dirk01

The Asian Spec Fund, managed by Jonathan Khamal, CFA, engages in currency speculation for its clients. If Khamal wants to relate interest and inflation rate differentials to expected exchange rate movements, the method that he should use is:

A) international Fisher relation.

B) uncovered interest rate parity.

C) covered interest rate parity.

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Combining PPP and the international Fisher relation results in the theory of uncovered interest rate parity, which links spot exchange rates, expected spot exchange rates, and nominal interest rates.

dirk01

Chao Wong, CFA, is the portfolio manager for the China Current Fund in Switzerland. Wong wants to relate inflation rate differentials to exchange rate movements. The appropriate method that he should use is:

A) international Fisher relation.

B) uncovered interest rate parity.

C) relative purchasing power parity (PPP).

Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries. Relative PPP implies that exchange rates adjust over the long term to reduce inflation uncertainty. Consequently, purchasing power will be similar whether importing or exporting goods.

MarginofSafety

Michael Zotov, CFA, is the economist and portfolio manager of the Zotov Investment Fund based in Germany. Zotov wants to relate inflation rates to interest rates. The appropriate method that he should use is the:

A) international Fisher relation.

B) uncovered interest rate parity.

C) relative purchasing power parity.

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The international Fisher relation specifies that the interest rate differential between two countries should be equal to the expected inflation differential. That means countries with higher expected inflation will have higher nominal interest rates.

MarginofSafety

Which international parity condition expresses the relationship between interest rate differentials and the expected change in the spot exchange rate?

A) Covered interest rate parity.

B) Uncovered interest rate parity.

C) International Fisher effect.

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Uncovered interest rate parity expresses the relationship between interest rate differentials and the expected change in the spot exchange rate. The international Fisher effect expresses the relationship between inflation rate differentials and interest rate differentials. Covered interest rate parity expresses the relationship between the forward discount/premium and interest rate differentials.

MarginofSafety

Michael Zotov, CFA, is the economist and portfolio manager of the Zotov Investment Fund based in Germany. Zotov believes that the Polish economy is due for a significant recovery as a result of governmental austerity programs enacted this year. Nominal interest rates and inflation have begun to trend lower. The current spot exchange rate is 4.6404 Polish Zioty per euro. Zotov believes that there is an opportunity to speculate on the Polish Zioty. Zotov wants to determine an expected exchange price one year from today. Assuming the one-year nominal interest rate for the European Economic Community is 11.76% and the Polish one-year nominal interest rate is 12.3%, what would be the expected exchange rate for the Polish Zioty one year from today?

A) 4.6627 PZ/EUR.

B) 4.6181 PZ/EUR.

C) 4.5430 PZ/EUR.

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The formula for uncovered interest rate parity is:

E (S1) / S0 = (1 + rFC) / (1 + rDC) or (E (S1) – S0) / S0 = %ΔS = [(1 + rFC) / (1 + rDC)] – 1

Where:
E (S1) = expected spot rate in the period, quoted in FC per unit of DC
S0 = spot rate today, quoted in FC per unit of DC
rFC = interest rate in the FC
rDC = interest rate in the DC
%ΔS = percentage change in the spot rate

By substituting:

%ΔS = [(1 + 0.123) / (1 + 0.1176)] – 1
= [1.123 / 1.1176] – 1
= 0.0048
E (S1) = 4.6404 PZ/EUR × (1 + 0.0048) = 4.6627 PZ/EUR

The Polish Zioty is expected to depreciate 0.48% against the euro over the next year. It will require more Polish Ziotys to convert into euro by next year. This is the case because of higher inflation expectations for Poland that are implied in its nominal interest rate.

MarginofSafety

Chao Wong, CFA, is the portfolio manager for the China Current Fund in Germany. The current spot exchange rate is 9.6246 Chinese yuan per euro. Wong believes that there is an opportunity to speculate on the Chinese yuan. Wong wants to determine an expected exchange price one year from today. Assuming the one-year nominal interest rate for the European Economic Community is 11.76% and the Chinese one-year nominal interest rate is 10.2%, what would be the expected exchange rate for the Chinese yuan one year from today?

A) 9.7608 CY/EUR.

B) 9.4903 CY/EUR.

C) 9.4884 CY/EUR.

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The formula for uncovered interest rate parity (IRP) is:

Exact methodology: E (S1) / S0 = (1 + rFC) / (1 + rDC) or (E (S1) – S0) / S0 = %ΔS = [(1 + rFC) / (1 + rDC)] – 1

where:
E(S1) = expected spot rate in one period, quoted in FC per unit of DC
S0 = spot rate today, quoted in FC per unit of DC
rFC = interest rate on the FC
rDC = interest rate on the DC
%ΔS = percentage change in the spot rate

By substitution:

%ΔS = [(1 + 0.102) / (1 + 0.1176)] − 1
= [1.102 / 1.1176] − 1
= −0.013958
E(S1) = 9.6246 CY/EUR × (1 − 0.013958) = 9.4903 CY/EUR

The Chinese yuan is expected to appreciate 1.3958% against the euro over the next year. It will require less Chinese yuan to convert into euro by next year. This is the case because of the lower inflation expectations for China that are implied in its nominal interest rate.

