Question 1

What is the empirical evidence on the holding of the covered and uncovered interest rate parity? How is the evidence different after the relaxation of capital controls in the early 1980s?

Accepted Answer

The answer of What is the empirical evidence on the...

Question 2

Speculating in a position exposed to exchange-rate risk is the act of reducing or eliminating a net asset or net liability position in the foreign currency.

Accepted Answer

Speculating in a position exposed to exchange-rate risk typically involves taking on risk to potentially earn profits from currency fluctuations, rather than reducing or eliminating a net asset or liability position.

Question 3

Hedging a position exposed to exchange-rate risk is the act of reducing or eliminating a net asset or net liability position in the foreign currency.

Accepted Answer

This is a correct definition of hedging currency risk.

Question 4

The profits and losses on a futures contract accrue to you daily, as the contract is "marked to market" daily.

Accepted Answer

This is true. Each day, the gains or losses on the futures contract are calculated and accrued to the buyer or seller's account. This is known as "marking to market."

Question 5

If the interest rate of a foreign country is less than that of the domestic country, then the foreign country will have a positive forward premium on its currency.

Accepted Answer

This is because a lower interest rate in the foreign country means that the currency is relatively more valuable in the future, resulting in a positive forward premium.

Question 6

Assume that the three-month forward exchange rate is $2.00/£ and a speculator believes that the spot rate in three months will be $2.05/£. How can this person speculate in the forward market? Also assume that the speculator is willing to take a position of about $20 million or £10 million. How much will the speculator earn if he or she is correct?

Accepted Answer

The answer of Assume that the three-month forward exchange rate...

Question 7

The current spot exchange rate is $1.14/euro. The current 90-day forward exchange rate is $1.11/euro. How could a U.S firm, who must repay a 40 million euro loan in 90 days, use a forward exchange contract to hedge its risk exposure?

Accepted Answer

The answer of The current spot exchange rate is $1.14/euro....

Question 8

Covered interest parity is rarely found to hold empirically.

Accepted Answer

Covered interest parity (CIP) is often found to hold empirically, especially in highly liquid and efficient financial markets, as it represents a fundamental principle ensuring that arbitrage opportunities involving the risk-free borrowing and lending of currencies are eliminated.

Question 9

If Canada has a current 90 day forward exchange rate value for its currency that is above the current spot exchange rate value of its currency, then the Canadian 90-day interest rate is relatively high.

Accepted Answer

A forward exchange rate above the spot rate typically indicates that the domestic currency (in this case, the Canadian dollar) is expected to depreciate. This is often associated with lower, not higher, domestic interest rates compared to foreign interest rates, according to the interest rate parity theory.

Question 10

If a currency is at a forward premium by as much as its interest rate is lower than the interest rate in the other country, covered interest parity holds.

Accepted Answer

Covered interest parity states that the forward exchange rate should equal the spot exchange rate adjusted for the interest rate differential between two countries. If a currency is at a forward premium by as much as its interest rate is lower than the interest rate in the other country, this means that the forward rate is higher than it would be if only the interest rate differential was considered. This reflects the market's expectation of future currency appreciation. As a result, covered interest parity still holds in this case.

Question 11

An unhedged international investment has a speculative element to it, and it is called a covered international investment.

Accepted Answer

An unhedged international investment is one that is not protected against fluctuations in currency exchange rates, making it more speculative in nature. A covered international investment, on the other hand, is one that is protected against such fluctuations through hedging strategies, making it less speculative.

Question 12

A bank deposit in Germany denominated in euros is a Eurocurrency deposit.

Accepted Answer

A Eurocurrency deposit refers to deposits made in a currency that is not the official currency of the country where the bank is located. Since euros are the official currency of Germany, a deposit in euros in a German bank is not considered a Eurocurrency deposit.

Question 13

Uncovered interest arbitrage is buying a country's currency spot and selling that country's currency forward, to make a net profit from the combination of the difference in interest rates between countries and the forward premium on the country's currency.

Accepted Answer

Uncovered interest arbitrage involves investing in a foreign currency with a higher interest rate without hedging the exchange rate risk with a forward contract, aiming to profit from the interest rate differential alone, not from a combination of interest rate differentials and forward premiums.

Question 14

Consider the case of a U.S. investor holding dollars and deciding whether to invest in Japanese treasury bills or in U.S. treasury bills. Assume that the investor wants to end up holding dollars. What are the three methods available to this investor to turn present dollars into future dollars? In your answer present an equation that shows the return per dollar invested under each method. Which of these methods is the riskiest and why?

Accepted Answer

The answer of Consider the case of a U.S. investor...

Question 15

Suppose that the dollar-yen spot exchange rate is $0.05/¥ and the 90-day forward exchange rate is $0.06/¥. Assuming that covered interest parity holds, are Japanese interest rates higher or lower than U.S. interest rates? Explain why.

Accepted Answer

The answer of Suppose that the dollar-yen spot exchange rate...

Question 16

Empirical studies suggest that, during normal times in the past two decades, covered interest rate parity applies almost perfectly to Eurocurrency markets for major currencies.

Accepted Answer

Empirical studies have found that covered interest rate parity applies almost perfectly to Eurocurrency markets for major currencies during normal times in the past two decades.

Question 17

When would a currency speculator buy a put option and when would it be worth exercising the option? What are some advantages and disadvantages of currency options compared to forward exchange contracts?

Accepted Answer

The answer of When would a currency speculator buy a...

Question 18

Suppose that the U.S. dollar-pound sterling spot exchange rate equals $1.60/£, while the 360-day forward rate is $1.64/£. The yield on a one-year U.S. treasury bill is 9% and that on a one-year U.K. treasury bill is 8%. Calculate the covered interest differential in favor of London. On the basis of this result, which country would you expect to face capital inflows and which to face capital outflows?

Accepted Answer

The answer of Suppose that the U.S. dollar-pound sterling spot...

Question 19

In a currency swap two parties agree to exchange flows of different bonds during a specified time period.

Accepted Answer

In a currency swap, two parties agree to exchange principal and interest payments in different currencies, not flows of different bonds.

Question 20

Forward exchange contracts are used for hedging but not for speculating.

Accepted Answer

Forward exchange contracts can be used for both hedging against currency risk and speculating on future currency movements.

Quiz 18: Forward Exchange and International Financial Investment