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chapter 6 review questions
International Corporate Finance (FIN 4920)
Baruch College CUNY
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International Financial Management, 8e (Eun) Chapter 6 International Parity Relationships and Forecasting Foreign Exchange Rates
- An arbitrage is best defined as A) a legal condition imposed by the CFTC. B) the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making reasonable profits. C) the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain guaranteed profits. D) none of the options
Answer: C Topic: Interest Rate Parity Accessibility: Keyboard Navigation
- Interest Rate Parity (IRP) is best defined as A) occurring when a government brings its domestic interest rate in line with other major financial markets. B) occurring when the central bank of a country brings its domestic interest rate in line with its major trading partners. C) an arbitrage condition that must hold when international financial markets are in equilibrium. D) none of the options
Answer: C Topic: Interest Rate Parity Accessibility: Keyboard Navigation
- When Interest Rate Parity (IRP) does not hold A) there is usually a high degree of inflation in at least one country. B) the financial markets are in equilibrium. C) there are opportunities for covered interest arbitrage. D) the financial markets are in equilibrium and there are opportunities for covered interest arbitrage.
Answer: C Topic: Interest Rate Parity Accessibility: Keyboard Navigation
- Suppose you observe a spot exchange rate of $1/€. If interest rates are 5% APR in the U. and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate? A) €1/$ B) $1/€ C) €1/$ D) $1/€
Answer: B Explanation: F = S[1 + i$)/(1 +i€)] = $1(1.05/1) = $1/€.
Topic: Interest Rate Parity
- Suppose you observe a spot exchange rate of $1/€. If interest rates are 3 percent APR in the U. and 5 percent APR in the euro zone, what is the no-arbitrage 1-year forward rate? A) €1/$ B) $1/€ C) €1/$ D) $1/€
Answer: D Explanation: F = S[1 + i$)/(1 +i€)] = $1(1.03/1) = $1/€.
Topic: Interest Rate Parity
- Suppose you observe a spot exchange rate of $2/£. If interest rates are 5 percent APR in the U. and 2 percent APR in the U., what is the no-arbitrage 1-year forward rate? A) £2/$ B) $2/£ C) £1/$ D) $1/£
Answer: B
Explanation: F = S[1 + i$)/(1 +i£)] = 2(1.05/1) = 2. Topic: Interest Rate Parity
- Suppose that the one-year interest rate is 4 percent in Italy, the spot exchange rate is $1/€, and the one-year forward exchange rate is $1/€. What must the one-year interest rate be in the United States? A) 2% B) 2% C) 5% D) none of the options
Answer: B Explanation: Solve the following for X: 1((1 + X) / 1) = 1. Topic: Covered Interest Arbitrage
- Covered Interest Arbitrage (CIA) activities will result in A) unstable international financial markets. B) restoring equilibrium prices quickly. C) a disintermediation. D) no effect on the market.
Answer: B Topic: Covered Interest Arbitrage Accessibility: Keyboard Navigation
- Suppose that the one-year interest rate is 5 percent in the United States and 3 percent in Germany, and that the spot exchange rate is $1/€ and the one-year forward exchange rate, is $1/€. Assume that an arbitrageur can borrow up to $1,000,000. A) This is an example where interest rate parity holds. B) This is an example of an arbitrage opportunity; interest rate parity does not hold. C) This is an example of a Purchasing Power Parity violation and an arbitrage opportunity. D) none of the options
Answer: B Explanation: 1 (1 / 1) = 1, which is less than 1, suggesting that an arbitrage opportunity exists. Topic: Covered Interest Arbitrage
- Suppose that you are the treasurer of IBM with an extra U. $1,000,000 to invest for six months. You are considering the purchase of U. T-bills that yield 1 percent (that's a six month rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is $1 = ¥100, and the six month forward rate is $1 = ¥110. The interest rate in Japan (on an investment of comparable risk) is 13 percent. What is your strategy? A) Take $1m, invest in U. T-bills. B) Take $1m, translate into yen at the spot, invest in Japan, and repatriate your yen earnings back into dollars at the spot rate prevailing in six months. C) Take $1m, translate into yen at the spot, invest in Japan, hedge with a short position in the forward contract. D) Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short position in the spot contract.
Answer: C Topic: Covered Interest Arbitrage
- Suppose that the annual interest rate is 2 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1/€ and the forward exchange rate, with one- year maturity, is $1/€. 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? A) $238. B) $14, C) $46, D) $7,
Answer: D Explanation: [F/S] (1+i€) = (1.58/1) (1) = 1, which is less than (1+i$) = 1. This
suggests that IRP is not holding. After adjusting for the exchange rates (F/S), the interest rate is lower in the U. than in Germany. The arbitrager should borrow $1,000,000, and repayment in one year will be $1,020,000 = ($1,000,000 × 1). Then, the $1,000,000 should be used to purchase $1,000,000 / 1 = €625,000. The euros will be invested in Germany, where the maturity value will be €625,000 × 1 = €650,000. Finally, sell the euros in exchange for $1,027,000 (found by €650,000 × 1). The new cash flow is found by $1,027,000 - $1,020, = $7,000. Topic: Covered Interest Arbitrage
- A U.-based currency dealer has good credit and can borrow $1,000,000 for one year. The one-year interest rate in the U. is i$ = 2% and in the euro zone the one-year interest rate is i€ =
6%. The spot exchange rate is $1 = €1 and the one-year forward exchange rate is $1 = €1. Show how to realize a certain dollar profit via covered interest arbitrage. A) Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1 = €1, gross proceeds = $1,017,600. B) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U. at i$ = 2% for
one year; translate €848,000 back into euro at the forward rate of $1 = €1. Net profit is $2,400. C) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1 = €1. Net profit is €2,000. D) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1 = €1. Net profit is €2,000. Alternatively, one could borrow €800,000 at i€ = 6%; translate to dollars at the spot,
invest in the U. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of
$1 = €1. Net profit is $2,400.
Answer: B Topic: Covered Interest Arbitrage
- An Italian currency dealer has good credit and can borrow €800,000 for one year. The one- year interest rate in the U. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%.
The spot exchange rate is $1 = €1 and the one-year forward exchange rate is $1 = €1. Show how to realize a certain euro-denominated profit via covered interest arbitrage. A) Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate
proceeds back at forward rate of $1 = €1, gross proceeds = $1,017,600. B) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U. at i$ = 2% for
one year; translate €848,000 back into euro at the forward rate of $1 = €1. Net profit is $2,400. C) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1 = €1. Net profit is €2,000. D) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U. at i$ = 2% for
one year; translate €850,000 back into euro at the forward rate of $1 = €1. Net profit is €2,000. Alternatively, one could borrow €800,000 at i€ = 6%; translate to dollars at the spot,
invest in the U. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of
$1 = €1. Net profit is $2,400.
Answer: C Topic: Covered Interest Arbitrage
- Suppose that you are the treasurer of IBM with an extra U. $1,000,000 to invest for six months. You are considering the purchase of U. T-bills that yield 1% (that's a six month rate, not an annual rate) and have a maturity of 26 weeks. The spot exchange rate is $1 = ¥100, and the six month forward rate is $1 = ¥110. What must the interest rate in Japan (on an investment of comparable risk) be before you are willing to consider investing there for six months? A) 1 percent B) 1 percent C) 7 percent D) −7 percent
Answer: A Explanation: Solve the following for X: (1/110) = (1/100) [(1)/X] Topic: Covered Interest Arbitrage
- How high does the lending rate in the euro zone have to be before an arbitrageur would not consider borrowing dollars, trading for euro at the spot, investing in the euro zone and hedging with a short position in the forward contract?
Bid Ask Borrowing Lending S 0 ($/€) $1 - €1 $1 - €1 i$ 4% APR 4% APR F 360 ($/€) $1 - €1 $1 - €1 i€
A) The bid-ask spreads are too wide for any profitable arbitrage when i€ > 0
B) 3% C) −2% D) none of the options
Answer: B Explanation: Solve the following for X:[(1/1) / (1/1)] (1 + X) = 4. Topic: Covered Interest Arbitrage
- Suppose that the one-year interest rate is 5 percent in the United States and 3 percent in Germany, and the one-year forward exchange rate is $1/€. What must the spot exchange rate be? A) $1/€ B) $1/€ C) $1/€ D) none of the options
Answer: B Explanation: Solve the following for X: 1 = X (1.05/1) Topic: Interest Rate Parity and Exchange Rate Determination
- Will an arbitrageur facing the following prices be able to make money?
Borrowing Lending Bid Ask $ 5% 4% Spot $1 = €1 $1 = €1. € 6% 5% Forward $0 = €1 $1 = €1. A) Yes, borrow $1,000 at 5 percent; trade for € at the ask spot rate $1 = €1; Invest €990. at 5 percent; hedge this with a forward contract on €1,044 at $0 = €1; receive $1.034. B) Yes, borrow €1,000 at 6 percent; trade for $ at the bid spot rate $1 = €1; invest $1, at 4 percent; hedge this with a forward contract on €1,045 at $1 = €1. C) No; the transactions costs are too high. D) none of the options
Answer: C Topic: Reasons for Deviations from Interest Rate Parity
- If IRP fails to hold, A) pressure from arbitrageurs should bring exchange rates and interest rates back into line. B) it may fail to hold due to transactions costs. C) it may be due to government-imposed capital controls. D) all of the options
Answer: D Topic: Reasons for Deviations from Interest Rate Parity Accessibility: Keyboard Navigation
- Although IRP tends to hold, it may not hold precisely all the time A) due to transactions costs, like the bid-ask spread. B) due to asymmetric information. C) due to capital controls imposed by governments. D) due to transactions costs, like the bid-ask spread, as well as capital controls imposed by governments.
Answer: D Topic: Reasons for Deviations from Interest Rate Parity Accessibility: Keyboard Navigation
- The interest rate at which the arbitrager borrows tends to be higher than the rate at which he lends, reflecting the A) transaction cost paradigm. B) midpoint. C) bid-ask spread. D) none of the options
Answer: C Topic: Reasons for Deviations from Interest Rate Parity Accessibility: Keyboard Navigation
- Governments sometimes restrict capital flows, inbound and/or outbound. They achieve this objective by means of A) jawboning. B) imposing taxes. C) bans on cross-border capital movements. D) all of the options
Answer: C Topic: Reasons for Deviations from Interest Rate Parity Accessibility: Keyboard Navigation
- Will an arbitrageur facing the following prices be able to make money?
Bid Ask Borrowing Lending S 0 ($/€) $1 - €1 $1 - €1 i$ 4%APR 4%APR F 360 ($/€) $1 - €1 $1 - €1 i€ 3%APR 3%APR
A) Yes, borrow €1,000,000 at 3 percent; trade for $ at the bid spot rate $1 = €1; invest at 4 percent; hedge this with a long position in a forward contract. B) Yes, borrow $1,000,000 at 4 percent; trade for € at the spot ask exchange rate $1 = €1; invest €699,300 at 3 percent; hedge this by going SHORT in forward (agree to sell € @ BID price of $1/€ in one year). Cash flow in 1 year $237. C) No; the transactions costs are too high. D) none of the options
Answer: B Topic: Reasons for Deviations from Interest Rate Parity
- If a foreign county experiences a hyperinflation, A) its currency will depreciate against stable currencies. B) its currency may appreciate against stable currencies. C) its currency may be unaffected-it's difficult to say. D) none of the options
Answer: A Topic: Purchasing Power Parity Accessibility: Keyboard Navigation
- If the annual inflation rate is 5 percent in the United States and 4 percent in the U., and the dollar depreciated against the pound by 3 percent, then the real exchange rate, assuming that PPP initially held, is A) 0. B) 0. C) −0. D) 4.
Answer: B Explanation: (1 + 0) / (1 + 0) (1 + 0) = 0. Topic: PPP Deviations and the Real Exchange Rate
- If the annual inflation rate is 2 percent in the United States and 4 percent in the U., and the dollar appreciated against the pound by 1 percent, then the real exchange rate, assuming that PPP initially held, is ________. A) parity B) 0. C) −0. D) 4.
Answer: B Explanation: (1 + 0) / (1 + 0) (1) = 0. Topic: PPP Deviations and the Real Exchange Rate
- In view of the fact that PPP is the manifestation of the law of one price applied to a standard commodity basket, A) it will hold only if the prices of the constituent commodities are equalized across countries in a given currency. B) it will hold only if the composition of the consumption basket is the same across countries. C) 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. D) none of the options
Answer: C Topic: Evidence on Purchasing Power Parity Accessibility: Keyboard Navigation
- Some commodities never enter into international trade. Examples include A) nontradables. B) haircuts. C) housing. D) all of the options
Answer: D Topic: Evidence on Purchasing Power Parity Accessibility: Keyboard Navigation
- Generally unfavorable evidence on PPP suggests that
A) substantial barriers to international commodity arbitrage exist. B) tariffs and quotas imposed on international trade can explain at least some of the evidence. C) shipping costs can make it difficult to directly compare commodity prices. D) all of the options
Answer: D Topic: Evidence on Purchasing Power Parity Accessibility: Keyboard Navigation
- The price of a McDonald's Big Mac sandwich A) is about the same in the 120 countries that McDonalds does business in. B) varies considerably across the world in dollar terms. C) supports PPP. D) none of the options.
Answer: B Topic: Evidence on Purchasing Power Parity Accessibility: Keyboard Navigation
- The Fisher effect can be written for the United States as:
A. i$ = ρ$ + E(π$) + ρ$ × E(π$)
B. ρ$ = i$ + E(π$) + i$ × E(π$)
C. q =
D. =
A) Option A B) Option B C) Option C D) Option D
Answer: A Topic: Fisher Effects
- The main approaches to forecasting exchange rates are A) Efficient market, Fundamental, and Technical approaches. B) Efficient market and Technical approaches. C) Efficient market and Fundamental approaches. D) Fundamental and Technical approaches.
Answer: A Topic: Forecasting Exchange Rates Accessibility: Keyboard Navigation
- The benefit to forecasting exchange rates A) are greatest during periods of fixed exchange rates. B) are nonexistent now that the euro and dollar are the biggest game in town. C) accrue to, and are a vital concern for, MNCs formulating international sourcing, production, financing, and marketing strategies. D) all of the options
Answer: C Topic: Forecasting Exchange Rates Accessibility: Keyboard Navigation
- The Efficient Markets Hypothesis states A) markets tend to evolve to low transactions costs and speedy execution of orders. B) current asset prices (e., exchange rates) fully reflect all the available and relevant information. C) current exchange rates cannot be explained by such fundamental forces as money supplies, inflation rates and so forth. D) none of the options
Answer: B Topic: Efficient Market Approach Accessibility: Keyboard Navigation
- Good, inexpensive, and fairly reliable predictors of future exchange rates include A) today's exchange rate. B) current forward exchange rates (e., the six-month forward rate is a pretty good predictor of the spot rate that will prevail six months from today). C) esoteric fundamental models that take an econometrician to use and no one can explain. D) today's exchange rate, as well as current forward exchange rates (e. the six-month forward rate is a pretty good predictor of the spot rate that will prevail six months from today).
Answer: D Topic: Efficient Market Approach Accessibility: Keyboard Navigation
- Which of the following is a true statement? A) While researchers found it difficult to reject the random walk hypothesis for exchange rates on empirical grounds, there is no theoretical reason why exchange rates should follow a pure random walk. B) While researchers found it easy to reject the random walk hypothesis for exchange rates on empirical grounds, there are strong theoretical reasons why exchange rates should follow a pure random walk. C) While researchers found it difficult to reject the random walk hypothesis for exchange rates on empirical grounds, there are compelling theoretical reasons why exchange rates should follow a pure random walk. D) none of the options
Answer: A Topic: Efficient Market Approach Accessibility: Keyboard Navigation
- If the exchange rate follows a random walk A) the future exchange rate is unpredictable. B) the future exchange rate is expected to be the same as the current exchange rate, St = E(St +
1). C) the best predictor of future exchange rates is the forward rate Ft = E(St + 1/It).
