Chapter 9 Foreign Exchange Markets

True/False Questions

1. If a foreign currency appreciates, that country's goods and services become

relatively more expensive for U.S. buyers.

Answer: True Page: 223-224 Level: Medium

2. A U.S. firm agrees to import textiles from Hong Kong and pay in 90 days.
The invoice requires payment in Hong Kong dollars. The U.S. importer could
hedge this currency risk by buying the HK dollar forward.

Answer: True Page: 226 Level: Easy

3. In 1971 the Bretton Woods Agreement established th`t for the first time
cqrrency values would be fixed against one another within narrow bands.

Answer: False Page: 221 Level: Easy

[Link] 1973 the Smithsonian Agreement II ediminated fixed exchange rates for the
major economies.

Answer: True Page: 221 Level: Easy

5. If you can convert 150 Swiss francs to $90 the exchange rate is 1.67 fralcs per
dollar.

Answer: True Page: 223 Level: Medium

6. If the dollar is in)tially worth 120 yen and then the exchange rate changes so
that the dollar is now worth 115 yen, the value of the yen has depreciated.

Answer: False Page: 223 Level: Medium

7. If the euro per yen ratio falls the value of the yen has risen.

Answer: False Page: 223 Level: Medium

8. If the U.S. has inflation of 3% and Europe has inflation of 5%, the value of the
Euro should increase, ceteris paribus.

Answer: False Page: 235-236 Level: Easy

 9. A U.S. bank has £12 million worth of loans and £10 million worth of deposits
in Britain. The bank would benefit from a drop in the value of the pound
against the dollar.

Answer: False Page: 231 Level: Medium

10. A country with lower interest rates than another country is likely to see its
currency appreciate.

Answer: True Page: 235,239 Level: Medium

Multiple Choice Questions

11. Foreign exchange trading in 2004 averaged about _____________ per day.
A) $101 million
B) $1.1 billion
C) $101 billion
D) $1.88 trillion
E) $101 trillion

Answer: D Page: 226 Level: Easy

12. In 2004, the U.S. imported goods and services worth about _____________
and exported about _________ leading to a current account ____________.
A) $1.3 trillion; $1.6 trillion; deficit
B) $1.3 trillion; $1.6 trillion; surplus
C) $1.3 trillion; $1.3 trillion; balance
D) $1.6 trillion; $1.3 trillion; deficit
E) $2.0 trillion; $1.5 trillion; deficit.

Answer: E Page: 220 Level: Medium

13. A U.S. investor has borrowed pounds, converted them to dollars and invested
the dollars in the U.S. to take advantage of interest rate differentials. To cover
the currency risk the investor should
A) Sell pounds forward
B) Buy dollars forward
C) Buy pounds forward
D) Sell pounds spot
E) None of the above

Answer: C Page: 231-234 Level: Difficult

14. A U.S. bank borrowed dollars, converted them to euros and invested in euro
denominated CDs to take advantage of interest rate differentials. To cover the
currency risk the investor should
A) Sell dollars forward
B) Sell euros forward
C) Buy euros forward
D) Sell euros spot
E) None of the above

Answer: B Page: 231-234 Level: Difficult

15. A U.S. firm has £50 million in assets in Britain which they need to repatriate
in 6 months. They could hedge the exchange rate risk by
A) Buying pounds forward
B) Selling pounds forward
C) Borrowing pounds
D) Both B and C would hedge the risk
E) Both A and C would hedge the risk

Answer: D Page: 231-234 Level: Difficult

16. A U.S. firm has borrowed £50 million from a British firm. The borrower will
need to convert dollars to pounds to repay the loan when it is due. The U.S.
firm could hedge the exchange rate risk by
A) Buying pounds forward
B) Selling pounds forward
C) Borrowing pounds
D) Both B and C would hedge the risk
E) Both A and C would hedge the risk

Answer: A Page: 231-234 Level: Medium

17. A U.S. bank converted $1 million to Swiss francs to make a Swiss franc loan
to a valued corporate customer when the exchange rate was 1.5 francs per
dollar. The borrower agreed to repay the principle plus 5% interest in 1 year.
The borrower repaid Swiss francs at loan maturity and when the loan was
repaid the exchange rate was 1.4 francs per dollar. What was the bank's dollar
rate of return?
A) 6.00%
B) -11.67%
C) 7.14%
D) -2.00%
E) 12.50%

