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The Worldwide Equity-Income Fund is a U.S. based mutual fund whose objective is to seek current income through participation in the U.S. and global equity and fixed-income markets. According to its bylaws, Worldwide can invest no more than 25% of its funds in the assets of any one country. Currently, it holds a substantial amount of foreign securities, heavily weighted in British stocks and bonds. Mary Larson, CFA, has recently joined Worldwide as a portfolio manager. Larson is a recent graduate of Washington State University with a double major in Economics and Finance, where she studied interest rate parity and purchasing power parity. Larson’s role at Worldwide will encompass many areas, including forecasting and strategy.Larson has been asked to examine the current portfolio holdings, and project how the current position will perform over the next year under various interest rate scenarios. U.S. interest rates are currently 7% and the real rate of interest has been about 2% over the past 20 years. Today's spot rate is $1.7921 per British pound.
Due to a weakening in world oil prices, as well as the results from the recent U.S. presidential election, Larson determines it is necessary to calculate her own forecast of the expected inflation rate in the U.S. The international Fisher relation predicts that the interest rate differential between two countries should be equal to the expected inflation differential. Therefore, countries with higher expected inflation rates will have higher nominal interest rates, and vice versa. A change in domestic rates could lead Larson to suggest substantial changes to the current portfolio corporation. Larson is asked to recall the correct representation of purchasing power parity. St is the exchange rate at time t, expressed in units of foreign currency per domestic currency. ID and IF are the expected rates of inflation in the domestic and foreign countries, and E( ) denotes an expected value. Which of the following is the most accurate representation of purchasing power parity (PPP)? A)
| E(S1) / S0 = [1 + E(iDC)] / 1 + E(iFC)]. |
| B)
| E(S1) / S0 = [1 + E(iFC)] / [1 + E(iDC)]. |
| C)
| E(S0) / S1 = [1 + E(iFC)] / 1 + E(iDC)]. |
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The correct representation of purchasing power parity is: E(S1) / S0 = [1 + E(iFC)] / [1 + E(iDC)]. (Study Session 4, LOS 18.g)
Larson predicts that the spot exchange rate for British pounds will be $1.8653 per pound in one year. Using the information above and assuming the expected inflation rate in the U.S. is 6%, Larson has arrived at her conclusion based upon the assumption that the inflation rate in Great Britain will be:
Using the information above and assuming the expected inflation rate in the U.S. is 6%, the expected inflation rate in Great Britain is 0.018, or 1.8%, computed as:
The relative form of the purchasing power parity condition implies that the expected future spot rate can be estimated as follows:St=0 x (1 + IUS)/(1 + IUK) = E[St+1]
So, we can rearrange this equation to isolate the unknown, the expected inflation rate in the United Kingdom:
1 + IUK = 1.06 (1.7921 / 1.8653) = 1.018
IUK = .018 = 1.8%
(Study Session 4, LOS 18.h)
Larson recalls that while relative PPP does tend to hold closely over the long term, PPP may not hold in the short run due to one of several reasons. Which of the following is least likely a reason why PPP may not hold in the short run? A)
| A common consumption basket does not exist across countries. |
| B)
| Factors of production are mobile in the short run. |
| C)
| Transactions costs prevent arbitrage. |
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Factors of production are immobile in the short run. Both remaining choices are valid reasons why PPP may not hold in the short run. (Study Session 4, LOS 14.a)
Based upon the interest rate information given above, and using the exact version of the Fisher relationship, Larson calculates that the market-consensus implied expected inflation rate in the U.S. is:
Using the information above and the exact version of the Fisher relationship, the market-consensus expected inflation rate in the U.S. is 1.07 / 1.02 − 1 = 0.049 or 4.9%. Remember that the alternate version of the international Fisher relation, the linear approximation, will produce a slightly different result. (Study Session 4, LOS 18.j)
The foundation of Larson’s predictions of future spot rates and interest rates depend upon several key assumptions. Larson knows that if capital markets are integrated, capital can flow freely across borders. Given this information about capital markets which one of the following statements is most accurate? A)
| Nominal interest rates should be equal across countries. |
| B)
| Inflation rates should be equal across countries. |
| C)
| Real interest rates should be equal across countries. |
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If capital markets are integrated, capital will flow freely across borders, and real interest rates should be equal across countries. Countries with high relative real rates will see their currencies appreciate as foreign investors sell their home currencies and buy the currency of the country with the high real rate. (Study Session 4, LOS 18.i)
Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5% in the U.S. and 7% in Britain, what is the expected spot exchange per pound rate 12 months from now according to uncovered interest rate parity?
Uncovered interest rate parity estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 × 1.05) / 1.07 = $1.4071. (Study Session 4, LOS 18.l) |
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发表于 2012-3-28 13:58
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