Reading 17- LOS d ～ Q1－2 concepts, following, statements, his, class

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1.Terrance Burnhart, a junior analyst at Wertheim Investments Inc., was discussing the concepts of purchasing power parity and interest rate parity with his colleague, Francis Ferngood. During the conversation Burnhart made the following statements:

Statement 1: Purchasing power parity is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; all countries use the same basket of goods and services to measure their price levels; and all countries measure their rates of inflation the same way.

Statement 2: Interest rate parity rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates.

Are the statements made by Burnhart regarding purchasing power parity and interest rate parity correct?

                 Statement 1                         Statement 2

   

A)                Correct                               Correct

B)                 Incorrect                             Correct

C)                 Correct                               Incorrect

D)                 Incorrect                             Incorrect

2.Which of the following statements regarding purchasing power parity is most accurate? Purchasing power states that exchange rates:

A)   will change to reflect differences in nominal interest rates between countries.

B)   will change to reflect differences in inflation between countries.

C)   will change to reflect differences in real interest rates between countries.

D)   must change so that risk-adjusted return on an investment in any currency will have the same return.

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1.Terrance Burnhart, a junior analyst at Wertheim Investments Inc., was discussing the concepts of purchasing power parity and interest rate parity with his colleague, Francis Ferngood. During the conversation Burnhart made the following statements:

Statement 1: Purchasing power parity is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; all countries use the same basket of goods and services to measure their price levels; and all countries measure their rates of inflation the same way.

Statement 2: Interest rate parity rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates.

Are the statements made by Burnhart regarding purchasing power parity and interest rate parity correct?

                 Statement 1                         Statement 2

   

A)                Correct                               Correct

B)                 Incorrect                             Correct

C)                 Correct                               Incorrect

D)                 Incorrect                             Incorrect

The correct answer was A)

Interest rate parity means that interest rates and exchange rates will adjust so the risk adjusted return on assets between any two countries and their associated currencies will be the same. Purchasing Power Parity is based on the idea that a given basket of goods should cost the same in different countries after taking into account the changes in exchange rates. Purchasing Power Parity does not hold due to transportation costs and other factors.

2.Which of the following statements regarding purchasing power parity is most accurate? Purchasing power states that exchange rates:

A)   will change to reflect differences in nominal interest rates between countries.

B)   will change to reflect differences in inflation between countries.

C)   will change to reflect differences in real interest rates between countries.

D)   must change so that risk-adjusted return on an investment in any currency will have the same return.

The correct answer was B)

Purchasing power parity states that exchange rates will change to reflect differences in inflation between countries. Interest rate parity states that exchange rates must change so that risk-adjusted returns on investments in any currency will be equal.