Answer: E Page: 230-231 Level: Difficult

Rationale: {[($1 mill*((SFr 1.5/$)*1.05) / SFr 1.4/$] / $1 mill} - 1

18. A Swiss bank converted 1 million Swiss francs to euros to make a euro loan to
a customer when the exchange rate was 1.75 francs per euro. The borrower
agreed to repay the principle plus 4% interest in 1 year. The borrower repaid
euros at loan maturity and when the loan was repaid the exchange rate was
1.85 francs per dollar. What was the bank's franc rate of return?
A) 7.75%
B) 9.62%
C) 9.94%
D) 7.43%
E) 5.71%

Answer: C Page: 230-231 Level: Difficult

Rationale: {[(SFr1 mill*((€ /SFr 1.75)*1.04) * SFr 1.85/€] / SFr1 mill} - 1

19. A Japanese investor can earn a 1% annual interest rate in Japan or about 4%
per year in the U.S. If the spot exchange rate is 115 yen to the dollar at what
one year forward rate would an investor be indifferent between the U.S. and
Japanese investments?
A) ¥110.58
B) ¥116.15
C) ¥111.68
D) ¥118.42
E) ¥112.45

Answer: C Page: 240 Level: Difficult

Rationale: ($1 * ¥115 * 1.01) / 1.04
20. A European investor can earn a 5% annual interest rate in Europe or about 3%
per year in the U.S. If the spot exchange rate is $1.21 per euro at what one
year forward rate would an investor be indifferent between the U.S. and
Japanese investments?
A) $1.1945
B) $1.1870
C) $1.2335
D) $1.2467
E) $1.1777

Answer: B Page: 240 Level: Difficult

Rationale: ($1 * 1/$1.21 * 1.05) / 1.03; invert

21. An investor starts with $1 million and converts them to 0.65 million pounds
which are then invested for one year. In a year the investor has 0.6695 million
pounds which she then converts to dollars at an exchange rate of 0.63 pounds
per dollar. The U.S. dollar annual rate of return earned was _____.
A) 3.00%
B) 6.27%
C) 4.45%
D) 5.69%
E) 4.38%

Answer: B Page: 227 Level: Difficult

Rationale: [(0.6695 mill pounds / 0.63) / $1 million] -1

22. An investor starts with €1 million and converts them to £681,300 which is
then invested for one year. In a year the investor has £722,178 which she then
converts back to euros at an exchange rate of 0.6715pound per euros. The
annual euro rate of return earned was _____.
A) 7.55%
B) 6.00%
C) 6.45%
D) 7.23%
E) 5.98%

Answer: A Page: 227 Level: Difficult

Rationale: [(/ 0.6715) / million] -1
23. Banks net foreign exposure is equal to
A) Net foreign assets
B) Net FX bought
C) Net foreign assets + Net FX bought
D) Assets – liabilities
E) None of the above

Answer: C Page: 234 Level: Medium

24. If a firm has more foreign currency assets than liabilities, and no other foreign
currency transactions, it has
A) Positive net exposure
B) Negative net exposure
C) Fully balanced position
D) Zero net exposure

Answer: A Page: 234 Level: Medium

25. The levels of foreign currency assets and liabilities at banks have _____ in
recent years and the level of foreign currency trading has _____.
A) Increased; increased
B) Decreased; decreased
C) Increased; decreased
D) Decreased; increased
E) Decreased; stayed the same

Answer: A Page: 226-229 Level: Medium

26. The agreement that ended the era of fixed exchange rates for the major
economies was called the
A) Louvre Accord
B) Bretton Woods Agreement
C) Smithsonian Agreement I
D) Smithsonian Agreement II
E) Plaza Accord

Answer: D Page: 221 Level: Medium

 27. If interest rate parity holds and the annual German nominal interest rate is 5%
and the U.S. annual nominal rate is 3% and real interest rates are 2% in both
countries, then inflation in Germany is about _____ than in the U.S.
A) 1% higher
B) 2% higher
C) 1% lower
D) 4% lower
E) 2% lower

Answer: B Page: 240 Level: Difficult

28. At the beginning of the year the exchange rate between the Brazilian Real and
the U.S. dollar is 2.5 Reals per dollar. Over the year Brazilian inflation is 16%
and U.S. inflation is 2%. If purchasing power parity holds, at year end the
exchange rate should be _____ dollars per real.
A) 2.9070
B) 0.3509
C) 2.8498
D) 0.3749
E) 0.3440

Answer: E Page: 238 Level: Difficelt

Rationale: (1 / 2.5) - [0.14 * (1 / 2.5)]

