International Corporate Finance 1st Edition Ashok Robin – Test Bank

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Chapter 05

Currency Parity Conditions

 

Multiple Choice Questions

  1. Currency-related parity conditions arise from:
    A. international currency markets.
    B. cross-border financial transactions.
    C. relationships between currency exchange rates and certain economic variables.
    D. the interaction of spot and forward currency exchange rates.

 

  1. Currencies trade in pairs which means that:
    A. an entity buying a target currency will always have to acquire some other currency in addition to the target currency.
    B. a currency can be acquired either directly or indirectly by buying a currency and then trading that currency for the target currency.
    C. a currency transaction will be more costly than if a single currency could be acquired.
    D. the volume of currency markets is exaggerated.

 

  1. For MNCs, the discrepancies in the price of currencies that can occur on different markets:
    A. means that MNCs have to shop carefully when they need to buy foreign currency.
    B. allows MNCs to avoid losses arising out of currency transactions.
    C. relieves MNCs from having to plan currency transactions carefully.
    D. has allowed MNCs to become the largest speculators in currencies.

 

  1. ___________ is based on the concept that if you buy something at one price and sell it at a higher price, you will make a profit.
    A. Arbitrage
    B. Capitalism
    C. Currency exchange
    D. Barter

 

 

  1. When a person simultaneously buys currency at a less expensive location and sells that same currency at a more expensive location, the transaction is known as:
    A. locational arbitrage.
    B. hedging.
    C. a currency swap.
    D. a currency conversion.

 

  1. What effect does the process of arbitrage have on currency markets?
    A. It interferes with the proper functioning of the currency markets.
    B. It creates unnatural demand for currencies that are the subject of arbitrage transactions.
    C. It makes them function properly and is responsible for the rational pricing of currencies.
    D. It does not affect the currency markets because it involves both purchases and sales of the same currency.

 

  1. When the a transaction involves the purchase and sale of three different currencies so that the person conducting the transaction begins with a specific amount of one currency and ends with a greater amount of that currency, the transaction is:
    A. a three-party currency exchange.
    B. a currency market currency swap.
    C. illegal unless approved by the countries issuing the currency involved.
    D. an example of triangular arbitrage.

 

  1. The part of the financial markets that trades financial instruments issued by governments, banks and corporations is called the:
    A. credit market.
    B. money market.
    C. equity market.
    D. currency market.

 

 

  1. Borrowing in one currency at a low interest rate and lending in another currency at a higher interest rate while protecting against adverse changes in currency exchange rates with forward contracts is known as:
    A. currency swaps.
    B. carry trade.
    C. cover interest arbitrage.
    D. interest swaps.

 

  1. In a covered interest arbitrage transaction, the borrowed currency is known as the ________________________ and the lent currency is known as the ___________________.
    A. target currency; funding currency
    B. funding currency; target currency
    C. funding currency; interest-bearing currency
    D. swap currency; target currency

 

  1. If an investor borrows funds in currency with a low interest rate and loans those funds in a currency with a higher interest rate but the investor does not acquire a forward contract that assures an acceptable exchange rate for the loaned currency, the transaction is called a (an) ________________ transaction.
    A. ill-advised
    B. currency swap gamble
    C. carry trade
    D. uncovered interest arbitrage

 

  1. In the context of covered interest arbitrage, the spot-forward differential refers to the difference between:
    A. the current interest rate and the interest rate at a specific date in the future.
    B. the spot or current exchange rate of a currency and the forward or predetermined exchange rate of that currency at a specific date in the future.
    C. the spot or current exchange rate of a currency and the to-be-determined exchange rate of that currency at a specific date in the future.
    D. the total, combined current exchange rate plus the future exchange rate.

 

 

  1. The effect of arbitrage transactions on markets can best be described as:
    A. currency and money markets will be destabilized.
    B. those who need currencies for business and trade purposes will be excluded from the markets.
    C. interest rates and values of the currencies involved will tend to converge.
    D. regulators will eventually restrict the ability to engage in arbitrage transactions.

 

  1. At equilibrium, arbitrage profits are:
    A. zero.
    B. maximized.
    C. difficult to predict.
    D. not possible and losses are probable.

 

  1. When a foreign interest rate is higher than a domestic interest rate, the foreign currency’s forward rate will be less than its spot rate. That means that:
    A. the value of the foreign currency is expected to decline in the future.
    B. the value of the foreign currency is expected to increase in the future.
    C. the foreign interest rate is expected to increase in the future.
    D. the foreign interest rate is expected to decline in the future.

