1. The foreign exchange market is a market for converting the currency of one

Transcription

1 Chapter 10 The Foreign Exchange Market True / False Questions 1. The foreign exchange market is a market for converting the currency of one country into that of another country. True False 2. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable and vice versa. True False 3. The rate at which one currency is converted into another is known as the fluctuation rate. True False

2 4. The risk that arises from volatile changes in exchange rates is known as foreign exchange risk. True False 5. Currency speculation typically involves the long-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. True False 6. Carry trade is non-speculative in nature. True False 7. When a tourist goes to a bank in a foreign country to convert money into the local currency, the exchange rate used is the forward rate. True False 8. The value of a currency is determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. True False

3 9. If the spot exchange rate is 1=$1.50 when the market opens, and 1=$1.48 at the end of the day, the pound has appreciated, and the dollar has depreciated. True False 10. A spot exchange rate is quoted for 30 days, 90 days, and 180 days into the future. True False 11. When two parties agree to exchange currency and execute the deal at some specific time in the future, a forward exchange occurs. True False 12. To minimize the risk of an unanticipated change in exchange rates, a company can protect itself by entering into a forward exchange contract. True False 13. If $1 bought more yen with a spot exchange than with a 30-day forward exchange it indicates the dollar is expected to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a premium on the 30-day forward market. True False

4 14. Differences in the spot exchange rate and the 30-day forward rate are normal and reflect the expectations of the foreign exchange market about future currency movements. True False 15. If the spot rate is $1 = 120, and the 30-day forward rate is $1 = 130, the dollar is selling at a discount in the forward market. True False 16. A currency swap is the rate at which a foreign exchange dealer converts one currency into another on a particular day. True False 17. A currency swap deal enables companies to insure themselves against foreign exchange risk. True False 18. The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. True False

5 19. The most important trading centers for currencies are Zurich, Frankfurt, Paris, Hong Kong, and Sydney. True False 20. The foreign exchange market is open for only 12 hours in a day. True False 21. Arbitrage opportunities abound in the foreign exchange markets and they tend to be available for long periods of time. True False 22. Although a foreign exchange transaction can involve any two currencies, most transactions involve pounds on one side. True False 23. If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. True False

6 24. There are no impediments to the free flow of goods and services in an efficient market. True False 25. The PPP theory argues that the exchange rate will change even if relative prices remain unchanged. True False 26. Inflation occurs when output increases faster than the money supply. True False 27. The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. True False 28. The PPP theory is a strong predictor of short-run movements in exchange rates covering time spans of five years or less. True False

7 29. The Fisher Effect states that a country's "real" rate of interest is the sum of the "nominal" interest rate and the expected rate of inflation over the period for which the funds are to be lent. True False 30. The International Fisher Effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates for the two countries. True False 31. The International Fisher Effect has proven to have substantial power at predicting short-run changes in spot exchange rates. True False 32. There is no evidence that psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. True False 33. The efficient market school argues that investing in exchange rate forecasting services would be a waste of money. True False

8 34. An inefficient market is one in which prices do not reflect all available information. True False 35. Technical analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. True False 36. If a country has an externally convertible currency, neither residents nor nonresidents are allowed to convert it into a foreign currency. True False 37. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation, or when a country's economic prospects are shaky in other respects. True False 38. Transaction exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. True False

9 39. The impact of currency exchange rates on the reported financial statements of a company is called economic exposure. True False 40. A lag strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. True False Multiple Choice Questions 41. Which term refers to the rate at which one currency is converted into another? A. Basis point B. Spread C. Exchange rate D. Interchange rate

10 42. What are the two main functions of the foreign exchange market? A. Trading of equities of foreign companies and currency conversion B. Reducing currency volatility and setting interest rates C. Insuring companies against interest rate risk and enabling imports and exports D. Currency conversion and providing some insurance against foreign exchange risk 43. A pair of shoes costs 40 in Britain. An identical pair costs $50 in the United States when the exchange rate is 1 = $1.50. Which of the following is correct? A. The U.S. offers a better deal. B. The deal is the same in both countries. C. Britain offers a better deal. D. A trader can make money by buying the shoes in Britain and selling it in the U.S. at $ An exchange rate of 1 = $1.30 indicates that: A. $1 is worth 1.30 euros. B. one could get 1.30 euros for $1. C. one euro buys 1.30 dollars. D. one euro buys 0.77 dollars.

