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SuggestedEndofCHAPTER6Solutions - CHAPTER 6 INTERNATIONAL...

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CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS Questions 1. Give a full definition of arbitrage. Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits. 2. Discuss the implications of the interest rate parity for the exchange rate determination. Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as: S = [(1 + I £ )/(1 + I $ )]E[S t+1 | I t ]. The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, I t , 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. 3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate. Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk premium is insignificant and (ii) foreign exchange markets are informationally efficient. 4. Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?
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Answer: The absolute version of purchasing power parity (PPP): S = P $ /P £. The relative version is: e = π $ - π £ . PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket. 5. Discuss the implications of the deviations from the purchasing power parity for countries’ competitive positions in the world market. Answer: If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market. 6. Explain and derive the international Fisher effect. Answer: The international Fisher effect can be obtained by combining the Fisher effect and the relative version of PPP in its expectational form. Specifically, the Fisher effect holds that E( π $ ) = I $ - ρ $ , E( π £ ) = I £ - ρ £ . Assuming that the real interest rate is the same between the two countries, i.e., ρ $ = ρ £ , and substituting the above results into the PPP, i.e., E(e) = E( π $ )- E( π £ ), we obtain the international Fisher effect: E(e) = I $ - I £ .
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