Chapter 09 The Foreign Exchange Market

Chapter 09 - The Foreign Exchange Market9-14Chapter 09The Foreign Exchange Market

True / False Questions1.(p.324)The foreign exchange market is a market for converting the currency of one country into that of another country.TRUE

2.(p.324)Currency fluctuations can make seemingly profitable trade and investment deals unprofitable and vice versa.TRUE3.(p.324)The rate at which one currency is converted into another is known as the fluctuation rate.FALSE4.(p.324)The risk that arises from volatile changes in exchange rates is known as foreign exchange risk.TRUE5.(p.324)It is possible for a firm to purchase complete insurance against the risks that arise from changes in exchange rates in the foreign exchange market.FALSE6.(p.325)When a tourist changes one currency into another, the tourist is participating in the foreign exchange market.TRUE7.(p.326)Currency speculation involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.TRUE8.(p.326)A currency swap is the rate at which a foreign exchange dealer converts one currency into another on a particular day.FALSE9.(p.326)When a tourist goes to a bank in a foreign country to convert money into the local currency, the exchange rate used is the spot rate.TRUE10.(p.326-327)The value of a currency is determined by the interaction between the demand and the supply of that currency relative to the demand and supply of other currencies.TRUE11.(p.327)If the spot exchange rate is 1=$1. 50 when the market opens and 1=$1. 48 at the end of the day, the dollar has appreciated, the pound has depreciated.TRUE12.(p.327)When two parties agree to exchange currency and execute the deal at some specific time in the future, a forward exchange occurs.TRUE13.(p.327)A spot exchange rate is quoted for 30 days, 90 days and 180 days into the future.FALSE14.(p.328)To minimize the risk of an unanticipated change in exchange rates, a company can protect itself by entering into a forward exchange contract.TRUE

15.(p.328)If $1 bought more yen with a spot exchange than with a 30-day forward exchange it indicates the dollar is expected to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a premium on the 30-day forward market. FALSE16.(p.328)Differences in the spot exchange rate and the 30-day forward rate are normal and reflect the expectations of the foreign exchange market about future currency movements.TRUE17.(p.328)The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates in known as a currency swap.TRUE18.(p.328)If the spot rate is $1=120 and the 30-day forward rate is $1= 130, the dollar is selling at a discount in the forward market.FALSE19.(p.329)The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems.TRUE20.(p.330)The most important trading centers for currencies are in Zurich, Frankfurt, Paris, Hong Kong and Sydney.FALSE21.(p.330)The foreign exchange market is open for only 12 hours in a day.FALSE22.(p.330)Arbitrage opportunities abound in the foreign exchange markets and they tend to available for long periods of time.FALSE23.(p.330)Although a foreign exchange transaction can involve any two currencies, most transactions involve pounds on one side.FALSE24.(p.331)The law of one price suggests that at the most basic level, exchange rates are determined by supply and demand.FALSE25.(p.331)An efficient market has no impediments to the free flow of goods and services.TRUE26.(p.332)According to a less extreme version of the PPP theory, given relatively efficient markets, the price of a "basket of goods" should be roughly equivalent in each country.TRUE27.(p.332)Price inflation occurs when the quantity of money in circulation rises faster than the stock of goods and services.TRUE28.(p.334)According to the PPP, a country with a high inflation rate will see depreciation in its currency exchange rate.TRUE29.(p.332-334)When the growth in a country's money supply is faster than output increases, inflation is fueled.TRUE30.(p.336)The PPP theory is a strong predictor of short-run movements in exchange rates covering time spans of five years or less.FALSE31.(p.337)The Fisher Effect states that a country's real interest rate is the sum of the nominal interest rate and the expected rate of inflation over the period for which the funds are to be lent.FALSE32.(p.338)The International Fisher Effect 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 for the two countries.TRUE33.(p.338)The International Fisher Effect has proven to have substantial power at predicting short-run changes in spot exchange rates.FALSE34.(p.340)An inefficient market is one in which prices do not reflect all available information.TRUE35.(p.341)Technical analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.FALSE

