International Economics, 7e (Husted/Melvin)
Chapter 13 The Foreign Exchange Market
Multiple-Choice Questions
1) The most common type of transaction in the foreign exchange market is a
A) forward transaction.
B) spot transaction.
C) swap transaction.
D) None of the above.
Answer: C
2) If the bank is selling euros for $0.89, then what is the implied euro price of the dollar?
A) 2.0
B) 1.999
C) 2.323
D) 1.123
Answer: D
3) The difference between bid (buying) rates and ask (selling) rates is called the
A) profit.
B) arbitrage.
C) spread.
D) forward transaction.
Answer: C
4) Riskless transactions to take advantage of profit opportunities due to a price differential or a
yield differential in excess of transaction costs are called
A) differential actions.
B) cash transactions.
C) arbitrage.
D) forward transactions.
Answer: C
5) Suppose in London £/$ = 0.5 while in New York £/SF = 0.2. The corresponding cross rate
(SF/$) is
A) 2.5.
B) 0.1.
C) 0.4.
D) 0.3.
Answer: A
6) The essential feature of a ________ is that it immediately fixes the rate at which a specified
amount of one currency is to be delivered in exchange for a specific amount of another at a
future date.
A) forward contract
B) spot contract
C) money contract
D) bid contract
Answer: A
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7) The euro is said to be selling at a ________ if the spot dollar price is $1.18 and the ninemonth forward rate is $1.16.
A) forward discount
B) forward premium
C) forward spread
D) none of the above
Answer: A
8) In the case where the spot and forward rates are equal, the currency is said to be selling.
A) profitably.
B) flat.
C) normal.
D) risky.
Answer: B
9) A ________ is a transaction in which both a spot transaction and a forward transaction are
agreed upon simultaneously.
A) arbitrage
B) call
C) swap
D) put
Answer: C
10) The ________ rate represents the difference between the spot and forward price.
A) profit
B) swap
C) spread
D) risk
Answer: B
11) The exchange rate is kept the same across geographically-separate markets by
A) hedging.
B) speculation.
C) government regulation.
D) arbitrage.
Answer: D
12) The reduction or covering of a foreign exchange risk is called
A) hedging.
B) speculation.
C) intervention.
D) arbitrage.
Answer: A
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13) In the ________ markets all profits and losses must be settled on a daily basis.
A) futures
B) forward
C) spot
D) swap
Answer: A
14) An important feature of a ________ is that the holder has the right, but not the obligation, to
buy or sell currency.
A) swap
B) foreign exchange arbitrage
C) foreign exchange option
D) futures market contract
Answer: C
15) A gain can be made by the holder of a call option when the current exchange rate
A) exceeds the exercise price.
B) exceeds the forward price.
C) is less than the futures price.
D) falls to zero.
Answer: A
16) Central banks intervene in the foreign exchange market
A) to smooth out currency fluctuations.
B) to facilitate the transfer of goods and services internationally.
C) to conduct foreign exchange operations for central governments.
D) All of the above.
Answer: D
17) Suppose that in the free market, where the supply of the foreign currency is equal to
demand for that currency, the peso-dollar exchange rate is 4 pesos = $1. Assume the central
bank sets an official exchange rate at 3 pesos = $1, we can say that in the official market the
dollar is
A) overvalued.
B) undervalued.
C) appreciated.
D) None of the above.
Answer: B
18) A European option differs from an American option in that it may be exercised
A) only on the spot date.
B) only on the expiration date.
C) only on the future date.
D) on any date.
Answer: B
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19) An increase in the exchange rate from $2.00 = 1 to $2.20 = 1
A) 10% depreciation of the euro with respect to the dollar.
B) 10% depreciation of the dollar with respect to the euro.
C) 10% appreciation of the dollar with respect to the euro.
D) None of the above.
Answer: B
is a
20) If a foreign exchange speculator expects the spot rate of the dollar nine months from today to
be lower than today's forward rate on the dollar for delivery in nine months, he will
A) buy dollars in the spot market nine months from today.
B) sell dollars in the spot market nine months from today.
C) sell dollars forward today and buy them in the spot market nine months from today.
D) buy dollars forward today and resell them in the spot market nine months from today.
Answer: C
21) In swap transactions, the trader is interested in
A) the difference between spot and forward rates.
B) only the spot rate.
C) only the forward rate.
D) both the spot and deposit interest rate.
Answer: A
22) In general, the lower the exercise price relative to the current spot rate, the more valuable
A) the put option.
B) the call option.
C) the arbitrage operation.
D) the triangular arbitrage.
Answer: B
23) The most common tool of analysis in international finance for measuring the average value
of a currency relative to several other currencies is
A) bilateral exchange rates.
