CH 6

Will an arbitrageur facing the following prices be able to make money? Borrowing Lending Bid Ask$5% 4.5%Spot$1.00 = €1.00 $1.01 = €1.00€6% 5.5%Forward$0.99 = €1.00 $1.00 = €1.00

No; the transactions costs are too high.

What are reasons commonly given for the unfavorable empirical evidence about PPP? Multiple select question. Transportation costs Nontradables Comparative advantage

Nontradables Transportation costs

If PPP holds for tradables and the relative prices between tradables and nontradables are maintained, then:

PPP can hold in its relative version

The theory that states that the exchange rate between currencies of two countries should be equal to the ratio of the countries' price levels is _______ ______ parity.

Purchasing Power

According to the monetary approach, the exchange rate can be expressed as

S (M$M£)×(V$V£)×(y$y£)

Use of the equation s = α + β1(m − m*) + β2(v − v*) + β3( y* − y) + u to forecast interest rates is an example of the _______ approach

fundamental

One implication of the random walk hypothesis is

given the efficiency of foreign exchange markets, it is difficult to outperform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.

The act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits is referred to as _________

arbitrage

The interest rate at which the arbitrager borrows tends to be higher than the rate at which he lends, reflecting the

bid-ask spread.

In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket,

both of the options it will hold only if the prices of the constituent commodities are equalized across countries in a given currency. it will hold only if the composition of the consumption basket is the same across countries.

Interest rate parity may not hold because of government ________ controls that can include taxes and restrictions on currency transactions.

capital

If a foreign county experiences a hyperinflation,

its currency will depreciate against stable currencies.

The notion that a product that is easily and freely traded in a perfectly competitive market should have the same price everywhere (once the prices are expressed in the same currency) is called the ______.

law of one price

If a trader knows that other traders use ______ analysis of historical patterns to forecast exchange rates, it can be rational for that trader to use it, too.

technical

The ______ market hypothesis is that current asset prices fully reflect all available and relevant information.

efficient

The _______ market hypothesis is that current asset prices fully reflect all available and relevant information.

efficient

Generating exchange rate forecasts with the fundamental approach involves

estimation of a structural model and substitution of the estimated values of the independent variables into the estimated structural model to generate the forecast.

The International Fisher Effect suggests that

the nominal interest rate differential reflects the expected change in the exchange rate.

If an exchange rate follows a random walk

D) the future exchange rate is expected to be the same as the current exchange rate, St = E(St+1).

The uncovered interest rate parity equation is (i$ - i£) ≈ ______.

E(e)

The idea that the nominal interest rate differential between two countries reflects the expected change in exchange rates is the

International Fisher Effect

Which statements about relative purchasing power are correct? Multiple select question. It holds that if India's inflation rate is 3% higher than China's, then India's currency should appreciate by about 3% relative to China's. It is given by the equation S = P$P£P$P£. It is given by the equation e = [π$−π£1+π£]π$-π£1+π£. It may hold even when absolute PPP does not hold.

It is given by the equation e = [π$−π£1+π£]π$-π£1+π£. It may hold even when absolute PPP does not hold.

What are features of the efficient market approach to forecasting interest rates? Multiple select question. It is inexpensive to generate forecasts using the assumption of efficient markets. It is not easy to outperform market-based forecasts. One has to forecast a set of independent variables to forecast the exchange rates with the efficient markets approach.

It is not easy to outperform market-based forecasts. It is inexpensive to generate forecasts using the assumption of efficient markets.

Which currencies have been popular for funding currency carry trades? Multiple select question. New Zealand dollar Swiss franc Japanese yen Australian dollar

Japanese yen Swiss franc

The equation for the quantity theory of money is ______, where M denotes the money supply, P the general price level, V the velocity of money that measures the speed at which money is being circulated in the economy, and Y the national aggregate output.

M V = P Y

When Interest Rate Parity (IRP) does not hold

there are opportunities for covered interest arbitrage

Good, inexpensive, and fairly reliable predictors of future exchange rates include

today's exchange rate, as well as current forward exchange rates

The two main reasons that IRP may not hold precisely at all time, especially over short periods is:

transaction costs and capital controls.

