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Multinational Business Finance, 13e (Eiteman/Stonehill/Moffett)
Chapter 7 International Parity Conditions
7.1 Prices and Exchange Rates
Multiple Choice
Question: If an identical product can be sold in two different markets, and no restrictions
exist on the sale or transportation costs, the products price should be the same in both
markets. This is known as:
A) relative purchasing power parity.
B) interest rate parity.
C) the law of one price.
D) equilibrium.
Answer:
Question: The Economist publishes annually the "Big Mac Index" by which they compare
the prices of the McDonalds Corporations Big Mac hamburger around the world. The
index estimates the exchange rates for currencies based on the assumption that the burgers
in question are the same across the world and therefore, the price should be the same. If a
Big Mac costs $2.54 in the United States and 294 yen in Japan, what is the estimated
exchange rate of yen per dollar as hypothesized by the Hamburger index?
A) $0.0086/
B) 124/$
C) $0.0081/
D) 115.75/$
Answer:
Question: If the current exchange rate is 113 Japanese yen per U.S. dollar, the price of a
Big Mac hamburger in the United States is $3.41, and the price of a Big Mac hamburger in
Japan is 280 yen, then other things equal, the Big Mac hamburger in Japan is:
A) correctly priced.
B) under priced.
C) over priced.
D) There is not enough information to determine if the price is appropriate or not.
Answer:
Question: The price of a Big Mac in the U.S. is $3.41 and the price in Mexico is Peso 29.0.
What is the implied PPP of the Peso per dollar?
A) Peso 8.50/$1
B) Peso 10.8/$1
C) Peso 11.76/$1
D) None of the above
Answer:
Question: Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is
8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso
10.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate
the peso is:
A) overvalued.
B) undervalued.
C) correctly valued.
D) There is not enough information to answer this question.
Answer:
Question: According to the Big Mac Index, the implied PPP exchange rate is Mexican peso
8.50/$1 but the actual exchange rate is peso10.80/$1. Thus, at current exchange rates the
peso appears to be ________ by ________.
A) overvalued; approximately 21%
B) overvalued; approximately 27%
C) undervalued; approximately 21%
D) undervalued; approximately 27%
Answer:
Question: Other things equal, and assuming efficient markets, if a Honda Accord costs
$24,682 in the U.S., then at an exchange rate of $1.57/, the Honda Accord should cost
________ in Great Britain.
A) 24,682
B) 38,751
C) 10,795
D) 15,721
Answer:
Question: One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$1.
Since that time the rate of inflation in the U.S. has been 4% greater than that in Canada.
Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for
Canadian dollars should be approximately:
A) $0.96/C$
B) $1/C$
C) $1.04/C$
D) Relative PPP provides no guide for this type of question.
Answer:
Question: ________ states that differential rates of inflation between two countries tend to
be offset over time by an equal but opposite change in the spot exchange rate.
A) The Fisher Effect
B) The International Fisher Effect
C) Absolute Purchasing Power Parity
D) Relative Purchasing Power Parity
Answer:
Question: Two general conclusions can be made from the empirical tests of purchasing
power parity (PPP):
A) PPP holds up well over the short run but poorly for the long run, and the theory holds
better for countries with relatively low rates of inflation.
B) PPP holds up well over the short run but poorly for the long run, and the theory holds
better for countries with relatively high rates of inflation.
C) PPP holds up well over the long run but poorly for the short run, and the theory holds
better for countries with relatively low rates of inflation.
D) PPP holds up well over the long run but poorly for the short run, and the theory holds
better for countries with relatively high rates of inflation.
Answer:
Question: A countrys currency that strengthened relative to another countrys currency by
more than that justified by the differential in inflation is said to be ________ in terms of
PPP.
A) overvalued
B) over compensating
C) undervalued
D) under compensating
Answer:
Question: If we set the real effective exchange rate index between Canada and the United
States equal to 100 in 1998, and find that the U.S. dollar has risen to a value of 112.6, then
from a competitive perspective the U.S. dollar is:
A) overvalued.
