Chapter 06 International Parity Relationships and

Forecasting Foreign Exchange Rates

Student: ___________________________________________________________________________

1. An arbitrage is best defined as

A. a legal condition imposed by the CFTC.

B. the act of simultaneously buying and selling the same or equivalent assets or commodities for
the purpose of making reasonable profits.
C. the act of simultaneously buying and selling the same or equivalent assets or commodities for
the purpose of making guaranteed profits.
D. None of the above

2. Interest Rate Parity (IRP) is best defined as

A. when a government brings its domestic interest rate in line with other major financial markets.
B. when the central bank of a country brings its domestic interest rate in line with its major trading
partners.
C. an arbitrage condition that must hold when international financial markets are in equilibrium.
D. None of the above

3. When Interest Rate Parity (IRP) does not hold

A. there is usually a high degree of inflation in at least one country.

B. the financial markets are in equilibrium.
C. there are opportunities for covered interest arbitrage.
D. both b and c

4. Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 5% APR in the U.S.
and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate?

A. €1.5291/$
B. $1.5291/€
C. €1.4714/$
D. $1.4714/€
5. Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 3% APR in the U.S.
and 5% APR in the euro zone, what is the no-arbitrage 1-year forward rate?

A. €1.5291/$
B. $1.5291/€
C. €1.4714/$
D. $1.4714/€

6. Suppose you observe a spot exchange rate of $2.00/£. If interest rates are 5% APR in the U.S.
and 2% APR in the U.K., what is the no-arbitrage 1-year forward rate?

A. £2.0588/$
B. $2.0588/£
C. £1.9429/$
D. $1.9429/£

7. A formal statement of IRP is

A.
.
B.
.
C.

.
D.
.

8. Suppose that the one-year interest rate is 5.0 percent in the United States; the spot exchange
rate is $1.20/€; and the one-year forward exchange rate is $1.16/€. What must one-year interest
rate be in the euro zone to avoid arbitrage?

A. 5.0%
B. 6.09%
C. 8.62%
D. None of the above
9. Suppose that the one-year interest rate is 3.0 percent in the Italy, the spot exchange rate is
$1.20/€, and the one-year forward exchange rate is $1.18/€. What must one-year interest rate be
in the United States?

A. 1.2833%
B. 1.0128%
C. 4.75%
D. None of the above

10. Suppose that the one-year interest rate is 4.0 percent in the Italy, the spot exchange rate is
$1.60/€, and the one-year forward exchange rate is $1.58/€. What must one-year interest rate be
in the United States?

A. 2%
B. 2.7%
C. 5.32%
D. None of the above

11. Covered Interest Arbitrage (CIA) activities will result in

A. an unstable international financial markets.

B. restoring equilibrium prices quickly.
C. a disintermediation.
D. no effect on the market.

12. 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.

A. This is an example where interest rate parity holds.

B. This is an example of an arbitrage opportunity; interest rate parity does NOT hold.
C. This is an example of a Purchasing Power Parity violation and an arbitrage opportunity.
D. None of the above
13. Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six months.
You are considering the purchase of U.S. T-bills that yield 1.810% (that's a six month rate, not an
annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is $1.00 =
¥100, and the six month forward rate is $1.00 = ¥110. The interest rate in Japan (on an
investment of comparable risk) is 13 percent. What is your strategy?

A. Take $1m, invest in U.S. T-bills.

B. Take $1m, translate into yen at the spot, invest in Japan, and repatriate your yen earnings
back into dollars at the spot rate prevailing in six months.
C. Take $1m, translate into yen at the spot, invest in Japan, hedge with a short position in the
forward contract.
D. Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short position in
the spot contract.

14. Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in
Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-
year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000. If
an astute trader finds an arbitrage, what is the net cash flow in one year?

A. $238.65
B. $14,000
C. $46,207
D. $7,000

15. 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 spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is
$1.20 = €1.00. Show how to realize a certain profit via covered interest arbitrage.

A. Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one
year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.
C. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
€2,000.
D. Both c and b
16. Suppose that the annual 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 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, what is the net cash flow in one year?

A. $10,690
B. $15,000
C. $46,207
D. $21,964.29

17. A U.S.-based currency dealer has good credit and can borrow $1,000,000 for one year. The one-
year interest rate in the U.S. is i$ = 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 to realize a certain dollar profit via covered interest arbitrage.

A. Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one
year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.
C. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
€2,000.
D. Both c and b

18. An Italian currency dealer has good credit and can borrow €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 to realize a certain euro-denominated profit via covered interest arbitrage.

A. Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one
year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.
C. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
€2,000.
D. Both c and b
19. Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six months.
You are considering the purchase of U.S. T-bills that yield 1.810% (that's a six month rate, not an
annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is $1.00 =
¥100, and the six month forward rate is $1.00 = ¥110. What must the interest rate in Japan (on an
investment of comparable risk) be before you are willing to consider investing there for six
months?

A. 11.991%
B. 1.12%
C. 7.45%
D. -7.45%

20. How high does the lending rate in the euro zone have to be before an arbitrageur would NOT
consider borrowing dollars, trading for euro at the spot, investing in the euro zone and hedging
with a short position in the forward contract?

A. The bid-ask spreads are too wide for any profitable arbitrage when i€ > 0
B. 3.48%
C. -2.09%
D. None of the above

21. Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in
Germany, and the one-year forward exchange rate is $1.16/€. What must the spot exchange rate
be?

A. $1.1768/€
B. $1.1434/€
C. $1.12/€
D. None of the above

22. A higher U.S. interest rate (i$ ↑) will result in

A. a stronger dollar.
B. a lower spot exchange rate (expressed as foreign currency per U.S. dollar).
C. both a and b
D. none of the above
23. If the interest rate in the U.S. is i$ = 5 percent for the next year and interest rate in the U.K. is i£ =
8 percent for the next year, uncovered IRP suggests that

A. the pound is expected to depreciate against the dollar by about 3 percent.

B. the pound is expected to appreciate against the dollar by about 3 percent.
C. the dollar is expected to appreciate against the pound by about 3 percent.
D. both a and c

24. 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?

