How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50
British pounds if the exchange rate is 1.25 dollars per one British pound?
A.
50 dollars
B.
60 dollars
C.
70 dollars
D.
62.5 dollars
E.
40 British pounds
Answer: D
2.
How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50
British pounds if the exchange rate is 1.50 dollars per one British pound?
A.
50 dollars
B.
60 dollars
C.
70 dollars
D.
80 dollars
E.
75 dollars
Answer: E
3.
How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50
British pounds if the exchange rate is 1.80 dollars per one British pound?
A. 40 dollars
B. 90 dollars
C. 50 dollars
D. 100 dollars
E. 95 dollars
Answer: B
4.
164
5.
How many British pounds would it cost to buy a pair of American designer jeans
costing $45 if the exchange rate is 1.50 dollars per British pound?
A.
10 British pounds
B.
20 British pounds
C.
30 British pounds
D.
35 British pounds
E.
25 British pounds
Answer: C
6.
How many British pounds would it cost to buy a pair of American designer jeans
costing $45 if the exchange rate is 1.80 dollars per British pound?
A.
10 British pounds
B.
25 British pounds
C.
20 British pounds
D.
30 British pounds
E.
40 British pounds
Answer: B
7.
How many British pounds would it cost to buy a pair of American designer jeans
costing $45 if the exchange rate is 2.00 dollars per British pound?
A.
22.5 British pounds
B.
32.5 British pounds
C.
12.5 British pounds
D.
40 British pounds
E.
30 British pounds
Answer: A
8.
How many British pounds would it cost to buy a pair of American designer jeans
costing $45 if the exchange rate is 1.60 dollars per British pound?
A.
38.125 British pounds
B.
28.125 British pounds
C.
48.125 British pounds
D.
58.125 British pounds
E.
18.125 British pounds
Answer: B
165
9.
What is the exchange rate between the dollar and the British pound if a pair of
American jeans costs 50 dollars in New York and 100 pounds in London?
A.
1.5 dollars per British pound
B.
0.5 dollars per British pound
C.
2.5 dollars per British pound
D.
3.5 dollars per British pound
E.
2 dollars per British pound
Answer: B
10.
What is the exchange rate between the dollar and the British pound if a pair of
American jeans costs 60 dollars in New York and 30 pounds in London?
A. 1.5 dollars per British pound
B. 0.5 dollars per British pound
C. 2.5 dollars per British pound
D. 3.5 dollars per British pound
E. 2 dollars per British pound
Answer: E
11.
12.
166
13.
14.
By early 2002,
A.
A Canadian dollar was worth only about 15 United States cents.
B.
A Canadian dollar was worth only about 20 United States cents.
C.
A Canadian dollar was worth only about 65 United States cents.
D.
A Canadian dollar was worth only about 100 United States cents.
E.
A Canadian dollar was worth only about 5 United States cents.
Answer: C
15.
16.
In 2001,
A.
20 percent of foreign exchange transactions involved exchanges of foreign
currencies for U.S. dollars.
B.
10 percent of foreign exchange transactions involved exchanges of foreign
currencies for U.S. dollars.
C.
30 percent of foreign exchange transactions involved exchanges of foreign
currencies for U.S. dollars.
D.
40 percent of foreign exchange transactions involved exchanges of foreign
currencies for U.S. dollars.
E.
90 percent of foreign exchange transactions involved exchanges of foreign
currencies for U.S. dollars.
Answer: E
167
17.
Which one of the following statements is the most accurate? The term spot exchange
rate is
A.
misleading because even spot exchanges usually become effective only three
days after a deal is struck.
B.
misleading because even spot exchanges usually become effective only four
days after a deal is struck.
C.
misleading because even spot exchanges usually become effective only five
days after a deal is struck.
D.
misleading because even spot exchanges usually become effective only six
days after a deal is struck.
E.
misleading because even spot exchanges usually become effective only two
days after a deal is struck.
Answer: E
18.