B) undervalued.
C) very competitive.
D) There is not enough information to answer this question.
Answer:
Question: If we set the real effective exchange rate index between the United Kingdom and
the United States equal to 100 in 2005, and find that the U.S. dollar has changed to a value
of 91.4, then from a competitive perspective the U.S. dollar is:
A) overvalued.
B) undervalued.
C) equally valued.
D) There is not enough information to answer this question.
Answer:
Question: The government just released international exchange rate statistics and reported
that the real effective exchange rate index for the U.S. dollar vs the Japanese yen decreased
from 105 last year to 95 currently and is expected to fall still further in the coming year.
Other things equal U.S. ________ to/from Japan think this is good news and U.S.
________ to/from Japan think this is bad news.
A) importers; exporters
B) importers; importers
C) exporters; exporters
D) exporters; importers
Answer:
Question: If a market basket of goods cost $100 is the US and €70 in France, then the PPP
exchange rate would be $.70/€.
Answer:
Question: The assumptions for relative PPP are more rigid than the assumptions for
absolute PPP.
Answer:
Question: Empirical tests prove that PPP is an accurate predictor of future exchange rates.
Answer:
Question: Consider the price elasticity of demand. If a product has price elasticity less than
one it is considered to have relatively elastic demand.
Answer:
Question: The authors state that empirical tests of purchasing power parity "have, for the
most part, not proved PPP to be accurate in predicting future exchange rates." The authors
then state that PPP does hold up reasonably well in two situations. What are some reasons
why PPP does not accurately predict future exchange rates, and under what conditions
might we reasonably expect PPP to hold?
Answer:
Question: ________ states that nominal interest rates in each country are equal to the
required real rate of return plus compensation for expected inflation.
A) Absolute PPP
B) Relative PPP
C) The Law of One Price
D) The Fisher Effect
Answer:
Question: In its approximate form the Fisher effect may be written as ________. Where: i
= the nominal rate of interest, r = the real rate of return and π = the expected rate of
inflation.
A) i = (r)(π)
B) i = r + π + (r)(π)
C) i = r + π
D) i = r + 2π
Answer:
Question: Assume a nominal interest rate on one-year U.S. Treasury Bills of 2.60% and a
real rate of interest of 1.00%. Using the Fisher Effect Equation, what is the approximate
expected rate of inflation in the U.S. over the next year?
A) 2.10%
B) 2.05%
C) 1.60%
D) 1.00%
Answer:
Question: Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.80% and a
real rate of interest of 2.00%. Using the Fisher Effect Equation, what is the exact expected
rate of inflation in the U.S. over the next year?
A) 1.84%
B) 1.80%
C) 1.76%
D) 1.72%
Answer:
Question: The relationship between the percentage change in the spot exchange rate over
time and the differential between comparable interest rates in different national capital
markets is known as:
A) absolute PPP.
B) the law of one price.
C) relative PPP.
D) the international Fisher Effect.
Answer:
Question: According to the international Fisher Effect, if an investor purchases a five-year
U.S. bond that has an annual interest rate of 5% rather than a comparable British bond that
has an annual interest rate of 6%, then the investor must be expecting the ________ to
________ at a rate of at least 1% per year over the next 5 years.
A) British pound; appreciate
B) British pound; revalue
C) U.S. dollar; appreciate
D) U.S. dollar; depreciate
Answer:
Question: ________ states that the spot exchange rate should change in an equal amount
but in the opposite direction to the difference in interest rates between two countries.
A) Fisher-open
B) Fisher-closed
C) The Fisher Effect
D) none of the above
Answer:
Question: Exchange rate pass-through may be defined as:
A) the bid/ask spread on currency exchange rate transactions.
B) the degree to which the prices of imported and exported goods change as a result of
exchange rate changes.
