CFA Level 2 - Economics Session 4 - Reading 19 Foreign Exchange Parity Relations

CFA Level 2 - Economics Session 4 - Reading 19 Foreign Exchange Parity Relations - LOS g (Practice Questions, Sample Questions) 1. Which of the following statements regarding relative Purchasing Power Parity (PPP) is least accurate? A) It claims that the exchange rate movements should exactly offset any inflation differential between two countries. B) In order for relative PPP to hold, countries with higher rates of expected inflation should see their currencies appreciate. C) Because PPP holds in the long run, it is somewhat useful in exchange-rate determination in the short run. [Explanation: In order for relative PPP to hold, countries with higher rates of expected inflation should see their currencies depreciate] 2. Which of the following statements regarding relative purchasing power parity (PPP) is least accurate? A) To keep the relative cost of goods and services the same across borders, countries with higher rates of expected inflation should see their currencies depreciate. B) Short-term inflation differentials are insignificant in regard to exchange rates; only the long-run differentials are important to relative PPP. C) If relative PPP holds, overvalued currencies will depreciate over time, while undervalued currencies will appreciate [Explanation: According to relative PPP, exchange rates will adjust to inflation differentials. However, empirical evidence indicates that relative PPP tends to hold over the longer term, but not over the short term] 3. The law of one price is: A) not dependent on the potential for arbitrage profits to hold in practice. B) consistent with absolute purchasing power parity (PPP) because it states that identical goods should have the same price in all locations after adjusting for exchange rate effects. C) inconsistent with purchasing power parity (PPP) because it states that identical goods should have the same price in all locations after adjusting for exchange rate effects. [Explanation: The law of one price is consistent with absolute purchasing power parity (PPP) because it states that identical goods should have the same price in all locations after adjusting for exchange rate effects] 4. Which of the following statements regarding purchasing power parity (PPP) is least accurate? A) Under absolute PPP the foreign price level expressed in domestic currency terms should be equal to the domestic country’s price level. B) Relative PPP states that prices for goods and services are the same whether it is for one good or for a basket of goods. C) Absolute PPP is similar to the law of one price, except it concerns a basket of goods rather than a single good [Explanation: Relative PPP does not state that prices for goods and services are the same, only that the rate of change in the FX rate is a function of the inflation differentials between the two countries] 5. The law of one price applies with respect to: A) both absolute and relative PPP. B) relative PPP, but does not apply to absolute PPP. C) absolute purchasing power parity (PPP), but does not apply to relative PPP. [Explanation: The law of one price focuses on a single, clearly comparable good and states that the same good should have the same real prices in all countries. Absolute PPP is an average version of the law of one price. Rather than focusing on a single good, absolute PPP focuses on a weighted average price level of a representative basket of goods and services. Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries. It is the rate of inflation (i.e., the relative rate of change in prices) that is critical here] 6. Which of the following purchasing power concepts depends on the growth rate of prices in two countries? A) Absolute PPP. B) Relative purchasing power parity (PPP). C) International Fisher relation [Explanation: Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries] 7. With respect to the relative purchasing power parity (PPP) equation, compounded inflation rates are applicable when: A) inflation rates are expected to hold for multiple periods over a certain stated time horizon. B) real interest rates are expected to hold for multiple periods over a certain stated time horizon. C) expected exchange rates are expected to hold for multiple periods over a certain stated time horizon [Explanation: Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries. It is the rate of inflation that is critical here. It is necessary to make a slight adjustment to the relative PPP equation to account for the compounded inflation rate over the time horizon if the problem involves multiple periods: St / S0 = (1 + iFC)t / (1 + iDC)t] 8. Kelly Gerard, CFA, a currency trader with the Mega Currencies Fund, is interested in using relative purchasing power parity (PPP) to identify value situations among currencies. Gerard believes that a currency’s fundamental value can be established by its inflation rate. Which of the following statements is CORRECT in Gerard’s assumptions regarding relative PPP? Relative PPP can help to identify: A) overvalued currencies that could tend to depreciate immediately. B) overvalued currencies that could tend to depreciate over the long run. C) undervalued currencies that could tend to depreciate over the long run [Explanation: Although evidence tends to suggest that PPP does not hold in the short run, empirical evidence suggests that relative PPP does tend to hold more closely over the longer term. Currencies that become overvalued or undervalued in relation to PPP over time tend to eventually revert back to the long-term level predicted by relative PPP. That means relative PPP is somewhat useful in exchange rate determination in the short run because currencies that are overvalued relative to their PPP-determined fundamental value will tend to depreciate, while undervalued currencies will tend to appreciate. However, the adjustment period can sometimes be quite long (i.e., several years)] 9. Harold Jennings, CFA, an economist the World Bank, is considering the use of purchasing power parity (PPP) as a useful tool in forecasting exchange rates for certain South American countries. The appropriate method he should use is: A) relative PPP because it tends to hold over the short run. B) relative PPP because it tends to hold over the long run. C) absolute PPP because it tends to hold over the long run [Explanation: Although evidence tends to suggest that PPP does not hold in the short run, empirical evidence suggests that relative PPP does tend to hold more closely over the longer term. Currencies that become overvalued or undervalued in relation to PPP over time tend to eventually revert back to the long-term level predicted by relative PPP. That means relative PPP is somewhat useful in exchange rate determination in the short run because currencies that are overvalued relative to their PPP-determined fundamental value will tend to depreciate, while undervalued currencies will tend to appreciate. However, the adjustment period can sometimes be quite long (i.e., several years). Note that absolute PPP is of little use In determining exchange rates because we would need to have identical individual goods and services to establish validity, and goods consumed are rarely identical between various countries]