Page 86 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 5: Currency Forecasting

Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in Notes
the price. It is a trade that profits by exploiting price differences of identical or similar financial
instruments, on different markets or in different forms.
Hedge: Making an investment to reduce the risk of adverse price movements in an asset. Normally,
a hedge consists of taking an offsetting position in a related security, such as a futures contract.

Interest Parity: Interest rate parity relates interest rates and exchange rates.
International Fisher Effect: The IFE uses interest rates rather than inflation rate differential to
explain the changes in exchange rates over time.

Purchasing Power Parity theory: The PPP theory focuses on the inflation-exchange rate
relationships.
Relative form of PPP Theory: Relative form of PPP theory is an alternative version which
postulates that the change in the exchange rate over a period of time should be proportional to
the relative change in the price levels in the two nations over the same time period.

Speculation: Taking large risks, especially with respect to trying to predict the future; gambling,
in the hopes of making quick, large gains.

5.7 Review Questions

1. Explain the Purchasing Power Parity theory and the rationale behind it.
2. What is the rationale for the existence of the International Fisher Effect?
3. Write a brief note on the relative form of PPP theory.
4. Compare and contrast the Purchasing Power Parity theory, Covered Interest Arbitrage
theory and the International Fisher Effect theory.
5. Give reason as to why Purchasing Power Parity does not hold true.
6. Define Interest Rate Parity.
7. What are the different types of Interest Rate Parity?

8. Explain the risk free interest rate.
9. Under what condition the exchange value of the country’s currency tends to decline?
10. What would happen if the forward rate was the same as the spot rate but the interest rates
were different?

Answers: Self Assessment

1. True 2. True
3. True 4. True
5. True 6. False

7. Non-arbitrage 8. arbitrage
9. Spot and forward 10. Covered
11. Mixed 12. nominal
13. exchange 14. Interest

15. Future

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