Deck 13: Foreign Exchange Risk

Question 1

State regulation of the U.S. insurance industry has an effect on the ability of insurance companies to invest in foreign securities.

Answer 1

True

Question 2

The FX markets of the world have become one of the largest of all financial markets.

Answer 2

True

Question 3

Forward contracts in FX are typically written for periods exceeding 6 months.

Answer 3

False

Question 4

As of March 2012, U.S. banks were net short British pounds.

Question 5

The exposure to foreign exchange risk by U.S. FIs has decreased with the growth of the various derivative markets.

Question 6

An FI can eliminate its currency risk exposure by matching its foreign currency assets to its foreign currency liabilities.

Question 7

The greater the volatility of foreign exchange rates given any net exposure position, the greater the fluctuations in value of the foreign exchange portfolio.

Question 8

The foreign exchange market in Tokyo is the largest FX trading market.

Question 9

U.S. pension funds invest approximately one percent (1%) of their portfolios in foreign securities.

Question 10

The market in which foreign currency is traded for future delivery is the forward foreign exchange market.

Question 11

A positive net exposure position in FX implies an FI has purchased more foreign currency than it has sold.

Question 12

The underlying cause of foreign exchange volatility reflects fluctuations in the demand and supply of a country's currency.

Question 13

Most profits or losses on foreign trading come from taking an open position in currencies.

Question 14

As the U.S. dollar appreciates against the Japanese yen, U.S. goods become less expensive to Japanese consumers.

Question 15

Most nonbank FIs have foreign exchange risk exposure that is smaller than the exposure of the large U.S. money-center banks.

Question 16

A positive net exposure position in FX implies the FI is net short in a currency.

Question 17

As the U.S. dollar appreciates against the Japanese yen, Japanese goods sold in the U.S. become less expensive to the U.S. consumer.

Question 18

The spot foreign exchange market is where forward and futures contracts and swap agreements are transacted.

Question 19

To a U.S. trader of foreign currencies, a direct quote indicates U.S. dollars received for each one unit of the foreign currency.

Question 20

U.S. life insurance companies generally hold less than ten percent (10%) of their portfolios in foreign securities.

Question 21

Purchasing power parity is based on the difference in productive output (GDP) that exists between two countries.

Question 22

During the late 2000's financial crisis, global stock market return correlations decreased relative to the decade before the crisis.

Question 23

Which of the following is NOT a source of foreign exchange risk?

A)Trading foreign currencies.
B)Making domestic-currency loans to foreign corporations.
C)Buying foreign-issued securities.
D)Issuing foreign currency-denominated debt.
E)Making foreign currency loans.

Question 24

On-balance-sheet hedging involves making changes in the on-balance-sheet assets and liabilities to protect FI profits from FX risk without the use of derivative securities.

Question 25

During 2012, the top four banks that operate in foreign currency trading comprised almost half of the market.

Question 26

FX trading risk exposure continues into the night until all FI operations are closed.

Question 27

Profits in foreign exchange trading have grown despite the decreased volatility in FX rates in European countries.

Question 28

Long-term violations of the interest rate parity relationship may occur if imperfections in the international financial markets are allowed to exist.

Question 29

The real interest rate reflects the underlying real sector demand and supply for funds denominated in the domestic currency.

Question 30

Violation of the interest rate parity theorem would allow arbitrage profits.

Question 31

The use of an exchange rate forward contract assures the FI of the opportunity to buy (or sell) the foreign currency at a future time at a known price.

Question 32

An FI can control its FX risk exposure by on-balance-sheet and off-balance-sheet hedging.

Question 33

Off-balance-sheet hedging involves taking a position in FX forward or other derivative securities even though no FX assets or liabilities are on the balance sheet.

Question 34

Directly matching foreign asset and liability books in the same FX currency will allow an FI to hedge or lock in a profit spread regardless of future changes in exchange rates.

Question 35

Average daily turnover in the FX market has recently been over $4 trillion.

Question 36

The total FX risk for a domestic bank that is making a one-year loan in a foreign currency is that the interest income expected on the loan is exposed to a depreciation of the foreign currency.

Question 37

FX trading income is derived only from profit (or loss) on the FI's speculative currency positions.

Question 38

The reason an FI receives a fee when purchasing foreign currencies to allow customers to complete international transactions is because the FI assumes some FX risk.

Question 39

The market in which foreign currency is traded for immediate delivery is the

A)spot market.
B)forward market.
C)futures market.
D)currency swap market.
E)London capital market.