MarginofSafety

The Asian Spec Fund, managed by Jonathan Khamal, CFA, engages in currency speculation for its clients. Based in Paris, Khamal believes that there is an opportunity to speculate on the Malaysian Ringgit. The current spot exchange rate is 4.417 Malaysian Ringgit per euro. Khamal wants to determine an expected exchange price one year from today. Assuming the one-year nominal interest rate for the European Economic Community is 11.76% and the Malaysian one-year nominal interest rate is 7.6%, what would be the expected exchange rate for the Malaysian Ringgit one year from today?

A) 4.586 MR/EUR.

B) 4.253 MR/EUR.

C) 4.246 MR/EUR.

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The formula for uncovered interest rate parity is:

E (S1) / S0 = (1 + rFC) / (1 + rDC) or (E (S1) – S0) / S0 = %ΔS = [(1 + rFC) / (1 + rDC)] – 1

where:
E (S1) = expected spot rate in one period, quoted in FC per unit of DC
S0 = spot rate today, quoted in FC per unit of DC
rFC = interest rate on the FC
rDC = interest rate on the DC
%ΔS = percentage change in the spot rate

By substituting:

%ΔS = [(1 + 0.076) / (1 + 0.1176)] – 1
= [ 1.076 / 1.1176 ] – 1
= - 0.0372
E (S1) = 4.417 MR/EUR × (1 – 0.0372) = 4.253 MR/EUR

The Malaysian Ringgit is expected to appreciate 3.72% against the euro over the next year. It will require less Malaysian Ringgits to convert into euro by next year. This is the case because of lower inflation expectations for Malaysia that are implied in its nominal interest rate.

MarginofSafety

The Asian Spec Fund, managed by Jonathan Khamal, CFA, engages in currency speculation for its clients. Based in Paris, Khamal believes that there is an opportunity to speculate on the Malaysian Ringgit. The current spot exchange rate is 4.417 Malaysian Ringgit per euro. Assuming the one-year risk-free rate for the European Economic Community is 11.76% and the Malaysian one-year risk-free interest rate is 7.6%, what should the one-year forward rate be for the Malaysian Ringgit?

A) 4.253 MR/EUR.

B) 4.246 MR/EUR.

C) 4.586 MR/EUR.

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The formula for covered interest rate parity is: F / S0 = (1 + rFC) / (1 + rDC)

Forward premium or discount:

(F – S0) / S0 = [(1 + rFC) / (1 + rDC)] − 1 = (rFC – rDC) / (1 + rDC)

By substituting:

%F = [(1 + 0.076) / (1 + 0.1176)] – 1
%F = [1.076 / 1.1176] – 1
%F = -0.0372
F = 4.417 MR/EUR × (1 – 0.0372) = 4.253 MR/EUR

MarginofSafety

Chao Wang, CFA, is a portfolio manager looking to take a currency position on the Chinese yuan. The current spot rate is 8.2781 yuan per U.S. dollar, while the two-year forward rate is 9.3336. Wang’s expected holding period is one year. Wang calculates the average expected percentage change in the exchange rate over the next year to be:

A) −6.18%.

B) −12.75%.

C) 5.68%.

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Using the foreign exchange parity relation allows for the calculation of the expected percentage change in the exchange over the next two years:

(F − S0) / S0 = E(%ΔS)

By substituting:

(9.3336 − 8.2781) / 8.2781 = E(%ΔS) for 2 years
12.75% = E(%ΔS) for 2 years

In order to convert the expected change over the next one-year period, use the standard effective interest rate formula:

[(1 + 0.1275)1/2] − 1 = E (%ΔS) for 1 year
[1.12751/2] − 1 = E(%ΔS)
6.18% = E(%ΔS)

The Chinese yuan can be expected to depreciate at an average of approximately 6.18% over the next year based on the two-year forward premium of 12.75% of the U.S. dollar.

MarginofSafety

Ronald Lots, CFA, is an international currency portfolio manager seeking speculative opportunities in the euro. While reviewing the forward rates for the euro, he notices that there is a forward premium of 4.25% on the euro relative to the U.S. dollar. Which of the following statements is correct? The euro is expected to:

A) appreciate at least 4.25% against the U.S. dollar.

B) depreciate 4.25% against the U.S. dollar.

C) appreciate 4.25% against the U.S. dollar.

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According to the foreign exchange expectation relation forward discounts and premiums can be unbiased predictors of expected changes in spot exchange rates. With the forward euro rate trading at a premium of 4.25%, the euro is expected to appreciate by the same 4.25% against the dollar.