Deck 10: The Foreign Exchange Market

Question 1

What happens in the foreign exchange market does not directly impact the sales, profits, and strategy of a multinational enterprise.

Answer 1

False
Explanation: What happens in the foreign exchange market can have a fundamental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand the foreign exchange market, and what the impact of changes in currency exchange rates might be for their enterprise.

Question 2

When companies wish to convert currencies, they typically enter the foreign exchange market directly.

Answer 2

False
Explanation: 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. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly.

Question 3

Currency 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.

Answer 3

True
Explanation: A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. 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.

Question 4

A common kind of currency swap is spot against forward.

Question 5

Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side.

Question 6

Inflation occurs when the money supply in a country increases faster than output increases.

Question 7

In the context of The Economist's "Big Mac Index," assume that the average price of a Big Mac in South Korea is $2.98 at the prevailing won/dollar exchange rate. The average price of a Big Mac in the United States is $3.58. This suggests that the Korean won is overvalued against the U.S. dollar.

Question 8

When a firm enters into a spot exchange contract, it is taking out insurance against adverse future exchange rate movements.

Question 9

The euro/dollar exchange rate is €1 = $1.20. If it costs $36 to buy a European product, the stated price of the product would be €36.

Question 10

For price discrimination to work, arbitrage opportunities must be unlimited.

Question 11

The forward exchange rate refers to the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

Question 12

The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates is known as countertrade.

Question 13

The foreign exchange market offers complete insurance against foreign exchange risk.

Question 14

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.

Question 15

Spot exchange rates and the 30-day forward rates are the same.

Question 16

In countries where inflation is expected to be high, interest rates also will be high.

Question 17

Unlike the purchasing power parity theory, the international Fisher effect is a good predictor of short-run changes in spot exchange rates.

Question 18

Companies engage in currency speculation to get minimal but assured returns from idle cash.

Question 19

Carry trade is a kind of speculation whose success is based upon a belief that there will be no adverse movement in exchange rates.

Question 20

The integration of financial centers implies there can be no significant difference in exchange rates quoted in the foreign exchange trading centers.

Question 21

The currency of the country of Venadia falls sharply in value against the currency of Lutetia, a neighboring country. Which of the following is a consequence of this exchange rate movement?

A)Lutetia's products will achieve a competitive pricing in Venadia.
B)Venadia's exports to Lutetia will increase, because Venadian goods will become cheaper in Lutetia.
C)Venadia's products will cost more in Lutetia.
D)There will be no difference in the volume or direction of trade.
E)Lutetia's exports to Venadia will increase, because Lutetian goods will become cheaper in Venadia.

Question 22

The interest rate on borrowings in Rhodia is 2 percent and the interest rate on bank deposits in Maritia is 7.5 percent. In this scenario, a carry trade would be to:

A)borrow money in Maritian currency, convert it into Rhodian currency, and deposit it in a Rhodian bank.
B)borrow money in Rhodian currency and invest in stocks with good growth potential in Rhodia.
C)borrow money in Rhodian currency, convert it into Maritian currency, and deposit it in a Maritian bank.
D)invest in bank deposits of Maritia and reinvest the earnings in Rhodia.
E)invest in bank deposits of Rhodia and reinvest the earnings in Maritia.

Question 23

When residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency, the phenomenon is generally referred to as capital flight.

Question 24

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates.

Question 25

Which of the following caused a decline in the dollar/yen carry trade during 2008-2009?

A)Increase in risk appetite making the carry trade less attractive
B)Decrease in interest rate differentials as the U.S. rates came down
C)Increase in interest rate differentials as Japanese interest rates came down
D)Decrease in interest rate differentials as the U.S. interest rates went up
E)Decrease in interest rate differentials as the Japanese rates went up

Question 26

Which of the following is a function of the foreign exchange market?

A)To provide some insurance against foreign exchange risk
B)To protect short-term cash flow from adverse changes in exchange rates
C)To eliminate volatile changes in exchange rates
D)To reduce the economic exposure of a firm
E)To enable companies to engage in capital flight when countertrade is not possible

Question 27

How are spot exchange rates determined?

A)By using historical average prices of different currencies
B)By the interaction between demand and supply of a currency relative to other currencies
C)By taking the average of a basket of currencies
D)By government decree
E)By predicting future currency movements

Question 28

Transaction exposure, a category of foreign exchange risk, refers to the impact of currency exchange rate changes on the reported financial statements of a company.

