Solocha EXAM 2, Chapter 6 and 7 and 8 UP THE YAMSSSSS

o The inflation rate in the United States is 3 percent while the inflation rate in Japan is 10 percent. The current exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen have adjusted in the manner suggested by purchasing power parity the new exchange rate for the yen will be:

$0.0070. (1.03/1.10) $.0075 = $.0070

o The inflation rate in the United States is 4 percent while the inflation rate in Japan is 1.5 percent. The current exchange rate for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen have adjusted according to purchasing power parity the new exchange rate for the yen will be

$0.0082

31. Assume the following information: You have $1,000,000 to invest urrent spot rate of pound = $1.60 90-day forward rate of pound = $1.57 3-month deposit rate in U.S. = 3% 3-month deposit rate in U.K. = 4% If you use covered interest arbitrage for a 90-day investment, what will be the amount of U.S. dollars you will have after 90 days?

$1,020,500 RATIONALE: $1,000,000/$1.60 = 625,000 pounds (1.04) = 650,000 pounds ´ 1.57 = $1,020,500 :

16. Assume the following information: You have $1,000,000 to invest urrent spot rate of pound = $1.30. 90-day forward rate of pound = $1.28. 3-month deposit rate in United States = 3% 3-month deposit rate in Great Britain = 4% If you use covered interest arbitrage for a 90-day investment, what will be the amount of U.S. dollars you will have after 90 days?

$1,024,000. $1,000,000/$1.30 = 769,231 pounds ´ (1.04) = 800,000 pounds ´ 1.28 = $1,024,000

37. Bank A quotes a bid rate of $.300 and an ask rate of $.305 for the Malaysian ringgit (MYR). Bank B quotes a bid rate of $.306 and an ask rate of $.310 for the ringgit. What will be the profit for an investor who has $500,000 available to conduct locational arbitrage?

$1,639 RATIONALE: $500,000/$.305 = MYR1,639,344 ´ $.306 = $501,639. Thus, the profit is $1,639. :

14. Assume the bid rate of a New Zealand dollar is $.33 while the ask rate is $.335 at Bank X. Assume the bid rate of the New Zealand dollar is $.32 while the ask rate is $.325 at Bank Y. Given this information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with?

$15,385 RATIONALE: $1,000,000/$.325 = NZ$3,076,923 ´ $.33 = $1,015,385. Thus, the profit is $15,385.

35. Assume the bid rate of an Australian dollar is $.60 while the ask rate is $.61 at Bank Q. Assume the bid rate of an Australian dollar is $.62 while the ask rate is $.625 at Bank V. Given this information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with?

$16,393 RATIONALE: $1,000,000/$.61 = A$1,639,344 ´ $.62 = $1,016,393. Thus, the profit is $16,393.

20. Assume the bid rate of a Singapore dollar is $.40 while the ask rate is $.41 at Bank X. Assume the bid rate of a Singapore dollar is $.42 while the ask rate is $.425 at Bank Z. Given this information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with?

$24,390. RATIONALE: $1,000,000/$.41 = S2,439,024 ´ $.42 = $1,024,390 : :

42. Refer to Exhibit 7-1 above. If you conduct covered interest arbitrage, what amount will you have after 180 days?

$318,109.10 RATIONALE: $300,000/$1.10 = €277,777.80 ´ (1.08) = €294,444.40 ´ $1.08 = $318,109.10

41. Assume the following information: You have $900,000 to invest urrent spot rate of Australian dollar (A$) = $.62 180-day forward rate of the Australian dollar = $.64 180-day interest rate in the United States = 3.5% 180-day interest rate in Australia = 3.0% If you conduct covered interest arbitrage, what is the dollar profit you will have realized after 180 days?

$56,903 RATIONALE: $900,000/$.62 = A$1,451,612 ´ (1.03) = A$1,495,161 ´ $.64 = $956,903. Thus, the profit is $56,903.

30. Assume the bid rate of a Swiss franc is $.57 while the ask rate is $.579 at Bank X. Assume the bid rate of the Swiss franc is $.560 while the ask rate is $.566 at Bank Y. Given this information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with?

$7,067 RATIONALE: $1,000,000/$.566 = SF1,766,784 ´ $.57 = $1,007,067. Thus, the profit is $7,067.

