dirk01

Donna Ackerman, CFA, is an analyst in the currency trading department at State Bank. Ackerman is training a new hire, Fred Bos, a recent college graduate with a BA in economics.
Ackerman asks Bos to attempt to estimate the inflation rate in the U.S. based on the following data:

• the spot exchange rate between the GBP and the USD is $0.500.
• the forward exchange rate is $0.520.
• the British rate of inflation is 4%.

Bos calculates the rate of U.S. inflation as:

A) 0%.

B) 8.2%.

C) 4.2%.

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According to the Interest Rate Parity, Purchasing Power Parity, and the International Fisher Relationship, the interest rate differential must equal the inflation differential, and we assume that the forward rate is an unbiased estimator of the future spot rate.
1 + US inflation = (0.520 / 0.500)(1.04) = 1.082, thus US inflation = 8.2%.

dirk01

Simon Peak, CFA, an international trader and economist with Canyon Peak Trading, is analyzing the inflation and interest rates trends for China. Peak is interested in taking a trading position in interest rate sensitive instruments. If Peak is to assume that the differences in inflation rates are substantially similar to the differences in interest rates, which theory does he prescribe to?

A) Relative purchasing power parity.

B) Asset markets approach.

C) International Fisher relation.

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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. This means countries with higher expected inflation will have higher nominal interest rates.

dirk01

George Canyon, CFA, an international trader and analyst with Canyon Peak Trading, is considering trading in the Chinese yuan. Canyon is considering the use of the international Fisher relation in his analysis of China. One concern that Canyon should consider is that the international Fisher relation assumes that:

A) nominal interest rates are stable across time and international borders.

B) real exchange rates are stable across time and international borders.

C) real interest rates are stable across time and international borders.

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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. This 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 borders.

anshultongia

George Canyon, CFA, an international trader and analyst with Canyon Trading, wants to use the international Fisher relation to determine his trading strategies. In analyzing expected inflation rates, he wants to correlate the expected rates to nominal interest rates. In doing so, he discovers that the international Fisher relation could approximate nominal interest rates by:

A) multiplying real interest rates by expected inflation rates.

B) adding real interest rates to expected inflation rates.

C) subtracting real interest rates from expected inflation rates.

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The nominal interest rate, r, is the compounded sum of the real interest rate, real r, and the expected rate of inflation, E(i), over an estimation horizon. The domestic version of the Fisher relation is stated as:

Exact methodology: (1 + r) = (1 + real r) × (1 + E(i))

    Where:
    r = nominal interest rate
    real r = real interest rate
    E(i) = expected inflation

Note that for the exact methodology, 1 must be added to each rate before they are multiplied.
The relationship can also be approximated by adding real interest rates to expected inflation rates: linear approximation: r = real r + E(i)

anshultongia

The Worldwide Equity-Income Fund is a U.S. based mutual fund whose objective is to seek current income through participation in the U.S. and global equity and fixed-income markets. According to its bylaws, Worldwide can invest no more than 25% of its funds in the assets of any one country. Currently, it holds a substantial amount of foreign securities, heavily weighted in British stocks and bonds. Mary Larson, CFA, has recently joined Worldwide as a portfolio manager. Larson is a recent graduate of Washington State University with a double major in Economics and Finance, where she studied interest rate parity and purchasing power parity. Larson’s role at Worldwide will encompass many areas, including forecasting and strategy.Larson has been asked to examine the current portfolio holdings, and project how the current position will perform over the next year under various interest rate scenarios. U.S. interest rates are currently 7% and the real rate of interest has been about 2% over the past 20 years. Today's spot rate is $1.7921 per British pound.
Due to a weakening in world oil prices, as well as the results from the recent U.S. presidential election, Larson determines it is necessary to calculate her own forecast of the expected inflation rate in the U.S. The international Fisher relation predicts that the interest rate differential between two countries should be equal to the expected inflation differential. Therefore, countries with higher expected inflation rates will have higher nominal interest rates, and vice versa. A change in domestic rates could lead Larson to suggest substantial changes to the current portfolio corporation. Larson is asked to recall the correct representation of purchasing power parity. St is the exchange rate at time t, expressed in units of foreign currency per domestic currency. ID and IF are the expected rates of inflation in the domestic and foreign countries, and E( ) denotes an expected value. Which of the following is the most accurate representation of purchasing power parity (PPP)?

