FE 427 FINAL

What are you buying if you purchase a U.S. dollar European put option against the Mexican peso with a strike price of MXN10.0/$ and a maturity of July? (Assume that it is May and the spot rate is MXN10.5/$.)

-It gives you the right to sell the underlying asset at the strike price at maturity -Buying the right to sell USD for MXN for MXN10/$ in July -currently out of the money because the strike is lower than the current exchange rate and option is worthless

MC: Which one of the following would be the most logical reason to use a synthetic forward contract to hedge? A) forward contracts are not available in the currency of choice B) when time horizons are short, forward contracts can be expensive C) the underlying transaction is too risky D) the underlying transaction gives you an asset

A) forward contracts are not available in the currency of choice

MC: Swaps provide a real economic benefit to the counterparties only if a barrier exists to prevent ________ from functioning fully. A) hedging B) factoring C) arbitrage D) forfaiting

A) hedging

MC: In general, a real depreciation of the domestic currency ________ importers and ________ exporters. A) hurts, helps B) helps, hurts C) bypasses, helps D) hurts, bypasses

A) hurts, helps

MC: Suppose the current spot rate for the pound is $01.7427. A put option with an exercise price of $01.7550 is said to be A) in-the-money. B) out-of-the-money. C) at-the-money. D) past breakeven.

A) in the money

MC: In what production process are materials and intermediate parts sensitive to the real exchange due to the fluctuations currency values? A) input sourcing B) production scheduling C) plant location decisions D) pricing policies

A) input sourcing

MC: Within the United States, what is the name for the power of a dollar when it is used to purchase an amount of goods and services? A) internal purchasing power B) external purchasing power C) absolute purchasing power parity D) relative purchasing power parity

A) internal purchasing power

MC: Due to arbitrage, the futures price at maturity ________. A) is driven to equality with the spot rate on that date B) remains the same as the price of the opening trade for the date C) represents the last trading price D) represents the average price of the open interest outstanding

A) is driven to equality with the spot rate on that date

If interest rate parity is in effect, there are_____. A) no profitable opportunities for covered interest arbitrage B) many opportunities for covered interest arbitrage C) currency dealers will arbitrage interest rate differentials in different countries D) currency dealers will be motivated to arbitrage forward market contracts

A) no profitable opportunities for covered interest arbitrage

MC: When the external purchasing power or a currency is greater than the internal purchasing power, the currency is said to be ________. A) overvalued B) undervalued C) at parity D) in arbitrage

A) overvalued

MC: When the possibility exists that the government of a nation may impose some form of exchange controls or tax on foreign investment, the risk is known as ________ risk. A) political B) exchange controls C) business risk D) government

A) political

MC: When a producer charges different prices for the same good in different markets, the practice is known as ________. A) pricing-to-market B) exchange rate pass-through C) marking-to-market D) market integration

A) pricing to market

MC: Two of the most often used determinants of exchange rates are ________. A) real interest rate differentials and current account balances B) nominal interest rates and current account balances C) real interest rate differentials and real price levels D) nominal interest rate and inflation rate differentials

A) real interest rate differentials and current account balances

The ________ on an asset is the expected return on the asset in excess of the return on a risk-free asset. A) risk premium B) covariance C) systematic risk D) beta

A) risk premium

MC: The ________ is the amount of basis points added to the yield to maturity on a government bond corresponding to that maturity to get the fixed interest rate of an interest rate swap. A) swap spread B) all-in cost C) right of offset D) yield to call

A) swap spread

MC: What is the market portfolio? A) the large, well-diversified portfolio that investors should hold according to finance theory B) the large, well-diversified portfolio without international securities C) the portfolio that represents a global portfolio D) the portfolio with strictly domestic securities

A) the large, well diversified portfolio that investors should hold according to finance theory

MC: When the forward rate equals the expected future spot rate, the forward rate is said to be a(n) ________ of the future spot rate. A) unbiased predictor B) forward market investment C) forward market return D) unsystematic risk

A) unbiased predictor

In the short run, equality of interest rates across country boundaries is ________. A) unlikely B) a good description of reality C) a good description of purchasing power parity D) a result of stable foreign currency markets

A) unlikely

MC: When the forward premium or discount on the foreign currency equals the interest differential between the domestic and foreign interest rates divided by one plus the foreign interest rate, what is being satisfied? A) covered interest arbitrage B) interest rate parity C) domestic and foreign interest rates D) spot and forward exchange rates

B) interest rate parity

The covered interest rate parity, uncovered interest rate parity, and purchasing power parity, together with the Fisher hypothesis are often referred to as the A) determinants of expected nominal exchange rates. B) determinants of expected nominal interest rates. C) international parity conditions. D) international arbitrage conditions.

C) international parity conditions

MC: A 150% return in Belarus is higher than a 15% dollar return in the U.S. A) because arbitrage opportunities exist. B) when the inflation controls are suspended in Belarus. C) it depends on whether these are nominal or real returns. D) regardless of nominal or real returns.