 

  1. If the interest rates in a country are higher relative to interest rates in other countries, the short-term and long-term effects on the value of the currency of that country are:
    A. the same, since interest rates do not affect currency values.
    B. the same, since the central bank of the country will lower interest rates so that interest rates will not affect currency value.
    C. the value of the currency will increase as capital flows into the country to take advantage of the higher interest rates, but the value of the currency will decline when investors withdraw their funds from that country.
    D. the value of the currency will decrease as confidence in the country’s currency suffers, but the value of the currency will eventually rise as confidence is restored.

 

 

  1. The majority of cover interest arbitrage transactions involve the use of instruments denominated in:
    A. USD.
    B. EUR.
    C. JPY.
    D. Eurocurrency.

 

  1. A country’s capital controls can affect interest rate parity by:
    A. causing interest rates to be higher independent of the forward premium of the country’s currency.
    B. limiting foreign investment in the country so that interest rates are artificially reduced.
    C. limiting foreign investment in the country so that interest rates are artificially increased.
    D. causing the forward premium of the country’s currency to be increased without regard to the real value of the currency.

 

  1. __________________________ say(s) that exchange rates should equalize prices of a basket of goods in two countries.
    A. Purchasing Power Parity
    B. Product market mechanics
    C. Government regulations
    D. Currency values

 

  1. Purchasing Power Parity is most useful in explaining currency misalignments when it compares:
    A. countries located in the same region of the world.
    B. dissimilar economies.
    C. countries at a similar stage of development.
    D. longer periods of time as opposed to shorter periods of time.

 

  1. Purchasing Power Parity is:
    A. the law of one price applied to national price indices.
    B. not a valid index of prices and currency values.
    C. used to determine if a country’s currency regulations are affecting the value of its currency.
    D. used to determine the proper forward premium of a currency.

 

 

  1. Absolute purchasing power parity requires that:
    A. government regulations assure that prices for goods are the same in all locations.
    B. the law of one price be in place and result in prices for goods in one location be equivalent to the price of those goods in another place.
    C. markets function efficiently so that the price of goods are the same everywhere they are sold.
    D. goods markets function efficiently and the price of goods fluctuate.

 

  1. Relative purchasing power parity focuses on ________________ while absolute purchasing power parity focuses on _________________.
    A. price levels; price changes
    B. inflation; price changes
    C. price changes; price levels
    D. price changes; inflation

 

  1. If absolute purchasing power parity is achieved, then relative purchasing power parity:
    A. is achieved only if inflation is not present.
    B. cannot be achieved.
    C. can only be achieved through government regulation of prices.
    D. is achieved automatically.

 

  1. Purchasing power parity can arise when:
    A. goods from a high-price country are purchased and then sold in a low-price country.
    B. goods from a low-price country are purchased and then sold in a high-price country.
    C. a country with low-price goods arbitrarily imposes tariffs that increase the price of the goods.
    D. manufacturers of goods restrict the sale of those goods in low-price countries.

 

  1. Purchasing power parity can arise from two types of transactions:
    A. trading and manufacturing.
    B. arbitrage and financing.
    C. speculating and hoarding.
    D. production and bartering.

 

 

  1. Anything that disrupts cross-border trading and manufacturing activities:
    A. violates international trade agreements.
    B. justifies retaliation by other countries suffering negative consequences from such disruptions.
    C. can be resolved by the World Trade Organization.
    D. can lead to disruption of purchasing power parity.

 

  1. If a price is “sticky”, it:
    A. does not change when currency values change but rather is affected by real world considerations.
    B. is directly related to or “stuck” to currency values.
    C. changes indirectly to currency value changes.
    D. is affected only by changes in currency values and is not affected by other considerations.

 

  1. In the short term:
    A. purchasing power parity can be accomplished, but only with government intervention to control prices.
    B. purchasing power parity will be accomplished if markets are allowed to operate freely.
    C. purchasing power parity is not reached and currency values do not tend to converge because of other factors affecting.
    D. purchasing power parity is not reached buy currency values do tend to converge anyway.

 

  1. Eurocurrency futures are:
    A. derivatives based on foreign currency exchange rates.
    B. short-term interest rate derivatives based on LIBOR or other similar rates.
    C. agreements to purchase specific foreign currencies at specific rates at specific dates in the future.
    D. derivatives based on the law of one price.

