Chapter 8

The interest rate differential between any two countries will be offset by the change in the spot rate of one of the currencies. Purchasing power parity (PPP) Interest rate parity (IRP) International Fisher effect (IFE) Direct foreign investment (DFI)

c

Assume that several European countries that use the euro as their currency experience lower inflation than the United States, while two other European countries that use the euro as their currency experience higher inflation than the United States. According to PPP, how will the euro's value against the dollar be affected? The low European inflation overall would (reduce/increase) the U.S. demand for European products, (reduce/increase) the European demand for U.S. products, and cause the euro to (appreciate/depreciate)against the dollar.

increase, reduce, appreciate

Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yen's value? Why does this expected relationship not always occur? Japan's low inflation should place (upward/downward) pressure on the yen's value. However, Japan heavily invests in U.S. securities, which places (upward/downward) pressure on the yen's value.

upward, downward

Assume that the spot exchange rate of the British pound is $1.71. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 8 percent while the United States experiences an inflation rate of 1 percent? Do not round intermediate calculations. Round your answer to three decimal places.

(1.01/1.08) * 171= $1.599

The United States and the country of Rueland have the same real interest rate of 1 percent. The expected inflation over the next year is 8 percent in the United States versus 21 percent in Rueland. Interest rate parity exists. The one-year currency futures contract on Rueland's currency (called the ru) is priced at $0.42 per ru. What is the spot rate of the ru? Do not round intermediate calculations. Round your answer to three decimal places.

1.09/1.22 =.89344 .42/ANS^ = .470

Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? If investors from the U.S. and Mexico required the same real (inflation adjusted) return, the inflation rate in Mexico is expected to be about (48/40/8) percent (above/below) the U.S. inflation rate. Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. According to PPP, the Mexican peso should (depreciate/appreciate) by the amount of the differential between U.S. and Mexican inflation rates. It means that the Mexican peso should (depreciate/appreciate) by about (48/40/8) percent. Thus, the expected nominal return to U.S. investors who invest in Mexico will be about (48/40/8) percent.

40, above, depreciate, depreciate, 40, 8

Demand for each good should adjust until the prices of the good are equal Relative PPP Absolute PPP

Absolute PPP

True or False: Results of this regression analysis will be the same, regardless of the base period chosen.

False

True or False: Statistical tests of real data show little to no differences from the results predicted by PPP.

False

__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). __suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. __suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. It is based on nominal interest rate differentials, which are influenced by expected inflation. (IFE/ IRP/ PPP)

IRP, PPP, IFE

Expected inflation rate =

Nominal IR- Real IR

Rate of change of prices of good should be similar Relative PPP Absolute PPP

Relative PPP

Would PPP be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungary's currency were allowed to float without any government intervention? Would the IFE be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungary's currency were allowed to float without any government intervention? (Yes or no)

Yes, yes

The inflation differential between any two countries will be offset by the change in the spot rate of one of the currencies. Purchasing power parity (PPP) Direct foreign investment (DFI) Interest rate parity (IRP) International Fisher effect (IFE)

a

How is it possible for PPP to hold if the IFE does not? a. PPP may still hold even if investors across countries do not require the same real returns. b. PPP may still hold even if the expected inflation rate embedded in the nominal interest rate does not occur. c. PPP may still hold even if the exchange rate does not adjust to the inflation rate differential. a/ b/ c/ a&b/ a&c

a&b

If the theory of PPP were true, what would be the values of a0a0 and a1a1?(Hint: Assume the average value of the error term is 0.) a0=0, a1=0 a0=0, a1=1 a0=1, a1=0 a0=1, a1= 1

a0=0, a1=1

If investors in the United States and Canada require the same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary expectations suggest about future exchange rates? Expected inflation in Canada is 2 percent (above/below) expected inflation in the U.S. If these inflationary expectations come true, PPP would suggest that the value of the Canadian dollar should (depreciate/appreciate) by 2 percent against the U.S. dollar.

above, depreciate

Higher domestic returns vs foreign when __ the line Consistent with IFE when __ Higher foreign return vs domestic when __ the line on, above or below

above, on, below

Purchasing power more favorable for foreign products when __ the line Purchasing power parity when __ Purchasing power more favorable for domestic products when __ the line on, above or below

above, on, below

Which of the following factors influence the exchange rate of a currency? Check all that apply. - Changes in expectations of future exchange rates - Changes in relative inflation rates - Changes in government controls - Changes in relative income levels - Changes in relative interest rates

all of them

Assume U.S. interest rates are generally below foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if they believe in the IFE? The IFE would suggest that the U.S. dollar will (appreciate/depreciate) over time if U.S. interest rates are currently lower than foreign interest rates. Consequently, foreign investors who purchased U.S. securities would on average receive a (similar/lower/higher) yield as what they receive in their own country, and U.S. investors that purchased foreign securities would on average receive a yield (similar to/lower than/higher than) U.S. rates.

appreciate, similar, similar to

Suppose that exchange rate between the dollar and the peso is in equilibrium when inflation in the U.S. rises to 4.00%. At the same time, inflation in Mexico is 6.00%. If the inflation rate in the U.S. is denoted as H and the inflation rate in Mexico is F, then which of the following expressions represents the percent change in the peso under PPP? a. (1+F)/(1+H)+1 b. (1+H)/(1+F)-1 c. (1+F)/(1+H)-1 d. (1+H)/(1+F)+1

b

The interest rate differential between any two currencies will be offset by the discount (or premium) on the forward rate of one of the currencies. Purchasing power parity (PPP) Interest rate parity (IRP) International Fisher effect (IFE) Direct foreign investment (DFI)

b

Because the exchange rate for a currency is influenced (by more than just/by only the) relative inflation, exchange rate movements cannot be predicted entirely by PPP.