23. Assume the following information: Spot rate today of Swiss franc = $.60 1-year forward rate as of today for Swiss franc = $.63 Expected spot rate 1 year from now = $.64 Rate on 1-year deposits denominated in Swiss francs = 7% Rate on 1-year deposits denominated in U.S. dollars = 9% From the perspective of U.S. investors with $1,000,000, covered interest arbitrage would yield a rate of return of ____ percent.

12.35 $1,000,000/$.60 = SF1,666,667 ´ (1.07) = SF1,783,333 ´ $.63 = $1,123,500 Yield = ($1,123,500 - $1,000,000)/$1,000,000 = 12.35%

o Assume that U.S. and British investors require a real return of 2 percent. If the nominal U.S. interest rate is 15 percent and the nominal British rate is 13 percent then according to the IFE the British inflation rate is expected to be about ____ the U.S. inflation rate and the British pound is expected to ____.

2 percentage points below; appreciate by about 2 percent

o Assume that the interest rate offered on pounds is 5 percent and the pound is expected to depreciate by 1.5 percent. For the international Fisher effect (IFE) to hold between the United Kingdom and the United States the U.S. interest rate should be ____.

3.43% SOLUTION: (1 + .05) x (1 + .015) - 1 = 3.43%

o Assume that the U.S. one-year interest rate is 3 percent and the one-year interest rate on Australian dollars is 6 percent. The U.S. expected annual inflation is 5 percent while the Australian inflation is expected to be 7 percent. You have $100000 to invest for one year and you believe that PPP holds. The spot exchange rate of an Australian dollar is $0.689. What will be the yield on your investment if you invest in the Australian market?

4% Solution: (1 + .05)/(1 + .07) x $0.689 = $0.676. ($100,000/A$0.689) x (1 + .06) = A$153,846 x $0.676 = $104,000. ($104,000 - $100,000)/$100,000 = 4%

o Assume that the U.S. one-year interest rate is 5 percent and the one-year interest rate on euros is 8 percent. You have $100000 to invest and you believe that the international Fisher effect (IFE) holds. The euro's spot exchange rate is $1.40. What will be the yield on your investment if you invest in euros?

5%

43. Refer to Exhibit 7-1 above. If you conduct covered interest arbitrage, what is your percentage return after 180 days? Is covered interest arbitrage feasible in this situation?

6.04 percent; feasible RATIONALE: $318,109.10/$300,000 - 1 = 6.04%. Since this rate is slightly higher than the U.S. interest rate of 6%, covered interest arbitrage is feasible.

o According to the international Fisher effect (IFE) if U.S. investors expect a 5 percent rate of domestic inflation over one year and a 2 percent rate of inflation in European countries that use the euro and if they require a 3 percent real return on investments over one year the nominal interest rate on one-year U.S. Treasury securities would be:

8% (SOLUTION: 5% + 3% = 8%)

26. Assume that the euro's interest rates are higher than U.S. interest rates, and that interest rate parity exists. Which of the following is true?

A. Americans using covered interest arbitrage earn the same rate of return as Germans who attempt covered interest arbitrage. B. Americans who invest in the United States earn the same rate of return as Germans who attempt covered interest arbitrage. C.Americans who invest in the United States earn the same rate of return as Germans who invest in Germany D.A and B E.None of the above

112. Which of the following is true regarding the euro?

A. Exchange rate risk between participating European currencies is completely eliminated, encouraging more trade and capital flows across European borders. B. It allows for more consistent economic conditions across countries. C. It prevents each country from conducting its own monetary policy. D. All of the above are true.

5. Which of the following is true regarding the euro?

A. Exchange rate risk between participating European currencies is completely eliminated, encouraging more trade and capital flows across European borders. B. It allows for more consistent economic conditions across countries. C. It prevents each country from conducting its own monetary policy. D. All of the above are true.

20. The euro is the currency?

A. adopted in all western European countries as of 1999. B. adopted in all eastern European countries as of 1999. C. adopted in all European countries as of 1999. D. none of the above

25. Assume that the dollar has been consistently appreciating over a long perioD. The Fed decides to counteract this movement by intervening in the foreign exchange market using nonsterilized intervention. The Fed would

A. buy dollars with foreign currency and simultaneously sell Treasury securities for dollars.

22. Among the reasons for government intervention are:

A. to smooth exchange rate movement. B. to establish implicit exchange rate boundaries. C. to respond to temporary disturbances. D. all of the above

64. Which of the following might discourage covered interest arbitrage even if interest rate parity does not exist?

A. transaction costs B. political risk C. differential tax laws D. all of the above

9. If the interest rate is higher in the United States than in the United Kingdom, and if the forward rate of the British pound (in U.S. dollars) is the same as the pound's spot rate, then:

British investors could possibly benefit from covered interest arbitrage.

7. It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S. government would like to reduce inflation. Which of the following is an appropriate action given this scenario?

Buy dollars with foreign currency

91. Which of the following is not true regarding covered interest arbitrage?

Covered interest arbitrage is a reason for observing interest rate parity (IRP).

90. Which of the following is not true regarding covered interest arbitrage?

Covered interest arbitrage opportunities only exist when the foreign interest rate is higher than the interest rate in the home country

o Which of the following is indicated by research regarding purchasing power parity (PPP)?

Deviations from PPP are reduced in the long run.

4. The exchange rate mechanism (ERM) refers to the method of linking ____ currencies to each other within boundaries.

European

98. Under the ____________ from 1979-1992 (before the euro existed), the currencies of many European countries were currencies of most of these member countries were allowed to fluctuate by no more than 2.25 percent (6 percent for some currencies) from the initially established values.

European Monetary System (EMS).

o Among the reasons that purchasing power parity (PPP) does not consistently occur are:

Exchange rates are affected by national income differentials and government controls. Exchange rates are affected by interest rate differentials. Supply and demand may not adjust if no substitutable goods are available. All of these are reasons that PPP does not consistently occur.

11. The European countries conforming to the euro are completely insulated from movements in the euro's value with respect to other currencies.

False

15. If the French government wants to decrease inflation in France, it will exchange foreign currency for euros.

False

16. The Bretton Woods Agreement created a system under which exchange rates are determined by market forces without intervention by various governments.

False

17. The Bretton Woods Agreement called for the establishment of a single European currency.

False

19. Direct intervention is usually more effective than indirect intervention.

False

46. If the cross exchange rate of two nondollar currencies implied by their individual spot rates with respect to the dollar is less than the cross exchange rate quoted by a bank, locational arbitrage is possible.

False

47. For locational arbitrage to be possible, one bank's ask rate must be higher than another bank's bid rate for a currency

False

51. Capitalizing on discrepancies in quoted prices involving no risk and no investment of funds is referred to as interest rate parity.

False

52. In a sterilized exchange rate arrangement, a country's home currency value is pegged to a foreign currency or to some unit of account.

False

53. Locational arbitrage involves investing in a foreign country and covering against exchange rate risk by engaging in forward contracts

False

54. The Fed's indirect method of intervention is to trade dollars for or against other currencies.

False

55. If interest rate parity (IRP) exists, then the rate of return achieved from covered interest arbitrage should be equal to the rate available in the foreign country A.

False

56. If interest rate parity (IRP) exists, then triangular arbitrage will not be possible.

False

70. Assume that the real interest rate in the United States and in the United Kingdom is 3 percent. The expected annual inflation in the United States is 3 percent, while in the United Kingdom it is 4 percent. The forward rate on the pound should exhibit a premium of about 1 percent.

False

72. Locational arbitrage is focused on capitalizing on the difference in nominal interest rates in two different locations

False

77. The word "covered" in "covered interest arbitrage" refers to the investors hedging their position to protect against the possibility of default risk.

False

79. Interest rate parity suggests that an exchange rate should change over time based on the difference in interest rates between foreign versus domestic risk-free interest-bearing securities as of today.

False

84. If interest rate parity (IRP) exists, then foreign investors will earn the same returns as U.S. investors.

False

o According to the international Fisher effect (IFE) the exchange rate percentage change should be approximately equal to the differential in income levels between two countries.

False

o Purchasing power parity (PPP) focuses on the relationship between nominal interest rates and exchange rates between two countries.

False

o The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

False

o The international Fisher effect (IFE) suggests that the currencies with relatively high interest rates will appreciate because those high rates will attract investment and increase the demand for that currency.