B) cross exchange rates.
C) exchange rate indexes.
D) All of above.
Answer: C
24) Which of the following is not true regarding "exchange rate indexes?"
A) They will all show the same general trends (i.e., appreciation or depreciation).
B) Neither economic theory nor practice gives a clear indication of which exchange rate is
best.
C) For short-term movements, there can be large differences across exchange rate indexes.
D) Exchange rate indexes are used to measure the average value of a currency relative to
several other currencies.
Answer: C
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25) The size of the spread that a dealer will quote for a foreign exchange transaction will vary
depending on
A) the degree of market volatility at the time.
B) the degree of risk associated with a particular currency.
C) the size of the market for the currency being traded.
D) All of above.
Answer: D
True or False Questions
1) Today's forward rate will equal the future spot rate.
Answer:
False
Explanation: None Given
2) Exchange rates (for instance, the dollar price of yen) tend to be different worldwide at any
point in time because of different tastes for currencies in each country.
Answer:
False
Explanation: because exchange arbitrage makes them equal, excluding transaction costs.
3) Speculation is the opposite of hedging.
Answer:
True
Explanation: While a speculator accepts a foreign exchange risk in the hope of making a profit,
a hedger tries to avoid a foreign exchange risk through hedging.
4) There is no limit for domestic central bank intervention.
Answer:
False
Explanation: They can run out of reserves.
5) In the Brokers market, a broker reveals the names of the banks making bids or offers to the
trading banks before the trade has been agreed upon.
Answer:
False
Explanation: He reveals the names after agreement.
6) An investor can write any size contract in both forward and futures markets as long as the
other party involved is in agreement.
Answer:
False
Explanation: This is true only for forward market, but not for futures.
7) The European option can only be exercised on the final day, the expiration date.
Answer:
True
Explanation: None Given
8) Both a parallel market and a black market are free markets permitted to coexist with the
official market.
Answer:
False
Explanation: Black market is an illegal market, but parallel market is permitted.
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9) In the case of an appreciating domestic currency, central banks often sell foreign currencies
in exchange for domestic currency to stop the appreciation.
Answer:
False
Explanation: They buy foreign currencies.
10) Foreign exchange activity is dominated by the spot and swaps markets.
Answer:
True
Explanation: None Given
Essay Questions
1) Why is it true that exchange rates tend to be equal worldwide? Briefly explain.
Answer: Explain that arbitrage would result in equal exchange rates, and end when
transactions costs are equal to the difference in exchange rates.
2) Suppose in Zurich £/$ = 0.5, while in New York SF/$=2.5, but in London £/SF = 0.1.
(a) Is there any arbitrage profit that could be made with a triangular arbitrage action?
Describe an example of how such a profit may be earned.
(b) What would you guess about the relationship between the dollar rates and crossrates after arbitrageurs notice this profit opportunity?
Answer: (a) Buy SF 1 million in London for £190,000
Use it to buy $ in New York, so that SF 1m = $400,000.
Buy pounds in Zurich so that $400,000 = £200,000
200,000 - 190,000 = £10,000 profit
(b) We expect the gap between rates to close as arbitrageurs buy pounds in Zurich
and sell in London through the New York market, i.e., the relationship between rates
is restored where cross-rates yield no potential profit.
3) Explain the similarities and differences between the forward and futures markets.
Answer: Similarities
Differences
Delivery at a future date.
In the forward market, a gain or loss
is realized on the maturity date,
while in the futures markets on a
daily basis as positions are marked
to market.
Gains and losses as a result of
currency fluctuations.
Total gain or loss depends on the
difference between the future price
In the futures market few currencies
(or forward price) and spot
exchange rate on the maturity of the are traded and trading occurs
through organized exchanges or
contract.
clearing houses, such as IMM.
Hedging facility and speculative
opportunity.
Forward contracts are written for
any amount, futures for fixed
amount.
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4) Briefly answer the following questions.
(a) What is a foreign currency option? Is there any difference between a European and
American option?
(b) Why might you prefer an option over a futures or forward contract?
(c) When can a gain be made by the holder of a call option? A put option?
Answer: (a) The right to buy or sell a designated quantity of a foreign currency at a specified
price is called an option. If the option can be used before the expiration date, it is an
American option; if only on the expiration date, it is a European option.
(b) Because there is no obligation to buy or sell at a set exchange rate in the case of an
option, while there is in futures or forward.
(c) A gain can be made by the holder of a call option any time the exchange rate
exceeds the exercise price. Similarly, the holder of a put option will gain if the option
is exercised at any rate below the striking price.
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