Ch 5

Question 1

2 requirements for Arbitrage

Answer 1

1) Profit must be ensured and there should be no possibility o a loss.
2) The transaction must be self-financing

Question 2

What is IRP

Answer 2

Interest Rate Parity. The equilibrium condition where the profit to covered interest arbitrage equals zero.

Question 3

What is the equation to check for IRP?

Answer 3

r-r* = F/S - 1
(1+r)/(1+r) = F/S
Multiple years: [(1/r)/1+r)]^t = F/S
LIBOR version: [1+r x (t/360)]/[1+r* x (t/360)] = F/S

Question 4

3 types of arbitrage

Answer 4

1) locational
2) triangular
3) ?

Question 5

Law of one price (LOP)

Answer 5

prices in various locations should be similar

Question 6

Purchasing power parity (PPP)

Answer 6

Exchange rates should equalize the price of a basket of goods between two countries.

Question 7

Two types of PPP

Answer 7

1) Absolute

2) Relative

Question 8

PPP absolute

Answer 8

requires equivalent prices – Law of one price (LOP) must hold

Question 9

PPP relative

Answer 9

less strict, more useful – focus on price changes (inflation)

Question 10

What should happen with PPP?

Answer 10

Price changes should be harmonized with currency changes

Question 11

Impediments to PPP?

Answer 11

1) Taxes increase price
2) Transportation costs: decrease trade
3) Consumer preferences cause different prices

Question 12

Do tests on PPP support it or reject it?

Answer 12

Reject it