Which one of the following statements is the most accurate? Trades of U.S. dollars
for Canadian dollars in New York are executed with
A.
a one-day lag.
B.
a two-day lag.
C.
a three-day lag.
D.
a four-day lag.
E.
a zero-day lag.
Answer: A
19.
20.
168
21.
22.
23.
24.
Which one of the following statements is the most accurate? Countries in the euro
zone include
A.
Austria, Australia, and Belgium.
B.
Austria, Belgium, and Finland.
C.
Austria and Finland.
D.
Austria, Belgium, Finland, and France.
E.
Austria, Belgium, Finland, France, and Germany.
Answer: E
169
25.
26.
Which one of the following statements is the most accurate? Countries in the euro
zone include
A.
Austria, Belgium, Finland, France, and Germany.
B.
Austria, Belgium, Finland, France, Germany, and Greece.
C.
Austria, Belgium, Finland, France, Germany, and Ireland.
D.
Austria, Belgium, Finland, France, Germany, and Italy.
E.
All of the above statements are correct.
Answer: E
27.
Which one of the following statements is the most accurate? Countries in the euro
zone include
A. Austria, Belgium, Finland, France, Germany, and Greece.
B. Austria, Belgium, Finland, France, Germany, and Luxembourg.
C. Austria, Belgium, Finland, France, Germany, Portugal, and Ireland.
D. Austria, Belgium, Finland, France, Germany, Spain, and Italy.
E.
All of the above statements are correct.
Answer: E
28.
Which one of the following statements is the most accurate? Countries in the euro
zone include
A. Austria, Belgium, Finland, France, Germany, Greece, Luxemburg, and Ireland.
B. Austria, Belgium, Finland, France, Germany, Luxembourg, Portugal, and Poland.
C. Austria, Belgium, Finland, France, Germany, Portugal, Ireland, and the Czeck
Republic.
D. Austria, Belgium, Finland, France, Germany, Spain, Italy, and Ukraine.
E.
All of the above statements are correct.
Answer: A
170
29.
30.
If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then
A.
an investor should invest only in dollars.
B.
an investor should invest only in euros.
C.
an investor should be indifferent between dollars and euros.
D.
it is impossible to tell given the information.
E.
All of the above.
Answer: D
31.
If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and the
expected return on dollar depreciation against the euro is zero percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: A
32.
If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and the
expected return on dollar depreciation against the euro is 4 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: C
171
33.
If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, and the
expected return on dollar depreciation against the euro is 8 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: B
34.
If the dollar interest rate is 10 percent, the euro interest rate is 12 percent, and the
expected return on dollar depreciation against the euro is negative 4 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: A
35.
36.
172
37.
Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113
per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the
interest rate on dollar deposits is 10 percent and on euros it is 4 percent. What is the
rate of return on a covered euro deposit?
A.
0.10
B.
0.101
C.
0.102
D.
0.103
E.
0.104
Answer: D
38.
Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113
per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the
interest rate on dollar deposits is 10 percent and on euros it is 4 percent. Under these
assumptions,
A.
covered interest parity does hold.
B.
covered interest parity does not hold.
C.
It is hard to tell whether covered interest parity does or does not hold.
D.
Not enough information is given to answer the question.
E.
None of the above.
Answer: B
173
Essay Questions
1.
In the year 2000, Americans flocked to Paris. What economic forces made French
goods appear so cheap to residents of the United States?
Answer: One major factor was a sharp fall in the dollar price of Frances currency.
2.
Answer:
1.
2.
3.
4.
3.
Commercial banks
Corporations
Nonblank financial institutions
Central banks
Based on the case study, A Tale of Two Dollars, explain why errors in the currency
market can be more costly to the Toronto Blue Jays baseball team than errors in the
field.
Answer: See page 329. The Toronto team has 80 percent of its revenue paid in Canadian
dollars and 80 percent of its expenses set in U.S. dollars. Since the Canadian dollar has
depreciated substantially, it causes big losses for the team by raising its expenses relative to
its receipts. To protect itself from the vagaries of the exchange rate, the team tries to predict
its need for U.S. dollars ahead of time so that it can sell Canadian dollars and purchase the
American currency in advance to lock in the exchange rate. Errors in the currency market
can thus be more costly to the team than on the field.
