Chap 009

Chapter 09 - The Foreign Exchange Market
Chapter 09
The Foreign Exchange Market
True / False Questions
1. Even though the foreign exchange market is critical to an economy as a whole, it does not
have a direct impact on the sales, profits, and strategy of a multinational enterprise.
True False
2. The foreign exchange market is a market for converting the currency of one country into
that of another country.
True False
3. Assume that the a falls sharply in value against the currency of Country B. This exchange
rate movement will boost Country B's exports to Country A.
True False
4. Although the foreign exchange market offers some insurance against foreign exchange risk,
it cannot provide complete insurance.
True False
5. Foreign exchange risk refers to the risk of not getting paid for a product that is exported
from one country to another.
True False
6. Assume that the euro/dollar exchange rate is €1 = $1.20. If it costs $36 to buy a European
product, the stated price of the product would be 30 euros.
True False
9-1
7. Tourists are the major participants in the foreign exchange market.

True False
8. Companies indulge in currency speculation in order to get minimal but assured returns from
idle cash.
True False
9. Carry trade has a speculative element attached to it.

True False
10. When a German tourist in Seoul goes to a bank to convert her euros into Korean wons, the
exchange rate used is the spot exchange rate for that day.
True False
11. For most major currencies, forward exchange rates are usually quoted for 1 year, 2 years,
and 3 years into the future.
True False
12. Spot exchange rates and the 30-day forward rates are usually the same.
True False
13. Assume that current dollar/yen spot exchange rate is $1 = 110. If the 30-day forward
exchange rate for converting dollars into yen is $1 = 105, we say the dollar is selling at a
discount on the 30-day forward market.
True False
9-2
14. By 2007, forward instruments accounted for 85 percent of all foreign exchange
transactions, while spot exchanges accounted for 15 percent.
True False
15. A common kind of swap is spot against forward.

True False
16. If the euro gains against the dollar, we say that the euro is strengthening, from a dollar
perspective. However, the reverse observation that the dollar is weakening against the euro
need not be true from a euro perspective.
True False
17. When companies wish to convert currencies, they typically enter the foreign exchange
market directly.
True False
18. The integration of financial centers implies there can be no significant difference in
exchange rates quoted in the foreign exchange trading centers.
True False
19. Foreign exchange transactions that occur when a dealer wants to sell a nondollar currency
and buy another rarely involve dollars.
True False
20. The British pound used to be second in importance to the dollar as a vehicle currency, but
its importance has diminished in recent years. This has resulted in London losing its leading
position in the global foreign exchange market.
True False
9-3
21. If the law of one price were true for all goods and services, the purchasing power parity
(PPP) exchange rate could be found from any individual set of prices.
True False
22. Assume that the average price of a Big Mac in South Korea is $2.98 at the prevailing
won/dollar exchange rate. The average price of a Big Mac in the United States is $3.58. This
suggests that the Korean won is overvalued against the U.S. dollar.
True False
23. Theoretically, a country in which price inflation is very high should expect to see its
currency depreciate against that of countries in which inflation rates are lower.
True False
24. When the growth in a country's money supply is faster than the growth in its output, price
inflation is fueled.
True False
25. For price discrimination to work, arbitrage opportunities must be unlimited.

True False
26. If the expected rate of inflation in the Germany is greater than that in Australia, German
nominal interest rates will be greater than Australian nominal interest rates.
True False
27. Unlike PPP, the international Fisher effect is a good predictor of short-run changes in spot
exchange rates.
True False
9-4
28. Relative monetary growth, relative inflation rates, and nominal interest rate differentials
are all moderately good predictors of long-run changes in exchange rates.
True False
29. The efficient market school argues that companies should spend additional money trying
to forecast short-run exchange rate movements.
True False
30. Technical analysis does not rely on a consideration of economic fundamentals.

True False
31. Capital flight is most likely to occur when the value of the domestic currency depreciates
because of deflation.
True False
32. Borrowing or lending of funds in foreign currencies involves transaction exposure.

True False
33. Since, translation exposure is concerned with the present measurement of past events, the
resulting accounting gains or losses are said to be unrealized, and therefore unimportant.
True False
34. Economic exposure is distinct from transaction exposure, which is concerned with the
effect of exchange rate changes on individual transactions, most of which are short-term
affairs that will be executed within a few weeks or months.
True False
9-5
35. Leading and lagging involves accelerating payments from weak-currency to strong-
currency countries and delaying inflows from strong-currency to weak-currency countries.
True False
Multiple Choice Questions
36. The _____ is the rate at which one currency is converted into another.
A. LIBOR
B. reference rate
C. exchange rate
D. par value
37. Which of the following will organizations have to resort to in order to conduct
international trade in the absence of the foreign exchange market?
A. Barter system
B. Spot market
C. Silver standard
D. Stock market
38. Assume that the currency of Country A falls sharply in value against the currency of
Country B. Which of the following will be a consequence of this exchange rate movement?
A. Country B's products will become more competitive.
B. Country A's exports to Country B will increase.
C. Country B's products will become less expensive in Country A.
D. There will be no difference in the volume or direction of trade.
39. Identify a main function of the foreign exchange market.

A. Provide some insurance against foreign exchange risk.
B. Prevent one-way movement of a currency with respect to another.
C. Ensure that currencies are not volatile.
D. Eliminate foreign exchange risk for companies involved in international trade.
9-6
40. _____ refers to adverse consequences of unpredictable changes in exchange rates.

A. Systemic risk
B. Foreign exchange risk
C. Portfolio risk
D. Liquidity risk
41. You exchanged $1,000 to 105,000 yen for a trip to Japan. During your stay, you spent
50,000 yen. Also, during this period the dollar weakened against the yen to 100 to a dollar. On
your return, you went to the bank to exchange the remaining yen. How many dollars did you
spend on the trip?
A. $550
B. $523
C. $450
D. $600
42. A French company has 20 million euros it wants to invest for three months. Investing in a
Thai money market account gives the company a higher return than domestic investments. Is
this investment risk-free? Why or why not?
A. Yes, because money market investments are considered to be equivalent to bank deposits.
B. No, because foreign currency movements in the intervening period can affect the
profitability.
C. Yes, because such investments also lock foreign exchange rates for the duration of the
investments.
D. No, because money markets instruments are considered to be the most speculative of all
investments.
43. _____ typically involves the short-term movement of funds from one currency to another
in the hopes of profiting from shifts in exchange rates.
A. Venture capital
B. Hedging
C. Currency speculation
D. Exchange rate manipulation
9-7
44. Robben Inc. converted 1 million dollars into euros when the exchange rate was $1 =
€0.75. The company converts this back into dollars after three months when the exchange rate
is $1 = €0.80. Which of the following is true of the outcome of this transaction?
A. Loss of $62,500
B. Loss of $66,667
C. Gain of $50,000
D. Gain of $62,500
45. Which of the following involves borrowing in one currency where interest rates are low,
and then using the proceeds to invest in another currency where interest rates are high?
A. Reinvestment
B. Refinancing
C. Contrarian trade
D. Carry trade
46. Assume that the interest rate on borrowings in Country A is 2 percent and that the interest
rate on bank deposits in Country B is 7.5 percent. A carry trade in this scenario would be:
A. borrow in Country B's currency, then convert the money into Country A's currency and
deposit it in a bank in Country A.
B. borrow in Country A's currency, and invest in stocks with good growth potential in
Country A.
C. borrow in Country A's currency, then convert the money into Country B's currency and
deposit it in a bank in Country B.
D. invest in bank deposits of Country B and reinvest the earnings in Country A.
47. A currency carry trade takes advantage of:

A. temporary undervaluation of one currency vis-à-vis another.
B. mispricing of stocks trading in two exchanges.
C. high volatility in currency exchange rates.
D. differences in interest rates between countries.
9-8
48. The speculative element of the carry trade is that its success is based upon a belief that:
A. there will be no adverse movement in exchange rates.
B. liquidity is the key factor in determining interest rates.
C. borrowing costs increase when demand for funds increases.
D. foreign exchange rates are highly volatile.
49. Identify one of the major reasons behind the decline in the dollar-yen carry trade during
2008-09.
A. Increase in risk appetite making the carry trade less attractive.
B. Increase in the value of Japanese yen against the U.S. dollar.
C. Increase in interest rate differentials as Japanese rates came down.
D. Decrease in interest rate differentials as the U.S. rates went up.
50. When a firm insures itself against foreign exchange risk, we say that it is engaging in:
A. speculating.
B. timing the market.
C. hedging.
D. market making.
51. When two parties agree to exchange currency and execute the deal immediately, the
transaction is referred to as a(n):
A. futures transaction.
B. call option exercise.
C. arbitrage transaction.
D. spot exchange.
52. How are spot exchange rates in the foreign exchange markets determined?
A. By using historical average prices.
B. By the relative demand and supply for different currencies.
C. By taking the average of a basket of currencies.
D. By government decree.
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53. A U.S. company that imports laptop computers from Japan knows that in 30 days it must
pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese
supplier 150,000 for each computer, and the current dollar/yen spot exchange rate is $1 =
110. The importer knows she can sell the computers the day they arrive for $1,600 each.
However, the importer will not have the funds to pay the Japanese supplier until the
computers have been sold. Which of the following will happen if the exchange rate after 30
days is $1 = 90?
A. The importer will earn a profit of $236 per computer.
B. The importer will earn a profit of $67 per computer.
C. The importer will incur a loss of $236 per computer.
D. The importer will incur a loss of $67 per computer.
54. A U.S. company that imports laptop computers from Japan knows that in 30 days it must
pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese
supplier 150,000 for each computer, and the current dollar/yen spot exchange rate is $1 =
110. The importer knows she can sell the computers the day they arrive for $1,600 each.
However, the importer will not have the funds to pay the Japanese supplier until the
computers have been sold. The importer enters into a 30-day forward exchange transaction
with a foreign exchange dealer at $1 = 105. Which of the following will happen if the
exchange rate after 30 days is $1 = 90?
C. The importer will earn a profit of $65 per computer.
55. A _____ occurs when two parties agree to exchange currency and execute the deal at some
specific date in the future.
A. forward exchange
B. spot exchange
C. carry trade
D. contrarian trade
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56. Why do spot exchange rates and forward rates differ?

A. Because forward rates reflect the expectations of the foreign exchange market about future
currency movements.
B. Because of the imbalance between demand and supply for the currency in the spot
exchange market.
C. Because of the volatility inherent in foreign exchange markets.
D. Because forward rates, by definition, should sell either at a premium or a discount.
57. Assume that the dollar is selling at a premium on the 30-day dollar/euro forward market.
Which of the following reflects the foreign exchange dealers' expectations about the dollar
over the next 30 days?
A. The dollar will depreciate against the euro.
B. The dealers are undecided about the direction of movement.
C. The dollar will appreciate against the euro.
D. The dollar/euro exchange rate will be steady.
58. A _____ is the simultaneous purchase and sale of a given amount of foreign exchange for
two different value dates.
A. currency barter
B. currency exercise
C. currency option
D. currency swap
59. Which of the following is transacted when it is desirable to move out of one currency into
another for a limited period without incurring foreign exchange risk?
A. Swap
B. Delivery
C. Commercial paper
D. Straddle
9-11
60. Which is the most important foreign exchange trading center in terms of percentage of
activity?
A. Zurich
B. London
C. New York
D. Singapore
61. Which of the following is a reason for London's dominance in the foreign exchange
market?
A. Great Britain's decision to retain the British pound instead of using the euro, making the
pound an important vehicle currency.
B. The preeminence of Financial Times Stock Exchange (FTSE) index as an economic health
indicator.
C. London's geographical position making it the link between the East Asian and New York
markets.
D. London being the preferred headquarters location for major multinational corporations.
62. Which of the following is a key feature of the foreign exchange market?
A. The market never sleeps.
B. The market is located in London.
C. The market is characterized by high transaction costs.
D. The market is shut for only three hours.
63. Which of the following refers to the purchase of securities in one market for immediate
resale in another to profit from a price discrepancy?
A. Exercise
B. Straddle
C. Arbitrage
D. Swap
9-12
64. Assume that the yen/dollar exchange rate quoted in London at 3 p.m. is 120 = $1, and
that the New York yen/dollar exchange rate at the same time is 123 = $1. Which profit
making situation exists here?
A. Option
B. Straddle
C. Swap
D. Arbitrage
65. Assume that the yen/dollar exchange rate quoted in London at 3 p.m. is 120 = $1, and
that the New York yen/dollar exchange rate at the same time is 123 = $1. What will be the
net profit if a dealer takes one million dollars to purchase 123 million in New York and
engages in an arbitrage trade?
A. $34,000
B. $24,390
C. $25,000
D. $46,666
66. Which of the following is true of arbitrage opportunities in foreign exchange markets?
A. They usually tend to be large.
B. They tend to disappear in minutes.
C. They tend to occur very frequently.
D. They are one of the riskiest trades.
67. A dealer wishes to sell Thai baht for Brazilian real. Which "third" currency is most likely
to appear in this transaction?
A. Euro
B. Japanese yen
C. British pound
D. U.S. dollar
9-13
68. Which is the world's most important vehicle currency?

A. Euro
B. U.S. dollar
C. British pound
D. Japanese yen
69. Which is the world's second most important vehicle currency?

A. Euro
B. Japanese yen
C. British pound
D. Saudi dinar
70. Which currency did the euro replace as the world's second most important vehicle
currency?
A. Japanese yen
B. Swiss franc
C. German mark
D. Russian ruble
71. Most economic theories of exchange rate movements agree that three factors have an
important impact on future exchange rate movements in a country's currency. Which of the
following is NOT one of these factors?
A. The country's price inflation
B. The country's interest rate
C. Market psychology
D. The country's population
72. The theory of purchasing power parity (PPP) links changes in the exchange rate between
two countries' currencies to:
A. changes in the countries' price levels.
B. changes in the countries' population.
C. changes in the countries' political structure.
D. changes in the countries' productivity levels.
9-14
73. Which of the following states that in competitive markets free of transportation costs and
barriers to trade, identical products sold in different countries must sell for the same price
when their price is expressed in terms of the same currency?
A. Law of money supply
B. Law of one price
C. Theory of competitive advantage
74. Assume that the exchange rate between the euro and the dollar is € 1 = $1.20. If the law of
one price holds, a camera that retails for $300 in New York should sell for _____ in Germany.
A. € 320
B. € 300
C. € 250
D. € 360
75. Assume that the exchange rate between the euro and the dollar is € 1 = $1.20. A camera
that retails for $300 in New York sells for € 200 in Berlin. Ignoring any transaction costs or
barriers, this represents an initial arbitrage profit potential of:
A. $60.
B. $80.
C. $20.
D. $100.
76. A(n) _____ has no impediments to the free flow of goods and services, such as trade
barriers, and prices reflect all available public information.
A. structured market
B. regional market
C. efficient market
D. mixed economy
9-15
77. Let P$ be the U.S. dollar price of a basket of particular goods and P be the price of the
same basket of goods in Japanese yen. The PPP theory predicts that the dollar/yen exchange
rate, E$/, should be equivalent to:
A. (1 + P)/P$
B. (1 + P$)/P
C. P/P$
D. P$/P
78. If a basket of goods costs $100 in the United States and €120 in Europe, PPP theory
predicts that the dollar/euro exchange rate should be:
A. $1 = €1.20
B. $1 = €1
C. $1 = €0.87
D. $1 = €0.83
79. Every year, the newsmagazine The Economist publishes its own version of the PPP
theorem, which it refers to as the:
A. "Commodity Index."
B. "Big Mac Index."
C. "Unilever Index."
D. "Walmart Index."
80. Why has the newsmagazine The Economist selected McDonald's Big Mac as a proxy for a
"basket of goods" in publishing its own version of the PPP theorem?
A. Because McDonald's holds the title rights for the index till 2015.
B. Because Big Mac is produced according to the same recipe in about 120 countries.
C. Because Big Mac is the most popular hamburger in the world.
D. Because no other product other than the Big Mac is available in all countries of the world.
9-16
81. The average price of a Big Mac in the United States is $3.58. If the "Big Mac Index" is an
accurate indicator, which of the following currencies would be the most overvalued?
A. Japan; average price of a Big Mac equals $3.50
B. South Africa; average price of a Big Mac equals $2.46
C. Norway; average price of a Big Mac equals $7.02
D. China; average price of a Big Mac equals $1.83
82. Which of the following occurs when the quantity of money in circulation rises faster than
the stock of goods and services?
A. Liquidity crunch
B. Deflation
C. Trade surplus
D. Inflation
83. A government increasing the money supply is analogous to:

A. giving people more money.
B. increasing interest rates.
C. discouraging spending.
D. reducing price inflation.
84. Which of the following occurs when a government increases money supply?
A. It results in an overall decrease in credit.
B. It makes it difficult for individuals and companies to borrow from banks.
C. It makes it easier for banks to borrow from the government.
D. It causes a decrease in demand for goods and services.
85. The PPP theory tells us that a country with a high inflation rate will see:
A. appreciation in its currency exchange rate.
B. decrease in interest rates.
C. increase in productivity.
D. depreciation in its currency exchange rate.
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86. How does an increase in a country's money supply affect its currency exchange rate?
A. It overheats the economy thereby reducing the production levels in the economy.
B. It changes the relative demand and supply conditions in the foreign exchange market.
C. It reduces the rate of inflation thus leading to an appreciation of the currency.
D. It leads to increased lending by banks thereby resulting in more savings.
87. Which of the following is a reasonable conclusion about the future of nation where the
government is strongly committed to controlling the rate of growth in money?
A. The country's future inflation rate may be low.
B. The country's currency will steadily depreciate in the foreign exchange market.
C. The country's economy will be marked by an abundance of liquidity.
D. The country may see a good number of populist measures not funded by taxation.
88. If a country's government lacks the political will to control the rate of growth in money
supply:
A. its future inflation rate will be low.
B. its taxes are sure to increase in the future.
C. it will see reduced spending.
D. its currency could depreciate in the future.
89. Which of the following countries have, in the past, failed to control the rate of growth in
money supply, resulting in higher inflation rate and currency depreciation?
A. Germany
B. Argentina
C. Norway
D. Australia
90. Studies indicate that the PPP theory seems to best predict exchange rate changes for
countries with:
A. appreciating currencies.
B. stable currencies.
C. underdeveloped capital markets.
D. small differentials in inflation rates.
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91. The failure to find a strong link between relative inflation rates and exchange rate
movements has been referred to as the:
A. one price paradox.
B. exchange rate paradox.
C. purchasing power parity puzzle.
D. relative movement puzzle.
92. Which of the following is an explanation for the failure of PPP theory to predict exchange
rates more accurately?
A. It assumes away transportation costs and trade barriers.
B. It does not take into account the law of one price.
C. It uses a small sample size of goods.
D. It assumes that the markets are not efficient.
93. Government intervention in cross-border trade, by violating the assumption of _____,

weakens the link between relative price changes and changes in exchange rates predicted by
PPP theory.
A. stable exchange rates
B. labor mobility
C. arbitrage
D. efficient markets
94. Dominant enterprises in an industry may be able to exercise a degree of pricing power,
setting different prices in different markets to reflect varying demand conditions. This is
referred to as:
A. price discrimination.
B. price fixing.
C. price war.
D. price skimming.
9-19
95. Identify a usual way in which a market dominating firm that practices price discrimination
prevents the arbitrage of its products across various markets.
A. Pricing its products identically despite huge differences in demand across different
markets.
B. Differentiating otherwise identical products among nations along some line, such as design
or packaging.
C. Adopting a pricing strategy of matching what competitors charge in each of the different
national markets.
D. Limiting sales of its products to only a few nations.
96. According to economic theory, interest rates reflect expectations about likely:
A. population growth rates.
B. current unemployment rates.
C. current exchange rates.
D. future inflation rates.
97. In countries where inflation is expected to be high, interest rates also will be high, because
investors want compensation for the decline in the value of their money. This relationship is
referred to as the:
A. interest rate paradox.
B. Tobin effect.
C. Fisher effect.
D. Domino effect.
98. The Fisher effect states that a country's "nominal" interest rate (i) is:
A. the sum of the required "real" rate of interest (r) and the expected rate of inflation over the
period for which the funds are to be lent (I).
B. the difference between the required "real" rate of interest (r) and the expected exchange
rate in the future (E).
C. the sum of the required "current" rate of interest (i) and the expected exchange rate (E).
D. the difference between the required "real" rate of interest (r) and the expected rate of
inflation over the period for which the funds are to be lent (I).
9-20
99. If the real rate of interest in a country is 4 percent and annual inflation is expected to be 9
percent, the nominal interest rate will be _____ percent.
A. 5
B. 13
C. 9
D. 7.5
100. The _____ states that for any two countries, the spot exchange rate should change in an
equal amount but in the opposite direction to the difference in nominal interest rates between
the two countries.
A. carry trade effect
B. law of one price
C. international Fisher effect
D. theory of comparative advantage
101. Applying the international Fisher effect, if the interest rate in Brazil is 9 percent and in
Japan it is 6 percent, we would expect the value of the Brazilian real to:
A. appreciate by 3 percent against the Japanese yen.
B. depreciate by 3 percent against the Japanese yen.
C. appreciate by 1.5 percent against the Japanese yen.
D. depreciate by 1.5 percent against the Japanese yen.
102. Which of the following is said to occur when traders move like a herd, all in the same
direction and at the same time, in response to each others' perceived actions?
A. Fire-sale
B. Flight to safety
C. Bandwagon effect
D. Fisher effect
9-21
103. The _____ school of thought argues that forward exchange rates do the best possible job
of forecasting future spot exchange rates, and, therefore, investing in forecasting services
would be a waste of money.
A. efficient market
B. inefficient market
C. quantitative
D. qualitative
104. Which of the following positions is adopted by the inefficient market school of thought?
A. Forward exchange rates do the best possible job of forecasting future spot exchange rates.
B. Forward exchange rates are unbiased predictors of future spot rates.
C. Companies cannot beat the markets because forward rates reflect all available information
about likely future changes in exchange rates.
D. Companies can improve the foreign exchange market's estimate of future exchange rates
by investing in forecasting services.
105. If the foreign exchange market is efficient, forward exchange rates should be unbiased
predictors of future spot rates. This means that
A. the predictions will be accurate in any specific situation.
B. inaccuracies will not be consistently above or below future spot rates; they will be random.
C. more accurate predictions of future spot rates can be calculated from publicly available
information.
D. market participants' collective predictions about future spot rates cannot be incorrect.
106. A(n) _____ is one in which prices do not reflect all available information.
A. inefficient market
B. primary market
C. fully priced market
D. inconsistent market
9-22
107. Which of the following draws on economic theory to construct sophisticated econometric
models for predicting exchange rate movements?
A. Technical analysis
B. SWOT analysis
C. Stochastic analysis
D. Fundamental analysis
108. Which of the following is a variable used in fundamental analysis?

