CHAPTER 4

Parity Conditions in International Finance and Currency Forecasting

EASY

4.1 A currency is said to be at a forward _________ if the forward rate is below the
spot rate.
a. discount
b. premium
c. position
d. forward
ANSWER: a: arbitrage and the law of one price

4.2 The theory of relative purchasing power parity states that, between two nations,
the
a. inflation rates are unrelated
b. exchange rate difference reflects the inflation rate difference
c. inflation rate is greater in weaker currencies
d. the interest rate is greater than the inflation rate during depreciations
ANSWER: b: purchasing power parity

4.3 The Fisher effect states that the _________ rate is made up of a real required rate
of return and an inflation premium.
a. nominal exchange
b. real exchange
c. nominal interest rate
d. adjusted dividend
ANSWER: c: The Fisher Effect

4.4 A rise in the inflation rate in one nation relative to others will be associated with
a fall in the first nation’s exchange rate and with a rise of its interest rate relative
to foreign interest rates. The two conditions combined result in the _________
Effect.
a. Fisher
b. Herstatt
c. Unbiased forward rate
d. International Fisher
ANSWER: d: The Fisher effect

4.5 The purchase of currency on one market for immediate resale in another market
in order to profit from the rate discrepancy is known as _________.
a. arbitrage
b. financial innovation
c. a line of credit
d. countertrade
4.6 In its absolute version, _______ states that price levels should be equal world-
wide when expressed in a common currency.
a. interest rate parity
b. purchasing power parity
c. the international Fisher effect
d. covered interest arbitrage

4.7 When there is a relative shortage of capital and high political risk in most
developing countries, it is likely to drive real interest rates in these countries to
a. decline below real interest rates in developed countries
b. exceed nominal interest rates in developed countries
c. exceed rate interest rates in developed countries
d. parity conditions in all developing countries

MODERATE

4.8 Suppose annual inflation rates in the U.S. and Mexico are expected to be 6% and
80%, respectively, over the next several years. If the current spot rate for the
Mexican peso is $.005, then the best estimate of the peso's spot value in 3 years
is
a. $.00276
b. $.01190
c. $.00321
d. $.00102
ANSWER: d: purchasing power parity

4.9 If the expected inflation rate is 5% and the real required return is 6%, then the
Fisher effect says that the nominal interest rate should be
a. 1%
b. 11.3%
c. 11%
d. 6%
ANSWER: b: The Fisher Effect

4.10The inflation rates in the U.S. and France are expected to be 4% per annum and
7% per annum, respectively. If the current spot rate is $.1050, then the expected
spot rate in three years is
a. $.1150
b. $.1112
c. $.0964
d. $.0992
ANSWER: c: purchasing power parity

4.11 If inflation in the U.S. is projected at 5% annually for the next 5 years and at
12% annually in Italy for the same time period, and the lira/$ spot rate is
 currently at L2400 = $1, then the PPP estimate of the spot rate five years from
now is
a. 1738
b. 3314
c. 2560
d. 2250
ANSWER: b: purchasing power parity

4.12If expected inflation is 20% and the real required return is 10%, then the Fisher
effect says that the nominal interest rate should be exactly
a. 30%
b. 32%
c. 22%
d. 12%
ANSWER: b: The Fisher effect

4.13Annual inflation rates in the U.S. and Greece are expected to be 3% and 8%,
respectively. If the current spot rate for the drachma is $.007, then the expected
spot rate in three years is
a. $.00607
b. $.00823
c. $.00751
d. $.00694
ANSWER: a: purchasing power parity

4.14If a country's freely floating currency is undervalued in terms of purchasing

power parity, its capital account is likely to be
a. in deficit or tending toward a deficit
b. in surplus or tending toward a surplus
c. Subsidized by the International Monetary Fund
d. a candidate for loans from the World Bank
ANSWER: a: purchasing power parity

4.15If the average rate of inflation in the world rises from 5% to 7%, this will tend to
make forward exchange rates move toward
a. smaller premiums or larger discounts in relation to the dollar
b. larger premiums or smaller discounts in relation to the dollar
c. no change on average
d. can't tell what will happen
ANSWER: c: purchasing power parity

4.16 A 150% real return in Brazil is higher than a 15% dollar return in the U.S.
a. because arbitrage opportunities exist
b. when the inflation controls are suspended in Brazil
c. it depends on whether these are nominal or real returns
d. regardless of nominal or real returns
ANSWER: c: purchasing power parity

4.17Annual inflation rates in the U.S. and Italy are expected to be 4% and 7%,
respectively. If the current spot rate is $1 = L2,000, then the expected spot rate
for the lira in three years is
a. $.0004591
b. $.0011590
c. $.0009892
d. $.0005471
ANSWER: a: purchasing power parity

