HOMEWORK ASSIGNMENT 1

VIKAS KUMAR SINGH

45260726

Q1.
Define the necessary conditions for a perfect capital market. Why do these assumptions
make the analysis of international parity conditions easier?
Ans.
The necessary conditions for a perfect capital market are(1) No transaction costs: No brokerage fees, other transaction costs are incurred when
securities are brought, sold, or issued, and there are no tax differentials either between
distributed and undistributed profits or between dividends and capital gains.
(2) No taxes: No taxes are incurred during any transfer
(3) Complete certainty: Complete certainty implies complete assurance on the part of every
investor as to the future investment programme and the future profits of every corporation.
These assumptions make the analysis of international parity conditions easier because there
will be no market frictions and barriers which limit the arbitrage. It should be intuitively clear that
profit- maximizing agents will act to eliminate all arbitrage opportunities- between goods in one
country and goods in another, between spot and forward exchange, and between real and
financial assets, along with all other arbitrage opportunities. Complete certainty implies no risk
and different financial opportunities can be evaluated as if their costs were known and certain
without any risk.
Q2:
Define and contrast absolute and relative Purchasing Power Parity. Provide an example of
each one.
Ans.
Absolute purchasing power parity predicts that the price of an identical basket of goods sold in
one country will be equal to the price of same basket of goods sold in another country after
adjusting for the exchange rate.
Pus = S x Puk
Lets assume a basket of goods is priced $20 in US and the spot price is 1.5. So according to
absolute purchasing power parity, the same basket would cost 20/1.5=13.33 pounds in UK.
Relative purchasing power parity says that the percentage rate of change in the prices of market
baskets in two countries differs by an amount equal to the percentage rate of change in the
exchange rate.
Percentage change in exchange rate= % change in US Prices - % change in UK Prices
Lets assume if UK prices rose by 20 percent and the US $ depreciated by 10% then it would be
necessary for US prices to rise by 32 percent.

Q7:
What empirical evidence tends to show that PPP holds in the long-term?
Ans:

HOMEWORK ASSIGNMENT 1

VIKAS KUMAR SINGH

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The law of one price is the empirical evidence that tends to show that PPP holds in the long run.
This shows that the price of one goods in one country relative to the price of goods in another
country will follow the PPP on the long run but it may not follow in the short run as prices may
vary in the short run period.

Q10:
Empirical evidence shows frequent deviations from Purchasing Power Parity. What kind of
threats and opportunities does this open up for financial managers?
Ans:
With frequent deviations from Purchasing Power Parity, the financial managers can use these
opportunities to source material and products from lower priced countries and sell it in the
higher priced countries. And they can make use of exchange rates.
The sourcing and productions decisions take a longer time to realize that the frequency of
changes in exchange rates so this could not work in their favour and it could be a costly
decision for the financial managers.

E1:
Suppose a Big Mac at a McDonald's in New York costs $2.50 and FFr 15 in Paris.
a. What spot exchange rate establishes the Law of One Price for these two commodities?
c. According to your calculation, is the dollar over- or under-valued? How about the
French franc?
Ans:
a. Let the spot exchange rate be S
S= 15/$2.50
S = FF6/$ or $ 0.16667/FF
C. As per Q2, the current spot exchange rate =FFr 5/$ or .$02/FF
This implies that ratio of current spot and calculated spot=
= $0.20 / $0.16667 = 1.20.
This shows that the dollar is undervalued by 20%. The FF is overvalued.
E2:
A bottle of champagne costs FF 150 in a Paris wine store. The same bottle of champagne
costs DM 45 in a Frankfurt wine store.
a. What spot exchange rate establishes the Law of One Price for these two commodities?
c. According to your calculation, is the DM over- or under-valued?
Ans:
a. Let the spot exchange rate be S
S = FF150/DM45
S = FF3.33/DM or DM 0.3003/FF

HOMEWORK ASSIGNMENT 1

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c. As per the pat b Current spot exchange rate=FF 3.55/$

Spot rate real = St/SPPP
=3.55/3.33 = 1.065 FF/DM
The DM is over-valued by 6.5%

E3:
Data on price index and exchange rates in 1973 and 1993 for 22 OECD countries are
included on the data diskette accompanying the instructors manual for this text. Estimate
a regression of the form: Yi = a + bXi where Y is the exchange rate change over the
20-year period and X is the total inflation over 20-year period for i=1, , 22 countries.
Do your results come close to the results computed by Obstfeld (1995) and reported in
this chapter?

