CH 10 The Foreign Exchange Market

PPP theory, according to research, seems to predict exchange rate movements best for countries in which two situations?

- Countries with underdeveloped capital markets - Countries with high inflation rates

Firms should only rely on what four things to predict exchange rate movements?

- transaction and translation exposure - monthly foreign exchange exposure reports - establishing good reporting systems - forecasting future exchange rates

f the interest rate in country A is 8% and the interest rate in country B is 4%, the international Fisher effect predicts the value of country A's currency will depreciate by ______ against country B's currency

4%

Borrowing in a currency from a country with low interest rates and then investing in another currency where interest rates are high is called ______.

A carry trade

Expectations becoming a self-fulfilling prophecy when currency traders move in the same direction at the same time is called the ______ effect.

bandwagon

According to the Fisher effect, if the real interest rate in country #1 is 8% and it is 5% in country #2, an investor would take advantage of this by

borrowing from #2 and investing in #1.

When a country's currency is nonconvertible, a company may engage in ______, where goods and services will be traded for other goods and services.

countertrade

In the foreign exchange market, it is _____ to profit through arbitrage.

difficult

An economist who believes that the foreign exchange market is effective at setting forward rates is a part of the _____ market school.

efficient

If the foreign exchange market is _____, forward exchange rates should be _____ predictors of future spot rates.

efficient; unbiased

Forward exchange rates are exchange rates that govern _____ transactions.

future

When a country's money supply grows faster than the output of goods and services, this causes

inflation

One main reason why the IFE is NOT good at explaining short-term exchange rate movements is the impact of ______ in determining the expectations of market traders.

investor psychology

The international Fisher effect states that for any two countries, the spot exchange rate should change in an equal amount, in the _____ direction to the difference in nominal interest rates between the two countries.

opposite

If a basket of goods costs $400 in the US and 40,000 yen in Japan, PPP theory predicts that the dollar/yen exchange rate should be

$.01 per Japanese yen.

What causes inflation to occur in a country?

Inflation occurs when the money supply in a country out paces the level of production of goods and services.

Empirical evidence suggest that the International Fisher effect does NOT explain short-term exchange rate movements well.

TRUE

If many national markets are controlled by a few multinational enterprises with the power to influence prices and distribution channels, PPP theory may not hold.

TRUE

Which approach to forecasting uses past trends of prices and volume data to predict the future?

Technical analysis

Suppose a US company agrees to buy products worth 1 million euros. At the time of the agreement, the dollar/euro exchange rate was $1 = €1.10, but at the time of payment, the exchange rate is $1 = €0.80. The additional money owed by the US company due the adverse movement in exchange rates between the time of the deal and the time when payment is due is called ______ exposure.

Transaction

If we could understand how exchange rates are determined, we might be able to identify exchange rate movements.

True

Spot against forward is a common type of currency swap.

True

The foreign exchange market is essentially open 24 hours per day.

True

The gains or losses identified by translation exposure are on paper only.

True

PPP theory predicts that changes in relative prices will result in

a change in exchange rates.

Buying a currency low and immediately selling it high to make a profit from the price discrepancy is called _____.

arbitrage

Economic exposure is concerned with the affect of ______ on a firm's international earning power.

changes in exchange rates

Jameson Electric Corp. would use the foreign exchange market when it needs to

covert currency

Most foreign exchange transactions involve the _____ on one side.

dollar

The extent to which a firm's future international earning power will be affected by exchange rate changes is called ______ exposure.

economic

A tactic that reduces translation and economic exposure is

entering into forward exchange rate contracts.

The rate at which the currency of one country can be converted into that of another country is called the _______ rate

exchange

The extent to which income from individual transactions is affected by fluctuations in foreign exchange values is known as transaction ______.

exposure

Able Appliances needs to convert the pounds it earns from selling products in Great Britain to dollars. What mechanism allows the company to make this conversion?

foreign exchange market

The volatile changes in exchange rates that can negatively affect a an international business are commonly referred to as

foreign exchange risk

When a country allows both residents and nonresidents to purchase unlimited amounts of a foreign currency, the country's currency is

freely convertible

In an efficient market, prices are said to

fully reflect all available information

The method of forecasting that draws on economic theory to construct sophisticated models is called the ______ approach.

fundamental

Which approach to forecasting draws on economic theory to develop models that predict exchange rate movements?

fundamental

Which school of thought on exchange rate forecasting does NOT believe that forward exchange rates are the best predictors of future spot exchange rates?

inefficient

The Fisher effect predicts that there is a strong relationship between ______ and interest rates.

inflation rates

When the growth in a country's money supply is faster than the growth in its output of goods, ______ tends to increase.

price inflation

The purchasing power parity puzzle is the name given to the failure to find a strong link between exchange rate movements and

relative inflation rates

The impact of psychological factors and investor expectations make it difficult for exchange rate theories to predict ______ changes in exchange rates.

short-term

Currency ______ involves buying, selling and holding currencies in order to make a profit from favorable fluctuations in exchange rates.

speculation

A ______ exchange rate is the price to exchange one currency for another for immediate delivery.

spot

A ________ exchange rate is the price to exchange one currency for another for immediate delivery.

spot

At the simplest of levels, exchange rates are determined by _____.

the supply and demand of currencies

Capital flight is most likely to occur when

the value of domestic currency is rapidly depreciating.

