FIN4435Homework3

FIN4435Homework3 - Chapter 8. 8. Comparing Parity Theories....

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Chapter 8. 8. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher effect (IFE). ANSWER: Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium (or discount). PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate differentials, which are influenced by expected inflation. Thus, the IFE is closely related to PPP. 11. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inflation than the United States, while two other European countries that use the euro as their currency experience lower inflation than the United States. According to PPP, how will the euro’s value against the dollar be affected? ANSWER: The high European inflation overall would reduce the U.S. demand for European products, increase the European demand for U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro's value would adjust in response to the weighted inflation rates of the European countries that are represented by the euro relative to the inflation in the U.S. If the European inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro. 13. PPP. Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yen’s value? Why does this expected relationship not always occur? ANSWER: Japan’s low inflation should place upward pressure on the yen’s value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yen’s value. 14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. ANSWER:
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FIN4435Homework3 - Chapter 8. 8. Comparing Parity Theories....

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