CHAPTER 12

TRUE/FALSE QUESTIONS

(T) 1. If interest rates are higher in Japan than in the United States, the cost of a yen per U.S.
dollar in the spot market will typically be higher than in the forward market.

(F) 2. A country's forward exchange rate will represent a higher home currency value
relative to its spot exchange rate when people expect it to have more inflation
than other countries.

(T) 3. A weak U. S. dollar will lead to increased foreign demand for U.S goods.

(T) 4. In the balance of payments, the difference between current account flows, capital and
financial account flows is shown as a statistical discrepancy.

(T) 5. A strong dollar would make imports cheaper, and may eventually force domestic
producers of goods with import substitutes to lower prices.

(T) 6. Eurobonds are bearer bonds and do not have to be registered and often pay interest annually
rather than semiannually.

(T) 7. If a government buys its domestic currency from foreigners, its exchange rate will rise all
else equal.

(T) 8. Governments whose country imports a lot encourage long-term foreign investment in
their countries because it helps balance their balance of payments.

(T) 9. A Canadian dollar cost $0.84 in U.S. dollars and later costs $0.86. The U.S. dollar has
depreciated relative to the Canadian dollar.

(F) 10. If a Canadian dollar costs $0.83 in U.S. dollars, a U.S. dollar costs a Canadian $1.17 in
Canadian dollars.

(F) 11. When the foreign demand for a country's goods and services increases, the demand for
the foreign country's currency also increases.

(F) 12. Exports grow when foreign currencies depreciate relative to the dollar.

(T) 13. Capital flight from a country tends to reduce the value of the country's currency relative
to other countries.

(F) 14. If a U.S. exporter agrees to receive payment in 60 days in pounds, the British importer
has assumed the exchange rate risk in the transaction.

(T) 15. The demand for foreign exchange by an importer is a demand derived from a pending
economic transaction.

(T) 16. A deficit in the trade balance of payments puts downward pressure on the exchange rate.

137
(T) 17. In balance of payments accounting, a deficit in the current account may be offset by a
surplus in the financial accounts.

(F) 18. If merchandise imports exceed merchandise exports, the trade balance is in a surplus
position.

(T) 19. If an investor can obtain more euros for a dollar in the forward market than in the
spot market, then the euro is said to be selling at a discount to its spot rate.

(T) 20. A foreign currency will, on average over the long term, appreciate against the U.S. dollar
at a percentage rate approximately equal to the amount by which its inflation rate
exceeds that of the United States if purchasing power parity holds.

(T) 21. Foreign financial investment in the U.S. is an inflow in the U.S. financial account and the
interest earned on the investments would be an outflow in the U.S. current account.

138
 MULTIPLE-CHOICE QUESTIONS

(c) 1. A foreign exchange rate is best described as

a. the cost of an imported good.
b. the current interest rates difference of varying countries.
c. the cost of a unit of one currency in terms of another currency.
d. the expected change in prices of international goods.

(c) 2. Exchange rate risk is best described as

a. the cost of a unit of currency in terms of another.
b. the variability in the current accounts balance of the balance of payments.
c. the variability of investment returns or prices of goods and services caused by
changes in the value of one currency versus another.
d. the difference between domestic and international interest rates.

(a) 3. Which of the following is NOT a reason that foreign exchange markets exist?
a. to allow firms to borrow money in their home currency.
b. to exchange purchasing power between trading partners with different local
currencies.
c. to provide a means for passing the risk associated with changes in foreign
exchange rates to professional risk-takers.
d. to accommodate credit extension and delayed payments for goods and services
between countries.

(c) 4. Which one of the following is the correct definition of segniorage?

a. the cost to print money
b. the difference between the current account and the financial account
c. the difference between the cost of the printed currency and the exchange value
of the currency
d. the change in the value of the dollar due to balance of payment imbalances

(b) 5. French importers of U.S. merchandise are most likely to be involved in foreign exchange
markets by
a. buying Euros in return for U.S. dollars.
b. selling Euros in return for U.S. dollars.
c. selling dollars in return for Euros.
d. buying both Euros and dollars.