An American tourist in Japan is interested in buying a souvenir that costs 1800 yen. How much is this in dollars if the exchange rate is $1 to Y400.

$4.50

Most economic theories of exchange rate movements agree that three factors have an impact on future exchange rate movements in a country's currency.

- Market psychology -The country's interest rate - The country's price inflation

What are three moderately decent predictors of long-term changes in exchange rates?

- Relative inflation rates - Nominal interest rate differentials - Relative monetary growth

What are the two schools of thought regarding the prediction of future exchange rates?

- efficient market school - inefficient market school

Rita knows that every euro she plans to purchase for her trip is worth 1.30 US dollars. What aspect of currency conversion is Rita considering?

Exchange rate

When General Electric won a contract for a $150 million generator project in Romania, it agreed to take payment in the form of Romanian goods that could be sold for $150 million on international markets. This is an example of

countertrade

An investment made to profit from future currency movements is called

currency speculation

The bandwagon effect occurs in investing when

currency traders move as a group in the same direction at the same time.

The value of a currency is determined by the ______ of that currency relative to other currencies.

demand and supply

It would be difficult to profit through arbitrage because the ______ for a currency would increase when dealers try to profit from exchange rate discrepancies leading to ______ of that currency, and the price differential would disappear.

demand; appreciation

In theory, if a country's price inflation is rising rapidly, it should expect to see its currency __________ against that of countries in which inflation rates are lower.

depreciate

When a dominant enterprise is able to set different prices in different markets to reflect varying demand conditions, it is practicing price ______.

discrimination

What is the key way a company can reduce economic exposure?

distribute production facilities and assets to various locations

Company A is based in Europe and does a large amount of business in the US. The company fears that the euro will gain in strength against the dollar, so it sets up a local production facility in the United States. This is a way to reduce ______ exposure.

economic

When a country experiences hyperinflation, money _________ value very rapidly.

loses

What are the two main functions of the foreign exchange market?

provide insurance against foreign exchange risk currency conversion

The Economists's version of the PPP uses ______ as a proxy for a "basket of goods."

the Big Mac

The effect of currency exchange rate changes on the reported financial statements of companies is called ______ exposure.

translation

If the exchange rate is 1 British pound to $1.35, an American in London will need ______ to purchase a purse priced at 20 pounds.

$27

International businesses use foreign exchange markets for what three reasons?

- to pay a foreign company for its products or services in its country's currency - to convert foreign currencies it receives from transactions into its own currency - to invest spare cash for the short term in money markets

What are considered the two most prominent features of the foreign exchange market?

-The market never sleeps. -The trading centers are integrated.

Place the currency with the greatest use at the top of the list and each subsequently-used currency below that.

1. dollar 2. euro 3. yen 4. pound

______ analysis is based on the premise that there are analyzable market trends and that these past trends can be used to predict future trends.

Technical

Suppose a company agrees to buy products in 2014 with payment due in 2015. ______ exposure refers to money lost due to an adverse movement in exchange rates between the time the deal is signed and the time when the products are paid for.

Transaction

________ exposure is the risk, faced by companies involved in international trade, that currency exchange rates will change after the companies have already entered into financial obligations. Such exposure to fluctuating exchange rates can lead to major losses for firms.

Transaction

_____ exposure involves the present measurement of past events using currency exchange rate changes on a company's financial statements.

Translation

Residents of the hypothetical nation of Jarna feared that the country's economy was failing. They rushed to convert their domestic currency into US dollars and investors in businesses in Jarna also converted their financial holdings. This mass conversion of currency is known as _____.

capital flight

Tyson is a trader and borrows money in Japanese yen (where the interest rate is 1%). He then invests the money in a Canadian bank, where the rate is 5%. This is an example of a(n) ______.

carry trade

Which type of control of exposure is MOST effective at protecting resources efficiently and ensuring that each subunit adopts the correct mix of tactics and strategies?

centralized

______ agreements are barter-like agreements used by companies in countries whose currency is nonconvertible.

countertrade

A foreign exchange market is where one country's ______ is converted into that of another country.

currency

In a forward exchange transaction, $1 buys more lira with a spot exchange than with a 30-day forward exchange. When this occurred, it is said that the dollar is selling at a _____ on the 30-day forward market.

discount

A policy of ______ convertibility is in place in some countries and places restrictions on residents' ability to convert domestic currency into a foreign currency.

external

Tonya was surprised to learn that her country limited the amount of currency she could convert to US dollars when she went to America to visit her cousin. This limit is an example of a policy of

external convertibility.