 

 

  1. Interest arbitrage transactions can be “covered” by long-term forward contracts, but the primary problem with long-term forward contract is that they:
    A. are expensive.
    B. are difficult to find.
    C. do not guarantee the arbitrage profit.
    D. offer a reduced level of liquidity.

 

  1. The actual, stated or contract interest rate on an investment or a loan is called the:
    A. real rate.
    B. calculated rate.
    C. nominal rate.
    D. unaltered rate.

 

  1. Real rates are:
    A. the same as nominal or stated rates.
    B. calculated on the basis of the nominal rate reduced by the stated rate.
    C. inflation rates.
    D. not observed or stated but rather the nominal rate reduced by the rate of inflation.

 

  1. “Grossing-up” nominal interest rates means:
    A. adding up all of the interest rates at major institutions in a country and dividing by the number of institutions considered to determine an average interest rate.
    B. determining the differential in interest rates in one country compared to interest rates in another country.
    C. reducing nominal rates by the inflation rate to compensate for the loss of purchasing power attributed to inflation.
    D. increasing nominal rates by the inflation percentage to determine the real purchasing power of consumers.

 

  1. The nominal interest rate contains two components:
    A. the real interest rate and the exchange rate.
    B. the real interest rate and the inflation rate.
    C. the inflation rate and a risk factor.
    D. the real interest rate and a risk factor.

 

 

  1. Because the International Fisher Effect references the future spot rate of a currency, it is also called:
    A. covered interest rate parity.
    B. nominal interest rate parity.
    C. uncovered interest rate parity.
    D. real interest rate parity.

 

  1. MNCs use currency forecasting in:
    A. speculating in purchasing and selling foreign currency.
    B. budgeting, financing, and working capital management.
    C. determining their operating cash needs at a specific future date.
    D. computing profit or loss on completed transactions.

 

  1. The basis theory in using spot rates to forecast future value of the currency is that:
    A. markets are notoriously unpredictable, so trying to determine what a currency will be worth in the future is unreliable and the current value of the currency is as good as any guess.
    B. over time, the spot rate of a currency determines the future value of the currency and it is easy and inexpensive to determine the spot rate of a currency.
    C. market participants are considered to all relevant information in their current trading, so all information that can affect the future value of a currency is already factored into the value of the currency.
    D. over time, the changes to the spot rate will be both positive and negative, so the spot rate, as somewhere near the average value of the currency over time, is a good estimation of the future value of the currency.

 

  1. Currency forwards are good indicators of the future spot rate of a currency because they:
    A. require that all parties trading in that currency at a specific future date value the currency at the same amount.
    B. contractually bind entities to transaction business in the currency in the future at the current spot rate.
    C. control what the future spot rate of the currency will be.
    D. represent the estimation of future currency values by entities that have contracted for those rates in future transactions.

 

 

  1. Forward parity refers to:
    A. the equality of a forward rate to the expected spot rate of the currency.
    B. the difference between a forward rate and the expected spot rate of the currency.
    C. the amount by which the future spot rate of a currency exceeds the forward rate of the currency.
    D. the amount by which the forward rate of a currency exceeds the future spot rate of the currency.

 

  1. Older studies say that forward rates are _________________________ but more recent studies suggest that forward rates __________________________________________.
    A. are not good indicators of future currency values; are even less accurate in predicting future currency values
    B. are not good indicators of future currency values; of currencies of emerging nations are fairly accurate
    C. accurate indicators of future currency values; are poor predictors of future currency values
    D. fairly accurate indicators of future currency values; are even better indicators of future currency values than previously thought

 

  1. Fundamental forecasting requires:
    A. a basic knowledge of currency value trends.
    B. the use of basic mathematical analysis applied to basic economic data.
    C. the construction of models that relate currency values to variable derived from economic theory.
    D. the use of sophisticated computer models to predict future currency values.

 

  1. Fundamental forecasting requires that factors directly affecting the supply and demand of a currency be identified. These direct factors can include:
    A. interest rate, money supply and productivity.
    B. efficiency of markets and government policies.
    C. the presence of the gold standard and government support of its currency.
    D. the price of commodities and government policies toward exports.

 

 

  1. Technical forecasting relies completely on:
    A. computer models that consider every factor that could affect the value of a currency.
    B. new information that can change the value of a currency.
    C. all information, old and new, that can change the value of a currency.
    D. an analysis of currency values over time rather than on a consideration of economic factors and their affects on the currency value.

