W6 - Relative PPP and CIP

Question 1

When does absolute PPP hold?

Answer 1

If the real exchange rate Q is equal to 1

Question 2

Where does absolute PPP tend to hold?

Answer 2

Developed countries but not for developing countries

Question 3

What are the general reasons for the failure of absolute PPP?

Answer 3

1. Trade costs
2. Non-tradable
3. Differentiated goods

Question 4

What is the future exchange rate influenced by?

Answer 4

The exchange rate in the future is influenced by the inflation rate differential

Question 5

How should you study Purchasing Power Parity?

Answer 5

You should focus on changes in the real exchange rate, rather than on its level

Question 5

What is relative PPP?

Answer 5

The value with one currency with respect to another is going to change over time reflecting inflation differentials between those currencies

Question 6

Does relative PPP hold in the long run?

Answer 6

Relative PPP holds in the long run between the US and the UK

Question 7

When does relative PPP hold?

Answer 7

Relative PPP holds if the rate of depreciation of the country’s currency against the dollar is equal to the inflation differential between the countries considered

Question 8

When does relative PPP holds in the long run?

Answer 8

If the average rate of depreciation of the domestic country’s currency against the foreign currency over a long period of time is equal to the average inflation differential

Question 9

Does relative PPP hold in the short-run?

Answer 9

No not as well, sometimes countries can be more expensive or cheaper but averages out in the long-run

Question 9

Does relative PPP hold well in practise?

Answer 9

Yes relative PPP holds well in the long-run empirically

Question 10

What does Covered Interest Parity (CIP) suggest?

Answer 10

Equality of returns on comparable financial market investments when the forward foreign exchange market is used to eliminate foreign exchange risk

Question 11

What would happen if CIP didn’t hold?

Answer 11

Arbitrage opportunities would exist

Question 12

What assumptions does CIP assume?

Answer 12

Assumes: capital mobility, low transactions costs and taxes, equal risk. Many say any deviations in CIP can be explained largely by any deviations in these assumptions

Question 12

What does CIP link?

Answer 12

The forward rate with the spot rate and the interest differential between the two countries

Question 13

Why do individuals engage in forward contracts?

Answer 13

To hedge risk
Or speculate

Question 14

Why is the parity condition called covered?

Answer 14

Because it covers the exchange risk

Question 15

Does CIP hold true?

Answer 15

Yes largely other than in the very short-lived high frequency data

Question 16

Why do deviations in CIP emerge?

Answer 16

• Default risk
• Exchange controls
• Political risk

Question 17

What is risk premium?

Answer 17

An increase in return associated with the asset issuers ability to pay