Question 29

Economic exposure, a category of foreign exchange risk, is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months.

Question 30

Robben Inc. converts $1,000,000 into euros when the exchange rate is $1 = €0.75. After three months, the company converts this back into dollars when the exchange rate is $1 = €0.80. Which of the following is the outcome of this transaction?

A)A loss of $62,500
B)A loss of $66,667
C)A gain of $50,000
D)A gain of $62,500
E)A loss of $50,000

Question 31

A French company wants to invest 20 million euros for three months. The company found that investing in a Thai money market account would give it a higher interest rate than domestic investments. Which of the following is true about this investment?

A)The investment is risk-free because money market investments are considered to be equivalent to bank deposits.
B)The investment is not risk-free because foreign currency movements in the intervening period can affect the profitability of the firm.
C)The investment is risk-free because such investments also lock foreign exchange rates for the duration of the investment.
D)The investment is not risk-free because money market instruments are considered to be the most speculative of all investments.
E)The investment is risk-free because the Thai money market is considered to be more stable and secure than other markets.

Question 32

Which of the following refers to carry trade?

A)Providing insurance or hedging against the risks that arise from volatile changes in exchange rates
B)A transaction between two parties that involves exchanging currency and executing a deal at some specific date in the future
C)Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
D)The purchase of securities in one market for immediate resale in another to profit from a price discrepancy
E)Borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high

Question 33

In terms of exchange rate forecasting, the efficient market school argues that companies should spend additional money trying to forecast short-run exchange rate movements.

Question 34

Leading and lagging strategies involve accelerating payments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.

Question 35

Steven converted $1,000 to ×105,000 for a trip to Japan. However, he spent only ×50,000. During this period, the value of the dollar weakened against the yen. Considering a current exchange rate of $1 = ×100, how many dollars did Steven spend on the trip?

A)$550
B)$523
C)$450
D)$600
E)$500

Question 36

Which of the following enables organizations to conduct international trade without having to resort to barter?

A)Foreign exchange market
B)Caribbean Single Market and Economy
C)Auction market
D)Countertrade
E)Balance-of-trade equilibrium

Question 37

Technical analysis, an approach to foreign exchange forecasting, does not rely on a consideration of economic fundamentals.

Question 38

Which of the following refers to currency speculation?

A)The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
B)The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day
C)Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
D)The purchase of securities in one market for immediate resale in another to profit from a price discrepancy
E)The growth in a country's money supply exceeding the growth in its output, leading to price inflation

Question 39

What is a firm engaging in when it insures itself against foreign exchange risk?

A)Currency speculation
B)Carry trade
C)Hedging
D)Currency swap
E)Arbitrage

Question 40

The speculative element of the carry trade is that its success is based upon a belief that:

A)there will be no adverse movement in exchange rates or interest rates.
B)liquidity is the key factor in determining interest rates.
C)increasing money supply will not drive inflation.
D)spot exchange rates are more favorable than forward exchange rates.
E)hedging insures a company against foreign exchange risks.

Question 41

Which of the following has no impediments to the free flow of goods and services, such as trade barriers?

A)Economic Union
B)Currency Board
C)Efficient market
D)Carry trade
E)European Monetary System

Question 42

What is meant by arbitrage?

A)To provide insurance or hedge against the risks that arise from volatile changes in exchange rates
B)A transaction between two parties that involves exchanging currency and executing a deal at some specific date in the future
C)Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
D)The purchase of securities in one market for immediate resale in another to profit from a price discrepancy
E)To borrow in one currency where interest rates are low and use the proceeds to invest in another currency where interest rates are high

Question 43

Which of the following transactions is used to move out of one currency and into another for a limited period without incurring foreign exchange risk?

A)Currency swap
B)Currency speculation
C)Carry trade
D)Spot exchange
E)Arbitrage

Question 44

The euro/dollar exchange rate is €1 = $1.20. According to the law of one price, how much would a camera that retails for $300 in New York sell for in Germany?

A)€320
B)€300
C)€250
D)€360
E)€150

Question 45

The law of one price states that:

A)by comparing the prices of identical products in different currencies, it would be possible to determine the "real" or PPP exchange rate that would exist if markets were efficient.
B)a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I).
C)a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower.
D)when the growth in a country's money supply is faster than the growth in its output, price inflation is fueled.
E)in competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

Question 46

To express the PPP theory in symbols, let P_$ be the U.S. dollar price of a basket of particular goods and P_× be the price of the same basket of goods in Japanese yen. What does the purchasing power parity (PPP) theory predict to be the equivalent of the dollar/yen exchange rate, E_$/×?

