CFA Level 2 - Portfolio Management Session 18 - Reading 62

CFA Level 2 - Portfolio Management Session 18 - Reading 6 (Practice Questions, Sample Questions) 1. Gerald Santana, CFA is the president and CEO of Dartmouth Ltd., a hedge fund management firm located in New York. The firm has been in existence for nearly fifteen years, and has shown consistently impressive returns since inception. Dartmouth has a wide variety of investments across a broad range of asset types that are based around the world. Members of the firm have a great deal of experience in assessing the currency exposure associated with investing in international markets. Due to a recent influx of new funds, Santana and his team have a substantial amount of uninvested cash and are currently evaluating several investment opportunities. One potential investment for the fund is a 25 percent stake in a closely-held manufacturing company located in Ireland which produces textiles for export to the United States. Prices are set and paid for in U.S. dollars, but all costs of production are incurred in Euros. Santana is somewhat concerned about the potential currency exposure of the company, although he is quite familiar with the risks involved with investing in foreign firms with multinational operations. He intends to do further analysis of expected returns given various anticipated interest rate and exchange rate scenarios. Additionally, Santana is considering placing some interim funds in some British bonds that appear cheap and are currently yielding a premium over other country’s comparable securities. In his opinion, inflation rates should remain reasonably stable over the next year and the real exchange rate between the two countries is expected to remain constant. The securities are highly liquid, so he does not anticipate any problem selling the bonds should he decide to liquidate the position prior to his anticipated one-year holding period. Current spot rates: U.S. Dollar ($) per Euro (€) 0.7600 U.S. Dollar ($) per British pound (₤): 0.5100 Current 1-year interest rates: United States 4.50% Great Britain 6.25% Expected one-year inflation rates: United States 2.25% Great Britain 5.00% International market efficiency is an effective impediment for managers from utilizing active asset allocation between countries to consistently beat the world index. However, there are six potential impediments to the international flow of capital. Which of the following factors is least likely to have an impact on market efficiency? A) Psychological barriers. B) Interest rate risk. C) Legal restrictions. Explanation: Interest rate risk, although present across all markets, is not one of the six potential barriers to international capital mobility. The other three barriers are transaction costs, political risks, and foreign currency risk. (Study Session 18, LOS 62.a) Which of the following statements regarding real exchange rates and domestic currency return is least accurate? A) Real exchange rate risk occurs if the nominal exchange rate does not change by the amount predicted by the inflation differential. B) The real exchange rate is the spot exchange rate divided by the ratio of the consumption basket price levels. C) Real exchange rate movements are defined as changes in the nominal exchange rate that are not explained by inflation differentials. Explanation: The real exchange rate is the spot exchange rate multiplied by the ratio of the consumption basket price levels. (Study Session 18, LOS 62.e) If the Euro experiences 7 percent real appreciation versus the dollar, the value of the investment in the Irish company will be impacted, all other things equal. Which of the following statements best describes the impact on Dartmouth’s investment? The Irish company will be: A) hurt by the appreciation of the Euro because the firm’s products will be more expensive in the United States. B) helped by the appreciation of the Euro because its costs of production will decline. C) hurt by the appreciation of the Euro because its costs of production will increase. Explanation: The currency appreciation will make the company’s products more expensive in the U.S., which will decrease sales. Costs will remain the same, so profitability will decline. (Study Session 18, LOS 62.l) According to the money demand model of equity exposure for a company, which of the following statements is most accurate? The money demand model: A) predicts that currency depreciation will lead to lower equity prices in a developed country. B) predicts that depreciation in the value of the domestic currency will cause an increase in the competitiveness of domestic industry. C) explains the positive correlation between changes in domestic currency and stock returns. Explanation: According to the money demand model, increased real economic activity leads to increased demand for the domestic currency. This increase in domestic currency demand causes the value of the domestic currency to appreciate, which in turn leads to increased stock returns. (Study Session 18, LOS 62.n) Santana wants to quantify the additional exchange rate risk associated with the purchase of the British securities. Calculate the expected exchange rate change at the end of one year. A) 0.4960. B) 0.5215. C) 0.5240. Explanation: If real rates remain constant, the change in the exchange