Deck 8: The Power of Arbitrage: Purchasing Power and Interest Rate Parities

Question 1

The absolute purchasing power parity condition cannot be satisfied if the law of one price does not hold.

Answer 1

True

Question 2

The fundamental concept related to the law of one price is:

A) arbitrage.
B) expectations.
C) efficiency.
D) adaptiveness.

Answer 2

A

Question 3

Past information is relevant:

A) for the formation of adaptive expectations only.
B) for the formation of rational expectations only.
C) for the formation of neither adaptive nor rational expectations.
D) for the formation of both adaptive and rational expectations.

Answer 3

D

Question 4

The forward exchange rate:

A) is determined today but applies to an exchange of currencies at a future date.
B) is determined today and applies to an immediate exchange of currencies.
C) is determined at a future date when currencies are to be exchanged.
D) is determined at a future date but applies to an immediate currency exchange.

Question 5

The factor that can account for failure of the forward exchange rate to equal currency traders- expectation of the future spot exchange rate is:

A) a tariff on goods.
B) a risk premium.
C) a quota on trade in physical merchandise.
D) costs of transporting physical merchandise.

Question 6

If the purchasing power parity and uncovered interest parity conditions simultaneously hold true, then it is unambiguously true that:

A) foreign exchange markets are efficient.
B) real interest rates are equalized.
C) there is covered interest parity.
D) people can profit from arbitrage in goods and financial markets.

Question 7

If the expected proportionate change in the nominal exchange rate, measured in units of domestic currency per unit of foreign currency, is 2 percent and the domestic interest rate is 6 percent, then according to the uncovered interest parity condition, the foreign interest rate should be equal to:

A) 6 percent × 2 percent = 12 percent.
B) 6 percent + 2 percent = 8 percent.
C) 6 percent - 2 percent = 4 percent.
D) 6 percent ÷ 2 percent = 3 percent.

Question 8

In the presence of a risk premium, which of the following conditions fail to hold true? (I) Uncovered interest parity. (II) Real interest parity. (III) Foreign exchange market efficiency.

A) both I and II
B) both I and III
C) both II and III
D) I, II, and III

Question 9

Real interest parity arises from combining: (I) Relative purchasing power parity. (II) Uncovered interest parity. (III) Covered interest parity.

A) both I and II
B) both I and III
C) both II and III
D) I, II, and III

Question 10

If the foreign currency is anticipated to appreci:ate with respect to the domestic currency and the relative purchasing power parity condition is satisfied, then

A) people expect higher inflation in the foreign nation than in the domestic nation.
B) people expect higher inflation in the domestic nation than in the foreign nation.
C) people anticipate that uncovered interest parity will hold true.
D) people anticipate that covered interest parity will hold true.

Question 11

If the nominal exchange is measured in units of domestic currency per unit of foreign currency, then the real exchange rate equals:

A) the ratio of the domestic price level to the foreign price level divided by the nominal exchange rate.
B) the ratio of the foreign price level to the domestic price level divided by the nominal exchange rate.
C) the nominal exchange rate multiplied by the ratio of the foreign price level to the domestic price level.
D) the nominal exchange rate multiplied by the ratio of the domestic price level to the foreign price level.

Question 12

If deviations from real interest parity increase over time, then this is evidence of greater integration of international goods and financial markets.

Question 13

If absolute purchasing power parity holds true, then the real exchange rate equals the nominal exchange rate.

Question 14

If absolute purchasing power parity holds true and the ratio of the domestic price level to the foreign price level is greater than the actual nominal exchange rate, then the domestic currency is currently overvalued.

Question 15

If the difference between the domestic inflation rate and the foreign inflation rate exceeds the percentage depreciation in the domestic currency, then relative purchasing power parity holds true.

Question 16

If people form expectations adaptively, then their predictions must be correct on average.

Question 17

If foreign exchange markets are efficient, then the relative purchasing power parity condition must hold true.

Question 18

The rational expectations hypothesis suggests that people form expectations based on all available past and current information and on a basic understanding of how markets function.

Question 19

If the foreign exchange market efficiency condition is satisfied, then the equilibrium spot and forward exchange adjust to reflect all available information, in which case the forward premium is equal to the expected rate of currency depreciation plus any risk premium.

Question 20

The real interest rate is a rate of return in current-dollar terms that is equal to the nominal interest rate plus the anticipated rate of inflation.

Question 21

Which of the following is not a possible explanation for why significant deviations from covered interest parity were observed during the recent global financial crisis?

A) A crisis-induced worsening of existing impediments to financial trade .
B) An inability of cash-poor institutions to be able to engage in covered transactions.
C) A decline in trust among banks that trade bonds internationally.
D) Crisis-induced increases in mobility of an substitutability among internationally traded bonds.