Test Bank



Chapter Eight

The Power of Arbitrage — Purchasing Power and Interest Rate Parities

True/False

1. The idea that identical goods and services that are traded across national borders should have the same price in two countries after converting their prices into a common currency is called arbitrage.

Ans: False

Dif: E

2. Purchasing power parity is the same concept as the law of one price.

Ans: True

Dif: E

3. Arbitrage is the process of taking advantage of the mispricing of an asset in two markets.

Ans: True

Dif: E

4. Absolute purchasing power parity states if the price of lumber is $10 a board foot in the U.S. the price of the same lumber in Canada should be C$6.45 in Canadian dollars per board foot if the exchange rate is C$1.55 per U.S dollar.

Ans: F

Dif: E

5. If Country A has a higher price level than Country B and absolute purchasing power parity holds then the exchange rate for Country A (expressed as the home currency price of a unit of foreign currency) must be greater than one.

Ans: True

Dif: D

6. If absolute purchasing power parity holds between Country X and Country Y and the exchange rate for Country X (expressed as the home currency price of a unit of foreign currency) is 0.65 then Country X must have the higher overall price level.

Ans: False

Dif: D

7. Country Z has an exchange rate equal to 1.25 Zs / Y1. Country Y has a price level of 110 and Country Z has a price level of 120. In absolute purchasing power parity terms, Country Z’s currency is overvalued.

Ans: False

Dif: D

8. Absolute purchasing power parity implies that the real exchange rate is always equal to the nominal exchange rate.

Ans: False

Dif: M

9. Absolute purchasing power parity may be stated as %∆S = %∆P – %∆P*.

Ans: False

Dif: E

10. Relative purchasing power parity holds very well even in the short run during periods of hyperinflation.

Ans: True

Dif: E

11. Although relative purchasing power parity holds true more often than absolute purchasing power parity, neither holds well in the short run.

Ans: True

Dif: E

12. The random walk behavior of real exchange rates provided strong evidence against both absolute and relative purchasing power parity.

Ans: True

Dif: M

13. If the interest rate on a bond in the U.S. was equal to the rate on a similar bond in the U.K. plus any forward premium or discount we would say that real interest parity holds.

Ans: False

Dif: M

14. If uncovered interest parity holds, one may assume that investors require no premium for risk in their foreign bond investments.

Ans: True

Dif: D

15. The interest rate on a bond in the U.S. is 7%. The pound is trading at £0.64 per dollar in the spot and is expected to trade at £0.6559 in one year. If the interest rate on similar bonds in Great Britain is 9.2% then uncovered interest rate parity holds.

Ans: False

Dif: M

16. If the U.S. has higher interest rates than Great Britain and covered interest rate parity holds then the pound must be trading at a forward discount to the dollar.

Ans: False

Dif: M

17. Covered interest rate parity is more likely to hold for countries that do not have capital controls.

Ans: True

Dif: M

18. Expectations that are formed based solely on past information are called adaptive expectations.

Ans: True

Dif: E

19. An individual who forms an expectation of a future exchange rate by examining the historical trend in exchange rates along with adapting the trend to new information by considering how projected economic data for the two countries under consideration will affect the exchange rate is said to be using an adaptive expectations model of exchange rate forecasting.

Ans: False

Dif: M

20. Having covered interest parity hold is a sufficient condition to state that the foreign exchange markets are efficient.

Ans: False

Dif: D

21. Foreign exchange market efficiency exists when the forward rate is an unbiased estimator of the expected future spot rate.

Ans: True

Dif: M

22. Real interest rate parity will hold for two countries if covered and uncovered interest rate parity also hold.

Ans: True

Dif: E

Multiple Choice

1. For absolute purchasing power parity to strictly hold in two countries all but which one of the following is required?

A) zero transportation costs on all goods and services

B) the same basket of goods must be consumed in the two countries

C) tax rates must be the same in the two countries

D) tariffs must be zero in both countries

E) the nominal exchange rate must equal 1

Ans: E

Dif: M

2. If flour costs $3 a pound in the U.S. and 35 pesos in Mexico, what should the exchange rate (S) be if absolute purchasing power parity holds?