A. $1.2471 = €1.00
B. $1.20 = €1.00
C. $1.1547 = €1.00
D. none of the above

25. Will an arbitrageur facing the following prices be able to make money?

A. Yes, borrow $1,000 at 5%; Trade for € at the ask spot rate $1.01 = €1.00; Invest €990.10 at
5.5%; Hedge this with a forward contract on €1,044.55 at $0.99 = €1.00; Receive $1.034.11.
B. Yes, borrow €1,000 at 6%; Trade for $ at the bid spot rate $1.00 = €1.00; Invest $1,000 at
4.5%; Hedge this with a forward contract on €1,045 at $1.00 = €1.00.
C. No; the transactions costs are too high.
D. None of the above

26. If IRP fails to hold

A. pressure from arbitrageurs should bring exchange rates and interest rates back into line.
B. it may fail to hold due to transactions costs.
C. it may be due to government-imposed capital controls.
D. all of the above
27. Although IRP tends to hold, it may not hold precisely all the time

A. due to transactions costs, like the bid ask spread.

B. due to asymmetric information.
C. due to capital controls imposed by governments.
D. both a and c

28. Consider a bank dealer who faces the following spot rates and interest rates. What should he set
his 1-year forward ask price at?

A. $1.4324/€
B. $1.4358/€
C. $1.4662/€
D. $1.4676/€

29. Consider a bank dealer who faces the following spot rates and interest rates. What should he set
his 1-year forward bid price at?

A. $1.4324/€
B. $1.4358/€
C. $1.4662/€
D. $1.4676/€
30. Will an arbitrageur facing the following prices be able to make money?

A. Yes, borrow €1,000,000 at 3.65%; Trade for $ at the bid spot rate $1.40 = €1.00; Invest at
4.1%; Hedge this with a long position in a forward contract.
B. Yes, borrow $1,000,000 at 4.2%; Trade for € at the spot ask exchange rate $1.43 = €1.00;
Invest €699,300.70 at 3.5%; Hedge this by going SHORT in forward (agree to sell € @ BID
price of $1.44/€ in one year). Cash flow in 1 year $237.76.
C. No; the transactions costs are too high.
D. None of the above

31. If a foreign county experiences a hyperinflation,

A. its currency will depreciate against stable currencies.

B. its currency may appreciate against stable currencies.
C. its currency may be unaffected—it's difficult to say.
D. none of the above

32. As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail
for the next year in the U.S. is 2% and 3% in the euro zone. What is the one-year forward rate
that should prevail?

A. €1.00 = $1.2379
B. €1.00 = $1.2623
C. €1.00 = $0.9903
D. $1.00 = €1.2623

33. Purchasing Power Parity (PPP) theory states that

A. the exchange rate between currencies of two countries should be equal to the ratio of the
countries' price levels.
B. as the purchasing power of a currency sharply declines (due to hyperinflation) that currency
will depreciate against stable currencies.
C. the prices of standard commodity baskets in two countries are not related.
D. both a and b
34. 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% and 3% in the euro zone. What is the one-year forward rate
that should prevail?

A. €1.00 = $1.6157
B. €1.6157 = $1.00
C. €1.00 = $1.5845
D. $1.00 × 1.03 = €1.60 × 1.02

35. 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

A. 0.07.
B. 0.9849.
C. -0.0198.
D. 4.5.

36. If the annual inflation rate is 2.5 percent in the United States and 4 percent in the U.K., and the
dollar appreciated against the pound by 1.5 percent, then the real exchange rate, assuming that
PPP initially held, is _____.

A. parity
B. 0.9710
C. -0.0198
D. 4.5

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

A. it will hold only if the prices of the constituent commodities are equalized across countries in a
given currency.
B. it will hold only if the composition of the consumption basket is the same across countries.
C. both a and b
D. none of the above

38. Some commodities never enter into international trade. Examples include

A. nontradables.
B. haircuts.
C. housing.
D. all of the above
39. Generally unfavorable evidence on PPP suggests that

A. substantial barriers to international commodity arbitrage exist.

B. tariffs and quotas imposed on international trade can explain at least some of the evidence.
C. shipping costs can make it difficult to directly compare commodity prices.
D. all of the above

40. The price of a McDonald's Big Mac sandwich

A. is about the same in the 120 countries that McDonalds does business in.
B. varies considerably across the world in dollar terms.
C. supports PPP.
D. none of the above.

41. The Fisher effect can be written for the United States as:

A. Option A
B. Option B
C. Option C
D. Option D

42. Forward parity states that

A. any forward premium or discount is equal to the expected change in the exchange rate.
B. any forward premium or discount is equal to the actual change in the exchange rate.
C. the nominal interest rate differential reflects the expected change in the exchange rate.
D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.
43. The International Fisher Effect suggests that

A. any forward premium or discount is equal to the expected change in the exchange rate.
B. any forward premium or discount is equal to the actual change in the exchange rate.
C. the nominal interest rate differential reflects the expected change in the exchange rate.
D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.

44. The Fisher effect states that

A. any forward premium or discount is equal to the expected change in the exchange rate.
B. any forward premium or discount is equal to the actual change in the exchange rate.
C. the nominal interest rate differential reflects the expected change in the exchange rate.
D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.

45. If you could accurately and consistently forecast exchange rates

A. this would be a very handy thing as girls prefer guys with skills.
B. you could impress your dates.
C. you could make a great deal of money.
D. all of the above

46. The main approaches to forecasting exchange rates are

A. Efficient market, Fundamental, and Technical approaches.

B. Efficient market and Technical approaches.
C. Efficient market and Fundamental approaches.
D. Fundamental and Technical approaches.