4.
Explain what a vehicle currency is. Why is the U.S. dollar considered a vehicle
currency?
Answer: A vehicle currency is one that is widely used to denominate international contracts
made by parties who do not reside in the country that issues the vehicle currency. Since
2001, ninety percent of foreign exchange transactions involve exchanges of foreign
currencies for U.S. dollars; therefore, the dollar is considered a vehicle currency.
5.
What are the factors affecting the demand for foreign currency?
Answer: Three factors affect the demand for foreign currency. They are expected return,
risk, and liquidity.
174
6.
Answer: The condition that the expected returns on deposits of any two currencies are equal
when measured in the same currency is called the interest parity condition. It implies that
potential holders of foreign currency deposits view them as equally desirable assets, i.e. risk
is assumed away.
In notational forms:
R$ = RE + (Ee$/E E$/E) / E$/E.
7.
Discusses the effects of a rise in the dollar interest rate on the exchanger rate.
Answer: For a given euro interest rate and constant expected exchange rate, a rise in the
interest rate offered by dollar deposits causes the dollar to appreciate.
175
8.
Discusses the effects of a rise in the interest rate paid by euro deposits on the
exchanger rate.
Answer: For a given U.S. interest rate and a given expectation with regard to the future
exchange rate, a rise in the interest rate paid by euro deposits causes the dollar to depreciate.
176
9.
Explain the purpose of the following figure. Show the effects of German unification
on Germanys interest rate.
Answer: The main purpose is to show that different interest rates exist for different assets
since foreign currencies are different assets. From 1990 to 1995, the DM interest rate is
higher than that of the United States. Excluding this period, the dollar rates are higher
reflecting higher inflation in the United States and depreciating of the dollar versus the
German currency.
177
10.
Answer: To show that spot and forward exchange rates are in general close to each other.
178
Quantitative/Graphing Problems
1.
Compute how many dollars it would cost to buy an Edinburgh Woolen Mill sweater
costing 50 British pounds for the following exchange rates:
Exchange Rate
Price of a sweater in British pounds Price in dollars
Number of dollars per one British pound
1
1.1
1.2
1.25
1.3
1.4
1.5
1.6
1.7
1.75
1.8
1.9
2
50
50
50
50
50
50
50
50
50
50
50
50
50
Answer:
Exchange Rate
Price of a sweater in British pounds Price in dollars
Number of dollars per one British pound
1
1.1
1.2
1.25
1.3
1.4
1.5
1.6
1.7
1.75
1.8
1.9
2
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50 $
50.00
55.00
60.00
62.50
65.00
70.00
75.00
80.00
85.00
87.50
90.00
95.00
100.00
179
2.
Compute how many British pounds it would cost to buy a pair of American designer
jeans costing $45:
Exchange Rate
Number of dollars per one British pound
1
1.1
1.2
1.25
1.3
1.4
1.5
1.6
1.7
1.75
1.8
1.9
2
45
45
45
45
45
45
45
45
45
45
45
45
45
Answer:
Price of a pair of American designer
jeans
Exchange Rate
Number of dollars per one British pound
1
1.1
1.2
1.25
1.3
1.4
1.5
1.6
1.7
1.75
1.8
1.9
2
45
45
45
45
45
45
45
45
45
45
45
45
45
45
40.90909091
37.5
36
34.61538462
32.14285714
30
28.125
26.47058824
25.71428571
25
23.68421053
22.5
180
3.
Find the exchange rate between the dollar and the British pound for the following
cases:
Answer:
Price of a pair of American designer
jeans
181
4.