 

  1. Technical forecasting requires the identification of factors affecting the supply and demand of currencies, including:
    A. interests rates, money supply, and productivity.
    B. inflation rates, monopolies, and derivatives.
    C. interest rates, rents, and derivatives.
    D. inflation rates, productivity, and new oil discoveries.

 

 

Essay Questions

  1. What is the difference between a risk-free transaction and an arbitrage transaction?

 

 

 

 

  1. The profit in a currency arbitrage transaction is the price differential in buying and selling the currency. What can cause the reduction or loss of that profit?

 

 

 

 

 

  1. What is covered interest arbitrage?

 

 

 

 

  1. What is the law of one price?

 

 

 

 

  1. What is the International Fisher Effect and what does it say about inflation?

 

 

 

 

 

 

Chapter 05 Currency Parity Conditions Answer Key
 

Multiple Choice Questions

  1. Currency-related parity conditions arise from:
    A.international currency markets.
    B. cross-border financial transactions.
    C. relationships between currency exchange rates and certain economic variables.
    D. the interaction of spot and forward currency exchange rates.

 

Difficulty Level: Easy
Section: Introduction

  1. Currencies trade in pairs which means that:
    A.an entity buying a target currency will always have to acquire some other currency in addition to the target currency.
    B. a currency can be acquired either directly or indirectly by buying a currency and then trading that currency for the target currency.
    C. a currency transaction will be more costly than if a single currency could be acquired.
    D. the volume of currency markets is exaggerated.

 

Difficulty Level: Easy
Section: 5.1, Basic Arbitrage in Currency Markets

  1. For MNCs, the discrepancies in the price of currencies that can occur on different markets:
    A.means that MNCs have to shop carefully when they need to buy foreign currency.
    B. allows MNCs to avoid losses arising out of currency transactions.
    C. relieves MNCs from having to plan currency transactions carefully.
    D. has allowed MNCs to become the largest speculators in currencies.

 

Difficulty Level: Easy
Section: 5.1, Basic Arbitrage in Currency Markets

 

  1. ___________ is based on the concept that if you buy something at one price and sell it at a higher price, you will make a profit.
    A.Arbitrage
    B. Capitalism
    C. Currency exchange
    D. Barter

 

Difficulty Level: Easy
Section: 5.1, Basic Arbitrage in Currency Markets

  1. When a person simultaneously buys currency at a less expensive location and sells that same currency at a more expensive location, the transaction is known as:
    A.locational arbitrage.
    B. hedging.
    C. a currency swap.
    D. a currency conversion.

 

Difficulty Level: Easy
Section: 5.1, Basic Arbitrage in Currency Markets; Locational Arbitrage

  1. What effect does the process of arbitrage have on currency markets?
    A.It interferes with the proper functioning of the currency markets.
    B. It creates unnatural demand for currencies that are the subject of arbitrage transactions.
    C. It makes them function properly and is responsible for the rational pricing of currencies.
    D. It does not affect the currency markets because it involves both purchases and sales of the same currency.

 

Difficulty Level: Intermediate
Section: 5.1, Basic Arbitrage in Currency Markets: Locational Arbitrage

 

  1. When the a transaction involves the purchase and sale of three different currencies so that the person conducting the transaction begins with a specific amount of one currency and ends with a greater amount of that currency, the transaction is:
    A.a three-party currency exchange.
    B. a currency market currency swap.
    C. illegal unless approved by the countries issuing the currency involved.
    D. an example of triangular arbitrage.

 

Difficulty Level: Easy
Section: 5.1, Basic Arbitrage in Currency Markets: Triangular Arbitrage

  1. The part of the financial markets that trades financial instruments issued by governments, banks and corporations is called the:
    A.credit market.
    B. money market.
    C. equity market.
    D. currency market.

 

Difficulty Level: Easy
Section: 5.2, Money Markets and Currency Markets

  1. Borrowing in one currency at a low interest rate and lending in another currency at a higher interest rate while protecting against adverse changes in currency exchange rates with forward contracts is known as:
    A.currency swaps.
    B. carry trade.
    C. cover interest arbitrage.
    D. interest swaps.

