FIN415

Midterm 2 Study Guide (Modules 8–12)

PPP, forwards and futures, carry trade, interest rate parity, and arbitrage. This page is a study guide only.

Exam: 3/31  •  No calculations  •  T/F only  •  60 total questions

How to study (fast & effective)

For each module: (1) read the Big Ideas (2) memorize the Key Terms (3) walk through the mini-example (4) review the Common Confusions. These are where many T/F questions come from.

5
modules on the exam
60
total T/F questions
0
calculation questions
3/31
exam date
T/F trap words checklist: always, never, only, guaranteed, riskless, immediately, exactly, same, equal, must.
Think like the examiner: Can you explain the direction of the logic? Can you tell the difference between two similar terms? Can you spot a statement that sounds right but is wrong because of one word?
Main traps in these modules: long run vs short run, hedge vs no hedge, bid vs ask, base vs quote currency, covered vs uncovered, and paper profit vs real profit after spreads.

Modules 8–12

Click each module to open. This page is a study guide only.

Module 8 Purchasing Power Parity (PPP)

absolute PPP • relative PPP • Law of One Price • inflation • overvalued / undervalued

Big Ideas (what you must be able to explain)

  • PPP is mainly a long-run idea about where exchange rates may move over time.
  • Absolute PPP is about price levels; relative PPP is about inflation differences and exchange-rate changes.
  • The Law of One Price is the intuition behind PPP, but real-world frictions weaken it.
  • Goods that are hard to trade, plus shipping costs, tariffs, and local costs, can keep currencies away from PPP for a long time.

Key Terms (one-sentence definitions)

Absolute PPP Same basket of traded goods should have the same price in a common currency in a frictionless world.
Relative PPP Exchange rates should change over time with inflation differentials.
Law of One Price The same traded good should not sell for different common-currency prices in efficient markets with no frictions.
Overvalued currency Currency appears too strong relative to price-level benchmarks.
Undervalued currency Currency appears too weak relative to price-level benchmarks.

Example (PPP in plain English)

Suppose prices in Country A rise faster than prices in Country B for a long time. Relative PPP says Country A’s currency would tend to depreciate over time, not because it must happen every day, but because higher inflation usually weakens purchasing power.

Common Confusions (where T/F statements come from)

  • “PPP predicts short-run daily FX moves well” → usually false.
  • “Absolute PPP and relative PPP mean the same thing” → false.
  • “If PPP does not hold exactly, it is useless” → false.
  • “Nontraded goods make PPP easier to satisfy” → false.
Module 9 Forward Contracts, Futures, Hedging, and Speculation

forward • futures • long • short • hedge • speculate • margin • OTC

Big Ideas

  • Forwards are usually customized contracts traded over the counter.
  • Futures are standardized contracts traded on exchanges.
  • A hedge reduces risk; speculation takes risk on purpose.
  • Long benefits if price rises; short benefits if price falls.
  • Margin and daily settlement are important differences for futures.

Key Terms

Forward contract Customized OTC agreement to exchange an asset or currency at a future date at a set price.
Futures contract Standardized exchange-traded contract with daily mark-to-market.
Hedging Taking a position to reduce unwanted risk.
Speculation Taking a position because you want to profit from expected price movement.
Margin Good-faith deposit that supports futures trading and daily settlement.

Example (hedger vs speculator)

A U.S. importer who must pay euros in 90 days may use a forward contract to lock in the exchange rate. That is hedging. A trader who buys the same contract because they think the euro will rise is speculating.

Common Confusions

  • “Forwards and futures are exactly the same” → false.
  • “A hedge is designed to maximize profit” → false.
  • “Long and short describe time length of the contract” → false.
  • “Forwards are always safer than futures” → false.
Module 10 Currency Carry Trade

borrow low-rate currency • invest high-rate currency • interest differential • crash risk • unwind

Big Ideas

  • Carry trade means borrowing in a low-interest-rate currency and investing in a higher-interest-rate currency.
  • The attraction is the interest differential, but the risk is exchange-rate loss.
  • Carry trades can look stable for a while and then unwind quickly in risk-off periods.
  • Higher yield does not mean free money.

Key Terms

Carry trade Strategy that tries to earn the interest-rate spread between two currencies.
Funding currency Low-rate currency used for borrowing.
Target currency Higher-rate currency used for investing.
Unwind Rapid exit from positions, often causing sharp exchange-rate moves.
Crash risk Risk that a strategy loses suddenly when market conditions change.

Example (yen to dollar story)

If investors borrow in yen at a very low rate and invest in U.S. dollar assets with a higher rate, they earn the spread only if the yen does not strengthen too much against the dollar. If the yen suddenly jumps, the trade can lose money fast.

Common Confusions

  • “Carry trade profit is riskless” → false.
  • “The highest interest-rate currency is always the best choice” → false.
  • “Carry trade is only about interest rates and not FX” → false.
  • “If a trade works last month, it must keep working” → false.
Module 11 Interest Rate Parity: Covered vs Uncovered

IRP • covered interest parity • uncovered interest parity • forward rate • spot rate • hedge

Big Ideas

  • Covered interest parity (CIP) connects interest-rate differences to the forward premium or discount when investors hedge exchange-rate risk.
  • Uncovered interest parity (UIP) is about expected spot-rate change when investors do not hedge.
  • Covered and uncovered are not the same because one uses a forward contract and the other does not.
  • IRP is about no-arbitrage logic, not just “higher rate means better investment.”

Key Terms

Spot rate Exchange rate for immediate exchange.
Forward rate Exchange rate agreed on today for exchange at a future date.
Covered position FX risk is hedged, usually with a forward contract.
Uncovered position FX risk is left open.
Forward premium / discount Forward rate is above or below the spot rate.

Example (covered vs uncovered in words)

A U.S. investor comparing euro and dollar deposits can either lock in the future exchange rate with a forward contract or leave the future conversion uncertain. With the forward hedge, the idea is covered. Without the hedge, it is uncovered.

Common Confusions

  • “Covered and uncovered parity mean the same thing” → false.
  • “Covered parity leaves FX risk open” → false.
  • “A higher foreign interest rate automatically means a better covered return” → false.
  • “Forward premium always means sure profit” → false.
Module 12 Locational Arbitrage and Triangular Arbitrage

bid • ask • dealer • cross rate • mispricing • arbitrage • spreads

Big Ideas

  • Locational arbitrage uses price differences for the same currency across locations or dealers.
  • Triangular arbitrage uses inconsistency across three exchange rates.
  • To see real profit, you must use the correct bid and ask sides.
  • Spreads and fees can remove what looks like easy profit on paper.
  • Arbitrage trading tends to push quotes back into alignment.

Key Terms

Bid Price at which the dealer buys the base currency.
Ask Price at which the dealer sells the base currency.
Base currency First currency in the quote, such as EUR in EUR/USD.
Quote currency Second currency in the quote, such as USD in EUR/USD.
Cross rate Exchange rate implied by two other exchange rates that share a currency.

Example (airport booth idea)

Suppose one airport booth sells euros at one dollar price and another booth nearby buys or sells at a quote that is inconsistent enough to beat the spread. Traders would try to buy where euros are cheaper and sell where euros are more expensive. That pressure tends to erase the gap.

Common Confusions

  • “Bid is the price the customer pays to buy” → usually false in dealer language.
  • “Ask is always the better side for the trader” → false.
  • “Any quoted mismatch creates arbitrage profit” → false because spreads matter.
  • “Triangular arbitrage uses only two currencies” → false.