A) 0.0857

B) 11.67

C) 32

D) 38

E) cannot tell without knowing the price levels in the U.S. and Mexico

Ans: A

Dif: M

3. Suppose that absolute purchasing power parity for lettuce does not hold for the U.S. and Mexico. The price of a box (containing about 50 heads) of lettuce in the U.S. is selling for $25 and is selling for 175 pesos in Mexico when the exchange rate is 9 pesos to the dollar. As people arbitrage away the price disparity, the price of lettuce in the U.S. will __________ and the value of the peso will tend to __________.

A) rise; rise

B) fall; fall

C) rise; fall

D) fall; rise

E) stay the same; stay the same

Ans: D

Dif: M

4. Assuming that absolute purchasing power parity holds, what should the U.S./Canadian exchange rate be if the CPI in Canada is 225 and the CPI in the U.S. is 179 and the U.S. interest rate is 6%?

A) 1.257

B) 0.796

C) 1.332

D) 0.843

E) none of the above

Ans: B

Dif: E

5. Suppose that the exchange rate between the Polish Zloty and the U.S. dollar is currently 4 Zls to the dollar. The one year forward rate for the Zloty is 4.5 Zls to the dollar. If U.S. inflation is 3% what is the approximate Polish inflation rate if relative purchasing power holds?

A) 12.75%

B) 9.50%

C) 8.11%

D) 15.50%

E) 14.11%

Ans: E

Dif: M

6. Suppose that the exchange rate between the Russian ruble and the U.S. dollar is currently $0.03 to the ruble. The one year forward rate for the ruble is $0.025 dollars to the ruble. If Russian inflation is 20% what is the approximate U.S. inflation rate if relative purchasing power holds?

A) 16.67%

B) 3.33%

C) 0.00%

D) 40.00%

E) 4.32%

Ans: B

Dif: M

7. If absolute purchasing power parity holds the real exchange rate must be __________, and if relative purchasing power parity holds the real exchange rate must be __________.

A) stable over time; greater than one

B) greater than one; stable over time

C) equal to one; stable over time

D) equal to one; less than one

E) less than one; greater than one

Ans: C

Dif: M

8. Most studies indicate that

I. relative PPP performs better than absolute PPP.

II. the Big Mac Index is a reliable predictor of short term exchange rate movements.

III. relative PPP only holds over long time periods.

A) I only

B) I and II only

C) II and III only

D) I and III only

E) I, II and III

Ans: D

Dif: M

9. Which one of the following is not true?

A) If relative purchasing power parity has any validity it must hold on average over long time intervals.

B) If exchange rates follow a random walk, purchasing power parity does not hold.

C) Absolute purchasing power parity is unlikely to hold because different countries consume different goods and services.

D) If relative purchasing power parity does not hold then covered interest parity cannot hold.

E) The Economist’s Big Mac Index performs better at predicting exchange rate movements when evaluated over long time intervals.

Ans: D

Dif: D

10. Some studies indicate that if an event occurs that moves a real exchange rate away from its relative purchasing power parity level then it typically takes between __________ to get __________ back to its parity level.

A) 3 to 7 years; halfway

B) 4 to 10 years; one-fourth of the way

C) 1 to 2 years; all the way

D) 3 to 5 years; most of the way

E) 2 to 4 years; all the way

Ans: A

Dif: M

11. As more countries move towards freer trade in goods, services and capital flows, we can expect which of the following parity conditions to hold more often?

I. relative purchasing power parity

II. covered interest parity

III. uncovered interest parity

A) I only

B) I and II only

C) II and III only

D) I and III only

E) I, II and III

Ans: E

Dif: M

12. A U.S. investor is considering investing in a bond denominated in Swiss francs. One year U.S bond rates are 6% and the Swiss franc is currently worth about 68¢ U.S. If Swiss bond rates on similar bonds are paying 7%, the investor is better off investing in the U.S. if over the next year the

A) dollar is expected to depreciate by more than 1%.

B) Swiss franc is expected to appreciate by more than 1%.

C) dollar is expected to appreciate by 3%.

D) Swiss franc is expected to appreciate by less than 1%.

