Chapter 8 International Finance

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 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 $100000 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%

According to the international Fisher effect (IFE) 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

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.

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.

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

Assume that the interest rate offered on pounds is 5 percent and the pound is expected to depreciate by 1.5 percent. 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% SOLUTION: (1 + .05) x (1 + .015) - 1 = 3.43%

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 $100000 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? 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.

5%

According to the international Fisher effect (IFE) 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% (SOLUTION: 5% + 3% = 8%)

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

Deviations from PPP are reduced in the long run.

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

Exchange rates are affected by national income differentials and government controls. Exchange rates are affected by interest rate differentials. Supply and demand may not adjust if no substitutable goods are available. All of these are reasons that PPP does not consistently occur.

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 then Country A's currency will weaken.

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

None of these are correct. the exchange rates of both countries will move in a similar direction against other currencies. The nominal interest rates of both countries are the same. The inflation rates of both countries are the same.

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

None of these are correct. The nominal interest rates of both countries will be the same. The inflation rates of both countries will be the same. The inflation rates of both countries will be the same AND the nominal interest rates of both countries will be the same.

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.

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 (IFE) the British pound's spot exchange rate should ____ by about ____ over the year.

appreciate; 1.9 percent SOLUTION: (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 (IFE) the franc will ____ by about ____.

appreciate; 2%

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

According to the international Fisher effect (IFE) 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.

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 = 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.

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

reduce the probability that PPP will hold

Because there are sometimes no substitutes for traded goods 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

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.

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

the British pound will depreciate against the dollar.

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.