Case
For the following 15 cases, compare the dollar rates of return on dollar and euro
deposits:
Rate of
Return
Difference
Expected
between
Rate of
Dollar and
Dollar
Euro
Dollar
Euro
Interest Interest Depreciation Deposits
Rate, R$ Rate, RE against Euro
1
0.1
0.06
0
2
0.1
0.06
0.04
3
0.1
0.06
0.08
4
0.1
0.12
-0.04
5
0.1
0.18
0
6
0.15
0.06
0
7
0.15
0.06
0.04
8
0.15
0.06
0.08
9
0.15
0.12
-0.04
10
0.15
0.18
0
11
0.2
0.06
0
12
0.2
0.06
0.04
13
0.2
0.06
0.08
14
0.2
0.12
-0.04
15
0.2
0.18
0
Answer:
Case
Rate of
Return
Difference
Expected
between
Rate of
Dollar and
Dollar
Euro
Dollar
Euro
Interest Interest Depreciation Deposits
Rate, R$ Rate, RE against Euro
1
0.1
0.06
0
0.04
2
0.1
0.06
0.04
0
3
0.1
0.06
0.08
-0.04
4
0.1
0.12
-0.04
0.02
5
0.1
0.18
0
-0.08
6
0.15
0.06
0
0.09
7
0.15
0.06
0.04
0.05
8
0.15
0.06
0.08
0.01
9
0.15
0.12
-0.04
0.07
10
0.15
0.18
0
-0.03
11
0.2
0.06
0
0.14
12
0.2
0.06
0.04
0.1
13
0.2
0.06
0.08
0.06
14
0.2
0.12
-0.04
0.12
15
0.2
0.18
0
0.02
182
5.
Case
R$
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
RE
0.1
0.1
0.1
0.1
0.1
0.15
0.15
0.15
0.15
0.15
0.2
0.2
0.2
0.2
0.2
Expected
Rate of
Rate of
Return
Dollar
Difference
Depreciation between
against Euro Dollar and
Euro
Exact
E
Deposits formula
0.06
0
0.04
0.06
0.04
0
0.06
0.08
-0.04
0.12
-0.04
0.02
0.18
0
-0.08
0.06
0
0.09
0.06
0.04
0.05
0.06
0.08
0.01
0.12
-0.04
0.07
0.18
0
-0.03
0.06
0
0.14
0.06
0.04
0.1
0.06
0.08
0.06
0.12
-0.04
0.12
0.18
0
0.02
RE
0.1
0.1
0.1
0.1
0.1
0.15
0.15
0.15
0.15
0.15
0.2
0.2
0.2
0.2
0.2
Expected
Rate of
Rate of
Return
Dollar
Difference
Depreciation between
against Euro Dollar and
Euro
Exact
E
Deposits formula
0.06
0
0.04
0.04
0.06
0.04
0 -0.0024
0.06
0.08
-0.04 -0.0448
0.12
-0.04
0.02
0.0248
0.18
0
-0.08
-0.08
0.06
0
0.09
0.09
0.06
0.04
0.05
0.0476
0.06
0.08
0.01
0.0052
0.12
-0.04
0.07
0.0748
0.18
0
-0.03
-0.03
0.06
0
0.14
0.14
0.06
0.04
0.1
0.0976
0.06
0.08
0.06
0.0552
0.12
-0.04
0.12
0.1248
0.18
0
0.02
0.02
Answer:
Case
R$
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
6.
Calculate the interest rate in the United States, if interest parity condition holds, for
the following 15 cases:
183
Expected
Rate of
Dollar
Depreciation
against Euro
Case
RE
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
E
0.06
0.06
0.06
0.12
0.18
0.06
0.06
0.06
0.12
0.18
0.06
0.06
0.06
0.12
0.18
R$
0
0.04
0.08
-0.04
0
0
0.04
0.08
-0.04
0
0
0.04
0.08
-0.04
0
Answer:
Case
7.