36.(p.342)If a country has an externally convertible currency neither residents nor nonresidents are allowed to convert it into a foreign currency.FALSE37.(p.343)Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country's economic prospects are shaky in other respects.TRUE38.(p.344)Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.TRUE39.(p.344)The impact of currency exchange rates on the reported financial statements of a company is translation exposure.TRUE40.(p.345)A lag strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.FALSEMultiple Choice Questions41.(p.324)The rate at which one currency is converted into another is called theA.Replacement percentageB.Resale rateC.Exchange rateD.Interchange ratio42.(p.324)The risks that arise from volatile changes in exchange rates are known asA.Interest rate risksB.Basis risksC.Operational risksD.Foreign exchange risks43.(p.324)The foreign exchange market serves two main functions. These areA.Collect duties on imported products and convert the currency of one country into the currency of anotherB.Insure companies against foreign exchange risk and set interest rates charged to foreign investorsC.Collect duties on imported products and set interest rates charged to foreign investorsD.Convert the currency of one country into the currency of another and provide some insurance against foreign exchange risk44.(p.325)A pair of shoes costs 30 in Britain. The identical pair costs $45 in the U.S. The exchange rate is 1=$1. 80. In terms of cost of the shoes,A.The U.S. offers a better dealB.The deal is same in both the countriesC.Britain offers a better dealD.The US deal is comparatively worse45.(p.325)An exchange rate of 1=$1.30 specifies thatA.One dollar is worth 1.30 eurosB.One could sell 1.30 euros for one dollarC.One euro buys 1.30 dollarsD.There are 1.30 euros for every dollar46.(p.325)The _____ helps us to compare the relative prices of goods and services in different countries.A.Interest rateB.Customs rateC.Exchange rateD.Tariff rate47.(p.325-326)International businesses use foreign exchange markets for all of the following reasons, exceptA.To receive payments from foreign investments that may be in foreign currenciesB.To pay a foreign company for its products or services in its country's currencyC.To invest for short terms in money markets when they have spare cashD.To cover themselves from all risks involved in currency speculation48.(p.326)One function of the foreign exchange market is to provide some insurance against the risks that arise from changes in exchange rates, commonly referred to asA.Foreign market hazardB.Global jeopardyC.Foreign exchange riskD.Commerce uncertainty49.(p.326)When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as aA.Point-in-time exchangeB.Temporal exchangeC.Spot exchangeD.Forward exchange50.(p.326)The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates is best known asA.Currency arbitrageB.Currency speculationC.Currency suppositionD.Short selling

51.(p.326)The _____ is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.A.Spot exchange rateB.Forward exchange rateC.Objective exchange rateD.Legal exchange rate52.(p.327)If lots of people want euros and euros are in short supply and a few people want Japanese yen and yen are in plentiful supply, the euro is likely to _____ against the yen.A.DepreciateB.AppreciateC.DevalueD.Stabilize

53.(p.327)_____ are exchange rates governing some specific future date foreign exchange transactions.A.Spot ratesB.Forward ratesC.Future ratesD.Currency swaps54.(p.327)A _____ exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.A.ReverseB.SpotC.HedgeD.Forward55.(p.328)Assuming the 30-day forward exchange rate were $1 = 130 and the spot exchange rate were $1 = 120, the dollar is selling at a _____ on the 30-day forward market.A.PremiumB.MarginC.DiscountD.Subsidy

56.(p.328)The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates is referred to as aA.Fiscal barterB.Liquid tradeC.Currency exchangeD.Currency swap

57.(p.330)The most important foreign exchange trading centers include all of the following, exceptA.LondonB.New York CityC.TokyoD.Seoul

58.(p.330)Assume that the yen/dollar exchange rate quoted in London at 3:00 p.m. is 120 = $1 and the New York yen/dollar exchange rate at the same time is 125 = $1. A dealer makes a profit by buying a currency low and selling it high. The dealer has engaged in a(n)A.Currency swapB.ArbitrageC.BackwardationD.Straddle59.(p.330)Although a foreign exchange transaction can involve any two currencies, some 89% of transactions in 2004 involved theA.Japanese yenB.British poundC.U.S. dollarD.French franc60.(p.331)According to the _____, in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.A.Law of one priceB.Principle of consistent pricingC.Model of fair pricingD.Principle of equitable pricing