Question 40

Interest rate parity implies that the discounted spread between interest rates in two currencies should equal the percentage spread between forward and spot exchange rates.

Question 41

The nominal interest rate is equal to the

A)real interest rate minus the inflation premium.
B)real interest rate minus the trailing inflation rate.
C)real interest rate plus the expected interest rate increase.
D)real interest rate plus the expected inflation rate.
E)real interest rate plus the interest rate volatility.

Question 42

The decrease in European FX volatility during the last decade has occurred because of

A)the stabilizing force of the euro.
B)reduction in inflation rates in European countries.
C)the reduced volatility in many emerging-market countries.
D)the greater volatilities of Asian currencies.
E)Answers A and B only.

Question 43

Most profits or losses on foreign trading for FIs come from

A)open positions or speculation.
B)market making.
C)acting as agents for retail customers.
D)acting as agents for wholesale customers.
E)hedging activities.

Question 44

As of 2012, which of the following FX "markets" is the largest?

A)London.
B)New York.
C)Tokyo.
D)Hong Kong.
E)Zurich.

Question 45

The FI is acting as a FX market agent for its customers when it

A)buys or sells currency to balance the FI's net exposure.
B)takes a nonzero net position in a particular currency.
C)processes an exporter's transaction in a foreign currency.
D)makes a market in its domestic currency.
E)advises customers on their international business.

Question 46

A positive net exposure position in FX implies that the FI is

A)net long in a currency and exposed to depreciation of the foreign currency.
B)net short in a currency and exposed to depreciation of the foreign currency.
C)net long in a currency and exposed to appreciation of the foreign currency.
D)net short in a currency and exposed to appreciation of the foreign currency.
E)neither long nor short in a currency.

Question 47

A negative net exposure position in FX implies that the FI is

A)net long in a currency and exposed to depreciation of the foreign currency.
B)net short in a currency and exposed to depreciation of the foreign currency.
C)net long in a currency and exposed to appreciation of the foreign currency.
D)net short in a currency and exposed to appreciation of the foreign currency.
E)neither long nor short in a currency.

Question 48

The FI is acting as a speculator when it

A)buys or sells currency to balance the FI's net exposure.
B)takes a nonzero net position in a particular currency.
C)processes an exporter's transaction in a foreign currency.
D)makes a market in a currency.
E)advises customers on their international business.

Question 49

The reasons nondepository FIs have less FX risk than major money center banks include

A)Smaller asset sizes.
B)Prudent person concerns.
C)Regulations.
D)All of the above.
E)Answers A and C only.

Question 50

When purchasing and selling foreign currencies to allow customers to take positions in foreign real and financial investments, the FI

A)acts defensively as a hedger.
B)acts aggressively as a speculator.
C)assumes the FX risk itself.
D)acts as an agent.
E)acts as a market maker.

Question 51

In which of the following FX trading activities does the FI not assume FX risk?

A)The purchase and sale of foreign currencies for the purpose of profiting from forecasting or anticipating future movements in FX rates.
B)The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.
C)The purchase and sale of foreign currencies for the purpose of offsetting customer exposure in any given currency.
D)The purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.
E)Answers B and D only.

Question 52

The decline in European FX volatility during the last decade has been offset in part by

A)the greater volatilities of Asian currencies.
B)a reduction in inflation rates in European countries.
C)the fixing of exchange rates among European countries.
D)the replacement of domestic currencies with the euro.
E)None of the above.

Question 53

The FI is acting as a hedger when it

A)buys or sells currency to balance the FI's net exposure.
B)takes a nonzero net position in a particular currency.
C)processes an exporter's transaction in a foreign currency.
D)makes a market in a currency.
E)advises customers on their international business.

Question 54

Deviations from the international currency parity relationships may occur because of

A)free capital movements across national boundaries.
B)barriers to cross-border financial flows.
C)perfect rationality of market participants.
D)differences in each country's productive capacity.
E)Basel capital regulations.

Question 55

If foreign currency exchange rates are highly positively correlated, how can a FI reduce its exchange rate risk exposure?

A)By taking net long positions in all currencies.
B)By taking net short positions in all currencies.
C)By taking opposing net short and net long positions in different currencies.
D)By maximizing net FX exposure in each currency, independently.
E)By minimizing net FX exposure in each currency, independently.

Question 56

U.S. pension funds hold approximately _______ of their assets in foreign securities, while British pension funds have traditionally invested approximately _______ of their funds in foreign assets.