A)E_$/× = (1 + P_×)/P_$
B)E_$/× = (1 + P_$)/P_×
C)E_$/× = P_×/P_$
D)E_$/× = P_$/P_×
E)E_$/× = (1 + P_$)/(1 + P_×)

Question 47

Which of the following instances indicates that the dollar is selling at a premium on the 30-day forward market?

A)The spot exchange rate is currently $1 = ×120 and changes to $1 = ×130 after 30 days.
B)The spot exchange rate is currently $1 = ×120 and changes to $1 = ×110 after 30 days.
C)The current spot exchange rate is $1 = ×120 and the 30-day forward rate is $1 = ×110 after 30 days.
D)The current spot exchange rate is $1 = ×120 and the 30-day forward rate is $1 = ×130 after 30 days.
E)The current spot exchange rate is $1 = ×120 and the 30-day forward rate is $1 = ×120.

Question 48

Which of the following occurs when two parties agree to exchange currency and execute the deal at some specific date in the future?

A)Forward exchange
B)Spot exchange
C)Carry trade
D)Currency swap
E)Arbitrage

Question 49

An American company imports laptop computers from Japan. The company knows that after a shipment arrives, it must pay in yen to the Japanese supplier within 30 days. In a particular exchange, the American company must pay the Japanese supplier ×150,000 for each computer at the current dollar/yen spot exchange rate of $1 = ×110. The company intends to resell the computers the day they arrive for $1,600 each but it does not have the funds to pay the Japanese supplier until the computers have been sold. Which of the following will happen if the exchange rate after 30 days is $1 = ×90?

A)The importer will earn a profit of approximately $236 per computer.
B)The importer will earn a profit of approximately $67 per computer.
C)The importer will incur a loss of approximately $236 per computer.
D)The importer will incur a loss of approximately $67 per computer.
E)The importer will incur a loss of approximately $90 per computer.

Question 50

The yen/dollar exchange rate is ×120 = $1 in London and ×123 = $1 in New York at the same time. What is the net profit if a dealer takes $1,000,000 to purchase ×123,000,000 in New York and engages in arbitrage by selling it in London?

A)$34,000
B)$20,390
C)$25,000
D)$46,666
E)$39,454

Question 51

Which of the following is true of the differences in relative demand and supply of currencies?

A)They cannot be used to explain the determination of exchange rates.
B)While they provide an understanding of the major factors underlying exchange rates, they exclude minor factors.
C)They provide a high-level understanding of exchange rates.
D)While they provide an accurate explanation for appreciation of currencies, they fail to explain depreciation.
E)They cannot explain or predict when the demand of a particular currency would exceed its supply and vice versa.

Question 52

Which of the following is true of the determination of exchange rates?

A)Differences in relative demand and supply do not explain the determination of exchange rates.
B)Differences in relative demand and supply explain the factors underlying the phenomenon behind the demand for and supply of a currency.
C)The differences in relative demand and supply alone provide a high-level understanding of what's behind the determination of exchange rates.
D)While the differences in relative demand and supply provide an accurate explanation for appreciation of currencies, they fail to explain depreciation.
E)The differences in relative demand and supply cannot explain or predict the conditions under which a particular currency will be in demand or not.

Question 53

Assume that the yen/dollar exchange rate quoted in London at 3 p.m. is ×120 = $1, and the New York yen/dollar exchange rate at the same time (10 a.m. New York time) is ×123 = $1. Which of the following transactions would yield immediate profit?

A)Forward exchange
B)Carry trade
C)Currency swap
D)Arbitrage
E)Currency speculation

Question 54

Assume that the dollar is selling at a premium on the 30-day dollar/euro forward market. Which of the following is true of the foreign exchange dealers' market's expectations about the dollar over the next 30 days?

A)The dollar will depreciate against the euro.
B)The market is undecided about the direction of currency movement.
C)The dollar will appreciate against the euro.
D)The dollar/euro exchange rate will be steady.
E)The dollar will buy more euros with a spot exchange than with a 30-day forward exchange.

Question 55

If a basket of goods costs $100 in the United States and €120 in Europe, what would the purchasing power parity theory's prediction of the dollar/euro exchange rate be?

A)$1 = €1.20
B)$1 = €1
C)$1 = €0.80
D)$1 = €0.90
E)$1 = €1.10

Question 56

Which of the following is a reason for London's dominance in the foreign exchange market?

A)Great Britain's decision to retain the British pound instead of using the euro
B)The preeminence of Financial Times Stock Exchange (FTSE) index as an economic health indicator
C)London's location making it the link between the East Asian and New York markets
D)London being the preferred headquarters destination for major multinational corporations
E)London's trading centers opening soon after Tokyo's and New York's trading centers closing for the night

Question 57

Which of the following foreign exchange trading centers has the highest percentage of activity?

A)Frankfurt
B)London
C)Paris
D)Hong Kong
E)Sydney

Question 58

A U.S. company that imports laptop computers from Japan knows that in 30 days it must pay in yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ×150,000 for each computer, and the current dollar/yen spot exchange rate is $1 = ×110. The importer can sell the computers the day they arrive for $1,600 each. However, the importer will not have the funds to pay the Japanese supplier until the computers have been sold. The importer enters into a 30-day forward exchange transaction with a foreign exchange dealer at $1 = ×105. Which of the following will happen if the exchange rate after 30 days is $1 = ×90?

A)The importer will earn a profit of approximately $236 per computer.
B)The importer will earn a profit of approximately $171 per computer.
C)The importer will earn a profit of approximately $65 per computer.
D)The importer will incur a loss of approximately $67 per computer.
E)The importer will incur a loss of approximately $105 per computer.

Question 59

Which of the following indicates that the dollar is selling at a discount on the 30-day forward market?

A)The spot exchange rate is $1 = ×120 currently and $1 = ×130 after 30 days.
B)The spot exchange rate is $1 = ×120 currently and $1 = ×100 after 30 days.
C)The current spot exchange rate is $1 = ×120 and the 30-day forward rate is $1 = ×110 after 30 days.
D)The current spot exchange rate is $1 = ×120 and the 30-day forward rate is $1 = ×130 after 30 days.
E)The current spot exchange rate is $1 = ×120 and the 30-day forward rate is $1 = ×120 after 30 days.

Question 60

Which of the following is a key feature of the foreign exchange market?

A)The foreign exchange market never sleeps.
B)The foreign exchange market is located in London.
C)The foreign exchange market is characterized by high transaction costs.
D)The foreign exchange market is shut for two hours every day.
E)The foreign exchange market is poorly interconnected giving rise to ample arbitrage opportunities.

Question 61

Which of the following is illustrated by the Big Mac Index published by The Economist?

A)The law of one price
B)The purchasing power parity theorem
C)The Fisher effect
D)Flow of FDI
E)The bandwagon effect

Question 62

In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship is referred to as the:

A)PPP theory puzzle.
B)lead strategy.
C)Fisher effect.
D)bandwagon effect.
E)international Fisher effect.

Question 63

The purchasing power parity (PPP) theory tells us that a country with a high inflation rate will see:

A)appreciation in its currency exchange rate.
B)a decrease in interest rates.
C)the collapse of the gold standard.
D)depreciation in its currency exchange rate.
E)a decrease in its money supply.

Question 64

Which of the following is a reason for the failure of the purchasing power parity (PPP) theory to predict exchange rates accurately?

A)It assumes away transportation costs and trade barriers.
B)It does not take into account the law of one price.
C)It does not take into account the practice of arbitrage.
D)It assumes that the markets are not efficient.
E)It does not consider government influence on a nation's money supply.

Question 65

The nominal interest rate is 9 percent in Brazil and 6 percent in Japan. Applying the international Fisher effect, the Brazilian real should:

A)appreciate by 3 percent against the Japanese yen.
B)depreciate by 3 percent against the Japanese yen.
C)appreciate by 1.5 percent against the Japanese yen.
D)depreciate by 1.5 percent against the Japanese yen.
E)appreciate by 15 percent against the Japanese yen.

Question 66

If a country's government does not control the rate of growth in money supply:

A)its future inflation rate will be low.
B)its taxes will decrease in the future.
C)it will see reduced spending on public infrastructure projects.
D)its currency could depreciate in the future.
E)its output of goods and services will exceed money supply, thereby fueling deflation.