That the interest rate differential between a pair of countries is (approximately) equal to the expected rate of change in the exchange rate is known as ________ interest rate parity.

uncovered

The currency carry trade is based _______ on interest parity not holding.

uncovered

The currency carry trade is based on ________ interest parity not holding.

uncovered

As of today, the spot exchange rate is €1.00 = $1.60 and the rates of inflation expected to prevail for the next year in the U.S. is 2 percent and 3 percent in the euro zone. What is the one-year forward rate that should prevail?

x1.6=(1.03/1.02)xthis is the formula you'd use in interest rate parity to see what the dollar is in one year forward rate €1.00 = $1.6157

A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The one-year forward exchange rate is $1.20 = €1.00; what must the spot rate be to eliminate arbitrage opportunities?

$1.2471 = €1.00

Suppose that the annual interest rate is 5.0 percent in the United States and 3.5 percent in Germany. 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. If an astute trader finds an arbitrage opportunity, what is the net cash flow in one year?

$21,964

If a country's currency ______ by more than is warranted by PPP, the competitiveness of the country's industries will ______ because the real exchange rate has changed.

-appreciates; decrease -depreciates; increase

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

0.9849.

Order the steps for creating an arbitrage portfolio that has (i) no net investment, as well as (ii) no risk, and that should generate no net cash flow in equilibrium.

1- borrow $S in the US, which is just enough to buy £1 at the prevailing spot exchange rate S. 2- Lend £1 in the UK at the UK interest rate 3- sell the maturity value of the UK investment forward

Suppose that the one-year 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 one-year forward exchange rate is $1.16/€. Assume that an arbitrageur can borrow up to $1,000,000.

1.12 (1.05 / 1.035) = 1.13, which is less than 1.16, suggesting that an arbitrage opportunity exists. This is an example of an arbitrage opportunity; interest rate parity does not hold.

Suppose that the one-year interest rate is 3.0 percent in Italy. The spot exchange rate is $1.20/€, and the one-year forward exchange rate is $1.18/€. What must the one-year interest rate be in the United States to avoid arbitrage opportunities?

1.2833%

How high does the lending rate in the euro zone have to be before an arbitrageur would not consider borrowing dollars, trading them for euro at the spot rate, investing those euros in the euro zone, and hedging with a short position in the forward euro contract? Bid Ask Borrowing LendingS0($/€) $1.40-€1.00 $1.43-€1.00i$4.20%APR 4.10%APRF360($/€) $1.44-€1.00 $1.49-€1.00i€

3.47%

The Fisher effect can be written for the United States as: A.is = ρs + E(πs) + ρs × E(πs) B.ρs = is + E(πs) + is × E(πs) C.q=1+π$(1+e)(1+π£)q=1+π$(1+e)(1+π£) D.F($/€)S($/€)=1+i$1 + i€F($/€)S($/€)=1+i$1 + i€

A. is = ρs + E(πs) + ρs × E(πs)

A simple and light-hearted approach to PPP is given by the ______ index.

Big Mac

The equation for the quantity theory of money is ______ = ______ _______/_________ , where M denotes the money supply, P the general price level, V the velocity of money that measures the speed at which money is being circulated in the economy, and Y the national aggregate output.

Blank 1: P Blank 2: M Blank 3: V Blank 4: Y

A Polish currency dealer has good credit and can borrow either €1,600,000 or $2,000,000 for one year. The one-year interest rate in the U.S. is i$ = 6.25% and in the euro zone the one-year interest rate is i€ = 2%. The spot exchange rate is $1.20 = €1.00 and the one-year forward exchange rate is $1.25 = €1.00. Show how you can realize a certain euro profit via covered interest arbitrage.

Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit €2,000

An Italian currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how you can realize a certain euro profit via covered interest arbitrage.

Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit €2,000

An American currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate is i$ = 2% in the U.S. and i€ = 6% in the euro zone, respectively. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how you can realize a certain dollar profit via covered interest arbitrage.

Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year;translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400

Suppose you observe a spot exchange rate of $2.00/£. If interest rates are 5 percent per annum in the U.S. and 2 percent per annum in the U.K., what is the no-arbitrage one-year forward rate?

F = S[1 + i$)/(1 +i£)] = 2(1.05/1.02) = 2.0588£

Suppose you observe a spot exchange rate of $1.0500/€. If interest rates are 5% per annum in the U.S. and 3% per annum in the euro zone, what is the no-arbitrage one-year forward rate?