False

o Assume that inflation in the United States is expected to be 9 percent while inflation in Australia is expected to be 5 percent over the next year. Today you receive an offer to purchase a one-year put option for $.03 per unit on Australian dollars at a strike price of $0.72. Today the Australian dollar is quoted at $0.70. You believe that purchasing power parity holds. You should accept the offer.

False; Spot rate in a year = (1.09/1.05) ́ $0.70 = $0.73

o Assume a two-country world: Country A and Country B. Which of the following is correct about purchasing power parity (PPP) as related to these two countries?

If Country A's inflation rate exceeds Country B's inflation rate then Country A's currency will weaken.

o Given a home country and a foreign country purchasing power parity suggests that:

None of these are correct. The nominal interest rates of both countries will be the same. The inflation rates of both countries will be the same. The inflation rates of both countries will be the same AND the nominal interest rates of both countries will be the same.

88. Assume you discovered an opportunity for locational arbitrage involving two banks and have taken advantage of it. Because of your and other arbitrageurs' actions, the following adjustments must take place.

One bank's ask price will rise, and the other bank's bid price will fall; One bank's bid/ask spread will widen, and the other bank's bid/ask spread will fall.

5. In which case will locational arbitrage most likely be feasible?

One bank's bid price for a currency is greater than another bank's ask price for the currency.

If the identical product or service can be sold in two different markets and no restrictions exist on the sale or transportation costs of moving the product between markets the products price should be the same in both markets. This theory is called:

Purchasing Power Parity

o Assume that the international Fisher effect (IFE) holds between the United States and the United Kingdom. The U.S. inflation is expected to be 5 percent while British inflation is expected to be 3 percent. The interest rate offered on pounds is 7 percent and the U.S. interest rate is 7 percent. What does this say about real interest rates expected by British investors?

Real interest rates expected by British investors are 2 percentage points above the real interest rates expected by U.S. investors.

13. Assume that a U.S. firm can invest funds for one year in the United States at 12 percent or invest funds in Mexico at 14 percent. The spot rate of the peso is $.10 while the one-year forward rate of the peso is $.10. If U.S. firms attempt to use covered interest arbitrage, what forces should occur?

Spot rate of peso increases; forward rate of peso decreases.

18. Which of the following did not occur as a result of Bretton Woods Agreement?

The United States experienced no balance-of-trade deficits.

8. From a financial management perspective, which of the following is true regarding the introduction of the Euro?

Transactions costs decline for MNCs that conduct transactions within Europe.

10. A major advantage of the euro is the complete elimination of exchange rate risk on transactions between participating European countries, which encourages more trade and capital flows within Europe.

True

101. Under a fixed exchange rate system, U.S. inflation would have a greater impact on inflation in other countries than it would under a freely floating exchange rate system.

True

12. The establishment of the euro allows for more consistent economic conditions across countries but eliminates the power of any individual European country to solve local economic problems with its own unique monetary policy.

True

14. A country with a currency board does not have control over its local interest rates.

True

20. Assume the Fed desires to strengthen the dollar. If it buys dollars and simultaneously buys Treasury securities, this is an example of sterilized intervention.

True

21. Using indirect intervention, the Fed attempts to affect the dollar's value indirectly by influencing the factors that determine it, such as interest rates.

True

48. Assume locational arbitrage is possible and involves two different banks. The realignment that would occur due to market forces would increase one bank's ask rate and would decrease the other bank's bid rate

True

52. Realignment in the exchange rates of banks will eliminate locational arbitrage. More specifically, market forces will increase the ask rate of the bank from which the currency was bought to conduct locational arbitrage and will decrease the bid rate of the bank to which the currency was sold to conduct locational arbitrage

True

54. To capitalize on high foreign interest rates using covered interest arbitrage, a U.S. investor would convert dollars to the foreign currency, invest in the foreign country, and simultaneously sell the foreign currency forward

True

57. Nonsterilized intervention is intervention by a central bank in the foreign exchange market without adjusting for the change in money supply.

True

60. An example of indirect intervention by the Bank of Japan would be for the Bank of Japan to use interest rates to increase the value of the yen vs. the dollar.

True

68. The interest rate on yen is 7 percent. The interest rate in the United States is 9 percent. The yen's forward rate should exhibit a premium of about 2 percent.