Case
RE
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Expected
Rate of
Dollar
Depreciation
against Euro
E
R$
0.06
0
0.06
0.04
0.06
0.08
0.12
-0.04
0.18
0
0.06
0
0.06
0.04
0.06
0.08
0.12
-0.04
0.18
0
0.06
0
0.06
0.04
0.06
0.08
0.12
-0.04
0.18
0
0.06
0.1
0.14
0.08
0.18
0.06
0.1
0.14
0.08
0.18
0.06
0.1
0.14
0.08
0.18
Calculate the interest rate in the euro zone if interest parity condition holds, for the
following 15 cases:
RE
Expected
Rate of
Dollar
R$
184
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Depreciation
against Euro
E
0
0.04
0.08
-0.04
0
0
0.04
0.08
-0.04
0
0
0.04
0.08
-0.04
0
0.06
0.11
0.16
0.05
0.1
0.11
0.16
0.21
0.1
0.15
0.16
0.21
0.26
0.15
0.2
Answer:
Case
RE
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
E
0.06
0.07
0.08
0.09
0.1
0.11
0.12
0.13
0.14
0.15
0.16
0.17
0.18
0.19
0.2
R$
0
0.04
0.08
-0.04
0
0
0.04
0.08
-0.04
0
0
0.04
0.08
-0.04
0
0.06
0.11
0.16
0.05
0.1
0.11
0.16
0.21
0.1
0.15
0.16
0.21
0.26
0.15
0.2
185
8.
Case
Assume that the euro interest rate is constant at 5 percent, and that the expected
exchange rate is 1.05 dollars per one euro. Find the expected dollar return on euro
deposits for the following cases:
Expected
Dollar
Todays
Interest Depreciation Expected Dollar
Dollar/Euro Rate on Rate Against Return on Euro
Exchange Euro
Euro
Deposits
Rate
Deposits (1.05 - E)/E Re + (1.05 - E)/E
1
1.07
2
1.06
3
1.05
4
1.04
5
1.03
6
1.02
7
1.01
8
1
9
0.99
10
0.98
Answer:
Case
9.
Expected
Dollar
Todays
Interest Depreciation Expected Dollar
Dollar/Euro Rate on Rate Against Return on Euro
Exchange Euro
Euro
Deposits
Rate
Deposits (1.05 - E)/E Re + (1.05 - E)/E
1
1.07
0.05 -0.0186916
0.031308411
2
1.06
0.05 -0.009434
0.040566038
3
1.05
0.05
0
0.05
4
1.04
0.05 0.0096154
0.059615385
5
1.03
0.05 0.0194175
0.069417476
6
1.02
0.05 0.0294118
0.079411765
7
1.01
0.05
0.039604
0.08960396
8
1
0.05
0.05
0.1
9
0.99
0.05 0.0606061
0.110606061
10
0.98
0.05 0.0714286
0.121428571
For the data in Question 8, plot todays dollar/euro exchange rate against the expected
dollar return on euro deposits.
186
Answer:
1.08
1.06
1.04
1.02
1
0.98
0.96
0
10.
0.02
0.04
0.06
0.08
0.1
0.12
0.14
Using the data from Question 8 and the plot in Question 9, show that if the interest
rate in the United States is 10 percent, the exchange rate will be 1, and if the interest
rate in the United States is 12 percent, the exchange rate will be 0.98 dollars per euro.
Answer: Points 1 and 2 in the figure below correspond to these two equilibrium points.
1.08
1.06
1.04
1.02
1
0.98
0.96
0
0.02
11.
0.04
0.06
0.08
0.1
0.12
0.14
Assume the U.S. interest rate is 10 percent, and the interest rate on euro deposits is 5
percent. For the following exchange rates, find the forward exchange rates.
Todays
Dollar/Euro
Exchange Forward
Rate
Exchange
Rate
E$/E
F$/E
1
1.05
1.1
1.2
1.3
187
Answer: Using the covered interest rate parity will yield the second column in the table:
F$/E
Todays
Dollar/Euro
Exchange Forward
Rate
Exchange
Rate
E$/E
F$/E
1
1.05
1.05
1.1025
1.1
1.155
1.2
1.26
1.3
1.365
188