11 45. The helps us to compare the relative prices of goods and services in different countries. A. interest rate B. GDP growth rate C. exchange rate D. tariff rate 46. Assume that an American company today invests some of its spare cash in a Hungarian money market account that will earn 8 percent for a period of two months. Which of the following, if it happens during the next two months, would imply that the company will earn less than 8 percent on its investment? A. The Hungarian forint rises in value against the dollar. B. Interest rates in the United States move down. C. Short-term interest rates in Hungarian money markets shoot up. D. The dollar appreciates against the Hungarian forint.

12 47. International businesses use foreign exchange markets for all of the following reasons except: A. to receive payments from foreign investments that may be in foreign currencies. B. to pay a foreign company for its products or services in its country's currency. C. to invest for short terms in money markets when they have spare cash. D. to cover themselves from all risks involved in currency speculation. 48. The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates is known as: A. currency arbitrage. B. currency speculation. C. currency hedging. D. currency risk mitigation.

13 49. Which of the following involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high? A. Carry trade B. Swing trade C. Channel trade D. Price action trade 50. Assume that the interest rate on borrowings in Japan is 1 percent, while the interest rate on deposits in Australian banks is 5 percent. A trader borrows in yen and then converts the money into Australian dollars and deposits it in an Australian bank to make a 4 percent margin. Which type of trade is this an example of? A. Swing trade B. Carry trade C. Channel trade D. Price action trade

14 51. When two parties agree to exchange currency and execute the deal immediately, the transaction is a: A. futures exchange. B. carry trade. C. spot exchange. D. forward exchange. 52. The is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. A. spot exchange rate B. forward exchange rate C. futures exchange rate D. spread 53. Assume that the current exchange rate is 1 = $1.50. If you exchange 1,000 euros for dollars, you will receive. A. $1,000 B. $750 C. $1,500 D. $667

15 54. are exchange rates governing some specific future date foreign exchange transactions. A. Spot exchange rates B. Forward exchange rates C. Future exchange rates D. Currency swaps 55. Assuming the 30-day forward exchange rate were $1 = 130 and the spot exchange rate were $1 = 120, the dollar is selling at a on the 30-day forward market. A. premium B. margin C. discount D. subsidy 56. Which of the following refers to the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates? A. Currency pairing B. Carry trade C. Currency exchange D. Currency swap

16 57. Which of the following is the most important foreign exchange trading center? A. London B. New York C. Tokyo D. Singapore 58. Assume that the yen/dollar exchange rate quoted in Tokyo at 3:00 p.m. is 120 = $1, and the yen/dollar exchange rate quoted in New York at the same time is 123 = $1. A dealer in New York uses dollars to purchase yen and then immediately sells the yen to buy dollars in Tokyo, thereby making a profit. The dealer has engaged in a(n): A. currency swap. B. arbitrage. C. carry trade. D. straddle.

17 59. If the demand for dollars outstrips its supply and if the supply of Japanese yen is greater than the demand for it, what will happen? A. The dollar will appreciate against the yen B. The dollar will depreciate against the yen C. The exchange rates will remain the same D. The yen will appreciate against the dollar 60. The states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. A. law of one price B. principle of consistent pricing C. model of fair pricing D. rational price theory

18 61. According to the law of one price, if the exchange rate between the British pound and the dollar is 1 = $1.50, a shirt that retails for $120 in New York should sell for in London. A. 180 B. 50 C. 60 D Assume that the law of one price holds. A shirt that retails for $120 in New York sells for 60 in London. The exchange rate between the British pound and the dollar is 1 = $1.50. Assuming away transportation costs and trade barriers, this creates a profit-making opportunity called. A. currency swap B. arbitrage C. carry trade D. straddle

19 63. The suggests that given relatively efficient markets, the price of a "basket of goods" should be roughly equivalent in each country. A. random walk theory B. theory of competitive advantage C. theory of price inflation D. purchasing power parity theory 64. Suppose the price of a Big Mac in New York is $3.00 and the price of a Big Mac in Paris is equivalent to $3.75 at the prevailing euro/dollar exchange rate. Using the concept of purchasing power parity, the euro is: A. undervalued by 25 percent against the dollar. B. overvalued by 25 percent against the dollar. C. appreciating relative to the dollar. D. depreciating relative to the dollar. 65. Identify the incorrect statement about the PPP theory. A. It predicts that exchange rates are determined by relative prices. B. It yields accurate predictions of short-run movements in exchange rates. C. It best predicts exchange rate changes for countries with high rates of inflation. D. It assumes away transportation costs and barriers to trade.

20 66. Which of the following occurs when the quantity of money in circulation in a country rises faster than the country's stock of goods and services? A. Inflation B. Credit squeeze C. Deflation D. Production surplus 67. Which of the following is referred to as the purchasing power parity puzzle? A. Reduced levels of inflation in countries where the growth in the money supply is faster than the growth in its output. B. The reason why countries with high inflation rates see depreciation in their currency exchange rates. C. Identical products being sold in different countries for the same price when their price is expressed in terms of the same currency. D. The failure to find a strong link between relative inflation rates and exchange rate movements.

21 68. The states that a country's "nominal" interest rate is the sum of the required "real" rate of interest and the expected rate of inflation over the period for which the funds are to be lent. A. PPP theory B. efficient market theory C. law of one price D. Fisher Effect 69. It follows from the Fisher Effect that if the real interest rate is the same worldwide; any difference in interest rates between countries reflects differing expectations about. A. foreign exchange rates B. inflation rates C. unemployment rates D. GDP growth rates

22 70. The states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. A. purchasing power parity theory B. efficient market theory C. International Fisher Effect D. law of one price 71. Which of the following occurs when traders start moving as a herd in the same direction at the same time? A. Fisher effect B. Bandwagon effect C. Arbitrage D. Decoupling of markets

23 72. The school of thought argues that forward exchange rates do the best possible job of forecasting future spot rates and therefore investing in forecasting services would be a waste of money. A. inefficient market B. efficient market C. random walk D. speculative 73. Which of the following would a follower of the inefficient market school of thought agree with? A. Companies would be better off investing in foreign exchange forecasting services. B. Forward exchange rates do the best possible job of forecasting future spot exchange rates. C. Companies can optimize their foreign exchange transactions by using forward markets. D. Forward rates reflect all available information about likely future changes in exchange rates.

24 74. uses price and volume data to determine past trends, which are expected to continue into the future. A. Technical analysis B. Fundamental analysis C. Efficient market theory D. Value investing 75. A currency is said to be freely convertible when: A. its exchange rate with respect to other currencies is decided by the central bank of the country. B. residents alone are allowed to convert it into a foreign currency without any limitations. C. neither residents nor nonresidents are allowed to convert it into a foreign currency. D. both residents and nonresidents are allowed to purchase unlimited amounts of a foreign currency with it.

25 76. is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country's economic prospects are shaky in other respects. A. The random walk effect B. The Fisher Effect C. The International Fisher Effect D. Capital flight 77. refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. A. Countertrade B. Carry trade C. Dumping D. Capital flight 78. The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values is known as: A. economic exposure. B. financial exposure. C. translation exposure. D. transaction exposure.

26 79. is the impact of short-run currency exchange rates changes on the reported financial statements of a company. A. Economic exposure B. Financial exposure C. Translation exposure D. Transaction exposure 80. A(n) involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A. follower strategy B. interim strategy C. lead strategy D. lag strategy Essay Questions

27 81. With the help of an example, explain how a tourist participates in the foreign exchange market. 82. What are the main uses of foreign exchange markets for international business?

28 83. What is the difference between a spot exchange rate and a forward exchange rate? 84. What is meant by the phrases the dollar is selling at a discount' on the 30-day forward market and the dollar is selling at a premium' on the 30-day forward market?

29 85. What is a currency swap? 86. Where is the foreign exchange market located? What is the nature of the market? Is the market growing or shrinking on a global basis?

30 87. Discuss the nature of the foreign exchange market. How fast has it been growing? Where are the most important trading centers? 88. What is the law of one price?

31 89. Explain PPP. Use an example to show how PPP can help explain exchange rates. 90. Discuss the failure of PPP theory to predict exchange rates accurately. What is the purchasing power puzzle?

32 91. Compare and contrast the Fisher Effect and the International Fisher Effect. 92. Consider the role of investor psychology and bandwagon effects on how well PPP and the International Fisher Effect explain short-term movements in exchange rates.

33 93. Discuss the two schools of thought on exchange rate forecasting. 94. Explain the difference between fundamental analysis and technical analysis. 95. Compare and contrast currencies that are freely convertible, externally convertible, and nonconvertible.

34 96. What is countertrade? Why would a firm engage in countertrade? 97. What is transaction exposure? How can transaction exposure be minimized? 98. Describe translation exposure. How can translation exposure be minimized?

35 99. Explain the notion of economic exposure. How can economic exposure be minimized? 100. How can a firm minimize its foreign exchange exposure?

36 Chapter 10 The Foreign Exchange Market Answer Key True / False Questions 1. The foreign exchange market is a market for converting the currency of one country into that of another country. TRUE The foreign exchange market is a market for converting the currency of one country into that of another country. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: Introduction

37 2. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable and vice versa. TRUE Currency fluctuations can make seemingly profitable trade and investment deals unprofitable, and vice versa. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: Introduction 3. The rate at which one currency is converted into another is known as the fluctuation rate. FALSE An exchange rate is the rate at which one currency is converted into another. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: Introduction

38 4. The risk that arises from volatile changes in exchange rates is known as foreign exchange risk. TRUE Foreign exchange risk refers to the adverse consequences of unpredictable changes in exchange rates. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market 5. Currency speculation typically involves the long-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. FALSE Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

39 6. Carry trade is non-speculative in nature. FALSE The speculative element of carry trade is that its success is based upon a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market 7. When a tourist goes to a bank in a foreign country to convert money into the local currency, the exchange rate used is the forward rate. TRUE When a tourist goes to a bank in a foreign country to convert money into the local currency, the exchange rate used is the spot rate fort that day. Blooms: Understand Difficulty: 2 Medium Learning Objective: Understand what is meant by spot exchange rates. Topic: The Functions of the Foreign Exchange Market

40 8. The value of a currency is determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. TRUE The value of a currency is determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. Blooms: Remember Difficulty: 1 Easy Learning Objective: Understand what is meant by spot exchange rates. Topic: The Functions of the Foreign Exchange Market 9. If the spot exchange rate is 1=$1.50 when the market opens, and 1=$1.48 at the end of the day, the pound has appreciated, and the dollar has depreciated. FALSE Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated. AACSB: Reflective Thinking Blooms: Apply Difficulty: 2 Medium Learning Objective: Understand what is meant by spot exchange rates. Topic: The Functions of the Foreign Exchange Market

41 10. A spot exchange rate is quoted for 30 days, 90 days, and 180 days into the future. FALSE Forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market 11. When two parties agree to exchange currency and execute the deal at some specific time in the future, a forward exchange occurs. TRUE A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market

42 12. To minimize the risk of an unanticipated change in exchange rates, a company can protect itself by entering into a forward exchange contract. TRUE When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed. Blooms: Understand Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market 13. If $1 bought more yen with a spot exchange than with a 30-day forward exchange it indicates the dollar is expected to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a premium on the 30-day forward market. FALSE If $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market. AACSB: Reflective Thinking Blooms: Apply

43 Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market 14. Differences in the spot exchange rate and the 30-day forward rate are normal and reflect the expectations of the foreign exchange market about future currency movements. TRUE Such differences are normal; they reflect the expectations of the foreign exchange market about future currency movements. Blooms: Understand Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market 15. If the spot rate is $1 = 120, and the 30-day forward rate is $1 = 130, the dollar is selling at a discount in the forward market. FALSE In this case, the dollar is selling at a premium on the 30-day forward market. AACSB: Reflective Thinking Blooms: Apply Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market

