Question 1

Whenever nations remove capital controls on their currencies:
A) returns are equalized and arbitrage opportunities disappear.
B) there is no opportunity for trade or arbitrage, and differences in returns disappear.
C) the government sets the returns on its currency, so traders cannot make profits.
D) in those nations, because government has ensured its safety, capital is free to move.

Accepted Answer

The answer of Whenever nations remove capital controls on their...

Question 2

Suppose the average interest rate on euro bonds is 4%, and the average interest rate on U.S. dollar bonds is 6%. Which should the investor choose?
A) neither-bonds have high default rates
B) both-an investor will choose some euro bonds and some U.S. bonds to diversify
C) the euro bond because their economies are usually more stable
D) It is not possible to answer without information on exchange rates.

Accepted Answer

The choice between euro bonds and U.S. dollar bonds depends on the exchange rate risk, as fluctuations in exchange rates can affect the returns on foreign investments. Without information on exchange rates, it's not possible to determine which investment is more favorable.

Question 3

If the U.S. interest rate is 4% per year and the U.K. interest rate is 9% per year, which of the following statements is TRUE?
A) The dollar will depreciate 4% in one year.
B) The pound will depreciate 9% in one year.
C) The pound will depreciate 5% in one year.
D) The dollar will appreciate 4% in one year.

Accepted Answer

According to the interest rate parity theory, the difference between the two interest rates should equal the percentage change in the exchange rate over time. Thus, if the U.K. interest rate is 9% and the U.S. interest rate is 4%, the pound should depreciate by approximately 5% in one year relative to the dollar. Therefore, option C is the correct choice.

Question 4

The situation in which the difference in interest rates between two currencies is equal to the expected change in the spot rate over the same period is known as:
A) covered interest arbitrage.
B) covered interest parity.
C) uncovered interest parity.
D) the forward-spot reversal.

Accepted Answer

Uncovered interest parity refers to the condition where the difference in interest rates between two countries is equal to the expected change in exchange rates between those countries' currencies. This concept does not involve the use of forward contracts to hedge against exchange rate risk, unlike covered interest parity.

Question 5

Suppose $1 = 120 yen in New York, $1 = 2 euros in London, and one euro = 75 yen in Tokyo. A speculator with $1 million would get a profit of _____ by engaging in a 3-point arbitrage.
A) $1.20
B) 150,000 yen
C) $250,000
D) $1.25 million

Accepted Answer

The speculator can convert $1 million to 120 million yen in New York, then convert 120 million yen to 1.6 million euros in Tokyo (120 million yen / 75 yen per euro), and finally convert 1.6 million euros back to $3.2 million in London (1.6 million euros * 2 dollars per euro), resulting in a profit of $2.2 million. However, since none of the provided options match this calculation, the closest correct option based on the given choices and the process of elimination is $250,000 (C), acknowledging a mistake in the initial calculation or interpretation of the provided options.

Question 6

As the expected future spot rate moves closer to the spot rate, uncovered interest parity indicates that:
A) interest rates should remain constant.
B) interest rates should converge.
C) interest rates should diverge.
D) The answer depends on whether the expected future spot rate is higher or lower than the spot rate.

Accepted Answer

Uncovered interest parity suggests that if the expected future spot rate moves closer to the current spot rate, interest rates between two countries should converge. This is because the difference in interest rates is compensated by the expected change in exchange rates, leading to an equilibrium where no arbitrage opportunities exist due to interest rate differentials.

Question 7

In equilibrium, the expected future spot rate is equal to the:
A) current spot rate.
B) current interest rate.
C) interest rate spread.
D) current forward rate.

Accepted Answer

In equilibrium, the expected future spot rate is equal to the current forward rate. This is because the forward rate represents the expected future spot rate, discounted by the interest rate differential between two currencies. Therefore, the current forward rate provides the best estimate of the future spot rate in equilibrium.

Question 8

Liquidity of an asset refers to:
A) its level of risk.
B) whether it is held domestically or overseas.
C) the ease with which it can be sold.
D) its volatility.

Accepted Answer

Liquidity refers to how easily an asset can be converted into cash without affecting its market price. The ease with which an asset can be sold is directly related to its liquidity. Therefore, option C is the correct answer. Options A, B, and D are all incorrect because they do not relate to liquidity.

Question 9

Approximately how many different national currencies exist in the world today?
A) more than 100
B) more than 5,000
C) 12
D) 535

Accepted Answer

There are currently around 180 different national currencies in circulation around the world, with some countries sharing a currency (e.g. the euro in the Eurozone). Option B is an extremely high number and option C and D are incorrect as there are more than 12 countries and 535 currencies in circulation.