 

Difficulty Level: Easy
Section: 5.2, Money Markets and Currency Markets; Covered Interest Arbitrage

 

  1. In a covered interest arbitrage transaction, the borrowed currency is known as the ________________________ and the lent currency is known as the ___________________.
    A.target currency; funding currency
    B. funding currency; target currency
    C. funding currency; interest-bearing currency
    D. swap currency; target currency

 

Difficulty Level: Intermediate
Section: 5.2, Money Markets and Currency Markets; Covered Interest Arbitrage

  1. If an investor borrows funds in currency with a low interest rate and loans those funds in a currency with a higher interest rate but the investor does not acquire a forward contract that assures an acceptable exchange rate for the loaned currency, the transaction is called a (an) ________________ transaction.
    A.ill-advised
    B. currency swap gamble
    C. carry trade
    D. uncovered interest arbitrage

 

Difficulty Level: Easy
Section: 5.2, Money Markets and Currency Markets; Covered Interest Arbitrage; Role of Forward Contracts

  1. In the context of covered interest arbitrage, the spot-forward differential refers to the difference between:
    A.the current interest rate and the interest rate at a specific date in the future.
    B. the spot or current exchange rate of a currency and the forward or predetermined exchange rate of that currency at a specific date in the future.
    C. the spot or current exchange rate of a currency and the to-be-determined exchange rate of that currency at a specific date in the future.
    D. the total, combined current exchange rate plus the future exchange rate.

 

Difficulty Level: Intermediate
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity: Convergence

 

  1. The effect of arbitrage transactions on markets can best be described as:
    A.currency and money markets will be destabilized.
    B. those who need currencies for business and trade purposes will be excluded from the markets.
    C. interest rates and values of the currencies involved will tend to converge.
    D. regulators will eventually restrict the ability to engage in arbitrage transactions.

 

Difficulty Level: Intermediate
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity; Convergence

  1. At equilibrium, arbitrage profits are:
    A.zero.
    B. maximized.
    C. difficult to predict.
    D. not possible and losses are probable.

 

Difficulty Level: Easy
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity; Equilibrium

  1. When a foreign interest rate is higher than a domestic interest rate, the foreign currency’s forward rate will be less than its spot rate. That means that:
    A.the value of the foreign currency is expected to decline in the future.
    B. the value of the foreign currency is expected to increase in the future.
    C. the foreign interest rate is expected to increase in the future.
    D. the foreign interest rate is expected to decline in the future.

 

Difficulty Level: Difficult
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity; Implications

 

  1. If the interest rates in a country are higher relative to interest rates in other countries, the short-term and long-term effects on the value of the currency of that country are:
    A.the same, since interest rates do not affect currency values.
    B. the same, since the central bank of the country will lower interest rates so that interest rates will not affect currency value.
    C. the value of the currency will increase as capital flows into the country to take advantage of the higher interest rates, but the value of the currency will decline when investors withdraw their funds from that country.
    D. the value of the currency will decrease as confidence in the country’s currency suffers, but the value of the currency will eventually rise as confidence is restored.

 

Difficulty Level: Difficult
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity; Implications

  1. The majority of cover interest arbitrage transactions involve the use of instruments denominated in:
    A.USD.
    B. EUR.
    C. JPY.
    D. Eurocurrency.

 

Difficulty Level: Easy
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity; Interest Rate Conventions

  1. A country’s capital controls can affect interest rate parity by:
    A.causing interest rates to be higher independent of the forward premium of the country’s currency.
    B. limiting foreign investment in the country so that interest rates are artificially reduced.
    C. limiting foreign investment in the country so that interest rates are artificially increased.
    D. causing the forward premium of the country’s currency to be increased without regard to the real value of the currency.

 

Difficulty Level: Intermediate
Section: 5.2, Money Markets and Currency Markets; Interest Rate Parity; Evidence

 

  1. __________________________ say(s) that exchange rates should equalize prices of a basket of goods in two countries.
    A.Purchasing Power Parity
    B. Product market mechanics
    C. Government regulations
    D. Currency values

 

Difficulty Level: Easy
Section: 5.3, Product Markets and Currency Markets; Law of One Price; Exhibit 5.4

  1. Purchasing Power Parity is most useful in explaining currency misalignments when it compares:
    A.countries located in the same region of the world.
    B. dissimilar economies.
    C. countries at a similar stage of development.
    D. longer periods of time as opposed to shorter periods of time.

 

Difficulty Level: Easy
Section: 5.3, Product Markets and Currency Markets; Law of One Price; Exhibit 5.4

  1. Purchasing Power Parity is:
    A.the law of one price applied to national price indices.
    B. not a valid index of prices and currency values.
    C. used to determine if a country’s currency regulations are affecting the value of its currency.
    D. used to determine the proper forward premium of a currency.