by more than just

The United States has expected inflation of 2 percent, while Country A, Country B, and Country C have expected inflation of 7 percent. Country A engages in much international trade with the United States. The products that are traded between Country A and the United States can easily be produced by either country. Country B engages in much international trade with the United States. The products that are traded between Country B and the United States are important health products, and there are no substitutes for these products that are exported from the United States to Country B or from Country B to the United States. Country C engages in considerable international financial flows with the United States but very little trade. If you were to use PPP to predict the future exchange rate over the next year for the local currency of each country against the dollar, do you think PPP would provide the most accurate forecast for the currency of Country A, Country B, or Country C? Briefly explain. PPP should provide the most accurate forecast for the currency of (Country A/Country B/Country C), because there (is/is not) much international trade, so price changes (can/cannot affect) the volume of foreign exchange in each direction. Also, the traded products (have/do not have) substitutes.

country A, is, can, have

Russia commonly experiences a high rate of inflation. Explain why the high Russian inflation typically places severe downward pressure on the value of the Russian ruble. As Russian prices were increasing, the purchasing power of Russian consumers was (declining/increasing). This would (encourage/discourage) them to purchase products in the U.S. and elsewhere, which results in a (large/small) supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian products would be (low/high). Thus, the ruble's value should depreciate against the dollar, and against other currencies.

declining, encourage, large, low

Assume that the inflation rate in Brazil is expected to decrease substantially. How will this affect Brazil's nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the lower inflation in Brazil? Explain. Brazil's nominal interest rate would likely (increase/decrease). The Brazilian real would be expected to (depreciate/appreciate) according to the IFE. If the IFE holds, the nominal return to U.S. investors who invest in Brazil (would not be affected/would be reduced/would be increased).

decrease, appreciate, would not be affected

When inflation is high in a particular country, foreign demand for products in that country will (decrease/increase). In addition, that country's demand for foreign products should (decrease/increase). Thus, the home currency of that country will (weaken/strengthen); this tendency should continue until the currency has (weakened/strengthened) to the extent that (a foreign/the home) country's products are no more attractive than (a foreign/the home) country's products.

decrease, increase, weaken, weakened, a foreign, the home

A increase in the real interest rate (with no change in the nominal interest rate) means that Canada's expected inflation rate is (increased/decreased). This new information causes an expected (increase/decrease) in U.S. demand for Canadian dollars and/or (an increased/a decreased) supply of Canadian dollars to be exchanged for U.S. dollars (due to international trade with the U.S.), which results in a weaker/stronger) Canadian dollar.

decreased, increase, a decreased, stronger

When the IFE holds, the expected return from international investing is what the investor would earn (domestically/in the foreign market). When IRP holds, covered interest arbitrage will achieve the same return as what the investor could earn (domestically/in the foreign market).

domestically, domestically

A decrease in the real interest rate (with no change in the nominal interest rate) means that Canada's expected inflation rate is (increased/decreased). This new information causes an expected (increase/decrease) in U.S. demand for Canadian dollars and/or (an increased/a decreased) supply of Canadian dollars to be exchanged for U.S. dollars (due to international trade with the U.S.), which results in a weaker/stronger) Canadian dollar.

increased, decrease, an increased, weaker

One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean? If all investors require the same real return, then the differentials in nominal interest rates should be solely due to differentials in anticipated (inflation/economic growth) among countries.

inflation

What is the force that causes the spot rate to change according to the IFE? The force that causes this expected effect on the spot rate is the (real interest rate/inflation) differential.

inflation

Assume that Mexico has a one-year interest rate that is higher than the U.S. one-year interest rate. Assume that you believe in the international Fisher effect (IFE) and interest rate parity. Assume zero transaction costs. Ed is based in the United States and attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of one year. Ed did not cover his position in the forward market. Maria is based in Mexico and attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars one year forward, investing the dollars in a risk-free asset for a year, and then converting the dollars back to pesos at the end of one year. Do you think the rate of return on Ed's investment will be higher than, lower than, or the same as the rate of return on Maria's investment? Explain. The rate of return on Ed's investment will be the (higher than/lower than/the same as) the rate of return on Maria's investment. Since interest rate parity exists, she will earn whatever the local risk-free interest rate is in (Mexico/the U.S.). Ed's expected rate of return is whatever the risk-free rate is in (Mexico/the U.S.) (based on the IFE).

lower than, Mexico, the US

PPP suggests that the purchasing power of a consumer will be (similar/different) when purchasing products in a foreign country or in the home country. Currencies in countries with high inflation will be (strong/weak) according to PPP, causing the purchasing power of products in the home country versus these countries to be (similar/different).

similar, weak, similar

You believe that interest rate parity and the international Fisher effect hold. Assume that the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables of 1 million New Zealand dollars that you will receive in one year. You could hedge the receivables with the one-year forward contract. Or, you could decide to not hedge. Is your expected U.S. dollar amount of the receivables in one year from hedging higher, lower, or the same as your expected U.S. dollar amount of the receivables without hedging? Explain. The expected amount is (higher/lower/the same), because the forward rate reflects the (inflation/interest rate)differential, and the expected spot rate (if you do not hedge) according to IFE reflects the (inflation/interest rate) differential.

the same, interest rate, interest rate

Graph of IFE

through (0,0) slope of 1

Graph of PPP

through (0,0) slope of 1

Inflation differentials between the United States and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP? The information suggests that the exchange rate movements (will/will not) necessarily conform to inflation differentials, and therefore PPP (will/will not) necessarily hold.

will not, will not