Ans: C

Dif: M

13. Suppose that the one year U.S. interest rate is 9% and the one year U.K. interest rate is 8%. If the current spot rate is $1.70 per pound what must the one year forward rate be if covered interest parity holds?

A) $1.717

B) $1.683

C) $1.723

D) $1.652

E) none of the above

Ans: A

Dif: E

14. Suppose that the one year Swiss franc interest rate is 5% and the one year U.K. interest rate is 4%. If the one year forward rate is 0.45 pounds per francs what must the spot exchange rate be (£/Sfr) if covered interest parity holds?

A) 0.2250

B) 0.4455

C) 0.4545

D) 1.4500

E) 0.4645

Ans: C

Dif: D

15. Suppose that the one year U.S. interest rate is 5%. If the one year forward rate against the pound is $1.75 per pound and the spot exchange rate is $1.78 per pound, what must the equivalent British interest rate be if covered interest parity holds?

A) 3.29%

B) 6.69%

C) 3.31%

D) 6.83%

E) 5.45%

Ans: B

Dif: M

16. For uncovered interest arbitrage to hold we must be considering two bonds in different countries with

I. equivalent risk and liquidity.

II. equivalent tax treatment and maturity.

III. the same interest rate.

A) I only

B) II only

C) II and III only

D) I and II only

E) I, II and III

Ans: D

Dif: M

17. If uncovered interest parity holds and the U.S. interest rate on a one year bond is 5% and the Russian rate on a similar one year bond is 8% which one of the following is true?

A) The forward rate for the dollar must be less than the spot rate.

B) The forward rate for the ruble must be greater than the spot rate.

C) The expected future spot rate for the ruble must be less than the 1 year forward rate.

D) The expected future spot rate for the dollar must be greater than the 1 year forward rate.

E) none of the above

Ans: E

Dif: D

18. A country with a history of monetary instability and unstable currency values and inflation rates is likely to have (ceteris paribus)

I. lower interest rates than other countries.

II. lower exchange rates than other countries.

III. higher risk premiums on interest rates.

A) I only

B) II only

C) II and III only

D) I and II only

E) I, II and III

Ans: C

Dif: M

19. Rates on one year British bonds are 9%. The expected one year change in the value of the dollar is +2%. If rates on similar maturity U.S. bonds are 6%, and investors charge a risk premium which of the following is true assuming that uncovered interest parity holds with a risk premium?

A) British bonds are perceived to be riskier than U.S. bonds.

B) U.S. bonds are perceived to be riskier than British bonds.

C) The risk premium must be zero.

D) All investors must prefer British bonds to U.S. bonds.

E) U.S. bonds and British bonds are equally risky.

Ans: A

Dif: M

20. Which of the following methods of currency forecasting are not strictly adaptive expectations?

A) Plotting historical exchange rates on a graph, you rough out a trend line and use the trend to forecast next years exchange rate.

B) Your regress historical exchange rates using ordinary least squares to estimate the intercept and slope of the line and then use the equation to give you a predicted exchange rate value.

C) You obtain a forecast of next year’s expected balance of payment data and try to figure out how this will cause the exchange rate to move.

D) You calculate a 3 year moving average of exchange rates and use the average as your prediction of exchange rates.

E) You estimate that the current exchange rate is the best estimate of the future exchange rate.

Ans: C

Dif: E

21. The problem with adaptive expectations is

A) they are too complicated to understand.

B) there is no way to tell which adaptive process is best.

C) these methods ignore new information.

D) Both A) and B) are problems with adaptive expectations.

E) Both B) and C) are problems with adaptive expectations.

Ans: E

Dif: M

22. The largest conceptual difference between adaptive and rational expectations is

A) the statistical methodology.

B) that rational expectations uses all available information to forecast an exchange rate rather than just past information.

C) adaptive expectations should work better because the forecast is always adapting to new information.

D) that rational expectations forecasts are seldom wrong.

Ans: B

Dif: E

23. An exchange trader learns that the European Central Bank has decided to lower interest rates to spur additional economic growth in Europe, particularly in Germany. The exchange trader then updates his forecast for the Euro/$ exchange rate. This is an example of

A) technical analysis.