 

Difficulty Level: Easy
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity

 

  1. Absolute purchasing power parity requires that:
    A.government regulations assure that prices for goods are the same in all locations.
    B. the law of one price be in place and result in prices for goods in one location be equivalent to the price of those goods in another place.
    C. markets function efficiently so that the price of goods are the same everywhere they are sold.
    D. goods markets function efficiently and the price of goods fluctuate.

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity

  1. Relative purchasing power parity focuses on ________________ while absolute purchasing power parity focuses on _________________.
    A.price levels; price changes
    B. inflation; price changes
    C. price changes; price levels
    D. price changes; inflation

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity

  1. If absolute purchasing power parity is achieved, then relative purchasing power parity:
    A.is achieved only if inflation is not present.
    B. cannot be achieved.
    C. can only be achieved through government regulation of prices.
    D. is achieved automatically.

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity

 

  1. Purchasing power parity can arise when:
    A.goods from a high-price country are purchased and then sold in a low-price country.
    B. goods from a low-price country are purchased and then sold in a high-price country.
    C. a country with low-price goods arbitrarily imposes tariffs that increase the price of the goods.
    D. manufacturers of goods restrict the sale of those goods in low-price countries.

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity; Impediments to PPP

  1. Purchasing power parity can arise from two types of transactions:
    A.trading and manufacturing.
    B. arbitrage and financing.
    C. speculating and hoarding.
    D. production and bartering.

 

Difficulty Level: Easy
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity; Impediments to PPP

  1. Anything that disrupts cross-border trading and manufacturing activities:
    A.violates international trade agreements.
    B. justifies retaliation by other countries suffering negative consequences from such disruptions.
    C. can be resolved by the World Trade Organization.
    D. can lead to disruption of purchasing power parity.

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity; Impediments to PPP

 

  1. If a price is “sticky”, it:
    A.does not change when currency values change but rather is affected by real world considerations.
    B. is directly related to or “stuck” to currency values.
    C. changes indirectly to currency value changes.
    D. is affected only by changes in currency values and is not affected by other considerations.

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity Evidence

  1. In the short term:
    A.purchasing power parity can be accomplished, but only with government intervention to control prices.
    B. purchasing power parity will be accomplished if markets are allowed to operate freely.
    C. purchasing power parity is not reached and currency values do not tend to converge because of other factors affecting.
    D. purchasing power parity is not reached buy currency values do tend to converge anyway.

 

Difficulty Level: Intermediate
Section: 5.3, Product Markets and Currency Markets; Purchasing Power Parity Evidence

  1. Eurocurrency futures are:
    A.derivatives based on foreign currency exchange rates.
    B. short-term interest rate derivatives based on LIBOR or other similar rates.
    C. agreements to purchase specific foreign currencies at specific rates at specific dates in the future.
    D. derivatives based on the law of one price.

 

Difficulty Level: Easy
Section: 5.4, Eurocurrency Futures Markets and Currency Markets

 

  1. Interest arbitrage transactions can be “covered” by long-term forward contracts, but the primary problem with long-term forward contract is that they:
    A.are expensive.
    B. are difficult to find.
    C. do not guarantee the arbitrage profit.
    D. offer a reduced level of liquidity.

 

Difficulty Level: Intermediate
Section: 5.4, Eurocurrency Futures Markets and Currency Markets

  1. The actual, stated or contract interest rate on an investment or a loan is called the:
    A.real rate.
    B. calculated rate.
    C. nominal rate.
    D. unaltered rate.

 

Difficulty Level: Easy
Section: 5.5, International Fisher Effect: Real Rates of Return and Inflation; Nominal Rates

  1. Real rates are:
    A.the same as nominal or stated rates.
    B. calculated on the basis of the nominal rate reduced by the stated rate.
    C. inflation rates.
    D. not observed or stated but rather the nominal rate reduced by the rate of inflation.

 

Difficulty Level: Intermediate
Section: 5.5, International Fisher Effect: Real Rates of Return and Inflation; Real Rates

 

  1. “Grossing-up” nominal interest rates means:
    A.adding up all of the interest rates at major institutions in a country and dividing by the number of institutions considered to determine an average interest rate.
    B. determining the differential in interest rates in one country compared to interest rates in another country.
    C. reducing nominal rates by the inflation rate to compensate for the loss of purchasing power attributed to inflation.
    D. increasing nominal rates by the inflation percentage to determine the real purchasing power of consumers.

