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Chao Wong, CFA, is the portfolio manager for the China Current Fund. He is concerned with the direction of inflation and its effects on interest rates in China. He wants to compare real interest rates across different countries in Asia to see if real interest rates hold according to the international Fisher relation. First, he needs to compute the real interest rate for China. The Chinese nominal interest rate is 10.2% and inflation is currently pegged at 7%. According to his calculations, the Chinese real interest rate is:
A)
2.99%.
B)
3.50%.
C)
1.03%.



According to the international Fisher relation:
(1 + Nominal interest rate) = (1 + real interest rate) × (1 + inflation rate)

By substituting, solve for the real interest rate:
(1 + 0.102) = (1 + r) × (1 + 0.07)
(1 + r) = 1.102/1.07
(1 + r) = 1.0299
r = 2.99%

TOP

Michael Zotov, CFA, is the economist and portfolio manager of the Zotov Investment Fund. 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. He wants to be sure that the real interest rate, the real cost of money in Poland, has also declined. The Polish nominal interest rate is 12.3%, while inflation holds at 9%. Assuming the international Fisher relation holds, the Polish real interest rate is:
A)
3.03%.
B)
1.03%.
C)
2.93%.



According to the international Fisher relation:
(1 + Nominal interest rate) = (1 + real interest rate) × (1 + inflation rate)

By substituting, solve for the real interest rate:
(1 + 0.123) = (1 + r) × (1 + 0.09)
(1 + r) = 1.123/1.09
(1 + r) = 1.0303
r = 3.03%

TOP

Chao Wong, CFA, is the portfolio manager for the China Current Fund in Switzerland. He is concerned with the direction of inflation and its effects on interest rates in China. For comparative purposes, he wanted to use Europe as a benchmark since most of his investor base is in Switzerland. The current spot exchange rate is 9.6246 Chinese yuan per euro. He wants to see if the ratio of interest rates between China and the European Economic Community (EEC) are the same as the ratio of inflation rates according to the international Fisher relation. The current nominal interest rate for the EEC is 11.76% and the annual inflation rate is 8.50%. The Chinese nominal interest rate is 10.20% and the annual inflation rate is 7.00%. According to his calculations, the result of the international Fisher relation is:
A)
1.000.
B)
1.014.
C)
0.986.


Using the international Fisher relation:

Exact methodology: (1 + rFC) / (1 + rDC) = (1 + E (iFC)) / (1 + E (iDC))


By substituting for the international Fisher relation:

(1 + 0.102) / (1 + 0.1176) = (1 + 0.07) / (1 + 0.085)
1.102 / 1.1176 ≈ 1.07 / 1.085
0.9860 ≈ 0.9862

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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. For comparative purposes, he wanted to use Europe as a benchmark since most of his investor base is in Germany. The current spot exchange rate is 4.6404 Polish Zioty per euro. He wants to see if the ratio of interest rates between Poland and the European Economic Community (EEC) are the same as the ratio of inflation rates according to the international Fisher relation. The current nominal interest rate for the EEC is 11.76% and the annual inflation rate is 8.50%. The Polish nominal interest rate is 12.30% and the annual inflation rate is 9.00%. According to his calculations, the result of the international Fisher relation and its linear approximation are:
A)
1.005 and −0.005.
B)
1.005 and 0.005.
C)
0.995 and −0.005.



Using the international Fisher relation:

Exact methodology: (1 + rFC) / (1 + rDC) = (1 + E(iFC)) / (1 + E (iDC))


Linear approximation: rFC – rDC = E(iFC) – E(iDC)

By substituting for the international Fisher relation:

(1 + 0.123) / (1 + 0.1176) = (1 + 0.09) / (1 + 0.085)
1.123 / 1.1176 ≈ 1.09 / 1.085
1.0048 ≈ 1.0046
1.005 ≈ 1.005

By substituting for the linear approximation of the international Fisher relation:

0.123 – 0.1176 ≈ 0.09 – 0.085
0.0054 ≈ 0.0050
0.005 ≈ 0.005

TOP

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. He believes that the international Fisher relation holds on the assumption that the ratios of interest and inflation rates are equal among developed and emerging countries. For comparative purposes, one of Malaysia’s main financial trading partners is Europe. The current nominal interest rate for the European Economic Community is 11.76% and the annual inflation rate is 8.50%. The Malaysian nominal interest rate is 7.60% and the annual inflation rate is 4.50%. According to his calculations, the result of the international Fisher relation and its linear approximation are:
A)
0.96 and (-0.04).
B)
1.04 and 0.04.
C)
0.96 and 0.04.


