International Economics, 9e (Husted/Melvin)
Chapter 14 Exchange Rates in the Short Run
14.1 Multiple-Choice Questions
1) A constant differential between the interest rates of two countries over different terms to
maturity implies that future changes in the exchange rate are expected to occur at a(n) ________
rate.
A) constant
B) increasing
C) decreasing
D) None of the above
2) If the term structure of interest rates in two countries differ, the differences reflect
A) expected price levels over time.
B) expected GDP differences.
C) the absence of covered interest arbitrage.
D) expected exchange rate changes over time.
3) Covered interest arbitrage ensures
A) exchange parity.
B) purchasing power parity.
C) interest parity.
D) All of the above.
4) The relationship that implies that the nominal interest rate is equal to the real interest rate plus
expected inflation is called the
A) exchange rate equation.
B) Fisher equation.
C) interest rate equation.
D) term structure of interest rates.
5) The relationship that says that the forward premium or discount is equal to the interest
differential is
A) interest rate parity.
B) purchasing power parity.
C) the Fisher equation.
D) the term structure of interest rates.
6) The effective return from a foreign investment is
A) the domestic interest rate plus the forward premium (discount).
B) the foreign interest rate plus the forward premium (discount).
C) the nominal interest rate minus inflation.
D) the real interest rate.
7) The domestic currency value of the return on a foreign investment when the foreign currency
proceeds are sold in the forward market, is defined to be the
A) covered return.
B) uncovered return.
C) forward return.
D) Both B and C.
8) If the 12-month interest rates for the United States and the United Kingdom are 6% and equal,
and £1 = $2 in the spot market, then what do you expect the 12-month forward rate to be?
A) 2.10
B) 1.90
C) 2.00
D) 2.11
9) Suppose that the 12-month interest rates for the United States and the United Kingdom are 7%
and 6% respectively, and E = 2.10 $/£. Given this information, what is the expected exchange
rate change over the year?
A) 1%
B) 4.2%
C) 2.1%
D) 2.0%
10) Suppose that the effective return to a U.S. investor from buying a U.K. bond is 5.55%.
Forward and spot exchange rates ($/£) are 2.10 and 2.00 respectively. The interest rate on the
U.K. bond is most likely equal to:
A) 5.45%
B) 5.500%
C) 5.650%
D) 5.60%
11) Careful studies of the data indicate that deviations from interest parity are
A) large.
B) non-existent.
C) small.
D) constant over time.
12) Deviations from interest rate parity occur due to
A) transaction costs.
B) government controls.
C) political risk.
D) All of the above.
13) We can expect very small deviations from interest rate parity in
A) the domestic markets.
B) the Eurocurrency market.
C) the goods market.
D) All of the above.
14) Given that real interest rates are constant, an increase in the expected rate of inflation will
tend to
A) decrease the nominal rate of interest.
B) increase the nominal rate of interest.
C) cause lower inflation rates.
D) cause no change in the nominal rate of interest.
15) Nominal interest rates tend to be higher in countries with
A) higher rates of inflation.
B) lower rates of inflation.
C) lower real interest rates.
D) Both B and C.
16) Suppose that in the United States and the United Kingdom the real rate of interest is 1
percent and constant. In this case, the nominal interest rates in both countries
A) are equal.
B) differ solely by the expected future spot rate differential.
C) differ solely by the expected inflation differential.
D) differ solely by the forward rate differential.
17) The interest parity condition indicates that the interest differential is equal to the
A) risk premium.
B) forward premium.
C) futures premium.
D) arbitrage premium.
18) When one country has higher nominal interest rates than another country, the high-interest-
rate currency is expected to ________ relative to the low-interest-rate currency.
A) depreciate
B) appreciate
C) stay constant
D) None of the above
19) The ________ relation indicates that the interest differential between investments in two
currencies will equal the forward premium or discount between the currencies.
A) Fisher equation
B) interest rate parity
C) purchasing power parity
D) term structure of interest rates
20) If real interest rates are equal in two countries, then the nominal interest differential on their
currencies will equal
A) the expected inflation differential.