C) it depends on whether these are nominal or real returns

When a currency depreciates, if the firm increases it foreign currency price to maintain its profits, it will ________. A) gain sales from foreign rivals B) maintain its market share C) lose sales to foreign rivals D) be forced to exit the market

C) lose sales to foreign rivals

MC: The ________ is the minimum amount that must be kept in the futures margin account to guard against severe volatility in the futures contract price. A) initial margin B) settle price C) maintenance margin D) open interest

C) maintinance margin

MC: Which one of the following practices in the futures markets adds greater stability to the market? A) credit checks B) the initial margin C) marking to market D) the right but not the requirement to perform the contract

C) marking to market

MC: ________ is a daily settlement feature of the currency futures exchange in which profits and losses are paid over every day at the end of trading. A) Open interest B) A margin call C) Marking to market D) A maintenance margin

C) marking to market

MC: The phenomenon where the profitability of the firm is at risk due to real exchange rate change is known as ________ exposure. A) translation B) sovereign risk C) operating D) accounting

C) operating

MC: In the absence of pure competition, firms who segment markets may be able to charge different prices in different countries for the same good. This practice is known as ________. A) mark to market B) interest rate arbitrage C) pricing to market D) speculation

C) pricing to market

MC: Understanding the theory of purchasing power parity is important because deviations from PPP significantly affect the A) operations of the central bank. B) hedging activities of multinational firms. C) profitability of multinational firms. D) arbitrage opportunities in the banking markets.

C) profitability of multinational firms

MC: Which of the following forecasting techniques is usually used for short-term forecasts using only past exchange rate data, and some other data such as the volume of currency trade, to predict future exchange rates? A) market-based forecasts B) fundamental analysis C) technical analysis D) statistical analysis

C) technical analysis

MC: When a futures contract is purchased, ________. A) no money changes hands B) the only cash flow is at the maturity of the contract C) the buyer must deposit a certain amount of cash into a margin account D) the futures commission merchant marks up the price to cover his commission

C) the buyer must deposit a certain amount of cash up front into a margin account

MC: What is more appropriate to use when attempting to find information about the purchasing power of a currency? A) the spot exchange rate B) the forward rate C) the price levels D) the price indexes

C) the price levels

MC: Unlike forward contracts, the size of currency futures contracts are ________. A) subject to the forces of supply and demand in the currency spot market B) based on the months in which they expire C) a function of the initial margin required at the open of the trade D) a standardized amount that differs for each currency traded

D) a standardized amount that differs for each currency traded

MC: Currency swaps are often used to provide long-term financing in foreign currencies because A) longterm capital markets are not well developed. B) longterm forward foreign exchange markets are absent. C) of high foreign taxes. D) both A and B

D) both A&B A: longterm capital markets are not well developed B: longterm forward foreign exchange markets are absent

MC: The only way a firm does not have real exchange risk is in the case of the firm that is ________. A) completely diversified internationally B) a net exporter C) a net importer D) completely domestic

D) completely domestic

MC: A higher nominal interest rate in one country indicates the fact that the country's currency was expected to ________. A) appreciate B) evaluate C) devalue D) depreciate

D) depreciation

When a real Depreciation occurs in the domestic currency, who tends to be more profitable? A) government subsidized companies B) importers C) export competitors D) import competitors

D) import competitors

MC: What is the term for the revenue immediately generated from exercising a currency option? A) open interest B) leading payment C) margin D) intrinsic value

D) intrinsic value

What is the difference between a price level and a price index?

Price level: weighted average of the prices of the goods that people consume, give information about purchasing power of currency Price index: ratio of price level at one point in time to the price level of a base year (usually multiplied by 100), information about rate of inflation between points in time EX) if he price level in year B is 30% higher than Base year A, the price index would be 130.

What do financial economists mean when they discuss the conditional expectation of the future spot exchange rate?

Probability weighted average of the future possible exchange rates. Mean of the conditional probability distribution of future spot rates

Describe how you construct the uncertain yen-denominated return from investing 1 yen in the Swiss franc money market.

first convert from Yen to Francs in the spot exchange market, invest francs in swiss money market leaving the investment unhedged, convert back to Yen at future exchange rate at the end of investment horizon

Given an example of how a money market hedge is constructed?

given a liability in a foreign currency -borrow domestic currency equal = in PV to liability after spot exchange, convert to foreign currency, invest foreign currency giving you an asset in a foreign currency = in value to the foreign liability

MC: A currency swap is equivalent to a A) currency option, with the exercise price equal to the current spot rate. B) longdated forward foreign exchange contract, where the forward rate is the current spot rate. C) interest rate swap, where the basis is the differential between the fixed and floating interest rates. D) short-term currency futures contract.