(c) 6. A Mexican importer of computer parts from Canada denominated in Canadian dollars
would take which action in the foreign exchange markets?
a. supply Canadian dollars
b. demand pesos
c. demand Canadian dollars
d. demand U.S. dollars

(c) 7. Some countries have adopted a process of dollarization. This means

a. they are members of the U.S. Federal Reserve System.
b. they are signers of the Basel Accord.
c. they have adopted the U.S. dollar as their currency.
d. they have agreed to pay segniorage to the U.S. Federal Reserve.

139
(a) 8. A Detroit bank pays a 6% APR for a $100,000 six-month certificate of deposit, while a
Windsor, Ontario bank advertises a rate of 7.5%. If it costs approximately $50 in
travel and forward contract commissions to invest in Canada, which CD should the
Detroit investor take given the foreign exchange rates below?
U.S. dollar Equiv. Rates
Canadian dollar spot rate $0.8345 USD
180 day Forward $0.8225 USD
a. Make the U.S. CD investment.
b. Make the Canadian CD investment.
c. The investor is indifferent between the two because interest parity holds in this
case.
d. One is unable to make this calculation with the data provided.

(c) 9. A U.S. investor purchased a C$100,000 Canadian dollar CD 6 months ago at an APR of 7
percent. The Canadian spot rate was 1.367 C$/U.S.$ when the investment was made.
The U.S. dollar cost of the investment was ________ and the total amount of
Canadian investment was _________ C$ after 6 months.
a. $136,700; C$107,000
b. $73,153; C$107,000
c. $73,153; C$103,500
d. $136,700; C$103,500

(b) 10. Suppose the current exchange rate between U.S. Dollar and Euro is $1.355/€. This means
that
a. one Dollar can buy 1.355 Euros.
b. one Euro can buy 0.738 Dollars.
c. one Dollar can buy 0.738 Euros.
d. the Dollar is worth more than the Euro.

(c) 11. If the cost of the yen per dollar changes from 100 to 110 yen per dollar,
a. The yen has appreciated against the dollar.
b. The dollar has depreciated against the yen.
c. The dollar has appreciated against the yen.
d. the cost of a yen has increased in terms of dollars.

(b) 12. Suppose the dollar is currently worth 110 yen. Based on trade flows and inflation, if the
U.S. trade deficit with Japan continues, and if U.S. inflation rates exceed those in
Japan which one of the following could be the correct result?
a. the yen is likely to appreciate to 120 yen per dollar.
b. the yen is likely to appreciate to 100 yen per dollar.
c. the yen is likely to depreciate to 100 yen per dollar.
d. the yen is likely to depreciate to 120 yen per dollar.

(a) 13. If a Canadian dollar costs $0.84 in U.S. dollars today and traded for $0.86 last year, the
U.S. dollar
a. has appreciated against the Canadian dollar.
b. has depreciated against the Canadian dollar.
c. has less buying power in Canada.
d. has violated purchasing power parity.

140
(c) 14. A U.S. financial account surplus represents
a. imports of goods and services greater than exports.
b. exports of goods and services greater than imports.
c. net foreign investment inflows to the U.S. from the foreign sector.
d. net foreign investment outflows from the U.S. to the foreign sector.

(c) 15. With reference to international balance of payment accounting, if a country's

merchandise imports exceed merchandise exports for a period,
a. the country will have a surplus in the balance on current account.
b. the country will have a deficit in the financial accounts for the period.
c. the country has a deficit in the merchandise trade account.
d. the country has a surplus in the merchandise trade account.

(b) 16. The U.S. exchange rate is unlikely to change if

a. the U.S. inflation rate is twice that of other developed nations.
b. the current account budget deficits/surpluses are offset by reverse capital flows.
c. the current account deficit in the U.S. is offset by financial flows much larger
than the current account deficit.
d. the U.S. has a current account deficit and the Fed sells dollars to acquire foreign
currency reserves.

