International finance mcq questions and answers

CHAPTER 4
PARITY CONDITIONS AND
CURRENCY FORECASTING

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CHAPTER OVERVIEW
I. ARBITRAGE AND THE LAW OF

ONE PRICE

II. PURCHASING POWER PARITY

III. THE FISHER EFFECT

IV. THE INTERNATIONAL FISHER EFFECT

V. INTEREST RATE PARITY THEORY

VI. THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE

VII. CURRENCY FORECASTING

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PART I. ARBITRAGE AND THE LAW OF ONE PRICE

I. THE LAW OF ONE PRICE

A. Law states:

Identical goods sell for the same price worldwide.

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ARBITRAGE AND THE LAW OF ONE PRICE

B. Theoretical basis:

If the price after exchange-rate

adjustment were not equal, arbitrage in the goods worldwide ensures eventually it will.

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ARBITRAGE AND THE LAW OF ONE PRICE

C. Five Parity Conditions Result From These Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect

(IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

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ARBITRAGE AND THE LAW OF ONE PRICE

D. Five Parity Conditions Linked by

1. The adjustment of various

rates and prices to inflation.

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ARBITRAGE AND THE LAW OF ONE PRICE

2. The notion that money should have no effect on real variables (since they have been adjusted for price changes).

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ARBITRAGE AND THE LAW OF ONE PRICE

E. Inflation and home currency depreciation:

1. jointly determined by the growth of domestic money supply;

2. Relative to the growth of

domestic money demand.

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ARBITRAGE AND THE LAW OF ONE PRICE

F. THE LAW OF ONE PRICE

- enforced by international

arbitrage.

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PART II. PURCHASING POWER PARITY

I. THE THEORY OF PURCHASING

POWER PARITY:

states that spot exchange rates between currencies will change to the differential in inflation rates between countries.

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PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING

POWER PARITY

A. Price levels adjusted for

exchange rates should be

equal between countries

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PURCHASING POWER PARITY

II. ABSOLUTE PURCHASING

POWER PARITY