Assume That Both the Law of One Price and the Expectations

question 40

Multiple Choice

Assume that both the law of one price and the expectations theory of forward rates hold. The spot rate for the Ruritanean doubloon is 0.455 doubloon/$, and the one-year forward rate is 0.476 doubloon/$. Suppose that next year's forecasted rate of inflation in Ruritania is now revised upward by 10 percent. How does this affect exchange rates?

• A)The current spot rate changes to 0.500 doubloon/$.
• B)The forward rate changes to 0.524 doubloon/$.
• C)Next year's expected spot rate changes to 0.501 doubloon/$.
• D)The forward rate changes to 0.501 doubloon/$.

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Definitions:

Auction

A public sale where goods or property are sold to the highest bidder.

Face Value

The nominal value stated on a financial instrument, such as a bond or stock certificate.

Commercial Paper

An unsecured, short-term debt instrument issued by corporations, typically used for financing payroll, accounts payable, and inventories.

Simple Interest

Interest that is computed solely on the initial sum invested or loaned, not taking into account any accumulated interest from previous periods.