CH 4: The International Flow of Funds and Exchange Rates
Approximately how many different currencies are used to make international payments for goods and services?
150
To fully appreciate the strengths and weaknesses of a country (such as Greece) against the rest of the world, and to ascertain its budget constraint, it is important to have a basic understanding of which of its statistics? a. Services balance b. Current account c. Balance of payments (BOP) d. Financial account
Balance of payments (BOP)
Over time, various international monetary systems have developed to facilitate international business. Which 1944 agreement established the International Monetary Fund (IMF), a financial authority that helps to ensure the stability of the international monetary and financial system? a. Jamaica Agreement b. Smithsonian Agreement c. Maastricht Treaty d. Bretton Woods Agreement
Bretton Woods Agreement
What would occur if country A's inflation rate exceeded that of countries B, C, and D? a. Country A's currency would depreciate relative to countries B, C, and D. b. Country A's currency would appreciate relative to countries B, C, and D. c. Inflation would not affect the currency. d. Countries B, C, and D's currency would depreciate relative to Country A's.
Country A's currency would depreciate relative to countries B, C, and D.
In 1979, the European community established the European Exchange Rate Mechanism (ERM). Under the ERM, a weighted basket of European currencies known as the ECU (European Currency Unit) was defined with varying exchange rates. The EMU introduced the euro as a new currency to replace the currencies of the member countries in the Eurozone, which has since grown to 19 members. The euro is currently a monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies. This is best described by which concept? a. Managed floating exchange rate system b. Clean float currency c. Dirty float currency d. Independent floating exchange rate system
Dirty float currency
What type of monetary system utilizes varying degrees of government intervention to maintain a range of acceptable values against other currencies?
Dirty float currency
Which country practices dollarization? a. El Salvador b. Malaysia c. South Africa d. China
El Salvador
discount
In the forward market, the selling of a currency at a forward rate that is less than the spot rate.
premium
In the forward market, the selling of a currency at forward rate that is more than the spot rate
Which country uses a managed floating exchange rate system? a. Canada b. Indonesia c. Saudi Arabia d. United States
Indonesia
If Greece resumed the drachma and you wanted to forecast future exchange rates of the euro in Germany (or elsewhere in the EU) against it, which theory suggests that forecasts of relative inflation rates in the two countries can be used to estimate the future exchange rate of the drachma to the euro? a. Purchasing power parity (PPP) b. Big Mac Index c. Law of one price d. Interest rate parity (IRP)
Purchasing power parity (PPP)
special drawing right
a basket of currencies consisting of dollars, euros, pounds, and yen created by the IMF in 1969 for use as a benchmark to value the currencies of differ- ent countries
foreign exchange markets
a global network of international banks, currency traders, and speculators as well as cen- tral banks that trade different countries' currencies
ABC Limited, a U.S.-based company, has a liability to deliver 2 million euros in nine months. To minimize the risk of significant currency fluctuations, it decides to enter into a contract to purchase 2 million euros on the same date to ensure it can buy and sell in the same currency on the same date. What is this an example of?
a hedge
For many countries, adopting the euro has provided many benefits EXCEPT which of the following? a. a decline in inflation b. a reduction in economic downturns c. a reduction in GDP d. a decline in currency fluctuations
a reduction in GDP
balance of payments
a statement of account that shows all transactions between the residents of one country and the rest of the world for a given period of time
fixed exchange rate system
a system in which the country pegs its currency at a fixed rate to a major currency or basket of currencies, while the exchange rate fluctuates within a narrow margin around a central rate
managed floating exchange rate system
a system that determines the value of some currencies partly by demand and supply in the foreign exchange market and partly by active central bank intervention in the foreign exchange market
independent floating exchange rate system
a system that sets the values of major currencies based on their demand and supply in world currency markets
purchasing power parity
a theory stating that a basket of goods should have approximately the same prices across different countries
inflation
an increase in the prices of goods and services caused by the supply of money exceeding the demand for goods and services
If you were a global distributor and purchased products in a lower priced market and then sold those products in a higher priced market, what would this practice be called? a. capitalism b. arbitrage c. purchasing power parity d. risk premium
arbitrage
What is the practice of buying goods in a lower priced market and selling them in a higher priced market to make a profit called?
arbitrage
How would a purchase of foreign goods from the United States that required importing be recorded in the balance of payment (BOP)?
as a debit in the current account
What is the statement of account that shows all transactions between the residents of one country and the rest of the world for a given period of time called?
balance of payments
arbitrage
buying goods in a lower priced market and selling them in a higher priced market to make profits
Big Mac Index
calculation using the cost of a McDonald's restaurant sandwich to assess the relative values of currencies
What are the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers collectively referred to as?