True

69. The interest rate on pounds in the United Kingdom is 8 percent. The interest rate in the United States is 5 percent. Interest rate parity exists. U.S. investors will earn a lower return domestically than British investors earn domestically.

True

75. Locational arbitrage explains why spot exchange rates among banks at different locations normally will not differ by a significant amount

True

78. The equilibrium state in which covered interest arbitrage is no longer possible is called interest rate parity (IRP).

True

80. Interest rate parity (IRP) states that the foreign currency's forward rate premium or discount is roughly equal to the interest rate differential between the United States and the foreign country.

True

82. The larger the degree by which the foreign interest rate exceeds the home interest rate, the larger will be the forward discount of the foreign currency specified by the interest rate parity (IRP) formula

True

83. For points lying to the left of the interest rate parity (IRP) line, covered interest arbitrage is not possible from a U.S. investor's perspective, but is possible from a foreign investor's perspective

True

85. If interest rate parity (IRP) does not hold, there is still the possibility that covered interest arbitrage is not worthwhile because of such factors as transaction costs, currency restrictions, and differential tax laws.

True

9. Under a fixed exchange rate system, U.S. inflation would have a greater impact on inflation in other countries than it would under a freely floating exchange rate system.

True

94. If the Fed decides to weaken the dollar utilizing unsterilized intervention, it should be aware that this action may backfire because it will increase money supply and thus increase inflation.

True

If inflation rate goes up then value of currency goes down

True

o According to purchasing power parity (PPP) if a foreign country's inflation rate is below the inflation rate at home then home country consumers will increase their imports from the foreign country and foreign consumers will lower their demand for home country products. These market forces cause the foreign currency to appreciate.

True

o If the international Fisher effect (IFE) holds the local investors are expected to earn the same return from investing internationally as they would from investing in their local markets.

True

o If there are no substitutes Then PPP will probably not hold

True

o Research indicates that deviations from purchasing power parity (PPP) are less pronounced over the long run.

True

o The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs and tariffs and quotas in establishing a relationship between inflation rates and exchange rate changes.

True

o The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs tariffs and quotas in establishing a relationship between inflation rates and exchange rate changes.

True

10. If the interest rate is lower in the United States than in the United Kingdom, and if the forward rate of the British pound is the same as its spot rate:

U.S. investors could possibly benefit from covered interest arbitrage

27. Assume the U.S. interest rate is 2 percentage points higher than the Swiss rate, and the forward rate of the Swiss franc has a 4 percent premium. Given this information:

U.S. investors who attempt covered interest arbitrage earn a higher rate of return than if they invested in the United States.

17. Assume that the U.S. interest rate is 10 percent, while the British interest rate is 15 percent. If interest rate parity exists, then:

U.S. investors will earn 10 percent whether they use covered interest arbitrage or invest in the United States.

23. Which of the following is not true regarding government intervention?

Under the direct method of intervention, an appreciation of the dollar would be accomplished by exchanging dollars for foreign currencies.

6. It has been argued that the exchange rate can be used as a policy tool. Assume that the U.S. government would like to reduce unemployment. Which of the following is an appropriate action given this scenario?

Weaken the dollar

92. Which of the following is not true regarding interest rate parity (IRP)?

When covered interest arbitrage is not feasible, interest rate parity must hold.

18. Assume the following information urrent spot rate of New Zealand dollar = $.41 Forecasted spot rate of New Zealand dollar 1 year from now = $.43 One-year forward rate of the New Zealand dollar = $.42 Annual interest rate on New Zealand dollars = 8% Annual interest rate on U.S. dollars = 9% Given the information in this question, the return from covered interest arbitrage by U.S. investors with $500,000 to invest is ____ percent.

about 10.63 $500,000/$.41 = NZ$1,219,512 ´ (1.08) = NZ$1,317,073 ´ .42 = $553,171 Yield = ($553,171 - $500,000)/$500,000 = 10.63%

33. Assume the following information urrent spot rate of Australian dollar = $.64 Forecasted spot rate of Australian dollar 1 year from now = $.59 1-year forward rate of Australian dollar = $.62 Annual interest rate for Australian dollar deposit = 9% Annual interest rate in the United States = 6% Given the information in this question, the return from covered interest arbitrage by U.S. investors with $500,000 to invest is ____percent.