B) longdated forward foreign exchange contract, where the forward rate is the current spot rate

When a currency depreciates, exporters to that country face the trade-off to ________. A) maintain production or outsource in other markets B) maintain profits or market share C) exit the market or choose to stay D) introduce new products or retire old ones

B) maintain profits or market share

MC: Which one of the following is an advantage to the investor of a currency futures contract as compared to a forward contract? A) more flexibility in contract size B) more liquidity when the investor wishes to sell the contract C) more currencies available D) more payment dates

B) more liquidity when the investor wishes to sell the contract

MC: The ________ is the conceptual principal amount that controls the cash flows of an interest rate swap. A) synthetic principal B) notional principal C) nominal principal D) discounted principal

B) notional principal

MC: What is the name of the total number of contracts outstanding for a particular derivative contract? A) a long position B) open interest C) settle amount D) open settlement

B) open interest

MC: The hedging contract that gives the buyer the right, but not the obligation, to sell a specific amount of foreign currency with domestic currency is known as the ________. A) call option B) put option C) American option D) European option

B) put option

An exchange rate pass-through describes the way managers of the firm choose to respond with their relative prices to changes in the ________. A) nominal exchange rate B) real exchange rate C) tariff rates D) real appreciation of the nominal exchange rates

B) real exchange rate

MC: When the firm's nominal profits are divided by the price level, the result is known as ________. A) nominal profitability B) real profitability C) inflation-adjusted profitability D) relative profitability

B) real profitability

MC: If the world capital market were fully integrated, the incentive to swap would be ________ because ________ arbitrage opportunities would exist. A) increased; more B) reduced; fewer C) increased; fewer D) reduced; more

B) reduced, fewer

MC: What is the name given to the risk associated with an asset's return arising from the covariance of the return on a large, well-diversified portfolio? A) covariance B) systematic risk C) idiosyncratic risk D) risk premium

B) systematic risk

MC: Which one of the following would be an answer to why the forward exchange rate is an unbiased predictor of the future spot rate? A) The forward rate is greater than the conditional expectation of the future spot rate. B) The forward rate equals than the conditional expectation of the future spot rate. C) The forward rate is less than the conditional expectation of the future spot rate. D) The current spot rate is greater than the conditional expectation of the future spot rate.

B) the forward rate is greater than the conditional expectation of the future spot rate

MC: When the value of the futures contract margin account falls below the maintenance margin, ________. A) no action is necessary by the investor B) there is a margin call C) there is a margin call at which point the account must be brought back up to the maintenance margin amount D) no money changes hands again until the expiration date

B) there is a margin call

MC: Most parallel loans include a ________ clause that requires additional advances or repayments of principal under special conditions. A) notional principal B) topping-up C) right of offset D) yield to call

B) topping-up

MC: What concept states that there is no systematic difference between the forward rate and the expected future spot rate, and that the expected forward market return is zero? A) unbiased predictor B) unbiasedness hypothesis C) uncovered interest rate parity D) unsystematic risk

B) unbiased hypothesis

MC: The version of purchasing power parity that states the exchange rates will adjust to equalize the internal and external purchasing power of a currency is known as the ________. A) relative purchasing power parity B) equilibrium purchasing power parity C) absolute purchasing power parity D) real exchange rate equilibrium

C) absolute purchasing power parity

MC: The difference between the current spot price and the futures price is known as the A) spread. B) barrier. C) basis. D) open interest.

C) basis

The development of what marketing strategy helps in situations of real exchange risk because consumers will not switch to competitors' products that enjoy a temporary pricing benefit from a favorable fluctuation in the exchange rate? A) market entry decisions B) the frequency of price adjustments C) brand loyalty D) pricing policy

C) brand loyalty

MC: When managers respond to changes in the real exchange rate with their relative price, it is known as ________. A) real exchange risk B) economic exposure C) exchange rate pass-through D) a real depreciation

C) exchange rate pass-through

When a real Appreciation occurs in the domestic currency, who tends to be more profitable? A) government subsidized companies B) exporters C) export competitors D) import competitors

C) export competitors

MC: What is the name for the bank market for deposits and loans that is denominated in a currency different to the currency of the country in which a bank is operating? A) internal currency market B) foreign exchange market C) external currency market D) interbank market

C) external currency market

What is the main determinant of the variability of forward market returns?

ONLY determinant is the variance of future exchange rate

How does a coupon bond's yield to maturity differ from the spot interest rate that applies to cash flows occurring at the maturity of the bond? When are the two the same?

-A coupon bonds YTM is the IRR that sets the PV of the coupon payments and principal payment equal to the bond price -AKA the YTM is basically an average of spot interest rates at various maturities -YTM = spot interest rates ONLY when the term structure of interest rates is flat (ie: when the spot interest rates at different maturities are identical)

What do economists mean by pricing-to-market?

-A producer charges different prices in different markets for the same good -requires markets to be segmented to prevent arbitrage, -producer must have some monopoly power since the demand curve that it faces in each market is not perfectly elastic

What is the value of the exchange rate that satisfies absolute PPP?

-Absolute purchasing power parity requires that internal PP of a currency = external PP -Internal PP = reciprocal of price level -External PP = exchange domestic currency into foreign currency, calculating the PP of that amount of foreign currency in foreign country -Absolute PPP found by setting IPP = EPP -FORMULA: Absolute PPP = IPP/ EPP

How does increasing time to maturity affect foreign currency option value?

-For American options, increasing the time to maturity always increases the options value because it increases the uncertainty of the spot rate at maturity. The holder can still exercise the option before maturity so it just gives more time insurance -for European options, the effect in ambiguous. Most often, option prices rise due to more uncertainty. BUT, this isnt always true because an option can lose money as time evolves. Euro options cannot be exercised before maturity

It is sometimes asserted that investors who hedge their foreign currency bond or stock returns remove the foreign exchange risk associated with the investment, reduce the volatility of their domestic currency returns, and thus get a "free lunch" because the mean return in domestic currency remains the same as the mean return in the foreign currency. Is this true or false? Why?

