CHAPTER 6
INTERNATIONAL PARITY CONDITIONS
1. Law of One Price. Define the law of one price carefully, noting its fundamental assumptions. Why
are these assumptions so difficult to find in the real world in order to apply the theory?
If identical products or services can be sold in two different markets, and no restrictions exist on the
sale or transportation of product between markets, the product’s price should be the same in both
2. Purchasing Power Parity. Define the following terms:
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3. Big Mac Index. How close does the Big Mac Index conform to the theoretical requirements for a one
price measurement of purchasing power parity?
The Big Mac may be a good candidate for the application of the law of one price and measurement of
4. Undervaluation and Purchasing Power Parity. According to the theory of purchasing power parity,
what should happen to a currency which is undervalued?
5. Nominal Effective Exchange Rate Index. Explain how a nominal effective exchange rate index is
constructed.
6. Real Effective Exchange Rate Index. What formula is used to convert a nominal effective exchange
rate index into a real effective exchange rate index?
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The real effective exchange rate index for the U.S. dollar, E$R, is found by multiplying the nominal
effective exchange rate index, E$N, by the ratio of U.S. dollar costs, C$, over foreign currency costs,
CFC, both in index form:
$
$$
=×
RN
F
C
C
EEC
7. Exchange Rate Pass-Through. Incomplete exchange rate pass-through is one reason that a
country’s real effective exchange rate can deviate for lengthy periods from its purchasing power
equilibrium level of 100. What is meant by the term exchange rate pass-through?
8. Partial Exchange Rate Pass-Through. What is partial exchange rate pass-through, and how can it
occur in efficient global markets?
9. Price Elasticity of Demand. How is the price elasticity of demand relevant to exchange rate pass-
through?
The concept of price elasticity of demand is useful when determining the desired level of pass-
through. Recall that the price elasticity of demand for any good is the percentage change in quantity
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BMWs purchased. If the price elasticity of demand for BMWs in the United States were greater than
one, total dollar sales revenue of BMWs would decline.
10. The Fisher Effect. Define the Fisher effect. To what extent do empirical test confirm that the Fisher
effect exists in practice?
11. Approximate Form of Fisher Effect.
The final compound term, r times π, is frequently dropped from consideration due to its relatively
12. The International Fisher Effect. Define the international Fisher effect. To what extent do empirical
tests confirm that the international Fisher effect exists in practice?
Irving Fisher stated that the spot exchange rate should change in an equal amount but opposite in
direction to the difference in nominal interest rates. Stated differently, the real return in different
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end of the period (S2). This is the approximation form commonly used in industry. The precise
formulation is:
$¥
12
¥
21
−
−
=
+
SS ii
Si
Empirical tests using ex-post national inflation rates have shown the Fisher effect usually exists for
short-maturity government securities, such as treasury bills and notes. Comparisons based on longer
maturities suffer from the increased financial risk inherent in fluctuations of the market value of the
bonds prior to maturity. Comparisons of private sector securities are influenced by unequal
creditworthiness of the issuers. All the tests are inconclusive to the extent that recent past rates of
inflation are not a correct measure of future expected inflation.
13. Interest Rate Parity. Define interest rate parity. What is the relationship between interest rate parity
and forward rates?
14. Covered Interest Arbitrage. Define the terms covered interest arbitrage and uncovered interest
arbitrage. What is the difference between these two transactions?
15. Uncovered Interest Arbitrage. Define uncovered interest arbitrage and explain what expectations an
investor or speculator would need to undertake an uncovered interest arbitrage investment?
16. Forward Rate Calculation. If someone you were working with argued that the current forward rate
quoted on a currency pair is the market’s expectation of where the future spot rate will end up, what
would you say?
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This is a common misconception. The forward rate is a calculation, using three observable market
rates: the spot exchange rate, the domestic interest rate, and the foreign interest rate. It is technically
categorized as a foreign currency loan agreement by the financial institution, and the rate makes that
evident. There is no “predictive” element in its calculation, although many people in the market
commonly use it as a forecast. In fact, the forward rate has been repeatedly tested over time as to its
forecasting accuracy, and it generally performs pretty well when forecasting out 30 to 90 days.
17. Forward Rate as an Unbiased Predictor of the Future Spot Rate. 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 is meant by “unbiased predictor” in terms
of how the forward rate performs in estimating future spot exchange rates?
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.
18. Transaction Costs. If transaction costs for undertaking covered or uncovered interest arbitrage were
large, how do you think it would influence arbitrage activity?
19. Carry Trade. The term carry trade is used quite frequently in the business press. What does it mean,
and what conditions and expectations do investors need to hold to undertake carry trade transactions?
20. Market Efficiency. Many academics and professionals have tested the foreign exchange and interest
rate markets to determine their efficiency. What have they concluded?