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Chapter 17   The Foreign Exchange Market

Multiple Choice Questions

1.      Foreign exchange is:

a.       The act of trading different nations’ monies.

b.      The holdings of foreign currency.

c.       The act of importing foreign goods and services.

d.      Both (a) and (b) are correct.

ANSWER:      D

2.      If the price of British pounds in terms of U.S. dollars is $1.80 per pound, then the price of U.S. dollars in terms of British pounds is:

a.       1.80£ per dollar.

b.      0.555£ per dollar.

c.       0.90£ per dollar.

d.      3.60£ per dollar.

ANSWER:      B

3.      Suppose the exchange rate between the Japanese yen and the U.S. dollar is 100 yen per dollar. A Japanese stereo with a price of 60,000 yen will cost:

a.       $1,667

b.      $600

c.       $6,000

d.      $100

ANSWER:      B

4.      Suppose that a Korean television set that costs 600 won in Korea costs $400 in the United States. These prices suggest that the exchange rate between the won and the dollar is:

a.       1.5 won per dollar

b.      0.75 won per dollar

c.       $1.50 per won

d.      $3 per won

ANSWER:      A

5.      The __________ exchange rate is the price for “immediate” currency exchange.

a.       Current

b.      Forward

c.       Future

d.      Spot

ANSWER:      D

6.      The __________ exchange rate is the price set now for an exchange that will take place sometime in the future.

a.       Current

b.      Forward

c.       Future spot

d.      Spot

ANSWER:      B

7.      The foreign exchange market is:

a.       A single gathering place where traders shout buy and sell orders at each other.

b.      Located in New York.

c.       A grouping, by electronic means, of banks and traders who work at banks that conduct foreign exchange trades.

d.      Located in London.

ANSWER:      C

8.      __________ foreign exchange trading involves currency exchanges done between individuals and banks.

a.       Interbank

b.      Consumer

c.       Intra-bank

d.      Retail

ANSWER:      D

9.      The U.S. dollar is called a __________ because it is often used as an intermediary to accomplish trading between two other currencies.

a.       Vehicle currency

b.      Main currency

c.       Common currency

d.      Primary currency

ANSWER:      A

10.  Suppose that the exchange value of the British pound is $2 per pound while the exchange value of the Swiss franc is 50 cents per franc. From this we can conclude that  the exchange rate between the pound and the franc is:

a.       1 franc per pound

b.      2 francs per pound

c.       3 francs per pound

d.      4 francs per pound

ANSWER:      D

11.  Which of the following is NOT a function of the interbank operations of the foreign exchange market?

a.       Provides a bank with a continuous stream of information on conditions in the foreign exchange market.

b.      Provides a bank the means to readjust its own position quickly and at low cost.

c.       Permits a bank to take on a position in a foreign currency quickly.

d.      Provides a bank with technological resources for use in foreign exchange trading.

ANSWER:      D

12.  Under the managed float system of exchange rates, a fall in the market price of a currency is called:

a.       Devaluation.

b.      Depreciation.

c.       Appreciation.

d.      Both (a) and (b).

ANSWER:      B

13.  Interbank trading is conducted directly between __________ or through the use of __________ that provide anonymity until the trade is complete and reduce search costs.

a.       Traders; brokers

b.      Brokers; traders

c.       Individual consumers; the government

d.      Individual consumers; brokers

ANSWER:      A

14.  A country’s demand for foreign currency is derived from:

a.       International transactions entering the debit column of its balance of payments accounts.

b.      International transactions entering the surplus column of its balance of payments accounts.

c.       The country’s demand for currency to finance exports and capital inflows.

d.      The country’s demand for currency to finance its government’s compensating transactions.

ANSWER:      A

15.  U.S. exports of goods and services will create a __________ foreign currency and a __________ U.S. dollars.

a.       Demand for; supply of

b.      Supply of; demand for

c.       Shortage of; demand for

d.      Supply of; shortage of

ANSWER:      B

16.  U.S. imports of goods and services will create a __________ foreign currency and a __________ U.S. dollars.

a.       Demand for; supply of

b.      Supply of; demand for

c.       Shortage of; demand for

d.      Supply of; shortage of

ANSWER:      A

17.  U.S. capital inflows will create a __________ foreign currency and a __________ U.S. dollars.

a.       Demand for; supply of

b.      Supply of; demand for

c.       Shortage of; demand for

d.      Supply of; shortage of

ANSWER:      B

18.  In a __________ exchange rate system there is no intervention by the government or central bankers.

a.       Fixed

b.      Pegged

c.       Floating

d.      Managed float

ANSWER:      C

19.  As the value of the yen falls relative to the U.S. dollar:

a.       Japanese goods become more expensive to U.S. consumers.

b.      The supply of dollars will fall.

c.       The demand for yen will rise.

d.      U.S. goods become less expensive to Japanese consumers.