4.18Annual inflation rates in the U.S. and France are expected to be 4% and 6%,
respectively. If the current spot rate is $.1250/FF, then the expected spot rate in
two years is
a. $.1299
b. $.1150
c. $.1203
d. $.1335
ANSWER: c: purchasing power parity

4.19Suppose five-year deposit rates on Eurodollars and Euromarks are 12% and 8%,
respectively. If the current spot rate for the mark is $0.50, then the spot rate for
the mark five years from now implied by these interest rates is
a. .5997
b. .4169
c. .5185
d. .4821
ANSWER: a: the international Fisher effect

4.20The direct spot quote for the Canadian dollar is $.76 and the 180-day forward
rate is $.74. The difference between the two rates is likely to mean that
a. inflation in the U.S. during the past year was lower than in Canada
b. interest rates are rising faster in Canada than in the U.S.
c. prices in Canada are expected to rise more rapidly than in the U.S.
d. the Canadian dollar's spot rate is expected to rise in terms of the U.S.
dollar
ANSWER: c: interest rate parity theory

4.21 The spot rate on the Dutch guilder is $0.39 and the 180-day forward rate is
$0.40. The difference between the spot and forward rates means that
a. interest rates are higher in the U.S. than in the Netherlands
b. the guilder has risen in relation to the dollar
c. the inflation rate in the Netherlands is declining
d. the guilder is expected to fall in value relative to the dollar
there is a high inflation rate in the U.S.
ANSWER: a: interest rate parity theory

4.22Suppose the price indexes in Mexico and the U.S., which both began the year at
100, are at 160 and 103, respectively, by the end of the year. If the exchange rate
began the year at Mex$4.5 = $1 and ended the year at Mex$5.9 = $1, then the
change in the real value of the peso (a "-" indicates a real devaluation) during the
year is
a. 0%
b. -5.0%
c. 18.5%
d. -8.2%
ANSWER: c: purchasing power parity

4.23Suppose the spot rates for the pound, mark, and Swiss franc are $1.20, $.32, and
$.40, respectively. The associated 90-day interest rates (annualized) are 16%,
8%, and 4%, while the U.S. 90-day interest rate is 12%. What is the 90-day
forward rate (to the nearest cent) on a TCU (TCU 1 = £1 + DM1 + SFr1) if
interest parity holds?
a $1.92
b $1.98
c $1.94
d $1.87
ANSWER: a: interest rate parity theory

4.24The current five-year Euroyen rate is 6% per annum (compounded annually).

The five-year Eurodollar rate is 8.5%. What is the implied forward premium or
discount of the yen (over the current spot rate) for a five-year forward contract?
a. 4.17% premium
b. 18.46% discount
c. 11.00% discount
d. 12.36% premium
ANSWER: d: interest rate parity theory

4.25 Suppose the spot rates for the pound, mark, and Swiss franc are $1.50, $.42, and
$.48, respectively. The associated 90-day interest rates (annualized) are 12%,
6%, and 4%, while the U.S. 90-day interest rate (annualized) is 8%. What is the
90-day forward rate on a DCU (DCU 1 = £1 + DM1 + SFr1) if interest parity
holds?
a. $2.4027
b. $2.3923
c. $2.4196
d. $2.3738
ANSWER: b: interest rate parity theory

4.26Suppose that spot pounds are selling at $1.7342, while 90-day forward pounds
are selling at $1.7156. At the same time, DM spot and 90-day forward rates are
$0.6138 and $0.6014, respectively. According to these quotes the
a. pound is selling at a 3.87% forward discount relative to the DM
b. pound is selling at a 2.37% forward premium relative to the DM
c. DM is selling at a 0.97% forward discount relative to the pound
d. DM is selling at a 1.54% forward premium relative to the pound
ANSWER: a: interest rate parity theory

4.27If annualized interest rates in the U.S. and France are 9% and 13%, respectively,
and the spot value of the franc is $.1109, then at what 180-day forward rate will
interest rate parity hold?
a. $.1070
b. $.1150
c. $.1088
d. $.1130
ANSWER: c: interest rate parity theory

4.28If annualized interest rates in the U.S. and Switzerland are 10% and 4%,
respectively, and the 90-day forward rate for the Swiss franc is $.3864, at what
current spot rate will interest rate parity hold?
a. $.3902
b. $.3874
c. $.3807
d. $.3792
ANSWER: c: interest rate parity theory

4.29The spot rate on the euro is $1.40 and the 180-day forward rate is $1.50. The
difference between the two rates means
a. interest rates are higher in the U.S. than in the European Union
b. the mark has risen in relation to the dollar
c. the inflation rate in Germany is declining
d. the euro is expected to fall in value relative to the dollar
ANSWER: a: interest rate parity theory