Question 67

Which of the following is true of the purchasing power parity (PPP) theory?

A)A country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I).
B)The exchange rate will not change if relative prices change.
C)The price of a "basket of goods" should be roughly equivalent in each country in relatively efficient markets.
D)In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price.
E)If the law of one price were true for all goods and services, the PPP exchange rate could not be found from any individual set of prices.

Question 68

The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the:

A)currency crisis.
B)banking crisis.
C)purchasing power parity puzzle.
D)bandwagon effect.
E)foreign exchange risk.

Question 69

The Fisher effect states that:

A)a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I).
B)by comparing the prices of identical products in different currencies, it is possible to determine the "real" or purchasing power parity exchange rate that would exist if markets were efficient.
C)a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower.
D)when the growth in a country's money supply is faster than the growth in its output, price inflation is fueled.
E)in competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price.

Question 70

According to the Fisher effect, if the "real" rate of interest in a country is 4 percent and the expected annual inflation is 9 percent, what would the "nominal" interest rate be?

A)5 percent
B)13 percent
C)9 percent
D)36 percent
E)2.25 percent

Question 71

Which of the following is true when a government is strongly committed to controlling the rate of growth in money?

A)The country's future inflation rate may be low.
B)The country's currency will steadily depreciate significantly and instantly in the foreign exchange market.
C)The country's economy will be marked by an abundance of liquidity.
D)The country will see a good number of populist measures not funded by taxation.
E)The country will struggle to match money supply with adequate supply of goods and services.

Question 72

During inflation, an increase in the amount of currency available leads to:

A)overheating of the economy thereby reducing the production levels in the economy.
B)changes in the relative demand-and-supply conditions in the foreign exchange market.
C)a reduction in the rate of inflation thus leading to an appreciation of the currency.
D)decreased lending by banks thereby resulting in more savings.
E)a decrease in the demand for goods and services, which drives currency value higher.

Question 73

Which of the following weakens the link between relative price changes and changes in exchange rates predicted by purchasing power parity (PPP) theory by violating the assumption of efficient markets?

A)Government intervention in cross-border trade
B)The relationship between money supply and price inflation
C)The impact of increase in currency on relative demand and supply conditions of currencies
D)Excessive growth in money supply
E)The insignificant impact of transportation costs on international trade

Question 74

Which of the following is a drawback of the purchasing power parity theory?

A)It does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years.
B)It does not explain change in exchange rates in terms of change in relative prices.
C)It cannot explain when the demand of a particular currency would exceed its supply and vice versa.
D)It does not address inflation in situations where governments control the rate of growth in money supply.
E)It cannot predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets.

Question 75

Which of the following is true of inflation?

A)It occurs when the demand for a particular currency is more than the supply.
B)It occurs when securities are purchased in one market for immediate resale in another.
C)It occurs when two parties agree to exchange currency and execute a deal at a specific date in the future.
D)It occurs when the quantity of money in circulation rises faster than the stock of goods and services.
E)It occurs when output increases faster than the money supply.

Question 76

Which of the following 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)Bandwagon effect
B)Law of one price
C)International Fisher effect
D)Helms-Burton Act
E)Purchasing power parity (PPP) theory

Question 77

Which of the following occurs when a government increases the money supply?

A)It results in an overall decrease in credit.
B)It makes it difficult for individuals and companies to borrow from banks.
C)It makes it easier for banks to borrow from the government.
D)It causes a decrease in demand for goods and services.
E)It causes price deflation as the money supply exceeds goods and services output.

Question 78

The purchasing power parity (PPP) theory best predicts exchange rate changes for countries with:

A)appreciating currencies.
B)stable currencies.
C)underdeveloped capital markets.
D)small differentials in inflation rates.
E)industrialized economies.

Question 79

When dominant enterprises in an industry exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions, it is referred to as:

A)price discrimination.
B)premium pricing.
C)psychological pricing.
D)price skimming.
E)price leadership.

Question 80

Which of the following is a way in which an enterprise with some market power might limit arbitrage so that their price discrimination policy works?

A)Pricing its products identically despite huge differences in demand across different markets
B)Differentiating otherwise identical products among nations along some line, such as design or packaging
C)Adopting a pricing strategy that matches what competitors charge in each of the different national markets
D)Limiting sales of its products to only a few nations
E)Selling its products at higher prices than normal to break even by selling fewer units