Chartered Financial Analyst (CFA) Practice Exam Level 2

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Prepare for the CFA Exam Level 2 with flashcards and multiple-choice questions. Each question includes hints and explanations to boost your confidence and enhance your study process. Get ready for success!

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How does Uncovered Interest Rate Parity define the relationship between interest rates and currency exchange rates?

A higher interest rate in one country leads to currency appreciation
The differences in interest rates between countries indicate no expected change in exchange rates
The expected change in exchange rates equalizes differences in interest rates
Interest rates are irrelevant in short-term currency activities

The correct answer is: The expected change in exchange rates equalizes differences in interest rates

Uncovered Interest Rate Parity (UIP) suggests that the expected change in exchange rates is directly linked to the differences in interest rates between two countries. According to UIP, if one country has a higher interest rate compared to another, this implies that the currency with the higher interest rate is expected to depreciate relative to the currency with the lower interest rate. This relationship arises because investors seek to take advantage of higher returns offered by the higher interest rate currency, leading to an adjustment in the exchange rate over time. In practical terms, when there is a difference in interest rates, the anticipated changes in currency values can offset the interest rate differential, thereby equalizing the potential returns for investors irrespective of the currency in which they invest. Thus, the expected change in exchange rates compensates for these differences in interest rates, maintaining a balance in anticipated returns from international investments. The other options do not accurately reflect the mechanics of UIP. For example, a higher interest rate does not automatically lead to currency appreciation, as seen in both higher expected depreciation scenarios and the rationale behind UIP. Likewise, the assertion that interest rates are irrelevant in short-term currency activities overlooks the significant role that interest rate differentials play in shaping currency movements and investor behavior.