A)20 percent; 5 percent
B)5 percent; 20 percent
C)0 percent; 30 percent
D)30 percent; 10 percent
E)20 percent; 20 percent

Question 57

Which of the following FX trading activities is used for purposes of speculation?

A)The purchase and sale of foreign currencies for the purpose of profiting from forecasting or anticipating future movements in FX rates.
B)The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.
C)The purchase and sale of foreign currencies for the purpose of offsetting customer exposure in any given currency.
D)The purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.
E)None of the above.

Question 58

Which of the following FX trading activities is used to hedge FX risk?

A)The purchase and sale of foreign currencies for the purpose of profiting from forecasting or anticipating future movements in FX rates.
B)The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.
C)The purchase and sale of foreign currencies for the purpose of offsetting customer exposure in any given currency.
D)The purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.
E)None of the above.

Question 59

Which of the following factors help explain the decline in FX trading in the early years of this century?

A)Introduction of the euro.
B)Consolidation in the banking industry.
C)Growth of electronic brokering.
D)Mergers in the corporate sector.
E)All of the above.

Question 60

FX risk exposure of an FI essentially relates to which of the following activities?

A)Purchase and sale of foreign currencies to allow customers to participate in and complete international commercial trade transactions.
B)Purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.
C)Purchase and sale of foreign currencies for hedging purposes to offset customer exposure in any given currency.
D)Purchase and sale of foreign currencies for speculative purposes through forecasting or anticipating future movements in FX rates.
E)None of the above.

Question 61

What is the FI's net exposure in the Japanese yen?

A)+30,000.
B)+40,600.
C)-19,400.
D)-40,600.
E)+20,600.

Question 62

According to purchasing power parity (PPP), foreign currency exchange rates between two countries adjust to reflect changes in each country's

A)unemployment rates.
B)export competitiveness.
C)inflation rates.
D)foreign exchange reserves.
E)reserve requirements.

Question 63

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year when the FI needed to repatriate the principal and interest on the loan. What would the dollar loan revenues at the end of the year be as a return on the original dollar investment?

A)13%.
B)12.55%.
C)16%.
D)8.75%.
E)7.25%.

Question 64

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year, the net interest margin for the FI on its balance sheet investments is

A)3.2875%.
B)-3.2875%.
C)4%.
D)8.75%.
E)0.375%.

Question 65

How would you characterize the FI's risk exposure to fluctuations in the Euro to dollar exchange rate?

A)The FI is net short in the Euro and therefore faces the risk that the Euro will rise in value against the U.S.dollar.
B)The FI is net short in the Euro and therefore faces the risk that the Euro will fall in value against the U.S.dollar.
C)The FI is net long in the Euro and therefore faces the risk that the Euro will fall in value against the U.S.dollar.
D)The FI is net long in the Euro and therefore faces the risk that the Euro will rise in value against the U.S.dollar.
E)The FI has a balanced position in the Euro.

Question 66

The following are the net currency positions of a U.S. FI (stated in U.S. dollars).
Note: Net currency positions are foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms. $$\begin{array} { | l | r | } \hline { \text { Currency } } & \text { Net Position } \\\hline \text { Canadian Dollar } & \text { +US \$1,200 } \\\hline \text { Euro } & \text {-US \$245,900 } \\\hline \text { Japanese Yen } & \text { +US \$505,000 } \\\hline \text { Swiss Franc } & \text {-US \$36,700 } \\\hline \text { British Pound } & \text { +US \$447,900 } \\\hline\end{array}$$

-What is the FI's total FX investment?

A)US $671,500.
B)US $1,236,700.
C)-US $671,500.
D)-US $1,236,700.
E)0

Question 67

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
The weighted return on the bank's portfolio of investments would be

A)15%.
B)12%.
C)16%.
D)13%.
E)7%.

Question 68

What is the portfolio weight of the Euro in this FI's portfolio of foreign currency?

A)+0.18 percent.
B)-36.62 percent.
C)+75.20 percent.
D)-5.47 percent.
E)+66.70 percent.

Question 69

What is the portfolio weight of the Japanese yen in this FI's portfolio of foreign currency?

A)+0.18 percent.
B)-36.62 percent.
C)+75.20 percent.
D)-5.47 percent.
E)+66.70 percent.

Question 70

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year, the weighted return on the FI's asset portfolio would be

A)13.29%.
B)12.56%.
C)16%.
D)8.75%.
E)9.375%.