Question 10

If 1 euro is priced at $1.25 and if 1 euro will also buy 88 Japanese yen (€1 = ¥88), in equilibrium, with no arbitrage opportunities, how much is the cross rate between the yen and the dollar (yen-dollar rate)?
A) ¥150/$
B) ¥70.4/$
C) ¥20/$
D) ¥5/$

Accepted Answer

To find the cross rate between yen and dollar, we need to convert both currencies to a common currency, in this case euros.

First, we can find the dollar-euro rate by taking the reciprocal of the euro-dollar rate:

$1/€1.25 = $0.80/€

Next, we can find the yen-euro rate:

¥88/€1

To find the yen-dollar rate, we can multiply these two rates:

¥88/€1 * $0.80/€ = ¥70.4/$

Therefore, the answer is B.

Question 11

The forward exchange rate:
A) allows investors to be sure of the price at which they can trade forex in the future.
B) is the rate at which a trader can purchase currency for immediate delivery.
C) is the rate of discount that international banks get when they purchase.
D) is the rate that speculators consider if they are looking for bargain prices.

Accepted Answer

The forward exchange rate is the price at which two parties agree to exchange currency at a future date. It allows investors to lock in a price for their future forex transactions, providing certainty and reducing the risk of currency fluctuations.

Question 12

If the future rate equals the spot rate, then in equilibrium:
A) the exchange rate must depreciate.
B) interest rates should be different.
C) the exchange rate will appreciate.
D) None of these will occur.

Accepted Answer

If the future rate equals the spot rate, it implies that the market expects the exchange rate to remain stable, not to appreciate or depreciate, and it does not necessarily imply a difference in interest rates.

Question 13

When it is possible to trade two separate currencies for a common third currency, economists refer to profit opportunities as:
A) backward arbitrage.
B) speculation.
C) triangular arbitrage.
D) forced equilibrium.

Accepted Answer

Triangular arbitrage is a trading strategy that takes advantage of price differences between three currencies. By trading two separate currencies for a common third currency, profit opportunities can arise. This is done by taking advantage of discrepancies in exchange rates between the different currency pairs.

Question 14

A vehicle currency is:
A) contraband-it is used to smuggle other assets into controlled economies.
B) a widely accepted, tradable currency that serves as a currency to use for buying or selling one's own.
C) a currency whose value changes rapidly and erratically.
D) a currency used to purchase imports of autos, buses, and other transportation equipment.

Accepted Answer

A vehicle currency is a widely accepted, tradable currency that serves as a medium of exchange to buy or sell one's own currency. It is usually a stable and trusted currency that is used in international trade and finance.

Question 15

If investors can cover themselves in the forward market, they will take advantage of interest rate differentials by:
A) buying assets (lending) denominated in the high-interest rate currency, and selling assets (borrowing) in the low-interest rate currency.
B) removing funds from both investments.
C) turning over their investment portfolio to an expert in one of the two nations.
D) selling assets denominated in high-interest rate currency and buying assets in the low-interest rate currency.

Accepted Answer

By buying assets (lending) denominated in the high-interest rate currency and selling assets (borrowing) in the low-interest rate currency, investors can take advantage of interest rate differentials and ensure their investments are covered in the forward market. This is known as a carry trade. Option B does not make sense as removing funds from both investments would mean the investor is not making any profit. Option C is not relevant as the question does not mention the involvement of an investment expert. Option D would result in losses for the investor as they would be selling assets in the high-interest rate currency and buying assets in the low-interest rate currency, resulting in a net loss.

Question 16

Whenever a nation's currency is expected to depreciate because of various market conditions, the following situation exists regarding its forward rate for another currency:
A) there is a forward discount from the spot rate by the rate of depreciation.
B) there is a forward premium from the spot rate by the rate of depreciation.
C) there is no difference between the spot and forward rates.
D) there is no predictable relationship between the spot and forward rates.

Accepted Answer

When a currency is expected to depreciate, the forward rate for another currency will have a premium from the spot rate by the rate of depreciation. This is because investors will demand a higher return (through the premium) to compensate for the expected loss in value of the currency being exchanged. Therefore, choice B is the correct answer.

Question 17

In equilibrium, if both uncovered and covered interest parity hold, what condition should exist?
A) World interest rates will be equal.
B) Rates of inflation will equalize.
C) The forward rate will equal the expected future spot rate.
D) The forward rate will decrease as the spot rate rises.