-If forward rates are unbiased, hedging foreign currency investments doesnt change expected returns and removes a source of volatility (without reducing mean return.) -BUT foreign exchange risk is not a priced risk if there is a risk premium in the forex market. -Hedged foreign bond and equity investments would have different expected returns than unhedged investments

If interest rate parity is satisfied, there are no opportunities for covered interest arbitrage. What does this imply about the relationship between spot and forward exchange rates when the foreign currency money market investment offers a higher return than the domestic money market investment?

-Implies that the foreign currency must be at a discount in terms of the domestic currency in the forward market -This forward discount creates a capital loss when trans exchange risk is offset, reducing the higher return of foreign currency to the domestic MM levels

It is often said that interest rate parity is satisfied when the differential between the interest rates denominated in two currencies equals the forward premium or discount between the two currencies. Explain why this is an imprecise statement when the interest rates are not continuously compounded.

-Interest rate parity REQUIRES the equality of returns between investments in the domestic money market vs. converting to foreign currency, investing in foreign currency, and selling foreign currency forward -FORMULA

Suppose you saw a set of quoted prices from a U.S. bank and a French bank such that you could borrow dollars, sell the dollars in the spot foreign exchange market for euros, deposit the euros for 90 days, and make a forward contract to sell euros for dollars and make a guaranteed profit. Would this be an arbitrage opportunity? Why or why not?

-It could be, but may also just reflect different risk -The French bank may have a higher default risk and as a result, raised their deposit rates -In that case, there is no arbitrage, just more risk of default

What effects does "marking to market" have on futures contracts?

-MtM implies that futures contracts have daily cash flows associated with them. -if the futures price moves in your favor (foreign currency price rises/ falls and strengthens/ weakens) then funds are placed into your margin account from the account fo the other party until maturity -short: sell the contract (favorable if futures prices fall) -long: buy the contract (favorable if futures prices rise)

Would technical analysis be useful if the international parity conditions held? Why or why not?

-No, because all that information would be available -forward rate would be best predictor if parity held

What determines how much a foreign producer allows the dollar price of a product sold in the United States to be affected by a change in the real exchange rate?

-PtM interacts with REX to prevent a full pass-through of a change in the exchange rate to the change in price -EX) if the REX moves in a favorable direction, the foreign price could be allowed to fall one-for-one with the appreciation of the foreign currency -BUT, monopolist will not allow that rate to decrease price one-for-one because he has the opportunity to make more profit -Basically, a monopolist monitors the exchange rate to take full advantage, not just let it fall/ rise 1 for 1

Why do American option values typically exceed their intrinsic values?

-TV of an option = current price of option minus intrinsic value -this is because of the possibility for better payoffs in the future compared to intrinsic value

What are you buying if you purchase a Swiss franc American call option against the U.S. dollar with a strike price of CHF1.30/$ and a maturity of January? (Assume that it is November and the spot rate is CHF1.35/$.)

-The right to purchase CHF with USD for a price of CHF1.30/$ before January -Option is currently out of the money because strike < current exchange rate

Suppose the government releases information that causes people to expect that the purchasing power of a money in the future will be less than they previously had expected. What will happen to the exchange rate today? Why?

-They will typically try to sell that currency for a more stable currency -reduced demand will cause the currency to weaken immediately (and exchange rate will fall)

You have been asked to evaluate possible sites for an Asian production facility that will manufacture your firm's products and sell them to the Asian market. What real exchange rate considerations should you entertain in your evaluation?

-be aware of the strength/ weakness of the REX in the various countries -exporting from the country where production is, profits can be hurt by real appreciation of that currency relative to countries exported to -So, if potential location is currently undervalued on forex market, it may appear to be cost effective, BUT this advantage would be wiped out by a real appreciation in the future

Explain why the absence of covered interest arbitrage possibilities can be characterized by two inequalities in the presence of bid-ask spreads int he forex and external currency markets.

-because of bid-ask spreads, we do not borrow/ convert currency at the same exchange rate 1. we cannot profit by borrowing domestic currency, converting to foreign currency, lending the foreign currency, and converting back to domestic currency in the forward market 2. cannot profit by borrowing foreign currency, converting to domestic currency, lending the domestic currency, and converting back to foreign currency

What is a carry trade?

-borrowing low interest rate currencies and lending high interest rate currencies. -if the high interest rate currency fails to depreciate as much as interest differential predicts, the carry trade has a positive return. -Done by going long in currencies that are selling at a forward discount.

Essay: Why do options provide insurance against foreign exchange risks in bidding situations? Why can't you hedge with a forward contract in a bidding situation?

-by bidding a fixed amount of foreign currency, the firm incurs transaction forex risk -firms want to hedge prior to winning a bid because the currency value can change during the bidding process -the company ultimately wants to sell the foreign currency if it wins the bid, so they should buy a foreign option against the domestic currency to hedge against the foreign currency weakening -with an option, the possible loss in value of the foreign currency is offset by the gain of the foreign currency put option -if the firm doesnt win the contract, the value of the foreign currency put option is the most they can lose (aka insurance) -if the firm tries to sell a currency forward, it has to pay the bank no matter what -if the firm doesnt get the contract, this means they have to purchase the foreign currency at the spot rate and will lose money if the currency has strengthened (aka no insurance)

What determines the bid-ask spread in the external currency market? why is it usually so small?

