International finance multiple choice questions and answers

Multinational Financial Management

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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

B. One unit of currency has same purchasing power globally.

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PURCHASING POWER PARITY

III. RELATIVE PURCHASING POWER PARITY

A. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.

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PURCHASING POWER PARITY

1. In mathematical terms:

where et = future spot rate

e0 = spot rate

ih = home inflation

if = foreign inflation

t = the time period

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PURCHASING POWER PARITY

2. If purchasing power parity is

expected to hold, then the best

prediction for the one-period

spot rate should be

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PURCHASING POWER PARITY

3. A more simplified but less precise relationship is

that is, the percentage change should be approximately equal to the inflation rate differential.

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PURCHASING POWER PARITY

4. PPP says

the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.

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PURCHASING POWER PARITY

B. Real Exchange Rates:

the quoted or nominal rate adjusted for a country’s inflation rate is

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PURCHASING POWER PARITY

C. Real exchange rates

1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.

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PURCHASING POWER PARITY

C. Real exchange rates

2. Competitive positions:

domestic and foreign firms

are unaffected.