47. The benefit to forecasting exchange rates

A. are greatest during periods of fixed exchange rates.

B. are nonexistent now that the euro and dollar are the biggest game in town.
C. accrue to, and are a vital concern for, MNCs formulating international sourcing, production,
financing and marketing strategies.
D. all of the above
48. The Efficient Markets Hypothesis states

A. markets tend to evolve to low transactions costs and speedy execution of orders.
B. current asset prices (e.g. exchange rates) fully reflect all the available and relevant information.
C. current exchange rates cannot be explained by such fundamental forces as money supplies,
inflation rates and so forth.
D. none of the above

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

A. today's exchange rate.

B. current forward exchange rates (e.g. the six-month forward rate is a pretty good predictor of
the spot rate that will prevail six months from today).
C. esoteric fundamental models that take an econometrician to use and no one can explain.
D. both a and b

50. Which of the following is a true statement?

A. While researchers found it difficult to reject the random walk hypothesis for exchange rates on
empirical grounds, there is no theoretical reason why exchange rates should follow a pure
random walk.
B. While researchers found it easy to reject the random walk hypothesis for exchange rates on
empirical grounds, there are strong theoretical reasons why exchange rates should follow a
pure random walk.
C. While researchers found it difficult to reject the random walk hypothesis for exchange rates on
empirical grounds, there are compelling theoretical reasons why exchange rates should follow
a pure random walk.
D. None of the above

51. If the exchange rate follows a random walk

A. the future exchange rate is unpredictable.

B. the future exchange rate is expected to be the same as the current exchange rate, St = E(St +
1).
C. the best predictor of future exchange rates is the forward rate Ft = E(St + 1|It).
D. both b and c
52. One implication of the random walk hypothesis is

A. 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.
B. 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 already reflected in the
current exchange rate.
C. given the relative inefficiency of foreign exchange markets, it is difficult to outperform the
technical forecasts unless the forecaster has access to private information that is not yet
reflected in the current futures exchange rate.
D. none of the above

53. The random walk hypothesis suggests that

A. the best predictor of the future exchange rate is the current exchange rate.
B. the best predictor of the future exchange rate is the current forward rate.
C. both a and b are consistent with the efficient market hypothesis.
D. None of the above

54. With regard to fundamental forecasting versus technical forecasting of exchange rates

A. the technicians tend to use "cause and effect" models.

B. the fundamentalists tend to believe that "history will repeat itself" is the best model.
C. both a and b
D. none of the above

55. Generating exchange rate forecasts with the fundamental approach involves

A. looking at charts of the exchange rate and extrapolating the patterns into the future
B. estimation of a structural model
C. substituting the estimated values of the independent variables into the estimated structural
model to generate the forecast
D. both b and c
56. Which of the following issues are difficulties for the fundamental approach to exchange rate
forecasting?

A. One has to forecast a set of independent variables to forecast the exchange rates. Forecasting
the former will certainly be subject to errors and may not be necessarily easier than forecasting
the latter.
B. The parameter values, that is the α's and β's, that are estimated using historical data may
change over time because of changes in government policies and/or the underlying structure
of the economy. Either difficulty can diminish the accuracy of forecasts even if the model is
correct.
C. The model itself can be wrong.
D. All of the above

57. Researchers have found that the fundamental approach to exchange rate forecasting

A. outperforms the efficient market approach.

B. fails to more accurately forecast exchange rates than either the random walk model or the
forward rate model.
C. fails to more accurately forecast exchange rates than the random walk model but is better than
the forward rate model.
D. outperforms the random walk model, but fails to more accurately forecast exchange rates than
the forward rate model.

58. Academic studies tend to discredit the validity of technical analysis. Which of the following is
true?

A. This can be viewed as support technical analysis.

B. It can be rational for individual traders to use technical analysis—if enough traders use
technical analysis the predictions based on it can become self-fulfilling to some extent, at least
in the short-run.
C. That can be explained by the difficulty professors may have in differentiating between technical
analysis and fundamental analysis.
D. None of the above

59. The moving average crossover rule

A. is a fundamental approach to forecasting exchange rates.

B. states that a crossover of the short-term moving average above the long-term moving average
signals that the foreign currency is appreciating.
C. states that a crossover of the short-term moving average above the long-term moving average
signals that the foreign currency is depreciating.
D. none of the above
60. According to the technical approach, what matters in exchange rate determination

A. the past behavior of exchange rates.

B. the velocity of money.
C. the future behavior of exchange rates.
D. the beta.

61. Studies of the accuracy of paid exchange rate forecasters

A. tend to support the view that "you get what you pay for".
B. tend to support the view that forecasting is easy, at least with regard to major currencies like
the euro and Japanese yen.
C. tend to support the view that banks do their best forecasting with the yen.
D. none of the above

62. According to the research in the accuracy of paid exchange rate forecasters,

A. as a group, they do not do a better job of forecasting the exchange rate than the forward rate
does.
B. the average forecaster is better than average at forecasting.
C. the forecasters do a better job of predicting the future exchange rate than the market does.
D. none of the above

63. According to the research in the accuracy of paid exchange rate forecasters,

A. you can make more money selling forecasts than you can following forecasts.
B. the average forecaster is better than average at forecasting.
C. the forecasters do a better job of predicting the future exchange rates than the market does.
D. none of the above.

64. According to the monetary approach, what matters in exchange rate determination are

A. the relative money supplies.

B. the relative velocities of monies.
C. the relative national outputs.
D. all of the above
65. According to the monetary approach, the exchange rate can be expressed as

A.

.
B.

.
C.

.
D. none of the above.

Please note that your answers are worth zero points if they do not include currency symbols ($, €)

66. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

67. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?
68. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

69. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

70. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that satisfies IRP from the perspective of a customer that borrowed $1m traded for
€ at the spot and invested at i€ = 4%.

71. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that that satisfies IRP from the perspective of a customer who borrowed €1m,
traded for dollars at the spot rate and invested at i$ = 2%.
72. There is (at least) one profitable arbitrage at these prices. What is it?

Please note that your answers are worth zero points if they do not include currency symbols ($, €)

73. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

74. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?
75. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

76. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

77. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that satisfies IRP from the perspective of a customer that borrowed $1m traded for
€ at the spot and invested at i€ = 3%.

78. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that that satisfies IRP from the perspective of a customer who borrowed €1m,
traded for dollars at the spot rate and invested at i$ = 4%.
79. There is (at least) one profitable arbitrage at these prices. What is it?

Assume that you are a retail customer (i.e. you buy as the ask and sell at the bid).

Please note that your answers are worth zero points if they do not include currency symbols ($, €)

80. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

81. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?
82. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

83. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

84. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID
exchange rate in $ per € that satisfies IRP from the perspective of a customer.

85. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.
86. There is (at least) one profitable arbitrage at these prices. What is it?

Assume that you are a retail customer.

Please note that your answers are worth zero points if they do not include currency symbols ($, €)

87. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

88. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?
89. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

90. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

91. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

92. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.
93. There is (at least) one profitable arbitrage at these prices. What is it?

Assume that you are a retail customer.

Please note that your answers are worth zero points if they do not include currency symbols ($, €)

94. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

95. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?
96. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

97. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

98. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

99. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.
100.There is (at least) one (smallish) profitable arbitrage at these prices. What is it?
 Chapter 06 International Parity Relationships and
Forecasting Foreign Exchange Rates Key

1. An arbitrage is best defined as

A. a legal condition imposed by the CFTC.

B. the act of simultaneously buying and selling the same or equivalent assets or commodities
for the purpose of making reasonable profits.
C. the act of simultaneously buying and selling the same or equivalent assets or commodities
for the purpose of making guaranteed profits.
D. None of the above
Eun - Chapter 06 #1
Topic: Interest Rate Parity

2. Interest Rate Parity (IRP) is best defined as

A. when a government brings its domestic interest rate in line with other major financial
markets.
B. when the central bank of a country brings its domestic interest rate in line with its major
trading partners.
C. an arbitrage condition that must hold when international financial markets are in equilibrium.
D. None of the above
Eun - Chapter 06 #2
Topic: Interest Rate Parity

3. When Interest Rate Parity (IRP) does not hold

A. there is usually a high degree of inflation in at least one country.

B. the financial markets are in equilibrium.
C. there are opportunities for covered interest arbitrage.
D. both b and c
Eun - Chapter 06 #3
Topic: Interest Rate Parity
4. Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 5% APR in the
U.S. and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate?

A. €1.5291/$
B. $1.5291/€
C. €1.4714/$
D. $1.4714/€
Eun - Chapter 06 #4
Topic: Interest Rate Parity

5. Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 3% APR in the
U.S. and 5% APR in the euro zone, what is the no-arbitrage 1-year forward rate?

A. €1.5291/$
B. $1.5291/€
C. €1.4714/$
D. $1.4714/€
Eun - Chapter 06 #5
Topic: Interest Rate Parity

6. Suppose you observe a spot exchange rate of $2.00/£. If interest rates are 5% APR in the
U.S. and 2% APR in the U.K., what is the no-arbitrage 1-year forward rate?

A. £2.0588/$
B. $2.0588/£
C. £1.9429/$
D. $1.9429/£
Eun - Chapter 06 #6
Topic: Interest Rate Parity

7. A formal statement of IRP is

A.
.
B.
.
C.

.
D.
.
Eun - Chapter 06 #7
Topic: Interest Rate Parity
8. Suppose that the one-year interest rate is 5.0 percent in the United States; the spot exchange
rate is $1.20/€; and the one-year forward exchange rate is $1.16/€. What must one-year
interest rate be in the euro zone to avoid arbitrage?

A. 5.0%
B. 6.09%
C. 8.62%
D. None of the above
Eun - Chapter 06 #8
Topic: Covered Interest Arbitrage

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

A. 1.2833%
B. 1.0128%
C. 4.75%
D. None of the above
Eun - Chapter 06 #9
Topic: Covered Interest Arbitrage

10. Suppose that the one-year interest rate is 4.0 percent in the Italy, the spot exchange rate is
$1.60/€, and the one-year forward exchange rate is $1.58/€. What must one-year interest rate
be in the United States?

A. 2%
B. 2.7%
C. 5.32%
D. None of the above
Eun - Chapter 06 #10
Topic: Covered Interest Arbitrage

11. Covered Interest Arbitrage (CIA) activities will result in

A. an unstable international financial markets.

B. restoring equilibrium prices quickly.
C. a disintermediation.
D. no effect on the market.
Eun - Chapter 06 #11
Topic: Covered Interest Arbitrage
12. 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.

A. This is an example where interest rate parity holds.

B. This is an example of an arbitrage opportunity; interest rate parity does NOT hold.
C. This is an example of a Purchasing Power Parity violation and an arbitrage opportunity.
D. None of the above
Eun - Chapter 06 #12
Topic: Covered Interest Arbitrage

13. Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six
months. You are considering the purchase of U.S. T-bills that yield 1.810% (that's a six month
rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate
is $1.00 = ¥100, and the six month forward rate is $1.00 = ¥110. The interest rate in Japan (on
an investment of comparable risk) is 13 percent. What is your strategy?

A. Take $1m, invest in U.S. T-bills.

B. Take $1m, translate into yen at the spot, invest in Japan, and repatriate your yen earnings
back into dollars at the spot rate prevailing in six months.
C. Take $1m, translate into yen at the spot, invest in Japan, hedge with a short position in the
forward contract.
D. Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short
position in the spot contract.
Eun - Chapter 06 #13
Topic: Covered Interest Arbitrage

14. Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in
Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-
year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000.
If an astute trader finds an arbitrage, what is the net cash flow in one year?

