anshultongia

Suppose the United States and Europe produce only one good, chocolate. The price of chocolate is $8.25/kg in the United States and €13.60/kg in Europe. According to the law of one price, the $ to € spot exchange rate should be closest to:

A) $0.607.

B) $1.607.

C) $1.648.

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Since the price of chocolate must be the same in both economies, the spot exchange rate should be:

anshultongia

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

C) absolute 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.

anshultongia

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.

anshultongia

Willie Muller is a senior loan officer with a money center bank in New York. He has many multinational clients, including several who do a large percentage of their business with customers in Germany. Recent political developments in Europe have led to uncertainty regarding future exchange rates. The risk management team at Muller’s bank is concerned about the potential impact that increased volatility in exchange rates may have on his clients’ operations. The bank’s loans are denominated in U.S. dollars; however, these particular clients conduct their operations primarily in Euros. Since the clients bear the exchange rate risk, Muller and his risk management team are concerned about their clients’ exposure and the implications to the bank. Any negative impact to earnings could ultimately impair the ability of his clients to repay their outstanding loans. Muller has been asked to assess the bank’s exposure to Muller’s customers under a variety of economic scenarios.
In order to better understand his clients’ foreign exchange risk, Muller undertakes a review of the factors that underlie exchange rates including the principle of purchasing power parity (PPP). To do so, he must factor in the interrelationships between exchange rates, interest rates, and inflation rates. Also of importance are growth projections for the German economy, and how these might be affected by government policy. Muller begins to gather information that he believes may be useful in his analysis. He discovers that over the past two years, the price level in the U.S. has increased from 100 to 112 while the price level in Germany has increased from 100 to 104. Also, he notes that the current $/€ spot quote is 0.9808, while the one-year forward rate is 0.9906.
Muller recalls that changes in exchange rates between the U.S. and Germany should exactly offset the price effects of any inflation differential between the two countries. This version of PPP is called:

A) relative purchasing power parity.

B) absolute purchasing power parity.

C) the law of one price.

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Relative PPP depends on the ratio of the growth rates in prices (i.e. inflation) in the two countries. (Study Session 4, LOS 18.g)

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Which of the following is least likely a valid reason for the failure of absolute PPP?

A) differences in taxes, labor, and transportation costs between countries.

B) forward rates are unreliable and thin.

C) consumers do not have the same basket of goods and services.

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Forward rates, and the liquidity of the forward market will not have a bearing on the correctness of absolute PPP. The other items listed will cause actual exchange rates to deviate from what is predicted by absolute PPP. (Study Session 4, LOS 18.g)

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Muller observes that the $/€ spot exchange rate was 0.9857 two years ago. What does a comparison of the spot rate predicted by PPP with the current spot rate, i.e., 0.9808, tell us about changes in the relative cost advantage of U.S. exporters vs. German exporters? Since the spot rate predicted by the PPP relationship is:

A) $1.0615 per euro, U.S. exporters have a competitive disadvantage relative to German exporters.

B) $1.0615 per euro, U.S. exporters have a competitive advantage relative to German exporters.

C) $0.9153 per euro, U.S. exporters have a competitive disadvantage relative to German exporters.

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PPP indicates that the current spot rate should be 0.9857 (112 / 104) = 1.0615, compared with the actual spot rate of 0.9808. Hence, the U.S. dollar is stronger than it should be. This means that American goods have become more expensive relative to German goods, putting U.S. exporters at a relative disadvantage. (Study Session 4, LOS 18.h)

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Which of the following statements regarding the international Fisher relation is least accurate?

A) Real interest rates are not stable over time.

B) Countries with higher expected inflation will have higher nominal interest rates.

C) Real interest rates are equal across international boundaries.

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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. The condition assumes that real interest rates are stable over time and equal across international boundaries. We could argue that this should be the case because differences in real interest rates between countries would encourage capital flows to take advantage of the differentials, ultimately equalizing real rates across countries. (Study Session 4, LOS 18.i)

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Muller is also interested in assessing the economic growth prospects for Germany. Suppose Germany's capital per labor hour grew by 1% while its real GDP per labor hour grew by 2%. Utilizing the one third rule, estimate the amount of real GDP per labor hour growth attributable to technological change.

A) 0.67%.

B) 0.33%.

C) 1.67%.

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Capital is responsible for 1/3 of the increase in real GDP so, 1/3 × 1% = 0.33%. The remaining 1.67% is attributed to technological change. (Study Session 4, LOS 14.b)

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Muller knows that government policies can have a significant impact on economic growth. Which of the following policies is least likely to foster a productivity speedup?

A) Pass laws that encourage higher rates of savings.

B) Foster technological advancement.

C) Restrict international trade.