-difference between the bid and ask rate is small because the market is very competitive -Banks are not subjected to as many government regulations (reserve requirements) for external currency -External currency market becomes more profitable and more competitive

Suppose the current spot rate is $1.29/€. What is your payoff if you purchase a down-and-in put option on the euro with a strike price of $1.31/€, a barrier of $1.25/€, and a maturity of 2 months? When would someone want to do this?

-for a down-and-in option, the exchange rate must first cross the border to activate the contract and give the buyer the option to exercise at maturity -payoff = max(0, k-s) of $/# -S($/#) is the exchange rate at maturity only if the rate falls below barrier of $1.25/# -this option is less expensive than a regular put option -When: someone bearish on the euro, believes in initial market volatility will make option more profitable, and wants to cut cost of a high payoff

How do fundamental analysis and technical analysis differ?

-fundamental analysis: uses formal economic models of exchange rate determination and macroeconomic data (like money supply, inflation rates, growth rates, and current account BOP) to predict rates -technical analysis: uses ONLY past exchange rate data and financial data (volume of currency trade) to predict future exchange rates

What is the term structure of interest rates? How are spot interest rates determined from coupon bond prices?

-term structure of interest rates: relation between the maturities of bonds & pure discount yields (spot interest rates for various maturities) -spot interest rate is discount rate that satisfies: PV of final coupon + principal repayment = bond price - PV of intervening coupons

How does a futures contract differ from a forward contract?

-futures allow you to buy/ sell specific amounts of foreign currency at an agreed-upon price determined on a future day. 1. futures are traded on an exchange, where forwards are made by banks and their clients. futures can only be made during trading hours priced by the market, forwards quote sale prices 2. futures standardize the amount of currency one contract represents and cannot be changed (just purchase more contracts), forwards can be tailored individually 3. futures only have a few maturity dates, forwards can be requested for any future maturity date 4. forwards have to take credit risk into account and are not normally traded with small firms or those with bad credit, anyone can purchase a future and goes through clearinghouses to reduce credit risk

Suppose that you have a foreign currency receivable (payable). What option strategy places a floor (ceiling) on your domestic currency revenue (cost)?

-if you have a receivable (payable), it means you eventually want to sell (buy) the foreign currency -purchasing a put (call) option provides a hedge that provides a floor (ceiling) on domestic currency revenue (cost)

What do economists mean by the external currency market?

-interbank market for deposits and loans denominated in currencies other than the local currency of where they operate -procedures similar to the forex market -first deposits were Eurodollars: $ deposits in Eurpoean banks

It is often claimed that the forward exchange rate is set by arbitrage to satisfy (covered) interest rate parity. Explain how interest rate parity can be satisfied and how the forward exchange rate can be set by speculators in reference to the expected future spot exchange rate.

-interest rate parity is a no-arbitrage relation between 4 variables: spot and forward exchange rates, interest rates of both currencies -if the forward exchange rate is set in reference to the expected future spot rate, the current spot rate of the two interest rates can adjust to satisfy interest rate parity. -Speculative dimension of trading must also be in equilibrium

What is the intrinsic value of a foreign currency call option? What is the intrinsic value of a foreign currency put option?

-intrinsic value: immediate revenue from exercising an option Call: max(s-K, 0) (aka strike - current spot) Put: max(K-s,0) (aka current spot - strike)

What is the payoff on an average-rate pound call option against the dollar?

-max(0, s-k) of $/# -s($/#) defines the average dollar-pound exchange rate between purchase and maturity -parties calculate average exchange rate based on agreed upon data -must decide on time interval of observations, arithmetic/ geometric average -at maturity, the seller settles the contract by delivering the dollar value to the buyer -average-rate options are less expensive than EuroOptions because future average future exchange rates are less volatile than future spot rates

Does a large increase in the domestic money supply always lead to a depreciation of the currency?

-most would predict that an increase in money supply would lead to a depreciation of the currency (especially in the long run) -BUT, a change in money supply could also imply an increase in real income that increases money demand, offsetting the money supply increase effect on the exchange rate

What is a money market hedge? How is it constructed?

-offset the underlying transaction exchange risk with borrowing/ lending the foreign money market instead of a forward contract -borrow the amount of domestic currency = PV of the foreign currency liability at the spot rate -EX) you get a foreign currency liability, borrow domestic currency & convert to foreign currency, invest the foreign currency to gain a foreign asset = in value to the foreign liability

What is a pure discount bond?

-one cash flow at the maturity of the bond -bond price < face value -discount in price is return for holding period of the bond

If the dollar interest rate is positive, explain why the value of $1M received every year for 10 years is not $10M today.

-positive interest rates make future money less valuable than present money -the PV of these future cash flows is <$1M based on the time waiting for the cash

What are the differences between foreign currency option contracts and forward contracts for foreign currency?

-primary difference: option contracts give you the opportunity to purchase/ sell a contract, but not an obligation -forward contracts are obligatory and unaffected by current market conditions

What is the real exchange rate, and how are fluctuations in the real exchange rate related to deviations from absolute PPP?

