Week 5

Question 1

A country with a high inflation rate ….

A country with a low inflation rate …

Answer 1

Will have a depreciating currency

WIll have an appreciatiing currency

Question 2

PPP:

What happens if Ph increases

Answer 2

The domestic goods become less competitive, more demand for the foreign goods and currency. Foreign currency appreciates

Question 3

When does absolute purchasing power parity (PPP) hold?

Answer 3

When the exchange rate between two countries is equal to the ratio of their prices

Question 4

What is the law of one price

Answer 4

A product that is easily and freely tradable should have the same price everywhere (epsilon = 1) so that there are no international aribtrage opportunties.

Question 5

Exchanges rates in the long run are driven by?

Answer 5

By the demand and supply for different countries’ goods and services

Question 6

What does CIP imply?

Answer 6

That the interest rate differential should be approximately equal to the forward premium = (f-e)/e

Question 7

Covered investment:
The foreign interest rate increases, what happens in the spot market?

The domestic interest rate increases, what happens spot market?

Answer 7

Increase If: foreign assets become more attractive. This increases demand for the foreign currency in spot market. Foreign currency appreciates

Increase Ih: Home assets more attractive. Reduced demand for foreign currency, it depreciates

Question 8

What is speculating?

Answer 8

Taking over net asset or net liability postitions in foreign currency to make a (potential) profit

Question 9

What is hedging?

Answer 9

Seeking a balance between liabilities in foreign currency and assets in foreign currency to cover the risk

Question 10

What is transaction risk?

What is translation risk?

Answer 10

Transaction risk: the value of a transaction is unknown (main risk in exporting/importing)
Translation risk: the value of a firm’s assets and liabilities is unknown (main risk in FDI + FPI)