 

Difficulty Level: Intermediate
Section: 5.5, International Fisher Effect: Real Rates of Return and Inflation; Real Rates

  1. The nominal interest rate contains two components:
    A.the real interest rate and the exchange rate.
    B. the real interest rate and the inflation rate.
    C. the inflation rate and a risk factor.
    D. the real interest rate and a risk factor.

 

Difficulty Level: Intermediate
Section: 5.5, International Fisher Effect: Real Rates of Return and Inflation; National Fisher Effect

  1. Because the International Fisher Effect references the future spot rate of a currency, it is also called:
    A.covered interest rate parity.
    B. nominal interest rate parity.
    C. uncovered interest rate parity.
    D. real interest rate parity.

 

Difficulty Level: Intermediate
Section: 5.5, International Fisher Effect: Real Rates of Return and Inflation; International Fisher Effect

 

  1. MNCs use currency forecasting in:
    A.speculating in purchasing and selling foreign currency.
    B. budgeting, financing, and working capital management.
    C. determining their operating cash needs at a specific future date.
    D. computing profit or loss on completed transactions.

 

Difficulty Level: Easy
Section: 5.6, Currency Forecasting

  1. The basis theory in using spot rates to forecast future value of the currency is that:
    A.markets are notoriously unpredictable, so trying to determine what a currency will be worth in the future is unreliable and the current value of the currency is as good as any guess.
    B. over time, the spot rate of a currency determines the future value of the currency and it is easy and inexpensive to determine the spot rate of a currency.
    C. market participants are considered to all relevant information in their current trading, so all information that can affect the future value of a currency is already factored into the value of the currency.
    D. over time, the changes to the spot rate will be both positive and negative, so the spot rate, as somewhere near the average value of the currency over time, is a good estimation of the future value of the currency.

 

Difficulty Level: Difficult
Section: 5.6, Currency Forecasting; Using the Spot or Forward Rates; Spot Rates

  1. Currency forwards are good indicators of the future spot rate of a currency because they:
    A.require that all parties trading in that currency at a specific future date value the currency at the same amount.
    B. contractually bind entities to transaction business in the currency in the future at the current spot rate.
    C. control what the future spot rate of the currency will be.
    D. represent the estimation of future currency values by entities that have contracted for those rates in future transactions.

 

Difficulty Level: Difficult
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Forward Rates

 

  1. Forward parity refers to:
    A.the equality of a forward rate to the expected spot rate of the currency.
    B. the difference between a forward rate and the expected spot rate of the currency.
    C. the amount by which the future spot rate of a currency exceeds the forward rate of the currency.
    D. the amount by which the forward rate of a currency exceeds the future spot rate of the currency.

 

Difficulty Level: Intermediate
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Forward Rates

  1. Older studies say that forward rates are _________________________ but more recent studies suggest that forward rates __________________________________________.
    A.are not good indicators of future currency values; are even less accurate in predicting future currency values
    B. are not good indicators of future currency values; of currencies of emerging nations are fairly accurate
    C. accurate indicators of future currency values; are poor predictors of future currency values
    D. fairly accurate indicators of future currency values; are even better indicators of future currency values than previously thought

 

Difficulty Level: Difficult
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Forward Rates

  1. Fundamental forecasting requires:
    A.a basic knowledge of currency value trends.
    B. the use of basic mathematical analysis applied to basic economic data.
    C. the construction of models that relate currency values to variable derived from economic theory.
    D. the use of sophisticated computer models to predict future currency values.

 

Difficulty Level: Intermediate
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Fundamental Forecasting

 

  1. Fundamental forecasting requires that factors directly affecting the supply and demand of a currency be identified. These direct factors can include:
    A.interest rate, money supply and productivity.
    B. efficiency of markets and government policies.
    C. the presence of the gold standard and government support of its currency.
    D. the price of commodities and government policies toward exports.

 

Difficulty Level: Intermediate
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Fundamental Forecasting

  1. Technical forecasting relies completely on:
    A.computer models that consider every factor that could affect the value of a currency.
    B. new information that can change the value of a currency.
    C. all information, old and new, that can change the value of a currency.
    D. an analysis of currency values over time rather than on a consideration of economic factors and their affects on the currency value.

 

Difficulty Level: Intermediate
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Technical Forecasting

  1. Technical forecasting requires the identification of factors affecting the supply and demand of currencies, including:
    A.interests rates, money supply, and productivity.
    B. inflation rates, monopolies, and derivatives.
    C. interest rates, rents, and derivatives.
    D. inflation rates, productivity, and new oil discoveries.