-real exchange rate: nominal exchange rate multiplied by the ratio of price levels -REX would be 1 if APPP held because nominal exchange rate should = IPP/EPP -fluctuations in APPP are fluctuations in REX

Suppose that the international parity conditions all hold and a country has a higher nominal interest rate than the United States. Characterize the country's inflation rate compared to the United States, the country's expected exchange rate change versus the dollar, the country's currency forward premium (or discount) versus the dollar, and the country's real interest rate compared to the U.S. real interest rate.

-real interest rates are equalized across countries, the a countries Real interest rates should equal the US -the countries higher nominal interest rate must reflect a higher expected rate of inflation relative to the US -a higher expected rate of inflation implies countries currency should depreciate relative to $ -currency will trade at a forward discount relative to $

Explain the concepts of present value and future value.

-relate to the time value of money -because of positive interest rates, money in the future is not worth as much as money in the present -the real value of future money is equal to its present value -the future value of present money is equal to the cash principal + interest on the investment -(PV of future cash is the amount you can borrow against the future, using the future amount to pay interest + principal on a loan)

Are devaluations of pegged exchange rates totally unexpected?

-some theories suggest that devaluations may be partially predictable -they say growing budget deficits, fast money growth, and rising wages/ prices usually precede devaluations. -increases in nominal interest rates typically reflect a combination of the probability and magnitude of a possible devaluation

MC: In a(n) ________ swap, one party pays a fixed rate calculated at the time off trade as a spread to a particular Treasury bond, and the other sides pays a floating rate. A) currency B) interest rate C) coupon D) basis

B) interest rate

Describe how you would calculate a 5-year forward exchange rate of yen per dollar if you knew the current spot exchange rate and the prices of 5-year pure discount bonds denominated in yen and dollars. Explain why this has to be the market price.

-the 5yr forward rate = spot rate*ratio of FV in 5 years of 1 yen to FV in 5 years of 1 $ -AKA if you can invest in yen directly for 5 years, you can convert 1 yen into the FV of yen in 5 years -you can also convert the 1 yen into $ in the spot market, invest the $ for 5 years to get the FV of $, and sell the $ in the forward market to get the FV of yen in 5 years -If these amounts differ, there is an arbitrage opportunity -FORMULA

What is basis risk?

-the difference between the price of the futures contract at time T for a future maturity, and the spot rate at time T -at maturity, basis = 0 -if maturities are different, basis is not 0 and relationship is more uncertain -for a perfect hedge: price of futures contract should move 1 for 1 with the spot rate -EX) being long in futures market could be hedged by going short in the spot market, if not, you suffer form basis risk

Describe qualitatively how changing the strike price of the option provides either more or less expensive insurance.

-the higher or lower a strike price is relative to the current price causes the option to be more expensive -the more risk that the options helps to avoid, the more expensive the option will be

Suppose you go long in a foreign currency futures contract. Under what circumstances is your cumulative payoff equal to that of buying the currency forward?

-the payoffs would only be equal because interest is earned on future profits in the marking to market process -Technically if there were no changes in future short-term rates, there would be an arbitrage opportunity if the forex rate were different from the futures price because you would know how to invest the profits -BUT, future rates are not certain, so prices could, differ slightly (but not that much, so we say they are essentially the same)

What does the purchasing power of a money mean? How can it be measured?

-the real value of money that indicates the amount of goods/ services that can be purchased with a given amount of the currency -measured by calculating price level (weighted average of the prices of goods people consume (weights reflect individual consumption)) --> purchasing power is the reciprocal of the price level, -units of price level are amount of money per consumption bundle -units of purchasing power are consumption bundles per unit of money

How would an exporter who always shifts exchange rate risk to the importer by invoicing in the home currency actually threaten future sales?

-there will always be forex risk when selling goods across borders -if you only invoice in dollars, you may lose sales to competitors willing to bear the risk of selling in the local currency

If people expect that their future purchasing power will decline, what will happen to the exchange rate today?

-they will sell the currency for a currency with more stable PP -reduced demand causes currency to weaken

Why does the strategy of pricing-to-market depend on the assumption of market segmentation?

-to prevent arbitrage in the goods market -the demand curve in each country is not perfectly elastic so the producer must have some degree of monopolistic power

Given that real exchange rates fluctuate, when would be the best time to enter the market of a foreign country as an exporter to that market?

-when the foreign currencies are strong in real terms -this allows the new product to set a comparatively low foreign currency price so that it can better compete -idea is to build consumer base before changes prices when the foreign currency depreciates relative to exporters currency

What are 2 ways to speculate in the currency markets without investing any money up front?

1. to be long in foreign currency: borrow domestic currency, convert to foreign currency in the spot exchange market, invest in foreign money market while leaving transaction exchange risk unhedged OR enter a forward contract to buy a foreign currency forward. 2. to be short in foreign currency: borrow foreign currency, convert to domestic currency, invest in domestic money market while leaving transaction risk unhedged OR enter a forward contract to sell foreign currency forward

MC: What does the term "Carry trade" mean? A) Borrow in the domestic currency to earn only the higher yield of the dollar implied by the regression. B) Borrow in the foreign currency to earn only the expected capital appreciation of the dollar implied by the regression. C) Borrow in the domestic currency to earn both the higher yield and the expected capital appreciation of the dollar implied by the regression. D) Borrow in the foreign currency to earn both the higher yield and the expected capital appreciation of the dollar implied by the regression.