Question 71

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
What amount, in sterling, will the FI have to repatriate back to the U.S. after one year if the exchange rate remains constant at $1.60 to ≤1.

A)≤6.25 million.
B)≤7.875 million.
C)≤7.25 million.
D)≤6.625 million.
E)≤11.26 million.

Question 72

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
If the spot foreign exchange rate remains constant at $1.60 to ≤1 throughout the year, the return from the U.K. investment will be

A)15%.
B)12%.
C)16%.
D)13%.
E)7%.

Question 73

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year when the FI needed to repatriate the principal and interest on the loan. What would be the dollar loan amount repatriated at the end of the year?

A)$6.25 million.
B)$11.6 million.
C)$7.25 million.
D)$6.625 million.
E)$10.875 million.

Question 74

How would you characterize the FI's risk exposure to fluctuations in the British pound to dollar exchange rate?

A)The FI is net short in the British pound and therefore faces the risk that the British pound will rise in value against the U.S.dollar.
B)The FI is net short in the British pound and therefore faces the risk that the British pound will fall in value against the U.S.dollar.
C)The FI is net long in the British pound and therefore faces the risk that the British pound will fall in value against the U.S.dollar.
D)The FI is net long in the British pound and therefore faces the risk that the British pound will rise in value against the U.S.dollar.
E)The FI has a balanced position in the British pound.

Question 75

What is the FI's net exposure in the Swiss franc?

A)+2,400.
B)+400.
C)-2,800.
D)-2,400.
E)+3,200.

Question 76

Which of the following is an example of interest rate parity?

A)The Japanese yen trades at the same exchange rate as the Swiss franc.
B)U.S.dollar rates on one year U.S.Treasury securities equal 1 year Japanese government bond rates.
C)U.S.dollar rates on one year U.S.Treasury securities equal 1 year Japanese government bond rates, restated in dollars.
D)British pound 2 year forward rates equal 2 year Swiss franc forward rates.
E)All currency exchange rates and interest rates move in unison.

Question 77

How would you characterize the FI's risk exposure to fluctuations in the Swiss franc/dollar exchange rate?

A)The FI is net short in the franc and therefore faces the risk that the franc will rise in value against the U.S.dollar.
B)The FI is net short in the franc and therefore faces the risk that the franc will fall in value against the U.S.dollar.
C)The FI is net long in the franc and therefore faces the risk that the franc will fall in value against the U.S.dollar.
D)The FI is net long in the franc and therefore faces the risk that the franc will rise in value against the U.S.dollar.
E)The FI has a balanced position in the Swiss franc.

Question 78

How would you characterize the FI's risk exposure to fluctuations in the yen/dollar exchange rate?

A)The FI is net short in the yen and therefore faces the risk that the yen will rise in value against the U.S.dollar.
B)The FI is net short in the yen and therefore faces the risk that the yen will fall in value against the U.S.dollar.
C)The FI is net long in the yen and therefore faces the risk that the yen will fall in value against the U.S.dollar.
D)The FI is net long in the yen and therefore faces the risk that the yen will rise in value against the U.S.dollar.
E)The FI has a balanced position in the Japanese yen.

Question 79

How would you characterize the FI's risk exposure to fluctuations in the yen/dollar exchange rate?

A)The FI is net short in the yen and therefore faces the risk that the yen will rise in value against the U.S.dollar.
B)The FI is net short in the yen and therefore faces the risk that the yen will fall in value against the U.S.dollar.
C)The FI is net long in the yen and therefore faces the risk that the yen will fall in value against the U.S.dollar.
D)The FI is net long in the yen and therefore faces the risk that the yen will rise in value against the U.S.dollar.
E)The FI has a balanced position in the Japanese yen.

Question 80

The following are the net currency positions of a U.S. FI (stated in U.S. dollars). $$\begin{array} { | l | l | r | r | r | } \hline \text { Currency } & \text { Assets } & \text { Liabilities } & \text { FX Bought } & \text { FX Sold } \\\hline \text { British pound } & 24,600 & 70,000 & 170,400 & 321,000 \\\hline \text { Yen } & 31,000 & 20,400 & 250,000 & 220,000 \\\hline \text { Swiss franc } & 10,200 & 9,800 & 8,000 & 10,800 \\\hline\end{array}$$

-What is the FI's net exposure in British pounds?

A)-45,400.
B)-150,600.
C)-196,000.
D)+105,200.
E)+196,000.