Lesson 4 -International Parity Relationships and Forecasting Exchange Rates

Question 1

What are international parity conditions?

Answer 1

Economic theories that link exchange rates, price levels, and interest rates together, forming the core of international finance.

Question 2

What is the Law of One Price (LOP)?

Answer 2

The principle that identical goods should sell for the same price in different markets, eliminating arbitrage opportunities.

Question 3

What is arbitrage?

Answer 3

The act of simultaneously buying and selling assets to make a profit from price differences in different markets.

Question 4

What does Interest Rate Parity (IRP) state?

Answer 4

IRP is a “no-arbitrage” condition that links the spot and forward exchange rates with interest rates between two countries.

Question 5

What is the formula for Interest Rate Parity (IRP)?

Answer 5

F = S * ((1+i(fc))/(1+i(dc))
Where F is the forward rate, S is the spot rate, i(fc) is the foreign interest rate, and i(dc) is the domestic interest rate

Question 6

What is covered interest arbitrage (CIA)?

Answer 6

It involves using forward contracts to hedge against exchange rate risk while exploiting interest rate differentials between countries.

Question 7

What is uncovered interest arbitrage (UIA)?

Answer 7

UIA involves investing in higher interest-rate currencies without hedging against exchange rate risk, exposing the investor to potential currency fluctuations.

Question 8

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

Answer 8

PPP states that in the long run, exchange rates should adjust so that the price of a basket of goods is equal across countries.

Question 9

What is the difference between absolute and relative PPP?

Answer 9

Absolute PPP suggests exchange rates should equalize the price of a basket of goods, while relative PPP considers the rate of change in prices over time to explain exchange rate changes.

Question 10

What is the International Fisher Effect (IFE)?

Answer 10

IFE states that the difference in nominal interest rates between two countries reflects expected changes in exchange rates.

Question 11

What are the three main approaches to forecasting exchange rates?

Answer 11

1. Efficient Market Approach: Exchange rates are unpredictable and follow a random walk.
2. Fundamental Approach: Uses economic variables like inflation and interest rates.
3. Technical Approach: Analyzes historical data to identify patterns.

Question 12

What is the Efficient Market Hypothesis (EMH)?

Answer 12

EMH suggests that financial markets are informationally efficient, meaning exchange rates reflect all available information, and changes only occur with new information.

Question 13

What is the Big Mac Index?

Answer 13

A real-world application of PPP developed by The Economist, comparing the price of a Big Mac in various countries to determine if currencies are overvalued or undervalued.

Question 14

What is the Fisher Effect?

Answer 14

The theory that nominal interest rates are the sum of the real interest rate and expected inflation.

Question 15

What is covered interest parity?

Answer 15

The condition where the forward exchange rate eliminates arbitrage opportunities due to differences in interest rates between two currencies.

Question 16

What is the difference between the fundamental and technical approaches to forecasting exchange rates?

Answer 16

The fundamental approach uses economic data like interest rates and inflation, while the technical approach relies on identifying patterns in historical data.