Chapter 10

when only nonresidents may convert it into a foreign currency without any limitation

Externally convertible Currency

Spot exchange rates and the 30-day forward rates are the same.

False

The foreign exchange market is the primary vehicle used to minimize monopolies within a marketplace.

False

states that a country's "nominal" interest rates (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent(I).

Fisher Effect

a market for converting the currency of one country of that into another country

Foreign Exchange Market

the adverse consequences of unpredictable changes in exchange rates

Foreign Exchange Risk

Exchange rates governing such future transactions

Forward Exchange Rate

When a country's government allows both residents and nonresidents to purchase unlimited amounts of foreign currency with it.

Freely convertible currency

________ is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months.

Transaction exposure

When companies wish to convert currencies, they typically do so through a bank.

True

Assume that the interest rate on borrowings in Japan is 3 percent while the interest rate on bank deposits in a U.S. bank is 5 percent. Laura, an active currency trader, borrows in Japanese yen, converts the money into U.S. dollars and deposits it in a U.S. bank. Laura is engaging in

carry trade

A(n) _____ refers to the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

currency swap

A(n) ________ is used to move out of one currency and into another for a limited period without incurring foreign exchange risk.

currency swap

The extent to which a firm's future international earning power is affected by changes in exchange rates is known as

economic exposure

Translation exposure refers to the

impact of currency exchange rate changes on the reported financial statements of a company

________ occurs when two parties agree to exchange currency and execute the deal at some specific date in the future

A forward exchange

Assume that the yen/dollar exchange rate quoted in Tokyo at 5 p.m. is ¥120 = $1, and the New York yen/dollar exchange rate at the same time (noon New York time) is ¥123 = $1. What action should a broker take to yield immediate profit?

Arbitrage

buying a currency low and selling it high

Arbitrage

occurs when residents and nonresidents rush to convert their holdings of domestic currency into foreign currency

Capital flight

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

Currency speculation

To express the PPP theory in symbols, let P$ be the U.S. dollar price of a basket of particular goods and P¥ be the price of the same basket of goods in Japanese yen. What does the purchasing power parity (PPP) theory predict to be the equivalent of the dollar/yen exchange rate, E$/¥?

E$/¥ = P$ ÷ P¥

has no impediments to the free flow of goods and services, such as trade barriers

Efficient Market

the rate at which one currency is converted into another

Exchange Rate

a market in which prices do not reflect all available information

Inefficient Market

London is able to dominate in the foreign exchange market because of its:

Location

The foreign exchange trading center in ________ has the highest percentage of activity.

London

FutureForm, a U.S. company, imports microprocessors from Japan. The company must pay in yen to the Japanese supplier within 30 days. In a particular exchange, the company must pay the Japanese supplier ¥150,000 for each microprocessor at the current dollar/yen spot exchange rate of $1 = ¥110. FutureForm intends to resell the microprocessors the day they arrive for $1,600 each but it does not have the funds to pay the Japanese supplier until these have been sold. What will happen if the exchange rate after 30 days is $1 = ¥90?

The importer will incur a loss of approximately $67 per microprocessor.

Assume that the interest rate on borrowings in India is 1 percent while the interest rate on bank deposits in a U.S. bank is 4 percent. Carlos, an active currency trader, borrows in Indian rupees, converts the money into U.S. dollars and deposits it in a U.S. bank. What is the speculative element of this carry trade?

There will be no adverse movement in exchange rates or interest rates.

the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

Transaction Exposure

the impact of currency exchange rates on the reported financial statement of a company

Translation Exposure

Carry trade occurs when borrowing is done in one currency where interest rates are low and using the proceeds to invest in another country where interest rates are high.

True

The spot exchange rate is the rate at which the foreign exchange dealer will convert one currency into another on a particular day.

True

Rae feels it is best for her company to pay their foreign supplier in Panama this month even though they will receive product for another six months. She recently learned that the currency in Panama is expected to appreciate and, by paying the supplier now, her company will save money. This is an example of

a lead strategy

Kendall Wood Products Corp. purchased securities on the London Stock Exchange and then immediately resold them on the New York Stock Exchange at a higher price. The profits from this transaction were used to buy new machinery for the mill. This company engaged in

arbitrage

Assume that the interest rate on borrowings in Argentina is 3 percent, but the interest rate on deposits in British banks is 9 percent. A trader borrows 1 million Argentine pesos, then converts the money into British pounds and deposits it in a British bank. What is the trader involved in?

carry trade

Assume that the exchange rate between the U.S. dollar and the Japanese yen is $1 = ¥150. A book that retails for $10 in New York should sell for ¥1,500 in Tokyo, if there are no trade barriers and transportation costs, according to the

countertrade

Jacob is the chief financial officer for RinseAll Detergent products. His company is interested in investing in a facility in Indonesia, but he is worried about unpredictable fluctuations in future exchange rates, which could cost his company millions of dollars. One way to ensure against this exchange risk is for Jacob to use

hedging

The law of one price states that

in competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

A(n) _____ market is one in which prices do not reflect all available information

inefficient

According to the _____, for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries

international Fisher effect

Lead Strategy

involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depreciate and paying foreign currency payables (to suppliers) before they are due when a currency is expected to appreciate

Lag Strategy

involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate

The rate at which a foreign exchange dealer converts one currency into another currency on a particular day is the

spot exchange rate

How are spot exchange rates determined?

the interaction between demand and supply of a currency relative to other currencies

Kristin was shopping in New York last week and saw a Coach purse for $210. When she returned to London, she saw that same purse for £105. She knew that the exchange rate was one pound for every two dollars. Her shopping experience demonstrates

the law of one price

Assume that the exchange rate between the euro and the dollar is €1.00 = $1.50. An American tourist in Germany is buying a product whose price is €80. How much in U.S. dollars would the tourist have to pay to buy the product?

$120

Steven converted $1,000 to ¥105,000 for a trip to Japan. However, he spent only ¥50,000. During this period, the value of the dollar weakened against the yen. Using a current exchange rate of $1 = ¥100, how many dollars does Steven have left?

$550

TransWare Inc., based in Atlanta, has a plant in Russia that builds road equipment. Each year this plant has been profitable, but TransWare Inc. is not able to convert the profits into U.S. dollars and take them out of the country. What type of convertibility does this represent?

nonconvertible

One function of the foreign exchange market is to

provide some insurance against foreign exchange risk.

A currency is considered freely convertible when

the country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it

Carlos is the manager of an American company. He expects the value of the British pound to appreciate in the near future and so delays the collection of payments from British customers until the next month. Which tactic is Carlos using to minimize the foreign exchange exposure?

lag strategy

The movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceived actions, is called

the bandwagon effect

World Auto Group, based in California, buys component parts from Indonesia. The Indonesian company must be paid in rupiah. World Auto Group will rely on ________ to convert dollars to rupiah.

The Foreign Exchange Market