B) adaptive expectations.

C) rational expectations.

D) irrational expectations.

E) none of the above

Ans: C

Dif: E

24. An exchange rate forecasting service looks back over its predictions for the last year and discovers that every single forecast was wrong. From this they may properly conclude that

A) their forecasts were irrational.

B) they used adaptive expectations to make their forecasts.

C) forecasting exchange rates is difficult with any method.

D) their forecasts had no value.

E) they need to update their forecast methods.

Ans: C

Dif: M

25. If the rational expectations hypothesis is true this implies that

A) anyone who forecasts will do better than those who do not.

B) not all people have the same amount of information available.

C) exchange rate forecasts and interest rate forecasts are unrelated.

D) to earn higher rates of return on your investment than others your forecast must be better than others.

E) covered interest parity cannot hold.

Ans: D

Dif: D

26. Suppose that an exchange trader is consistently able to come up with a forecast of exchange rates that is better than available anywhere else. This would be evidence that

I. the rational expectations hypothesis does not hold.

II. the foreign exchange market is not efficient.

III. foreign exchange rates follow a random walk.

IV. an adaptive expectations forecast is superior to the rational expectations forecast.

A) I only

B) II only

C) I and II only

D) II and IV only

E) I, II, III and IV

Ans: C

Dif: M

27. If the following holds: RUS – RUK = (F–S)/S ( %∆Se we would conclude

I. covered interest parity does not hold.

II. uncovered interest parity does not hold.

III. the foreign exchange market for the two countries is not efficient.

A) I only

B) II only

C) I and II only

D) II and III only

E) I, II and III

Ans: D

Dif: M

28. The major implications of the efficient markets hypothesis include all but which one of the following?

A) There should be a relationship between the market price or return and traders’ expectation of price or return.

B) The forward rate is not a valid forecast of the expected future spot rate.

C) Some factors are likely to cause greater movements in prices or returns than others.

D) Traders will not be able to consistently earn higher than average rates of return.

E) Investors rationally form their expectations of prices and returns.

Ans: B

Dif: M

29. If covered and uncovered interest parity hold and if the spot exchange rate is $0.05 per peso and the one year forward discount on the peso is 5% what is the expected future spot rate in one year?

A) $0.0475

B) $0.0525

C) $0.0550

D) $0.0450

E) none of the above

Ans: B

Dif: E

30. Most empirical work on foreign exchange markets indicates that risk premiums __________ and foreign exchange markets __________.

A) are unimportant; are efficient

B) are unimportant; are not efficient

C) are important; may or may not be efficient

D) are important; are efficient

E) are not important; may or may not be efficient

Ans: C

Dif: E

31. Real interest parity will hold if

A) covered interest parity holds.

B) uncovered interest parity holds.

C) both covered and uncovered interest parity holds.

D) uncovered interest parity and relative purchasing power parity holds, even if covered interest parity does not hold.

Ans: C

Dif: M

32. Nominal one year interest rates in the U.S. are 9% and U.S. inflation is 3%. One year British interest rates are 11% and the current British CPI is 190. What is the projected CPI level in Britain in one year if real interest parity holds?

A) 191.9

B) 180.5

C) 188.1

D) 199.5

E) 193.4

Ans: D

Dif: D

33. Nominal one year interest rates in the U.S. are 6% and U.S. inflation is 3%. One year British inflation is 4%. What is the equivalent one year interest rate in Britain if real interest parity holds?

A) 6%

B) 7%

C) 5%

D) 8%

E) 2%

Ans: B

Dif: E

34. If we find that real interest rate parity holds in two countries we would conclude that

A) the foreign exchange markets are not efficient.

B) relative purchasing power parity does not hold.

C) absolute purchasing power parity also holds.

D) covered interest parity does not hold.

E) the two countries financial markets are integrated.

Ans: E

Dif: E

35. The U.S. nominal interest rate is the growth rate in __________. The growth rate in __________ is called the real interest rate.

A) dollars; purchasing power

B) purchasing power; dollars

C) dollars; exchange rates

D) inflation; prices

Ans: A

Dif: E

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