A. $238.65
B. $14,000
C. $46,207
D. $7,000
Eun - Chapter 06 #14
Topic: Covered Interest Arbitrage
15. 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 spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is
$1.20 = €1.00. Show how to realize a certain profit via covered interest arbitrage.

A. Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
$2,400.
C. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
€2,000.
D. Both c and b
Eun - Chapter 06 #15
Topic: Covered Interest Arbitrage

16. Suppose that the annual 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 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, what is the net cash flow in one year?

A. $10,690
B. $15,000
C. $46,207
D. $21,964.29
Eun - Chapter 06 #16
Topic: Covered Interest Arbitrage

17. A U.S.-based currency dealer has good credit and can borrow $1,000,000 for one year. The
one-year interest rate in the U.S. is i$ = 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 to realize a certain dollar profit via covered interest arbitrage.

A. Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
$2,400.
C. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
€2,000.
D. Both c and b
Eun - Chapter 06 #17
 Topic: Covered Interest Arbitrage

18. An Italian currency dealer has good credit and can borrow €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 to realize a certain euro-denominated profit via covered interest arbitrage.

A. Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
$2,400.
C. Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit
€2,000.
D. Both c and b
Eun - Chapter 06 #18
Topic: Covered Interest Arbitrage

19. Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six
months. You are considering the purchase of U.S. T-bills that yield 1.810% (that's a six month
rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate
is $1.00 = ¥100, and the six month forward rate is $1.00 = ¥110. What must the interest rate in
Japan (on an investment of comparable risk) be before you are willing to consider investing
there for six months?

A. 11.991%
B. 1.12%
C. 7.45%
D. -7.45%
Eun - Chapter 06 #19
Topic: Covered Interest Arbitrage
20. How high does the lending rate in the euro zone have to be before an arbitrageur would NOT
consider borrowing dollars, trading for euro at the spot, investing in the euro zone and hedging
with a short position in the forward contract?

A. The bid-ask spreads are too wide for any profitable arbitrage when i€ > 0
B. 3.48%
C. -2.09%
D. None of the above
Eun - Chapter 06 #20
Topic: Covered Interest Arbitrage

21. Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in
Germany, and the one-year forward exchange rate is $1.16/€. What must the spot exchange
rate be?

A. $1.1768/€
B. $1.1434/€
C. $1.12/€
D. None of the above
Eun - Chapter 06 #21
Topic: Interest Rate Parity and Exchange Rate Determination

22. A higher U.S. interest rate (i$ ↑) will result in

A. a stronger dollar.
B. a lower spot exchange rate (expressed as foreign currency per U.S. dollar).
C. both a and b
D. none of the above
Eun - Chapter 06 #22
Topic: Interest Rate Parity and Exchange Rate Determination

23. If the interest rate in the U.S. is i$ = 5 percent for the next year and interest rate in the U.K. is i£
= 8 percent for the next year, uncovered IRP suggests that

A. the pound is expected to depreciate against the dollar by about 3 percent.

B. the pound is expected to appreciate against the dollar by about 3 percent.
C. the dollar is expected to appreciate against the pound by about 3 percent.
D. both a and c
Eun - Chapter 06 #23
 Topic: Interest Rate Parity and Exchange Rate Determination

24. 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?

A. $1.2471 = €1.00
B. $1.20 = €1.00
C. $1.1547 = €1.00
D. none of the above
Eun - Chapter 06 #24
Topic: Interest Rate Parity and Exchange Rate Determination

25. Will an arbitrageur facing the following prices be able to make money?

A. Yes, borrow $1,000 at 5%; Trade for € at the ask spot rate $1.01 = €1.00; Invest €990.10 at
5.5%; Hedge this with a forward contract on €1,044.55 at $0.99 = €1.00; Receive
$1.034.11.
B. Yes, borrow €1,000 at 6%; Trade for $ at the bid spot rate $1.00 = €1.00; Invest $1,000 at
4.5%; Hedge this with a forward contract on €1,045 at $1.00 = €1.00.
C. No; the transactions costs are too high.
D. None of the above
Eun - Chapter 06 #25
Topic: Reasons for Deviations from Interest Rate Parity

26. If IRP fails to hold

A. pressure from arbitrageurs should bring exchange rates and interest rates back into line.
B. it may fail to hold due to transactions costs.
C. it may be due to government-imposed capital controls.
D. all of the above
Eun - Chapter 06 #26
Topic: Reasons for Deviations from Interest Rate Parity
27. Although IRP tends to hold, it may not hold precisely all the time

A. due to transactions costs, like the bid ask spread.

B. due to asymmetric information.
C. due to capital controls imposed by governments.
D. both a and c
Eun - Chapter 06 #27
Topic: Reasons for Deviations from Interest Rate Parity

28. Consider a bank dealer who faces the following spot rates and interest rates. What should he
set his 1-year forward ask price at?

A. $1.4324/€
B. $1.4358/€
C. $1.4662/€
D. $1.4676/€
Eun - Chapter 06 #28
Topic: Reasons for Deviations from Interest Rate Parity

29. Consider a bank dealer who faces the following spot rates and interest rates. What should he
set his 1-year forward bid price at?

A. $1.4324/€
B. $1.4358/€
C. $1.4662/€
D. $1.4676/€
Eun - Chapter 06 #29
Topic: Reasons for Deviations from Interest Rate Parity
30. Will an arbitrageur facing the following prices be able to make money?