about 5.59 RATIONALE: $500,000/$.64 = A$781,250 ´ (1.09) = A$851,563 ´ $.62 = $527,969 Yield = ($527,969 - $500,000)/$500,000 = 5.59%

o Assume that the one-year interest rate in the United States is 7 percent and in the United Kingdom is 5 percent. According to the international Fisher effect (IFE) the British pound's spot exchange rate should ____ by about ____ over the year.

appreciate; 1.9 percent SOLUTION: (1 + .07)/(1 + .05) 1 = 1.9%

o Assume U.S. and Swiss investors require a real rate of return of 3 percent. Assume the nominal U.S. interest rate is 6 percent and the nominal Swiss rate is 4 percent. According to the international Fisher effect (IFE) the franc will ____ by about ____.

appreciate; 2%

An important limitation of the relative PPP is:

assumes that consumption patterns between two countries are the same

The most important limitation of the International Fisher Effect is:

assumes that investors are risk neutral with respect of country

The most important limitation of the Fisher Effect in an open economy is:

assumes that real interest rates are the same between countries

24. Assume that the dollar has been consistently depreciating over a long perioD. The Fed decides to counteract this movement by intervening in the foreign exchange market using sterilized intervention. The Fed would

buy dollars with foreign currency and simultaneously buy Treasury securities with dollars.

29. To strengthen the dollar using sterilized intervention, the Fed would ____ dollars and simultaneously ____ Treasury securities.

buy; buy

87. American Bank quotes a bid rate of $0.026 and an ask rate of $0.028 for the Indian rupee (INR); National Bank quotes a bid rate of $0.024 and an ask rate for $0.025. Locational arbitrage would involve

buying rupees from National Bank at the ask rate and selling them to American Bank at the bid rate.

2. Under a fixed exchange rate system central bank intervention in the foreign exchange market is often necessary.

central bank intervention in the foreign exchange market is often necessary.

1. Due to ____, market forces should realign the relationship between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies

covered interest arbitrage

4. If interest rate parity exists, then ____ is not feasible.

covered interest arbitrage

7. When using ____, funds are typically tied up for a significant period of time

covered interest arbitrage

63. Points below the IRP line represent situations where:

covered interest arbitrage is feasible from the perspective of domestic investors and results in a yield above what is possible domestically.

62. Points above the IRP line represent situations where:

covered interest arbitrage is feasible from the perspective of foreign investors and results in a yield above what is possible in their local markets.

45. Assume that interest rate parity holds. The Mexican interest rate is 50 percent, and the U.S. interest rate is 8 percent. Subsequently, the U.S. interest rate decreases to 7 percent. According to interest rate parity, the peso's forward ____ will ____.

discount; increase

11. Assume that U.S. investors are benefiting from covered interest arbitrage due to high interest rates on euros. Which of the following forces should result from this covered interest arbitrage activity?

downward pressure on the euro's forward rate

95. A strong dollar places ____ pressure on U.S. inflation, which in turn places ____ pressure on U.S. interest rates, which in turn place ____ pressure on U.S. bond prices.

downward; downward; upward

17. A strong dollar places ____ pressure on inflation, which in turn places ____ pressure on the dollar.

downward; upward

1. A primary result of the Bretton Woods Agreement was:

establishing that exchange rates of most major currencies were to be allowed to fluctuate 1% above or below their initially set values.

16. Which of the following is an example of direct intervention in foreign exchange markets?

exchanging dollars for foreign currency

5. Consider two countries that trade with each other, called X and Y. According to the text, inflation in Country X will have a greater impact on inflation in Country Y under the ____ system. Now, consider two other countries that trade with each other, called A and B. Unemployment in Country A will have a greater impact on unemployment in Country B under the ____ system.

fixed rate; fixed rate

o According to the international Fisher effect (IFE) if Venezuela has a much higher nominal interest rate than other countries its inflation rate will likely be ____ than other countries and its currency will ____.

higher; weaken

13. Assume Countries A, B, and C produce goods that are substitutes of each other and that these countries engage in trade with each other. Assume that Country A's currency floats against Country B's currency, and that Country C's currency is pegged to B's. If A's currency depreciates against B, then A's exports to C should ____, and A's imports from C should ____.