61.(p.331)According to the law of one price, if the exchange rate between the British pound and the dollar is 1 = $1.50, a jacket that retails for $75 in New York should sell for _____ in LondonA.40B.50C.60D.75

62.(p.331)If the demand for dollars outstrips its supply and if the supply of Japanese yen is greater than the demand for it, what will happen?A.The dollar will appreciate against the yenB.The dollar will depreciate against the yenC.The exchange rates will remain the sameD.The yen will appreciate against the dollar

63.(p.332)The _____ suggests that given relatively efficient markets, the price of a basket of goods should be roughly equivalent in each country.A.Theory of efficient marketsB.Law of one priceC.Theory of price inflationD.PPP theory

64.(p.332)Suppose the price of a Big Mac in New York is $3. 00 and the price of a Big Mac in Paris is $3. 75 at the prevailing euro/dollar exchange rate, then according to PPP the euro isA.Undervalued by 25% against the dollarB.Overvalued by 25% against the dollarC.Appreciating relative to the dollarD.Depreciating relative to the dollar

65.(p.336)Identify the incorrect statement about the PPP theory.A.It predicts that exchange rates are determined by relative pricesB.It yields accurate predictions in the short runC.It best predicts exchange rate changes for countries with high rates of inflationD.It assumes away transportation costs and barriers to trade66.(p.336)_____ involves dominant enterprises setting different prices in different markets to reflect varying demand conditions.A.Conditional pricingB.Dual pricingC.Price discriminationD.Foreign market pricing67.(p.337)The _____ states that a country's "nominal" interest rate is the sum of the required "real" rate of interest and the expected rate of inflation over the period for which the funds are to be lent.A.PPP theoryB.Efficient Market theoryC.Inefficient Market theoryD.Fisher Effect theory68.(p.337)Economic theory suggests that when inflation is expected to be highA.Interest rates will be lowB.Exchange rates will be highC.The International Fisher Effect does not holdD.Interest rates will be high69.(p.338)_____ 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.The Fisher EffectB.The International Fisher EffectC.The Efficient Market theoryD.The Inefficient Market theory70.(p.338)When traders move as a herd in the same direction at the same time such as what occurred when George Soros betted against the British pound in 1992, a(n) _____ occurs.A.Efficient marketB.Inefficient marketC.Bandwagon effectD.Fisher effect71.(p.339)The _____ argues that forward exchange rates do the best possible job of forecasting future spot rates and therefore investing in forecasting services would be a waste of money.A.Inefficient market schoolB.Efficient market schoolC.Fisher EffectD.International Fisher Effect

72.(p.339)_____ is one in which prices reflect all available public information.A.An efficient marketB.An inefficient marketC.A market economyD.A capitalist economy73.(p.341)_____ draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.A.Efficient market theoryB.Inefficient market theoryC.Fundamental analysisD.Technical analysis74.(p.342)_____ uses price and volume data to determine past trends, which are expected to continue into the future.A.Technical analysisB.Fundamental analysisC.The Fisher EffectD.The International Fisher Effect75.(p.342)A currency is said to be freely convertible whenA.The country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with itB.Only nonresidents may convert it into a foreign currency without any limitationsC.Neither residents nor nonresidents are allowed to convert it into a foreign currencyD.Only residents may convert it internally into a foreign currency

76.(p.342)A currency is said to be externally convertible whenA.The country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with itB.Only nonresidents may convert it into a foreign currency without any limitationsC.Neither residents nor nonresidents are allowed to convert it into a foreign currencyD.Only residents may convert it internally into a foreign currency

