Question 1

Suppose the U.S. dollar interest rate is 3%, while the interest rate in the United Kingdom is 6%. Your friend thinks he can convert his dollars, invest in the United Kingdom and convert his pounds back into dollars at the end of a year, allowing him to make a lot higher return. Assuming uncovered interest parity (UIP), explain why he is incorrect.

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Question 2

Explain the difference between risky and riskless arbitrage.

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Question 3

If a pair of shoes in the United States costs $45, and a pair of the exact same shoes is sold in Mexico for 430 pesos while the exchange rate is E = $0.1100/pesos, what arbitrage opportunities exist (if any)? Ignoring transactions costs, explain how you would take advantage of this.

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Question 4

Suppose the U.S. dollar interest rate is 5% and the euro interest rate is 6%. Assume no transaction costs, fees, or commissions. In all markets, the spot rate for euros is $1.25. You believe in one year's time the spot rate for euros will be $1.30. An investor would like to invest $100,000 for one year and is willing to take on risk for a higher return.
I. How would you advise him?
II. What if you are incorrect and the euro rate is lower? Calculate the "break-even" exchange rate; that is, an investment that returns the same as investing $100,000 at 5%.

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Question 5

From uncovered interest parity, we know that when the domestic currency is expected to depreciate, the domestic interest rate should be:
A) greater than the foreign interest rate.
B) greater than the foreign exchange rate.
C) less than the foreign interest rate.
D) less than the foreign exchange rate.

Accepted Answer

Uncovered interest parity suggests that if the domestic currency is expected to depreciate, investors will demand a higher interest rate on domestic assets to compensate for the expected loss in currency value. Therefore, the domestic interest rate should be greater than the foreign interest rate.

Question 6

You have studied how nations have adopted a wide variety of exchange rate regimes from freely floating with almost no intervention to rigid and fixed with complete control by the government. Other nations have chosen different paths, relinquishing some or all control over their currencies. Discuss two such systems and comment on their differences.

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Question 7

Suppose a country trades with three countries: Brazil (20% of trade), China (45%), and France (35%). Over the last year, the currency of this country has depreciated by 4% against the Brazilian real, appreciated by 3% against the Chinese yuan, and depreciated by 7% against the euro. What has happened to the effective exchange rate of the country?

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Question 8

Explain two of the four main types of derivatives used in the foreign exchange market, and why they are used.

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Question 9

In July 2015, the spot rate is $1 exchanging for 1,250 won. You are convinced that the won will appreciate by the end of the year. How might you profit if your hunch is correct?

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Question 10

In equilibrium, the interest parity condition requires that:
A) all rates of returns will equalize.
B) all spot and forward rates will equalize.
C) the home interest rate minus its expected rate of currency depreciation (against the foreign country) will equal the foreign interest rate on similar assets.
D) all rates of returns and forward rates will equalize.

Accepted Answer

The interest parity condition states that the difference between the home interest rate and the expected rate of currency depreciation (against the foreign country) should be equal to the foreign interest rate on similar assets in order to achieve equilibrium. Therefore, option C is the correct answer. Option A, B, and D are incorrect because they do not accurately reflect the interest parity condition.

Question 11

Explain in your own words the effective exchange rate and why policy makers pay more attention to it than the bilateral exchange rate.

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Question 12

Assume your company has a contract to purchase 100,000 computers from a Korean company. The payment is due on receipt of the shipment and must be delivered in Korea on December 31, 2015. In July 2015, when you are arranging the contract, the computers are priced at 500,000 won each. The spot rate in July 2015 is $1 in exchange for 1,250 won.
I. Calculate the U.S. dollar price (in July 2015) of one unit of Korean currency.
II. What is the total price of the computers in dollars?
III. What is the total price of the computers in won?
IV. What would you advise your firm to do to avoid a loss on the deal if the Korean won costs 10% more compared with the U.S. dollar when payment is due in December?

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Question 13

From uncovered interest parity, we know that when the domestic interest rate is greater than the foreign one:
A) the domestic currency is expected to appreciate.
B) the domestic currency is expected to depreciate.
C) the foreign currency is expected to appreciate.
D) the foreign currency is expected to depreciate.

Accepted Answer

According to uncovered interest parity, when the domestic interest rate is greater than the foreign one, investors will shift their funds to the foreign currency to earn a higher return. This increase in demand for the foreign currency will result in the domestic currency depreciating. Therefore, the correct answer is B, the domestic currency is expected to depreciate.

Question 14

What are the similarities and differences between a currency union and dollarization?

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Question 15

Explain how a trader can exploit an arbitrage opportunity using the spot market and the forward market, after discovering a difference in interest rate returns on two currencies.

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Question 16

Is it possible to engage in arbitrage under the following scenario? The exchange rate in New York is E = $1.25/euro, and it is E = $1.35/euro in London. Explain how you would do it.

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Question 17

The expected rate of currency depreciation is equal to the proportional difference between the forward rate and the spot rate. This is known as the:
A) forward depreciation.
B) backward depreciation.
C) forward premium.
D) backward premium.

Accepted Answer

The expected rate of currency depreciation is calculated by subtracting the spot rate from the forward rate and dividing the result by the spot rate. If the result is positive, then it is considered a forward premium. Therefore, the answer is C, forward premium.

Question 18

What role(s) might the government play in the foreign exchange markets? Explain.

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Question 19

Suppose interest rates in the United States are 5.5%, while they are 3% in the euro area. Currently the dollar-euro exchange rate is at $2.50 per euro. If UIP holds, what do you expect the exchange rate to be in the future? Round to three decimals.

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Question 20

The total rate of return on an international asset is the:
A) spot rate plus the forward rate.
B) rate of return on the asset plus or minus the expected capital gain or loss on currency changes.
C) rate of return on the asset minus commissions.
D) rate of return plus inflation minus taxes.

Accepted Answer

The total rate of return on an international asset includes the rate of return on the asset (dividends or interest payments) and also the expected capital gain or loss on currency changes. Therefore, option B is the correct answer.

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

Explain the difference between risky and riskless arbitrage.

If a pair of shoes in the United States costs $45, and a pair of the exact same shoes is sold in Mexico for 430 pesos while the exchange rate is E = $0.1100/pesos, what arbitrage opportunities exist (if any)? Ignoring transactions costs, explain how you would take advantage of this.

From uncovered interest parity, we know that when the domestic currency is expected to depreciate, the domestic interest rate should be:

Explain two of the four main types of derivatives used in the foreign exchange market, and why they are used.

In July 2015, the spot rate is $1 exchanging for 1,250 won. You are convinced that the won will appreciate by the end of the year. How might you profit if your hunch is correct?

In equilibrium, the interest parity condition requires that:

Explain in your own words the effective exchange rate and why policy makers pay more attention to it than the bilateral exchange rate.

From uncovered interest parity, we know that when the domestic interest rate is greater than the foreign one:

What are the similarities and differences between a currency union and dollarization?

Explain how a trader can exploit an arbitrage opportunity using the spot market and the forward market, after discovering a difference in interest rate returns on two currencies.

Is it possible to engage in arbitrage under the following scenario? The exchange rate in New York is E = $1.25/euro, and it is E = $1.35/euro in London. Explain how you would do it.

The expected rate of currency depreciation is equal to the proportional difference between the forward rate and the spot rate. This is known as the:

What role(s) might the government play in the foreign exchange markets? Explain.

Suppose interest rates in the United States are 5.5%, while they are 3% in the euro area. Currently the dollar-euro exchange rate is at $2.50 per euro. If UIP holds, what do you expect the exchange rate to be in the future? Round to three decimals.

The total rate of return on an international asset is the: