Deck 20: The Foreign Exchange Market

Question 1

If e_f = the forward rate on three-months Swiss francs, e = the current spot rate on Swiss francs, and E(e) = the expected future rate of the Swiss franc in three months, then the Swiss franc is said to be at a forward discount if __________ is negative.

A)
$\frac { \mathrm { e } _ { f } - \mathrm { e } } { \mathrm { e } }$
B)
$\frac { \mathrm { e } - \mathrm { e } _ { \underline { f } } } { \mathrm { e } }$
C)
$\frac { E ( e ) - e } { e }$
D)
$\frac { E ( e ) - e _ { f } } { e _ { f } }$

Answer 1

$\frac { \mathrm { e } _ { f } - \mathrm { e } } { \mathrm { e } }$

Question 2

Suppose that the one-year interest rate in the United States is 6% and that the one-year interest rate in the United Kingdom is 3%. In the context of "uncovered" interest arbitrage and with other things equal, funds would tend to flow out of the United States and into the United Kingdom

A) if the British pound is expected to depreciate by 2% relative to the dollar during the coming year.
B) if the British pound is expected to depreciate by 5% relative to the dollar during the coming year.
C) if the British pound is expected to appreciate by 2% relative to the dollar during the coming year.
D) if the British pound is expected to appreciate by 5% relative to the dollar during the coming year.

Answer 2

if the British pound is expected to appreciate by 5% relative to the dollar during the coming year.

Question 3

If U.K. interest rates are higher than Japanese interest rates, then the theory of covered Interest arbitrage would suggest that, in the pound/yen exchange markets, the yen would Be at a forward __________ and the pound would __________.

A) discount; be at a forward premium
B) discount; also be at a forward discount
C) premium; also be at a forward premium
D) premium; be at a forward discount

Answer 3

premium; be at a forward discount

Question 4

(a) Why does a "demand for foreign exchange" exist by a country's economic actors? Explain. Why does this demand curve have its downward slope? Briefly explain.
(b) What economic actions give rise to a "supply of foreign exchange" to a country? Explain. Can we be sure that this supply curve will always have an upward slope? Briefly explain.
(c) Finally, put a demand curve and supply curve of foreign exchange together and indicate the equilibrium exchange rate. Then explain how and why the equilibrium exchange rate would change if there were a sudden increase in the supply of foreign exchange to the country.

Question 5

Explain the difference between the spot rate, the forward rate, the real exchange rate, and the effective exchange rate. Then discuss a situation in which you would use each of these different exchange rates.

Question 6

You and a friend get into a heated discussion about the value of the U.S. dollar in which you argue that the dollar is currently undervalued against the Japanese yen. Failing to resolve the issue, you decide to prove that your position has the greatest economic merit given what you have recently learned in your international economics class. How might you go about trying to demonstrate to your friend that you are correct and that, indeed, the dollar is undervalued?

Question 7

You note that over the last five years, the Swiss franc has appreciated from Sfr 1.60/$1 to Sfr 1.45/$1. During that same period, the U.S. consumer price index rose from 100 to 120 and the Swiss consumer price index rose from 100 to 105. On the basis of these movements, would you expect the Swiss to be buying more or less U.S. goods? Why? Would you advise a foreign exchange speculator to buy Swiss francs at this point or to change Swiss francs into U.S. dollars? Why or why not?

Question 8

If interest rates differ between two countries, it is an indication that the financial markets are not in equilibrium, and that investment flows should be taking place between the two countries. Agree? Disagree? Explain.

Question 9

In which of the following relationships between the expected future spot rate [E(e)] of a foreign currency and the current forward rate (e_fwd) of a foreign currency would a Speculator have an incentive to sell foreign currency in the forward market?

A) E(e) < e_fwd
B) E(e) > e_fwd
C) E(e) = e_fwd
d. E(e) = (1/e_fwd)

Question 10

The Wall Street Journal indicated, in its issue of Friday, November 9, 2012, that, in late trading on Thursday, November 8, 2012, the spot U.K. pound was selling at a price of $1.5983 per pound. At the same time, the six-months forward U.K. pound was selling at a price of $1.5974 per pound. Observation of these rates indicates that the U.K. pound was selling at a six-months forward __________ against the dollar, and, if covered interest parity had indeed been attained at that time, the conclusion could validly be reached that interest rates in the United Kingdom were __________ than comparable interest rates in the United States.

A) premium; lower
B) premium; higher
C) discount; lower
D) discount; higher

Question 11

Suppose that, in a system of floating or market-determined exchange rates, the equilibrium exchange rate is 80 Japanese yen = $1. If there is then a change in preferences of U.S. consumers such that they now prefer more Japanese goods in their consumption bundle, then, other things equal, the equilibrium exchange rate __________, which is __________.