44 16. A currency swap is the rate at which a foreign exchange dealer converts one currency into another on a particular day. FALSE A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Blooms: Remember Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market 17. A currency swap deal enables companies to insure themselves against foreign exchange risk. TRUE A currency swap deal enables companies to insure themselves against foreign exchange risk. Blooms: Understand Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market

45 18. The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. TRUE The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market 19. The most important trading centers for currencies are Zurich, Frankfurt, Paris, Hong Kong, and Sydney. FALSE The most important trading centers are London (37 percent of activity), New York (18 percent of activity), and Zurich, Tokyo, and Singapore (all with around 5 to 6 percent of activity). Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market

46 20. The foreign exchange market is open for only 12 hours in a day. FALSE A key feature of the foreign exchange market is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market 21. Arbitrage opportunities abound in the foreign exchange markets and they tend to be available for long periods of time. FALSE Because foreign exchange dealers are always watching their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes. Blooms: Understand Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market

47 22. Although a foreign exchange transaction can involve any two currencies, most transactions involve pounds on one side. FALSE Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side. Blooms: Remember Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market 23. If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. TRUE If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. Blooms: Understand Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination

48 24. There are no impediments to the free flow of goods and services in an efficient market. TRUE An efficient market has no impediments to the free flow of goods and services, such as trade barriers. Blooms: Remember Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination 25. The PPP theory argues that the exchange rate will change even if relative prices remain unchanged. FALSE The PPP theory argues that the exchange rate will change if relative prices change. Blooms: Remember Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination

49 26. Inflation occurs when output increases faster than the money supply. FALSE Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises faster than the stock of goods and services, that is, when the money supply increases faster than output increases. Blooms: Understand Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination 27. The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. TRUE The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. Blooms: Understand Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination

50 28. The PPP theory is a strong predictor of short-run movements in exchange rates covering time spans of five years or less. FALSE While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less. Blooms: Understand Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination 29. The Fisher Effect states that a country's "real" rate of interest is the sum of the "nominal" interest rate and the expected rate of inflation over the period for which the funds are to be lent. FALSE The Fisher Effect states that a country's "nominal" interest rate is the sum of the required "real" rate of interest and the expected rate of inflation over the period for which the funds are to be lent. Blooms: Remember Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their

51 relative merits. Topic: Economic Theories of Exchange Rate Determination 30. The International Fisher Effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates for the two countries. TRUE The International Fisher Effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. Blooms: Understand Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination 31. The International Fisher Effect has proven to have substantial power at predicting short-run changes in spot exchange rates. FALSE The International Fisher Effect is not a good predictor of short-run changes in spot exchange rates. Blooms: Understand Difficulty: 2 Medium

52 Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination 32. There is no evidence that psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. FALSE Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. 20 Blooms: Remember Difficulty: 2 Medium Learning Objective: Understand the different theories explaining how currency exchange rates are determined and their relative merits. Topic: Economic Theories of Exchange Rate Determination

53 33. The efficient market school argues that investing in exchange rate forecasting services would be a waste of money. TRUE The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money. Blooms: Understand Difficulty: 2 Medium Learning Objective: Identify the merits of different approaches toward exchange rate forecasting. Topic: Exchange Rate Forecasting 34. An inefficient market is one in which prices do not reflect all available information. TRUE An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates. Blooms: Remember Difficulty: 2 Medium Learning Objective: Identify the merits of different approaches toward exchange rate forecasting. Topic: Exchange Rate Forecasting

54 35. Technical analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. FALSE Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. Blooms: Remember Difficulty: 2 Medium Learning Objective: Identify the merits of different approaches toward exchange rate forecasting. Topic: Exchange Rate Forecasting 36. If a country has an externally convertible currency, neither residents nor nonresidents are allowed to convert it into a foreign currency. FALSE A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations. Blooms: Remember Difficulty: 2 Medium Learning Objective: Identify the merits of different approaches toward exchange rate forecasting. Topic: Exchange Rate Forecasting

