Question 1

What are the major differences between the interbank foreign exchange market and the foreign currency exchanges?

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Question 2

What are the major purposes of the foreign exchange markets?

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Question 3

You can buy or sell the yen spot at ¥102 to the dollar. You can buy or sell the yen one-year forward at ¥104 to the dollar. If U.S. annual interest rates are 4%, what must be the approximate one-year Japanese interest rate if interest rate parity holds?

Accepted Answer

Interest rate parity implies that the difference in interest rates between two countries should equal the difference between the forward and spot exchange rates. Using the formula for interest rate parity, the Japanese interest rate is approximately 5.92%.

Question 4

Why does the size of the U.S. current account deficit put pressure on the value of the dollar to decline? How does the size of the capital account affect that pressure? Explain.

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Question 5

A U.S. FI has U.S. $200 million worth of one-year loans earning an average rate of return of 6%. The FI also has one-year single payment Canadian dollar loans of C$110 million earning 8%. The FI's funding source is $300 million in U.S.$ one-year CDs, on which they are paying 4%. Initially the exchange rate is C$1.10 per $1 U.S. The one-year forward rate is C$1.14 per $1 U.S. What is the bank's dollar % spread if they hedge fully using forwards?

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Question 6

A U.S. bank has made £50 million in Britain and has £40 in deposits. The bank's currency trading desk has also contracted to buy £20 million and has short positions of £15 million. What is the bank's net exposure? How could they use forward contracts to hedge the exposure? If the bank has exposures in euros and yen, would you recommend they use the forward hedge? Why or why not?

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Question 7

A U.S. bank has £120 million in loans to corporate customers and has £70 million in deposits it owes to customers with the same maturity. The bank has also sold £20 million pounds forward. The bank's net exposure is

Accepted Answer

The bank's net exposure is calculated by subtracting the deposits it owes (£70 million) and the forward sale (£20 million) from the loans it has given out (£120 million), resulting in a net exposure of £30 million.

Question 8

The concept underlying purchasing power parity is the

Accepted Answer

Purchasing power parity (PPP) is based on the law of one price, which states that identical goods in different countries should have the same price when expressed in a common currency. PPP suggests that exchange rates should adjust to equalize the prices of identical goods and services in different countries. The Fisher effect relates to the relationship between inflation and nominal interest rates, the Bretton Woods Agreement was a fixed exchange rate system that operated from 1944 to 1971, the Big Mac Index is a way of measuring currency valuations based on the price of a Big Mac burger in different countries, and the balance of payments concept refers to the record of all international transactions undertaken by a country in a particular time period. None of these concepts directly relate to the idea behind purchasing power parity.

Question 9

The ________________ measures the net flows of imports and exports of goods, services, income payments, and unilateral transfers.

Accepted Answer

The current account measures the net flows of imports and exports of goods, services, income payments, and unilateral transfers. The other options do not include all of these components or are not relevant to measuring these flows.

Question 10

Is it reasonable to expect real rates of interest to be identical across countries? Explain. What does this imply about parity?

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Question 11

A bank has committed to deliver yen in 6 months to a corporate customer. The spot rate is 110 yen to the dollar and the 6-month forward rate is 105 yen per dollar. Are there costs to hedging this exposure with the forward market? Explain.

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Question 12

You can buy or sell the £ spot at $1.98 to the pound. You can buy or sell the pound one-year forward at $2.01 to the pound. If U.S. annual interest rates are 5%, what must be the approximate one-year British interest rate if interest rate parity holds?

Accepted Answer

Using interest rate parity, we can solve for the approximate one-year British interest rate as:

1 + iGBP = (1 + iUSD) x (F/S)

where iGBP is the unknown British interest rate, iUSD is the U.S. annual interest rate (5%), F is the one-year forward exchange rate ($2.01/£), and S is the current spot exchange rate ($1.98/£).

Plugging in the values, we get:

1 + iGBP = (1 + 0.05) x (2.01/1.98)
1 + iGBP = 1.050505

Solving for iGBP, we get:

iGBP = 0.050505 = 5.05%

Therefore, the approximate one-year British interest rate is 5.05%. None of the answer choices match exactly, but the closest one is D, 3.48%.

Question 13

A British bank has borrowed dollars in the United States, but is now concerned about its currency risk. What alternatives does it have to limit its risk? Be specific.

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Question 14

An FI's position in FX markets generally reflects four trading activities. What are they, and which cause the FI to bear FX risk?

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Question 15

Explain how a drop in the value of the dollar could affect the U.S. import and export sectors.

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Quiz 9: Foreign Exchange Markets