C) the PPP of lesser-developed countries.
D) the practice by Great Britain of maintaining the relative strength of the currencies of the
Commonwealth countries under the current floating exchange rate regime.
Answer:
Question: Phillips NV produces DVD players and exports them to the United States. Last
year the exchange rate was $1.25/euro and Plillips charged 120 euro per player in Euroland
and $150 per DVD player in the United States. Currently the spot exchange rate is
$1.45/euro and Phillips is charging $160 per DVD player. What is the degree of pass
through by Phillips NV on their DVD players?
A) 92%
B) 33.3%
C) 41.7%
D) 4.1%
Answer:
Question: Jaguar has full manufacturing costs of their S-type sedan of 22,803. They sell
the S-type in the UK with a 20% margin for a price of 27,363. Today these cars are
available in the US for $55,000 which is the UK price multiplied by the current exchange
rate of $2.01/. Jaguar has committed to keeping the US price at $55,000 for the next six
months. If the UK pound appreciates against the USD to an exchange rate of $2.15/, and
Jaguar has not hedged against currency changes, what is the amount the company will
receive in pounds at the new exchange rate?
A) 22,803
B) 25,581
C) 27,363
D) 55,000
Answer:
Question: Jaguar has full manufacturing costs of their S-type sedan of 22,803. They sell
the S-type in the UK with a 20% margin for a price of 27,363. Today these cars are
available in the US for $55,000 which is the UK price multiplied by the current exchange
rate of $2.01/. Jaguar has committed to keeping the US price at $55,000 for the next six
months. If the UK pound appreciates against the USD to an exchange rate of $2.15/, and
Jaguar has not hedged against currency changes, what is the percentage margin the
company will realize given the new exchange rate?
A) 20.0%
B) 15.3%
C) 12.4%
D) 7.2%
Answer:
Question: The price elasticity of demand for DVD players manufactured by Sony of Japan
is greater than one. If the Japanese yen appreciates against the U.S. dollar by 10% and the
price of the Sony DVD players in the U.S also rises by 10%, then other things equal, the
total dollar sales revenues of Sony DVDs would:
A) decline.
B) increase.
C) stay the same.
D) insufficient information
Answer:
Question: The final component of the equation for the Fisher Effect, (r)(π), where r = the
real rate of return and π = the expected rate of inflation, is often dropped from the equation
because the number is simply too large for most Western economies.
Answer:
Question: Empirical studies show that the Fisher Effect works best for short-term
securities.
Answer:
Question: The current U.S. dollar-yen spot rate is 125/$. If the 90-day forward exchange
rate is 127/$ then the yen is at a forward premium.
Answer:
Question: The premium or discount on forward currency exchange rates between any two
countries is visually obvious when you plot the interest rates of each country on the same
yield curve. The currency of the country with the higher yield curve should be selling at a
forward discount.
Answer:
Question: Use interest rate parity to answer this question. A U.S. investor has a choice
between a risk-free one-year U.S. security with an annual return of 4%, and a comparable
British security with a return of 5%. If the spot rate is $1.43/, the forward rate is $1.44/,
and there are no transaction costs, the investor should invest in the U.S. security.
Answer:
Question: Both covered and uncovered interest arbitrage are risky operations in the sense
that even without default in the securities, the returns are unknown until all transactions are
complete.
Answer:
Question: All that is required for a covered interest arbitrage profit is for interest rate parity
to not hold.
Answer:
Question: The authors describe an application of uncovered interest arbitrage (UIA) known
as "yen carry trade." Define UIA and describe the example of yen carry trade. Why would
an investor engage in the practice of yen carry trade and is there any risk of loss or lesser
profit from this investment strategy?
Answer:
Question: The Fisher Effect is a familiar economic theory in the domestic market. In
words, define the Fisher Effect and explain why you think it is also appropriately applied
to international markets.
Answer:
Question: If the forward rate is an unbiased predictor of the expected spot rate, which of
the following is NOT true?
