Question 1

A speculator who expects a foreign currency to appreciate could purchase the currency forward and, when received, sell it in the spot market.

Accepted Answer

By purchasing the currency forward, the speculator is locking in the current exchange rate and eliminating the risk of currency fluctuations. If the currency does appreciate as expected, the speculator can sell it in the spot market at a higher price, realizing a profit.

Question 2

When countries experience substantial net outflows of funds, they commonly use indirect intervention by raising interest rates to discourage excessive outflows of funds and therefore limit any downward pressure on the value of their currency.

Accepted Answer

This statement is true. Countries often use indirect intervention, such as raising interest rates, to limit net outflows of funds and prevent their currency from depreciating due to excessive demand for foreign currency.

Question 3

The forward rate is the exchange rate for immediate delivery.

Accepted Answer

The forward rate is the exchange rate for delivery on a future date, not immediate delivery.

Question 4

Purchasing power parity suggests that the forward rate premium (or discount) should be about equal to the differential in interest rates between the countries of concern.

Accepted Answer

The answer of Purchasing power parity suggests that the forward...

Question 5

The following information refers to Fresno Bank and Champaign Bank.
  Based on this information, locational arbitrage would be profitable.

Accepted Answer

Locational arbitrage refers to the process of taking advantage of price differences between two or more markets by buying low in one market and selling high in another market. Based on the information provided in the data, Fresno Bank is quoting a bid price of 0.7894 for the euro, while Champaign Bank is quoting an ask price of 0.7900 for the same currency. This represents a price difference of 0.0006, which could be exploited through locational arbitrage. By buying euros from Fresno Bank and selling them to Champaign Bank, a trader could make a profit of 0.0006 per euro.

Question 6

The primary advantage of currency options over forward and futures contracts is that they provide a right rather than an obligation to purchase or sell a particular currency at a specified price within a given period.

Accepted Answer

Currency options provide the holder with the right, but not the obligation, to buy or sell a currency at a specified price and time. Forward and futures contracts, on the other hand, create an obligation to buy or sell at a future date and at a specified price.

Question 7

The euro is presently pegged to the British pound in order to stabilize international payments between European countries.

Accepted Answer

The euro is not pegged to the British pound. In fact, the euro is a separate currency used by European Union countries, while the British pound is used by the United Kingdom. The euro's exchange rate is determined by the market forces of supply and demand.

Question 8

Exchange rates usually change precisely as suggested by the purchasing power parity (PPP) theory.

Accepted Answer

Exchange rates do not always change precisely as suggested by the PPP theory. There are numerous factors that can impact exchange rate movements, such as interest rates, political stability, and supply and demand for currencies. While PPP can offer an estimate of where exchange rates should be in the long run, it is not a perfect predictor of short-term fluctuations.

Question 9

If British interest rates suddenly increase substantially relative to U.S. interest rates, the demand by U.S. investors for British pounds ____, the supply of British pounds to be sold in exchange for dollars ____, and the British pound will ____.

Accepted Answer

When British interest rates increase relative to U.S. rates, U.S. investors are more likely to invest in Britain to take advantage of higher returns, increasing demand for pounds. The supply of pounds decreases as fewer pounds are sold in exchange for dollars, leading to the appreciation of the pound.

Question 10

Financial institutions rarely use the forward market.

Accepted Answer

Financial institutions often use the forward market to manage and hedge their currency and interest rate risks. Forward contracts allow them to lock in a future exchange rate or interest rate, which can help them avoid losses or take advantage of favorable market conditions.

Question 11

Central bank intervention can be overwhelmed by market forces and may not always succeed in reversing exchange rate movements.

Accepted Answer

Central bank intervention can only influence exchange rates temporarily as market forces can be stronger and can ultimately dictate the direction of the exchange rate. Therefore, central bank intervention may not always succeed in reversing exchange rate movements.

