Fundamentals of Multinational Finance, 5e (Moffett et al.)
Chapter 6 International Parity Conditions
Multiple Choice and True/False Questions
6.1 Prices and Exchange Rates
1) If an identical product can be sold in two different markets, and no restrictions exist on the
sale or transportation costs, the product’s 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.
2) ________ states that the spot exchange rate is determined by the relative prices of similar
baskets of goods.
A) Absolute purchasing power parity
B) Relative purchasing power parity
C) Interest rate parity
D) The Fisher Effect
3) The Economist publishes annually the “Big Mac Index” by which they compare the prices of
the McDonald’s Corporation’s 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 $3.73 in the
United States and 320 yen in Japan, what is the estimated exchange rate of yen per dollar as
hypothesized by the Hamburger index?
A) $0.015/¥
B) 87.2¥/$
C) $0.00012/¥
D) 85.79¥/$
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4) 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.
5) The price of a Big Mac in the U.S. is $3.73 and the price in Mexico is Peso 32.0. What is the
implied PPP of the peso per dollar?
A) Peso 8.58/$1
B) Peso 10.8/$1
C) Peso 11.76/$1
D) None of the above
6) The implied PPP rate of exchange of Mexican pesos per U.S. dollar is 8.58 according to the
Big Mac Index. The current exchange rate is Peso 10.8/$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.
7) According to the Big Mac Index, the implied PPP exchange rate is Mexican Peso 8.58/$1 but
the actual exchange rate is Peso 11.80/$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%
8) If a market basket of goods cost $100 in the US and 70 euros in France, then the PPP
exchange rate would be $.70/euro.
9) If according to the law of one price if the current exchange rate of dollars per British pound is
$1.75/£, then at an exchange rate of $1.85/£, the dollar is
A) overvalued.
B) undervalued.
C) correctly valued.
D) unknown relative valuation.
10) Generally speaking, the theory of absolute purchasing power parity works better for a market
basket of goods than for a single good.
11) Other things equal, and assuming efficient markets, if a Honda Accord costs $21,375 in the
U.S. then at an exchange rate of $1.63/£, the Honda Accord should cost ________ in Great
Britain.
A) £21,375
B) £18,365
C) £13,113
D) £42,322
12) The assumptions for absolute PPP are more rigid than the assumptions for relative PPP.
13) ________ 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
14) 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$1.
C) $1.04/C$1.
D) Relative PPP provides no guide for this type of question.
15) Empirical tests fail to conclusively demonstrate that PPP is an accurate predictor of future
exchange rates.
16) What 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.
17) A country’s currency that strengthened relative to another country’s 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
18) If a country’s real effective exchange rate index were to be less than 100, this would suggest
an ________ currency.
A) overvalued
B) over compensating
C) undervalued
D) under compensating
19) 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.
20) If we set the real effective exchange rate index between the United Kingdom and the United
States equal to 100 in 2010, 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.
21) 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
22) 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.
23) Incomplete exchange rate pass-through refers to
A) the rates at which domestic suppliers decrease its prices to accommodate foreign exchange
volatility.
B) the degree of un-proportional change in prices of imports and exports relative to periodic
changes in the exchange rate.
C) the fee charged by foreign exchange dealer when the exporter cancels the transaction.
D) the rate at which exporters increase prices when their home currency depreciates.
24) Phillips NV produces DVD players and exports them to the United States. Last year the
exchange rate was $1.25/euro and Phillips 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%
25) 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
$44,600 which is the UK price multiplied by the current exchange rate of $1.63/£. Jaguar has
committed to keeping the US price at $44,600 for the next six months. If the UK pound
appreciates against the USD to an exchange rate of $1.75/£, 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) £25,486
C) £27,363
D) £44,600
26) Consider the price elasticity of demand. If a product has price elasticity less than one it is
considered to have relatively elastic demand.
6.2 Interest Rates and Exchange Rates
1) ________ 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
2) 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 + 2 π
3) 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.
4) Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.10% 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) 2.00%
D) 1.90%
5) 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%
6) Empirical studies show that the Fisher Effect works best for short-term securities.