current account
soft currencies
emerging market countries' currencies that are less stable in value than hard currencies and are sometimes pegged to hard currency values
foreign direct investment
encompasses purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services
forward market
exchange that enables purchases and sales of currencies in the future with prices (or the forward rate) established at a previous time
spot market
exchange that trades currencies on a real-time basis for immediate delivery
International Monetary Fund (IMF)
financial authority established under the Bretton Woods Agreement in 1944 to help ensure the stability of the international monetary and financial system
How many major accounts comprise the balance of payments (BOP)?
five
What is a global network of international banks and currency traders that trade different countries' currencies called?
foreign exchange market
How many sub accounts does the financial account of the balance of payments (BOP) have?
four
How many subaccounts does the current account have? a. two b. three c. four d. five
four
What is the net of investment income from abroad and investment payments to foreigners called?
income balance
Imagine you were evaluating a system that sets the values of major currencies based on their demand and supply in world currency markets. What type of system is this?
independent floating exchange rate system
hedge
insurance that reduces future risk
An individual wants to invest in the currency of their own country and then convert it into the currency of another country with the intent of making a profit. Which theory states that is not possible? a. purchase power parity b. hedge c. arbitrage d. interest rate parity
interest rate parity
The annual interest rate in Country A is 8%, while in Country B it is 6%. Which theory suggests that the currency in Country A will fall two percent against the currency of Country B until the two are equal? a. purchasing power parity (PPP) b. interest rate parity (IRP) c. net present value (NPV) d. internal rate of return (IRR)
interest rate parity (IRP)
hard currencies
leading world currencies of developed industrialized countries, including the U.S. dollar, European euro, Japanese yen, and British pound sterling
gold standard
monetary system that pegs currency values to the market value of gold
clean float currency
monetary system with minimal government intervention; largely market determined
dirty float currency
monetary system with varying degrees of government invention to maintain a range of acceptable values against other currencies
direct quote
prices of a foreign currency in dollars or the number of dollars per one unit of foreign currency
uncovered interest rate parity
principle implying that expected future spot exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
covered interest rate parity
principle implying that forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
law of one price
principle stating that identical goods should sell for the same price in different countries according to local currencies
What theory states that a basket of goods should have approximately the same prices across different countries?
purchasing power parity
Assume that a candy bar in Germany is priced at EUR 1 and in the United States it is USD 1.50. The exchange rate between the EUR/USD would be 1.50 (the USD/EUR). What theory does this example illustrate? a. net present value (NPV) b. internal rate of return (IRR) c. purchasing power parity (PPP) d. interest rate parity (IRP)
purchasing power parity (PPP)
Which theory suggests that forecasts of relative inflation rates in two countries can be used to estimate the future exchange rate of a certain amount of domestic currency relative to foreign currencies?
purchasing power parity (PPP)
Which of the following theories can be used to forecast exchange rates?
purchasing power parity (PPP) and interest rate parity (IRP)
net errors and omissions
reconciles any imbalance between the current account plus capital account and the financial account to ensure that all debit and credit entries in the balance of payments statement sum to zero
current account
reflects the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers
An investor requires the added return for risk associated with a security or asset. What would this added return be called?
risk premium
capital account
shows credit and debit entries for non-produced non-financial assets and capital transfers between residents and non-residents
Country A is an emerging economy and Country B is a developed economy with a hard currency. Country A's currency is less stable in value than Country B's currency and is pegged to Country B's currency value. How would you describe Country A's currency?
soft
Bretton Woods Agreement
the 1944 decision to establish a global currency system with the U.S. dollar pegged at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to the dollar
Smithsonian Agreement
the 1971 decision allowing the United States to devalue the dollar against other countries' currencies, thereby beginning the breakdown of the 1944 Bretton Woods Agreement
Jamaica Agreement
the 1976 international monetary order that allowed countries to adopt different exchange rate systems including floating their currencies in world markets
risk premium
the added return required by investors for risk associated with a security or asset
What information would the balance of payments (BOP) provide to a manager of an international firm?
the demand for a country's currency and potential changes in its economic environment
bid-ask spread
the difference between bid and ask prices of a currency; the transaction fee earned by the bank
Which three currencies make up roughly 60% of the world's currency transactions in global business?
the dollar, euro, and ye
services balance
the net of exports of services and imports of services
income balance
the net of investment income from abroad and investment payments to foreigners
trade balance
the net of merchandise exports and merchandise imports
dollarization
the practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country
forward rate
the price at an earlier time of a currency in terms of another currency established for future delivery in the forward market
exchange rate
the price at which one currency can be converted to another currency
indirect quote
the reciprocal of the direct quote or the prices of a dollar (for example) in foreign currency terms
interest rate parity
theory stating that interest rates on bonds in different countries should be the same, as investors would buy and sell these bonds to make arbitrage profits until this condition holds
A country that conducts international transactions with only one major country may find it more beneficial to do what?
to use dollarization
What concept best describes a country that imports more than it exports?
trade deficit
trade deficit
when merchandise imports exceed merchandise exports for a country
