Reading 19: Foreign Exchange Parity Relations-LOS g习题精选 regarding, following, statements, 2010, class

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Session 4: Economics: Economics for Valuation
Reading 19: Foreign Exchange Parity Relations

LOS g: Define and discuss absolute purchasing power parity and relative purchasing power parity.

 

 

 

Which of the following statements regarding relative Purchasing Power Parity (PPP) is least accurate?

A) It claims that the exchange rate movements should exactly offset any inflation differential between two countries.

B) In order for relative PPP to hold, countries with higher rates of expected inflation should see their currencies appreciate.

C) Because PPP holds in the long run, it is somewhat useful in exchange-rate determination in the short run.

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In order for relative PPP to hold, countries with higher rates of expected inflation should see their currencies depreciate.

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Kelly Gerard, CFA, a currency trader with the Mega Currencies Fund, is interested in using relative purchasing power parity (PPP) to identify value situations among currencies. Gerard believes that a currency’s fundamental value can be established by its inflation rate. Which of the following statements is CORRECT in Gerard’s assumptions regarding relative PPP? Relative PPP can help to identify:

A) overvalued currencies that could tend to depreciate immediately.

B) overvalued currencies that could tend to depreciate over the long run.

C) undervalued currencies that could tend to depreciate over the long run.

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Although evidence tends to suggest that PPP does not hold in the short run, empirical evidence suggests that relative PPP does tend to hold more closely over the longer term. Currencies that become overvalued or undervalued in relation to PPP over time tend to eventually revert back to the long-term level predicted by relative PPP. That means relative PPP is somewhat useful in exchange rate determination in the short run because currencies that are overvalued relative to their PPP-determined fundamental value will tend to depreciate, while undervalued currencies will tend to appreciate. However, the adjustment period can sometimes be quite long (i.e., several years).

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Harold Jennings, CFA, an economist the World Bank, is considering the use of purchasing power parity (PPP) as a useful tool in forecasting exchange rates for certain South American countries. The appropriate method he should use is:

A) relative PPP because it tends to hold over the short run.

B) absolute PPP because it tends to hold over the long run.

C) relative PPP because it tends to hold over the long run.

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Although evidence tends to suggest that PPP does not hold in the short run, empirical evidence suggests that relative PPP does tend to hold more closely over the longer term. Currencies that become overvalued or undervalued in relation to PPP over time tend to eventually revert back to the long-term level predicted by relative PPP. That means relative PPP is somewhat useful in exchange rate determination in the short run because currencies that are overvalued relative to their PPP-determined fundamental value will tend to depreciate, while undervalued currencies will tend to appreciate. However, the adjustment period can sometimes be quite long (i.e., several years). Note that absolute PPP is of little use In determining exchange rates because we would need to have identical individual goods and services to establish validity, and goods consumed are rarely identical between various countries.

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Carole Holden, CFA, is an economist for the International Monetary Fund. As a believer of purchasing power parity (PPP), she wants to create a suitable basket of goods for use in all countries as a means of determining exchange rates. Although she is very idealistic in her endeavor, one major shortcoming in her approach is that absolute PPP assumes:

A) real interest rates are constant throughout the world.

B) there are no restraints to trade.

C) inflation rates are constant throughout the world.

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Absolute PPP is of little use in determining exchange rates. In order to directly compare the prices of goods and services between two countries, identical individual goods and services are necessary to establish the validity of the law of one price. However, goods are rarely identical between various countries. In reality, restraints to trade, including differences in taxes, transportation and labor costs, rents, and government controls (e.g., tariffs) provide complexities that prevent direct comparison. Therefore, it is difficult (if not impossible) to confirm whether exchange rates are under- or overvalued according to absolute PPP.

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The law of one price applies with respect to:

A) absolute purchasing power parity (PPP), but does not apply to relative PPP.

B) both absolute and relative PPP.

C) relative PPP, but does not apply to absolute PPP.

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The law of one price focuses on a single, clearly comparable good and states that the same good should have the same real prices in all countries. Absolute PPP is an average version of the law of one price. Rather than focusing on a single good, absolute PPP focuses on a weighted average price level of a representative basket of goods and services. 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. It is the rate of inflation (i.e., the relative rate of change in prices) that is critical here.

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Which of the following purchasing power concepts depends on the growth rate of prices in two countries?

A) Relative purchasing power parity (PPP).

B) Absolute PPP.

C) International Fisher relation.

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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.

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With respect to the relative purchasing power parity (PPP) equation, compounded inflation rates are applicable when:

A) real interest rates are expected to hold for multiple periods over a certain stated time horizon.

B) inflation rates are expected to hold for multiple periods over a certain stated time horizon.

C) expected exchange rates are expected to hold for multiple periods over a certain stated time horizon.

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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. It is the rate of inflation that is critical here.

It is necessary to make a slight adjustment to the relative PPP equation to account for the compounded inflation rate over the time horizon if the problem involves multiple periods:

S_t / S₀ = (1 + i_FC)^t / (1 + i_DC)^t

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Suppose the United States and Europe produce only one good, chocolate. The price of chocolate is $8.25/kg in the United States and