A. Relative strength indicator
B. Moving average
C. Inflation rate
D. Rate of change
109. Which of the following is true of a country that is running a deficit on a balance-of-
payments current account?
A. It is importing more goods and services than it is exporting.
B. It will result in steady appreciation of the country's currency.
C. It will lead to very high interest rates in the country.
D. It will lead to a shortage of the country's currency in the foreign exchange market.
110. Which of the following uses price and volume data to determine past trends, which are
expected to continue into the future?
B. SWOT analysis
C. Variable analysis
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111. Which of the following analysis is based on the premise that there are analyzable market
trends and waves and that previous trends and waves can be used to predict future trends and
waves?
A. Variable analysis
B. Fundamental analysis
C. SWOT analysis
D. Technical analysis
112. Which of the following observations is true of technical analysis?

A. This approach relies on economic fundamentals.
B. The variables contained in these models typically include relative money supply growth
rates, inflation rates, and interest rates.
C. There is no theoretical rationale for the assumption of predictability underlying this
approach.
D. This approach has declined in importance over the last few years.
113. A country's currency is said to be _____ when the country's government allows both
residents and nonresidents to purchase unlimited amounts of a foreign currency with it.
A. externally convertible
B. nonconvertible
C. internally convertible
D. freely convertible
114. A currency is said to be _____ when only nonresidents may convert it into a foreign
currency without any limitations.
B. nonconvertible
C. part-convertible
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115. Country A tightly controls the ability of its residents to convert its currency into other
currencies. However, all foreign businesses with deposits in banks of Country A may, at any
time, convert all their currency into foreign currency and take them out of the country.
Country A's currency is:
A. part-convertible.
B. nonconvertible.
C. externally convertible.
D. freely convertible.
116. Which of the following is a major reason why governments limit convertibility of their
currency?
A. To encourage foreign investments.
B. To have a tight grip on fiscal policy.
C. To maintain an illusion of growth.
D. To preserve their foreign exchange reserves.
117. Which of the following happens when residents and nonresidents of a country rush to
convert their holdings of domestic currency into a foreign currency?
A. Deflation
B. Stagflation
C. Liquidity rush
D. Capital flight
118. When is capital flight most likely to occur?

A. During the recovery phase post an economic depression.
B. When domestic currency depreciates rapidly because of hyperinflation.
C. When a country's economic prospects appears bright in many respects.
D. When interest rates are low for a prolonged period of time.
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119. Companies can deal with the nonconvertibility problem by engaging in:
B. countertrade.
C. cartelization.
D. price skimming.
120. _____ refers to a range of barter-like agreements by which goods and services can be
traded for other goods and services.
A. Countertrade
B. Price discrimination
C. Cartelization
D. Dumping
121. Countertrade can make most sense when a country's currency is:
B. nonconvertible.
122. Which of the following refers to the extent to which the income from individual
transactions is affected by fluctuations in foreign exchange values?
A. Translation exposure
B. Economic exposure
C. Income exposure
D. Transaction exposure
123. Which of the following is an example of transaction exposure?

A. Obligations for the purchase of goods at previously agreed prices.
B. Borrowing of funds in domestic currency.
C. Impact of currency exchange rate changes on the reported financial statements of a
company.
D. Long-run effect of changes in exchange rates on future prices, sales, and costs.
9-26
124. ______ is the impact of currency exchange rate changes on the reported financial
statements of a company.
A. Economic exposure
B. Translation exposure
C. Income exposure
125. Which of the following is concerned with the present measurement of past events?
B. Transaction exposure
C. Income exposure
D. Translation exposure
126. In 2002-2007, the euro rose in value against the dollar. This boosted the dollar profits of
American multinationals with significant operations in Europe. Which of the following is this
an example of?
C. Translation exposure
D. Income exposure
127. _____ is the extent to which a firm's future international earning power is affected by
changes in exchange rates.
C. Income exposure
9-27
128. Which of the following is concerned with the long-run effect of changes in exchange
rates on future prices, sales, and costs?
A. Income exposure
C. Economic exposure
129. The rapid rise in the value of the dollar on the foreign exchange market in the 1990s hurt
the price competitiveness of many U.S. producers in world markets. U.S. manufacturers that
relied heavily on exports saw their export volume and world market share decline. This is an
example of:
A. income exposure.
B. transaction exposure.
C. economic exposure.
D. translation exposure.
130. A _____ strategy involves attempting to collect foreign currency receivables early when
a foreign currency is expected to depreciate and paying foreign currency payables before they
are due when a currency is expected to appreciate.
A. lag
B. forward
C. contrarian
D. lead
131. A _____ strategy involves delaying collection of foreign currency receivables if that
currency is expected to appreciate and delaying payables if the currency is expected to
depreciate.
A. lag
B. forward
C. contrarian
D. lead
9-28
132. Which of the following observations is true of leading and lagging strategies?
A. They involve delaying inflows from weak-currency to strong-currency countries.
B. They are used to maximize foreign exchange exposure of companies.
C. They can help firms minimize their transaction and translation exposure.
D. The involve accelerating payments from strong-currency to weak-currency countries.
133. Which of the following observations is true of leading and lagging strategies?
A. They are easy to implement.
B. They primarily protect long-term cash flows from adverse changes in exchange rates.
C. Firms need minimal bargaining power to implement them.
D. Government rules often limit leads and lags.
134. Which of the following is relatively more useful to predict foreign long-term exchange
rates?
A. Forward exchange rates
C. Moving averages
135. A firm needs to develop a mechanism for ensuring it maintains an appropriate mix of
tactics and strategies for minimizing its foreign exchange exposure. Which of the following is
true of the mechanism required?
A. Firms should focus solely on managing transaction and translation exposures.
B. Forecasting future exchange rate movements should be avoided as it is speculative.
C. Firms need to develop strategies for dealing with economic exposure.
D. Firms should avoid central control of exposure.
Essay Questions
9-29
136. International businesses have four main uses of foreign exchange markets. Describe
them.
137. What is carry trade? Is it speculative in nature? Explain with an example.
138. Differentiate between spot exchange rates and forward exchange rates.
139. What is a currency swap?
9-30
140. How does purchasing power parity and the law of one price relate to prices and exchange
rate movements? Describe the purchasing power parity theory and the law of one price.
141. How does an increase in the money supply in an economy lead to inflation?
142. Describe the factors that help explain the failure of PPP theory to predict exchange rates
accurately.
143. What is the Fisher effect?
9-31
144. Explain how the psychology of investors and bandwagon effects can have an impact on
the movement in exchange rates. Do you believe that bandwagon effects really happen?
Explain your answer.
145. Describe the efficient and inefficient market schools of thought. What conflicting
theories do these schools offer?
146. In the context of forecasting exchange rate movements, describe the difference between
fundamental analysis and technical analysis. Which approach is preferred by economists?
Why?
147. Explain the concepts of (1) transaction exposure and (2) translation exposure.
9-32
148. Explain the concept of economic exposure. How is it different from transaction
exposure?
149. Differentiate between a lead strategy and a lag strategy.
150. Organizations should develop a mechanism for ensuring it maintains an appropriate mix
of tactics and strategies for minimizing foreign exchange exposure. What are some of the
accepted common themes for this mechanism?
9-33
Chapter 09 The Foreign Exchange Market Answer Key
True / False Questions
1. (p. 312) Even though the foreign exchange market is critical to an economy as a whole, it does
not have a direct impact on the sales, profits, and strategy of a multinational enterprise.
FALSE
What happens in the foreign exchange market can have a fundamental impact on the sales,
profits, and strategy of an enterprise.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Learning Objective: 09-01
Topic: Introduction
2. (p. 313) The foreign exchange market is a market for converting the currency of one country
into that of another country.
TRUE
The foreign exchange market is a market for converting the currency of one country into that
of another country.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Topic: Introduction
9-34
3. (p. 313) Assume that the a falls sharply in value against the currency of Country B. This
exchange rate movement will boost Country B's exports to Country A.
FALSE
The currency movement will make Country B's products more expensive in Country A. This
will reduce its exports to Country A.
AACSB: Reflective Thinking

