International Financial Management - Chapter6

Chapter 6 – Questions & Problems

Question 2. Discuss the implications of interest rate parity for exchange rate determination Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as:

[

] x E(St+1│It)

The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information It as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.

Question 10. Explain the following three concepts of purchasing power parity (PPP):

a. The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries. b. Absolute PPP holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries. c. Relative PPP holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries. Question 11. Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on: a. Short-term basis (for example, three months) PPP is not useful for predicting exchange rates on the short-term basis mainly because international commodity arbitrage is a time-consuming process. b. Long-term basis (for example, six years) PPP is more useful for predicting exchange rates on the long-term basis.

Problem 2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and...