Deck 32: The Market for Foreign Exchange and Risk Control Instruments

Question 1

Foreign-exchange risk ________.

A) is the risk that a currency's value may change adversely.
B) is an unimportant consideration for all participants in the international financial markets.
C) cannot affect an international investor's return after adjusting for changes in the exchange rate.
D) cannot affect issues denominated in a foreign currency (e.g., in terms of the effective value of the cash payments owed to investors).

Answer 1

A

Question 2

In regards to the perspective of a U.S. investor, which of the below statements is FALSE?

A) The cash flows of assets denominated in a foreign currency expose the investor to uncertainty as to the actual level of the cash flow measured in U.S. dollars.
B) The actual number of U.S. dollars that the investor eventually gets depends on the exchange rate between the U.S. dollar and the foreign currency at the time the nondollar cash flow is received and exchanged for U.S. dollars.
C) If the foreign currency depreciates (declines in value) relative to the U.S. dollar (that is, the U.S. dollar appreciates), the dollar value of the cash flows will be proportionately less, leading to foreign exchange risk.
D) The cash flows of assets denominated in a foreign currency expose the investor to uncertainty as to the actual level of the cash flow measured in that foreign currency.

Answer 2

D

Question 3

The exchange rate between the U.S. dollar and the euro can be quoted as ________.

A) the amount of U.S. dollars necessary to acquire one British pound, and this is the dollar price of one pound.
B) the number of euros necessary to acquire one Japanese yet, or the yen price of one dollar.
C) the amount of U.S. dollars needed to acquire one euro, and this is the dollar price of one euro.
D) the amount of U.S. dollars needed to acquire one Mexican peso, and this is the dollar price of one peso.

Answer 3

C

Question 4

The countries of the European Union electing to be members of the Economic and Monetary Union (EMU) are subject to a ________ conversion rate against their national currencies and relative to the euro, but the value of the euro against all other currencies ________ according to market conditions.

A) flexible oscillates
B) fixed fluctuates
C) flexible is fixed
D) fixed is stationary

Question 5

A ________ is the number of units of a local currency exchangeable for one unit of a foreign currency, while an ________ is the number of units of a foreign currency that can be exchanged for one unit of a local currency.

A) direct price; indirect sale
B) indirect price; direct quote
C) direct quote; indirect quote
D) indirect quote; direct sale

Question 6

Given a direct quote, we can obtain an indirect quote (which is simply the reciprocal of the direct quote), and vice versa. For example, on March 9, 2009, a U.S. investor is given a direct quote of 1.2674 U.S. dollars for one euro. That is, the price of a euro is $1.2674. What would be the indirect quote for the U.S. investor; that is, one U.S. dollar can be exchanged for how many euros (which is the euro price of a U.S. dollar)?

A) 1.2674
B) 1.0000
C) 0.8988
D) 0.7889

Question 7

Which of the below statements is TRUE?

A) Looking at it from a U.S. participant's perspective, we see that a quote indicating the number of dollars exchangeable for one unit of a foreign currency is an indirect quote.
B) A direct quote from a U.S. participant's perspective would be the number of units of the foreign currency that can be exchanged for one U.S. dollar.
C) From the point of view of a non-U.S. participant, the number of U.S. dollars exchangeable for one unit of a non-U.S. currency is an indirect quote.
D) From the point of view of a non-U.S. participant, the number of units of a non-U.S. currency exchangeable for a Japanese yen is a direct quote.

Question 8

The ________ is the market for settlement of a foreign-exchange transaction within two business days.

A) forward exchange rate market
B) futures exchange rate market
C) current exchange rate market
D) spot exchange rate market

Question 9

The birth of the euro on January 4, 1999, was smooth and uneventful in terms of both market volatility and operations. Several notable outcomes resulted from this event including: ________.

A) The birth of the euro proved impossible.
B) The birth of the euro proved unstable.
C) The birth of the euro also gave birth to a large public and corporate capital market denominated in the euro.
D) The birth of the euro created differences in currency risk.

Question 10

The fundamental fact of international finance is that different countries issue different currencies, and the relative values of those currencies may change ________.

A) quickly, substantially, and without warning.
B) reflect economic developments.
C) as a response to political events that make no economic sense.
D) All of these

Question 11

In general, an exchange rate is defined ________.

A) as the amount of one currency that can be exchanged for a unit of another currency.
B) as the amount of two currencies that can be exchanged for a unit of another currency.
C) as the amount of a Japanese yen (and no other currency) that can be exchanged for a unit of any other currency in the world.
D) as the amount of one currency (of any country) that can be exchanged for a unit of a U.S. dollar and no other currency.

Question 12

A key factor affecting the expectation of changes in a country's exchange rate with another currency is the relative ________ of the two countries.

A) known inflation rate
B) known purchasing power
C) expected inflation rate
D) expected risk-free rate

Question 13

Quoting in terms of U.S. dollars per unit of foreign currency is called ________ terms, while quoting in terms of the number of units of the foreign currency per U.S. dollar is called ________ terms.

A) United States; European
B) American; European
C) domestic; foreign
D) local or current; non-U.S.

Question 14

The three currency pairs (and their abbreviations) that are most commonly traded are ________.

A) Euro against U.S. dollar (GBP/USD).
B) U.S. dollar against Japanese yen (USD/JPY).
C) British pound against mexican peso (GBP/MP).
D) Swiss franc against U.S. dollar (SF/USD).

Question 15

In regards to the perspective of a U.S. investor, which of the below statements is FALSE?

A) A French investor who acquires a yen-denominated Japanese bond is exposed to the risk that the Japanese yen will increase in value relative to the euro.
B) Suppose that IBM issues bonds denominated in euros. IBM's foreign-exchange risk is that, at the time the coupon interest payments must be made and the principal repaid, the U.S. dollar will have depreciated relative to the euro, requiring that IBM pay more dollars to satisfy its obligation.
C) Foreign-exchange risk is a consideration for the issuer.
D) Any investor who purchases an asset denominated in a currency that is not the medium of exchange in the investor's country faces foreign-exchange risk.

Question 16

To qualify as a participating country in the Economic and Monetary Union (EMU) requires that a country satisfy certain economic standards. These standards include: ________.

A) the annual fiscal deficit is to be no more than 3% of the gross disposable product (GDP).
B) the total outstanding government indebtedness is to be no more than 60% of GDP.
C) the voters of a country seeking membership have to approve the joining of the EMU by popular referendum.
D) All of these

Question 17

The most traded currency pair is ________, which has captured about 30% of the global turnover. The ________ and ________ represent about 20% and 11%, respectively.

A) GBP/USD; USD/JPY; EUR/USD
B) USD/JPY; EUR/USD; GBP/USD
C) EUR/USD; USD/JPY; GBP/USD
D) EUR/USD; GBP/USD; USD/JPY

Question 18

Since the early 1970s, exchange rates among major currencies have been free to float, with ________ determining the relative value of a currency. Thus, each day a currency's price relative to that of another freely floating currency may stay the ________.

A) risk/beta forces; increase or decrease.
B) market forces; increase or stay the same.
C) risk/beta forces; same, increase, or decrease.
D) market forces; same, increase, or decrease.

Question 19

If the number of units of a foreign currency that can be obtained for one dollar (the price of a dollar in that currency or indirect quotation) rises, the dollar is said to ________ relative to the currency, and the currency is said to ________. Thus, appreciation means a decline in the ________ quotation.

A) appreciate; depreciate; direct
B) depreciate; appreciate; indirect
C) appreciate; depreciate; direct
D) depreciate; appreciate; indirect

Question 20

Which of the below statements is FALSE?

A) Spot exchange rates adjust to compensate for the relative inflation rate reflecting the so-called purchasing power parity relationship.
B) The purchasing power parity relationship posits that the exchange rate - the domestic price of the foreign currency - is proportional to the domestic inflation rate, and inversely proportional to foreign inflation.
C) Because of the importance of the euro in the international financial system, currency quotations are all relative to the euro.
D) Suppose that on day 1 the spot exchange rate between the U.S. dollar and country X is $0.80 and on the next day, day 2, it changes to $0.81. Thus, the currency unit of country X appreciated relative to the U.S. dollar from day 1 to day 2.

Question 21

Which of the below statements is FALSE?

A) Interest rate parity provides that a borrower who hedges in the forward exchange rate market realizes the same domestic borrowing rate whether borrowing domestically or in a foreign country.
B) In deriving the theoretical forward exchange rate using the arbitrage argument, we assume the investor faces commissions or bid-ask spread when exchanging in the spot market today and at the end of the investment horizon.
C) In deriving the theoretical forward exchange rate using the arbitrage argument, we assume that the borrowing and lending rates in each currency are the same.
D) Any restrictions on foreign investing or borrowing in each country impede arbitrage and may cause a divergence between actual and theoretical forward exchange rates.

Question 22

Mathematically, interest rate parity between the currencies of two countries, A and B, can be expressed as where ________.

A) I = amount of A's currency to be invested for a time period of length t
B) F = spot exchange rate: price of foreign currency in terms of domestic currency (units of domestic currency per unit of foreign currency)
C) S = t-period forward rate: price of foreign currency t periods from now
D) iB = interest rate on an investment maturing at time t in country A

Question 23

For foreign exchange, the ________ is the market of choice, and trading there is much ________ trading on exchanges.

A) future market smaller than
B) forward market larger than
C) cash market larger than
D) spot market the same compared to

Question 24

Which of the below statements is FALSE?

