Tutorial 3 Suggested Answers

TOPIC: International Parity Conditions

1. Define the following terms:

(a) The law of one price.
Answer: The law of one prices state that producers’ prices for goods or services of identical
quality should be the same in different markets; i.e., different countries (assuming
no restrictions on the sale and allowing for transportation costs). If a country has
higher inflation than other countries, its currency should devalue or depreciate so
that the real price remains the same as in all countries. Application of this law
results in the theory of Purchasing Power Parity (PPP).
(b) Absolute purchasing power parity.
Answer: If the law of one price were true for all goods and services, the purchasing power
parity (PPP) exchange rate could be found from any individual set of prices. By
comparing the prices of identical products denominated in different currencies, one
could determine the “real” or PPP exchange rate which should exist if markets
were efficient. This is the absolute version of the theory of purchasing power parity.
Absolute PPP states that the spot exchange rate is determined by the relative prices
of similar baskets of goods.
(c) Relative purchasing power parity.
Answer: If the assumptions of the absolute version of PPP theory are relaxed a bit more, we
observe what is termed relative purchasing power parity. This more general idea
is that PPP is not particularly helpful in determining what the spot rate is today,
but that the relative change in prices between two countries over a period of time
determines the change in the exchange rate over that period. More specifically, if
the spot exchange rate between two countries starts in equilibrium, any change in
the differential rate of inflation between them tends to be offset over the long run
by an equal but opposite change in the spot exchange rate.

2. The one-year interest rate in Singapore and U.S. is 11 percent and 6 percent respectively. The
spot rate of the Singapore dollar (S$) is US$0.50 and the one year forward rate of the S$ is
$0.45. Assume zero transactions costs. Does interest rate parity exist?

Note: IRP states that: Ffx = Sfx x (1 + iUS$) / (1 + iS$)

Or approximately:
Interest rate differential (iUS$ - iS$) ≈ (F-S) / S = forward prem/discount (on S$ against US$)

ANSWER: No, because if IRP holds, then 0.50 x (1.06 / 1.11) = 0.478 ≠ 0.45

Therefore the one year forward rate is undervalued (the Singapore dollar supposed to buy
US$0.478 but in the forward market is buying only US$0.45)

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3. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France
are 6 percent.

a). According to IRP, what should the forward rate premium or discount of the euro be?

b). If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?

ANSWER:

(1.04)
a). Using IRP conditions, we get: p = − 1 = −.0189 = −1.89%
(1.06)

This suggests that if IRP holds, then euro will be at a forward discount of 1.89% against
the US dollar.

b). F = $1.10(1 − .0189) = $1.079

This suggests that if IRP holds, then the one year forward rate of euro would be US$1.079.

4. Assuming the last year short-term interest rate in France was 4.2% and forecast inflation
was 1.8%. At the same time, the short-term German interest rate was 3.5% and forecast
inflation was 1.6%. Based on these figures, compute the real interest rates in France and
Germany according to the Fisher effect.
ANSWER:

French real interest rate:

(1+r) = (1+a) (1+i)
(1+0.042) = (1+a) (1+0.018)
1.042 = (1+a) (1.018)
(1.042 / 1.018) – 1 =a
0.0235 or 2.35% =a

German real interest rate:

(1+r) = (1+a) (1+i)
(1+0.035) = (1+a) (1+0.016)
1.035 = (1+a) (1.016)
(1.035 / 1.016) – 1 =a
0.0187 or 1.87% =a

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5. Suppose a change in expectations regarding future inflation in Malaysia causes the
expected future spot rate to decline to 6.8400/£. The spot rate of foreign currencies is
6.8585. Given that the one-year interest rate is 12%. Determine the consequence which
happen to interest rate in Malaysia.

ANSWER:

e1/ e0 = (1+rh)1 / (1+rf)1

(1 + rh)1 = e1/ e0 (1+rf)1
(1 + rh) = 6.8400 x 1.12 / 6.8585
rh = 1.1169 – 1
rh = 11.69%