A) The expected value of the future spot rate at time 2 equals the present forward rate for
time 2 delivery, available now.
B) The distribution of possible actual spot rates in the future is centered on the forward
rate.
C) The future spot rate will actually be equal to what the forward rate predicts.
D) All of the above are true.
Answer:
Question: Which of the following is NOT an assumption of market efficiency?
A) Instruments denominated in other currencies are perfect substitutes for one another.
B) Transaction costs are low or nonexistent.
C) All relevant information is quickly reflected in both spot and forward exchange
markets.
D) All of the above are true.
Answer:
Question: Empirical tests have yielded ________ evidence about market efficiency with a
general consensus that developing foreign markets are ________.
A) conflicting; not efficient
B) conflicting; efficient
C) consistent; inefficient
D) none of the above
Answer:
Question: A ________ is an exchange rate quoted today for settlement at some time in the
future.
A) spot rate
B) forward rate
C) currency rate
D) yield curve
Answer:
Question: Assume the current U.S. dollar-British spot rate is 0.6993/$. If the current
nominal one-year interest rate in the U.S. is 5% and the comparable rate in Britain is 6%,
what is the approximate forward exchange rate for 360 days?
A) 1.42/$
B) 1.43/$
C) 0.6993/$
D) 0.7060/$
Answer:
Question: Assume the current U.S. dollar-yen spot rate is 90 /$. Further, the current
nominal 180-day rate of return in Japan is 1% and 2% in the United States. What is the
approximate forward exchange rate for 180 days?
A) 89.12/$
B) 89.55/$
C) 90.89/$
D) 90.45/$
Answer:
Question: The current U.S. dollar-yen spot rate is 125/$. If the 90-day forward exchange
rate is 127 /$ then the yen is selling at a per annum ________ of ________.
A) premium; 1.57%
B) premium; 6.30%
C) discount; 1.57%
D) discount; 6.30%
Answer:
Question: The theory of ________ states that the difference in the national interest rates for
securities of similar risk and maturity should be equal to but opposite in sign to the
forward rate discount or premium for the foreign currency, except for transaction costs.
A) international Fisher Effect
B) absolute PPP
C) interest rate parity
D) the law of one price
Answer:
Question: With covered interest arbitrage:
A) the market must be out of equilibrium.
B) a "riskless" arbitrage opportunity exists.
C) the arbitrageur trades in both the spot and future currency exchange markets.
D) all of the above
Answer:
Question: Covered interest arbitrage moves the market ________ equilibrium because
________.
A) toward; purchasing a currency on the spot market and selling in the forward market
narrows the differential between the two
B) toward; investors are now more willing to invest in risky securities
C) away from; purchasing a currency on the spot market and selling in the forward market
increases the differential between the two
D) away from; demand for the stronger currency forces up interest rates on the weaker
security
Answer:
Question: If exchange markets were not efficient, it would pay for a firm to spend
resources on forecasting exchange rates.
Answer:
Question: If the forward exchange rate is an unbiased predictor of future spot rates, then
future spot rates will always be equal to current forward rates.
Answer:
Question: COVERED interest arbitrage (CIA), is where investors borrow in countries and
currencies exhibiting relatively low interest rates and convert the proceeds into currencies
that offer much higher interest rates. The transaction is "covered," because the investor
does not sell the higher yielding currency proceeds forward.
Answer:
Question: According to the International Fisher Effect, the forecast change in the spot rate
between two countries is equal to:
A) the current spot rate multiplied by the ratio of the inflation rates in the respective
countries.
B) but the opposite sign to the difference between nominal interest rates.
C) but the opposite sign to the difference between inflation rates.
D) but the opposite sign to the difference between real interest rates.
Answer:
Question: In their approximate form, PPP, IRP, and forward rates as an unbiased predictor
of the future spot rate lead to similar forecasts of the future spot rate.
Answer:
