BA 390 Chapter 10

What is meant by a currency swap?

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. A common kind of swap is spot against forward.

Which of the following refers to countertrade?

A range of barter-like agreements by which goods and services can be exchanged for other goods and services

Which of the following refers to the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values?

Transaction exposure

___, a category of foreign exchange risk, refers to the extent to which the reported consolidated results and balance sheet of a corporation are affected by fluctuations in foreign exchange values.

Translation exposure

In terms of the approach to exchange rate forecasting, ___ draw(s) on economic theory to construct sophisticated econometric models for predicting exchange rate movements.

fundamental analysis

In terms of exchange rate forecasting, a(n) ___ market is one in which prices do not reflect all available information.

inefficient

The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates is known as countertrade.

False

The euro/dollar exchange rate is €1 = $1.20. If it costs $36 to buy a European product, the stated price of the product would be €36.

False

The foreign exchange market offers complete insurance against foreign exchange risk.

False

The forward exchange rate refers to the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

False

Explain how investor psychology and bandwagon effects impact the movement in exchange rates.

Empirical evidence suggests that neither the purchasing power parity theory nor the international Fisher effect is particularly good at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. In turn, expectations have a tendency to become self-fulfilling prophecies. When traders move like a herd, all in the same direction at the same time, in response to each others' perceived actions, it is known as the bandwagon effect. According to a number of studies, investor psychology and bandwagon effects play an important role in determining short-run exchange rate movements. However, these effects can be hard to predict. Investor psychology can be influenced by political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behavior of politicians.

Foreign exchange risk refers to the risk of not getting paid for a product that is exported from one country to another.

False

In the context of The Economist's "Big Mac Index," assume that the average price of a Big Mac in South Korea is $2.98 at the prevailing won/dollar exchange rate. The average price of a Big Mac in the United States is $3.58. This suggests that the Korean won is overvalued against the U.S. dollar.

False

Which of the following is true of the efficient market school of thought toward exchange rate forecasting?

Inaccuracies in predictions will not be consistently above or below future spot rates; they will be random.

Which of the following is a variable used in exchange rate forecasting models based on fundamental analysis?

Inflation rate

Which of the following premises is technical analysis, an approach to exchange rate forecasting, based on?

Previous market trends and waves can be used to predict future market trends and waves.

How do the purchasing power parity theory and the law of one price relate the prices of commodities to exchange rate movements?

Purchasing power parity (PPP) theory and the law of one price help us understand how prices relate to exchange rate movements. The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. According to the PPP theory, if the law of one price were true for all goods and service, the PPP exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the PPP exchange rate that would exist if markets were efficient. In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates.

Describe the factors that explain the failure of the purchasing power parity theory to predict exchange rates accurately.

Several factors explain the failure of PPP theory to predict exchange rates accurately. PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are significant and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods. Government intervention in cross-border trade, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory. In addition, the PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offering between nations. Another factor of some importance is that governments also intervene in the foreign exchange market in attempting to influence the value of their currencies. One more factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates is the impact of investor psychology and other factors on currency purchasing decisions and exchange rate movements.

What is meant by translation exposure?

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

Companies can deal with the problem of noncovertibility of currency be engaging in ___.

countertrade