Using the international Fisher relation:

Exact methodology: (1 + rFC) / (1 + rDC) = (1 + E (iFC)) / (1 + E (iDC))


Linear approximation: rFC – rDC = E (iFC) – E (iDC)

By substituting for the international Fisher relation:

(1 + 0.076) / (1 + 0.1176) = (1 + 0.045) / (1 + 0.085)
1.076 / 1.1176 ≈ 1.045 / 1.085
0.9628 ≈ 0.9631

By substituting for the linear approximation of the international Fisher relation:

0.076 – 0.1176 ≈ 0.045 – 0.085
- 0.0416 ≈ -0.0400

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Simon Peak, CFA, an international trader and economist for Canyon Peak Trading, feels that the interest and inflation rate differentials should be similar for both China and the United States. The inflation rates for China and the U.S. were 7% and 3%, respectively. Using the linear approximation of the international Fisher relation to calculate the inflation differential, his result is:
A)
4.0%.
B)
3.2%.
C)
3.0%.


Using the linear approximation for the international Fisher relation:
rC – rUS = E (iC) – E (iUS) = 0.07 – 0.03 = 0.04 or 4.0%

TOP

Justine Kravitz is the Chief Executive Officer for Fantatradcom, a global designer and manufacturer of consumer luxury goods. Under Kravitz’ direction, Fantatradcom has grown from a modest operation in the Euro zone to a truly global organization, with manufacturing facilities in 32 countries and sales operations in more than 100.
The firm’s global expansion has caused the management of foreign exchange and interest rate risk to become a paramount concern to certain outside investors. In response, the Chief Financial Officer, Leonardo DiLorenzo, has established a large and active foreign exchange trading and hedging operation under the direction of Omar Nasser.
Kravitz is uncertain about the need for the foreign exchange hedging operations. She points out, “The asset market approach indicates that even though an unexpected increase in money supply will cause the domestic currency to depreciate in the short run, it should return to purchasing power parity equilibrium (PPP) in the long run.” Nasser disagrees, arguing, “Absolute purchasing power parity is of little use in determining exchange rates.”
Nasser provides the example of the United States and Switzerland to support his argument in favor of maintaining the foreign currency hedging operations:
International Economic Statistics

US$/CHF spot rate

1/1


1-year U.S. interest rate

6%


Expected annual U.S. inflation

3%


1-year Swiss interest rate

4%


Expected annual Swiss inflation

2%


Nasser argues that international parity relations suggest that the interest rates in the U.S. and Switzerland are in disequilibrium, saying, “International parity relations would put U.S. rates at approximately 4.9%, given the relative inflation rates and Swiss interest rates.” DiLorenzo agrees that there is currently a disequilibrium between the U.S. and Switzerland and suggests, “The high interest rates in the U.S. indicate that in the 1-year forward market, the U.S. dollar should trade at 1.02 CHF because of covered interest rate parity.”
DiLorenzo adds an additional point about expected exchange rate movements. He reminds Kravitz, “Purchasing power parity and uncovered interest parity both predict that the U.S. should experience an appreciation of its currency relative to Switzerland because of its higher interest and inflation rates.” He argues that such knowledge should be used to manage Fantatradcom’s currency exposures.
Kravitz remains unconvinced. She reminds DiLorenzo, “The theory of the traditional balance of payments approach to determining exchange rates suggests that exchange rate adjustments are required to restore balance of payments equilibrium. Since even small changes in the current account flows drive dramatic changes in the foreign currency markets,” she points out, “the balance of payments approach is the most useful means of explaining how exchange rates are determined in practice.”Which of the following is most likely to be considered an implication of the combined international parity relationships?
A)
Investors interested in real returns face exchange rate risk.
B)
Investors will earn the same expected real return in their own currency on any investment denominated in a foreign currency.
C)
The real risk-free return differs across countries.



The combined parity relationships imply that exchange rate risk is inflation risk and expected return on risk-free securities should be the same in all countries. Thus, investors interested in real returns face no exchange rate risk, investing in countries with high nominal interest rates will not generate excess returns, and the real risk-free return is the same across countries. The only true statement is that investors earn the same expected real return in their own currency on any investment in a foreign currency.