7) 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.
8) 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
9) 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
10) Assume the current U.S. dollar-British spot rate is 0.6134£/$. If the current nominal one-year
interest rate in the U.S. is 2.5% and the comparable rate in Britain is 3.5%, what is the
approximate forward exchange rate for 360 days?
A) 1.42£/$
B) 0.6075£/$
C) 0.6134£/$
D) 0.6194£/$
11) The current U.S. dollar-yen spot rate is 85¥/$. If the 90-day forward exchange rate is 88 ¥/$
then the yen is at a forward premium.
12) The current U.S. dollar-yen spot rate is 85¥/$. If the 90-day forward exchange rate is 88 ¥/$
then the yen is selling at a per annum ________ of ________.
A) premium; 1.57%
B) premium; 6.30%
C) discount; 3.41%
D) discount; 13.64%
13) 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.
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14) 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
15) 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
16) 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
17) 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.
18) All that is required for a covered interest arbitrage profit is for interest rate parity to not hold.
19) A Macedonian homeowner deciding for a Euro-denominated, lower rate mortgage is
A) effectively initiating long term covered interest arbitrage.
B) should start seeking US dollar salary to mitigate the risk of falling behind the payment
schedule.
C) creating debt service FX exposure for the whole life of the loan.
D) remaining “uncovered” unless she has sub-lease contract denominated in Macedonian Denar.
6.3 Forward Rate as an Unbiased Predictor of the Future Spot Rate
1) 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.
2) If the forward exchange rate is unbiased predictor of future spot rates, the expected mean of
the deviations from the forward rate is zero.
3) 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.
4) 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
5) If exchange markets were not efficient, it would pay for a firm to spend resources on
forecasting exchange rates.
6) 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.
7) If the efficient market hypothesis is correct than the current quotations on the forward market
are reflecting all available information about likely future rates and providing unbiased estimate
of the future spot rate.
6.4 Prices, Interest Rates, and Exchange Rates in Equilibrium
1) One-year interest rates are currently 3.30% in the United States and 2.60% in “Euroland”. The
current spot rate between the euro and dollar is $1.3225/euro. What is the expected spot rate in
one year if the international Fisher effect holds?
A) $1.3315/euro
B) $1.3135/euro
C) $1.3225/euro
D) None of the above
2) One-year interest rates are currently 2.50% in the United States and 3.70% in Great Britain.
The current spot rate between the pound and dollar is $1.9000/£. What is the expected spot rate
in one year if the international Fisher effect holds?
A) $1.9000/£
B) $1.9222/£
C) $1.8780/£
D) $1.8500/£
3) When the spot and forward exchange markets are not in equilibrium as described by interest
rate parity, the potential for “riskless” arbitrage profit exists. This is called
A) covered interest arbitrage (CIA).
B) interest rate parity.
C) the Fisher Effect.
D) dancing on the head of a pin.
4) According to the theory of interest rate parity, the difference in national interest rates for
securities of similar risk and maturity should be ________ and ________ sign to the forward rate
discount or premium for the foreign currency, except for transaction costs.
A) equal to; of the same
B) less than; of the same
C) greater than; opposite in
D) equal to; opposite in
5) According to the International Fisher effect, the differential between nominal 6 months
interest rates is equal to but opposite in sign with the yearly forecast on the change in the spot
rate.
Essay Questions
6.1 Prices and Exchange Rates
1) 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?
6.2 Interest Rates and Exchange Rates
1) 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?
2) 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.
6.3 Forward Rate as an Unbiased Predictor of the Future Spot Rate
1) Some forecasters believe that foreign exchange markets for the major floating currencies are
“efficient” and forward exchange rates are unbiased predictors of future spot exchange rates.
What are the three conditions of market efficiency as defined by the authors? What is implied by
the term unbiased predictors? What does the empirical evidence have to say about the forward
rate as an unbiased predictor of future spot rates?
6.4 Prices, Interest Rates, and Exchange Rates in Equilibrium
1) There are no questions in this section.