Bloom's: Apply
Difficulty: Hard
Topic: Introduction
4. (p. 313) Although the foreign exchange market offers some insurance against foreign
exchange risk, it cannot provide complete insurance.
TRUE
Although the foreign exchange market offers some insurance against foreign exchange risk, it
cannot provide complete insurance. It is not unusual for international businesses to suffer
losses because of unpredicted changes in exchange rates.
AACSB: Analytic
Bloom's: Understand
Difficulty: Easy
Topic: Introduction
5. (p. 313) Foreign exchange risk refers to the risk of not getting paid for a product that is
exported from one country to another.
FALSE
One function of the foreign exchange market is to provide some insurance against the risks
that arise from such volatile changes in exchange rates, commonly referred to as foreign
exchange risk.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Topic: Introduction
9-35
6. (p. 314) Assume that the euro/dollar exchange rate is €1 = $1.20. If it costs $36 to buy a
European product, the stated price of the product would be 30 euros.
TRUE
Since the euro/dollar exchange rate is €1 = $1.20, 30 euros would be equal to 36 dollars (30 x
1.2).

Bloom's: Apply
Difficulty: Medium
Topic: The Functions of the Foreign Exchange Market
7. (p. 314) Tourists are the major participants in the foreign exchange market.
FALSE
Tourists are minor participants in the foreign exchange market; companies engaged in
international trade and investments are major ones.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
8. (p. 314-315) Companies indulge in currency speculation in order to get minimal but assured
returns from idle cash.
FALSE
Speculation by definition is a very risky business.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-36
9. (p. 314-315) Carry trade has a speculative element attached to it.

TRUE
The speculative element of the carry trade is that its success is based upon a belief that there
will be no adverse movement in exchange rates (or interest rates for that matter) that will
make the trade unprofitable.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
10. (p. 315) When a German tourist in Seoul goes to a bank to convert her euros into Korean
wons, the exchange rate used is the spot exchange rate for that day.
TRUE
The spot exchange rate is the rate at which a foreign exchange dealer converts one currency
into another currency on a particular day.

Bloom's: Apply
Difficulty: Easy
11. (p. 317) For most major currencies, forward exchange rates are usually quoted for 1 year, 2
years, and 3 years into the future.
FALSE
For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180
days into the future.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-37
12. (p. 317) Spot exchange rates and the 30-day forward rates are usually the same.
FALSE
Differences in spot exchange rates and the 30-day forward rates are normal; they reflect the
exchange market about future currency movements.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
13. (p. 317) Assume that current dollar/yen spot exchange rate is $1 = 110. If the 30-day
forward exchange rate for converting dollars into yen is $1 = 105, we say the dollar is selling
at a discount on the 30-day forward market.
TRUE
The dollar is selling at a discount because it is worth less than on the spot market.

Bloom's: Apply
Difficulty: Medium
14. (p. 318) By 2007, forward instruments accounted for 85 percent of all foreign exchange
transactions, while spot exchanges accounted for 15 percent.
FALSE
By April 2007, the latest date for which information is available, forward instruments
accounted for some 69 percent of all foreign exchange transactions, while spot exchanges
accounted for 31 percent.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-38
15. (p. 318) A common kind of swap is spot against forward.

TRUE
Swaps are transacted between international businesses and their banks, between banks, and
between governments when it is desirable to move out of one currency into another for a
limited period without incurring foreign exchange risk. A common kind of swap is spot
against forward.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
16. (p. 319) If the euro gains against the dollar, we say that the euro is strengthening, from a
dollar perspective. However, the reverse observation that the dollar is weakening against the
euro need not be true from a euro perspective.
FALSE
The euro gains against the dollar, so the euro is strengthening, or becoming dearer, from a
dollar perspective. Meanwhile, the same observation indicates its mirror image, that the dollar
is weakening, becoming cheaper against the euro, from a euro perspective.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
17. (p. 319) When companies wish to convert currencies, they typically enter the foreign
exchange market directly.
FALSE
When companies wish to convert currencies, they typically go through their own banks rather
than entering the market directly.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Topic: The Nature of the Foreign Exchange Market
9-39
18. (p. 320) The integration of financial centers implies there can be no significant difference in
exchange rates quoted in the foreign exchange trading centers.
TRUE
High-speed computer linkages between trading centers around the globe have effectively
created a single market. The integration of financial centers implies there can be no significant
difference in exchange rates quoted in the trading centers.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
19. (p. 320) Foreign exchange transactions that occur when a dealer wants to sell a nondollar
currency and buy another rarely involve dollars.
FALSE
Although a foreign exchange transaction can involve any two currencies, most transactions
involve dollars on one side. This is true even when a dealer wants to sell a nondollar currency
and buy another.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
20. (p. 320) The British pound used to be second in importance to the dollar as a vehicle
currency, but its importance has diminished in recent years. This has resulted in London
losing its leading position in the global foreign exchange market.
FALSE
The British pound used to be second in importance to the dollar as a vehicle currency, but its
importance has diminished in recent years. Despite this, London has retained its leading
position in the global foreign exchange market.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-40
21. (p. 321) If the law of one price were true for all goods and services, the purchasing power
parity (PPP) exchange rate could be found from any individual set of prices.
TRUE
If the law of one price were true for all goods and services, the purchasing power parity (PPP)
exchange rate could be found from any individual set of prices.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
Topic: Economic Theories of Exchange Rate Determination
22. (p. 322) Assume that the average price of a Big Mac in South Korea is $2.98 at the prevailing
won/dollar exchange rate. The average price of a Big Mac in the United States is $3.58. This
suggests that the Korean won is overvalued against the U.S. dollar.
FALSE
Dividing the price in South Korea by the average price of a Big Mac in the United States
gives 0.83, which suggests that the won is undervalued by 17 percent against the U.S. dollar.

