The Foreign Exchange Market and Parity Conditions (Answer Key)

The Foreign Exchange Market and Parity Conditions 1. * 2. * 3. * 4. * 5. * The foreign exchange market is referred to as a market where one country's currency is exchanged for another currency. The currency exchange is usually made through the following methods . A. buyers and sellers of foreign exchange meet at a physical location. B. buyers and sellers of foreign exchange meet through a telephone network C. buyers and sellers of foreign exchange meet through computer communications D. A and B E. B and C Which of the following is not a function of a commercial bank in the foreign exchange market? A. they operate the payment mechanism B. they determine exchange rates C. they extend credit D. they help reduce foreign exchange risk E. they buy and sell foreign exchange Which of the following is not a characteristic of speculation A. profit motive B. exchange rate fluctuation C. hedging D. risk taking E. deliberate uncovered position . A cross rate is an exchange rate between ___ and ___. A. The US dollar and the Japanese yen B. any two non-home currencies C. the Mexican peso and the euro D. the domestic currency and a foreign currency E. the euro and the Japanese yen A US company is expected to receive £100,000 in 120 days. If the company wants to minimize the risk of foreign exchange, then it would . A. buy British pounds forward B. sell British pounds forward C. buy British pounds 120 days from now D. sell British pounds 120 days from now E. sell British pounds in the current spot market 6. * Speculation in foreign exchange markets entails . A. covering in the forward market B. covering in the money market C. hedging in the option market D. buying in the current spot market and selling in the future spot market E. covering in the futures market 7. * Foreign exchange markets are efficient if . A. good information is available at no or little cost B. you have inside information C. markets are highly regulated D. market information is secretive E. most foreign exchange dealers are speculators 8. The theory of purchasing power parity says that . A. the inflation rates in two countries are unrelated B. the exchange rate will adjust to reflect changes in the price levels of two countries C. the inflation rate is greater than the interest rate D. the interest rate is greater than the inflation rate E. the interest rate and the inflation rate are identical * 9. * 10. * The Fisher Effect assumes that the . A. real interest rate is equal to the nominal interest rate B. nominal interest rate is equal to the real interest rate plus the inflation rate C. inflation rate is equal to the real interest rate D. nominal interest rate is equal to the inflation rate E. nominal interest rate is lower than the inflation rate The International Fisher Effect says that the . A. exchange rate difference reflects the inflation rate difference between two countries B. future spot rate should move in an amount equal to, but in the opposite direction from, the difference in interest rates between two countries C. future spot rate reflects the forward rate D. interest rate is greater than the inflation rate E. all of the above 11. * 12. * 13. * 14. * 15. * 16. * The theory of interest rate parity means that the . A. interest rates are equal in two countries B. difference between a forward rate and a spot rate equals the difference between a domestic interest rate and a foreign interest rate C. difference between the spot rate and the future spot rate reflects the interest rate difference between two countries D. future spot rate reflects the inflation difference between two countries E. all of the above A forward rate is equal to a future spot rate if foreign exchange markets are A. controlled by the government B. efficient C. controlled by speculators D. are partially controlled by the International Monetary Fund E. none of the above Actual exchange market participants include A. banks B. companies C. individuals D. governments E. all of the above . . Commercial banks play the flowing role in international transactions ___. A. they operate the payment mechanism B. they extend credit C. they help reduce risk D. A and B E. all of the above ___ is used a major means of reducing risk in international transactions. A. exchange trading B. the payment mechanism C. letter of credit D. the US Federal Reserve E. bank trading rooms Central banks ___. A. attempt to control the growth of the money supply within their jurisdictions B. serve as their governments’ banker for domestic and international payments C. strive to maintain the value of their own currency against any foreign currency D. A and C all of the above E. 17. * If the spot rate of the Malaysian ringgit is $.30 and the six month forward rate