International Finance Midterm

Assume that the balance-of-payments accounts for a country are recorded correctly. Balance on the current account = BCA = $130 billion Balance on the capital account = BKA = −$86 billion Balance on the reserves account = BRA =? The balance on the reserves account (BRA), under the FIXED exchange regime is

-$44 billion

International reserve assets include "foreign exchanges". These are

foreign currency held by a country's central bank.

The most important international reserve asset, comprising 94 percent of the total reserve assets held by IMF member countries is

foreign exchanges

Currently, international reserve assets are comprised of

gold, foreign exchanges, special drawing rights (SDRs), and reserve positions in the International Monetary Fund (IMF).

A depreciation will begin to improve the trade balance immediately if

imports and exports are responsive to the exchange rate changes.

If a country is grappling with a major balance-of-payment difficulty, it may not be able to expand imports from the outside world. Instead, the country may be tempted to

impose measures to restrict imports and discourage capital outflows.

The capital account is divided into three subcategories: direct investment, portfolio investment, and other investment. Portfolio investment involves

investments in foreign stocks and bonds that do not involve acquisitions of control.

Since security returns tend to have low correlations among countries,

investors can reduce risk more effectively if they diversify their portfolio holdings internationally rather than purely domestically.

The US trade deficit

is both a capital account surplus and a current account deficit.

More important than the absolute size of a country's balance-of-payments disequilibrium

is the nature and cause of the disequilibrium

When Honda, a Japanese auto maker, built a factory in Ohio,

it was engaged in foreign direct investment.

Invisible trade refers to

legal, consulting, and engineering services.

As of 2011, gold accounted for

less than one percent of the total reserve assets held by IMF member countries.

The current account is divided into four finer categories:

merchandise trade, services, factor income, and unilateral transfers.

the balance of payments records

not only international trade, (exports and imports) but also cross-border investments.

If Japan exports more than it imports, then

one can infer that the yen would be likely to appreciate against other currencies.

Regarding the statistical discrepancy in the balance-of-payments accounts,

there is some evidence that financial transactions may be mainly responsible for the discrepancy, and the sum of the balance on the capital account and the statistical discrepancy is very close to the balance of the current account in magnitude.

If the central banks of the world chose to diversify their foreign-exchange reserves away from the dollar and into the euro,

this have the result of a weakening in the value of the dollar.

The price of a McDonald's Big Mac sandwich

varies considerably across the world in dollar terms.

Over the last several years, the U.S. has run persistent

current account deficits.

A country experiencing a significant balance-of-payments surplus would be likely to

expand imports, offering marketing opportunities for foreign enterprises, and refrain from imposing foreign exchange restrictions.

A currency depreciation will begin to improve the trade balance immediately

if the demand for imports and exports are elastic.

A country that gives foreign aid to another country can be viewed as

importing goodwill from the latter

The vast majority of the foreign-exchange reserves held by central banks are denominated in

US Dollars

A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The one-year forward exchange rate is $1.20 = €1.00; what must the spot rate be to eliminate arbitrage opportunities?

$1.2471 = €1.00 Explanation Solve the following for X: (1.06/1.02) × 1.2 = X

Suppose you observe a spot exchange rate of $2.00/£. If interest rates are 5 percent APR in the U.S. and 2 percent APR in the U.K., what is the no-arbitrage 1-year forward rate?

$2.0588/£ Explanation F = S[1 + i$)/(1 +i£)] = 2(1.05/1.02) = 2.0588.

Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000. If an astute trader finds an arbitrage, what is the net cash flow in one year?

$7,000 Explanation [F/S] (1+i€) = (1.58/1.6) (1.04) = 1.027, which is less than (1+i$) = 1.02. This suggests that IRP is not holding. After adjusting for the exchange rates (F/S), the interest rate is lower in the U.S. than in Germany. The arbitrager should borrow $1,000,000, and repayment in one year will be $1,020,000 = ($1,000,000 × 1.02). Then, the $1,000,000 should be used to purchase $1,000,000 / 1.6 = €625,000. The euros will be invested in Germany, where the maturity value will be €625,000 × 1.04 = €650,000. Finally, sell the euros in exchange for $1,027,000 (found by €650,000 × 1.58). The new cash flow is found by $1,027,000 - $1,020,000 = $7,000.

The "one word that haunts the dollar" is

(Central bank) diversification.

The capital account is divided into three subcategories: direct investment, portfolio investment, and other investment. Direct investment involves

acquisitions of controlling interests in foreign businesses.

Generally speaking, any transaction that results in a receipt from foreigners

will be recorded as a credit, with a positive sign, in the U.S. balance of payments.

Generally speaking, any transaction that results in a payment to foreigners

will be recorded as a debit, with a negative sign, in the U.S. balance of payments.

According to the research in the accuracy of paid exchange rate forecasters,

you can make more money selling forecasts than you can following forecasts.

Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six months. You are considering the purchase of U.S. T-bills that yield 1.810% (that's a six month rate, not an annual rate) and have a maturity of 26 weeks. The spot exchange rate is $1.00 = ¥100, and the six month forward rate is $1.00 = ¥110. What must the interest rate in Japan (on an investment of comparable risk) be before you are willing to consider investing there for six months?

11.991 percent Solve for X as follows: 110/100*(1.0181)-1=11.991%

A higher U.S. interest rate (i$ ↑) relative to interest rates abroad, ceteris paribus, will result in

A stronger dollar

Continued U.S. trade deficits coupled with foreigners' desire to diversify their currency holdings away from U.S. dollars

All of the options could further diminish the position of the dollar as the dominant reserve currency. could lend steam to the emergence of the euro as a credible reserve currency. could affect the value of U.S. dollar (e.g., through the currency diversification decisions of Asian central banks).

with regard to the capital account

All of the options: U.S. sales (or exports) of assets are recorded as credits, as they result in capital inflow. U.S. purchases (imports) of foreign assets are recorded as debits, as they lead to capital outflow. the capital account balance measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.

In the latter half of the 1980s, with a strong yen, Japanese firms A. faced difficulty exporting. B. could better afford to acquire U.S. assets that had become less expensive in terms of yen. C. financed a sharp increase in Japanese FDI in the United States. D. all of the above

All the options

The statistical discrepancy in the balance-of-payments accounts

All the options arise since recordings of payments and receipts are done at different times, in different places, possibly using different methods. represents omitted and misreported transactions. arise because some transactions (illegal transactions) occur "off the books."

Balance of payments

All the options: provides detailed information concerning the demand and supply of a country's currency. can be used to evaluate the performance of a country in international economic competition. is defined as the statistical record of a country's international transactions over a certain period of time presented in the form of a double-entry bookkeeping.

The balance of payments identity is given by BCA + BKA + BRA = 0. Rearrange the identity for a country with a pure flexible exchange rate regime.

BCA = −BKA

A U.S.-based currency dealer has good credit and can borrow $1,000,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain dollar profit via covered interest arbitrage.

Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is $2,400.

An Italian currency dealer has good credit and can borrow €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain euro-denominated profit via covered interest arbitrage.

Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is €2,000.

A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain profit via covered interest arbitrage.

Both Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is $2,400. Additionally, one may borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is €2,000. Explanation [1.2 / 1.25] (1.06) = 1.0176, which is less than 1.02. Thus, the interest rate is lower in the euro zone after adjusting for the exchange rates (F/S), meaning an arbitrage opportunity should involve borrowing in the euro zone and lending in the U.S.

What is the correct label for the vertical axis in the J-curve?

Change in the Trade Balance

When Nestlé, a Swiss firm, bought the American firm Carnation, it was engaged in foreign direct investment. If Nestlé had only bought a non-controlling number of shares of the firm,

Nestlé would have been engaged in portfolio investment.

Assume that the balance-of-payments accounts for a country are recorded correctly. Balance on the current account = BCA = $130 billion Balance on the capital account = BKA = −$86 billion Balance on the reserves account = BRA =? The balance on the reserves account (BRA), under the PURE flexible exchange regime is

None of the options

Suppose the InBev Corporation (a non-U.S. MNC) buys the Anheuser-Busch Corporation, paying the U.S. shareholders cash.

Payment by InBev will be recorded as a credit.

Suppose the McDonalds Corporation imports Canadian beef, paying for it by transferring the funds to a New York bank account kept by the Canadian beef producer.

Payment by McDonalds will be recorded as a debit.

The difference between Foreign Direct Investment and Portfolio Investment is that

Portfolio Investment mostly represents the sale and purchase of foreign financial assets such as stocks and bonds that do not involve a transfer of control.

The world's largest debtor nation and creditor nation, respectively, are

The U.S. and Japan.

The most popular reserve currency is now the

U.S. dollar

The balance of payments identity is given by BCA + BKA + BRA = 0. Rearrange the identity to solve for the statistical discrepancy.

The statistical discrepancy = BCA + BKA + BRA

True or False: Over half of all dollar bills in circulation are held outside American's borders.

True

The US is considered

a net debtor nation

A country with a current account surplus

acquires IOUs from foreigners, thereby increasing its net foreign wealth.

Some commodities never enter into international trade. Examples include

all of the options: housing. nontradables. haircuts.

If IRP fails to hold,

all of the options: pressure from arbitrageurs should bring exchange rates and interest rates back into line it may fail to hold due to transactions costs. it may be due to government-imposed capital controls.

The capital account includes

all purchases and sales of assets such as stocks, bonds, bank accounts, real estate, and businesses.

The official reserve account includes

all purchases and sales of international reserve assets such as dollars, foreign exchanges, gold, and special drawing rights (SDRs).

Statistical discrepancy, which, by definition, represents errors and omissions,

all the options: cannot be calculated directly. probably has some elements that are honest mistakes, it can't all be money laundering and drugs. is calculated by taking into account the balance-of-payments identity.