Bloom's: Apply
Difficulty: Medium
23. (p. 322) Theoretically, a country in which price inflation is very high should expect to see its
TRUE
Theoretically, a country in which price inflation is running wild should expect to see its
AACSB: Analytic
Bloom's: Understand
Difficulty: Easy
9-41
24. (p. 324) When the growth in a country's money supply is faster than the growth in its output,
price inflation is fueled.
TRUE
Inflation is a monetary phenomenon. When the growth in a country's money supply is faster
than the growth in its output, price inflation is fueled.
AACSB: Analytic
Bloom's: Understand
Difficulty: Easy
25. (p. 326) For price discrimination to work, arbitrage opportunities must be unlimited.
FALSE
For price discrimination to work, arbitrage must be limited.
AACSB: Analytic
Bloom's: Understand
Difficulty: Easy
26. (p. 327) If the expected rate of inflation in the Germany is greater than that in Australia,
German nominal interest rates will be greater than Australian nominal interest rates.
TRUE
In countries where inflation is expected to be high, interest rates also will be high, because
investors want compensation for the decline in the value of their money. It follows from the
Fisher effect that if the real interest rate is the same worldwide, any difference in interest rates
between countries reflects differing expectations about inflation rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-42
27. (p. 328) Unlike PPP, the international Fisher effect is a good predictor of short-run changes
in spot exchange rates.
FALSE
Like PPP, the international Fisher effect is not a good predictor of short-run changes in spot
exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
28. (p. 330) Relative monetary growth, relative inflation rates, and nominal interest rate
differentials are all moderately good predictors of long-run changes in exchange rates.
TRUE
Relative monetary growth, relative inflation rates, and nominal interest rate differentials are
all moderately good predictors of long-run changes in exchange rates. They are poor
predictors of short-run changes in exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
29. (p. 330) The efficient market school argues that companies should spend additional money
trying to forecast short-run exchange rate movements.
FALSE
The efficient market school argues that forward exchange rates do the best possible job of
forecasting future spot exchange rates, and, therefore, investing in forecasting services would
be a waste of money.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Topic: Exchange Rate Forecasting
9-43
30. (p. 332) Technical analysis does not rely on a consideration of economic fundamentals.
TRUE
Technical analysis uses price and volume data to determine past trends, which are expected to
continue into the future. This approach does not rely on a consideration of economic
fundamentals.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
31. (p. 333) Capital flight is most likely to occur when the value of the domestic currency
depreciates because of deflation.
FALSE
Capital flight is most likely to occur when the value of the domestic currency is depreciating
rapidly because of hyperinflation, or when a country's economic prospects are shaky in other
respects.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
32. (p. 334) Borrowing or lending of funds in foreign currencies involves transaction exposure.
TRUE
Transaction exposure is the extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values. Such exposure includes obligations for
the purchase or sale of goods and services at previously agreed prices and the borrowing or
lending of funds in foreign currencies.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
Topic: Focus on Managerial Implications
9-44
33. (p. 335) Since, translation exposure is concerned with the present measurement of past
events, the resulting accounting gains or losses are said to be unrealized, and therefore
unimportant.
FALSE
Translation exposure is concerned with the present measurement of past events. The resulting
accounting gains or losses are said to be unrealized—they are "paper" gains and losses—but
they are still important.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
34. (p. 335) Economic exposure is distinct from transaction exposure, which is concerned with
the effect of exchange rate changes on individual transactions, most of which are short-term
affairs that will be executed within a few weeks or months.
TRUE
Economic exposure is concerned with the long-run effect of changes in exchange rates on
future prices, sales, and costs. This is distinct from transaction exposure, which is concerned
with the effect of exchange rate changes on individual transactions, most of which are short-
term affairs that will be executed within a few weeks or months.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-45
35. (p. 335) Leading and lagging involves accelerating payments from weak-currency to strong-
currency countries and delaying inflows from strong-currency to weak-currency countries.
TRUE
Leading and lagging involves accelerating payments from weak-currency to strong-currency

countries and delaying inflows from strong-currency to weak-currency countries. These
tactics primarily protect short-term cash flows from adverse changes in exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
Multiple Choice Questions
36. (p. 313) The _____ is the rate at which one currency is converted into another.
A. LIBOR
B. reference rate
C. exchange rate
D. par value
An exchange rate is simply the rate at which one currency is converted into another.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Topic: Introduction
9-46
37. (p. 313) Which of the following will organizations have to resort to in order to conduct
international trade in the absence of the foreign exchange market?
A. Barter system
B. Spot market
C. Silver standard
D. Stock market
Without the foreign exchange market, international trade and international investment on the
scale that we see today would be impossible; companies would have to resort to barter.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
Topic: Introduction
38. (p. 313) Assume that the currency of Country A falls sharply in value against the currency of
Country B. Which of the following will be a consequence of this exchange rate movement?
A. Country B's products will become more competitive.
B. Country A's exports to Country B will increase.
C. Country B's products will become less expensive in Country A.
D. There will be no difference in the volume or direction of trade.
The currency movement will make Country B's products more expensive in Country A. This
will reduce its exports to Country A. Country A's products will become less expensive in
Country B thereby increasing overall exports to Country B.

Bloom's: Apply
Difficulty: Hard
Topic: Introduction
9-47
39. (p. 313) Identify a main function of the foreign exchange market.
A. Provide some insurance against foreign exchange risk.
B. Prevent one-way movement of a currency with respect to another.
C. Ensure that currencies are not volatile.
D. Eliminate foreign exchange risk for companies involved in international trade.
The foreign exchange market serves two main functions. The first is to convert the currency
of one country into the currency of another. The second is to provide some insurance against
foreign exchange risk, by which we mean the adverse consequences of unpredictable changes
in exchange rates.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
40. (p. 313) _____ refers to adverse consequences of unpredictable changes in exchange rates.
A. Systemic risk
B. Foreign exchange risk
C. Portfolio risk
D. Liquidity risk
By foreign exchange risk, we mean the adverse consequences of unpredictable changes in

exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-48
41. (p. 314) You exchanged $1,000 to 105,000 yen for a trip to Japan. During your stay, you
spent 50,000 yen. Also, during this period the dollar weakened against the yen to 100 to a
dollar. On your return, you went to the bank to exchange the remaining yen. How many
dollars did you spend on the trip?
A. $550
B. $523
C. $450
D. $600
The remaining 55,000 yen would yield 550 dollars when the exchange rate is 100 yens for a
dollar. Amount spend during the trip is $450 ($1,000 - $550).

Bloom's: Apply
Difficulty: Hard
42. (p. 314) A French company has 20 million euros it wants to invest for three months.
Investing in a Thai money market account gives the company a higher return than domestic
investments. Is this investment risk-free? Why or why not?
A. Yes, because money market investments are considered to be equivalent to bank deposits.
B. No, because foreign currency movements in the intervening period can affect the
profitability.
C. Yes, because such investments also lock foreign exchange rates for the duration of the
investments.
D. No, because money markets instruments are considered to be the most speculative of all
investments.
The rate of return it earns on this investment depends not only on the Thai interest rate, but
also on the changes in the value of the Thai Baht against the euro in the intervening period.

Bloom's: Understand
Difficulty: Medium
9-49
43. (p. 315) _____ typically involves the short-term movement of funds from one currency to
another in the hopes of profiting from shifts in exchange rates.
A. Venture capital
B. Hedging
C. Currency speculation
D. Exchange rate manipulation
Currency speculation typically involves the short-term movement of funds from one currency
to another in the hopes of profiting from shifts in exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
44. (p. 315) Robben Inc. converted 1 million dollars into euros when the exchange rate was $1 =
€0.75. The company converts this back into dollars after three months when the exchange rate
is $1 = €0.80. Which of the following is true of the outcome of this transaction?
A. Loss of $62,500
B. Loss of $66,667
C. Gain of $50,000
D. Gain of $62,500
In the first transaction, the company receives euros. These euros when converted back into
dollars yields only $937,500 (€750,0000.80). Net loss = $937,500 - $1,000,000.

Bloom's: Apply
Difficulty: Medium
9-50
45. (p. 315) Which of the following involves borrowing in one currency where interest rates are
low, and then using the proceeds to invest in another currency where interest rates are high?
A. Reinvestment
B. Refinancing
C. Contrarian trade
D. Carry trade
The carry trade involves borrowing in one currency where interest rates are low, and then
using the proceeds to invest in another currency where interest rates are high.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
46. (p. 315) Assume that the interest rate on borrowings in Country A is 2 percent and that the
interest rate on bank deposits in Country B is 7.5 percent. A carry trade in this scenario would
be:
A. borrow in Country B's currency, then convert the money into Country A's currency and
deposit it in a bank in Country A.
B. borrow in Country A's currency, and invest in stocks with good growth potential in
Country A.
C. borrow in Country A's currency, then convert the money into Country B's currency and
deposit it in a bank in Country B.
D. invest in bank deposits of Country B and reinvest the earnings in Country A.