B) the risk premium.
C) the forward premium or discount.
D) Both A and C.
21) If the nominal interest rate is 5.6 percent and the rate of inflation is 7.1 percent in a given
year, then what is the corresponding real rate of return?
A) 12 .7 percent
B) 1.5 percent
C) -1.5 percent
D) -12.7 percent
22) Suppose that at some point the spot exchange rate is equal to 100 yen per one U.S. dollar,
while the interest rate in dollars is 6% and the interest rate in yen is 1%. What is the approximate
forward rate that is consistent with this situation?
A) 95.3 yen per dollar
B) 105 yen per dollar
C) 107 yen per dollar
D) 92 yen per dollar
23) Suppose that the forward rate of Mexican pesos per dollar is selling flat, with both the spot
and forward rates trading at 15 pesos per dollar. If the relevant interest rates for a foreign
exchange speculator are 3 percent on dollars and 13 percent in pesos, a potential arbitrage
operation would involve
A) selling pesos in the forward market.
B) buying pesos in the forward market.
C) borrowing pesos now.
D) All of the above.
24) If the nominal interest rate is 0.6 percent and the rate of inflation is 2.9 percent in a given
year, then what is the corresponding real rate of return?
A) 3.5 percent
B) 2.3 percent
C) -3.5 percent
D) None of the above.
25) If the nominal interest rate is 2.9 percent and the rate of inflation is 0.6 percent in a given
year, then what is the corresponding real rate of return?
A) 3.5 percent
B) 2.3 percent
C) -3.5 percent
D) None of the above.
26) Suppose that the spot exchange rate for a foreign currency is equal to $120, while the interest
rate in dollars is 2% and the interest rate in the foreign currency is 3%. What is the approximate
forward rate that is consistent with this situation?
A) $115.56
B) $124.44
C) $118.77
D) None of the above.
14.2 True or False Questions
1) In order to infer expected future exchange rates, we must have a forward exchange market in a
currency.
2) The term structure relationships regarding different interest rates approximately reflect
expected exchange rate changes.
3) Interest rate parity is more likely to hold in the short run than purchasing power parity.
4) There are several reasons why interest rate parity may not hold exactly and, therefore, we can
earn arbitrage profits from this situation.
5) Interest rate parity holds well in the Eurocurrency market.
6) The higher the expected inflation rate in a country, the lower is the nominal interest rate in
that country.
7) If the real rate of interest is the same internationally, then the nominal interest rates differ
solely by the expected inflation differential in two countries.
8) Interest differentials cause exchange rate changes.
9) Deviations from interest rate parity could be due to transaction costs, differential taxation,
government controls, and political risk.
10) Change in U.S. policy can lead to changes in inflationary expectations, interest rates, and
exchange rates simultaneously as they all adjust to new equilibrium levels.
11) Money is more mobile geographically now than in the past.
12) One of the negative side effects of financial globalization is that national economic policies
lack the discipline that they did in the past.
13) Arbitrage opportunities exist when uncovered interest rate parity does not hold.
14.3 Essay Questions
1) Derive the interest parity condition and interpret it.
2) Suppose we observe the following 1-year interest rates:
Euro $ = 15%
Euro SF = 12%
The exchange rate is quoted as the dollar price of Swiss francs and is currently E = 0.40.
(a) Given the information above, what is the 12-month forward rate?
(b) Suppose the actual 12-month forward rate is not what you found from (a), but instead is
$0.42. What would profit-seeking arbitrageurs do?
3) Explain briefly PPP and IRP. Why might the latter hold better than the former over time?
4) Write down the Fisher equation and IRP relationship for the United States and the United
Kingdom. Using these relationships, how can we determine the link between interest, inflation,
and exchange rates? How can a change in U.S. policy affect this link?
5) Give 3 reasons for deviations from IRP. Do these deviations indicate unexploited profit
opportunities for investors?
6) How are interest rates and inflation rates related?
7) How has the globalization of financial markets affected the way in which countries conduct
their economic policies?