(c) 17. Everything else equal, significant trade deficits should have what effect on a country's
exchange rate?
a. Trade levels do not affect exchange rates.
b. The country's currency should appreciate in value relative to their major trading
countries.
c. The country's currency should depreciate in value relative to their major trading
countries.
d. The country’s currency will first appreciate, then depreciate over the long term.

(d) 18. The United States can import more goods that it exports without experiencing a decline
in its exchange rate if
I. the U.S. is investing more abroad than foreigners are investing in the U.S.
II. foreigners are buying more long-term investments in the United States than U.S.
citizens are buying abroad.
III. foreigners need enough dollars to pay for dollar denominated goods and services and
pay off dollar denominated debts.
IV. foreign governments loan their excess dollars to the U.S.
a. I and II
b. II and III
c. I, II and III
d. II, III and IV

141
(d) 19. Exchange rates are influenced by
I. trade flows.
II. financial flows.
III. government intervention.
IV. differences in inflation rates.
a. I and II
b. II, III and IV
c. I, II and III
d. I, II, III and IV

(b) 20. The Bretton Woods system of fixed exchange rate ended in the
a. 1960s
b. 1970s
c. 1980s
d. 1990s

(a) 21. EURIBOR refers to

a. the rate on deposits denominated in euros offered by one bank to another
within the EMU.
b. the rate on loans of dollar denominated deposits between banks.
c. the rate the Federal Reserve charges for banks to borrow euros.
d. the London interbank borrowing rate.

(b) 22. Investment flows from one country to another occur based on the investors'
a. nominal rate of return on the foreign investment
b. the expected real rate of return on the foreign investment.
c. spot exchange rate when making the investment.
d. the realized real rate of return on the foreign investment.

(c) 23. A receipt issued to the exporter by a common carrier that acknowledges possession of the
goods described on the face of the bill is called a ______.
a. time draft
b. sight draft
c. bill of lading
d. letter of credit

(d) 24. A financial instrument issued by an importer’s bank that obligates the bank to pay the
exporter a specified amount of money once certain conditions are fulfilled is
called a ______.
a. time draft
b. sight draft
c. bill of lading
d. letter of credit
e. banker’s acceptance

(a) 25. A government that wants to promote domestic exports could take which action?
a. sell its currency in the foreign exchange markets
b. sell assets (securities) abroad
c. raise its interest rates
d. impose severe import restrictions

142
(b) 26. If a government wanted to promote exports and a trade surplus, it might institute all of
the following policies except:
a. Establish import trade tariffs and quotas.
b. Buy domestic currency in the foreign exchange markets.
c. Provide low cost financing for export industries.
d. Require local content on all imports.

(a) 27. Foreign merchants often conduct transactions in U.S. dollars because
a. the dollar is a generally acceptable medium of exchange in international
transactions.
b. they don't have enough local currency of their own.
c. interest rates on the dollar are higher than on their currency.
d. inflation is higher in the United States.

(b) 28. If purchasing power parity existed in foreign exchange rates,

a. foreign exchange rates would remain constant.
b. goods and services would cost the same in terms of dollars everywhere in the
world.
c. goods and services would cost the same in each local currency.
d. foreign exchange rates would be the same anywhere in the world markets.

(b) 29. A major reason that exchange rates do not adjust so purchasing power parity holds
precisely is that
a. investors are using forward contracts when trading.
b. there are barriers that prevent arbitraging different prices in different countries.
c. consumers and businesses of each country are not concerned about the cost of
goods in other countries.
d. purchasing power parity is only a theory.
e. Exchange rates do, in fact, adjust to ensure that purchasing power parity holds.