77.(p.342)When a currency is nonconvertibleA.The country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with itB.Only nonresidents may convert it into a foreign currency without any limitationsC.Neither residents nor nonresidents are allowed to convert it into a foreign currencyD.Only residents may convert it internally into a foreign currency78.(p.343)_____ is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country's economic prospects are shaky in other respects.A.The bandwagon effectB.The fisher effectC.ArbitrageD.Capital flight79.(p.343)A range of barter-like agreements by which goods and services can be traded for other goods and services are known asA.CountertradeB.Protracted tradeC.Intermediate salesD.Countersale80.(p.343)Countries might be forced to use counter trade when a currency isA.Freely convertibleB.Externally convertibleC.Internally convertibleD.Nonconvertible81.(p.344)The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values is known asA.Economic exposureB.Financial exposureC.Translation exposureD.Transaction exposure82.(p.344)_____ is the impact of currency exchange rates changes on the reported financial statements of a company.A.Economic exposureB.Financial exposureC.Translation exposureD.Transaction exposure83.(p.344)The extent to which a firm's future international earning power is affected by changes in exchange rates is known asA.Translation exposureB.Financial exposureC.Economic exposureD.Transaction exposure

84.(p.345)A(n) _____ involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.A.Follower strategyB.Interim strategyC.Lead strategyD.Lag strategy

85.(p.345)A(n) _____ involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate.A.Follower strategyB.Interim strategyC.Lead strategyD.Lag strategyEssay Questions86.(p.325)With the help of an example explain how a tourist participates in the foreign exchange market.The foreign exchange market is a market for converting the currency of one country into that of another country. When a tourist changes one currency into another, the tourist is participating in the foreign exchange market. If the euro/dollar exchange rate is 1=$1. 30, then one euro buys 1.30 U.S. dollars. If the tourist wants to buy a T-shirt in France that costs 20 euros, the tourist can go to a bank and exchange her $26 for 20.87.(p.325-326)What are the main uses of foreign exchange markets for international business?The foreign exchange market serves four primary functions for international companies. First, the market is used to convert payments a company receives in foreign currencies into the currency of its home country. Second, the market is used to convert the currency of a company's home country into another currency when they must pay a foreign company for its products and services in their currency. Third, international businesses may use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets (of another country). Fourth, the market is used for currency speculation.88.(p.326-327)What is the difference between a spot exchange rate and a forward exchange rate?The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Spot exchange rates are reported daily in the financial section of the newspapers. Spot rates are continually changing, their value being determined by supply and demand for that currency relative to others. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates governing such transactions are referred to as forward rates. Most major currencies are quoted 30, 90 and 120 days into the future.89.(p.328)What is meant by the phrases the dollar is selling at a discount' on the 30-day forward market' and the dollar is selling at a premium on the 30-day forward market?'When a dollar is selling at a discount on the 30 day forward market, it is worth less than on the spot market or one dollar buys more foreign currency with a spot exchange than with a 30 day forward contract. If the dollar is selling at a premium on the 30 day forward market, foreign exchange dealers anticipate the dollar will appreciate against the foreign currency over the next 30 days.90.(p.328)What is a currency swap?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 foreignexchange risk.91.(p.329-330)Where is the foreign exchange market located? What is the nature of the market? Is the market growing or shrinking on a global basis?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. The foreign exchange market has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and investment.92.(p.329-330)Discuss the nature of the foreign exchange market. How fast has it been growing? Where are the most important trading centers? The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems. The market has been growing at a rapid pace. In April 2004, the average total value of global foreign exchange trading was about $1. 8 trillion. The most important trading centers are London, New York, Tokyo and Singapore.93.(p.331)What is the law of one price? The law of one price states that in competitive markets, free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their prices is expressed in terms of the same currency. If the exchange rate is 1=$1. 50, a bracelet that sells for $75 in New York should sell for 50 in London94.(p.332)Explain PPP. Use an example show how PPP can help explain exchange rates.

PPP theory states that given relatively efficient markets, the price of a basket of goods should be roughly equivalent in each country. So, if a basket of goods costs $200 in the U.S. and 20,000 in Japan, PPP predicts that the dollar/yen exchange should be $200/20,000 or $.01 per Japanese yen.

95.(p.336-337)Discuss the failure of PPP theory to predict exchange rates accurately. What is the purchasing power puzzle?