A) Borrow in the domestic currency to earn only the higher yield of the dollar implied by the regression.

MC: The term covered means the investment is ________ transaction foreign exchange risk. A) hedged against B) exposed to C) completely free from D) structured to activate forward contracts that free it from

A) Hedged against

MC: If there is no systematic difference between the forward rate and the expected future spot rate, then the expected forward market return should be ________. A) zero B) greater than one C) equal to the stockholders' required rate of return D) less than one but greater than zero

A) Zero

MC: To construct the uncertain yen-denominated return from investing one yen in the Swiss franc, what is your first step? A) convert from yen into Swiss francs in the spot market B) convert from Swiss francs into yen in the forward market C) invest in the Swiss money market D) convert from Swiss francs into yen at the future spot rate

A) convert from yen to francs in the spot market

MC: A currency swaps allows a multinational corporation to change the ________. A) currency of denomination of its debts B) forward rate on contracts it secures to hedge exchange rate risk C) principal and interest rate on its debt D) nature of its debt from a fixed interest rate to a floating interest rate

A) currency denomination of its debts

MC: Marking to market is the process by which the clearing house of an exchange ________. A) debits and credits the losses and profits to the margin accounts from the daily price changes of futures prices; closes the contract, and opens a new one at the new price B) forces the investor to go long the currency C) allows the market forces to affect daily prices until the expiration date D) closes the old contract and sets the price of a new contract a zero

A) debits and credits the losses and profits to the margin accounts from the daily price changes

MC: The decomposition of the nominal interest rate into the sum of the expected real interest rate and the expected rate of inflation is known as the A) Fisher Effect. B) Siegel Paradox. C) bid-ask spread. D) exchange rate pass-through.

A) fisher effect

MC: An interest rate swap allows an MNC to change the nature of its debt from a ________. A) fixed interest rate to a floating interest rate B) local bank interest charge to a international bank interest charge C) pegged currency exchange system to a floating currency exchange system D) debt security to an equity security

A) fixed interest rate to a floating interest rate

...

B)

MC: When parity conditions are not in effect in currency and money markets, traders could make extraordinary profits from a practice known as ________. A) covered interest rate parity B) covered interest rate arbitrage C) triangular arbitrage D) forward market arbitrage

B) Cover interest rate arbitrage

MC: An example of an external currency market that was the first to form was the market where the dollar-denominated deposits were known as A) Euros. B) Eurodollars. C) petrodollars. D) exchange traded funds.

B) Eurodollars

MC: Within Germany, what is the name for the power of a U.S. dollar when it is used to purchase an amount of goods and services? A) internal purchasing power B) external purchasing power C) absolute purchasing power parity D) relative purchasing power parity

B) External purchasing power

When the forward rate is equal to the expected future spot rate, the forward rate is said to be ________ the future spot rate. A) an information signal for B) an unbiased predictor of C) a hedge for D) in parity with the expected future spot rate

B) an unbiased predictor of

MC: If the underlying transaction gives you a liability, denominated in foreign currency, the general principal behind a money market hedge states you need an equivalent ________ in the money market to provide a hedge. A) liability B) asset C) forward contract D) foreign bank account

B) asset

MC: Because systematic risk measures how much an asset's return co-moves with the market, it ________. A) can be diversified away with the appropriate hedging B) cannot be diversified away C) is partially driven by idiosyncratic risk D) can be completely eliminated using international securities

B) cannot be diversified away

MC: A major difference between foreign currency futures contracts and forward contracts is that forward contracts are ________. A) sold by government agencies B) created by banks C) created by writers D) marketed on the over-the-counter market

B) created by banks

The theory of relative purchasing power parity states that, between two nations, the ________. A) inflation rates are unrelated B) exchange rate differential reflects the inflation rate differential C) inflation rate is smaller in weaker currencies D) the interest rate is greater than the inflation rate during depreciations

B) exchange rate differential reflects the inflation rate differential

The Fisher Effect decomposes nominal interest rates into the ________ and the expected rate of inflation. A) expected real exchange rate B) expected real interest rate C) expected forward rate of return D) nominal exchange rate

B) expected real interest rate

MC: What currency forecasting technique links exchange rates to macroeconomic variables such as money supply and inflation? A) technical analysis B) fundamental analysis C) exchange rate forecasting D) mean absolute error

B) fundamental analysis

MC: Which of the following forecasting techniques is typically based on formal economic models of exchange determination, which link exchange rates to money supply, inflation rates, productivity growth rates, and the current account? A) market-based forecasts B) fundamental analysis C) technical analysis D) statistical analysis

B) fundamental analysis

MC: ________ techniques are typically based on formal economic models of exchange rate determination. A) Technical analysis B) Fundamental analysis C) Exchange rate forecasting D) Mean absolute error

B) fundamental analysis

MC: A real depreciation of the domestic currency hurts domestic ________ firms who must then compete against less expensive imports. A) exporting B) import-competing C) importing D) export-competing

B) import-competing

If market efficiency is identified with parity, currency markets that are ________ provide no opportunities for currency traders to earn profits. A) not in parity B) in parity C) in interest rate parity only D) in purchasing power parity

B) in parity

MC: One important reason to study the purchasing power parity theory is because A) investors should borrow in a foreign currency, when there is a forward discount. B) when inflation rates differ across international borders, PPP provides a baseline forecast of future exchange rates. C) forecasting exchange rates is difficult and PPP makes it easier. D) it provides currency dealers with a way to identify arbitrage opportunities.