Interest Rate Parity (IRP) is best defined as

an arbitrage condition that must hold when international financial markets are in equilibrium.

Forward parity states that

any forward premium or discount is equal to the expected change in the exchange rate.

Government controlled investment funds, known as sovereign wealth funds,

are mostly domiciled in Asian and Middle Eastern countries.

The capital account is divided into three subcategories: direct investment, portfolio investment, and other investment. "Other" investment involves

bank deposits, currency investment, trade credit, and the like. Correct

In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket,

both it will hold only if the prices of the constituent commodities are equalized across countries in a given currency or if the composition of the consumption basket is the same across countries.

If the interest rate rises in the U.S. while other variables remain constant

capital inflows into the U.S. will increase

Factor Income

consists largely of interest, dividends, and other income on foreign investments.

In 2012, the United States had a current account deficit. The current account deficit implies that the United States

consumed more output than it produced.

A country's international transactions can be grouped into the following three main types:

current account, capital account, and official reserve account.

The Efficient Markets Hypothesis states

current asset prices (e.g., exchange rates) fully reflect all the available and relevant information.

The capital account may be divided into three categories—

direct investment, portfolio investment, and other investment

If a country must make a net payment to foreigners because of a balance-of-payments deficit, the country should

either run down its official reserve assets or borrow anew from foreigners.

Since the balance of payments is presented as a system of double-entry bookkeeping,

every credit in the account is balanced by a matching debit and every debit in the account is balanced by a matching credit.

In the long run, both exports and imports tend to be

responsive to changes in exchange rates.

Covered Interest Arbitrage (CIA) activities will result in

restoring equilibrium prices quickly.

Credit entries in the U.S. balance of payments

result from foreign sales of U.S. goods and services, goodwill, financial claims, and real assets, and give rise to the demand for dollars.

When a country must make a net payment to foreigners because of a balance-of-payments deficit, the central bank of the country

should either run down its official reserve assets (e.g., gold, foreign exchanges, and SDRs) or borrow anew from foreign central banks.

Transactions in currency, bank deposits and so forth

tend to be sensitive to both changes in relative interest rates and the anticipated change in exchange rate.

Under the FIXED exchange rate regime,

the COMBINED balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the official reserves.

The central bank of the United States is

the Federal Reserve System

An arbitrage is best defined as

the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain guaranteed profits.

BKA stands for

the balance on the capital account

BCA stands for

the balance on the current account

Under the pure flexible exchange rate regime,

the balance on the current and capital accounts will be equal in size, but opposite in sign.

When a country's currency depreciates against the currencies of major trading partners,

the country's exports tend to rise and imports fall.

The current account includes

the export and import of goods and services.

International portfolio investments have boomed in recent years, as a result of

the general relaxation of capital controls and regulation in many countries.

The "J-curve effect" shows

the initial deterioration and the eventual improvement of a country's trade balance following a currency depreciation.

Which of the following would not count as a foreign-exchange reserve held by a central bank?

the local currency

The International Fisher Effect suggests that

the nominal interest rate differential reflects the expected change in the exchange rate.

Which of the following is most indicative of the pressure that a country's currency faces for depreciation or appreciation?

the official settlement balance

If the interest rate in the U.S. is i$ = 5 percent for the next year and interest rate in the U.K. is i£ = 8 percent for the next year, uncovered IRP suggests that

the pound is expected to depreciate against the dollar by about 3 percent and the dollar is expected to appreciate against the pound by about 3 percent.

If the United States imports more than it exports, then this means that

the supply of dollars is likely to exceed the demand in the foreign exchange market, ceteris paribus

If the United States imports more than it exports, then this means that

the supply of dollars is likely to exceed the demand in the foreign exchange market, ceteris paribus, and one can infer that the U.S. dollar would be under pressure to depreciate against other currencies.

When Interest Rate Parity (IRP) does not hold

there are opportunities for covered interest arbitrage.

In the short run a currency depreciation can make a trade balance worse if

there is no domestic producer of an import

Foreign direct investment (FDI) occurs

when an investor acquires a measure of control of a foreign business and when there is an acquisition, by a foreign entity in the U.S., of 10 percent or more of the voting shares of a business.

When the balance-of-payments accounts are recorded correctly, the combined balance of the current account, the capital account, and the reserves account must be

zero

As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next year in the U.S. is 2 percent and 3 percent in the euro zone. What is the one-year forward rate that should prevail?

€1.00 = $1.2379 Explanation Solve the following for X: 1.25 = (1.03/1.02)X

Assume that the balance-of-payments accounts for a country are recorded correctly. Balance on the current account = BCA = $130 billion Balance on the capital account = BKA = −$86 billion Balance on the reserves account = BRA =? In a pure flexible exchange rate regime, a country's central banks will not need to maintain official reserves. Under this regime

−BCA = BKA.