International parity

Question 1

what’s the law of one price

Answer 1

• exchange-adjusted prices of all identical tradable goods and financial assets must be equal or be within transaction costs bounds

Question 2

Suppose two identical goods are priced differently in two different countries

Answer 2

-arbitrage opp
- demand for the cheaper on increases, so does its prices
- opposite for the other
- adjustment

Question 3

How is PPP different from LOP

Answer 3

PPP is different in that it deals with a basket of goods rather than with a single good

Question 4

Problems with absolute PPP

Answer 4

• assumes free and frictionless trade conditions
• ignores transportations costs, tariffs and quotas
• basket of goods may vary across countries
• Result: absolute PPP may not hold while LOP still does

Question 5

Relative version of the PPP

Answer 5

• exchange rate between two countries adjusts to reflect changes in the price levels in the respective countries
• therefore, spot exchange rate cannot be determined based on the PPP between these countries

Question 6

Does realtive PPP hold

Answer 6

Doesn’t hold short run but long run yeah. Because a monetary shock has an immediate
effect on exchange rate but a delayed yet a
persistent effect on output, investment, and
consumption. This implies that capital markets
adjust much faster than commodities market to the exchange rate changes.

Question 7

What is exchange rate pass-through

Answer 7

• measure of response in prices of imported and exported goods to changes in the exchange rate
• incomplete exchange rate pass-through is the result that PPP does not hold in the short run

Question 8

State the IFE in words (international fisher effect)

Answer 8

States that countries with low interest rates are expected to appreciate relative to currencies with high interest rates

Question 9

What does interest rate Parity conditions provide

Answer 9

the linkage between foreign exchange and international money markets

Question 10

What does uncovered interest rate parity imply

Answer 10

• implies the relation between the return on an unhedged investment in a foreign currency in term of the domestic currency
• does not guarantee that the return on foreign investment will be equal to the domestic interest rate on investment of equal risk

Question 11

Covered interest rate parity

Answer 11

-Cip is the relation between the return on a hedged investment in a foreign currency in terms of the domestic currency
- does guarantee that the return on foreign investment will be equal the domestic interest rate on investment of identical risk

Question 12

Chapter conclusions

Answer 12

• LOP is the fundamental no-arbitrage condition
• all parity conditions follow from LOP
• all parity conditions do not account for possible markets imperfections

Question 13

test results on parity conditions

Answer 13

• domestic currency appreciates when nominal interest rate is higher
• profitable trading exists: buy the bond of the country with higher nominal int rate
• violation of the semi strong form of market efficiency hypothesis
• existence of a foreign exchange risk premium with no violation of market efficiency