Ben HickmanFIN480AtkinsT/Th 2:20pmChapter 7 Homework1. The law of one price is when producers’ prices for goods or services of identical quality should be the same no matter what the market is. For example, if a country has higher inflation than others, its currency should devaluate so that the real price remains the same as other countries. Absolute purchasing power is when one price were to be true for all goods and services the PPP exchange rate could be found from any individual set of prices. Relaxed purchasing power parity is the assumptions of absolute version of PPP but a little less strict. This idea is that PPP is not particularly helpful in determined the spot rate today.5. Incomplete exchange rate is the main reason why a country’s real effective exchange rate can vary and change for long periods of time from its purchasing equilibrium. Exchange rate pass through is when the degreeat which prices of imported and exported goods changing from exchange rate changes. 6. The Fisher effect states that nominal interest rates are equal to the required rate of return plus compensation for the country’s expected inflation. 7. The international Fisher effect is the idea that the spot exchange rate should change equally in the opposite in direction in the difference in nominal interest rate and vice versa. 8. The interest rate parity provides connections between the foreign exchange markets and the international money markets. The true definition of the theory is, “The difference in the national interest rates for securities of similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency, except for transaction costs”. 9. Covered Interest arbitrage is when there is no risk on the arbitrage. Where asuncovered there is risk. The uncovered transaction is when the investor doesnot sell the higher yielding currency proceeds forward. On the other handspot and forward exchange markets are not, however, constantly in the state of equilibrium described by interest rate parity10. Many forecasters believe that foreign exchange markets for the major floatingcurrencies are efficient and forward exchange rates are unbiased predictors of future spot exchange rates. Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward
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