(a) 30. An item costs $5.00 in the U.S. and 525 yen in Japan. If purchasing power parity holds,
what is the yen/dollar exchange rate?
a. 105 yen/dollar
b. 525 yen/dollar
c. 100 yen/dollar
d. 125 yen/dollar
e. .0095 yen/dollar

(b) 31. If an item costs 4 Euros in Germany, assuming purchasing power parity with current
exchange rates of $1.3135/€, what is the price of the item in the U.S.?
a. $0.33
b. $5.25
c. $3.05
d. $4.00
e. €4.00

(b) 32. If a country experiences inflation, then generally its

a. currency will depreciate relative to countries with lower inflation
b. currency will depreciate relative to countries with higher inflation
c. imports will increase significantly.
d. interest rates will fall.

143
(c) 33. If expected inflation in the United States is below that in Britain, one would expect
a. U.S. exports to Britain to increase significantly.
b. the United States to experience balance of payments problems in the future.
c. the dollar to appreciate against the pound.
d. U.S. interest rates to be above British rates.

(b) 34. If the rate of inflation in the U.S. is twice the rate in Japan,
a. purchasing power parity will not be maintained.
b. the yen/dollar exchange rate is likely to decrease.
c. the yen/dollar exchange rate is likely to increase.
d. the exchange rate will not change because inflation has no effect on exchange
rates.

(d) 35. Which of the following are largely responsible for keeping exchange rates the same in all
world markets?
a. foreign exchange deals
b. forward markets
c. futures markets
d. arbitragers
e. central banks

(c) 36. The foreign exchange market

a. is an auction market with a physical exchange floor, similar to the NYSE.
b. has restricted trading hours.
c. is composed of a group of informal markets closely interlocked through
international banking relationships.
d. ensures that purchasing power parity holds.
e. consists primarily of trading activity between central banks

(c) 37. A U.S. commercial bank must pay 20 million Canadian dollars (C$) in 90 days. It
wishes to hedge the risk in the futures market. To best do so the bank should
a. sell $20 million USD in Canadian dollar futures with two months maturity.
b. buy $20 million USD in Canadian dollar futures that mature in 90 days.
c. buy C$20 million in Canadian dollar futures that mature in 90 days.
d. sell C$20 million in Canadian dollar futures that mature in 3 months.

(a) 38. The action of foreign exchange _______ tends to keep exchange rates among different
currencies consistent with each other.
a. arbitragers
b. regulators
c. traders
d. brokers
e. bankers

(a) 39. An importer who must pay yen in 60 days may hedge the foreign exchange risk
a. in the forward market.
b. in the spot market today.
c. by waiting 60 days from now to purchase the yen.
d. by waiting 60 days from now to sell the yen.

144
(b) 40. An American firm sells farm equipment to a British company for ₤250,000 to be paid in
180 days. The current exchange rate is $1.98/₤. The exporter hedges its exchange
rate risk by selling ₤250,000 forward 180 days at the prevailing 180-day forward
exchange rate of $2.01/₤. What is the dollar amount the American firm is expected
to receive in 180 days?
a. $495,000
b. $502,500
c. $201,000
d. $198,000
e. ₤250,000

(c) 41. An American firm sells farm equipment to a British company for ₤250,000 to be paid in
180 days. The current exchange rate is $1.98/₤. The exporter hedges its exchange
rate risk by buying a put option on ₤250,000 with the strike exchange rate of $1.92/₤.
The put expiring in 180 days cost the firm $5,000. What is the dollar amount the
American firm will net on this transaction if the exchange rate is $1.96/₤ in 180 days?
a. $495,000
b. $490,000
c. $485,000
d. $480,000
e. $475,000

(c) 42. A payment guarantee issued by a commercial bank on behalf of an importer is a

a. sight draft.
b. time draft.
c. letter of credit.
d. documented transfer.
e. bill of lading.