A. Yes, borrow €1,000,000 at 3.65%; Trade for $ at the bid spot rate $1.40 = €1.00; Invest at
4.1%; Hedge this with a long position in a forward contract.
B. Yes, borrow $1,000,000 at 4.2%; Trade for € at the spot ask exchange rate $1.43 = €1.00;
Invest €699,300.70 at 3.5%; Hedge this by going SHORT in forward (agree to sell € @ BID
price of $1.44/€ in one year). Cash flow in 1 year $237.76.
C. No; the transactions costs are too high.
D. None of the above
Eun - Chapter 06 #30
Topic: Reasons for Deviations from Interest Rate Parity

31. If a foreign county experiences a hyperinflation,

A. its currency will depreciate against stable currencies.

B. its currency may appreciate against stable currencies.
C. its currency may be unaffected—it's difficult to say.
D. none of the above
Eun - Chapter 06 #31
Topic: Purchasing Power Parity

32. As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to
prevail for the next year in the U.S. is 2% and 3% in the euro zone. What is the one-year
forward rate that should prevail?

A. €1.00 = $1.2379
B. €1.00 = $1.2623
C. €1.00 = $0.9903
D. $1.00 = €1.2623
Eun - Chapter 06 #32
Topic: Purchasing Power Parity
33. Purchasing Power Parity (PPP) theory states that

A. the exchange rate between currencies of two countries should be equal to the ratio of the
countries' price levels.
B. as the purchasing power of a currency sharply declines (due to hyperinflation) that currency
will depreciate against stable currencies.
C. the prices of standard commodity baskets in two countries are not related.
D. both a and b
Eun - Chapter 06 #33
Topic: Purchasing Power Parity

34. 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% and 3% in the euro zone. What is the one-year
forward rate that should prevail?

A. €1.00 = $1.6157
B. €1.6157 = $1.00
C. €1.00 = $1.5845
D. $1.00 × 1.03 = €1.60 × 1.02
Eun - Chapter 06 #34
Topic: Purchasing Power Parity

35. 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

A. 0.07.
B. 0.9849.
C. -0.0198.
D. 4.5.
Eun - Chapter 06 #35
Topic: PPP Deviations and the Real Exchange Rate

36. If the annual inflation rate is 2.5 percent in the United States and 4 percent in the U.K., and the
dollar appreciated against the pound by 1.5 percent, then the real exchange rate, assuming
that PPP initially held, is _____.

A. parity
B. 0.9710
C. -0.0198
D. 4.5
Eun - Chapter 06 #36
Topic: PPP Deviations and the Real Exchange Rate
37. In view of the fact that PPP is the manifestation of the law of one price applied to a standard
commodity basket,

A. it will hold only if the prices of the constituent commodities are equalized across countries in
a given currency.
B. it will hold only if the composition of the consumption basket is the same across countries.
C. both a and b
D. none of the above
Eun - Chapter 06 #37
Topic: Evidence on Purchasing Power Parity

38. Some commodities never enter into international trade. Examples include

A. nontradables.
B. haircuts.
C. housing.
D. all of the above
Eun - Chapter 06 #38
Topic: Evidence on Purchasing Power Parity

39. Generally unfavorable evidence on PPP suggests that

A. substantial barriers to international commodity arbitrage exist.

B. tariffs and quotas imposed on international trade can explain at least some of the evidence.
C. shipping costs can make it difficult to directly compare commodity prices.
D. all of the above
Eun - Chapter 06 #39
Topic: Evidence on Purchasing Power Parity

40. The price of a McDonald's Big Mac sandwich

A. is about the same in the 120 countries that McDonalds does business in.
B. varies considerably across the world in dollar terms.
C. supports PPP.
D. none of the above.
Eun - Chapter 06 #40
Topic: Evidence on Purchasing Power Parity
41. The Fisher effect can be written for the United States as:

A. Option A
B. Option B
C. Option C
D. Option D
Eun - Chapter 06 #41
Topic: Fisher Effects

42. Forward parity states that

A. any forward premium or discount is equal to the expected change in the exchange rate.
B. any forward premium or discount is equal to the actual change in the exchange rate.
C. the nominal interest rate differential reflects the expected change in the exchange rate.
D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.
Eun - Chapter 06 #42
Topic: Fisher Effects

43. The International Fisher Effect suggests that

A. any forward premium or discount is equal to the expected change in the exchange rate.
B. any forward premium or discount is equal to the actual change in the exchange rate.
C. the nominal interest rate differential reflects the expected change in the exchange rate.
D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.
Eun - Chapter 06 #43
Topic: Fisher Effects
44. The Fisher effect states that

A. any forward premium or discount is equal to the expected change in the exchange rate.
B. any forward premium or discount is equal to the actual change in the exchange rate.
C. the nominal interest rate differential reflects the expected change in the exchange rate.
D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.
Eun - Chapter 06 #44
Topic: Fisher Effects

45. If you could accurately and consistently forecast exchange rates

A. this would be a very handy thing as girls prefer guys with skills.
B. you could impress your dates.
C. you could make a great deal of money.
D. all of the above
Eun - Chapter 06 #45
Topic: Forecasting Exchange Rates

46. The main approaches to forecasting exchange rates are

A. Efficient market, Fundamental, and Technical approaches.

B. Efficient market and Technical approaches.
C. Efficient market and Fundamental approaches.
D. Fundamental and Technical approaches.
Eun - Chapter 06 #46
Topic: Forecasting Exchange Rates

47. The benefit to forecasting exchange rates

A. are greatest during periods of fixed exchange rates.

B. are nonexistent now that the euro and dollar are the biggest game in town.
C. accrue to, and are a vital concern for, MNCs formulating international sourcing, production,
financing and marketing strategies.
D. all of the above
Eun - Chapter 06 #47
Topic: Forecasting Exchange Rates
48. The Efficient Markets Hypothesis states

A. markets tend to evolve to low transactions costs and speedy execution of orders.
B. current asset prices (e.g. exchange rates) fully reflect all the available and relevant
information.
C. current exchange rates cannot be explained by such fundamental forces as money
supplies, inflation rates and so forth.
D. none of the above
Eun - Chapter 06 #48
Topic: Efficient Market Approach