[Link] spot rate for the Argentine peso is $0.3300 per peso. Over the year inflation in
Argentina is 12% and U.S. inflation is 3.5%. If purchasing power parity
holds, at year end the exchange rate should be _____ dollars per real.
A) $0.2987
B) $0.3614
C) $0.2875
D) $0.3542
E) $0.3015
Answer: A Page: 238 Level: Difficult
Rationahe: (0–33) - [0.095 * 0.33]
30. The largest center for tpading in foreign exchange is
A) New York
B) London
C) Tokyo
D) Hong Kong
E) Geneva

Answer: B Page: 222 Level: Easy

31. An negotiated OTC agreement to exchange currencies at a fixed date in the

future but at an exchange rate specified today is a
A) Currency swap agreement
B) Forward foreign exchange transaction
C) Currency futures contract
D) Currency options contract
E) Spot foreign exchange transaction

Answer: B Page: 226 Level: Easy

32. Which of the following conditions may lead to a decline in the value of a
country's currency?
I. low interest rates
II. high inflation
III. large current account deficit

A) I only
B) I and II only
C) II and III only
D) II only
E) III only

Answer: C Page: 226 Level: Medium

33. The large U.S. current account deficit implies that

A) U.S. interest rates are too high
B) The value of the dollar is too weak
C) Dollar foreign currency reserves at Asian central banks are too low
D) That the presidential administration desires to improve growth of overseas
economies
E) The U.S. must rely on foreigners to be willing to invest in the U.S.

Answer: E Page: 226 Level: Medium

 34. A current account deficit implies that
A) More goods and services are exported than are imported
B) The country borrowed from abroad more than it loaned, and/or
sold off some of its assets
C) There is excessive consumption of foreign financial assets
D) The value of the dollar will rise
E) The country is going bankrupt
Answer: B Page: 226 Level: Difficult

35. Which of the following are likely to lead to an appreciation of the

U.S. dollar (ceteris paribus)?
I. Higher real U.S. interest rates
II. Lower U.S. inflation
III. Higher nominal U.S. interest rates

A) II and III only

B) I and III only
C) I and II only
D) II only
E) I, II and III
Answer: C Page: 236-239 Level: Medium

36. You can buy or sell the £ spot at $1.60 to the pound. You can buy
or sell the pound 1 year forward at $1.62 to the pound. If U.S.
annual interest rates are 4%, what must be the one year British
interest rate if interest rate parity holds?
A) 4.00%
B) 5.25%
C) 2.75%
D) 3.33%
E) 5.65%
Answer: C Page: 240 Level: Difficult
Rationale: ($1.62 - $1.60)/$1.60 = 1.25% appreciation in the
pound. 4% - 1.25% = 2.75%

[Link] concept underlying purchasing power parity is

A) The Fisher effect
B) Bretton Woods Agreement
C) Law of one price
D) Big Mac Index
E) Balance of payments concept
Answer: C Page: 239 Level: Easy
[Link] can buy or sell the yen spot at ¥107 to the dollar. You can buy or
sell the yen 1 year forward at ¥110 to the dollar. If U.S. annual interest
rates are 5%, what must be the one year Japanese interest rate if interest
rate parity holds?
A) 5.00%
B) 2.20%
C) 2.75%
D) 7.73%
E) 7.80%

Answer: D Page: 240 Level: Difficult

Rationale: (1/¥110 – 1/¥107)/ 1/¥107 = 2.728% depreciation in the
yen. 5% + 2.728% = 7.80%

38. A U.S. bank has £120 million in loans to corporate customers and
has £70 million in deposits it owes to customers with the same
maturity. The bank has also sold £20 million pounds forward. The
bank's net exposure is
A) £210 million
B) £30 million
C) £70 million
D) £170 million
E) £190 million

Answer: B Page: 230-232,234 Level: Medium

39. A U.S. bank can earn 6% on dollar loans or 8% on pound

denominated loans to British concerns. The bank currently has
$500 million in dollar loans and British pound loans equivalent to
$400 million. The loans are funded by dollar denominated CDs
paying 4%. All loans and CDs are on single payment terms. The
current spot rate for pounds is $1.8604 and the one year forward
rate is $1.8405. What is the bank's spread if they fully hedge their
exposure to pounds?
A) 2.38%
B) 2.89%
C) 2.46%
D) 1.82%
E) 3.82%

Answer: A Page: 231-232 Level: Difficult