rate is equal to the inflation differential. The current difference between the two countries rates is 2.75% (5.00% − 2.25%), so the expected depreciation of the pound is 2.75%. The expected exchange rate is calculated as: $0.5100/₤ × (1 − 0.0275) = $0.4960/₤ (Study Session 18, LOS 62.f) Assume that the British pound will depreciate by 3 percent over the next year. Calculate the hedge fund’s expected return on the British investment for a one year holding period. A) 3.00%. B) 3.25%. C) 4.50%. Explanation: The hedge fund is located in New York, so the domestic currency is the U.S. $. The expected dollar return on the British bond for one year is approximately equal to the British interest rate minus the depreciation of the pound. Therefore: 6.25% - 3.00% = 3.25% (Study Session 18, LOS 62.f) 2. John Swanson is an economic advisor for the international division of BMC Investments. He has been asked to gather economic data and present a seminar to other analysts regarding international economic concerns. The following three issues were raised in the seminar. Choose the most reasonable statement that Swanson should make in replying to the questions raised.The issue of growth rates across various countries was discussed and there was some disagreement regarding future expectations for growth rates across countries. Which of the following statements most accurately describe expectations of future growth rates under neoclassical theory? A) The best method for measuring the difference in growth rates internationally is using endogenous growth theory. B) Conditional convergence is predicted for countries with similar economic attributes, including savings and population growth rates. C) High-growth countries that have historically made high investment for growth will ultimately enter a steady state. Explanation: Under neoclassical theory the concept of convergence implies that high-growth countries that have historically made high investment for growth will ultimately enter a steady state. Absolute convergence, not conditional convergence, is predicted for countries with similar economic attributes, including savings and population growth rates. There is empirical evidence to suggest that countries that invest more will grow faster, but the accelerated growth is not permanent. Endogenous (new) growth theory is not of much value in explaining differences in growth rates internationally. The vice president of equity analysis believes that Japan is an integrated world market with few impediments to international flow of capital. Which of the following factors would NOT cause Swanson to question the international efficiency of Japan? A) The gross domestic product (GDP) is less for Japan than the local GDP. B) Foreign currency risk is not completely hedged away. C) The accounting system in Japan is not in accordance with Generally Accepted Accounting Principles (GAAP). Explanation: The level of GDP is not a factor in questioning the international efficiency of a country. In addition to the other factors mentioned in this question, there are several other impediments to international flow of capital. The six potential impediments to international flow of capital are psychological barriers, legal restrictions, transaction cost, discriminatory taxation, political risks, and foreign currency risk. Swanson has reason to believe that Japan will soon be making monetary policy changes that will cause the yen to suddenly depreciate 1%. If the value of a Japanese firm falls when the yen depreciates, the asset return and currency movement are: A) negatively correlated from a U.S. investor's perspective which exaggerates the currency movement impact. B) positively correlated from a U.S. investor's perspective which lessens the currency movement impact. C) positively correlated from a U.S. investor's perspective which exaggerates the currency movement impact. Explanation: If the value of a Japanese firm falls when the yen depreciates, the asset return and currency movement are positively correlated from a U.S. investor’s perspective, and this exaggerates the currency movement impact. 3. Which of the following is considered an impediment to international capital mobility? A) Foreign currency risk. B) Greek risk. C) Market risk. Explanation: Foreign currency risk is an impediment to international capital mobility. The other risks listed exist in any market, domestic or international (note: Greek risk refers to derivative securities models). 4. Which of the following is NOT an impediment to international capital mobility? A) Psychological barriers. B) Model risk. C) Discriminatory taxation. Explanation: The impediments to international capital mobility do not include model risk. Model risk exists in all markets. 5. If the international markets are segmented, which of the following is most accurate? A) Risk will not be priced the same in all markets. B) The international capital asset pricing model will still be valid. C) The extended capital asset pricing model must be used to price international assets. Explanation: If markets are segmented, then assets with similar risk/return parameters will not necessarily be priced the same. 6. Which of the following is NOT a factor that favors international market integration? A) Many institutional investors diversify internationally. B) Governments borrow and lend internationally. C) International tax laws are determined by the International Monetary Fund (IMF). Explanation: There is little in the way of uniform international tax law. Further, the IMF does not determine tax law. The other factors listed promote market integration. 