Accepted Answer

If both uncovered and covered interest parity hold, it implies that there are no arbitrage opportunities and that exchange rates are in equilibrium. In this situation, the forward rate will equal the expected future spot rate, which means that investors are indifferent between investing in domestic or foreign currencies. Therefore, option C is the correct choice. Option A may not necessarily be true as interest rate differentials could exist to compensate for differences in risk. Option B does not have a direct relationship with interest parity, and option D is incorrect as it suggests a violation of interest parity.

Question 18

Covered interest parity refers to the situation in which:
A) interest rates are the same in both currencies.
B) spot and forward rates are the same in both currencies.
C) the forward rate between the two currencies is equal to the ratio of their returns times the spot rate between the two currencies.
D) there is an opportunity for arbitrage whenever prices are sluggish and sticky.

Accepted Answer

Covered interest parity implies that the relationship between the spot exchange rate, forward exchange rate, and interest rates in two countries must hold. This relationship is given by the formula: 
(1 + i₁)/(1 + i₂) = F/E 
Where i₁ is the interest rate in the first country, i₂ is the interest rate in the second country, F is the forward exchange rate, and E is the spot exchange rate. This implies that the forward exchange rate between two currencies is equal to the ratio of their returns times the spot exchange rate between the two currencies.

Question 19

Uncovered interest parity refers to:
A) borrowing in the low-interest currency and lending in the high-interest currency without covering against a change in the exchange rates.
B) foolish actions that usually are not successful.
C) activities that are designed to raise or lower interest rates but are risky.
D) the practice of depositing all of one's funds in one currency without regarding the pros and cons of such a transaction.

Accepted Answer

Uncovered interest parity is a concept in international finance where investors borrow money in a country with a lower interest rate and invest in a country with higher interest rates, expecting to make a profit from the interest rate difference. This is done without covering against a potential change in exchange rates, hence the term "uncovered."

Question 20

There can be an opportunity for covered interest arbitrage if:
A) the interest rate is low and the exchange rate is high.
B) the forward/spot rate difference is either larger or smaller in percentage terms than the difference in the interest rates on two currencies.
C) there is a time lag on the settlement of the transactions.
D) the interest rate is high and the exchange rate is low.

Accepted Answer

Covered interest arbitrage can be profitable if the percentage difference between the forward/spot rate and the interest rate differential is large enough to cover transaction costs. Therefore, option B is the correct answer as it describes the conditions needed for covered interest arbitrage. Option A and D are incorrect as they denote only the direction of interest rates and exchange rates, which is not sufficient information to determine an arbitrage opportunity. Option C is also incorrect as transaction settlement time does not affect the opportunity for covered interest arbitrage.

Quiz 13: Introduction to Exchange Rates and the Foreign Exchange Market

Whenever nations remove capital controls on their currencies:

Suppose the average interest rate on euro bonds is 4%, and the average interest rate on U.S. dollar bonds is 6%. Which should the investor choose?

If the U.S. interest rate is 4% per year and the U.K. interest rate is 9% per year, which of the following statements is TRUE?

The situation in which the difference in interest rates between two currencies is equal to the expected change in the spot rate over the same period is known as:

Suppose $1 = 120 yen in New York, $1 = 2 euros in London, and one euro = 75 yen in Tokyo. A speculator with $1 million would get a profit of _____ by engaging in a 3-point arbitrage.

As the expected future spot rate moves closer to the spot rate, uncovered interest parity indicates that:

In equilibrium, the expected future spot rate is equal to the:

Liquidity of an asset refers to:

Approximately how many different national currencies exist in the world today?

If 1 euro is priced at $1.25 and if 1 euro will also buy 88 Japanese yen (€1 = ¥88) , in equilibrium, with no arbitrage opportunities, how much is the cross rate between the yen and the dollar (yen-dollar rate) ?

The forward exchange rate:

If the future rate equals the spot rate, then in equilibrium:

When it is possible to trade two separate currencies for a common third currency, economists refer to profit opportunities as:

A vehicle currency is:

If investors can cover themselves in the forward market, they will take advantage of interest rate differentials by:

Whenever a nation's currency is expected to depreciate because of various market conditions, the following situation exists regarding its forward rate for another currency:

In equilibrium, if both uncovered and covered interest parity hold, what condition should exist?

Covered interest parity refers to the situation in which:

Uncovered interest parity refers to:

There can be an opportunity for covered interest arbitrage if: