Question

a) What does an exchange rate tell us? b) What is triangle arbitrage? c) What are absolute purchasing power parity and relative purchasing power parity? d) What are covered interest arbitrage and interest rate parity? e) What are uncovered interest parity and the International Fisher Effect? f) What are the two methods for international capital budgeting? g) What is the difference between short-run interest rate exposure and long-run interest rate exposure? How can you hedge each type? h) What is political risk, and what types of businesses face the greatest risk?

Answer 1

a)A foreign exchange rate is the relative value between two currencies. Simply put by The Balance: "Exchange rates are the amount of one currency you can exchange for another."

b)Triangular arbitrage (also referred to as cross currency arbitrage or three-point arbitrage) is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market.

c)Absolute PPP. Absolute purchasing power parity is the kind discussed in A Beginner's Guide to Purchasing Power Parity Theory (PPP Theory). Specifically, it implies that "a bundle of goods should cost the same in Canada and the United States once you take the exchange rate into account".

Relative purchasing power parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolutepurchasing power parity theory.
d)Covered interest arbitrage is anarbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to cover (eliminate exposure to) exchange rate risk.
Interest rate parity is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
e)The uncovered interest parity (UIP) is a non-arbitrage condition. It postulates that the nominal interest differential between two countries should be equal to the expected depreciation of the exchange rate.

The international Fisher effect(sometimes referred to as Fisher'sopen hypothesis) is a hypothesis ininternational finance that suggests differences in nominal interest rates reflect expected changes in the spot exchange rate between countries.