55 37. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation, or when a country's economic prospects are shaky in other respects. TRUE Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation, or when a country's economic prospects are shaky in other respects. Blooms: Remember Difficulty: 2 Medium Learning Objective: Identify the merits of different approaches toward exchange rate forecasting. Topic: Exchange Rate Forecasting 38. Transaction exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. TRUE Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

56 Blooms: Understand Difficulty: 2 Medium Learning Objective: Compare and contrast the differences between translation; transaction; and economic exposure; and explain what managers can do to manage each type of exposure. Topic: Implications for Managers 39. The impact of currency exchange rates on the reported financial statements of a company is called economic exposure. FALSE Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Blooms: Remember Difficulty: 2 Medium Learning Objective: Compare and contrast the differences between translation; transaction; and economic exposure; and explain what managers can do to manage each type of exposure. Topic: Implications for Managers

57 40. A lag strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. FALSE A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Blooms: Understand Difficulty: 2 Medium Learning Objective: Compare and contrast the differences between translation; transaction; and economic exposure; and explain what managers can do to manage each type of exposure. Topic: Implications for Managers Multiple Choice Questions

58 41. Which term refers to the rate at which one currency is converted into another? A. Basis point B. Spread C. Exchange rate D. Interchange rate The foreign exchange market is a market for converting the currency of one country into that of another country. An exchange rate is simply the rate at which one currency is converted into another. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: Introduction

59 42. What are the two main functions of the foreign exchange market? A. Trading of equities of foreign companies and currency conversion B. Reducing currency volatility and setting interest rates C. Insuring companies against interest rate risk and enabling imports and exports D. Currency conversion and providing some insurance against foreign exchange risk The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates. Blooms: Understand Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

60 43. A pair of shoes costs 40 in Britain. An identical pair costs $50 in the United States when the exchange rate is 1 = $1.50. Which of the following is correct? A. The U.S. offers a better deal. B. The deal is the same in both countries. C. Britain offers a better deal. D. A trader can make money by buying the shoes in Britain and selling it in the U.S. at $50. All else being equal, at an exchange rate 1 = $1.50, the shoe should have cost $60 (40 1.5) in the U.S. At $50 for a pair, the U.S. offers a better deal. AACSB: Reflective Thinking Blooms: Apply Difficulty: 3 Hard Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

61 44. An exchange rate of 1 = $1.30 indicates that: A. $1 is worth 1.30 euros. B. one could get 1.30 euros for $1. C. one euro buys 1.30 dollars. D. one euro buys 0.77 dollars. The exchange rate is the rate at which the market converts one currency into another. An exchange rate of 1 = $1.30 indicates that every euro is worth 1.3 dollars. AACSB: Reflective Thinking Blooms: Apply Difficulty: 2 Medium Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

62 45. The helps us to compare the relative prices of goods and services in different countries. A. interest rate B. GDP growth rate C. exchange rate D. tariff rate The exchange rate is the rate at which the market converts one currency into another. The exchange rate allows us to compare the relative prices of goods and services in different countries. Blooms: Remember Difficulty: 1 Easy Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

63 46. Assume that an American company today invests some of its spare cash in a Hungarian money market account that will earn 8 percent for a period of two months. Which of the following, if it happens during the next two months, would imply that the company will earn less than 8 percent on its investment? A. The Hungarian forint rises in value against the dollar. B. Interest rates in the United States move down. C. Short-term interest rates in Hungarian money markets shoot up. D. The dollar appreciates against the Hungarian forint. If the dollar appreciates, it will mean that the company will get lesser amount of dollars when it takes its back. Each Hungarian forint will buy lesser dollars than in the past. AACSB: Reflective Thinking Blooms: Apply Difficulty: 3 Hard Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

