International Financial Management, 2e (Bekaert / Hodrick)

Chapter 7 Speculation and Risk in the Foreign Exchange Market

7.1 Multiple Choice Easy

1) If there is no systematic difference between the forward rate and the expected future spot rate, then the expected forward market return should be ________.

A) zero

B) greater than one

C) equal to the stockholders' required rate of return

D) less than one but greater than zero

Answer: A

Comment: Uncovered interest rate parity and the unbiasedness hypothesis, p. 223

2) When the forward rate is equal to the expected future spot rate, the forward rate is said to be ________ the future spot rate.

A) an information signal for

B) an unbiased predictor of

C) a hedge for

D) in parity with the expected future spot rate

Answer: B

Comment: The unbiasedness hypothesis, p. 225

3) If market efficiency is identified with parity, currency markets that are ________ provide no opportunities for currency traders to earn profits.

A) not in parity

B) in parity

C) in interest rate parity only

D) in purchasing power parity

Answer: B

4) Which one of the following would some say invalidates the unbiasedness hypothesis?

A) the Fisher Effect

B) the efficient market hypothesis

C) the Siegel paradox

D) the law of one price

Answer: C

Comment: The Siegel Paradox (Advanced), p.226

5) The ________ on an asset is the expected return on the asset in excess of the return on a risk-free asset.

A) risk premium

B) covariance

C) systematic risk

D) beta

Answer: A

Comment: What Determines Risk Premiums? p. 228

6) The risk that is associated with an asset's return arising from the covariance of the return with the return on a large, well-diversified portfolio is known as ________ risk.

A) business

B) exchange rate

C) market

D) systematic

Answer: D

Comment: Systematic and unsystematic risk, p.228

7) What is the market portfolio?

A) the large, well-diversified portfolio that investors should hold according to finance theory

B) the large, well-diversified portfolio without international securities

C) the portfolio that represents a global portfolio

D) the portfolio with strictly domestic securities

Answer: A

Comment: Systematic and unsystematic risk, p.228

8) Because systematic risk measures how much an asset's return co-moves with the market, it ________.

A) can be diversified away with the appropriate hedging

B) cannot be diversified away

C) is partially driven by idiosyncratic risk

D) can be completely eliminated using international securities

Answer: B

Comment: Systematic and unsystematic risk, p.228

9) Modern portfolio theory developed by William F. Sharpe is the foundation of ________.

A) currency market parity models

B) the balance sheet hedge

C) the capital asset pricing model

D) adjusted net present value model

Answer: C

Comment: The CAPM, p.229

10) The ________ holds that it is the covariance of an asset's return with that of the market portfolio that determines the asset's risk premium.

A) Law of One Price

B) Law of Iterated Expectations

C) Capital Asset Pricing Model

D) Interest Rate Parity Model

Answer: C

Comment: The CAPM, p. 229

11) Multinational corporations most often hedge their transaction exchange rate risk using currency ________.

A) options

B) futures

C) spreads

D) forward contracts

Answer: D

Comment: The cost of Hedging, p.232

12) If investors ________, we would assume that do not make systematic mistakes when forecasting exchange rates.

A) have rational expectations

B) have complete knowledge of all possible bid and ask quotes

C) know that interest rate differentials provide information about the intensity of devaluations

D) anticipate events that occur

Answer: A

Comment: Incorporating rational expectations into the test, p 235

13) A phenomenon known as ________ arises when rational investors anticipate events that do not with the frequency that the investors expect.

A) interest rate parity

B) the peso problem

C) rational expectations

D) purchasing power parity

Answer: B

Comment: Peso problems, p.244

14) Regression tests of the unbiasedness hypothesis indicate that it is ________ with real life events.

A) an unbiased indicator of expected future exchange rates

B) very consistent

C) not consistent

D) has a strong correlation to the current account

Answer: C

Comment: Regression tests of the unbiasedness of forward rates, p.238

15) What concept states that there is no systematic difference between the forward rate and the expected future spot rate, and that the expected forward market return is zero?

A) unbiased predictor

B) unbiasedness hypothesis

C) uncovered interest rate parity

D) unsystematic risk

Answer: B

Comment: Uncovered interest rate parity and the unbiasedness hypothesis, p.223

16) When the forward rate equals the expected future spot rate, the forward rate is said to be a(n) ________ of the future spot rate.

A) unbiased predictor

B) forward market investment

C) forward market return

D) unsystematic risk

Answer: A

Comment: The unbiasedness hypothesis, p. 225

17) What is the name given to the risk associated with an asset's return arising from the covariance of the return on a large, well-diversified portfolio?

A) covariance

B) systematic risk

C) idiosyncratic risk

D) risk premium

Answer: B

Comment: Systematic and unsystematic risk, p.228

18) What does the "carry trade" term mean?

A) Borrow in the domestic currency to earn only the higher yield of the dollar implied by the regression.

B) Borrow in the foreign currency to earn only the expected capital appreciation of the dollar implied by the regression.

C) Borrow in the domestic currency to earn both the higher yield and the expected capital appreciation of the dollar implied by the regression.

D) Borrow in the foreign currency to earn both the higher yield and the expected capital appreciation of the dollar implied by the regression.

Answer: D

Comment: A popular interpretation, p.239

19) What problem occurred as the result of a monetary stabilization plan consisting of tiding two currencies to the same exchange rate?

