Section A [40 marks]
Answer ALL questions.
1. Suppose you start with $100 and buy stock for £50 when the exchange rate is £1 = $2.
One year later, the stock rises to £60. You are happy with your 20 percent return on the
stock, but when you sell the stock and exchange your £60 for dollars, you only get $45
since the pound has fallen to £1 = $0.75. This loss of value is an example of
A) Exchange Rate Risk
B) Political Risk
C) Market imperfections
D) Weakness in the dollar
Answer: A
2. If a country unexpectedly imposes restrictions on imports, this trade barrier is an
example of:
A) Exchange Rate Risk
B) Political Risk
C) Market Imperfections
D) Expanded Opportunity Set
Answer: B
3. A domestic firm that produces and sells its products in one country
A) Is protected from foreign exchange risk.
B) Could face foreign exchange risk.
C) Can face no political risk.
D) Is an example of a market imperfection
Answer: A
4. The fundamental goal of sound business management is
A) Shareholder wealth maximization
B) Market share maximization
C) Globalization
D) Increasing the size of the firm
Answer: A
5. The theory of comparative advantage states that
A) Economic well-being in enhanced if countries produce those goods for which they have
comparative advantage and then trade those goods for goods that they do not enjoy a
comparative advantage in producing.
B) Economic well-being in enhanced if countries consume those goods for which they have
a comparative advantage and then trade for those goods.
C) Tariffs and other protectionist measures can enhance the mercantile success of
countries that adopt them.
D) Countries should first produce the goods and services that they need, and then produce
goods for export.
Answer: A
6. The key arguments in favor of flexible exchange rates rests on
A) Easier external adjustments.
B) National Policy autonomy
C) a) and b) are correct.
D) None of the above.
Answer: C
7. Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to
gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current
market exchange rate is $1.80 per pound, how would you take advantage of this
situation?
A) Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce. Convert the gold to
£200 at £20 per ounce. Exchange the £200 for dollars at the current rate of $1.80 per pound
to get $360.
B) Start with £350. Buy 17.5 ounces of gold at £20 per ounce. Convert the gold to dollars at
$35 per ounce. Exchange the dollars for pounds at the current market exchange rate is
$1.80 per pound.
C) Both of the above are correct
D) None of the above are correct
Answer: A
8. One advantage of monetary union
A) Loss of national monetary and exchange-rate political independence.
B) Transition of asymmetric macro-economic shocks.
C) Reduced transactions costs and the elimination of exchange-rate uncertainty.
D) Enhanced control of interest rates in the member countries.
Answer: C
9. A Fixed Exchange rate regime
A) Forces a country to give up free international flows of capital
B) Can eliminate exchange rate uncertainty.
C) Forces a country to abandon independent monetary policy.
D) Is the model provided by the U.S. Federal Reserve.
Answer: B
10. If the United States imports more than it exports, one can expect:
A) The U.S. dollar would be likely to appreciate against other currencies.
B) The supply of dollars is likely to exceed the demand in the foreign exchange market,
ceteris paribus.
C) The U.S. dollar would be under pressure to depreciate against other currencies.
D) b) and c) are correct.
Answer: D
11. If a country must make a net payment to foreigners because of a balance-of-payments
deficit, the country can:
A) Increase its official reserve assets, such as SDRs.
B) Borrow anew from foreigners.
C) Print more currency.
D) Countries must now buy their currencies back from the World Bank.
Answer: B
12. Many companies have provided managers with executive stock options
A) These are a form of incentive contracts.
B) These can serve as a mechanism of aligning the interests of shareholders and
managers.
C) These options can offer managers an incentive to run the company in such as way that
enhances shareholder wealth as well as their own.
D) All of the above
Answer: D
13. Free cash flow
A) Represents a firm’s internally generated funds in excess of the amount needed to
undertake all profitable investment projects.
B) Tends to be highest in mature industries with low future growth prospects.
C) Represents a temptation to managers.
D) All of the above
Answer: D
14. Suppose a U.S. company continually performs poorly and all of its internal governance
mechanism fail to correct the problem.
A) Over time this situation may prompt an outsider (corporate raider) to mount a takeover
bid.
B) A hostile takeover bid can serve as a drastic governance mechanism of the last resort.
C) The market for corporate control may discipline managers.
D) All of the above
Answer: D
15. Suppose you observe the following exchange rates: €1 = $1.25; £1 = $2.00. What must
the euro-pound exchange rate be?
A) €1 = £1.60
B) €1 = £0.625
C) €2.50 = £1
D) €1 = £2.50
Answer: A
16. Suppose you observe the following exchange rates: €1 = $.85; £1 = $1.60; and €2.00 =
£1.00. Starting with $1,000,000, how can you make money?
A) Exchange $1m for £625,000 at £1 = $1.60. Buy €1,250,000 at €2 = £1.00; trade for
$1,062,500 at €1 = $.85.
B) Start with dollars, exchange for euros at €1 = $.85; exchange for pounds at €2.00 =
£1.00; exchange for dollars at £1 = $1.60.