ANSWER:      C

20.  The demand curve for foreign currency slopes downward because as the exchange rate __________ the quantity demanded __________.

a.       Increases; decreases

b.      Increases; increases

c.       Decreases; decreases

d.      Decreases; stays fixed

ANSWER:      A

21.  Shifts in demand away from French products and toward U.S. products (caused by forces other than changes in the exchange rate) would result in extra attempts to __________ euros and __________ dollars.

a.       Buy; buy

b.      Sell; sell

c.       Sell; buy

d.      Buy; sell

ANSWER:      C

22.  Other things equal, if American exports to Japan increase and American imports from Japan decrease, then under a floating exchange rate system, we would expect the dollar to:

a.       Weaken against the Japanese yen.

b.      Depreciate against the Japanese yen.

c.       Devalue against the Japanese yen.

d.      Strengthen against the Japanese yen.

ANSWER:      D

23.  A decrease in German residents' willingness to invest in dollar-denominated assets will shift the demand curve for:

a.       Euros to the right.

b.      Euros to the left.

c.       Dollars to the right.

d.      Dollars to the left.

ANSWER:      D

24.  In a __________ exchange rate system the government or central bankers intervene to keep the exchange rate virtually steady.

a.       Fixed

b.      Market driven

c.       Floating

d.      Forward

ANSWER:      A

Exchange Rate

$/£

Figure 17.1: The Market for British Pounds

25.  Referring to Figure 17.1, a downward movement along the vertical axis would correspond to a(n) __________ of the U.S. dollar.

a.       Arbitraging.

b.      Devaluation

c.       Appreciation

d.      Depreciation

ANSWER:      C

26.  Referring to Figure 17.1, at $2.50 per pound, there is a(n) __________. Under the system of flexible exchange rates, this would cause __________ the ________ curve(s).

a.       Excess demand of 1 million pounds, leftward shift of, demand

b.      Excess supply of 1 million pounds, rightward shift of, supply

c.       Excess demand of 1 million pounds, downward movement along, demand & supply

d.      Excess supply of 1 million pounds, downward movement along, demand & supply

ANSWER:      D

27.  Referring to Figure 17.1, if the British government wants to peg the exchange rate of the pound at $2.50 per pound, what action would British monetary authorities have to undertake?

a.       Sell 1 million pounds and buy 2.5 million dollars.

b.      Buy 1 million pounds and sell 1 million dollars.

c.       Buy 1 million pounds and sell 2.5 million dollars.

d.      Buy 5.5 million pounds and sell 11 million dollars.

ANSWER:      C

28.  Referring to Figure 17.1, if the British pound is pegged at $2.50 per pound the pound will be:

a.       Overvalued.

b.      Undervalued.

c.       Devalued.

d.      In equilibrium.

ANSWER:      A

29.  Referring to Figure 17.1, if the British pound is pegged at $2.50 per pound who will this help?

a.       US importers.

b.      British importers.

c.       British exporters.

d.      British import-competing producers.

ANSWER:      B

30.  Referring to Figure 17.1, if the British pound is pegged at $2.50 per pound and the government gives up the peg and allows the pound to float, the pound will experience a(n):

a.       Revaluation.

b.      Devaluation.

c.       Appreciation.

d.      Depreciation.

ANSWER:      D

31.  Referring to Figure 17.1, if the U.S. Federal Reserve was to conduct a contractionary monetary policy, the ______ curve would shift right and the pound would __________.

a.       Supply, appreciate

b.      Demand, depreciate

c.       Supply, depreciate

d.      Demand, appreciate

ANSWER:      C

32.  Which of the following best characterizes the current U.S. exchange rate policy?

a.       An adjustable pegged rate.

b.      A crawling pegged rate.

c.       A freely floating.

d.      A fixed exchange rate.

ANSWER:      C

33.  Other things equal, if American exports to Japan increase and American imports from Japan decrease, then, under a floating exchange rate system, we would expect the dollar to:

a.       Weaken against the Japanese yen.

b.      Depreciate against the Japanese yen.

c.       Devalue against the Japanese yen.

d.      Strengthen against the Japanese yen.

