Fin 333A(a) (FS 21)
Problem set #4 (80 points) Due date: 11/14/21
1.(a) What is the law of one price? How is it related to purchasing power parity?
(b) Write down the absolute form and the relative forms of PPP and interpret them. (15 points)
2. (a) If a bottle of champagne costs 20 and the same bottle cost $26, what spot rate ($/) establishes the Law of One Price (purchasing power parity) for these two commodities?
(b) If U.S. and euro expected inflation rates are 4% and 2% respectively, (a) what is the expected percentage change in the euro rate? (b) what is the one-year forecast for the PPP rate, if the spot rate is the same as in part (a)? (20 points)
3.(a) Define real exchange rate.
(b) If the price levels (indices) in Canada and the U.S. are 120 and 110 respectively, what is the PPP rate for Canadian dollar? If prevailing spot rate is $0.8334/C$, what is the real exchange rate of Canadian dollar? Which currency is overvalued/undervalued in PPP terms? (15 points)?
4. You see the following quotes: St = C$1.2125/$, Ft+6 = C$1.2100/$, iC$ = 4%, and i$ = 3%.
(a) Do these rates offer covered interest arbitrage opportunity?
(b) If yes, which way the arbitrage capital move? Calculate the arbitrage profit.
5.(a) Define real interest rate. How is it related to nominal interest rate?
(b) Suppose the expected annual inflation rate in the U.S. is 1.5% and current nominal interest rate is 2%, what is the approximate real interest rate? What is the actual real interest rate? (10 points)