The failure to find a strong link between inflation rates and exchange rate movements has been referred to as the purchasing power puzzle. Several reasons contribute the failure of PPP as a predictive tool. First, PPP theory assumes away transportation costs and barriers to entry, yet in practice this is not realistic. Second, PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels and differentiate their product offerings between nations. Third, government intervention in the foreign exchange market influences the value of currencies. Finally, investor psychology has a role in determining exchange rates.96.(p.337-338)Compare and contrast the Fisher Effect and the International Fisher Effect.The Fisher Effect was put forth by Irvin Fisher who formalized the notion that in countries where inflation is expected to be high, interest rates will also be high because investors want compensation for the decline in the value of their money. More specifically, the Fisher Effect states that a country's nominal interest rate is the sum of the required real rate of interest and the expected rate of inflation over the period for which the funds are to be lent.The Fisher Effect was extended to incorporate the link between interest rates and exchange rates. The International Fisher Effect 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.97.(p.338)Consider the role of investor psychology and bandwagon effects on how well PPP and the International Fisher Effect explain short-term movements in exchange rates.Neither PPP nor the International Fisher Effect have proven to be good at explaining short-term movements in exchange rates. One reason for their poor explanatory power may be the impact of investor psychology on short-run exchange movements. Studies show that expectations about exchange rates tend to become self-fulfilling prophecies.A bandwagon effect occurs when investors in increasing numbers start following the lead of someone who may be pushing the value of a currency up or down due to psychological reasons. As a bandwagon effect builds up, the expectations of investors become a self-fulfilling prophecy and the market moves in the way the investors expected.98.(p.339-40)Discuss the two schools of thought on exchange rate forecasting.

There are two schools of thought on whether it is worthwhile for a firm to invest in exchange rate forecasting services. The efficient market school argues that forward exchange rates do the best possible job of forecasting exchange rates and therefore, it is not necessary to invest in forecasting services. The inefficient market however, suggests that forward exchange rates are not the best predictors of future spot rates and that consequently there is value in forecasting services.

99.(p.341-342)Explain the difference between fundamental analysis and technical analysis.

Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. Technical analysis uses price and volume data to determine past trends that are expected to continue into the future. Both schools of thought are used to forecast exchange rate movements.

100.(p.342)Compare and contrast currencies that are freely convertible, externally convertible and nonconvertible.

A country's currency is said to be freely convertible when the country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it. In contrast, a currency is said to be externally convertible if only nonresidents may convert it into a foreign currency without limitations. Finally, a currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.101.(p.343)What is countertrade? Why would a firm engage in countertrade?Countertrade refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. When a country's currency is nonconvertible, a firm may turn to countertrade. The number of countertrade deals as been falling in recent years as more governments make their currencies freely convertible.102.(p.344-345)Describe translation exposure. How can translation exposure be minimized?Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is basically concerned with the present measurement past events. Like transaction exposure, translation exposure can be minimized by entering into forward contracts or swaps or by leading and lagging payables and receivables.103.(p.344-345)What is transaction exposure? How can transaction exposure be minimized?Transaction exposure is the extent to which the income from various transactions is affected by fluctuations in foreign exchange values. Transaction exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. Transaction exposure can be minimized by entering into forward contracts or swaps or by leading and lagging payables and receivables.104.(p.344-345)Explain the notion of economic exposure. How can economic exposure be minimized?Economic exposure is the extent to which a firm's future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales and costs. To reduce economic exposure, a firm must distribute the firm's productive assets to various locations so the firm's long-run financial well-being is not severely affected by adverse changes in exchange rates.105.(p.345-347)How can a firm minimize its foreign exchange exposure?There are several strategies a firm can follow to minimize foreign exchange exposure. First, central control of exposure is needed to protect resources and ensure that each subunit adopts the correct mix of tactics and strategies. Second, firms should distinguish between transaction and translation exposure as compared to economic exposure. Third, the firm needs to forecast future exchange rate movements. Fourth, the firm needs to establish a good reporting system to monitor the firm's exposure positions. Finally, the firm should produce monthly foreign exchange exposure report forms.