of the ringgit is $.32, what is the forward premium or discount on an annual basis? A. premium; about 14.5% B. discount; about 14.5% C. premium; about 13.3% D. discount; about 13.3% E. premium; about 16.7% Solution: use Equation (5-4) [(.32 - .30)/.30] x (360/180) = 13.3% 18. * 19. * If the spot rate of the Israel shekel is $.32 and the six month forward rate is $.30, what is the forward premium or discount on an annual basis? A. discount; 11.5% B. premium; 11.5% C. premium; 12.5% D. discount; 12.5% E. premium; 22.5% Solution: use Equation (5-4) [(.30 - .32)/.32] x (360/180) = -12.5% If the Canadian dollar is equal to $.86 and the Brazilian real is equal to $.28, what is the value of the Brazilian real in terms of Canadian dollars? A. about .3256 reals B. about .3568 reals C. about 1.2 reals D. about 1.5 reals E. about .5600 reals Solution: cross rate .28/.86 = .3256 20. * If the Japanese yen was worth $.0035 six months ago and is worth $.0045 today, how much has the yen appreciated or depreciated? A. appreciated; about 29% B. appreciated; about 25% C. depreciated; about 20% D. depreciated; about 18% E. appreciated; about 15% Solution: use Equation (5-1) (.0045 - .0035)/.0035 = 29% 21. * Assume: (1) the US annual interest rate = 10%; (2) the Malaysian annual interest rate = 4%; and (3) the 90-day forward rate for the Malaysian ringgit = $.3864. At what current spot rate will interest rate parity hold? A. $.3922 B. $.3855 C. $.3807 D. $.3752 E. $.6000 Solution: use Equation (5-8) [(.3864 - S)/S) x (360/90)] = .10 - .04 S = .3807 22. * Suppose annual inflation rates in the US and Cambodia are expected to be 5% and 90%, respectively over the next year. If the current spot rate for the Cambodian riel (KHR) is 3342.62 riels per dollar, then the best estimate of the riel's future spot rate one year from now is: A. $6053.27 B. $6350.99 C. $3342.62 D. $6685.24 E. $7800.00 Solution: use Equation (5-6). Remember that the reciprocal of 3342.63 = 0.0002991. new exchange rate = $0.0002991[(1 + .05)/(1 + .90)] = $.0001652/KHR; or KHR1/$.0001653 = KHR6053.27/$ 23. * If the expected inflation rate is 4% and the real required return is 5%, what is the nominal interest rate? A. 1% B. 9% C. 6% D. 5% E. 11% Solution: Use Equation (5-7): nominal rate = real rate + inflation rate. Nominal rate = 5% + 4% = 9% Use the following information to answer the next three questions. Assume the following: you have $10,000 to invest; the current spot rate of British pounds is $1.800; the 90-day forward rate of the pound is $1.780; the annual interest rate in the US is 4%; the annual interest rate in the UK is 6%. 24. * Where would you invest your $10,000 to maximize your yield with no foreign exchange risk? A. in the United States B. in the United Kingdom C. cannot tell D. does not make any difference E. in Germany Solution: invest in the US: $10,000 x 1.01 = $10,100 Invest in the UK and cover in the forward market. Buy pounds at the present spot rate: $10,000/1.8 = £5,555 invest in the UK: £5,555 x 1.015 = £5,638 sell pounds forward: £5,638 x 1.78 = $10,036 The investor would earn $64 more by investing in the United States instead of the United Kingdom. 25. * Given the US interest rate, the UK interest rate, and the spot rate, what would be an equilibrium forward exchange quotation? A. 1.800 B. 1.780 C. 1.809 D. 1.905 E. 2.000 Solution: use Equation (5-8) and solve for the forward rate: [(F - 1.800)/1.800 x (360/90)] = 0.04 - 0.06 F = £1.809 26. * Given the spot rate, the forward rate, and the US interest rate, what is the equilibrium UK interest rate? A. 6.0% B. 8.9% C. 4.0% D. 6.0% E. 8.4% Solution: use Equation (5-8) and solve for the UK interest rate. [(1.780 - 1.800)/1.800 x (360/90)] = 0.04 - if if = 0.084 Use the following information to answer the next two questions: Assume that the spot rate changed from $0.64 per Swiss franc on January 1 in one recent year to $0.68 per Swiss franc on December 31 of that year. 27. * What is the percentage change in the franc spot rate using direct quotes for a US company? A. 5.55% B. 6.25% C. 7.55% D. 8.00% E. 9.99% Solution: Use Equation (5-1). % Change = (0.68 - 0.64)/0.64 = 0.0625 or 6.25% 28. * What is the percentage change in the franc spot rate using indirect quotes for a US company? A. B. C. D. E. 6.25% 7.77% 8.88% 9.45% 5.55% Solution: Converting the above example into indirect quotations, the Swiss franc changes from 1.5625 francs to 1.4706 francs. Use Equation (5-2) to solve this problem. % Change = (1.5625 - 1.4706)/1.4706 = 6.25% 29. * The bid price is $0.64 for the Canadian dollar and the ask price is $0.68 for the Canadian dollar. What is the bid-ask spread for the Canadian dollar? A. 6.77% B. 7.77% C. 8.75% D. 6.25% E. 5.25% Solution: Use Equation (5-3). Spread = (0.68 - 0.64)/0.64 = 0.0625 or 6.25%