A) Futures options are options to enter into foreign-exchange futures contracts.
B) Only options on the major currencies are traded in the over-the-counter market.
C) In addition to the organized exchanges, an over-the-counter market exists for options on currencies.
D) In the case of currency options, the underlying is the foreign currency specified by the option contract.

Question 25

The largest sector of the Eurocurrency market involves bank deposits and bank loans in U.S. dollars and is called the ________.

A) Eurodollar sector.
B) Eurofutures market.
C) Eurodeposits sector.
D) Eurodollar market.

Question 26

Consider a currency swap where two companies issue bonds in the other's bond market and enter into an agreement. This agreement requires that ________.

A) the two parties exchange the proceeds received from the sale of the bonds.
B) the two parties make the coupon payments to service the debt of the other party.
C) both parties agree to exchange the par value of the bonds with the exchange coming at the termination date of the currency swap (which coincides with the maturity of the bonds).
D) All of these

Question 27

Which of the below statements is FALSE?

A) In the real world, it is rare that the theoretical cross rate, as computed from actual dealer dollar exchange rate quotes, will differ from the actual cross rate quoted by dealers.
B) Arbitraging to take advantage of cross-rate mispricing is called triangular arbitrage, so named because it involves positions in three currencies.
C) The arbitrage keeps actual cross rates dissimilar to theoretical cross rates.
D) Barring any government restrictions, riskless arbitrage will assure that the exchange rate between two countries will be the same in both countries.

Question 28

Consider a U.S. investor with a one-year investment horizon who can either deposit money in a U.S. bank for investment or deposit money in a bank in a foreign country. To determine the proper choice, the investor must know ________.

A) the taxes paid in both countries on investment income.
B) the spot exchange rate between U.S. dollars and the foreign country's currency.
C) the spot exchange rate one year from now between U.S. dollars and the foreign currency.
D) All of these

Question 29

The theoretical forward rate implied by the interest rates and spot exchange rate can be expressed as ________.

A)
$\mathrm{S}=\mathrm{F}\left(\frac{1-\mathrm{i}_{\mathrm{A}}}{1+\mathrm{i}_{\mathrm{B}}}\right)$

B)
$\mathrm{F}=\mathrm{S}\left(\frac{1+\mathrm{i}_{\mathrm{A}}}{1-\mathrm{i}_{\mathrm{B}}}\right)$

C)
$F=S\left(\frac{1+i_{A}}{1+i_{B}}\right)$

D)
$F=S\left(\frac{1-i_{A}}{1-i_{B}}\right)$

Question 30

A ________ in the foreign exchange market leads arbitrageurs to act, with the result that the forward exchange rate changes.

A) riskless and uncertain arbitrage situation
B) risky arbitrage situation
C) risky opportunity possibility
D) riskless arbitrage situation

Question 31

Which of the below statements is FALSE?

A) The Eurocurrency market is the name of the unregulated and informal market for bank deposits and bank loans denominated in a currency other than that of the country where the bank initiating the transaction is located.
B) Just like a forward or futures contract, an option gives the option buyer the opportunity to benefit from favorable exchange rate movements but establishes a maximum loss.
C) Foreign-exchange futures contracts for the major currencies are traded on the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.
D) The two types of foreign currency options are options on the foreign currency and futures options.

Question 32

The one-year ________ fixes today the exchange rate one year from now.

A) forward exchange rate
B) spot exchange rate
C) forward transaction rate
D) All of these

Question 33

Barring any government restrictions, ________ will assure that the exchange rate between two countries will be the same in both countries. The ________ between two countries other than the United States can be inferred from their exchange rates with the U.S. dollar.

A) certainty arbitrage; empirical exchange rate
B) riskless arbitrage; theoretical exchange rate
C) riskless arbitrage; empirical spot rate
D) certainty arbitrage; theoretical spot rate

Question 34

The arbitrage process that forces interest rate parity is called ________.

A) uncovered interest parity.
B) covered dividend arbitrage.
C) covered interest arbitrage.
D) covered interest parity.

Question 35

Mathematically, interest rate parity between the currencies of two countries, A and B, can be expressed as ________.

A)
$\mathrm{I}(1+\mathrm{i} \mathrm{B})=\left(\frac{1}{\mathrm{~S}}\right)(1-\mathrm{i} \mathrm{A}) \mathrm{F}$

B)
$\mathrm{I}(1-\mathrm{i} \mathrm{A})=\left(\frac{1}{\mathrm{~F}}\right)(1+\mathrm{i} \mathrm{B}) \mathrm{S}$

C)
$\mathrm{I}(1-\mathrm{i} \mathrm{A})=\left(\frac{1}{\mathrm{~S}}\right)(1-\mathrm{i} \mathrm{B}) \mathrm{F}$

D)
$\mathrm{I}\left(1+\mathrm{i}_{\mathrm{A}}\right)=\left(\frac{1}{\mathrm{~S}}\right)\left(1+\mathrm{i}_{\mathrm{B}}\right) \mathrm{F}$

Question 36

Consider the theoretical cross rate between Swiss francs and Japanese yen on March 10, 2009. The spot exchange rate for the two currencies in American terms was $0.8647 per Swiss franc and $0.0101 per Japanese yen. Which of the below is TRUE?