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Technological advancement and higher rates of savings are important factors that tend to promote economic growth. (Study Session 4, LOS 14.b)

anshultongia

Which of the following statements regarding relative purchasing power parity is most accurate? Relative purchasing power states that exchange rates:

A) will change to reflect differences in inflation between countries.

B) will change to reflect differences in real interest rates between countries.

C) will change to reflect differences in nominal interest rates between countries.

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Purchasing power parity states that exchange rates will change to reflect differences in inflation between countries. Interest rate parity states that exchange rates must change so that risk-adjusted returns on investments in any currency will be equal.

anshultongia

Terrance Burnhart, a junior analyst at Wertheim Investments Inc., was discussing the concepts of purchasing power parity (PPP) and interest rate parity (IRP) with his colleague, Francis Ferngood. During the conversation Burnhart made the following statements:

Statement 1: Absolute PPP is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; all countries use the same basket of goods and services to measure their price levels; and all countries measure their rates of inflation the same way.

Statement 2: IRP rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates.

With respect to these statements:

A) only statement 1 is correct.

B) both are correct.

C) only statement 2 is correct.

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IRP means that interest rates and exchange rates will adjust so the risk adjusted return on assets between any two countries and their associated currencies will be the same. PPP is based on the idea that a given basket of goods should cost the same in different countries after taking into account the changes in exchange rates. PPP does not hold due to transportation costs and other factors.

anshultongia

According to the concept of relative purchasing power parity, when the relationship between prices in two countries changes, those changes should be reflected in the:

A) exchange rate.

B) interest rates.

C) relative inflation rate.

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Purchasing power parity implies that changes in the price levels in two countries should be reflected in changes in the exchange rate.

anshultongia

Kathy Smith, CFA, is an analyst with the Borderless Fund and is doing research on the country of Kenya for her colleague, John Dolan. Smith wants to calculate the inflation rate implied in the forward rates that she obtains from her bank, Global Bank. The current spot exchange rate is 90.772 Kenyan Shillings (KS) for one euro (EUR). The one-year forward rate for the Kenyan Shilling is 95.7686 KS/EUR. The current rate of inflation the European Economic Community is 9%. Smith does not know the current inflation rate for Kenya. Assuming relative purchasing power parity (PPP) applies, the calculated expected inflation rate implied in the forward rate is:

A) 10%.

B) 17%.

C) 15%.

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Solve for the expected inflation rate for Kenya implied in the forward rate (iK) by using the same formula for relative PPP:

S1 = S0 × [(1 + iFC) / (1 + iDC)]
S1 = KS95.7686 = KS90.772 × [(1 + iK) / (1 + 0.09)]
iK = 15%

anshultongia

Brian Kenny, CFA, is an economist for Borderless Fund and was instructed by his colleague, John Dolan to create a forecasted exchange rate at the end of two years, Kenny’s investment horizon for the country of Kenya. The current spot exchange rate is 90.772 Kenyan Shillings (KS) for one euro (EUR). Kenny calculates annual inflation rates of 13% for the next two years for Kenya and 11% for the Economic European Community. Assuming relative purchasing power parity (PPP) holds, the expected spot exchange rate at the end of two years is:

A) 92.4075 KS/EUR.

B) 89.1654 KS/EUR.

C) 94.0725 KS/EUR.

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The KS is the foreign currency and the EUR is the domestic currency because the spot quote is KS/EUR:

S1 = S0 × [(1 + iFC)2 / (1 + iDC )2]
S1 = 90.772 × [(1 + 0.13)2 / (1 + 0.11)2] = 94.0725 KS/EUR

The KS is expected to depreciate against the EUR over the next two years.

anshultongia

John Dolan, CFA, is an international fund manager with the Borderless Fund. Dolan is considering an investment in the country of Kenya. He is concerned with the inflationary environment in Kenya, but he feels that it is mitigated by the degree of high economic growth over the next year. Based on his research, Dolan found that Kenya is expecting inflation rates of 17% while the European Economic Community is expecting 9%. The current exchange rate is 90.772 Kenyan Shillings (KS) per euro (EUR). Dolan assumes that relative purchasing power parity applies. If Dolan wants to compute an exchange rate at the end of the year so that he can use it for purposes of portfolio valuation, the closest exchange rate (KS/EUR) would be:

A) 84.5654 KS/EUR.

B) 98.9415 KS/EUR.

C) 97.4342 KS/EUR.

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The KS is the foreign currency and the EUR is the domestic currency because the spot quote is KS/EUR:

S1 = S0 × [(1 + iFC) / (1 + iDC)]
S1 = KS90.772 × [(1 + 0.17) / (1 + 0.09)] = 97.4342 KS/EUR

The Kenyan Shilling is expected to depreciate against the euro over the next year.