C) Start with euros; exchange for pounds; exchange for dollars; exchange for euros
Answer: A
17. In the forward market
A) Market participants agree to buy or sell foreign currency in the future at prices agreedupon today.
B) Market participants agree to buy (not sell) foreign currencies in the future at prices
agreed-upon today.
C) Market participants pay today for a specific amount of foreign currency to be received in
the future.
D) Market participants agree to buy and sell fixed amounts of foreign currency at spot
prices that will prevail in the future.
Answer: A
18. Consider a trader who takes a long position in a six-month forward contract on British
pounds. The forward rate is $1.75 = £1.00; the contract size is £62,500. At the maturity
of the contract the spot exchange rate is $1.65 = £1.00
A) The trader has lost $625.
B) The trader has lost $6,250.
C) The trader has made $6,250.
D) The trader has lost $66,287.88
Answer: B
19. An exchange rate quoted in American terms
A) Says how many units of foreign currency you get for one U.S. dollar.
B) Says how many U.S. dollars one unit of foreign currency is worth.
C) Is the same as the indirect quotation.
D) Is the inverse of the direct quotation.
Answer: B
20. The spot and forward foreign exchange market:
A) Is an over-the-counter market.
B) Is open 24 hours a day, 7 days a week, somewhere in the world.
C) Is the largest and most active financial market in the world.
D) All of the above are correct.
E) None of the above are correct.
Answer: D
Section B [60 marks]
Answer ALL questions.
Question 1 [15 marks]
In a floating exchange rate system, if the current account is running a deficit, what are the
consequences for the nation’s balance on capital account and its overall balance of
payments?
Definition of current account deficit & capital account [8 marks]
Explanation of how devaluation can reduce trade deficit in floatingrate system [6 marks]
Explanation of excess savings = capital account deficit [6 marks]
(National output < Domestic expenditure)
Total marks: Max of 15 marks
Question 2 [15 marks]
Suppose that a three-month interest rates (annualized) in Malaysia and the United States
are 7% and 9%, respectively. If the spot rate is RM3.50:$1 and the 90-day forward rate is
RM3.39:$1,
a. Where would you invest? [3 marks]
Invest in Malaysia
b. Where would you borrow? [3 marks]
Invest in US
c. What arbitrage opportunity do these figures present? [4 marks]
1. Borrow USD1,000,000 @ 9% for 90 days (Amount to repay
USD1,022,191-78)
2. Convert USD to RM at spot (RM3,500,000) for investment
3. Invest RM3.5 million at 7% for 90 days (Amount to receive
at the end of 90 days is RM3,560,410-96)
4. Enter into forward contract to sell RM3,560,410-96 at
RM3.39:$1
5. At the end of 90 days, collect RM3,560,410-96, convert to
USD at RM3.39 = USD1,050,268-72, repay USD1,022,191-78
and profit USD28,076-94
d. Assuming no transaction costs, what would be your arbitrage profit per dollar or
dollar-equivalent borrowed? [5 marks]
USD1,050,268-72 less USD1,022,191-78 = USD28,076.97
Question 3 [15 marks]
Suppose that Corporation XYZ must pay a French supplier FF 500 million in 90 days.
a. Explain how Corporation XYZ can use currency options to hedge its exchange risk.
Assuming that each option contract is FF 500,000.
b. Discuss the advantages and disadvantages of using currency futures versus
currency options to hedge the corporation’s exchange risk.
Purchase FF call option to deliver FF 100 million at specified
exercise price
For example, if option premium is $2.00 and exercise price is $0.64,
Corporation XYZ pay $2,000 for 200 call option contracts that gives
the company the right to buy FF500 million at $0.64 at the end of 90
days.
Further explanation of in-the-money, out-of-the-money to generate
profit or loss for Corporation XYZ.
[Max of: 10 marks]
Advantages of futures contract
Small size
Liquidation at any time
Disadvantages of futures contract
Limited currencies
Limited delivery dates
Limit to contractual amount
Options
Protection / Insurance
Speculation
[Max of: 7 marks]
Total marks max of 15 marks
Question 4 [15 marks]
Suppose the short-term interest rate in France was 3.5% while the forecast French inflation
was 2.0% while the short-term German interest rate was 2.6% and the forecast German
inflation was 1.6%.
a. Based on these figures, what were the real interest rates in France and Germany?
b. How would you explain the differences in real rates between France and Germany?
1+r = (1+a)(1+I)
r = nominal rate of interest
a = real rate of interest
I = expected inflation rate
Real rate for France
(1+0.035) / (1+0.02) = 1+a
a = 1.47% [3 marks]
Real rate for Germany
(1+0.026) / (1+0.016) = 1+a
a = 0.98% [3 marks]
[Total marks: 6]
Differences in real rates:
1. Currency risk
2. Inflation risk
3. Nominal or actual exchange rate adjusted for changes in
relative purchasing power
3 marks each [1 mark for identifying, 2 marks for explanation]
[Total max of 15 marks]