International Parity Conditions

International parity conditions refer to the economic theories which are associated with exchange rates, prices and interest rates. 

 

International Parity Conditions

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Purchasing power parity (PPP) is a method that helps to calculate the exact value of currency. This theory is driven by the law of one price, which specifies that prices of goods in all locations of the world must be equal to each other when measured in one single currency under certain assumptions.  PPP in absolute terms states that the spot exchange rate is determined by the relative prices of similar baskets of goods. The PPP has two versions: Absolute, that matches the prices of a product, and Relative PPP, that states the difference between exchange rates.

International Parity Conditions

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International Fisher Effect states the relationship between the percentage change in the spot exchange rates of any two countries and the difference between their nominal interest rates for a specific period of time. In other words, it explains the expected change in the spot exchange rates of any two countries is almost equal to the difference between their nominal interest rates for a certain period. 

International Parity Conditions

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Interest rate parity explains the difference in interest rate between two countries is equal to the difference between the forward exchange rate and the spot exchange rate. It is very crucial in foreign exchange markets.

Here are some questions related to these topics:

Question 1

Annual inflation rates and exchanges rates in the US and Brazil were as follow. 

Date	USD/BRL	PI_BRL	PI_US
2009	2.6800	112	103
2010	1.8500	122	106
2011	1.5700	129	108

What would be the real exchange rate of BRL in 2011 if we used 2009 as base year?

1. 1.5334
2. 1.9545
3. 1.2345
4. 1.8752

Answer

4 - 1.8752

Question 2

Suppose that on January 1st the annual cost of borrowing in JPY and US dollars are 2% and 7% respectively (Rjpy=2% and RUS=7%). The spot rate of USD on January 1st is USD/JPY110 or 110 Yen per $1. One year later, the spot rate is quoted as USD/JPY102. If the U.S. investor decides to borrow in JPY, what is the USD cost of borrowing in JPY?

1. -5.4%
2. 2%
3. 7%
4. 10%

Answer

4 - 10%

Question 3

USD price of BicMac in South Africa and the US are $4.50 and $3.90 respectively. PPP implied exchange rate of South African Rand is 9.50 SAR per dollar. What is the extent of SAR undervaluation or overvaluation (Calculate it in percentages)

1. 13.36% Undervaluation
2. 10% Undervaluation
3. 15.38% Overvaluation
4. 20% overvaluation

Answer

3 - 15.38% Overvaluation

Question 4

According to the international Fisher effect, if U.S. investors expect a 5% rate of domestic inflation over one year, and a 2% rate of inflation in Japan, and require a 3% real return on investments over one year, the nominal interest rate on one-year U.S. Treasury securities would be:

1. 2%
2. 3%
3. -2%
4. 8.15%

Answer

4 - 8.15%

Question 5

Assume that Swiss investors have francs available to invest in securities, and they initially view U.S. and British interest rates as equally attractive. Now assume that U.S. interest rates increase while British interest rates stay the same. This would likely cause:

1. the Swiss demand for dollars to decrease and the dollar will depreciate against the pound.
2. the Swiss demand for dollars to increase and the dollar will appreciate against the Swiss franc.
3. the Swiss demand for dollars to increase and the dollar will depreciate against the Swiss franc.
4. the Swiss demand for dollars to decrease and the dollar will appreciate against the pound

Answer

2 - The Swiss demand for dollars to increase and the dollar will appreciate against the Swiss franc.