Bloom's: Understand
Difficulty: Medium
9-51
47. (p. 315) A currency carry trade takes advantage of:

A. temporary undervaluation of one currency vis-à-vis another.
B. mispricing of stocks trading in two exchanges.
C. high volatility in currency exchange rates.
D. differences in interest rates between countries.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
48. (p. 315) The speculative element of the carry trade is that its success is based upon a belief
that:
A. there will be no adverse movement in exchange rates.
B. liquidity is the key factor in determining interest rates.
C. borrowing costs increase when demand for funds increases.
D. foreign exchange rates are highly volatile.
The speculative element of the carry trade is that its success is based upon a belief that there
will be no adverse movement in exchange rates (or interest rates for that matter) that will
make the trade unprofitable.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-52
49. (p. 315) Identify one of the major reasons behind the decline in the dollar-yen carry trade
during 2008-09.
A. Increase in risk appetite making the carry trade less attractive.
B. Increase in the value of Japanese yen against the U.S. dollar.
C. Increase in interest rate differentials as Japanese rates came down.
D. Decrease in interest rate differentials as the U.S. rates went up.
The dollar-yen carry trade declined in importance during 2008-09 precisely because the
Japanese yen was increasing in value against the dollar, making the trade riskier (in addition,
interest rate differentials were falling as U.S. rates came down, making the trade less
profitable even if exchange rates were stable).
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
50. (p. 315) When a firm insures itself against foreign exchange risk, we say that it is engaging
in:
A. speculating.
B. timing the market.
C. hedging.
D. market making.
When a firm insures itself against foreign exchange risk, we say that it is engaging in hedging.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-53
51. (p. 315) When two parties agree to exchange currency and execute the deal immediately, the
transaction is referred to as a(n):
A. futures transaction.
B. call option exercise.
C. arbitrage transaction.
D. spot exchange.
When two parties agree to exchange currency and execute the deal immediately, the
transaction is referred to as a spot exchange.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
52. (p. 316) How are spot exchange rates in the foreign exchange markets determined?
A. By using historical average prices.
B. By the relative demand and supply for different currencies.
C. By taking the average of a basket of currencies.
D. By government decree.
Spot rates change continually, often on a minute-by-minute basis. The value of a currency is
determined by the interaction between the demand and supply of that currency relative to the
demand and supply of other currencies.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
9-54
53. (p. 316-317) A U.S. company that imports laptop computers from Japan knows that in 30 days
it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the
Japanese supplier 150,000 for each computer, and the current dollar/yen spot exchange rate
is $1 = 110. The importer knows she can sell the computers the day they arrive for $1,600
each. However, the importer will not have the funds to pay the Japanese supplier until the
computers have been sold. Which of the following will happen if the exchange rate after 30
days is $1 = 90?
C. The importer will incur a loss of $236 per computer.
Initially, the importer had estimated a profit of $236 per computer ($1,600 Selling price -
$1,364 Cost). However, at an exchange rate of $1 = 90, the importer will have to pay $1,667
per computer (150,000/90). The outcome will be a loss of $67 ($1,600 Selling price - $1,667
Cost).

Bloom's: Apply
Difficulty: Hard
9-55
54. (p. 317) A U.S. company that imports laptop computers from Japan knows that in 30 days it
must pay yen to a Japanese supplier when a shipment arrives. The company will pay the
Japanese supplier 150,000 for each computer, and the current dollar/yen spot exchange rate
is $1 = 110. The importer knows she can sell the computers the day they arrive for $1,600
each. However, the importer will not have the funds to pay the Japanese supplier until the
computers have been sold. The importer enters into a 30-day forward exchange transaction
with a foreign exchange dealer at $1 = 105. Which of the following will happen if the
exchange rate after 30 days is $1 = 90?
C. The importer will earn a profit of $65 per computer.
Initially, the importer had estimated a profit of $236 per computer ($1,600 Selling price -
$1,364 Cost). With the forward contract in place, the importer will have to pay no more than
$1,429 per computer (150,000/105). The outcome will be a guaranteed profit of $171
($1,600 Selling price - $1,429 Cost).

Bloom's: Apply
Difficulty: Hard
55. (p. 317) A _____ occurs when two parties agree to exchange currency and execute the deal at
some specific date in the future.
A. forward exchange
B. spot exchange
C. carry trade
D. contrarian trade
A forward exchange occurs when two parties agree to exchange currency and execute the deal
at some specific date in the future.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-56
56. (p. 317) Why do spot exchange rates and forward rates differ?
A. Because forward rates reflect the expectations of the foreign exchange market about future
currency movements.
B. Because of the imbalance between demand and supply for the currency in the spot
exchange market.
C. Because of the volatility inherent in foreign exchange markets.
D. Because forward rates, by definition, should sell either at a premium or a discount.
Differences in spot exchange rates and the 30-day forward rates are normal; they reflect the
expectations of the foreign exchange market about future currency movements.

Bloom's: Understand
Difficulty: Medium
57. (p. 317) Assume that the dollar is selling at a premium on the 30-day dollar/euro forward
market. Which of the following reflects the foreign exchange dealers' expectations about the
dollar over the next 30 days?
A. The dollar will depreciate against the euro.
B. The dealers are undecided about the direction of movement.
C. The dollar will appreciate against the euro.
D. The dollar/euro exchange rate will be steady.
The dollar selling at a premium on the 30-day forward market reflects the foreign exchange
dealers' expectations that the dollar will appreciate against the euro over the next 30 days.

Bloom's: Understand
Difficulty: Medium
9-57
58. (p. 318) A _____ is the simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates.
A. currency barter
B. currency exercise
C. currency option
D. currency swap
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange
for two different value dates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
59. (p. 318) Which of the following is transacted when it is desirable to move out of one
currency into another for a limited period without incurring foreign exchange risk?
A. Swap
B. Delivery
C. Commercial paper
D. Straddle
Swaps are transacted between international businesses and their banks, between banks, and
between governments when it is desirable to move out of one currency into another for a
limited period without incurring foreign exchange risk.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-58
60. (p. 319) Which is the most important foreign exchange trading center in terms of percentage
of activity?
A. Zurich
B. London
C. New York
D. Singapore
The most important trading centers are London (34 percent of activity), New York (16 percent
of activity), and Zurich, Tokyo, and Singapore (all with around 6 percent of activity).
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
61. (p. 319) Which of the following is a reason for London's dominance in the foreign exchange
market?
A. Great Britain's decision to retain the British pound instead of using the euro, making the
pound an important vehicle currency.
B. The preeminence of Financial Times Stock Exchange (FTSE) index as an economic health
indicator.
C. London's geographical position making it the link between the East Asian and New York
markets.
D. London being the preferred headquarters location for major multinational corporations.
Today London's central position between Tokyo and Singapore to the east and New York to
the west has made it the critical link between the East Asian and New York markets. Due to
the particular differences in time zones, London opens soon after Tokyo closes for the night
and is still open for the first few hours of trading in New York.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
9-59
62. (p. 319-320) Which of the following is a key feature of the foreign exchange market?
A. The market never sleeps.
B. The market is located in London.
C. The market is characterized by high transaction costs.
D. The market is shut for only three hours.
The market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of
every 24. During these three hours, trading continues in a number of minor centers,
particularly San Francisco and Sydney, Australia.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
63. (p. 320) Which of the following refers to the purchase of securities in one market for
immediate resale in another to profit from a price discrepancy?
A. Exercise
B. Straddle
C. Arbitrage
D. Swap
Arbitrage is the purchase of securities in one market for immediate resale in another to profit
from a price discrepancy. A dealer could buy yen in London and resell it in New York
immediately.