A(n) ______ convertible currency allows only nonresidents to convert it into a foreign currency without any limitations.

externally

When only nonresidents can convert a currency into a foreign currency with no limitations, the currency is considered

externally convertible

The efficient market school believes that the foreign exchange market is efficient at setting ______ exchange rates.

forward

Some country's governments do not put any limits on the purchase of foreign currency for residents and nonresidents. These country's have a _____ currency.

freely convertible

The chief financial officer of Linwell Corp. is concerned that since he can't predict changes in future exchange rates, there could be adverse consequences for the firm. One way the company can insure itself against this possibility is by engaging in _____.

hedging

The ______ market school believes that forward exchange rates are NOT the best predictors of future spot exchange rates.

inefficient

A(n) ______ is based on the theory that prices don't reveal all available information and more is needed to predict future spot exchange rates.

inefficient market

In the context of the Fisher Effect, different interest rates between countries reflect differing expectations about ______ between those countries.

inflation rates

A swap deal is just like a conventional forward deal in that it

insures against foreign exchange risk.

A business is using hedging when it

insures itself against foreign exchange risk.

According to the international Fisher effect, there is a relationship between spot exchange rates and _____ between countries. Multiple choice question.

interest rates

According to research, PPP theory is a relatively good predictor of ______ exchange rate movements, but is not as good a predictor of ______ movements.

long-run ; short-run

The text suggests that as a way to take control of exchange rate risk, firms should produce _____ foreign exchange reports.

monthly

A(n) ______ currency is one that neither residents nor nonresidents are allowed to convert into a foreign currency.

nonconvertible

Countertrade is a logical choice when a country's currency is

nonconvertible

When neither residents nor nonresidents are allowed to convert a currency to a foreign currency, the currency is considered

nonconvertible

Identical products sold in different countries must sell for the same price in competitive markets when their price is expressed in terms of the same currency. This is called the law of _____ ________.

one price

The law of ______ is the economic theory that the price of a given security, asset or commodity must have the same price when exchange rates are taken into consideration.

one price

When $1 buys more lira with a forward exchange than with a spot exchange, it is said that the dollar is selling at a _____ on the 30-day forward market.

premium

Foreign exchange markets can provide some insurance against volatile changes in exchange rates, which is called foreign exchange ______

risk

The adverse consequences of unpredictable changes in exchange rates is called foreign exchange _____.

risk

The Fisher effect equates the nominal interest rate as

the required real interest rate + expected rate of inflation.

When a government intervenes in cross-border trade by implementing a trade barrier, it ______ the link between relative price changes and changes in exchange rates predicted by PPP theory.

weakens

If an American firm has a subsidiary in the EU and the value of the euro depreciates rapidly against the value of the dollar over a year, you would see a reduction in the dollar value of the euro profit made by the European subsidiary. This would result in _____ translation exposure.

negative

A _________ strategy is when a firm attempts to delay the collection of foreign currency receivables when a currency is expected to appreciate and delay foreign currency payables when a currency is expected to depreciate.

lag

Two strategies that can be used to reduce translation and transaction exposure are:

lag strategy lead strategy

What is the transaction called where two parties agree to exchange currency at some specific date in the future?

Forward exchange

The most important foreign exchange trading center is ______ with 37% of the activity.

London

According to PPP theory, a country with a high inflation rate will see ______ in its currency exchange rate.

a depreciation

If the demand for the yen outstrips its availability and if the supply of the dollar outweighs the demand, the yen will ________ against the dollar.

appreciate

A lag strategy occurs when a firm attempts to delay the collection of foreign currency receivables when a currency is expected to ______ and delay foreign currency payables when a currency is expected to ______.

appreciate;depreciate

The New York yen/dollar exchange rate was Y125=$1. Through ______, a dealer can make a profit on this currency transaction by buying it low and selling it high.

arbitrage

The five most important foreign exchange trading centers in terms of level of activity are

London, New York, Zurich, Tokyo and Singapore.

What is hyperinflation?

An explosive and seemingly uncontrollable price inflation in which money loses value very rapidly

If the interest rate in Canada is 6.5% and the interest rate in the US is 4%, the international Fisher effect predicts that

Canada's currency will depreciate by 2.5% against the US dollar.

_____ typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Currency speculation

Feldman Technology Group has international holdings in India. The company often needs to fund large orders in India for parts with the knowledge that an Indian importer will soon buy completed product from Feldman. These transactions require large sums of capital in both dollars and rupee and as a way to move from one currency to another without incurring foreign exchange risk, the company should use a(n) _____.

Currency swap

Government intervention in the foreign exchange markets does NOT affect the ability of PPP in predicting exchange rate movements.

FALSE

Like transaction exposure, economic exposure is concerned with the effect of exchange rates changes on individual transactions, most of which are short-term situations.

False

More companies pay more attention to economic exposure than translation exposure when managing foreign exchange risk.

False

The failure to find a link between which two of the following conditions has been referred to as the purchasing power parity puzzle?

Inflation rates Exchange rates