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FIN 321 > International Purchasing Parity > Flashcards

International Purchasing Parity Flashcards

1
Q

What is the International Fisher Effect (IFE)?

A

The IFE states that the nominal interest rate differential reflects the expected change in exchange rate.

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2
Q

How does the International Fisher Effect explain currency depreciation?

A

Countries with higher inflation rates will tend to have higher interest rates, causing their currency to depreciate against a country with a lower interest rate.

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3
Q

What formula is used to forecast the future spot rate using IFE?

A

S_t = S_0 * [(1 + i_f) / (1 + i_d)]^t

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4
Q

True or False: The International Fisher Effect assumes that real interest rates in all countries are the same.

A

True

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5
Q

What does Covered Interest Rate Parity (CIRP) suggest about the relationship between forward and spot exchange rates?

A

The forward exchange rate should equal the spot exchange rate times the interest rate of the home country divided by the interest rate of the foreign country.

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6
Q

What happens when the interest rate in South Africa is higher than in Brazil?

A

The South African currency is expected to depreciate against the Brazilian currency.

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7
Q

Fill in the blank: The forward exchange rate is an unbiased predictor of the _______.

A

future spot rate.

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8
Q

List the factors influencing exchange rates.

A
  • Inflation rate
  • Interest rate
  • Recession
  • Government debt
  • Terms of trade
  • Political stability
  • Economic performance
  • Speculation
  • Country’s current account/balance of payments
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9
Q

What is the theory of Purchasing Power Parity (PPP)?

A

PPP states that identical goods should sell for the same price worldwide when expressed in the same currency.

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10
Q

What is Absolute Purchasing Power Parity?

A

It states that the exchange rate is in equilibrium when purchasing power is the same in both countries.

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11
Q

What assumptions are required for PPP to exist?

A
  • All goods and services are tradable
  • Transportation and other trading costs are zero
  • Consumers in all countries consume the same proportions of goods and services
  • Law of One Price should prevail
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12
Q

When a country’s domestic price level is increasing, what must happen to its exchange rate to return to PPP?

A

The exchange rate must depreciate.

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13
Q

What is the relationship between inflation rates and interest rates according to the Fisher Effect?

A

An increase in expected inflation leads to a proportionate increase in the interest rate.

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14
Q

What is the significance of the real exchange rate in relation to PPP?

A

If PPP holds, the real exchange rate will be unity (q = 1); deviations affect international competitiveness.

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15
Q

What happens when the real exchange rate q > 1?

A

Competitiveness of industries in the domestic country deteriorates.

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16
Q

How does covered interest rate arbitrage work?

A

It involves borrowing from a country with a low interest rate and investing in a country with a high interest rate, adjusting for exchange rates.

17
Q

What does it mean if Interest Rate Parity does not hold?

A

It indicates the existence of covered interest rate arbitrage opportunities.

18
Q

What is the law of one price in the context of PPP?

A

Identical goods should sell for the same price worldwide when prices are expressed in the same currency.

19
Q

What is the expected behavior of the exchange rate if a country’s domestic price level decreases?

A

The exchange rate must appreciate to return to PPP.

20
Q

What is the real exchange rate?

A

The real exchange rate (q) measures the relative value of currencies adjusted for price levels.

If PPP holds, the real exchange rate will be unity (q = 1).

21
Q

What does Purchasing Power Parity (PPP) imply when there is a higher inflation rate in one country?

A

The currency of the country with the higher inflation rate should depreciate.

This prevents arbitrage by ensuring it is not cheaper to buy goods in the country with higher inflation.

22
Q

What does the Big Mac Index illustrate?

A

It compares the prices of Big Macs in different countries to assess whether currencies are undervalued or overvalued.

It uses the concept of patty-power parity.

23
Q

What is the implication if the South African Rand is found to be undervalued by 53% according to the Big Mac Index?

A

The Rand is expected to appreciate in the future.

This assessment is based on the comparison of Big Mac prices in South Africa and the U.S.

24
Q

Define Relative Purchasing Power Parity (Relative PPP).

A

Relative PPP states that the rate of appreciation of a currency is equal to the difference in inflation rates between two countries.

It determines the change in exchange rates over time.

25
Q

If South Africa has an inflation rate of 8% and the U.K. has an inflation rate of 5%, what is the expected depreciation of the Rand against the Pound?

A

The Rand is expected to depreciate by 3%.

This is based on the inflation rate differential.

26
Q

What does the term ‘real exchange rate’ refer to?

A

It measures the degree of deviations from PPP over a certain period, assuming PPP held roughly at the starting point.

It reflects how international competitiveness is affected by exchange rate changes.

27
Q

What is the significance of International Parity Relationships?

A

They help understand how exchange rates are determined and forecasted through relationships with interest rates and inflation.

They are based on the law of one price.

28
Q

What happens when the South African interest rate is higher than the U.K. interest rate according to Covered Interest Rate Parity (CIRP)?

A

The Rand trades at a forward discount to the Pound, implying expected depreciation of the Rand.

The higher interest rate compensates for future depreciation.

29
Q

When the South African interest rate is lower than the U.K. interest rate, what does this indicate about the Rand’s future?

A

The Rand is expected to appreciate against the Pound.

The lower interest rate compensates for future appreciation.

30
Q

What is arbitrage in the context of international finance?

A

Arbitrage is the simultaneous buying and selling of equivalent assets to guarantee profits.

It is prevented when the law of one price holds.

31
Q

What is the law of one price (LOP)?

A

The law of one price states that equivalent goods should sell for the same price in different markets to prevent arbitrage opportunities.

It underpins international parity relationships.

32
Q

What impact do deviations from PPP have on international competitiveness?

A

Deviations from PPP can affect the international competitiveness of countries by altering their export market positions.

This occurs when exchange rate changes do not offset inflation rate differentials.

33
Q

What are the three approaches to forecasting exchange rates mentioned?

A
  1. Efficient Market Approach
  2. Fundamental Approach
  3. Technical Approach

Each approach offers different methodologies for predicting exchange rate movements.

FIN 321 (2 decks)

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