Question 12

Assume the following information. 
$\bullet$Interest rate on borrowed euros is 5 percent annualized.
$\bullet$Interest rate on dollars loaned out is 6 percent annualized.
$\bullet$Spot rate is 1.10 euros per dollar (one euro = $0.909).
$\bullet$Expected spot rate in five days is 1.15 euros per dollar.
$\bullet$Fabrizio Bank can borrow 10 million euros.
If Fabrizio Bank attempts to capitalize on the above information, its profit over the five-day period is

Accepted Answer

1. Use the borrowed 10 million euros to buy dollars at the spot rate: 
10,000,000 euros x 1.10 = $11,000,000

2. Loan out the $11,000,000 at 6% annualized rate: 
Interest earned in 5 days = $11,000,000 x 6% x (5/365) = $301,369.86

3. Convert the dollars back to euros at the expected spot rate in 5 days: 
$11,000,000 x 1/1.15 = 9,565,217.39 euros

4. Repay the borrowed euros with interest: 
10,000,000 euros x 5% x (5/365) = 68,493.15 euros

5. Calculate profit: 
9,565,217.39 - 10,000,000 - 68,493.15 = $496,724.86 = 455,266.81 euros (using the spot rate of 1.10)

Therefore, the best answer is B, as it represents the profit earned by Fabrizio Bank over the five-day period.

Question 13

A country that pegs its exchange rate to another exchange rate does not have complete control over its interest rates.

Accepted Answer

When a country pegs its exchange rate to another currency, it must adjust its interest rates to match those of the country to which it has pegged. This limits the country's ability to set interest rates independently to achieve its economic goals.

Question 14

The indirect exchange rate specifies the value of the currency in U.S. dollars.

Accepted Answer

The indirect exchange rate specifies the amount of foreign currency needed to buy one unit of the domestic currency, not the value of the currency in U.S. dollars.

Question 15

If the quoted cross rate between two foreign currencies is not aligned with the two corresponding exchange rates, investors can profit from triangular arbitrage.

Accepted Answer

Triangular arbitrage involves exploiting inconsistencies in the cross exchange rates between three currencies, which can lead to profitable trades. Therefore, if the quoted cross rate between two foreign currencies is not consistent with the two corresponding exchange rates, investors can potentially profit from triangular arbitrage.

Question 16

The forward rate premium reflects the percentage by which the spot rate exceeds the forward rate on an annualized basis.

Accepted Answer

The forward rate premium reflects the percentage by which the forward rate exceeds the spot rate on an annualized basis.

Question 17

The potential benefits from using foreign exchange derivatives are independent of the expected exchange rate movements.

Accepted Answer

The potential benefits from using foreign exchange derivatives, such as hedging against currency risk, are highly dependent on the expected exchange rate movements. These financial instruments are used to lock in exchange rates or speculate on future changes, making their benefits closely tied to how the exchange rates are anticipated to move.

Question 18

The Smithsonian Agreement allowed for a devaluation of the dollar and for a widening of the boundaries within which currencies were allowed to fluctuate.

Accepted Answer

The Smithsonian Agreement, signed in 1971, allowed for a devaluation of the dollar and for an increase in the range (from 1% to 2.25%) within which currencies were allowed to fluctuate.

Question 19

The forward rate premium is dictated by the national income differential of the two currencies.

Accepted Answer

The forward rate premium is primarily determined by interest rate differentials between the two currencies, not national income differentials. Other factors that can impact the forward rate premium include political stability, inflation expectations, and overall market sentiment.

Question 20

A country that pegs its currency does not have complete control over its local interest rates, as its interest rates must be aligned with the interest rates of the currency to which it is tied.

Accepted Answer

When a country pegs its currency, it fixes the exchange rate of its currency to another currency, typically the US dollar. This means that the pegged currency's interest rates must be in line with the interest rates of the peg currency. Therefore, the country loses some flexibility in setting its own local interest rates.

Quiz 16: Foreign Exchange Derivative Markets