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Flashcards in Exam 2 Deck (25):
1

For prices in two countries to be equal, the exchange rate between the two countries must change by the difference between the countries’ rates of inflation.

Purchasing Power Parity

2

In July of 2017, in Japan the Big Mac cost 380 Yen and it cost $5.30 in the US. In September 2017, the market exchange rate between the US dollar and the Japanese yen was 108 yen = 1 USD. According to the Big Mac index, this means:
a. the yen is overvalued against the USD but moving in the direction (compared to July) that PPP would predict.
b. the yen is overvalued against the USD and moving in the opposite direction (compared to July) that PPP would predict.
c. the yen is undervalued against the USD but moving in the direction (compared to July) the PPP would predict.
d. the yen is undervalued against the USD and moving in the opposite direction (compared to July) that PPP would predict.

c. the yen is undervalued against the USD but moving in the direction (compared to July) the PPP would predict.

3

The Fisher effect states that:
a. An increase (decrease) in the expected inflation rate in a country will cause an increase (decrease) in the nominal interest rate in the country.
b. If expected real interest rates differ between two countries, capital will flow to the country with the higher real rate until the real rates of interest in both countries are equal.
c. For prices in two countries to be equal, the exchange rate between the two countries must change by the difference between the countries’ rates of inflation.
d. In an efficient market with no transactions costs, the nominal interest rate differential should be approximately equal the forward differential.
e. (a) and (b) above.

e. (a) and (b) above.

4

The International Fisher effect states that:
a. For prices in two countries to be equal, the exchange rate between the two countries must change by the difference between the countries’ rates of inflation.
b. If the real interest rates differ between two countries, capital will flow to the country with the higher real rate until the exchange adjusted returns are equal in both countries.
c. In an efficient market with no transaction costs the nominal interest rate differential should approximately equal the forward differential.
d. Equilibrium is achieved when the forward differential is approximately equal to the expected change in the exchange rate.
e. (a) and (b) above.

b. If the real interest rates differ between two countries, capital will flow to the country with the higher real rate until the exchange adjusted returns are equal in both countries.

5

If an efficient market with no transactions costs, the nominal interest rate differential should approximately equal the forward differential.

Interest Rate Parity

6

Which of the following best describes the risks associated with the yen carry trade discussed in the article “Understanding the Carry trade”?
a. The forward premium on the yen may be smaller than expected, decreasing the gains from converting to dollars and investing in the US.
b. The weakening dollar may offset gains from borrowing at a lower interest rate in Japan and investing at higher rates in the US.
c. Interest rates in Japan may be higher than expected.
d. The weakening yen may offset gains from borrowing at a lower interest rate in Japan and investing at higher rates in the US.

b. The weakening dollar may offset gains from borrowing at a lower interest rate in Japan and investing at higher rates in the US.

7

In the article “Why hedge funds are shorting the yen despite its strength,” what is meant by “aborting the yen”?

Borrowing the yen, and then converting it in order to invest in higher yielding securities of other countries.

8

Suppose the Canadian (CAD) to US dollar spot rate is 1.27 CAD/USD and that one year forward rate is 1.40 CAD/USD. The interest rate in the US is 2.5% and the interest rate on similar Canadian securities is 3%. Ignore transaction costs. An investor in the US with $10,000 is trying to decide between investing in US securities versus using covered interest arbitrage invest in Canadian securities. Which is the better choice?
a. The investment in US securities may potentially yield more but is very risky if exchange rates move against the investor.
b. At 3% interest, the investment in Canada offers higher returns as opposed to the return of 2.5% return in the US.
c. The investment in the US is the better choice because the forward premium on the dollar more than offsets the interest rate differential.
d. Given these parameters, the investor would be indifferent between the two securities.

c. The investment in the US is the better choice because the forward premium on the dollar more than offsets the interest rate differential.

