Misa GOAL International Financial Management Chapter 5 International Parity Conditions ™ Multiple Choice and True/False Questions 1. The Economist publishes annually the “hamburger standard” by which they compare the prices of the MeDonalds Corporation 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. [fa 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) S.00860 (b) 124¥8 (©) 8.0081 (a) 115.7588 Topic: PPP Skill: Analytical Answer: D 2. Ifthe current exchange rate is 124 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is $2.54, and the price of a Big Mac hamburger in Japan is 294 yen, then other things equal, the Big Mac hamburger in Japan is (2) comectly priced () under priced (c) over priced (d) not enough information to determine if the price is appropriate or not Topic: PPP Skil: Analytical Answer: B 3. [according to the law of one price the current exchange rate of dollars per British pound is $1.43/£, then at an exchange rate of $1.28/£, the dollar is, (@) overvalued (b) undervalued (©) comectly valued (4) unknown relative valuation Topic: Law of One Price Skill: Analytical ‘Answer: AMisa GOAL International Financial Management 6, ‘Other things equal, and assuming efficient markets, ifa Honda Accord costs $18,365 in the U.S. then at an exchange rate of $1.43/£, the Honda Accord should cost (a) 26,2626 (b) 18,3658 (©) 12.8436 (@) 9.1836 Topic: Law of One Price Skill: Analytical Answer: C ‘One year ago the spot rate of U.S. dollars for Canadian dollars was $1/CS1. 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 (@) so.96ics () sUics (©) SLosiest (@) Relative PPP provides no guide for this type of question. ‘Topic: PPP Skill: Analytical ‘Answer: C 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, (@) There is not enough information to answer this question. Topic: Real Effective Exchange Rate Skill: Analytical ‘Answer: A Research by Dimson, Marsh, and Staunton (2002) found that for the 1900-2000 period, relative purchasing power parity did not hold, (a) True (b) False Topic: PPP Skill: Recognition Answer: B Dimson, Marsh, and Staunton (2002) found that real exchange rates to exhibit a long. term upward or downward trend, and they clearly volatile (@) appear: are (b) appear; are not (©) do not appear, are (d) do not appear; are not ‘Topic: PPP Skill: RecognitionMirig GbA& International Financial Management 10. u 12 13, ‘Answer C Devia nis from PPP appear to be related to _ (a) changes in relative inflation (b) changes in productivity differentials (©) confounding economic and political factors (@) Allof the above ‘Topic: PPP Skill: Recognition Answer: D Products that are relatively price inelastic tend to also demonstrate a low degree of exchange rate pass-through. (@) True (b) False ‘Topic: Exchange Rate Pass-Through Skill: Conceptual Answer: B Empirical tests show that the Fisher effect usually exists for short maturity government securities but less so for longer-term maturity securities. (2) True (&) False ‘Topic: Fisher Effect Skill: Conceptual Answer: A Criticisms of the intemational Fisher effect include (a) the lack of intemational capital flows (b) false impressions due to Dollarization. (©) the existence ofa foreign exchange risk premium for most currencies (d) Allof the above. Topic: Intemational Fisher Effect Skill: Conceptual Answer: C Which of the following is necessary for the calculation of the forward rate? (a) the spot rate (b) the foreign currency deposit rate (©) the home currency deposit rate (d) Allof the above Topic: Forward Rate Skill: Recognition Answer: DGE Haag eb ee tncoatina Financial Management ed as 14. Exchange rate pass-through may be de (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. (©) the PPP of lesser-developed countries. (@) the practice by Great Britain of maintaining the relative strength of the currencies of the Commonwealth countries under the current floating exchange rate regime. Topic: Exchange Rate Pass-through Skill: Recognition Answer: B 15, Sony of Japan produces DVD players and exports them to the United States. Last year the exchange rate was 130¥/$ and Sony charged $150 per DVD player, Currently the spot exchange rate is 110¥/S. and Sony is charging $170 per DVD player. What is the degree of pass through by Sony of Japan on their DVD players? (a) 95.9% (b) 86.7% (0) 73.2% (@) 4.1% Topic: Exchange Rate Pass-through Skill: Analytical Answer: C 16. Consider the price elasticity of demand. If a product has price elasticity less than one it is considered to have relatively elastic demand, (a) Tre (b) False Topic: Price Elasticity Skill: Conceptual Answer: B 17. The price elasticity of demand for DVD players manufactured by Sony of Japan is greater than one. Ifthe 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 (©) stay the same (@) insufficient information Topic: Price Elasticity Skill: Analytical ‘Answer: AMisa GOAL International Financial Management 20, al In its approximate form the Fisher effect may be written as Where: i= the nominal rate of