 

Difficulty Level: Medium
Section: 5.6, Currency Forecasting: Using the Spot or Forward Rates; Technical Forecasting

 

Essay Questions
 

  1. What is the difference between a risk-free transaction and an arbitrage transaction?

A risk-free transaction is, as its name suggests, a transaction in which the outcome is determined at the time that the transaction is entered into; that is, the entity entering into the transaction is assured of the outcome of the transaction. An arbitrage transaction is essentially a risk-free transaction because the entity entering into the transaction essentially enters into two transactions that will occur simultaneously and ensure the outcome that the entity desires. From that standpoint, a risk-free transaction and an arbitrage transaction are the same. The difference in the two types of transactions is in how they are financed. In a risk-free transaction, the entity makes an investment or a commitment which will eventually produce the outcome that the entity desires, but the entity is required to make the investment or commitment before the results are achieved; that is, the entity must finance its participation in the transaction in some way. In an arbitrage transaction, the entity entering into the transaction buys an asset in one market at one price and sells that asset in another market at a higher price, thereby making a profit. Because the purchase and the sale are simultaneous, the transaction is self-funding (the purchase price is provided by the sale price), and no investment is required by the entity conducting the transaction.

 

Difficulty Level: Intermediate
Section: 5.1, Basic Arbitrage in Currency Markets

  1. The profit in a currency arbitrage transaction is the price differential in buying and selling the currency. What can cause the reduction or loss of that profit?

In a currency arbitrage transaction, currency is purchased in one market at a certain price and then immediately sold in another market at a higher price. This price differential, which is often very small and which does not exist for very long, can be reduced or eliminated by the transaction costs involved. An entity purchasing currency in a market will have to pay a commission or fee to the dealer handling the purchase and a commission or fee to the dealer in the other market for selling the currency. Since the price differential in the currency involved will be small, the profit per unit of currency will be small. If the commissions or fees – the transaction costs – are even reasonable, they may be more than the price differential in the currency, so that the profit that is available from the transaction is reduced or eliminated by the transaction costs.

 

Difficulty Level: Medium
Section: 5.1, Basic Arbitrage in Currency Markets: Locational Arbitrage

 

  1. What is covered interest arbitrage?

If an investor can borrow funds in one currency at a low interest rate and loan those funds in a different currency at a higher interest rate, the opportunity for an arbitrage profit exists in the interest rate differential. However, simply borrowing in the low interest currency and lending in the higher interest currency leaves the investor exposed to a risk that could eliminate the profit and potentially create a loss in the transaction. That risk is a currency risk or risk that the exchange rate between the two currencies will change during the term of the loans in such a way that conversion of the high interest currency into the low interest currency will result in a loss of some or all of the profit gained from the interest rate differential. The investor can protect against this risk – cover – by purchasing a currency forward contract that guarantees an exchange rate the time that the loans mature and the conversion of funds will take place that will ensure that the profit from the interest rate differential is protected.

 

Difficulty Level: Difficult
Section: 5.2, Money Markets and Currency Markets; Covered Interest Arbitrage; Role of Forward Contracts

  1. What is the law of one price?

The law of one price says that if goods (or anything else that has a value) move across borders and between markets freely, without restrictions or encumbrances, and if the markets were those goods are sold are efficient, then the price of the goods will be the same in all markets. The idea is that goods have a certain price, but that price can increase if the goods cannot move freely between markets. For instance, if a good is produced in one country and sold in another country, the price should be the same unless some increase in price results from the good moving from one country to another. One of the things that can happen to a good as a result of tat movement would be an import duty or tax. If the good is product in one country where it is priced at $100 and it is shipped to another country where it is subject to a $10 import tax, its price in the second country will have to be higher to compensate for the import tax.

 

Difficulty Level: Easy
Section: 5.3, Product Markets and Currency Markets; Law of One Price

 

  1. What is the International Fisher Effect and what does it say about inflation?

The Fisher Effect simply says that the nominal or stated rate of an obligation is composed of the real rate and the inflation rate. The International Fisher Effect expands this truth and focuses on what happens when international investors consider an investment, and determines that because investors “gross-up” nominal rates (that is, they account for inflation rates that vary from country-to-country), the differences between nominal rates from country-to-country is the difference between inflation rates from country-to-country. Therefore, cross-border movement of funds will be caused by differences in real rates, and, since cross-border movement of funds eventually results in equilibrium, there will be no differences in real rates from country-to-country.

 

Difficulty Level: Intermediate
Section: 5.5, International Fisher Effect: Real Rates of Return and Inflation

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