ANSWER:      D

34.  Which of the following groups is most likely to benefit from a strengthening of the U.S. dollar against major currencies?

a.       U.S. exporters.

b.      The U.S. government.

c.       U.S. consumers.     

d.      Foreign consumers.

ANSWER:      C

35.  Under a fixed exchange rate system a fall in the market price (the exchange rate value) of a currency is called a(n) __________ of that currency.

a.       Revaluation

b.      Devaluation

c.       Appreciation

d.      Depreciation

ANSWER:      B

36.  Exchange rates are equalized in different locations due to:

a.       Arbitrage.

b.      Government intervention in foreign exchange markets.

c.       Free trade in goods and services.

d.      The actions of importers and exporters.

ANSWER:      A

37.  How could you profit if the exchange rate in London was $2/£ while in New York the exchange rate was $1.95 per pound?

a.       Buy dollars in New York and sell them in London.

b.      Buy pounds in London and sell them in New York.

c.       Buy pounds in New York and sell them in London.

d.      Buy dollars in London and sell pounds in New York.

ANSWER:      C

38.  Under the system of pegged exchange rates, when the domestic currency’s value presses against the top of its official price range, officials must:

a.       Sell foreign currency and buy domestic currency.

b.      Buy foreign currency and sell domestic currency.

c.       Let the domestic currency appreciate further and refrain from intervention in the foreign exchange market.

d.      Let the foreign currency appreciate further and refrain from intervention in the foreign exchange market.

ANSWER:      B

39.  The 2001-2007 rapid growth in global foreign exchange trading can be explained by:

a.       Large increases in short-term international currency activities by hedge funds.

b.      Increases in long-term foreign financial investments by large institutional investors.

c.       Increases in the U.S. long term government bond yields.

d.      Both (a) and (b)

ANSWER:      D

True/False Questions

40.  The greater part of the money assets traded in foreign exchange markets are demand deposits in banks.

ANSWER:    TRUE

41.  Most foreign exchange trading is done among the banks themselves in the retail part of the foreign exchange market.

ANSWER:    FALSE

42.  The spot exchange rate is the price now for an exchange that will take place sometime in the future.

ANSWER:    FALSE

43.  French imports of goods and services will create a demand for foreign currency and a supply of euros.

ANSWER:    TRUE

44.  In the floating exchange rate system, government officials must intervene in the exchange rate market to keep the exchange rate from fluctuating.

ANSWER:    FALSE

45.  Government officials wanting to defend a fixed exchange rate may not have sufficient reserves of foreign currency to keep the price fixed indefinitely.

ANSWER:    TRUE

46.  Assuming the Japanese have a floating exchange rate, an increase in Japanese exports of goods and services will tend to cause the value of the yen to appreciate.

ANSWER:    TRUE

47.  To maintain an undervalued currency, monetary authorities must intervene in the foreign exchange market to buy its currency.

ANSWER:    FALSE

48.  Arbitrage ensures that the spot price of the currency will equal the forward price of the currency.

ANSWER:    FALSE

49.  Triangular arbitrage will not cause the exchange rate between two foreign currencies to equalize.

ANSWER:    FALSE

50.  Most interbank trading occurs through electronic brokering systems, with only a small remaining role for voice brokers.

ANSWER:    TRUE

51.  From 2001 to 2007, global foreign exchange trading more than doubled.

ANSWER:    TRUE

52.  Greece was among the 11 EU countries deemed to meet the five criteria in early 1998.

ANSWER:    FALSE

53.  The Maastricht Treaty set a process for establishing a monetary union and a single union wide currency.

ANSWER:    TRUE

54.  The three countries that joined the euro area in 2007-2008 were Slovenia, Greece & Malta.

ANSWER:    FALSE

Essay Questions

55.  A retailer in Mexico wants to buy $100,000 worth of Apple computers from the United States. The Mexican retailer has pesos while the seller in the United States wants to be paid in U.S. dollars. Explain how this transaction is completed with particular emphasis on the foreign exchange market and banks in the United States and Mexico.

POSSIBLE RESPONSE: The Mexican buyer has to sell pesos to get dollars to pay the U.S. exporter. The Mexican firm contacts its bank and requests a quotation of the exchange rate for selling pesos and acquiring 100,000 dollars. If the rate is acceptable, the Mexican firm instructs its bank to take pesos from its checking account, convert into 100,000 dollars and transfer the dollars to the U.S. producer. The Mexican bank holds the dollar denominated deposits in the United States, at its correspondent bank in New York. The Mexican bank instructs its correspondent bank in New York to take dollars from its checking account and transfer the dollars to the U.S. producer. This completes the international payment for computers.

56.  Suppose $1 = 0.85 euros in New York, 1 euro = 150 yen in Paris, and 1 yen = $0.008 in Tokyo.

  1. If you begin by holding $1, how could you profit from these exchange rates? What is your arbitrage profit per dollar initially traded?
  2. Identify the forces at work that will make the cross exchange rates consistent in currency arbitrage. That is, what forces will lead to a situation in which no profitable arbitrage is possible?

POSSIBLE RESPONSE:

a. Buy .85 euros, then buy 127.5 yen in Paris with .85 euros then convert 127.5 yen back to dollars which makes 1.02 dollars yielding a profit of $.02.

b. The forces of demand and supply will ensure that there is no arbitrage opportunity. For instance, this could happen by depreciating the euro in Paris to about 1 euro = 147 yen.

 

57.  Explain how the following factors affect the dollar’s exchange rate under a floating exchange rate system:

a.       Tariffs and quotas placed by the U.S. on all imports into the country.

b.      Decreased demand by foreign consumers for U.S. exports and increased U.S. demand for imports.

c.       Rising real interest rates in the United States relative to interest rates in Europe leads to capital inflows.

d.      Rising U.S. fiscal deficits reduce investor confidence and lead to capital outflows.

POSSIBLE RESPONSE:

a.   Tariffs and quotas placed by the U.S. on all imports into the country would decrease demand for foreign currency. This in turn would lead to an appreciation of the dollar

b.   Decreased demand by foreign consumers for U.S. exports would decrease demand for U.S. dollars and lead to a depreciation of the dollar. Increased U.S. demand for import would increase demand for foreign currency. Foreign currency would appreciate and the dollar would depreciate.

c.   Rising real interest rates in the United States relative to interest rates in Europe lead to capital inflows. To invest in the United States foreign investors would first have to purchase dollars in the foreign exchange market. This would increase demand for dollars, thus appreciating the dollar.

d.   The rising U.S. deficits reduce investor confidence that leads to capital outflows and increases demand for foreign currency in the foreign exchange market. Investors would have to sell dollars to buy foreign currency thus the supply of dollars would increase while the demand for foreign currency would decrease. The dollar as a result would depreciate.

58.  For each case below, state whether the euro has appreciated or depreciated and give an example of an event that could cause the change in the exchange rate.

a.       The spot rate goes from 450 euros/Mexican peso to 440 euros/Mexican peso.

b.      The spot rate goes from 0.011 Mexican pesos/euro to 0.006 Mexican pesos/euro.

c.       The spot rate goes from 1.48 euros/British pound to 1.51 euros/British pound.

d.      The spot rate goes from 0.73 British pounds/euro to 0.75 British pounds/euro.

POSSIBLE RESPONSE:

a.       The euro appreciates; there is an increased demand for euros.

b.      The euro depreciates; there is an increased supply of euros.

c.       The euro depreciates; there is an increased demand for the British pound.

d.      The euro appreciates; there is a decreased supply of euros.

59.  Provide a description for the following terms:

a.       Foreign exchange swap

b.      Arbitrage

c.       Triangular arbitrage

d.      Forward exchange rate

POSSIBLE RESPONSE:

a.       A package trade that includes both a spot exchange of two currencies and an agreement to the reverse forward exchange of the two currencies.

b.      Arbitrage is the process of buying and selling to make a riskless profit.

c.       Arbitraging through three exchange rates.

d.      The forward exchange rate is the price agreed now for a currency exchange that will occur sometime in the future.

60.  How does the interbank foreign exchange trading work? What is being traded in the interbank part of the foreign exchange markets? What functions does it serve?

POSSIBLE RESPONSE: A little more than 40% of foreign exchange trading is among banks themselves. Demand deposits denominated in different currencies are being traded where each deal is between one foreign exchange trader and another trader, not an “outside” customer. It serves several functions. Participation in the interbank part of the market provides a bank with continuous stream of information on conditions of the foreign exchange market. Interbank trading allows the bank to readjust its position quickly and at a low cost. It allows the bank to take on a speculative position quickly. Quoted interbank rates are for amounts of $1 million or more.

 
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