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

A. today's exchange rate.

B. current forward exchange rates (e.g. the six-month forward rate is a pretty good predictor of
the spot rate that will prevail six months from today).
C. esoteric fundamental models that take an econometrician to use and no one can explain.
D. both a and b
Eun - Chapter 06 #49
Topic: Efficient Market Approach

50. Which of the following is a true statement?

A. While researchers found it difficult to reject the random walk hypothesis for exchange rates
on empirical grounds, there is no theoretical reason why exchange rates should follow a
pure random walk.
B. While researchers found it easy to reject the random walk hypothesis for exchange rates on
empirical grounds, there are strong theoretical reasons why exchange rates should follow a
pure random walk.
C. While researchers found it difficult to reject the random walk hypothesis for exchange rates
on empirical grounds, there are compelling theoretical reasons why exchange rates should
follow a pure random walk.
D. None of the above
Eun - Chapter 06 #50
Topic: Efficient Market Approach
51. If the exchange rate follows a random walk

A. the future exchange rate is unpredictable.

B. the future exchange rate is expected to be the same as the current exchange rate, St = E(St
+ 1).
C. the best predictor of future exchange rates is the forward rate Ft = E(St + 1|It).
D. both b and c
Eun - Chapter 06 #51
Topic: Efficient Market Approach

52. One implication of the random walk hypothesis is

A. 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.
B. 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 already
reflected in the current exchange rate.
C. given the relative inefficiency of foreign exchange markets, it is difficult to outperform the
technical forecasts unless the forecaster has access to private information that is not yet
reflected in the current futures exchange rate.
D. none of the above
Eun - Chapter 06 #52
Topic: Efficient Market Approach

53. The random walk hypothesis suggests that

A. the best predictor of the future exchange rate is the current exchange rate.
B. the best predictor of the future exchange rate is the current forward rate.
C. both a and b are consistent with the efficient market hypothesis.
D. None of the above
Eun - Chapter 06 #53
Topic: Efficient Market Approach

54. With regard to fundamental forecasting versus technical forecasting of exchange rates

A. the technicians tend to use "cause and effect" models.

B. the fundamentalists tend to believe that "history will repeat itself" is the best model.
C. both a and b
D. none of the above
Eun - Chapter 06 #54
Topic: Fundamental Approach
55. Generating exchange rate forecasts with the fundamental approach involves

A. looking at charts of the exchange rate and extrapolating the patterns into the future
B. estimation of a structural model
C. substituting the estimated values of the independent variables into the estimated structural
model to generate the forecast
D. both b and c
Eun - Chapter 06 #55
Topic: Fundamental Approach

56. Which of the following issues are difficulties for the fundamental approach to exchange rate
forecasting?

A. One has to forecast a set of independent variables to forecast the exchange rates.
Forecasting the former will certainly be subject to errors and may not be necessarily easier
than forecasting the latter.
B. The parameter values, that is the α's and β's, that are estimated using historical data may
change over time because of changes in government policies and/or the underlying
structure of the economy. Either difficulty can diminish the accuracy of forecasts even if the
model is correct.
C. The model itself can be wrong.
D. All of the above
Eun - Chapter 06 #56
Topic: Fundamental Approach

57. Researchers have found that the fundamental approach to exchange rate forecasting

A. outperforms the efficient market approach.

B. fails to more accurately forecast exchange rates than either the random walk model or the
forward rate model.
C. fails to more accurately forecast exchange rates than the random walk model but is better
than the forward rate model.
D. outperforms the random walk model, but fails to more accurately forecast exchange rates
than the forward rate model.
Eun - Chapter 06 #57
Topic: Fundamental Approach
58. Academic studies tend to discredit the validity of technical analysis. Which of the following is
true?

A. This can be viewed as support technical analysis.

B. It can be rational for individual traders to use technical analysis—if enough traders use
technical analysis the predictions based on it can become self-fulfilling to some extent, at
least in the short-run.
C. That can be explained by the difficulty professors may have in differentiating between
technical analysis and fundamental analysis.
D. None of the above
Eun - Chapter 06 #58
Topic: Technical Approach

59. The moving average crossover rule

A. is a fundamental approach to forecasting exchange rates.

B. states that a crossover of the short-term moving average above the long-term moving
average signals that the foreign currency is appreciating.
C. states that a crossover of the short-term moving average above the long-term moving
average signals that the foreign currency is depreciating.
D. none of the above
Eun - Chapter 06 #59
Topic: Technical Approach

60. According to the technical approach, what matters in exchange rate determination

A. the past behavior of exchange rates.

B. the velocity of money.
C. the future behavior of exchange rates.
D. the beta.
Eun - Chapter 06 #60
Topic: Technical Approach

61. Studies of the accuracy of paid exchange rate forecasters

A. tend to support the view that "you get what you pay for".
B. tend to support the view that forecasting is easy, at least with regard to major currencies
like the euro and Japanese yen.
C. tend to support the view that banks do their best forecasting with the yen.
D. none of the above
Eun - Chapter 06 #61
Topic: Performance of the Forecasters
62. According to the research in the accuracy of paid exchange rate forecasters,

A. as a group, they do not do a better job of forecasting the exchange rate than the forward
rate does.
B. the average forecaster is better than average at forecasting.
C. the forecasters do a better job of predicting the future exchange rate than the market does.
D. none of the above
Eun - Chapter 06 #62
Topic: Performance of the Forecasters

63. According to the research in the accuracy of paid exchange rate forecasters,

A. you can make more money selling forecasts than you can following forecasts.
B. the average forecaster is better than average at forecasting.
C. the forecasters do a better job of predicting the future exchange rates than the market
does.
D. none of the above.
Eun - Chapter 06 #63
Topic: Performance of the Forecasters

64. According to the monetary approach, what matters in exchange rate determination are

A. the relative money supplies.

B. the relative velocities of monies.
C. the relative national outputs.
D. all of the above
Eun - Chapter 06 #64
Topic: Appendix 6A: Purchasing Power Parity and Exchange Rate Determination

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

A.

