Deck 7: International Financial Markets, Fx Risks, and Hedging Fx Risks

Question 1

Suppose a Central Bank sells $30 billion in foreign reserves to the non-bank public in return for $30 billion in currency from the non-bank public to try to bolster up a country's FX rate, show the Balance Sheet accounts for the Central Bank's asset and liabilities how this would be carried out with a sterilized foreign exchange intervention, so there will be $0 change in the monetary base of the country.

Answer 1

This open market operation reduces the supply of international reserves in circulation, raising the value of foreign currency, and thus reducing the value of the currency for the domestic currency.
With the central bank selling foreign reserves to the non-bank public in return for currency, the currency in the country goes down by $30 billion. To offset this with a sterilized foreign intervention, the bank buys securities from the non-bank public putting $30 billion of currency back into circulation, resulting no change in the monetary base.

Question 2

What type of exchange rate regime is the U.S. under? Give an example of a country that has a fixed rate. What disadvantages does a fixed rate regime have?

Answer 2

The U.S. has a managed float system. An example of a fixed rate regime is the Bahamas, which has a fixed rate with the U.S. dollar. Advantages are U.S. tourists have an easy time visiting the Bahamas with a fixed rate with the U.S. dollar. Disadvantages are that the country depends on the U.S. dollar with their currency fluctuating in value with the U.S. dollar which is out of their control, and to keep the rate fixed the central bank has to buy or sell foreign reserves which can affect the currency in circulation for the country. If the central bank runs out of currency, it may have to engage in a devaluation, which results in a loss of confidence in the currency, which can contribute to an economic downturn.

Question 3

Under modern asset theory, what are five different factors that affect a country's exchange rate relative to another country?

Answer 3

Under modern asset theory, relative supply and demand factors determine the value of a currency relative to its trading partners.
Factors that affect a country's FX rate include:
(1) Relative inflation-higher inflation-more costly a country's goods-leading to a lower FX rate;
(2) Relative demand for a country's products & services-higher demand leads to more demand for a country's currency and a higher FX rate;
(3) Relative productivity-more efficient production, lower costs of goods and more demand for a country's currency and higher FX rate; and
(4) Tariffs and barriers keep out goods from other countries making lower demand for their currencies and a higher relative FX rate for a country.

Question 4

Based on the modern asset theory (which is similar to the loanable funds theory), using supply and demand factors, explain what would likely happen to the value of the U.S. dollar (holding other factors constant) under the following scenarios:
a. The European Central Bank engages in quantitative easing with a target of lower the country's real interest rate.
b. The U.S. increases trade barriers and tariffs for imported goods from other countries.
c. A trading partner of the U.S. offers desired products globally with technological breakthroughs offering these goods at an attractive price relative to the U.S.
d. The U.S. inflation rate goes up and is higher than its trading partner countries.

Question 5

In March, a U.S. Company is expecting to receive funds in Euros in June from its European customers of 500 million Euros, and wants to hedge against a fall in the value of the Euro relative to the U.S. dollar in December. At this time the spot exchange rate Euro is worth $1.109 USD. The CME Group currency future settle rate for a June Euro FX futures contacts is 1 Euro = $1.11875 USD, with each futures contract for 125,000 Euros per contract.
a. What position and how many contracts should the financial manager take to hedge against a fall in the Euro? Explain why. (Hint # contracts = Amount of Euros Hedging / 125,000 Euros per contract; always take a position that will give you a futures gain to offset your spot loss in the event of what you want to hedge.)
b. Suppose later in June, the spot rate for the Euro falls to $0.9981 USD and the futures settle rate has falls to $ 1.00688 USD. Calculate the spot opportunity loss or gain for the company and the futures gain or loss. What is the net hedging result?
c. What are the advantages and disadvantages of hedging with FX options on futures contracts instead?

