Quick Questoin on Fisher Parity

Chao Wong, CFA, is the portfolio manager for the China Current Fund in Switzerland. He is concerned with the direction of inflation and its effects on interest rates in China. For comparative purposes, he wanted to use Europe as a benchmark since most of his investor base is in Switzerland. The current spot exchange rate is 9.6246 Chinese yuan per euro. He wants to see if the ratio of interest rates between China and the European Economic Community (EEC) are the same as the ratio of inflation rates according to the international Fisher relation. The current nominal interest rate for the EEC is 11.76% and the annual inflation rate is 8.50%. The Chinese nominal interest rate is 10.20% and the annual inflation rate is 7.00%. According to his calculations, the result of the international Fisher relation and its linear approximation are: A) 0.986 and (-0.015). B) 0.986 and 0.015. C) 1.014 and 0.015. Your answer: C was incorrect. The correct answer was A) 0.986 and (-0.015). Using the international Fisher relation: Exact methodology: (1 + rFC) / (1 + rDC) = (1 + E (iFC)) / (1 + E (iDC)) Linear approximation: rFC – rDC = E (iFC) – E (iDC) By substituting for the international Fisher relation: (1 + 0.102) / (1 + 0.1176) = (1 + 0.07) / (1 + 0.085) 1.102 / 1.1176 ≈ 1.07 / 1.085 0.9860 ≈ 0.9862 By substituting for the linear approximation of the international Fisher relation: 0.102 – 0.1176 ≈ 0.07 – 0.085 - 0.0156 ≈ -0.0150 ------------------------------------------------------------------------------------------------------------------ I thought for the international fisher equation ,we use domestic interest rates for the numerator and foreign for the denominator Thanks

that is an interesting observation, and i would say so too. if you look at the numbers they substituted, they used them accordingly, so i think their statement of foreign/domestic in the formula is wrong, but the application seems ok, or am i missing something?

you can only use the methodology of putting the foreign int rate or infl. rate on top if the currency is given as DC:FC. in this case you need to look at the currency as FC:DC. Be prepaired to see the currencies either way on the test. I have found the best way to look at it for me is to match the excheange rate to the int rate/infl. rate. an example: you are given 9.6246 Yuan/Euro Since Yuan is on top in the exchange rate you would use the yaun int rate or infl rate as the numerator of the equation. This has yet to fail me, hope it helps everyone else!

Nice I will take your word on Using whatever exchange rate is on top for the inflation rate for the numerator.

Guys , Chinese real interest rate is lower ( 10.2 nominal - 7 inflation ) than Euro interest rate ( 11.76 nominal - 8.5 inflation ) . So Chinese is 3.20 versus 3.26 for Euro. So the Chinese Yuan must appreciate . Because the rate is given as Chinese Yuan per Euro , if Chinese Yuan appreciates , we get less Yuan . ( think Chinese more expensive so me get less Chinese ). So the factor has to be less than 1. That narrows down to choice A or B. I’d choose A because it had a negative sign ( i.e. less Yuan to the Euro )