Question 1

The market for foreign exchange is primarily&#10;A) Based on organized exchanges&#10;B) Over-the-counter based&#10;C) Electronic communications network (ECN) based&#10;D) Futures based

Accepted Answer

The foreign exchange market is primarily over-the-counter based, meaning that trades are conducted directly between two parties without the use of a centralized exchange.

Question 2

A country with an undervalued currency will experience&#10;A) Price increases that exceed those in its trading partners&#10;B) Fairly stable prices if it succeeds in sterilizing foreign exchange operations&#10;C) Falling prices&#10;D) Both a and b

Accepted Answer

Both a and b&#10;

Question 3

The law of one price&#10;A) Is an international legal principle&#10;B) Is achieved through arbitrage when the price of a good differs across nations (allowing for exchange rates)&#10;C) Holds more in the short run than in the long run&#10;D) All of the above

Accepted Answer

The law of one price states that in the presence of a competitive market structure and the absence of transportation costs and barriers to trade, identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. This is achieved through the process of arbitrage, where traders would buy the good in the market where it is cheaper and sell it in the market where it is more expensive, thus equalizing prices across locations. This principle does not pertain to an international legal principle, nor does it hold more in the short run than in the long run; instead, it is a theoretical economic principle explaining how prices are determined in global markets.

Question 4

A currency swap&#10;A) Involves a spot transaction&#10;B) Involves a forward transaction&#10;C) Involves a letter of credit&#10;D) Both a and b

Accepted Answer

Currency swaps involve both spot and forward transactions, where two parties exchange principal and interest in different currencies at the spot rate and agree to reverse the transaction at a future date using a forward rate. Letters of credit are not a component of currency swaps.

Question 5

Purchasing power parity (PPP)&#10;A) Is similar to the law of one price&#10;B) States that the prices of baskets of goods (price levels) will tend to be the same across borders in the long run, allowing for exchange rates&#10;C) Requires that, under fixed exchange rates, price levels adjust in the different markets to achieve comparability across borders (allowing for exchange rates)&#10;D) All of the above

Accepted Answer

Purchasing power parity (PPP) is similar to the law of one price in that it suggests prices for the same goods should equalize across borders when accounting for exchange rates. It states that the prices of baskets of goods will tend to be the same across borders in the long run, allowing for exchange rates. While PPP is more commonly associated with floating exchange rates, the concept can apply broadly to understanding how price levels should adjust across different markets to achieve comparability, hence all the given statements are correct interpretations or implications of PPP.

Question 6

If interest rates decline in a recession, the extent of the weakening of the economy will be limited (cushioned) by&#10;A) The effect of the lower interest rates on its exchange rate, if its currency floats&#10;B) The effect of the lower interest rates on the foreign exchange market, if its currency is fixed&#10;C) What happens in the foreign exchange market is of no consequence for the economy&#10;D) Both a and b

Accepted Answer

Lower interest rates can lead to a depreciation of a floating currency, making exports cheaper and potentially boosting economic activity.

Question 7

Under covered interest arbitrage&#10;A) The currency of the country with the higher short-term interest rates will experience an appreciation in the period ahead&#10;B) The currency of the country with higher short-term interest rates will experience a depreciation in the period ahead&#10;C) The cost of carry will discourage transactions in foreign exchange&#10;D) Interest rates have nothing to do with exchange rate movements

Accepted Answer

Covered interest arbitrage involves investing in foreign currency that has a higher interest rate, while simultaneously hedging against exchange rate risk. This process tends to equalize the interest rate differentials between countries, leading to the expectation that the currency of the country with higher short-term interest rates will depreciate in the future. This depreciation offsets the higher interest earnings, ensuring no arbitrage profit is made due to interest rate differentials alone.

Question 8

Higher interest rates will&#10;A) Result in currency appreciation under a floating exchange rate&#10;B) Result in currency depreciation under a floating exchange rate&#10;C) Have no affect on the exchange rate&#10;D) None of the above

Accepted Answer

Higher interest rates attract foreign capital due to the higher returns, leading to an appreciation of the currency under a floating exchange rate system.

Question 9

An increase in the real exchange rate of a country&#10;A) Will result in an appreciation of its nominal exchange rate under a floating exchange rate&#10;B) Will result in higher domestic prices in relation to foreign prices under a fixed exchange rate&#10;C) Will result in lower domestic prices under a fixed exchange rate&#10;D) Both a and b

Accepted Answer

An increase in the real exchange rate of a country indicates that its currency has appreciated in value relative to foreign currencies. Under a floating exchange rate system, this appreciation is reflected in the nominal exchange rate (A). Additionally, under a fixed exchange rate system, an increase in the real exchange rate can lead to higher domestic prices in relation to foreign prices, as the fixed nominal rate does not adjust to reflect the change in real value (B).

Question 10

For a country with a fixed exchange rate that engages in sterilized intervention&#10;A) It short-circuits the normal adjustment process&#10;B) Its central bank must sell assets, such as sovereign debt, from its portfolio if its currency is undervalued&#10;C) Its central bank must buy assets, such as sovereign debt, for its portfolio if its currency is overvalued&#10;D) All of the above

Accepted Answer

Sterilized intervention involves a central bank buying or selling foreign currency in exchange for its own currency to influence the exchange rate, while simultaneously engaging in offsetting transactions in the domestic bond market to neutralize the impact on the domestic money supply. This process can indeed short-circuit the normal adjustment mechanisms in the foreign exchange market (A), requires the central bank to sell assets if its currency is undervalued to support its value (B), and to buy assets if its currency is overvalued to decrease its value (C).

Question 11

Countries with overvalued currencies are prone to&#10;A) Inflationary pressures&#10;B) To buy foreign currencies with newly created local currency&#10;C) Engage in exchange controls&#10;D) All of the above

Accepted Answer

The answer of Countries with overvalued currencies are prone to&#10;A)...

Question 12

With both a currency board and dollarization&#10;A) The country's central bank can pursue a monetary policy based on domestic objectives, such as high employment&#10;B) The country can use adjustments to its exchange rate to achieve policy goals&#10;C) The country is dependent on the monetary policy of another economy&#10;D) None of the above

Accepted Answer

The answer of With both a currency board and dollarization&#10;A)...

Deck 16: The Foreign Exchange Market and Exchange Rate Regimes