.
B.

.
C.

.
D. none of the above.
Eun - Chapter 06 #65
Topic: Appendix 6A: Purchasing Power Parity and Exchange Rate Determination
 Please note that your answers are worth zero points if they do not include currency symbols
($, €)
Eun - Chapter 06

66. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #66

Topic: Covered Interest Arbitrage

67. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #67

Topic: Covered Interest Arbitrage

68. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

Eun - Chapter 06 #68

Topic: Covered Interest Arbitrage
69. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

Eun - Chapter 06 #69

Topic: Covered Interest Arbitrage

70. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that satisfies IRP from the perspective of a customer that borrowed $1m traded
for € at the spot and invested at i€ = 4%.

Feedback:

Eun - Chapter 06 #70

Topic: Covered Interest Arbitrage

71. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that that satisfies IRP from the perspective of a customer who borrowed €1m,
traded for dollars at the spot rate and invested at i$ = 2%.

Feedback:

Eun - Chapter 06 #71

Topic: Covered Interest Arbitrage
72. There is (at least) one profitable arbitrage at these prices. What is it?

Feedback:

Eun - Chapter 06 #72

Topic: Covered Interest Arbitrage

Please note that your answers are worth zero points if they do not include currency symbols
($, €)
Eun - Chapter 06

73. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #73

Topic: Covered Interest Arbitrage

74. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #74

Topic: Covered Interest Arbitrage
75. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

Eun - Chapter 06 #75

Topic: Covered Interest Arbitrage

76. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

Eun - Chapter 06 #76

Topic: Covered Interest Arbitrage

77. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that satisfies IRP from the perspective of a customer that borrowed $1m traded
for € at the spot and invested at i€ = 3%.

Feedback:

Eun - Chapter 06 #77

Topic: Covered Interest Arbitrage
78. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward exchange
rate in $ per € that that satisfies IRP from the perspective of a customer who borrowed €1m,
traded for dollars at the spot rate and invested at i$ = 4%.

Feedback:

Eun - Chapter 06 #78

Topic: Covered Interest Arbitrage

79. There is (at least) one profitable arbitrage at these prices. What is it?

Feedback:

Eun - Chapter 06 #79

Topic: Covered Interest Arbitrage

Assume that you are a retail customer (i.e. you buy as the ask and sell at the bid).

Please note that your answers are worth zero points if they do not include currency symbols
($, €)
Eun - Chapter 06
80. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #80

Topic: Covered Interest Arbitrage

81. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #81

Topic: Covered Interest Arbitrage

82. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

Eun - Chapter 06 #82

Topic: Covered Interest Arbitrage

83. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

Eun - Chapter 06 #83

Topic: Covered Interest Arbitrage
84. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID
exchange rate in $ per € that satisfies IRP from the perspective of a customer.

Eun - Chapter 06 #84

Topic: Covered Interest Arbitrage

85. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

Eun - Chapter 06 #85

Topic: Covered Interest Arbitrage

86. There is (at least) one profitable arbitrage at these prices. What is it?

Feedback:

Eun - Chapter 06 #86

Topic: Covered Interest Arbitrage
 Assume that you are a retail customer.

Please note that your answers are worth zero points if they do not include currency symbols
($, €)
Eun - Chapter 06

87. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #87

Topic: Covered Interest Arbitrage

88. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #88

Topic: Covered Interest Arbitrage

89. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

Eun - Chapter 06 #89

Topic: Covered Interest Arbitrage
90. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

Eun - Chapter 06 #90

Topic: Covered Interest Arbitrage

91. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

Eun - Chapter 06 #91

Topic: Covered Interest Arbitrage

92. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

Eun - Chapter 06 #92

Topic: Covered Interest Arbitrage
93. There is (at least) one profitable arbitrage at these prices. What is it?

Feedback:

Eun - Chapter 06 #93

Topic: Covered Interest Arbitrage

Assume that you are a retail customer.

Please note that your answers are worth zero points if they do not include currency symbols
($, €)
Eun - Chapter 06

94. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #94

Topic: Covered Interest Arbitrage

95. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?

Eun - Chapter 06 #95

Topic: Covered Interest Arbitrage
96. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you
receive?

Eun - Chapter 06 #96

Topic: Covered Interest Arbitrage

97. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

Eun - Chapter 06 #97

Topic: Covered Interest Arbitrage

98. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

Eun - Chapter 06 #98

Topic: Covered Interest Arbitrage
99. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK
exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

Eun - Chapter 06 #99

Topic: Covered Interest Arbitrage

100. There is (at least) one (smallish) profitable arbitrage at these prices. What is it?

Feedback:

Eun - Chapter 06 #100

Topic: Covered Interest Arbitrage
Chapter 06 International Parity Relationships and
Forecasting Foreign Exchange Rates Summary

Category # of Questions
Eun - Chapter 06 105
Topic: Appendix 6A: Purchasing Power Parity and Exchange Rate Determination 2
Topic: Covered Interest Arbitrage 48
Topic: Efficient Market Approach 6
Topic: Evidence on Purchasing Power Parity 4
Topic: Fisher Effects 4
Topic: Forecasting Exchange Rates 3
Topic: Fundamental Approach 4
Topic: Interest Rate Parity 7
Topic: Interest Rate Parity and Exchange Rate Determination 4
Topic: Performance of the Forecasters 3
Topic: PPP Deviations and the Real Exchange Rate 2
Topic: Purchasing Power Parity 4
Topic: Reasons for Deviations from Interest Rate Parity 6
Topic: Technical Approach 3