Question 6

In October, a U.S. Company is expecting to pay funds in British Pounds in June to its British suppliers of 625 million British Pounds, and wants to hedge against a rise in the value of the British Pound relative to the U.S. dollar in December. At this time the spot exchange rate British Pound is worth $1.25 USD. The CME Group currency future settle rate for a December British Pound FX futures contacts is 1 British Pound = $1.2470 USD, with each futures contract for 62,500 British Pounds per contract.
a. What position and how many contracts should the financial manager take to hedge against a rise in the British Pound? Explain why. (Hint # contracts = Amount of British Pounds Hedged / 62,500 British Pounds per contract; always take a position that will give you a futures gain to offset your spot loss in the event of what you want to hedge.)
b. Suppose later in December the spot rate for the British Pound rises to $1.375 USD and the futures settle rate rises to $1.3717. Calculate the spot opportunity loss or gain for the company and the futures gain or loss. What is the net hedging result?

Question 7

Discuss the experience of the U.S. under a gold standard in the 1800's. What problems arose with this standard in terms of controlling the money supply when gold production rose or fell, and what problems were there for countries that are respectively net exporters and net importer countries?

Question 8

Discuss the Bretton Woods Agreement and the establishment of a fixed exchange rate in gold for the U.S. dollar. Explain what happened in the 1970s with the end of the fixed rate gold standard FX exchange rate system, the Bretton Woods system. What system was put in its place and what are popular reserve currencies?

Question 9

What are the IMF's special drawing rights (SDR) and what does the SDR consist of? How has the IMF helped to respond to balance of payment problems for poorer countries, and what reforms have been made?

Question 10

Suppose a central bank purchases $30 billion in foreign reserves from the non-bank public in return for $30 billion in deposits for the non-bank public to try to reduce its country's FX rate. Show the Balance Sheet accounts for the central bank's asset and liabilities and how this would be carried out with a sterilized foreign exchange intervention, so there will be $0 change in the monetary base of the country.

Question 11

Give a brief overview of the Group of Five (G5) and the Group of Seven (G7) and the Group of 20.

Question 12

An international bank in Paris has loans maturing in a year of 500 million Euros with a 10% annual interest rate financed by U.S. certificates of deposit maturing in a year of $400 million with a 5% rate.
What is the expected interest rate spread in Euros for the bank if $1 U.S. is worth 0.70 Euros, and what is the expected interest rate spread in Euros if the dollar rises to be worth 1 Euro?

A) 36 million Euros, 30 million Euros
B) 36 million Euros, 36 million Euros
C) 15 million Euros, 10 million Euros
D) 21 million Euros, 30 million Euros

Question 13

If the value of $1 U.S. dollars is worth 1.34 Canadian dollars, what is the value of the Canadian dollar in U.S. dollars?

A) $0.5036
B) $0.7463
C) $1.00
D) $1.34

Question 14

Crazy Boris Export Company plans to receive 200,000 British pounds in six months from now. Suppose at this time, 1 U.S. dollar = 0.81 British pounds. In U.S. dollars, what amount does in U.S. dollars does Boris expect to receive?

A) $200,000
B) $162,000
C) $246,914
D) None of the above

Question 15

Under the Modern Asset Theory for FX rates, if a country has significant inflation in its nominal prices for goods and services relative to other countries, which of the following statements is true under exchange rate theory for the country's currency exchange rate relative to the currency of other countries?

A) The country's FX rate will fall, since demand for the currency will fall.
B) The country's FX rate will rise, since demand for the currency will rise.
C) Inflation rates are not relevant to FX rates.
D) All of the above.

Question 16

The theory of purchase power parity states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. Purchase power parity focuses on how FX rates are determined in the long run.

Question 17

Under the Modern Asset Theory for FX rates, based on supply and demand factors for a foreign currency, which of the following factors affect foreign exchange rates between two different countries?

A) The relative supply and demand for goods in different countries.
B) The relative interest rates for investments in different countries.
C) The relative price levels (inflation) in different countries.
D) All of the above.

Question 18

Suppose hypothetically that the inflation rate in Britain was 6%, and the inflation rate in the U.S. was 4%, under the theory of purchase power parity, what should happen to the value of the British pound in U.S. dollars?

A) It should rise by 10%
B) It should rise by 2%
C) It should fall by 10%
D) It should fall by 2%

Question 19

Suppose hypothetically that the interest rate on Euro Deposits was 7% and the interest rate on U.S. Dollar Deposits was 5%, and the value of the dollar relative to the Euro is expected to appreciate by 4% in the future. Which of the following statements is correct?

A) The expected return on Euro Deposits in terms of the U.S. Dollar should be 3%.
B) The expected return on Euro Deposits in terms of U.S. Dollars should be 11%.

Question 20

A fall in the domestic money supply of a country should result in which of the following for the value (FX rate) of the domestic currency, holding other factors constant?

A) A depreciation in the value of the domestic currency in the short run
B) An appreciation in the value of the domestic currency in the short run

Question 21

When a central bank engages in an unsterilized foreign exchange rate intervention to increase the country's FX rate, which of the following statements is (are) true?

A) On the central bank's balance sheet there will be a reduction in foreign assets (i.e. international reserves).
B) On the central bank's balance sheet there will be a reduction in the domestic currency in circulation.
C) The outcome of the sale of foreign assets and the purchase of dollar deposits will reduce the country's monetary base, and result in a tightening effect on the economy.
D) All of the above.

Question 22

With a sterilized foreign exchange intervention, which of the following statements is true?

A) When foreign assets are sold, the central bank also sells an equal amount of government bonds to the non-bank public, resulting in no change in the monetary base.
B) When foreign assets are sold, government bonds will also be purchased by the central bank in an equal amount, resulting in no change in the monetary base.

Question 23

The U.S. is under a managed float (dirty float) FX system, where the U.S. has a floating FX rate, but if the FX rates get too much out of line with its trading partners, the Fed can intervene with a sterilized intervention.

Question 24

Weaknesses of a fixed exchange rate system include which of the following:

A) A loss of control by a country's central bank.
B) The potential for a loss of international reserves if the central bank
Must intervene to keep its currency at the established fixed rate with
Another country's currency.
C) Both a and b

Question 25

A country's balance of payments includes which of the following:

A) The current account which are international transactions involving currently produced goods and services (including the difference between exports and imports) and the capital account which includes the flows of capital into a country (receipts less flows of capital out of a country).
B) Noncurrent Accounts which include all short-term debts owed to other countries that must be paid in a year or less.

Question 26

Which of the following statement(s) are true?

A) To hedge against a rise in the value of a foreign currency, a long futures position is taken to make a gain on the futures contract to offset a spot loss.
B) To hedge against a fall in the value of a foreign currency, a short futures position is taken to make a gain on the futures contract to offset a spot loss.
C) A short futures contract is a contract to sell foreign currency in the future at the futures contract rate.
D) A long futures contract is a contract to purchase foreign currency in the future at the futures contract rate.
E) All of the above.

Question 27

An international bank in the U.S. expects to receive 10 million Euros for a loan repayment in 60 days and wants to hedge against the Euro falling in value by getting a Euro futures contract. Suppose hypothetically the Euro's value at this time in U.S. dollars is $1.27. A futures contract for two months from now has a contract amount is 125,000 Euros per contact and a futures FX rate of $1.20. Two months later, the spot FX rate for the Euro falls to $1.00, and the futures contract FX rate falls to $1.05.
What type of hedge should be taken, and what is the net hedging result?

A) Short Hedge. Net Hedging Loss of $1.2 million
B) Long Hedge. Net Hedging Loss of $1.2 million
C) Short Hedge. Net Hedging Gain of $1.2 million
D) Long Hedge. Net Hedging Gain of $1.2 million

Question 28

Which of the following statement(s) is correct?

A) A gold standard works well since a central bank doesn't have to control the money supply and there won't be any inflation or deflation, and a currency will maintain its value being backed by gold.
B) Under a gold standard, economic problems often arise with little control over the money supply and rises in gold production or circulation increasing the supply of currency in circulation leading to inflation and contractions in gold production or circulation leading to deflation and recession, leading to bank panics, with a scarcity of gold limiting the ability of an economy to grow.

Question 29

Under modern asset theory, if a country has higher interest rates than another country, that country will have a higher demand for its currency, and its FX rate should rise.

Question 30

Under modern asset theory, if a country has lower demand for its goods and services than another country, its FX rate should rise.

Question 31

Advantage of using forward contracts is that a contract can be tailor made for a given amount and delivery date and type of foreign exchange.