A) will move toward a lower price for the dollar ; an appreciation of
The yen relative to the dollar
B) will move toward a lower price for the dollar ; an appreciation of
The dollar relative to the yen
C) will move toward a higher price for the dollar ; an appreciation of
The yen relative to the dollar
D) will move toward a higher price for the dollar ; an appreciation of
The dollar relative to the yen

Question 12

If, in time period #1, the equilibrium value of the pound is $1.60, but then U.K. prices double between time period #1 and time period #2 while U.S. prices rise by 60 percent, then the (relative) purchasing power parity theory would say that the equilibrium value of the pound in time period #2 is

A) $0.80.
B) $1.25.
C) $1.28.
D) $2.00

Question 13

In a setting of flexible exchange rates, suppose that the U.S. citizens decrease their import purchases from the United Kingdom at the same time that British citizens increase their purchases of stocks and bonds in the United States. The first action (the U.S. imports) by itself would lead to __________ of the dollar against the pound; the second action by itself would __________ of the dollar against the pound.

A) an appreciation; lead to a depreciation
B) an appreciation; also lead to an appreciation
C) a depreciation; also lead to a depreciation
D) a depreciation; lead to an appreciation

Question 14

(a) Draw a demand curve for foreign exchange (spot foreign exchange) by a home country and briefly indicate why the curve has a downward slope. Then draw an upward-sloping supply curve of foreign exchange to that country. (You do not need to explain why it is upward-sloping.) Then indicate the equilibrium exchange rate in this spot market and briefly explain why the market moves to this equilibrium position.
(b) Define the "forward market" for foreign exchange, draw a demand curve and supply curve for the forward market, and indicate the equilibrium forward exchange rate.Assume that the equilibrium forward exchange rate is identical to the equilibrium spot exchange rate in part (a) of this question.
(c) Into this situation where the spot and exchange rates are equal, now suppose that, for whatever reason, short-term interest rates suddenly rise in the home country while they do not change in foreign countries. In the context of covered interest arbitrage, what forces are set in motion and what will happen to the spot and forward exchange rates because of this change in domestic interest rates? Carefully explain.

Question 15

How do speculators and arbitragers affect the foreign exchange market? Briefly describe the different ways that arbitragers can "cover" themselves in the foreign exchange market. Finally, will speculation in foreign exchange always have a stabilizing effect on the foreign exchange market? Why or why not?

Question 16

If, because of Japan's high saving rate (in excess of domestic investment spending), Japan invests overseas, then this investment can cause __________ of the Japanese yen And thus a consequent trade __________ for Japan.

A) a depreciation; deficit
B) a depreciation; surplus
C) an appreciation; deficit
D) an appreciation; surplus

Question 17

Indicate the meaning of the terms "covered interest parity" (CIP) and "uncovered interest parity" (UIP). Then, focusing on "covered interest parity," explain by numerical example and with at least one graph how such parity is conceptually attained in the context of a home country
and a foreign country if the short-term interest rate in the foreign country is greater than the short-term interest rate in the home country at the same time that the spot rate on the foreign currency equals the forward rate on the foreign currency. (Assume that the two interest rates are on comparable assets of the same risk.)

Question 18

Which one of the following sets of exchange rates shows "cross-rate equality" (or"consistent cross rates")?

A) 50 Indian rupees = $1; $2 = 1; 25 Indian rupees = 11ef1740_3292_ecfe_8934_e31845226625_TB1413_11 1
B) 1 Indian rupee = 1.5 Pakistani rupees; 50 Pakistani rupees = 1 Singapore
Dollar; 1 Singapore dollar = 75 Indian rupees
C) 2 Swiss francs = $1; 1 Swiss franc = € ; €1 = $1.50
D) $2 = 1; €1.5 = 11ef1740_7107_b200_8934_c98f271c1260_TB1413_11 1; €1 = $0.75

Question 19

Balance-of-payments accounting indicates that any surplus (deficit) in the current account must be offset by a deficit (surplus) in the financial account. Explain why this is so, using demand and supply curves of foreign exchange. Suppose that a country had a current account surplus. What would you expect to happen to the current account balance if there were a relative decline in the domestic interest rate? Why?

Question 20

Other things equal, if exchange rates are flexible, and if U.S. consumers increase their demand for Japanese goods at the same time that Japanese consumers increase their demand for U.S. goods, then we would expect the dollar to

A) appreciate relative to the yen.
B) depreciate relative to the yen.
C) remain unchanged in value relative to the yen.
D) appreciate, depreciate, or remain unchanged in value relative to the yen - impossible To determine without more information.

Question 21

A simultaneous increase in U.S. demand for German products and decrease in the desire of German investors to send funds to the United States would, under a flexible exchange Rate system and with other things equal, lead to __________ of the U.S. dollar against the euro and to __________ of the euro against the dollar.

A) an appreciation; a depreciation
B) an appreciation; an appreciation
C) a depreciation; a depreciation
D) a depreciation; an appreciation

Question 22

If a "Big Mac" costs $4.00 in the United States and 5 francs in Switzerland, then the implied "purchasing-power-parity" exchange rate using the "Big Mac" is __________. If the actual exchange rate in the market is 1 franc = $0.90, then an economist would say that the actual Swiss franc is __________ in comparison with its "purchasing-power-parity" rate.