HOMEWORK ASSIGNMENT 1

VIKAS KUMAR SINGH

45260726

E4:
Suppose the expected annual inflation rate in the UK is 4.5% and that in the US 3%.
According to PPP, will the dollar appreciate or depreciate? By which percentage?
Ans:
The expected currency depreciation is the differential of inflation rates between the two
countries:
s$/ = p$ - p measures the US$ depreciation.
3% - 4.5% = -1.5%;
US$ appreciation of 1.5% or UK depreciation of 1.5%
E5:
Suppose the current spot rate is $ 1.55/ on the first of January. By year's end, the US CPI is
expected to climb from 144 to 150 and the UK CPI is expected to climb from 120 to 130.
According to PPP, what is the expected spot rate on December 31?
Ans.:
Expected spot rate is given by
SPPP,t+1 = St,$/ * (CPIt+1,US/CPIt,US)/(CPIt+1,UK/CPIt,UK)
Therefore:
Expected spot rate = $1.55/ * (150/144)/(130/120) = $ 1.4904/ 6

HOMEWORK ASSIGNMENT 1

VIKAS KUMAR SINGH

45260726

Chapter 5
Q1:
Describe how covered interest arbitrage acts to enforce interest rate parity. Describe the impact
of each transaction on the interest rates and exchange rates. Provide one example using data
from todays newspaper.
Ans:
Covered interest arbitrage transactions put pressure on prices, at the margin, that restore
interest rate parity.
Let the forward rate for one currency one be higher to C1, then the investors would sell
securities in currency 2, this will lead toincrease in rate for currency 2 and then then they would
buy the currency one this would lead to higher spot prices and then they buy securities in
currency 1which leads to fall in its rate and then they sell the currency 2 which leads to fall
inspot for currency 2 and hence working towards restoring the interest rate parity.
Q3:
Describe the forward rate unbiased condition.
Ans:
The Forward Rate Unbiased condition states that over a large number of observations, the
average deviation between today's forward rate (Ft,1) and the actual future spot exchange rate
(St+1) will be small and near zero at time when the forward contract expires. This forward rate is
an unbiased.
Q4:
If the forward rate unbiased condition is true, then the forward rate should not vary from the
future spot rate by more than 1 percent. Is this statement true or false? Explain.
Ans:
This is a false statement. The Forward Rate Unbiased condition includes the large number of
observations which are then averaged and used. And individual outcomes may vary
significantly.
Q5:
Discuss the impact of transaction costs on the interest rate parity condition.
Ans:
The impact of transaction cost would be that it will affect the interest rate parity with the amount
of the transaction cost and in this case the interest rate parity will not hold in totality.

Q8:

HOMEWORK ASSIGNMENT 1

VIKAS KUMAR SINGH

45260726

Describe several alternative methods of testing the interest parity condition. What is the most
appropriate method?
Ans:
The alternative methods of testing the interest parity condition could be
(1)using regression analysis in which we use forward premium and regress it on the interest rate
differential
(2)by measuring the average deviation from parity.
The better way of testing the interest rate parity condition would be to calculate the change in
four prices that is S, F, i$ and iforeign.

Q11:
When interest rate parity holds, it does not matter which currency you choose for borrowing or
lending purposes. Is this statement true or false?
Ans:
Yes, the above statement is true. But we will have to make the assumption that we are
borrowing and lending under the fully covered basis.

E1:
Suppose the US and UK three month interest rates are, respectively, 6% and 8% per annum
and that the spot rate is 1.55/e.
a. Calculate the forward premium or discount on the e expressed on a per annum basis.
b. What value of the three month forward rate establishes interest rate parity?
a. Forward Premium = (i$/4 - i/4)/(1+i/4)
= (0.06/4 - 0.08/4) / (1 + 0.08/4)
= -0.004902;
b. (F-S)/S = (i$/4 - i/4)/(1+i/4)
F = S + S * (i$/4 - i/4)/(1+i/4);
F = $1.55/ + $1.55/ * -0.004902 = $1.542402/.

E3:
Assume that the Citibank trading room is dealing on the following quotations Spot Sterling =

HOMEWORK ASSIGNMENT 1

VIKAS KUMAR SINGH

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$1.5000 , Euro-Sterling interest rate (6-months) = 11.00% p.a. Euro-$ interest rate (6-months)
= 6.00% p.a. and that Barclays Bank is quoting Forward Sterling (6-months) at $1.4550.
a. Describe the transactions you would make to earn risk-free covered interest arbitrage
profits?
b. How much profit would you expect to make?
Ans:
The forward rate given by Citibank will be
FCiti = S (1 + i/2) / (1 + i*/2)
= $1.50 * 1.03 / 1.055 = $1.4645 /
Since FBarclays = $1.4550 / ,
This implies that forward rate given by Barclays are cheaper than the forward rate given
Citibank.
a. The transaction that one should make is to buy forwards at Barclays and sell forwards at
Citibank to earn profit .
b. The profit would be $1.4645 / -$1.4550 / = $0.0095/