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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.

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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.

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What is the end of year real exchange rate?

A) 0.013.

B) 0.021.

C) 0.010.

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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

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

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

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

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

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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.

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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.

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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.

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Which of the following assumptions is required in order to extend the domestic capital asset pricing model (CAPM) to an international setting?

A) All countries have identifiable consumption baskets.

B) Purchasing power parity holds at all times.

C) Exchange rate risk is perfectly hedged.

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Extending the CAPM to an international setting requires two additional assumptions: (1) purchasing power parity holds at all times, and (2) all investors have identical (not identifiable) consumption baskets.

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Some market participants have argued that, under certain circumstances, the domestic capital asset pricing model (CAPM) can be extended to the international environment. When using the domestic CAPM in the international environment, the model is referred to as the:

A) extended CAPM.

B) international CAPM.

C) ICAPM.

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When using the domestic CAPM in an international setting, the model is referred to as the extended CAPM.

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Which of the following assumptions is needed to justify the extended capital asset pricing model (CAPM)? Purchasing power parity (PPP) holds:

A) approximately at any point in time.

B) approximately over extended periods of time.

C) exactly at any point in time.

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The extended CAPM assumes that PPP holds exactly at any point in time.

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Which of the following assumptions is needed to justify the extended capital asset pricing model (CAPM)? Investors throughout the world have:

A) identical consumption baskets.

B) similar consumption baskets.

C) nearly-identical consumption baskets.

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Investors throughout the world need to have identical consumption baskets to justify the extended CAPM.

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Which of the following assumptions is NOT needed to justify the extended capital asset pricing model?

A) World markets are integrated (i.e. no segmentation).

B) Investors throughout the world have identical consumption baskets.

C) The rate of inflation must be identical throughout the world.

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The rate of inflation need not be identical throughout the world. In a world where identical consumption baskets exist and where purchasing power parity holds exactly at any point in time, exchange rate changes would mirror inflation differences between any two countries.

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The capital asset pricing model (CAPM) is least effective when used to value:

A) thinly traded stocks.

B) extremely volatile stocks.

C) bonds.

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The CAPM uses beta to reflect volatility, so it can handle volatile stocks. Thinly traded stocks are a problem, but as long as trading is sufficient to provide a beta, the CAPM can be used. It is also possible to estimate beta for thinly traded stocks. However, the CAPM does not work at all for bonds. It uses an equity risk premium, and as such is designed for use only with equities.

invic

Horace Malthusson likes to use the CAPM in his stock valuation. When using the CAPM to value stocks, Malthusson assumes that he can borrow money at the risk-free rate, tax rates are stable, and every investor has the same expected rate of return. The assumptions required by the CAPM differ from Malthusson’s assumptions with regard to:

A) expected returns.

B) tax rates.

C) borrowing capability.

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The capital asset pricing model requires that investors assume there are no taxes. Malthusson’s other assumptions match those of the CAPM.

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Users of the capital asset pricing model (CAPM) must assume that:

A) inflation remains moderate.

B) all investors are risk-averse.

C) exchange rates are not excessive.

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One of the assumptions of the CAPM is that all investors are risk-averse, preferring more return and less risk, all else equal. The other assumptions are not required.