A) E(S1) / S0 = [1 + E(iDC)] / 1 + E(iFC)].

B) E(S1) / S0 = [1 + E(iFC)] / [1 + E(iDC)].

C) E(S0) / S1 = [1 + E(iFC)] / 1 + E(iDC)].

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The correct representation of purchasing power parity is:  E(S1) / S0 = [1 + E(iFC)] / [1 + E(iDC)]. (Study Session 4, LOS 18.g)

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Larson predicts that the spot exchange rate for British pounds will be $1.8653 per pound in one year. Using the information above and assuming the expected inflation rate in the U.S. is 6%, Larson has arrived at her conclusion based upon the assumption that the inflation rate in Great Britain will be:

A) 1.8%.

B) 3.6%.

C) 10.3%.

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Using the information above and assuming the expected inflation rate in the U.S. is 6%, the expected inflation rate in Great Britain is 0.018, or 1.8%, computed as:
The relative form of the purchasing power parity condition implies that the expected future spot rate can be estimated as follows:

St=0 x (1 + IUS)/(1 + IUK) = E[St+1]

So, we can rearrange this equation to isolate the unknown, the expected inflation rate in the United Kingdom:

1 + IUK = 1.06 (1.7921 / 1.8653) = 1.018
IUK = .018 = 1.8%

(Study Session 4, LOS 18.h)

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Larson recalls that while relative PPP does tend to hold closely over the long term, PPP may not hold in the short run due to one of several reasons. Which of the following is least likely a reason why PPP may not hold in the short run?

A) A common consumption basket does not exist across countries.

B) Factors of production are mobile in the short run.

C) Transactions costs prevent arbitrage.

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Factors of production are immobile in the short run. Both remaining choices are valid reasons why PPP may not hold in the short run. (Study Session 4, LOS 14.a)

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Based upon the interest rate information given above, and using the exact version of the Fisher relationship, Larson calculates that the market-consensus implied expected inflation rate in the U.S. is:

A) 5.0%.

B) −4.7%.

C) 4.9%.

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Using the information above and the exact version of the Fisher relationship, the market-consensus expected inflation rate in the U.S. is 1.07 / 1.02 − 1 = 0.049 or 4.9%. Remember that the alternate version of the international Fisher relation, the linear approximation, will produce a slightly different result. (Study Session 4, LOS 18.j)

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The foundation of Larson’s predictions of future spot rates and interest rates depend upon several key assumptions. Larson knows that if capital markets are integrated, capital can flow freely across borders. Given this information about capital markets which one of the following statements is most accurate?

A) Nominal interest rates should be equal across countries.

B) Inflation rates should be equal across countries.

C) Real interest rates should be equal across countries.

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If capital markets are integrated, capital will flow freely across borders, and real interest rates should be equal across countries. Countries with high relative real rates will see their currencies appreciate as foreign investors sell their home currencies and buy the currency of the country with the high real rate. (Study Session 4, LOS 18.i)

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Suppose that the current spot exchange rate for U.S. Dollars into British Pounds is $1.4339 per pound. If the current interest rate is 5% in the U.S. and 7% in Britain, what is the expected spot exchange per pound rate 12 months from now according to uncovered interest rate parity?

A) $1.4612.

B) $1.4212.

C) $1.4071.

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Uncovered interest rate parity estimates future exchange rates based on the relationship in nominal interest rates. Multiplying the current spot exchange rate by the nominal annual U.S. interest rate and dividing by the nominal annual British interest rate yields the estimate of the spot exchange rate 12 months from now ($1.4339 × 1.05) / 1.07 = $1.4071. (Study Session 4, LOS 18.l)

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.

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

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

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

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.