increase; decrease

o Assume that the U.S. inflation rate is higher than the New Zealand inflation rate. This will cause U.S. consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States. According to purchasing power parity (PPP) this will result in a(n) ____ of the New Zealand dollar (NZ$).

increase; reduce; appreciation

89. If the Fed ____ the interest rates when inflationary expectations remain unchanged, the most likely result is that the value of dollar will ____ and the economy may ____.

increases; appreciate; weaken

The theory that the interest rate differential is equal to the inflation differential between two countries is called

interest rate parity

32. Assume the following information: U.S. investors have $1,000,000 to invest: 1-year deposit rate offered by U.S. banks = 12% 1-year deposit rate offered on Swiss francs = 10% 1-year forward rate of Swiss francs = $.62 Spot rate of Swiss franc = $.60 Given this information:

interest rate parity doesn't exist and covered interest arbitrage by U.S. investors results in a yield above what is possible domestically. RATIONALE: $1,000,000/$.60 = SF1,666,667 ´ (1.1) = SF1,833,333 ´ $.62 = $1,136,667 Yield = ($1,136,667 - $1,000,000)/$1,000,000 = 13.7% This yield exceeds what is possible domestically.

60. Assume the following information: U.S. investors have $1,000,000 to invest: 1-year deposit rate offered by U.S. banks = 10% 1-year deposit rate offered on British pounds = 13.5% 1-year forward rate of Swiss francs = $1.26 Spot rate of Swiss franc = $1.30 Given this information:

interest rate parity exists and covered interest arbitrage by U.S. investors results in the same yield as investing domestically. RATIONALE: $1,000,000/$1.30 = 793,651 pounds ´ (1.135) = 900,794 ´ $1.26 = $1,100,076. Yield: ($1,100,076 - $1,000,000)/($1,000,000) = 10%.

24. Countries that have adopted the euro tend to have very similar ____.

interest rates

The absolute version of PPP:

is based on the law of one price

o According to the international Fisher effect (IFE) if investors in all countries require the same real rate of return the differential in nominal interest rates between any two countries:

is due to their inflation differentials.

15. Based on interest rate parity, the larger the degree by which the foreign interest rate exceeds the U.S. interest rate, the ____

larger will be the forward discount of the foreign currency.

21. Based on interest rate parity, the larger the degree by which the U.S. interest rate exceeds the foreign interest rate, the____

larger will be the forward premium of the foreign currency.

30. As foreign exchange activity has grown, a given degree of central bank intervention has become:

less effective.

2. Due to ____, market forces should realign the spot rate of a currency among banks.

locational arbitrage

10. The value of the Canadian dollar, Japanese yen, and Australian dollar with respect to the U.S. dollar are part of a

managed float system.

Deviations from absolute PPP can occur for extended periods of time because of:

market imperfections such as quality standards

14. Assume a central bank exchanges its currency for other foreign currencies in the foreign exchange market, but does not adjust for the resulting change in the money supply. This is an example of:

nonsterilized intervention.

88. Assume that the Fed intervenes by exchanging dollars for euros in the foreign exchange market. This will cause an ____ U.S. dollars and an ____ euros.

outward shift in supply of; outward shift in demand for

65. Assume that interest rate parity holds. The U.S. interest rate is 13 percent and the British interest rate is 10 percent. The forward rate on British pounds exhibits a ____ of ____ percent.

premium; 2.73

29. Assume that interest rate parity holds, and the euro's interest rate is 9 percent while the U.S. interest rate is 12 percent. Then the euro's interest rate increases to 11 percent while the U.S. interest rate remains the same. As a result of the increase in the interest rate on euros, the euro's forward ____ will ____ in order to maintain interest rate parity.

premium; decrease

93. If a speculator expects that the Fed will intervene by exchanging euros for U.S. dollars, she would most likely ____ to capitalize on this intervention.

purchase euro put options

o Which of the following theories suggests that the percentage change in the spot exchange rate of a currency should be equal to the inflation differential between two countries?

purchasing power parity (PPP)

o The following regression analysis was conducted for the inflation rate information and exchange rate of the British pound: Regression results indicate that a0 = 0 and a1 = 2. Therefore:

purchasing power parity underestimated the exchange rate change during the period under examination.

o Latin American countries have historically experienced relatively high inflation and their currencies have weakened. This information is somewhat consistent with the concept of:

purchasing power parity.