Which most accurately describes the statements made by Nasser and DiLorenzo about the current disequilibrium relationship between the US and Switzerland?
NasserDiLorenzo
A)
IncorrectIncorrect
B)
CorrectCorrect
C)
IncorrectCorrect



Both are incorrect. Nasser is incorrect because international parity relations suggest that the U.S. rate should be slightly higher than 5.0%:
(1 + X) / 1.04 = (1.03) / (1.02)
1 + X = (1.04)(1.03) / (1.02)
1 + X = 1.0502
DiLorenzo is incorrect because covered interest rate parity suggests that the US$ should equal the spot rate times the ratio of the interest rates, or (1.00) × (1.06 / 1.04) = 1.02 US$/CHF, not 1.02 CHF/US$.


Kravitz’ statements describing the theory behind the balance of payments approach to determining foreign exchange rates and assessing its usefulness in practice are best described as:
A)
correct in description of the theory but incorrect in assessment of its usefulness in practice.
B)
correct in both theory and practice.
C)
incorrect in both theory and practice.



Kravitz’ description of the theory is correct. The traditional approach to foreign exchange rate determination indicates that exchange rate adjustments are required to restore balance of payments equilibrium. Her assessment of its usefulness in practice is incorrect because the small changes in current account flows cannot explain the volatility in exchange rates.



Empirical evidence suggests that relative purchasing power parity (PPP) tends to hold in the:
short run?long run?
A)
NoNo
B)
NoYes
C)
YesNo



PPP does not tend to hold in the short run for a variety of reasons, including differences in goods, transaction and transportation costs, short-term immobility in the factors of production, and constraints on arbitrage in physical goods. However, currencies do tend to converge to PPP over the long run.

DiLorenzo’s statement about the implications of both purchasing power parity (PPP) and uncovered interest parity for expected exchange rate movements in the US$ is best described as:
A)
incorrect about PPP but correct about uncovered interest parity.
B)
incorrect about both PPP and uncovered interest parity.
C)
correct about both PPP and uncovered interest parity.



DiLorenzo’s statement about PPP and uncovered interest parity is incorrect in both parts. Purchasing power parity predicts that countries with higher relative expected inflation should experience a depreciation of their currencies. Uncovered interest parity predicts that countries with higher relative interest rates will experience a depreciation of their currencies. Both theories indicate the US$ should depreciate, not appreciate, relative to the Swiss franc.



Are Kravitz and Nasser correct in their statements regarding the currency fluctuations and purchasing power parity (PPP)?
KravitzNasser
A)
YesYes
B)
YesNo
C)
NoYes



Although the statements appear contradictory, both are correct. Absolute purchasing power parity is of little use in determining exchange rates because goods and services are rarely identical between two countries. However, exchange rates do tend to revert to purchasing power parity equilibrium levels in the long run.

TOP

Which of the following economic concepts links inflation and interest rates to exchange rates?
A)
Relative purchasing parity (PPP).
B)
International Fisher relation.
C)
Uncovered interest Rate Parity.



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. The international Fisher relation relates nominal interest rates to inflation, while relative PPP links exchange rates to inflation. Only the theory of uncovered interest rate parity links interest rates, inflation rates and exchange rates together.

TOP

Which of the following economic methods is useful and easy to use in forecasting future spot exchange rates?
A)
Absolute purchasing power parity (PPP).
B)
International Fisher relation.
C)
Uncovered interest rate parity.



Uncovered interest rate parity can be used to forecast future spot exchange rates using market interest rates. The international Fisher relation relates interest rates to inflation rates. Absolute PPP uses a basket of goods for comparative purposes in exchange rate determination. This limits its application because it requires an identical basket of goods across all countries and makes unrealistic assumptions regarding impediments to trade.

TOP

China’s nominal interest rates, along with the inflation rate, have been declining over the past five years as a result of governmental efforts to privatize state-owned enterprises and monetary austerity controls over its economy. Over the long run, the Chinese yuan would be expected to:
A)
depreciate relative to countries with high interest rates.
B)
appreciate relative to countries with high interest rates.
C)
appreciate relative to countries with low inflation.



According to uncovered interest rate parity, countries with high nominal interest rates should experience a depreciation of their currency in the long run, while countries with low nominal interest rates should experience an appreciation of their currency in the long run.

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