International Arbitrage and Interest Rate Parity

Question 1

What is the Law of One Price in international markets?

Answer 1

In competitive markets exchange-adjusted prices of identical tradable goods and financial assets must be within transaction costs of equality worldwide.

Question 2

What are the five key theoretical economic relationships that we see?

Answer 2

• Purchasing Power Parity (PPP).
• Fisher Effect (FE).
• International Fisher Effect (IFE).
• Interest Rate Parity (IRP).
• Forward rates as unbiased predictors of future spot rates (UFR).

Question 3

Why was the Purchasing Power Parity (PPP) introduced?

Answer 3

It was initially suggested in the aftermath of World War I to allow for the resumption of normal trade relations.

Question 4

What does the absolute version of PPP says?

Answer 4

That the equilibrium exchange rate between 2 currencies equals the ratio between domestic and foreign price levels. It implies that a unit of home currency should have the same purchasing power around the world.

Question 5

What does the theory of PPP assume?

Answer 5

That free trade will equalise the price of any good in all countries. It neglects transportation costs, tariffs, quotas and other restrictions, and product differentiation E O MUNDO REAL SE CALHAR
and we’re all depressed

Question 6

What does the relative version of PPP states?

Answer 6

That the changes in the ratio of domestic and foreign prices would indicate the necessary adjustment in the exchange rate between any pair of currencies.

Question 7

Regarding the relative version of PPP, what does higher inflation in the home country makes us expect?

Answer 7

expected increase in the equilibrium exchange rate

Question 8

Regarding the relative version of PPP, what does higher inflation in the foreign country makes us expect?

Answer 8

expected decrease in the equilibrium exchange rate

Question 9

Regarding the PPP relative version, what does higher inflation in the home country leads to?

Answer 9

an expected increase in the equilibrium exchange
rate

Question 10

Regarding the PPP relative version, what does higher inflation in the foreign country leads to?

Answer 10

an expected decrease in the equilibrium exchange
rate

Question 11

True or false: Changes in exchange rates may indicate nothing more than the reality that countries have different inflation rates.

Answer 11

True

Question 12

True or false: Exchange rate movements don’t offset changes in price levels between the home and foreign countries.

Answer 12

False

Question 13

In terms of a country competitiveness, should look we look to real exchange rates instead or nominal exchange rates?

Answer 13

Real exchange rates

Question 14

What is the real exchange rate (e’t)

Answer 14

the nominal rate adjusted for changes in the relative purchasing power of each currency

Question 15

What needs to happen for changes in the nominal exchange rate to be fully offset by changes in relative price levels (inflation) between both countries, and as a consequence the real exchange rate remains unchanged.

Answer 15

PPP needs to hold

Question 16

According to the Fisher effect, if the required real rate of return (measured in purchasing power) is 3% and expected inflation is 2%, what is the nominal interest rate?

Answer 16

5.06%

Question 17

What does the generalised Fisher effect states to avoid arbitrage opportunities?

Answer 17

To avoid arbitrage opportunities, the real interest rate across different countries should be the same: ah=af. If they’re different, we should observe funds moving from the country with the lowest real interest rate to the country with the highest real interest rate, until they are equalised.

Question 18

What happens if real interest rates are different across countries?

Answer 18

If they’re different, we should observe funds moving from the country with the lowest real interest rate to the country with the highest real interest rate, until they are equalised.

Question 19

True or false: The Fisher effect shows that the differential in interest rates and inflation rates should be the same across countries.

Answer 19

True

Question 19

Why do we apply the natural logarithm to the resulting equation from the Fisher effect?

Answer 19

To convert from discrete to continuous time variables

Question 19

True or false: Empirical evidence is consistent with the hypothesis that most of the variation in nominal interest rates across countries can be attributed to expected differences in inflation rates.

Answer 19

True

Question 20

True of false: Empirical evidence is consistent with the hypothesis that most of the variation in the expected real rate of returns across countries can be attributed to expected differences in inflation rates.

Answer 20

False, it is impossible to test that directly.

Question 21

True or false: most economists believe that it is unlikely that significant real interest rate differentials could survive in the long run.

Answer 21

True

Question 22

How do we get the International Fisher Effect for a single period?

Answer 22

By inserting the relative PPP in the Fisher effect equation

Question 23

What does the international Fisher Effect states?

Answer 23

The International Fisher Effect basically states that arbitrage between two countries should ensure that the interest differential between two countries is an unbiased estimator of future changes in the spot exchange rate.

Question 24

True or false: As predicted by the IFE, there is a tendency for currencies with high interest rates to depreciate.

Answer 24

True

Question 25

True or false: As predicted by the IFE, there is a tendency for currencies with high interest rates to appreciate.

Answer 25

False

Question 26

True or false: As predicted by the IFE, there is a tendency for currencies with low interest rates to depreciate.

Answer 26

False

Question 27

True or false: As predicted by the IFE, there is a tendency for currencies with low interest rates to appreciate.

Answer 27

True

Question 28

Why is it that a large body of current literature now shows the evidence that the IFE does not hold in the short-run for nations with low to moderate inflation rates?

Answer 28

One possible explanation for these results relies on the existence of a time-varying exchange rate premium.

Question 29

How is internal arbitrage defined?

Answer 29

Defined as capitalising on a discrepancy in quoted prices. There is no investment of funds tied up for any length of time and no risk involved in the strategy.

Question 30

What are the forms of international arbitrage in the money markets?

Answer 30

* Locational arbitrage; * Triangular arbitrage; * Covered interest arbitrage.

Question 31

What does the term locational arbitrage refers to?

Answer 31

capitalising on the differential exchange rates between two locations

Question 32

What does the term triangular arbitrage refers to?

Answer 32

capitalising on the differential exchange rates between three locations

Question 33

What does the covered interest arbitrage do?

Answer 33

It tends to force a relationship between interest rates of two countries and their forward rates.

Question 34

What is the Interest Rate Parity (IRP)?

Answer 34

The equilibrium we reach once all arbitrage opportunities disappear due to Covered interest Arbitrage

Question 35

How do we get that the expected spot rate in the settlement date t is the current forward rate?

Answer 35

Once we combine the IFE with the no arbitrage condition for the forward rate

Question 36

In the Eurocurrency markets, how is the forward rate calculated?

Answer 36

from the interest differential between the two currencies using the no arbitrage condition

Question 37

Why do deviations from interest parity occur between national capital markets?

Answer 37

Mainly driven by capital controls, the imposition of taxes on interest payments to foreigners and transaction costs.