A) 1 franc = $1.25; overvalued
B) 1 franc = $1.25; undervalued
C) 1 franc = $0.80; overvalued
D) 1 franc = $0.80; undervalued

Question 23

Suppose that a speculator notes that the current three-months forward rate on the euro is $1.36 and the speculator expects that, in three months, the euro will have a value of $1.40. In this situation, the speculator would __________ euros on the forward market, and this activity __________ for the speculator.

A) buy; involves risk
B) buy; involves no possible risk
C) sell; involves risk
D) sell; involves no possible risk

Question 24

Suppose that, in Year 1, the price of the U.K. pound is $1.44 = £1. In year 2, the price is $1.48 = £1. An economist would validly conclude that, from Year 1 to Year 2, the U.K. pound __________ relative to the U.S. dollar and, simultaneously, the U.S. dollar __________ relative to the U.K. pound.

A) appreciated; appreciated
B) appreciated; depreciated
C) depreciated; appreciated
D) depreciated; depreciated

Question 25

If a speculator observes that the current 3-months forward rate on Swiss francs is $1.05 = 1 franc, but he/she expects that the spot rate in 3 months will be $1.10 = 1 franc, then this Speculator would now

A) buy dollars on the forward market.
B) buy francs on the forward market.
C) sell francs on the forward market.
D) buy francs on the spot market and simultaneously sell francs on the 3-months forward Market if the current spot rate is $1.07 = 1 franc.

Question 26

Suppose that the United States trades only with Germany and Japan. Suppose also that in 2005 the spot rates were 0.70 euro = $1 peso and ¥110 = $1, and that in 2010 the spot rates were 0.84 euro = $1 and ¥99 = $1 peso. If United States trade is 50 percent With Germany and 50 percent with Japan, calculation of the effective exchange rate for The United States indicates that the dollar

A) appreciated from 2005 to 2010.
B) did not change in value from 2005 to 2010.
C) depreciated from 2005 to 2010.
D) appreciated, did not change in value, or depreciated from 2005 to 2010 - cannot be Determined without more information.

Question 27

The "Big Mac" Index

A) is a popular example of a relative PPP index of a particular commodity.
B) is an absolute PPP index of the international value of the U.S. dollar based on a single commodity.
C) demonstrates the growth in international sales of the Big Mac starting in 1983.
D) has proven to be totally inconsistent with other more sophisticated PPP measures of Currency values.

Question 28

If a PPP estimate of the dollar/pound exchange rate is $1.61/£ and the current spot rate is observed to be $1.68/£, on the basis of these two rates you should, viewing the long run,

A) expect the pound to appreciate against the dollar.
B) expect the dollar to appreciate against the pound.
C) take a "short" position in dollars.
D) have no expectation regarding the likely movement of the dollar/pound exchange rate.

Question 29

A given exchange rate will be more or less the same in all of the world's financial Markets because of

A) hedging.
B) interest arbitrage.
C) speculation.
D) currency arbitrage.

Question 30

If a "Big Mac costs $4.00 in the United States and 200 yen in Japan, then the implied "purchasing-power-parity" exchange rate using the "Big Mac" is __________. If the actual exchange rate in the market is 120 yen = $1, then an economist would say that the actual Japanese yen is __________ in comparison with its "purchasing-power-parity" rate.

A) 800 yen = $1; undervalued
B) 800 yen = $1; overvalued
C) 50 yen; undervalued
D) 50 yen; overvalued

Question 31

An exporter who is to receive payment in foreign currency in three months and who wants to engage in "hedging" would __________ the foreign currency on the three-Months forward market in order to protect himself/herself from __________ of the Foreign currency.

A) buy; an appreciation
B) buy; a depreciation
C) sell; an appreciation
D) sell; a depreciation

Question 32

Given the following partially-completed table showing the quantity demanded of euros and the quantity supplied of dollars in exchange for the euros:
$\begin{array} { l c c } \text { exchange rate } & \text { euros demanded } & \text { dollars supplied } \\\hline\$ 2.00 = € 1 & € 600 & \mathrm { x } \\\$ 1.50 = € 1 & \mathrm { y } & \$ 1,500\end{array}$
The missing values are __________.

A) x = $1,200, y = €2,250
B) x = $1,200, y = €1,000
C) x = $300, y = €2,250
D) x = $300, y = €1,000

Question 33

Suppose that the three-months interest rate in New York is 4 percent and the three-Months interest rate in London is 3 percent, and that the spot rate is $2.00/£1 and the Three-months forward rate is $2.10/£1. In this situation, there is an incentive for short-Term interest arbitrage funds to flow

A) from New York to London.
B) from London to New York.
C) neither from New York to London nor from London to New York.
D) from New York to London, from London to New York, or in neither direction -Cannot be determined without more information.