(d) 43. A _______ draft is paid on demand; whereas a bank would pay a _______ draft at
maturity as stated in the _______.
a. time; sight; bill of lading
b. sight; time; bill of lading
c. time; sight; letter of credit
d. sight; time; letter of credit

(d) 44. Which of the following instruments are not commonly used to facilitate international
transactions?
a. letters of credit
b. bills of lading
c. sight drafts
d. repurchase agreements
e. commercial paper

(c) 45. Eurodollars are

a. dollar currency ($100 bills) in less-developed countries in Europe.
b. Euros held by U.S. citizens.
c. a dollar-denominated bank deposit held outside the U. S.
d. the common currency in Europe.

145
(a) 46. Eurocurrency is
a. Any currency held in a time deposit account outside of its country of origin.
b. Any currency held in a time deposit account in Europe.
c. Any currency held in a time deposit account outside of the U.S.
d. Euros held in a time deposit account in Europe.

(b) 47. Eurocurrency markets are a source of attractively priced working capital loans for
multinational firms because:
I. Lower regulatory costs allow lenders to offer lower cost loans.
II. Economies of scale in the wholesale market allow better pricing.
III. Dollars are more expensive to hold than other currencies.
a. I only
b. I and II only
c. II and III only
d. I, II and III

(b) 48. Which of the following is not the reason the Eurocurrency market is an attractive place to
store excess liquidity for corporations, countries, and central banks?
a. Investors are allowed to hold debt securities in bearer form
b. Automatic withholding of tax on interest earned
c. Investments earn higher returns
d. High liquidity of Eurocurrency deposits

(c) 49. Which of the following is not correct concerning U.S. issued bonds and Eurodollar
bonds?
a. Eurobonds are usually issued in bearer form; bonds sold in the U.S. are usually
registered bonds.
b. Eurobonds usually pay interest once a year; bonds sold in the U.S. usually pay
interest semiannually.
c. Eurobonds are denominated in Euros; bonds sold in the U.S. are denominated in
dollars.
d. Interest on Eurobonds is computed using a 360-day year vs. a 365-day year for
bonds issued in the U.S.

(c) 50. Which of the following is true about Eurobonds?

a. They are underwritten by European banks only.
b. Eurobonds are registered bonds
c. Interest or coupon payments are annual and are calculated based on a 360-day year.
d. Eurobonds are denominated in any currency other than dollars.

146
(b) 51. One year ago, a U.S. investor converted dollars to yen and purchased 100 shares of
Nardasausau stock in a Japanese company at a price of 3,150 yen per share. The total
purchasing cost was 315,000 yen. At the time of purchase, in the currency market 1
yen equaled $0.00952. Today, Nardasausau stock is selling at a price of 3,465 yen
per share, and in the currency market $1 equals 130 yen. The stock does not pay a
dividend. If the investor were to sell the stock today and convert the proceeds back to
dollars, what would be his realized return on his initial dollar investment from

holding Nardasausau stock?

a. +10.00%
b. -11.12%
c. +12.48%
d. +11.12%
e. -12.48%

(b) 52. If interest rate parity holds and the annual Taiwan nominal interest rate is 7% and
the U.S. annual nominal rate is 5% and real interest rates are 2% in both
countries, then inflation in Taiwan is about _____ than in the U.S.
a. 1% higher
b. 2% higher
c. 1% lower
d. 2% lower
e. 3% lower

(d) 53. Suppose that at the beginning of 2015, the exchange rate between the Australian
dollar (AD) and the U.S. dollar (USD) was 2.2 AD per USD. Over the
year, Australia’s inflation was 12% and the U.S. inflation was 4%. If
purchasing power parity holds, at the end of 2015, the exchange rate should be
approximately _____ USDs per AD.
a. 2.3913
b. 0.4895
c. 2.8498
d. 0.4182
e. 0.3440

(c) 54. Which of the following conditions may lead to a decline in the
value of a country’s currency all else equal?
I. high interest rates
II. high inflation
III. large current account deficit
IV. widespread labor strikes and violent protests that shut
down business
a. I only
b. I and II only
c. II, III, and IV only
d. II and IV only
e. I and III only

147
(a) 55. A U.S. current account surplus implies that
a. More goods and services are exported than are imported
b. The U.S. borrowed from abroad more than it loaned, and/or sold off some
of its assets
c. There is under consumption of foreign financial assets
d. The value of the dollar will drop
e. The country’s credit rating is going to be downgraded

148
 ESSAY QUESTIONS

1. Explain how and why the U.S. forward exchange rates against the Euro are related to
short-term interest rates in the United States and Germany.