interest, r= the real rate of retum and x = the expected rate of inflation, (@) i= ©) (b) i=r+ n+) (0 isrtn (@ i-rt20 Topic: Fisher Effect Skill: Recognition Answer: C Assume a nominal interest rate on one-year U.S. Treasury Bills of 4.60% and a real rate of interest of 2.50%, Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the USS. over the next year? (a) 2.10% (b) 2.05% (©) 2.00% @ 1.90% Topic: Fisher Effect Skill: Analytical ‘Answer: A 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 (2) absolute PPP (b) the law of one price (©) relative PPP (@ the intemational Fisher Effect x Effect ‘Topic: Intemational Fis! Skill: Recognition ‘Answer: D From the viewpoint of a U.S. investor or trader, the indirect quote for a curreney exchange rate would be quoted in (a) terms of dollars per unit of foreign currency (eg., $/£) (b) cents (©) 1/8ths (@) terms of foreign currency units per dollar (e.g., £/S) Topic: Intemational Fisher Eff Skill: Conceptual Answer: DGE Haag eb ee tncoatina Financial Management 22. According to the intemational Fisher Effet, ifan 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 1%, then the investor must be expecting the to ata rate of at least 1% per year over the next 5 years. (a) British pound; appreciate (b) British pound; revalue (©) US. dollar; appreciate (@) US. dollar; depreciate ‘Topic: Intemational Fisher Effect Skill: Analytical Answer: C 2B. A is an exchange rate quoted today for settlement at some time in the future. (a) spot rate (b) forward rate (©) currency rate (@) yield curve Topic: Forward Rate Skill: Recognition Answer: B 24, ‘The current U.S. dollar-yen spot rate is 125W. If the 90-day forward exchange rate is 127 ¥/S then the yen is selling at a per annum of. (a) premium; 1.57% (b) premium; 6.30% (©) discount; 1.57% (@) discount; 6.30% Topic: Forward Rate Premium/Discount Skill: Analytical Answer: D 25. With covered interest arbitrage, (a) the market must be out of equilibrium, (b) a “riskless” arbitrage opportunity exists. (©) the arbitrageur trades in both the spot and future currency exchange markets. (d) Allof the above. Topic: Covered Interest Arbitrage Skill: Recognition Answer: D 26. 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 x1 > Th cec acne see ‘Gowert aotiar proevede A the era afte period, the band lite Fenske ad ect experi ie fee bvhio USdoties in Fachash governmant bods ie fored exchange va ‘Teich govern tbe markt 20> pers) Note that the profits from the arbitrage activity as described here are in U.S. dollars. This ‘was also a characteristic of the Turkish bank positions—ultimately positioning their profitability in the foreign hard currency, the U.S. dollar. The arbitrage activity could continue as long as the exchange rate atthe end of the period did not change radically against the banks—a severe devaluation of the lira. This was what, in the end, occurred. 3. How could the Turkish banks be contributing to financial crisis if they were purchasing Turkish govemment bonds and helping finance and support their own government? Answer: While it sounds helpful that the Turkish banks were promoting an active and growing ‘market for Turkish government debt, and in the process allowing the goverament to finance its expenditures at a lower cost than without their activity, the source of their funds was the problem. By acquiring large quantities of dollar-denominated debt, for a country already running a current account deficit, this would inevitably lead to a currency crisis as the ability of the Turkish economy to generate sufficient hard-currency earnings (USS. dollars in this case) in order to service this debt would fall short, oldeMisa GOAL International Financial Management Which do you think is more critical to « country such as Turkey, fighting inflation or fighting a large ‘rade and current account deficit? rt Answer: The consensus among most intemational economists and various international organizations is that inflation is the first and foremost problem that must be controlled in order to establish a solid foundation for economic growth, industrial development, fall employment, and managed trade. Current account deficits are not of themselves necessarily evil or destructive, but actually often a characteristic of a fully employed rapidly expanding economy. 5. ‘The quote from Corporate Finance magazine, although noting the outside possibility of a devaluation, was largely positive regarding Turkey's future in January 2001. What would you have thought? Answer: 11 seems that throughout history, after every currency crisis, there isthe wailing voice erying out “why didn’t you see this coming?” This quotation is rather useful in pointing out that in many (most?) currency crises there were at least murmurs in the marketplace prior to the crisis. The quotation points out that there have been some positive actions—the IMF capital injections but that there are continuing problems with inflation, The latter was expected to drive the value of the lira down in the near future -15-