Class 5 (continuation)

Question 1

Find the 6 month forward rate for USD to EUR, given the info below:
-Spot rate: 1.15 (1 USD = 1.15 EUR)
-One year US int rate: 2%
-One year EUR int rate: 1%

Answer 1

Forward rate = ((1+domestic int) / (1+foreign int)) x Spot rate
=((1 + (0.02 x 0.5)) / (1 + (0.01 x 0.5))) x 1.15
=1.161386

Question 2

What is interest rate parity? Give an example

Answer 2

Theory that states that FX rates cancels out any interest rate gain that could be achieved by investing in foreign countries
-Ex: US rate is 10% and Canada rate is 5%. People think that you can’t invest in the USA and achieve a gain since the FX from USD to CAD would cancel it out

Question 3

What is covered interest parity

Answer 3

it is when you use a forward rate contract to protect against FX rates

Question 4

What is uncovered interest parity

Answer 4

is it when you DONT use a forward rate to protect against FX rates

Question 5

What is an exchange rate pass through

Answer 5

It is a measure of how much a change in exchange rate affect domestic prices of imported and exported goods. The more the price of goods change, the more it is affected by the change in interest rates

Question 6

What is a complete pass through

Answer 6

When the change in interest rates is fully represented in the change in the price of the good (ex: rates go down by 10% and good goes up by 10%)

Question 7

What is a partial pass through

Answer 7

When the change in the interest rate is only partially reflected in the change of the good (ex: interest goes up by 10% and good goes down by 6%)

Question 8

What is a zero pass through

Answer 8

When the change in interest rate does not affect the price of the good

Question 9

What is the fisher effect

Answer 9

Theory that says that nominal interest rate is equal to he real interest rate plus the inflation rate

Question 10

What is the nominal interest rate

Answer 10

interest rate on a loan or financial product, not adjusted for inflation

Question 11

What is real interest rate

Answer 11

the purchasing power of the interest income adjusted for inflation

real interest rate = nominal rate - inflation rate

Question 12

What is the law of one price?

Answer 12

It states that identical goods should sell for the same price, when expressed in a currency, assuming no transportation costs and no differential taxes applied in different markets

Question 13

What is PPP

Answer 13

Theory that suggests that in the long term, identical goos should have the same price when expressed in a common currency, taking into account cost of living and inflation in different countries

Question 14

What is the difference in usage between PPP and law of one price?

Answer 14

PPP is for a basket of goods whereas law of one price is for one good/item

Question 15

What does PPP allow you to do? How is that done?

Answer 15

To see if a currency is under or over valued by comparing the implied PPP exchange rate with the actual spot rate

Question 16

What is relative PPP

Answer 16

similar idea as PPP but focuses on the rate of change in exchange rates over time in relation to inflation rates in different countries

Question 17

What is the difference between absolute PPP (regular PPP) and relative PPP

Answer 17

Relative PPP considers how to the exchange rate between two currencies will adjust based on the inflation in differentials between the two countries over a specific period

Question 18

What is the international fisher effect

Answer 18

States that change nominal interest rates in different countries lead to changes in exchange rates

Question 19

What does the international fisher effect say about nominal interest rates?

Answer 19

That the difference in nominal interest rates between two countries will equal the expected change in the exchange rate between their currencies

Question 20

How do higher nominal interest rates react compared to lower nominal interest related, in terms of currency valuation

Answer 20

Currencies with high nominal interest rates will depreciate relative to currencies with lower nominal interest rates, which reflect the inflation differentials

Question 21

What does international fisher effect assume about long term exchange rates and short term volatility?

Answer 21

Assumes that exchange rates will adjust in the long term but may not account for short-term volatility and market reactions

Question 22

What may play with interest and exchange rates in the short term? (3)

Answer 22

-Geopolitical risks
-Speculations
-Market sentiment