A) The number of units of yen per unit of Swiss franc is 85.61386 yen per Swiss franc.
B) The number of Swiss francs exchangeable for one Japanese yen is 0.01168.
C) Taking the reciprocal gives the number of Swiss francs exchangeable for one Japanese yen
D) All of these

Question 37

Forward contracts ________.

A) typically have a maturity of more than 2 years.
B) that are shorter-dated have relatively large bid-ask spreads.
C) are not attractive for hedging long-dated foreign currency exposure.
D) that are longer-dated have a the bid-ask spread (for a given currency) that decreases with the maturity of the contract.

Question 38

On the corporate side, the primary issuance of corporate debt denominated in the euro has become small and not liquid.

Question 39

Four instruments are available to borrowers and investors to protect against adverse foreign-exchange rate movements including ________.

A) currency forward contracts and currency futures contracts.
B) currency forward contracts but not currency swaps.
C) currency futures contracts but not currency options.
D) currency options but not currency swaps.

Question 40

Which of the below statements is FALSE?

A) The foreign-exchange market is an over-the-counter market that operates 24 hours a day.
B) Market participants who want to buy or sell a currency must search different dealers to get the best exchange rate on a specific currency.
C) Foreign-exchange dealers do not quote one price, but quote an exchange rate at which they are willing to buy a foreign currency and one at which they are willing to sell a foreign currency.
D) Dealers in the foreign-exchange market are large international banks and other financial institutions that specialize in making markets in foreign exchange with commercial banks playing a small part of this market.

Question 41

The currency pair that is most commonly traded is U.S. dollar against Japanese yen (USD/JPY).

Question 42

As the currency swap market developed, the arbitrage opportunities for reduced funding costs that were available in the early days of the swap market became more common.

Question 43

The foreign exchange market can best be described as an interbank over-the-counter market.

Question 44

Exchange rate quotations may be either direct or indirect. The difference depends on identifying one currency as a local currency and the other as a foreign currency.

Question 45

Prior to the establishment of the currency swap market, capitalizing on such arbitrage opportunities did not require use of the currency forward market.

Question 46

On March 9, 2009, a U.S. investor is given a direct quote of 0.010113 U.S. dollars for one Japanese yen. That is, the price of a yen is $0.010113. The reciprocal of the direct quote is 98.88263, which would be the indirect quote for the U.S. investor; that is, one U.S. dollar can be exchanged for 98.88263 yens, which is the yen price of a U.S. dollar.

Question 47

Dealers in the foreign exchange market realize revenue from commissions charged on foreign exchange transactions.

Question 48

Members of the EMU are said to be part of "Euroland" or the "euro zone" because the euro became the only legal currency.

Question 49

Both European and U.S. investment banks play insignificant roles in the primary issuance of corporate debt denominated in euros.

Question 50

How do we mathematically express interest rate parity? In your answer describe all relevant variables.

Question 51

The market for long-dated forward exchange rate contracts is thin, which decreases the cost of eliminating foreign-exchange risk.

Question 52

What is a key factor affecting the expectation of changes in a country's exchange rate with another currency? Explain in terms of the purchasing power parity relationship?

Question 53

In a world with market imperfections, it may be possible for an issuer to reduce its borrowing cost by borrowing funds denominated in a foreign currency and hedging the associated exchange rate risk, also known as an arbitrage opportunity.

Question 54

The development of the swap market reduced arbitrage opportunities.

Question 55

Exchange rate quotations may be either direct or indirect. Distinguish between a direct and an indirect quote.

Question 56

From the perspective of a U.S. investor, the cash flows of assets denominated in a foreign currency offer the investor to certainty as to the actual level of the cash flow measured in U.S. dollars.

Question 57

To qualify as a participating country in the EMU requires that a country satisfy certain economic standards. Describe these standards. Have they been achieved?

Question 58

The birth of the euro was smooth and uneventful in terms of both market volatility and operations.

Question 59

What is the spot (or cash) exchange rate market? Are exchange rates free to float?

Question 60

Dealers in the foreign exchange market realize revenue from the bid-ask spread but not from trading profits.

Question 61

Contrast what a currency option contract gives compared to a forward or futures contract. What is the option price?

Question 62

To derive the theoretical forward exchange rate using the arbitrage argument, we made several assumptions. When the assumptions are violated, the actual forward exchange rate may deviate from the theoretical forward exchange rate. Describe two of these assumptions.