

According to the international Fisher effect (IFE):

the exchange rate-adjusted rate of return on a foreign investment should be equal to the interest rate on a local money market investment.

Which of the following is indicated by research regarding purchasing power parity (PPP)?

Deviations from PPP are less pronounced in the long run.

Assume a two-country world: Country A and Country B. Which of the following is correct about purchasing power parity (PPP) as related to these two countries?

If Country A's inflation rate exceeds Country B's inflation rate, Country A's currency will weaken.

The inflation rate in the United States is 3 percent while the inflation rate in Japan is 10 percent. The current exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen have adjusted in the manner suggested by purchasing power parity, the new exchange rate for the yen will be:

$0.0070. (1.03/1.10) $.0075 = $.0070

The inflation rate in the United States is 4 percent, while the inflation rate in Japan is 1.5 percent. The current exchange rate for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen have adjusted according to purchasing power parity, the new exchange rate for the yen will be

$0.0082.

Assume that the U.S. one-year interest rate is 5 percent and the one-year interest rate on euros is 8 percent. You have $100,000 to invest and you believe that the international Fisher effect (IFE) holds. The euro's spot exchange rate is $1.40. What will be the yield on your investment if you invest in euros?

5 percent

According to the international Fisher effect, if U.S. investors expect a 5 percent rate of domestic inflation over one year and a 2 percent rate of inflation in European countries that use the euro, and if they require a 3 percent real return on investments over one year, the nominal interest rate on one-year U.S. Treasury securities would be:

8 percent. 5% + 3% = 8%

Which of the following is not true regarding limitations of PPP and the IFE?

All of the above are true.

According to the international Fisher effect (IFE), the exchange rate percentage change should be approximately equal to the differential in income levels between two countries.

False

Assume that inflation in the United States is expected to be 9 percent, while inflation in Australia is expected to be 5 percent over the next year. Today you receive an offer to purchase a one-year put option for $.03 per unit on Australian dollars at a strike price of $0.72. Today the Australian dollar is quoted at $0.70. You believe that purchasing power parity holds. You should accept the offer.

False

If interest rate parity holds, then the international Fisher effect must hold.

False

If purchasing power parity holds, then the Fisher effect must also hold.

False

If the IFE theory holds, that means that covered interest arbitrage is not feasible.

False

According to purchasing power parity (PPP), if a foreign country's inflation rate is below the inflation rate at home, home country consumers will increase their imports from the foreign country, and foreign consumers will lower their demand for home country products. These market forces cause the foreign currency to appreciate

True

According to the IFE, when the nominal interest rate at home exceeds the nominal interest rate in the foreign country, the home currency should depreciate.

True

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively high interest rates should have forward discounts, and those currencies would be expected to depreciate.

True

If the international Fisher effect (IFE) holds, the local investors are expected to earn the same return from investing internationally as they would from investing in their local markets.

True

Assume that the U.S. and Chile nominal interest rates are equal. Then, the U.S. nominal interest rate decreases while the Chilean nominal interest rate remains stable. According to the international Fisher effect, this implies expectations of ____ than before, and that the Chilean peso should ____ against the dollar.

lower U.S. inflation; depreciate

Which of the following theories suggests that the percentage change in the spot exchange rate of a currency should be equal to the inflation differential between two countries?

purchasing power parity (PPP)

The following regression analysis was conducted for the inflation rate information and exchange rate of the British pound: Regression results indicate that a0 = 0 and a1 = 1. Therefore:

purchasing power parity holds.

Because there are sometimes no substitutes for traded goods, this will:

reduce the probability that PPP will hold.

If the international Fisher effect (IFE) did not hold based on historical data, this would suggest that:

some corporations with excess cash could have generated higher profits on average from foreign short-term investments than from domestic short-term investments.

Assume that the interest rate offered on pounds is 5 percent and the pound is expected to depreciate by 1.5 percemt. For the international Fisher effect (IFE) to hold between the United Kingdom and the United States, the U.S. interest rate should be ____.

3.43 percent (1 + .05) (1 + .015) 1 = 3.43%

Assume that U.S. and British investors require a real return of 2 percent. If the nominal U.S. interest rate is 15 percent, and the nominal British rate is 13 percent, then according to the IFE, the British inflation rate is expected to be about ____ the U.S. inflation rate, and the British pound is expected to ____.

2 percentage points below; appreciate by about 2 percent

Interest rate parity can only hold if purchasing power parity holds.

False

Purchasing power parity (PPP) focuses on the relationship between nominal interest rates and exchange rates between two countries

False

There is much evidence to suggest that Japanese investors invest in U.S. Treasury securities when U.S. interest rates are higher than Japanese interest rates. These investors most likely believe in the international Fisher effect.

False

According to the international Fisher effect, if investors in all countries require the same real rate of return, the differential in nominal interest rates between any two countries:

is due to their inflation differentials.

The following regression analysis was conducted for the inflation rate information and exchange rate of the British pound: Regression results indicate that a0 = 0 and a1 = 2. Therefore:

purchasing power parity underestimated the exchange rate change during the period under examination.

The following regression was conducted for the exchange rate of the British pound (BP): Regression results indicate that a0 = 0 and a1 = 2. Therefore,

purchasing power parity underestimated the exchange rate change during the period under examination.

Latin American countries have historically experienced relatively high inflation, and their currencies have weakened. This information is somewhat consistent with the concept of:

purchasing power parity.

The international Fisher effect (IFE) suggests that the foreign currency will appreciate when:

the current home nominal interest rate exceeds the current foreign nominal interest rate.

Given a home country and a foreign country, purchasing power parity (PPP) suggests that:

the home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate.

Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and:

the inflation differential.

If interest rates on the euro are consistently below U.S. interest rates, then for the international Fisher effect (IFE) to hold:

the value of the euro would often appreciate against the dollar.