D) the future exchange rate is expected to be the same as the current exchange rate, St = E(St +
1), and the best predictor of future exchange rates is the forward rate Ft = E(St + 1/It).
Answer: B Topic: Efficient Market Approach Accessibility: Keyboard Navigation
- One implication of the random walk hypothesis is A) given the efficiency of foreign exchange markets, it is difficult to outperform the market- based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate. B) given the efficiency of foreign exchange markets, it is difficult to outperform the market- based forecasts unless the forecaster has access to private information that is already reflected in the current exchange rate. C) given the relative inefficiency of foreign exchange markets, it is difficult to outperform the technical forecasts unless the forecaster has access to private information that is not yet reflected in the current futures exchange rate. D) none of the options
Answer: A Topic: Efficient Market Approach Accessibility: Keyboard Navigation
- Which of the following issues are difficulties for the fundamental approach to exchange rate forecasting? A) One has to forecast a set of independent variables to forecast the exchange rates. Forecasting the former will certainly be subject to errors and may not be necessarily easier than forecasting the latter. B) The parameter values, that is the α's and β's, that are estimated using historical data may change over time because of changes in government policies and/or the underlying structure of the economy. Either difficulty can diminish the accuracy of forecasts even if the model is correct. C) The model itself can be wrong. D) none of the options
Answer: D Topic: Fundamental Approach Accessibility: Keyboard Navigation
- Researchers have found that the fundamental approach to exchange rate forecasting A) outperforms the efficient market approach. B) fails to more accurately forecast exchange rates than either the random walk model or the forward rate model. C) fails to more accurately forecast exchange rates than the random walk model but is better than the forward rate model. D) outperforms the random walk model, but fails to more accurately forecast exchange rates than the forward rate model.
Answer: B Topic: Fundamental Approach Accessibility: Keyboard Navigation
- Academic studies tend to discredit the validity of technical analysis. Which of the following is true? A) This can be viewed as support technical analysis. B) It can be rational for individual traders to use technical analysis—if enough traders use technical analysis the predictions based on it can become self-fulfilling to some extent, at least in the short-run. C) The statement can be explained by the difficulty professors may have in differentiating between technical analysis and fundamental analysis. D) none of the options
Answer: B Topic: Technical Approach Accessibility: Keyboard Navigation
- The moving average crossover rule A) is a fundamental approach to forecasting exchange rates. B) states that a crossover of the short-term moving average above the long-term moving average signals that the foreign currency is appreciating. C) states that a crossover of the short-term moving average above the long-term moving average signals that the foreign currency is depreciating. D) none of the options
Answer: B Topic: Technical Approach Accessibility: Keyboard Navigation
- According to the technical approach, what matters in exchange rate determination A) is the past behavior of exchange rates. B) is the velocity of money. C) is the future behavior of exchange rates. D) is the beta.
Answer: A Topic: Technical Approach Accessibility: Keyboard Navigation
- Studies of the accuracy of paid exchange rate forecasters A) tend to support the view that "you get what you pay for". B) tend to support the view that forecasting is easy, at least with regard to major currencies like the euro and Japanese yen. C) tend to support the view that banks do their best forecasting with the yen. D) none of the options
Answer: D Topic: Performance of the Forecasters Accessibility: Keyboard Navigation
- According to the research in the accuracy of paid exchange rate forecasters, A) as a group, they do not do a better job of forecasting the exchange rate than the forward rate does. B) the average forecaster is better than average at forecasting. C) the forecasters do a better job of predicting the future exchange rate than the market does. D) none of the options
Answer: A Topic: Performance of the Forecasters Accessibility: Keyboard Navigation
chapter 6 review questions
Course: International Corporate Finance (FIN 4920)
University: Baruch College CUNY
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