64 47. International businesses use foreign exchange markets for all of the following reasons except: A. to receive payments from foreign investments that may be in foreign currencies. B. to pay a foreign company for its products or services in its country's currency. C. to invest for short terms in money markets when they have spare cash. D. to cover themselves from all risks involved in currency speculation. In general, companies should beware, because speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While speculators may profit handsomely if future currency movements go in the direction predicted, they can also lose vast amounts of money if they move in the other direction. Blooms: Understand Difficulty: 2 Medium Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

65 48. The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates is known as: A. currency arbitrage. B. currency speculation. C. currency hedging. D. currency risk mitigation. Currency speculation is one of the uses of foreign exchange markets. Blooms: Remember Difficulty: 2 Medium Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

66 49. Which of the following involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high? A. Carry trade B. Swing trade C. Channel trade D. Price action trade The carry trade involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high. Blooms: Remember Difficulty: 2 Medium Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

67 50. Assume that the interest rate on borrowings in Japan is 1 percent, while the interest rate on deposits in Australian banks is 5 percent. A trader borrows in yen and then converts the money into Australian dollars and deposits it in an Australian bank to make a 4 percent margin. Which type of trade is this an example of? A. Swing trade B. Carry trade C. Channel trade D. Price action trade The carry trade involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high. AACSB: Reflective Thinking Blooms: Apply Difficulty: 3 Hard Learning Objective: Describe the functions of the foreign exchange market. Topic: The Functions of the Foreign Exchange Market

68 51. When two parties agree to exchange currency and execute the deal immediately, the transaction is a: A. futures exchange. B. carry trade. C. spot exchange. D. forward exchange. When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Blooms: Remember Difficulty: 2 Medium Learning Objective: Understand what is meant by spot exchange rates. Topic: The Functions of the Foreign Exchange Market

69 52. The is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. A. spot exchange rate B. forward exchange rate C. futures exchange rate D. spread The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Blooms: Remember Difficulty: 2 Medium Learning Objective: Understand what is meant by spot exchange rates. Topic: The Functions of the Foreign Exchange Market

70 53. Assume that the current exchange rate is 1 = $1.50. If you exchange 1,000 euros for dollars, you will receive. A. $1,000 B. $750 C. $1,500 D. $667 Each euro is worth $1.5. Therefore, you will receive $1,500 (1, ) for 1,000 euros. AACSB: Reflective Thinking Blooms: Apply Difficulty: 2 Medium Learning Objective: Understand what is meant by spot exchange rates. Topic: The Functions of the Foreign Exchange Market

71 54. are exchange rates governing some specific future date foreign exchange transactions. A. Spot exchange rates B. Forward exchange rates C. Future exchange rates D. Currency swaps Forward exchange rates represent market participants' collective predictions of likely spot exchange rates at specified future dates. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market

72 55. Assuming the 30-day forward exchange rate were $1 = 130 and the spot exchange rate were $1 = 120, the dollar is selling at a on the 30-day forward market. A. premium B. margin C. discount D. subsidy $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. AACSB: Reflective Thinking Blooms: Apply Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market

73 56. Which of the following refers to the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates? A. Currency pairing B. Carry trade C. Currency exchange D. Currency swap Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Functions of the Foreign Exchange Market

74 57. Which of the following is the most important foreign exchange trading center? A. London B. New York C. Tokyo D. Singapore The most important trading centers are London (37 percent of activity), New York (18 percent of activity), and Zurich, Tokyo, and Singapore (all with around 5 to 6 percent of activity). Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney Blooms: Remember Difficulty: 1 Easy Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market

75 58. Assume that the yen/dollar exchange rate quoted in Tokyo at 3:00 p.m. is 120 = $1, and the yen/dollar exchange rate quoted in New York at the same time is 123 = $1. A dealer in New York uses dollars to purchase yen and then immediately sells the yen to buy dollars in Tokyo, thereby making a profit. The dealer has engaged in a(n): A. currency swap. B. arbitrage. C. carry trade. D. straddle. Buying a currency low and selling it high is arbitrage. AACSB: Reflective Thinking Blooms: Understand Difficulty: 2 Medium Learning Objective: Recognize the role that forward exchange rates play in insuring against foreign exchange risk. Topic: The Nature of the Foreign Exchange Market