Answer: Interest rate differentials between developed countries are reflected in the
forward/spot differential, affected by covered interest arbitrage activities of investors.
That is, one can borrow in the country with the lower interest rate and invest in the
country with the higher interest rate unless the exchange rate of the higher interest rate
country declines sufficiently to eliminate the difference in interest rates.

2. Explain why a decline in a country's exchange rate will generally increase the demand for
its goods and reduce its demand for foreign goods.

Answer: A decline in a country’s exchange rate, the amount of a foreign currency

purchased with a unit of domestic currency, makes foreign goods more expensive to
domestic customers and a country’s exports more attractively priced to foreign
consumers. Think of the exchange rate as a price that has to be paid in order to acquire a
country’s goods, services and financial assets. If the price is higher, a stronger currency,
it cost more to buy that country’s products and there are fewer exports and more imports.

3. Under what conditions could a country have a sizable deficit in its trade balance and still
have an appreciating currency?

Answer: Such has been the case for the United States for many years. The dollar has
generally strengthened even though the U.S. has had a current account deficit for years.
The deficit should decrease the value of the dollar relative to its trading partners, but
investors’ financial flows into the U.S. financial markets have, at times, more than offset
the glut of dollars into forex markets from the trade deficit. Some of this has been due to
the safe haven status of the U.S., some is due to good investment opportunities in real
assets in the U.S. and some is due to foreign central banks accumulating dollars to keep
their own currency values competitive in order to support their export markets. The extra
dollars have typically wound up being invested in the U.S.

4. Increased U.S. inflation, relative to other trading partner nations, should have what
impact on the value of the U.S. dollar? Explain in terms of purchasing power parity.

Answer: Increased U.S. inflation and higher U.S. prices relative to other trading
countries should decrease the value of the U.S. dollar all else equal. The concept of
purchasing power parity is that a tradeable good or service should have the same cost in
different countries. Hence if an item cost $100 in the U.S. it should have a cost
equivalent to $100 in another country after converting your dollars to the local currency.
Hence, if prices rise faster in the U.S. than elsewhere then the dollar has to depreciate to
keep the cost the same to a foreign buyer.

149
5. List four main reasons for the increased internationalization of financial markets in the
last two decades.

1) Governments allowing freer movement of trade and capital flows

2) Emergence of floating exchange rates
3) Globalization of business and growth of large multinational firms
4) Improvements in technology that have allowed cheaper transportation and
communication

6. Forrest Gump Bank, a U.S. bank, has 1-year U.S. $200 million loan that earns an average
rate of return of 6%. Forrest Gump Bank also has one year single payment Euro loans of
€110 million earning 8%. Forrest Gump Bank’s funding source is $300 million in US$
one year NCDs, on which they are paying 4%. Initially the exchange rate is €1.10 per $1
U.S. The one year forward rate is €1.14 per $1 U.S. What is the bank's dollar % spread
if they hedge fully using Euro forwards?

Answer: Since Forrest Gump Bank will receive Euro and wants to convert as US$ at the
end of period, it should Hedge by selling € forward. The current € amount is €110
million. In one year these loans will be worth €110 Million * 1.08 = €118,800,000.
Selling this amount forward €118,800,000/€1.14 will give $104,210,526. This gives a
rate of return in dollars of [$104,210,526 / U.S.$100 million] – 1 = 4.211%.
Average rate of return = (2/3 * 6%) + (1/3 * 4.211%) = 5.404% and the cost rate = 4%, so
the spread = 5.404% - 4% = 1.404%.

150