CFA Level 2 - Economics Session 4 - Reading 18 Currency Exchange Rates - LOS h

CFA Level 2 - Economics Session 4 - Reading 18 Currency Exchange Rates - LOS h (Practice Questions, Sample Questions) 1. Assume the 1 year USD:EUR forward rate is 0.89348, the German interest rate is 3.38 percent, and the U.S. interest rate is 1.90 percent. If interest rate parity (IRP) holds, the USD:EUR spot rate is approximately: A) 0.91204. B) 1.56670. C) 0.88069 [Explanation: Interest rate parity is given by: Forward FCC = Spot FCC × [(1 + rdomestic) / (1 + rforeign)], or alternatively Spot FCC = Forward FCC × [(1 + rforeign) / (1 + rdomestic)] = 0.89348 × (1.0190 / 1.0338) = 0.88069 Note that in this question, the dollar is the foreign currency and the Euro is the domestic currency] 2. Assume that the domestic nominal rate of return is 4% and the foreign nominal rate of return is 5%. If the current exchange rate is FCC 0.400, the forward rate consistent with interest rate parity is: A) 0.396. [Explanation: F/S= (1 + rD) / (1 + rF) where the currency is quoted as FCC F = (1.04/1.05)(0.400) = 0.396] B) 0.400. C) 0.318 3. Given a forward exchange rate of 5 DC/FC, a spot rate of 5.102 DC/FC, domestic interest rates of 8%, and foreign rates of 10%, which of the following statements is CORRECT based on the approximation formula? A) Arbitrage opportunities exist. B) Borrow local currency and lend foreign currency. C) Arbitrage opportunities do not exist [Explanation: If (rD ? rF) is approximately equal to the forward premium, which is (Forward D/F) ? Spot(D/F) / Spot(D/F), then no arbitrage opportunities exist. 0.08 ? 0.10 ? (5 ? 5.102) / 5.102. -0.02 ? -0.01999] 4. Suppose the Argentina peso is at a 1-year forward premium of 4% relative to the Brazilian real and that Argentina’s 1-year interest rate is 7%. If interest rate parity holds, then the Brazilian interest rate is closest to: A) 6.60%. B) 3.00%. C) 11.00% [Explanation: According to interest rate parity the currency with the lower interest rate is expected to appreciate so the Argentina rate of 7% is approximately 4% less than the Brazilian rate of 7 + 4 = 11%] 5. Given the following information, what is the forward exchange rate implied by interest rate parity? U.S. interest rate = 9%. North Korea interest rate = 10%. Spot rate = 1.65 KPW/$. A) 1.665 KPW/$. [Explanation: Forward rate (DC/FC) = Spot Rate (DC/FC) × [(1 + domestic rate) / (1 + foreign rate)], Forward rate = 1 / 1.65 (KPW/$) × (1.09 / 1.10) = 0.60055 $/KPW, or 1.665 KPW/$. Alternatively, forward rate = 1.65 (KPW/$) × (1.10 / 1.09) = 1.665 (KPW/$)] B) 0.612 KPW/$. C) 1.635 KPW/$ 6. The domestic interest rate is 8% and the foreign interest rate is 6%. If the spot rate is 4 domestic units/foreign unit, what should the forward exchange rate be for interest rate parity to hold? A) 3.930. B) 4.075. [Explanation: Using the following interest rate parity equation: ForwardDC/FC=SpotDC/FC × [(1 + rdomestic) / (1 + rforeign )] Solving for the forward rate: ForwardDC/FC = 4 × [(1 + 0.08) / (1 + 0.06)] = 4(1.08) / (1.06) = 4(1.01887) = 4.07547] C) 4.250 7. Lance Tuipuloto, CFA, is reviewing interest rate parity for a client meeting on a planned foreign investment. The domestic interest rate is 8% and the foreign interest rate is 6%. If the forward rate is 4.00 domestic units per foreign unit, what should the spot exchange rate be for interest rate parity to hold? A) 3.98. B) 4.08. C) 3.93 [Explanation: F/S = (1 + rdomestic) / (1 + rforeign). Note in this equation exchange rates are quoted as Domestic/Foreign. S = F (1 + rF) / (1 + rD) = (4.00)(1.06) / (1.08) = 3.93]