Because there are a variety of factors in addition to inflation that affect exchange rates this will:

reduce the probability that PPP will hold.

o Because there are sometimes no substitutes for traded goods this will:

reduce the probability that PPP will hold.

o Assume that the New Zealand inflation rate is higher than the U.S. inflation rate. This will cause U.S. consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States. According to purchasing power parity (PPP) this will result in a(n) ____ of the New Zealand dollar (NZ$).

reduce; increase; depreciation

85. To weaken the dollar using sterilized intervention, the Fed will ____ U.S. dollars and simultaneously ____ Treasury securities.

sell; sell

8. Assume that the interest rate in the home country of Currency X is much higher than the U.S. interest rate. According to interest rate parity, the forward rate of Currency X?

should exhibit a discount.

o If the international Fisher effect (IFE) did not hold based on historical data this would suggest that:

some corporations with excess cash could have generated higher profits on average from foreign short-term investments than from domestic short-term investments.

Forward rates as unbiased predictors of future spot rates implies:

that actual spot rates in the future are centered on the forward rate

o According to the IFE if British interest rates exceed U.S. interest rates:

the British pound will depreciate against the dollar.

That the spot exchange rate should change in an equal but opposite direction to the difference in inflation rates between two countries is called:

the International Fisher Effect

That the spot exchange rate should change in an equal but opposite direction to the difference in interest rates between two countries is called:

the International Fisher Effect

19. Assume the following bid and ask rates of the pound for two banks as shown below id Ask Bank A $1.41 $1.42 Bank B $1.39 $1.40 As locational arbitrage occurs

the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will increase.

34. Assume the following bid and ask rates of the pound for two banks as shown below id Ask Bank C $1.61 $1.63 Bank D $1.58 $1.60 As locational arbitrage occurs

the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will increase.

o The international Fisher effect (IFE) suggests that the foreign currency will appreciate when:

the current home nominal interest rate exceeds the current foreign nominal interest rate.

o According to the international Fisher effect (IFE):

the exchange rate-adjusted rate of return on a foreign investment should be equal to the interest rate on a local money market investment.

o Given a home country and a foreign country the international Fisher effect (IFE) suggests that:

the exchange rates of both countries will move in a similar direction against other currencies. The nominal interest rates of both countries are the same. The inflation rates of both countries are the same. None of these are correct.

44. According to interest rate parity (IRP)

the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.

o Given a home country and a foreign country. purchasing power parity (PPP) suggests that:

the home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate

o Under purchasing power parity the future spot exchange rate is a function of the initial spot rate in equilibrium and:

the inflation differential

o If interest rates on the euro are consistently below U.S. interest rates then for the international Fisher effect (IFE) to hold:

the value of the euro would often appreciate against the dollar.

61. If quoted exchange rates are the same across different locations, then ____ is not feasible.

triangular arbitrage And locational arbitrage

12. Assume that Swiss investors are benefiting from covered interest arbitrage due to a high U.S. interest rate. Which of the following forces results from this covered interest arbitrage activity?

upward pressure on the Swiss franc's forward rate

28. Assume that British interest rates are higher than U.S. rates, and that the spot rate equals the forward rate. Covered interest arbitrage puts ____ pressure on the pound's spot rate and ____ pressure on the pound's forward rate.

upward; downward

75. Assume that Japan and the United States frequently trade with each other. Under the freely floating exchange rate system, high inflation in the U.S. will place ____ pressure on Japanese yen, ____ the amount of Japanese yen available for sale, and result in ____ inflation in Japan.

upward; reduce; unchanged

19. A weaker dollar places ____ pressure on U.S. inflation, which in turn places ____ pressure on U.S. interest rates, which places ____ pressure on U.S. bond prices.

upward; upward; downward

3. Under a managed float exchange rate system, the Fed may attempt to stimulate the U.S. economy by ____ the dollar. Such an adjustment in the dollar's value should ____ the U.S. demand for products produced by major foreign countries.

weakening; decrease

13. The interest rate of a country with a currency board:

will move in tandem with the interest rate of the currency to which it is tied.