B) when inflation rates differ across international borders, PPP provides a baseline forecast of future exchange rates

MC: When is a currency said to be overvalued? A) when its internal purchasing power is greater than its external purchasing power B) when its external purchasing power is greater than its internal purchasing power C) when its external purchasing power is less than its internal purchasing power D) when its internal purchasing power is equal than its external purchasing power

B) when its EPP > IPP

MC: The original or first seller of the option is known as the ________. A) option broker B) writer C) option commission merchant D) clearing member

B) writer

MC: The ________ holds that it is the covariance of an asset's return with that of the market portfolio that determines the asset's risk premium. A) Law of One Price B) Law of Iterated Expectations C) Capital Asset Pricing Model D) Interest Rate Parity Model

C) Capital Asset Pricing Model CAPM

MC: To determine the risk premium associated with an asset's expected return, two components of the return are usually cited, only the first, the covariance of the asset's return with the market portfolio, is used, because ________. A) the risk associated with the asset depends on the market risk B) it is the only part of the asset's expected return that has risk C) the risk of the second component can be diversified away D) the market risk is the most difficult to calculate

C) the risk of the second component can be diversified away

Why does an increase in the strike price of an option decrease the value of a call option and increase the value of a put option?

Call: -would decrease its value because it removes possible states all over the world where the lower strike price provide revenue Put: -increase its value because it adds possible states all over the world where the higher strike would provide more revenue

MC: Suppose annual inflation rates in the U.S. and Mexico are expected to be 6% and 80%, respectively, over the next several years. If the current spot rate for the Mexican peso is $.005, then the best estimate of the peso's spot value in 3 years is ________. A) $.00276 B) $.01190 C) $.00321 D) $.00102

D) $.00102

MC: Multinational corporations most often hedge their transaction exchange rate risk using currency ________. A) options B) futures C) spreads D) forward contracts

D) Forward contracts

MC: Which one of the following is NOT a reason for using hedges such as a synthetic forward? A) In some currency markets, forward contracts may not be available, but they can be manufactured using a money market hedge. B) Individual companies are not able to borrow and lend at the interest rates available in the interbank market. C) When time horizons are long, forward contracts can be expensive as the bid-ask spread widens substantially. D) It may be unfavorable to consider borrowing and lending to hedge one's currency risk.

D) it may be unfavorable to consider borrowing and lending to hedge one's currency risk

MC: To make predictions regarding fixed exchange rate systems and devaluations, forecasters may employ A) macroeconomic information. B) financial information. C) interest rate differentials. D) macroeconomic, financial and even interest rate differentials.

D) macroeconomic, financial, and even interest rate differentials

MC: In the face of a currency depreciation, if the firm maintains its foreign currency price, it will ________. A) lose its market share but gain profits B) lose its market share and lose profits C) maintain its market share and gain profits D) maintain its market share but lose profits

D) maintain its market share but lose profits

MC: What is the name of the expression that refers to the costs that a firm incurs in changing its prices? A) fixed costs B) variable costs C) cost-base pricing D) menu costs

D) menu costs

MC: A currency swap is most similar in economic purpose to a A) basis swap. B) parent company loan. C) debt equity swap. D) parallel loan.

D) parallel loan

MC: When there are no intervening cash flows between the time a deposit is made and the maturity of the deposit, the interest rates are said to be ________. A) discount rate B) compound interest rate C) covered interest rate D) spot interest rates

D) spot interest rates

MC: The risk that is associated with an asset's return arising from the covariance of the return with the return on a large, well-diversified portfolio is known as ________ risk. A) business B) exchange rate C) market D) systematic

D) systematic

MC: Whereas other forecasters use macroeconomic data to forecast future exchange rates, ________ techniques focus entirely on historical financial data. A) equilibrium condition B) parity condition C) rational expectations D) technical analysis

D) technical analysis

MC: Which one of the following is the only determinant of volatility in the forward currency markets? A) interest rate parity B) economic recovery C) political turmoil D) variance of the future exchange rates

D) variance of the future exchange rates

MC: Which of the following conditions would be "in the money" for an American call option for foreign currency? A) when the market price limits are reached and trading is halted B) when the strike price is greater than the spot price C) when the strike price is equal to the spot price D) when the strike price is lower than the spot price

D) when the strike price is lower than the spot price

What does it mean for the 90-day forward exchange rate to be an unbiased predictor of the future spot exchange rate?

It means the forward rate = the expected future spot rate. There will not be any systematic errors on either side. Therefore, the expected forward market return = 0.

What is a Sharpe ratio?

measure of risk-return tradeoff on an asset or a portfolio. Measured by taking the ratio of the average excess return divided by standard deviation of returns

Explain what is meant by the real exchange rate?

the REX is the nominal exchange rate multiplied by the ratio of price levels