9

Suppose the Canadian (CAD) to US dollar spot rate is 1.27 CAD/USD and that one year forward rate is 1.40 CAD/USD. The interest rate in the US is 2.5% and the interest rate on similar Canadian securities is 3%. Ignore transaction costs. What can you predict will happen in the spot and forward markets given the parameters above?
a. Nothing, there is nothing to be gained from switching markets.
b. Speculators will engage in uncovered interest arbitrage, driving the CAD even stronger.
c. Speculators will engage in uncovered interest arbitrage, driving the USD even stronger.
d. Speculators will engage in covered interest arbitrage until the forward premium on the dollar is just approximately equal to the interest rate differential.

d. Speculators will engage in covered interest arbitrage until the forward premium on the dollar is just approximately equal to the interest rate differential.

10

According to the text, which of the following is a good, inexpensive, and fairly reliable predictor of future exchange rates?
a. technical models from well-known financial analysts
b. current forward exchange rates (for example, the six-month forward rate reasonably forecasts the spot rate in six months).
c. fundamental models using proprietary models to predict the explanatory variables that influence exchange rates.
d. all the above

b. current forward exchange rates (for example, the six-month forward rate reasonably forecasts the spot rate in six months).

11

Borrowing money in a currency where interest rates are very low to purchase assets in a currency where rates are higher.

The carry trade

12

What risk is associated with the yen carry trade?

Interest rates in Japan rising and falling in other countries.

13

Getting rid of a loan from Japan is known as:

unwinding the carry trade

14

Investors are unwinding the Yen because:

the Yen is appreciating, making carry trade investments unprofitable.

15

Because investors have little faith in the Yen and think it will depreciate in the future investors are:

shorting the yen and investing in short term securities.

16

While the rupee, yuan, and rand are appreciating the dollar, investors are:

borrowing more because it is cheap to do so and that is causing the rates of these currencies to increase.

17

Involves the almost-immediate purchase or sale of foreign exchange.

Spot Market

18

Involves contracting today for the future purchase of sale of foreign exchange at a price agreed upon today.

Forward Market

19

How does the risk of an uncovered interest arbitrage investment differ from the risk of a covered interest arbitrage investment?
a. With covered interest arbitrage the investor knows the interest rate in both markets but with uncovered interest arbitrage the nominal interest rate in the foreign market is variable.
b. Nominal interest rates are known under both covered and uncovered interest arbitrage but the exchange rate at which the foreign investment is converted is known under covered interest arbitrage and unknown under uncovered interest arbitrage.
c. The risks are actually very similar, so it depends on the situation.
d. With uncovered interest arbitrage the investor hedges her investment in the spot market versus covered interest arbitrage which is unhedged.

b. Nominal interest rates are known under both covered and uncovered interest arbitrage but the exchange rate at which the foreign investment is converted is known under covered interest arbitrage and unknown under uncovered interest arbitrage.

20

When Interest Rate Parity (IRP) does not hold:

there are opportunities for covered interest arbitrage.

21

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.

International Fisher

22

The 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
e. none of the above

c. prices in Canada are expected to rise more rapidly than in the U.S.

23

Suppose the spot rate on the Korean won is $0.39 and the 180-day forward rate is $0.40. According to the parity conditions covered in class, the difference between the spot and forward rates would imply:
a. interest rates are higher in the U.S. than in South Korea
b. the won has risen in relation to the dollar
c. the inflation rate in South Korea is declining
d. the won is expected to fall in value relative to the dollar
e. there is a high inflation rate in the U.S.

a. interest rates are higher in the U.S. than in South Korea

24

Three reasons why deviations from PPP might occur; then carefully explain how each causes such deviations.

Transaction costs, Non-traded goods, Time lags

25

How does the risk of an uncovered interest arbitrage investment differ from the risk of a covered interest arbitrage investment?

Covered interest arbitrage is secure in that there is no risk for the arbitrager because the forward rate is “locked in.” Uncovered interest arbitrage basically involves speculating on the spot rate, and there is a risk of losing money because the spot rate could change unfavorably for the speculator.