Exam 6: International Parity Conditions

The final component of the equation for the Fisher Effect, (r)(?), where r = the real rate of return and ? = the expected rate of inflation, is often dropped from the equation because the number is simply too large for most Western economies.

Arbitragers applying Covered Interest Arbitrage drive the international currency and money markets toward the equilibrium described by:

The government just released international exchange rate statistics and reported that the real effective exchange rate index for the U.S. dollar vs. the Japanese yen decreased from 105 last year to 95 currently and is expected to fall still further in the coming year. Other things equal, U.S. ________ to/from Japan think this is good news, and U.S. ________ to/from Japan think this is bad news.

Explain the logic behind the application of the PPP theory to explain changes in the spot exchange rate.

The current U.S. dollar-yen spot rate is ¥125/$. If the 90-day forward exchange rate is ¥127/$ then the yen is selling at a per annum ________ of ________.

Both covered and uncovered interest arbitrage are risky operations in the sense that even without default in the securities, the returns are unknown until all transactions are complete.

Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.80% and a real rate of interest of 2.00%. Using the Fisher Effect Equation, what is the exact expected rate of inflation in the U.S. over the next year?

According to the international Fisher Effect, if an investor purchases a five-year U.S. bond that has an annual interest rate of 5% rather than a comparable British bond that has an annual interest rate of 6%, then the investor must be expecting the ________ to ________ at a rate of at least 1% per year over the next 5 years.

The theory of ________ states that the difference in the national interest rates for securities of similar risk and maturity should be equal to but opposite in sign to the forward rate discount or premium for the foreign currency, except for transaction costs.

If we set the real effective exchange rate index between the United Kingdom and the United States equal to 100 in 2005, and find that the U.S. dollar has changed to a value of 91.4, then from a competitive perspective the U.S. dollar is:

Assume the current U.S. dollar-yen spot rate is ¥90/$. Further, the current nominal 180-day rate of return in Japan is 1% and 2% in the United States. What is the approximate forward exchange rate for 180 days?

In their approximate form, PPP, IRP, and forward rates as an unbiased predictor of the future spot rate lead to similar forecasts of the future spot rate.

In its approximate form the Fisher effect may be written as ________, where i = the nominal rate of interest, r = the real rate of return and ? = the expected rate of inflation.

Exchange rate pass-through may be defined as:

The authors describe an application of uncovered interest arbitrage (UIA) known as "yen carry trade." Define UIA and describe the example of yen carry trade. Why would an investor engage in the practice of yen carry trade and is there any risk of loss or lesser profit from this investment strategy?

Instruments denominated in different currencies are perfect substitutes for one another. Empirical studies of the efficient foreign exchange market hypothesis have yielded conflicting results. Nevertheless, a consensus is developing that rejects the efficient market hypothesis. It appears that the forward rate is not an unbiased predictor of the future spot rate and that it does pay to use resources to attempt to forecast exchange rates.

COVERED interest arbitrage (CIA), is where investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is "covered," because the investor does not sell the higher yielding currency proceeds forward.

________ states that differential rates of inflation between two countries tend to be offset over time by an equal but opposite change in the spot exchange rate.

According to the International Fisher Effect, the forecast change in the spot rate between two countries is equal to:

A ________ is an exchange rate quoted today for settlement at some time in the future.