F = S[1 + i$)/(1 +i€)] = $1.05(1.05/1.03) = $1.0704/€.

A formal statement of IRP is

F($/€)/S($/€)=1+i$/1+i€

That an increase in the expected inflation rate in a country should cause a proportionate increase in the interest rate in the country is predicted by the ______ effect.

Fisher

Suppose that you are the treasurer of IBM with an extra $1,000,000 to invest for six months. You are considering the purchase of U.S. T-bills that yield 1.810 percent over a six-month period. The spot exchange rate is $1.00 = ¥100, and the six-month forward rate is $1.00 = ¥110. Alternatively, the six-month interest rate in Japan on an investment of comparable risk is 13 percent. What is your strategy to maximize guaranteed dollar proceeds in six months?

Take $1mn, convert them into yen at the spot rate, invest in Japan, and hedge with a short position on the forward contract.

According to the monetary approach, which factors determine exchange rates? The relative money supplies The relative interest rates The relative velocities of money The relative national outputs

The relative velocities of money The relative money supplies The relative national outputs

Why might interest rate parity not hold? Multiple select question. The interest rates in two countries differ. The spot and forward rates differ. There are bid-ask spreads in capital markets. There are transaction costs in buying and selling currency.

There are bid-ask spreads in capital markets. There are transaction costs in buying and selling currency.

Will an arbitrageur facing the following prices be able to make money? Bid Ask Borrowing LendingS0($/€) $1.40 / €1.00 $1.43 / €1.00i$4.20% 4.10%F360($/€) $1.44 / €1.00 $1.49 / €1.00i€3.65% 3.50%

Yes, borrow $1,000,000 at 4.2 percent; trade for € at the spot ask exchange rate of $1.43 = €1.00; invest €699,300.70 at 3.5 percent; hedge the maturity value by going short on a forward and agreeing to sell € at the bid price of $1.44/€ in one year. The net cash flow will be positive in one year.

A higher U.S. interest rate (i$) relative to interest rates abroad, ceteris paribus, will result in

a stronger dollar.

Technical analysis tends to be discredited by ________ but supported by ________.

academic studies; traders

The benefit to forecasting exchange rates

accrue to, and are a vital concern for, MNCs formulating international sourcing, production, financing, and marketing strategies.

Interest Rate Parity (IRP) is best defined as

an arbitrage condition that must hold when international financial markets are in equilibrium.

The Fisher effect states that

an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country

When the interest rate parity equation does not hold and it is possible to earn profits without exchange-rate risk, there is a(n) ________ interest arbitrage opportunity.

covered

Calculation of interest rate parity is done using the interest rates of U.S. Treasury notes and their equivalents because they are considered ______.

default-free risk-free

If (1 + i$) > FSFS (1 + i£), then a profitable arbitrage opportunity is to ______ in the United States and ______ in the U.K.

lend; borrow

The currency carry trade involves being ______ a high-yielding currency, being ______ a low-yielding currency and ______ hedging exchange rate risk.

long; short; not

Studies of the accuracy of paid exchange rate forecasters

none of the options

With regard to fundamental forecasting versus technical forecasting of exchange rates

none of the options

Changes in nominal exchange rates can cause changes in real exchange rates, affecting the international competitive positions of countries, when____ ___ parity does not hold.

purchasing power

Covered Interest Arbitrage (CIA) transactions will result in

restoring equilibrium prices quickly.

In the equation: s = α + β1(m − m*) + β2(v − v*) + β3( y* − y) + u, match the variables to their descriptions. Instructions

s- natural logarithm of the spot exchange rate m − m*- natural logarithm of domestic/foreign money supply v − v*- natural logarithm of domestic/foreign velocity of money y* − y- natural logarithm of domestic/foreign output u- random error term with mean zero

According to a survey study conducted by Rossi (2013), the exchange rate predictability depends on:

sample period and model the choice of predictor forecast horizon and evaluation method

The moving average crossover rule

states that a crossover of the short-term moving average below the long-term moving average signals that the foreign currency is depreciating. states that a crossover of the short-term moving average above the long-term moving average signals that the foreign currency is appreciating.