7. For the international capital asset pricing model (ICAPM), which of the following statements regarding the integration of national markets is most accurate? If international markets are: A) integrated, there is no need for the ICAPM. B) integrated, the ICAPM breaks down. C) segmented, the ICAPM breaks down. Explanation: For the ICAPM to be valid, international markets must be integrated. If markets are segmented, risk will be priced differently in different national markets so the world risk premium will not be a robust comparison measure. 8. If international markets are integrated, which of the following statements is least accurate? A) The international risk-free rate will be the appropriate base rate for asset pricing. B) Risk will be priced similarly in all markets. C) The international capital asset pricing model will be valid. Explanation: There is no such thing as an “international risk-free rate,” hence it cannot be used in asset pricing. In broad terms, both remaining answers will be correct in the presence of well-integrated world markets. 9. Paul McCormack is a U.S. investor interested in valuing a Japanese security. Which of the following regression equations would be useful to McCormack in assessing the currency exposure of the Japanese security to changes in the dollar/yen exchange rate? A) Local currency return = α + β (world market return). B) Domestic currency return = α + β (exchange rate movement). C) Domestic currency return = α + β (world market return). Explanation: To assess currency exposure, regress domestic currency returns against exchange rate movements [Domestic currency return = α + β (exchange rate movement)]. In this formulation, β would be an estimate of the currency exposure and would likely be called γ if used in the international capital asset pricing model. 10. A French investor holds a U.K. security. The investor has estimated the currency exposure in local currency terms to be 1.3. What is the currency exposure in domestic currency terms? A) 2.3. B) 1.3. C) 0.3. Explanation: The investor estimated γFC = 1.3. To translate local (or FC) exposure to domestic currency exposure, we use: γ = γFC + 1. Hence, the domestic currency exposure is: γ = γFC + 1 = 1.3 + 1 = 2.3. 11. Suppose that a U.K. investor holds a U.S. security. The U.S. security has a negative correlation with changes in the value of the U.S. dollar in local currency terms. What does the negative correlation mean for the U.K. investor? The: A) security exaggerates the impact of currency movements. B) domestic currency γ is greater than one. C) security provides a natural hedge against currency movements. Explanation: A negative correlation means that as the value of the dollar falls (depreciates) the value of the security rises. Hence, the security provides a natural hedge against exchange rate movements to the U.K. investor. If the correlation is negative, the local currency γ will be less than zero. 12. Suppose the value of the euro depreciates by 5 percent in real terms. Of the following firms, which will most likely be hurt by the change in the euro? (The euro is used as the official currency in France and the pound is used in the U.K.) A: A) U.K. firm that imports food from French suppliers. B) French firm that exports food to U.K. distributors. C) French firm that imports and resells computers in France. Explanation: The firm that imports and resells goods in France. 13. Suppose an analyst is assessing the currency exposure of a French firm that imports bicycles from the U.K. If the value of the British pound appreciates, will the French firm’s cost structure improve or deteriorate? Why? A) Deteriorate, because the French cost of imported bicycles will go down. B) Improve, because the French cost of imported bicycles will go down. C) Deteriorate, because the French cost of imported bicycles will go up. Explanation: If the pound appreciates, then bicycles imported from the U.K will be more expensive in France. Hence, the cost structure of the French bicycle importer will deteriorate. 14. Consider a Canadian firm that exports hockey sticks to the U.S. Prices are set and collected in U.S. dollars. The inflation differential between Canada and the U.S. is 2% (Canadian inflation minus U.S. inflation). What is the valuation impact on the Canadian exporter if the value of the Canadian dollar falls by 2% during the next year? A) The firm is helped by the falling value of the Canadian dollar. B) The firm is hurt by the falling value of the Canadian dollar. C) All currency changes are nominal, so the change has no real impact. Explanation: The change in the valuation of the currency is fully explained by the inflation differential. Hence, there should be no impact on the valuation of the firm in real terms. 