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Reading 68: International Asset Pricing Los e~Q1-5

 

LOS e: Determine whether the real exchange rate has changed in a period, given the beginning-of-period (nominal) exchange rate, the inflation rates in the period, and the end-of-period (nominal) exchange rate.

Q1. The exchange rate between the U.S. and Canada was 1.5 to 1 ($/Can$) one year ago. At that time, the ratio of the price levels of the U.S. consumption basket to the Canadian consumption basket was also 1.5. During the year, U.S. inflation was 4% and Canadian inflation was 2%. What must the end-of-period nominal exchange rate be in order for the end-of-period real exchange rate to be the same as the beginning of period real exchange rate?

A)   1.53.

B)   1.45.

C)   1.62.

 

Q2. A domestic investor from the U.S. invested in securities in Mexico one year ago. At that time, the exchange rate was $0.07/peso. The ratio of the price levels of the domestic consumption basket to the foreign consumption basket was equal to 7. Over the past year the U.S. inflation rate was 2% and the inflation rate in Mexico was 6%. The current end-of-the year spot exchange rate is $0.085/peso.

What was the beginning real exchange rate one year ago?

A)   0.035.

B)   0.010.

C)   0.070.

 

Q3. What is the end of year real exchange rate?

A)   0.013.

B)   0.021.

C)   0.010.

 

Q4. Which of the following statements regarding the real exchange rate is least accurate? Using the data in this example, the:

A)   changes in rates imply that exchange rate risk was present.

B)   change in the nominal exchange rate does not reflect the inflation differential; therefore, the real exchange rate has changed.

C)   constant real rate implies that the changes in the nominal rate are simply a reflection of the inflation differential.

 

Q5. Suppose the real currency exchange rate between two countries changes during the year. Which of the following best describes the change in real exchange rates?

A)   International markets are segmented.

B)   The change in the nominal exchange rate does not reflect the inflation differential.

C)   The market in one country outperforms the market in the other.

 

At the beginning of the period, the exchange rate between Country A and Country B is 3 (quoted as A/B). The ratio of the prices of the consumption basket in Country A to Country B is 2. During the year, Country A has inflation of 10% and Country B has inflation of 0%. At the end of the year, the exchange rate is 3.5. What is the end-of-period real exchange rate?

A)   1.00.

B)   1.59.

C)   1.50.

[2009]Session18-Reading 68: International Asset Pricing Los e~Q1-5

 

LOS e: Determine whether the real exchange rate has changed in a period, given the beginning-of-period (nominal) exchange rate, the inflation rates in the period, and the end-of-period (nominal) exchange rate. fficeffice" />

Q1. The exchange rate between the ffice:smarttags" />U.S. and Canada was 1.5 to 1 ($/Can$) one year ago. At that time, the ratio of the price levels of the U.S. consumption basket to the Canadian consumption basket was also 1.5. During the year, U.S. inflation was 4% and Canadian inflation was 2%. What must the end-of-period nominal exchange rate be in order for the end-of-period real exchange rate to be the same as the beginning of period real exchange rate?

A)   1.53.

B)   1.45.

C)   1.62.

Correct answer is A)

The beginning-of-period real exchange rate is 1 (X = S (PF/PD) = 1.5 (1 / 1.5) = 1). After the inflation during the year, the ratio of the price levels (PF/PD) will be 0.6538 [= (1 × 1.02) / (1.5 × 1.04) = 1.02 / 1.56]. Hence, for the real exchange rate to equal one, the rate must be 1 / 0.6538 = 1.53.

 

Q2. A domestic investor from the U.S. invested in securities in Mexico one year ago. At that time, the exchange rate was $0.07/peso. The ratio of the price levels of the domestic consumption basket to the foreign consumption basket was equal to 7. Over the past year the U.S. inflation rate was 2% and the inflation rate in Mexico was 6%. The current end-of-the year spot exchange rate is $0.085/peso.

What was the beginning real exchange rate one year ago?

A)   0.035.

B)   0.010.

C)   0.070.

Correct answer is B)

The real exchange rate is defined as the actual spot exchange rate, S, multiplied by the ratio of the price levels of the consumption baskets in the two countries.

X = S(PF / PD) = 0.07(1 / 7) = 0.01.

 

Q3. What is the end of year real exchange rate?

A)   0.013.

B)   0.021.

C)   0.010.

Correct answer is A)

Real exchange rate movements are defined as changes in the exchange rate that are not explained by inflation differentials.

X = S(PF / PD) = 0.085(1.06 / 7.14) = 0.01262

 

Q4. Which of the following statements regarding the real exchange rate is least accurate? Using the data in this example, the:

A)   changes in rates imply that exchange rate risk was present.

B)   change in the nominal exchange rate does not reflect the inflation differential; therefore, the real exchange rate has changed.

C)   constant real rate implies that the changes in the nominal rate are simply a reflection of the inflation differential.

Correct answer is C)

In this example, the real rate was not constant over this period of time. The beginning exchange rate was 0.01 and the ending exchange rate was 0.013. The nominal exchange rate does not reflect the inflation differential and the real rate has changed. Changes in the real rate of interest reflect the fact that exchange rate risk is present and these changes can have a significant impact on realized returns.

 

Q5. Suppose the real currency exchange rate between two countries changes during the year. Which of the following best describes the change in real exchange rates?

A)   International markets are segmented.

B)   The change in the nominal exchange rate does not reflect the inflation differential.

C)   The market in one country outperforms the market in the other.

Correct answer is B)

If the real exchange rate changes during a period, the exchange rate change does not mirror the inflation differential.

At the beginning of the period, the exchange rate between Country A and Country B is 3 (quoted as A/B). The ratio of the prices of the consumption basket in Country A to Country B is 2. During the year, Country A has inflation of 10% and Country B has inflation of 0%. At the end of the year, the exchange rate is 3.5. What is the end-of-period real exchange rate?

A)   1.00.

B)   1.59.

C)   1.50.

Correct answer is B)

The real exchange rate is calculated as: X = S (PF/PD). Using Country A as the home country, the end-of-period real exchange rate is: X = 3.5(1 / 2.2). The ratio of the price levels reflects the inflation rates in the two countries (1 × 1.0 = 1 for Country B; 2 × 1.1 = 2.2 for Country A).

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