A) Peso problem

B) Argentina 2000

C) Swedish problem

D) Survey data problem

Answer: B

Comment: Argentina in 2000, p.245

20) The peso problem got its name during the period 1955-1976 when the ________ authorities were attempting to peg the peso-dollar exchange rate.

A) Argentine

B) Brazilian

C) Mexican

D) Honduran

Answer: C

Comment: Peso Problems, p. 244

7.2 Multiple Choice Moderate

1) Which one of the following is the only determinant of volatility in the forward currency markets?

A) interest rate parity

B) economic recovery

C) political turmoil

D) variance of the future exchange rates

Answer: D

2) To construct the uncertain yen-denominated return from investing one yen in the Swiss franc, what is your first step?

A) convert from yen into Swiss francs in the spot market

B) convert from Swiss francs into yen in the forward market

C) invest in the Swiss money market

D) convert from Swiss francs into yen at the future spot rate

Answer: A

3) Which one of the following would be an answer to why the forward exchange rate is an unbiased predictor of the future spot rate?

A) The forward rate is greater than the conditional expectation of the future spot rate.

B) The forward rate equals than the conditional expectation of the future spot rate.

C) The forward rate is less than the conditional expectation of the future spot rate.

D) The current spot rate is greater than the conditional expectation of the future spot rate.

Answer: B

4) To determine the risk premium associated with an asset's expected return, two components of the return are usually cited, only the first, the covariance of the asset's return with the market portfolio, is used, because ________.

A) the risk associated with the asset depends on the market risk

B) it is the only part of the asset's expected return that has risk

C) the risk of the second component can be diversified away

D) the market risk is the most difficult to calculate

Answer: C

5) Which one of the following is NOT a drawback when economists use survey data to examine the unbiasedness hypothesis?

A) Participants may not have an incentive to respond honestly.

B) Participants' investment actions are not consistent with their answers.

C) Selfish motives are generally not significant.

D) They don't know the marginal investor's expectations.

Answer: C

7.3 Short Answer

1) What is the main determinant of the volatility of forward market returns?

Answer: The main and only determinant of the volatility of forward market returns is the variance of the future exchange rate.

2) Describe how you construct the uncertain -denominated return from investing 1 in the Swiss franc money market.

Answer: If you invest in the Swiss money market, you first must convert from into Swiss francs in the spot foreign exchange market. With the Swiss francs that you get, you invest in the Swiss money market, leaving the investment unhedged. At the end of the investment horizon, you convert from Swiss francs back into at the future spot exchange rate.

3) If interest rate parity prevails, what is the return from a hedged foreign currency investment?

Answer: A hedged foreign currency investment sells the known foreign currency return in the forward market at the time of the investment. This eliminates exposure to foreign exchange risk, but it also eliminates possible gains from appreciation of the foreign currency. By interest rate parity, we know that the domestic currency return from the hedged foreign currency investment is just the domestic currency money market return.

4) If you were attempting to forecast the forward exchange rate for a particular horizon such as 90 days, how would the forward exchange rate be an unbiasedpredictor of the future spot exchange rate?

Answer: If the forward exchange rate for 90 days is an unbiased predictor of the future spot rate, the forward rate is equal to the expected future spot rate. While there will be forecast errors that may be large, there will not be systematic errors on one side or the other. Therefore, the expected forward market return is zero.

5) It is often argued that forward exchange rates should be unbiased predictors of future spot exchange rates. When the foreign exchange market is efficient, forward rates are not able to be an unbiased predictor. Is this true or false?

Answer: Market efficiency means that asset prices accurately incorporate all available information and expected returns on assets correspond to true sources of risk. If forward rates are biased predictors of future spot exchange rates, the source of the bias could be an equilibrium risk premium. Thus, the claim that forward exchange rates should be unbiased predictors of future spot exchange rates if the foreign exchange market is efficient is wrong.

7.4 Essay

1) What is the prediction of the CAPM for the relationship between the forward exchange rate and the expected future spot exchange rate?

Answer: The CAPM predicts that the expected excess return on an asset is the beta of the asset times the expected excess return on the market portfolio. The beta is the covariance of the return on the asset with the return on the market portfolio divided by the variance of the market portfolio. By applying the CAPM to uncovered foreign money market investments and using interest rate parity, one can demonstrate that the expected return on a forward contract equals the beta on the return on the forward contract times the expected excess return on the market portfolio. The expected return on a forward contract to purchase foreign currency is the difference between the expected future spot exchange rate and the forward exchange rate scaled by the current spot rate.

2) Why is it true that the hypothesis that the forward exchange rate is an unbiased predictor of the future spot exchange rate is equivalent to the hypothesis that the forward premium (or discount) on a foreign currency is an unbiased predictor of the rate of its appreciation (or depreciation)?

Answer: When the forward exchange rate is an unbiased predictor of the future spot exchange rate, we know that the forward rate equals the conditional expectation of the future spot rate. For example, at the 90 day maturity, we have

F(t,90) = Et [ S(t + 90) ]

Because the current spot rate, S(t), is in the information set that is used to take the conditional expectation, we can divide by it on both sides of the above equation. Subtracting one from both sides then gives

[ (F(t,90) - S(t)) / (S(t)) ] = Et [ (S(t + 90) - S(t)) / (S(t)) ]

This equation states that the forward premium on the foreign currency equals the expected rate of appreciation of the foreign currency. 7Copyright 2012 Pearson Education, Inc.