This document discusses several concepts relating to exchange rates and purchasing power parity (PPP) theory:
1) According to PPP, higher inflation in some European countries using the euro would cause the euro to depreciate against the dollar.
2) Japan's typically lower inflation should strengthen the yen, but other factors like Japanese investment in U.S. securities can offset this.
3) A higher interest rate in Mexico (48%) than the U.S. (8%) suggests Mexico has higher expected inflation (~40% higher) by interest rate parity (IFE). Under PPP, the peso would then depreciate by ~40% against the dollar. For U.S. investors
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Attribution Non-Commercial (BY-NC)
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This document discusses several concepts relating to exchange rates and purchasing power parity (PPP) theory:
1) According to PPP, higher inflation in some European countries using the euro would cause the euro to depreciate against the dollar.
2) Japan's typically lower inflation should strengthen the yen, but other factors like Japanese investment in U.S. securities can offset this.
3) A higher interest rate in Mexico (48%) than the U.S. (8%) suggests Mexico has higher expected inflation (~40% higher) by interest rate parity (IFE). Under PPP, the peso would then depreciate by ~40% against the dollar. For U.S. investors
This document discusses several concepts relating to exchange rates and purchasing power parity (PPP) theory:
1) According to PPP, higher inflation in some European countries using the euro would cause the euro to depreciate against the dollar.
2) Japan's typically lower inflation should strengthen the yen, but other factors like Japanese investment in U.S. securities can offset this.
3) A higher interest rate in Mexico (48%) than the U.S. (8%) suggests Mexico has higher expected inflation (~40% higher) by interest rate parity (IFE). Under PPP, the peso would then depreciate by ~40% against the dollar. For U.S. investors
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as DOCX, PDF, TXT or read online from Scribd
This document discusses several concepts relating to exchange rates and purchasing power parity (PPP) theory:
1) According to PPP, higher inflation in some European countries using the euro would cause the euro to depreciate against the dollar.
2) Japan's typically lower inflation should strengthen the yen, but other factors like Japanese investment in U.S. securities can offset this.
3) A higher interest rate in Mexico (48%) than the U.S. (8%) suggests Mexico has higher expected inflation (~40% higher) by interest rate parity (IFE). Under PPP, the peso would then depreciate by ~40% against the dollar. For U.S. investors
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as DOCX, PDF, TXT or read online from Scribd
Download as docx, pdf, or txt
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Escherika Williams
Int’l Banking and Finance
Chapter 8 1. 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? a. 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. 2. 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? a. 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. 3. 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. a. If investors from the U.S. and Mexico required the same real (inflation-adjusted) return, then any difference in nominal interest rates is due to differences in expected inflation. Thus, the inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate. According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact formula, since the concept is stressed here more than precision.) 4. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent? a. According to PPP, the exchange rate of the pound will depreciate by 4.7 percent. Therefore, the spot rate would adjust to $1.73 × [1 + (–.047)] = $1.65. 5. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? (You may use the approximate formula to answer this question.) a. $.70 × (1 + .04) = $.728 6. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is available: 7. U.S. Mexico Real rate of interest required by investors 2% 2% Nominal interest rate 11% 15% Spot rate — $.20 One-year forward rate — $.19 A. Use the forward rate to forecast the percentage change in the Mexican peso over the next year. a. ($.19 – $.20)/$.20 = –.05, or –5% B. Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year. a. 11% – 15% = –4%; the negative sign represents depreciation of the peso. C. Use the spot rate to forecast the percentage change in the Mexican peso over the next year. a. zero percent change