15. Suppose you are an investor that holds foreign bonds. What does it mean if bonds have positive currency exposure to the foreign currency? A) The exposure is always a return enhance attribute of the foreign bond. B) As interest rates go up, the value of the foreign currency increases. C) As interest rates go up, the value of the foreign currency falls. Explanation: Positive exposure implies that interest rate changes and currency valuation changes amplify the impact of each other. That is, as local rates increase (bad for bond investors) the value of the local currency tends to fall (bad for foreign bond investors). 16. Sally Metford, CFA, has just accepted a position working for the Canadian government. As an economic advisor, Metford has been asked to comment on the implications of changes in domestic currency, government policy, and inflation expectations.According to money demand theory, an increase in economic activity in Canada will most likely lead to a(n): A) increase in demand for Canadian dollars causing a depreciation in Canadian currency. B) increase in demand for Canadian dollars causing an appreciation in Canadian currency. C) decrease in demand for Canadian dollars causing a depreciation in Canadian currency. Explanation: According to money demand theory, an increase in economic activity in Canada will most likely lead to an increase in demand for Canadian dollars causing an appreciation in Canadian currency. Therefore, the money demand model explains the positive short-run correlation between exchange rate movements and stock returns. Metford’s supervisor has asked for recommendations regarding interest rate policies. The Canadian government is concerned that the value of the Canadian dollar has approached the upper target range. Assuming the Canadian government introduces a “leaning-against-the-wind” policy, the Canadian government will most likely: A) induce negative currency exposure. B) ease interest rates. C) raise interest rates. Explanation: A strong domestic currency will lead local governments to ease interest rates. This is often referred to as a “leaning-against-the-wind” policy that induces positive currency exposure. Which of the following are most likely to occur if the Canadian real rate of interest increases? There will be a(n): A) a positive currency exposure from bond investors. B) capital flow out of Canada. C) increased demand for Canadian currency from abroad. Explanation: An increase in the Canadian real rate of interest will cause capital to flow into Canada from foreign investors. This increased demand for Canadian dollars causes an increase in the value of the Canadian dollar. This in turn will create negative currency exposure for bond investors. 17. What is the likely long-term impact of real depreciation of a nation’s currency? A) Decreased standard of living. B) Increased competitiveness of domestic industry. C) Increased budget deficits. Explanation: In the long run, real depreciation makes a nation’s domestic industry more competitive in the international marketplace. 18. Assume that a country has a negative trade balance. In the traditional model of the impact of currency appreciation on domestic economic activities, what is the likely short-run impact of currency depreciation? A) The cost of imports increases widening the trade balance. B) Domestic industry becomes more competitive narrowing the trade balance. C) The cost of imports decreases narrowing the trade balance. Explanation: In the short run, if a country’s currency depreciates in real terms, the cost of imports increases causing a widening in the trade balance (exports – imports) and an increase in domestic inflation. Currency depreciation tends to reduce economic activity in the short run. 19. According to the traditional model, a decline in the value of a country’s currency has what effect upon national competitiveness in the long run and domestic inflation in the short run? A) Both will increase. B) Both will decrease. C) Only one will increase. Explanation: Under the traditional model, a decline in the value of a country’s currency increases national competitiveness in the long run and increases domestic inflation in the short run. This will occur due to an increase in exports for the country whose currency is less valuable. In the short run the cost of imports increases for the country with the decline in currency value. 20. Suppose a nation’s monetary authority increases real interest rates. What does economic theory tell us will happen to the value of the nation’s currency? A) Changes in the nominal rate, not the real rate, cause appreciation. B) The value of the currency will fall. C) The value of the currency will rise. Explanation: If the monetary authority (e.g., the central bank) increases real rates, capital will flow into the country. The increased demand for the nation's currency will cause the currency to appreciate. 21. In the money demand model, what is the relationship between appreciation in the domestic currency and the equity markets? Currency appreciation: A) is negatively correlated with equity returns. B) hurts competitiveness and stock market returns. C) is positively correlated with equity returns. Explanation: In the money demand model, an increase in real economic activity leads to an increase in the demand for the domestic currency. The increased currency demand causes the value of the currency to appreciate. Because stock prices are highly correlated with gross domestic product growth, the money demand model explains the positive short-run correlation between exchange rate movements and stock returns.