4.30 Suppose the spot rates for the pound, mark, and Swiss franc are $1.30, $.35, and
$.40, respectively. The associated 90-day interest rates (annualized) are 16%,
8%, and 4%, while the U.S. 90-day interest rate (annualized) is 12%. What is the
90-day forward rate on an ACU (ACU 1 = £1 + DM1 + SFr1) if interest parity
holds?
a. $2.0512
 b. $2.1134
c. $2.0397
d. $2.0489
ANSWER: d: interest rate parity theory

4.31The current five-year Euroyen and Eurodollar rates are 8% and 12.5% per
annum, respectively. What is the implied forward premium or discount of the
yen (over the current spot rate for a five-year forward contract)?
a. 4.17% premium
b. 18.46% discount
c. 17.74% discount
d. 22.64% premium
ANSWER: d: interest rate parity theory

4.32The 90-day interest rates (annualized) in the U.S. and Japan are, respectively,
10% and 7%, while the direct spot quote for the yen in New York is $.004300.
At what 90-day forward rate would interest rate parity hold?
a. .004430
b. .004271
c. .004332
d. .004176
ANSWER: c: interest rate parity theory

4.33If annualized interest rates in the U.S. and France are 9% and 13%, respectively,
and the spot value of the franc is $.1109, then at what 180-day forward rate will
interest rate parity hold?
a. $.1070
b. $.1150
c. $.1088
d. $.1130
ANSWER: c: interest rate parity theory

DIFFICULT

4.34 Suppose the pound devalues from $1.25 at the start of the year to $1.00 at the
end of the year. Inflation during the year is 15% in England and 5% in the U.S.
What is the real devaluation (-) or real revaluation (+) of the pound during the
year?
a. - 12.38%
b. - 20.71%
c. + 2.39%
 d. + 1.46%
ANSWER: a: purchasing power parity

4.35Suppose the price indexes in Spain and the U.S., which both began the year at
100, are at 117 and 105, respectively, by the end of the year. If the beginning and
ending exchange rates, respectively, for the peseta are $.1320 and $.1125, then
the change in the real value of the peseta (a "-" indicates a real devaluation)
during the year is
a. 0%
b. -5.0%
c. 2.4%
d. -8.2%
ANSWER: b: purchasing power parity

4.36Suppose the Swiss franc revalues from $0.40 at the beginning of the year to
$0.44 at the end of the year. U.S. inflation is 5% and Swiss inflation is 3% during
the year. What is the real devaluation (-) or real revaluation (+) of the Swiss
franc during the year?
a. + 7.9%
b. - 5.3%
c. + 8.1%
d. - 1.6%
ANSWER: a: purchasing power parity

4.37Suppose the value of the Polish zloty moves from Z 1000 = $1 at the start of the
year to Z 1,800 at the end of the year. At the same time, the Polish price level
changes from an index of 100 on January 1 to 134 on December 31. U.S.
inflation during the year was 4.5%. If the one-year interest rate on the zloty is
44%, what was the real dollar cost of borrowing the zloty during the year?
a. 17.53%
b. 27.81%
c. -23.44%
d. -8.76%
ANSWER: c: purchasing power parity

4.38 Suppose inflation rates in the U.S. and France are expected to be 4% and 9%,
respectively, next year and 6% and 7%, respectively, in the following year. If the
current spot rate is $.1050, then the expected spot value of the franc in two years
is
a. $.1111
b. $.1024
 c. $.0992
d. $.1074
ANSWER: c: purchasing power parity

4.39Suppose the Deutsche mark revalues from $.30 at the beginning of the year to
$.33 at the end of the year. Inflation during the year is 5% in the U.S. and 3% in
Germany. What is the real devaluation (-) or real revaluation (+) of the Deutsche
mark during the year?
a. + 7.9%
b. - 5.3%
c. + 8.1%
d. - 1.6%
ANSWER: a: purchasing power parity

4.40If the U.S. trade balance with Japan is expected to go from a deficit this year to a
surplus next year, the forward rate on yen would
a. be less than the spot rate
b. be higher than the spot rate
c. equal the spot rate
d. could be either above or below the spot rate
ANSWER: d: the relationship between the forward rate and the future spot rate

4.41 The following exchange and interest rate quotations were recently observed:

Eurocurrency rates Exchange rate per $

90-days (% annum) 90-day
(Discretely-compounded) Spot forward
$ DM £ DM £ DM £

Bid: 15 5/8 7 7/8 12 1/4 1.881 .4961 1.801 .4937

Ask: 16 8 1/4 13 1.843 .4902 1.773 .4889

An arbitrage profit can be obtained by

a. borrowing pounds and lending dollars
b. borrowing dollars and lending DM
c. borrowing DM and lending pounds
d. there are no arbitrage opportunities
ANSWER: a: interest rate and parity theory