Question 1

The International Fisher Effect states that 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 for the two countries.

Accepted Answer

The International Fisher Effect is a widely accepted theory in finance that predicts the relationship between exchange rates and nominal interest rates. According to this theory, if two countries have different nominal interest rates, the country with the higher interest rate will experience a depreciation in its currency value, while the country with the lower interest rate will experience an appreciation of its currency value. This is due to the fact that higher interest rates attract foreign investors who seek to earn higher returns, and this increased demand for the currency causes its value to rise. Conversely, lower interest rates reduce the appeal of a country's currency to foreign investors, which leads to a decline in its currency value. Overall, the International Fisher Effect suggests that exchange rates should adjust in order to equalize the real return on investment across different countries.

Question 2

Inflation occurs when output increases faster than the money supply.

Accepted Answer

Inflation occurs when the money supply increases faster than the output, leading to a decrease in the value of money and an increase in prices for goods and services.

Question 3

Transaction exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies.

Accepted Answer

Transaction exposure refers to the risk of loss that arises from obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies. Therefore, the statement is true.

Question 4

An inefficient market is one in which prices do not reflect all available information.

Accepted Answer

In an inefficient market, prices do not fully incorporate all available information, creating opportunities for investors to profit from undervalued or overvalued securities.

Question 5

The International Fisher Effect has proven to have substantial power at predicting short-run changes in spot exchange rates.

Accepted Answer

The International Fisher Effect, also known as the uncovered interest rate parity, states that the difference in interest rates between two countries should equal the expected change in exchange rates over a certain period. However, empirical evidence suggests that the International Fisher Effect does not necessarily hold in the short-run and is therefore not a reliable predictor of short-term changes in spot exchange rates.

Question 6

Governments allow convertibility to preserve their foreign exchange reserves.

Accepted Answer

Governments limit convertibility to preserve their foreign exchange reserves.

Question 7

If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices.

Accepted Answer

The law of one price states that identical goods/services should have the same price in different countries after accounting for exchange rates. If this were true for all goods and services, we could use any set of prices to calculate the PPP exchange rate.

Question 8

Although a foreign exchange transaction can involve any two currencies, most transactions involve pounds on one side.

Accepted Answer

Most foreign exchange transactions involve the US dollar on one side, not the British pound. The US dollar is the world's primary reserve currency and is widely used in global trade and finance.

Question 9

The Fisher Effect states that a country's "real" rate of interest is the sum of the "nominal" interest rate and the expected rate of inflation over the period for which the funds are to be lent.

Accepted Answer

The Fisher Effect states that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation, not the real rate being the sum.

Question 10

The PPP theory is a strong predictor of short-run movements in exchange rates covering time spans of five years or less.

Accepted Answer

The PPP theory is a long-run predictor of exchange rates, covering periods of over five years. In the short run, other factors such as interest rates, political events, and market sentiment can have a greater impact on currency values.

Question 11

There are no impediments to the free flow of goods and services in an efficient market.

Accepted Answer

In an efficient market, there are no barriers to the free flow of goods and services, as buyers and sellers have access to all relevant information and can easily trade without interference. However, in real-world markets, various factors such as tariffs, regulations, monopolies, and information asymmetries can impede the free flow of goods and services, leading to market inefficiencies.

Question 12

If a country has an externally convertible currency, neither residents nor nonresidents are allowed to convert it into a foreign currency.

Accepted Answer

If a country has an externally convertible currency, it means that both residents and nonresidents are allowed to convert it into a foreign currency.

Question 13

Restrictions on external convertibility can limit domestic companies from investing abroad.

Accepted Answer

Restrictions on external convertibility, such as limits on the ability to freely exchange domestic currency for foreign currency, can make it more difficult for domestic companies to invest abroad. Without the ability to easily exchange currencies, it may be harder to navigate foreign exchange risks and finance foreign investments.

Question 14

Technical analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.

Accepted Answer

Technical analysis analyzes price charts and statistical indicators to identify trends and make trading decisions, while econometric models are mostly used in fundamental analysis to forecast macroeconomic variables.

Question 15

Arbitrage opportunities abound in the foreign exchange markets and they tend to be available for long periods of time.

Accepted Answer

Arbitrage opportunities in the foreign exchange markets are usually short-lived and traders need to act quickly to take advantage of them. The efficiency of the markets and the advancements in technology have reduced the occurrence of profitable arbitrage opportunities.

Question 16

The efficient market school argues that investing in exchange rate forecasting services would be a waste of money.

Accepted Answer

The efficient market hypothesis suggests that market prices reflect all available information, making it difficult to consistently outperform the market through forecasting. Therefore, according to this school of thought, investing in exchange rate forecasting services would be a waste of money.

Question 17

Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation, or when a country's economic prospects are shaky in other respects.

Accepted Answer

Capital flight refers to the large-scale and sudden outflow of capital from a country. It is more likely to occur when investors perceive that the economic prospects of a country are deteriorating, or when the value of the domestic currency is depreciating rapidly due to hyperinflation. In such situations, investors try to move their money out of the country to protect their wealth and avoid losses.

Question 18

The PPP theory argues that the exchange rate will change even if relative prices remain unchanged.

Accepted Answer

The Purchasing Power Parity (PPP) theory suggests that exchange rates should adjust to equalize the price of identical goods and services in different countries, meaning they change when relative prices change, not when they remain unchanged.

Question 19

The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate.

Accepted Answer

According to the Purchasing Power Parity (PPP) theory, a country's exchange rate should adjust to reflect changes in the price levels between countries. Therefore, a country with a higher inflation rate will have a decrease in the purchasing power of its currency, which leads to the depreciation of its exchange rate.

Question 20

There is no evidence that psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates.

Accepted Answer

Psychological factors such as emotions and biases have been shown to affect market traders and their expectations of future exchange rates. Studies have found that traders' mood, confidence, and previous experiences can influence their perceptions of market trends and affect their decision making.

Quiz 10: The Foreign Exchange Market