Bloom's: Apply
Difficulty: Easy
9-60
64. (p. 320) Assume that the yen/dollar exchange rate quoted in London at 3 p.m. is 120 = $1,
and that the New York yen/dollar exchange rate at the same time is 123 = $1. Which profit
making situation exists here?
A. Option
B. Straddle
C. Swap
D. Arbitrage
Arbitrage is the purchase of securities in one market for immediate resale in another to profit
from a price discrepancy. A dealer could buy yen in London and resell it in New York
immediately.

Bloom's: Apply
Difficulty: Easy
65. (p. 320) Assume that the yen/dollar exchange rate quoted in London at 3 p.m. is 120 = $1,
and that the New York yen/dollar exchange rate at the same time is 123 = $1. What will be
the net profit if a dealer takes one million dollars to purchase 123 million in New York and
engages in an arbitrage trade?
A. $34,000
B. $24,390
C. $25,000
D. $46,666
123 million could be sold for dollars in London to get $1,025,000 (123 million  120). Net
profit = $1,025,000 - $1,000,000 = $25,000.
AACSB: Analytic
Bloom's: Apply
Difficulty: Hard
9-61
66. (p. 320) Which of the following is true of arbitrage opportunities in foreign exchange
markets?
A. They usually tend to be large.
B. They tend to disappear in minutes.
C. They tend to occur very frequently.
D. They are one of the riskiest trades.
Because foreign exchange dealers are always watching their computer screens for arbitrage
opportunities, the few that arise tend to be small, and they disappear in minutes.
AACSB: Analytic
Bloom's: Understand
Difficulty: Easy
67. (p. 320) A dealer wishes to sell Thai baht for Brazilian real. Which "third" currency is most
likely to appear in this transaction?
A. Euro
B. Japanese yen
C. British pound
D. U.S. dollar
Although a foreign exchange transaction can involve any two currencies, most transactions
involve dollars on one side. This is true even when a dealer wants to sell a nondollar currency
and buy another.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-62
68. (p. 320) Which is the world's most important vehicle currency?
A. Euro
B. U.S. dollar
C. British pound
D. Japanese yen
Due to its central role in so many foreign exchange deals, the dollar is a vehicle currency. In
2007, 86 percent of all foreign exchange transactions involved dollars on one side of the
transaction.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
69. (p. 320) Which is the world's second most important vehicle currency?
A. Euro
B. Japanese yen
C. British pound
D. Saudi dinar
In 2007, 86 percent of all foreign exchange transactions involved dollars on one side of the
transaction. After the dollar, the most important vehicle currencies were the euro (37 percent),
the Japanese yen (16.5 percent), and the British pound (15 percent)—reflecting the
importance of these trading entities in the world economy.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-63
70. (p. 320) Which currency did the euro replace as the world's second most important vehicle
currency?
A. Japanese yen
B. Swiss franc
C. German mark
D. Russian ruble
The euro has replaced the German mark as the world's second most important vehicle
currency.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
71. (p. 321) Most economic theories of exchange rate movements agree that three factors have
an important impact on future exchange rate movements in a country's currency. Which of the
following is NOT one of these factors?
A. The country's price inflation
B. The country's interest rate
C. Market psychology
D. The country's population
Most economic theories of exchange rate movements seem to agree that three factors have an
important impact on future exchange rate movements in a country's currency: the country's
price inflation, its interest rate, and market psychology.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-64
72. (p. 321) The theory of purchasing power parity (PPP) links changes in the exchange rate
between two countries' currencies to:
A. changes in the countries' price levels.
B. changes in the countries' population.
C. changes in the countries' political structure.
D. changes in the countries' productivity levels.
The theory of purchasing power parity (PPP) links changes in the exchange rate between two
countries' currencies to changes in the countries' price levels.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
73. (p. 321) Which of the following states that in competitive markets free of transportation costs
and barriers to trade, identical products sold in different countries must sell for the same price
when their price is expressed in terms of the same currency?
A. Law of money supply
B. Law of one price
C. Theory of competitive advantage
The law of one price states that in competitive markets free of transportation costs and
barriers to trade (such as tariffs), identical products sold in different countries must sell for the
same price when their price is expressed in terms of the same currency.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-65
74. (p. 321) Assume that the exchange rate between the euro and the dollar is € 1 = $1.20. If the
law of one price holds, a camera that retails for $300 in New York should sell for _____ in
Germany.
A. € 320
B. € 300
C. € 250
D. € 360
Since one euro is equal to 1.2 dollars, the price of the camera is € 250 ($300/1.2).

Bloom's: Apply
Difficulty: Medium
75. (p. 321) Assume that the exchange rate between the euro and the dollar is € 1 = $1.20. A
camera that retails for $300 in New York sells for € 200 in Berlin. Ignoring any transaction
costs or barriers, this represents an initial arbitrage profit potential of:
A. $60.
B. $80.
C. $20.
D. $100.
€ 200 = $240 (€ 200 x 1.2). The difference of $60 ($300-$240) is the profit potential.

Bloom's: Apply
Difficulty: Hard
9-66
76. (p. 321) A(n) _____ has no impediments to the free flow of goods and services, such as trade
A. structured market
B. regional market
C. efficient market
D. mixed economy
An efficient market has no impediments to the free flow of goods and services, such as trade
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
77. (p. 321) Let P$ be the U.S. dollar price of a basket of particular goods and P be the price of
the same basket of goods in Japanese yen. The PPP theory predicts that the dollar/yen
exchange rate, E$/, should be equivalent to:
A. (1 + P)/P$
B. (1 + P$)/P
C. P/P$
D. P$/P
The PPP theory predicts that the dollar/yen exchange rate, E$/, should be equivalent to:
P$/P.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-67
78. (p. 321-322) If a basket of goods costs $100 in the United States and €120 in Europe, PPP
theory predicts that the dollar/euro exchange rate should be:
A. $1 = €1.20
B. $1 = €1
C. $1 = €0.87
D. $1 = €0.83
By comparing the prices of identical products in different currencies, it would be possible to

determine the "real" or PPP exchange rate that would exist if markets were efficient. In this
case dollar/euro exchange rate should be $100/€120 or $.833 per euro. In other words, $1 =
€1.20.
AACSB: Analytic
Bloom's: Apply
Difficulty: Medium
79. (p. 322) Every year, the newsmagazine The Economist publishes its own version of the PPP
theorem, which it refers to as the:
A. "Commodity Index."
B. "Big Mac Index."
C. "Unilever Index."
D. "Walmart Index."
Every year, the newsmagazine The Economist publishes its own version of the PPP theorem,
which it refers to as the "Big Mac Index."
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-68
80. (p. 322) Why has the newsmagazine The Economist selected McDonald's Big Mac as a proxy
for a "basket of goods" in publishing its own version of the PPP theorem?
A. Because McDonald's holds the title rights for the index till 2015.
B. Because Big Mac is produced according to the same recipe in about 120 countries.
C. Because Big Mac is the most popular hamburger in the world.
D. Because no other product other than the Big Mac is available in all countries of the world.
The Economist has selected McDonald's Big Mac as a proxy for a "basket of goods" because
it is produced according to more or less the same recipe in about 120 countries.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
81. (p. 322-323) The average price of a Big Mac in the United States is $3.58. If the "Big Mac
Index" is an accurate indicator, which of the following currencies would be the most
overvalued?
A. Japan; average price of a Big Mac equals $3.50
B. South Africa; average price of a Big Mac equals $2.46
C. Norway; average price of a Big Mac equals $7.02
D. China; average price of a Big Mac equals $1.83
Dividing the average price of Big Mac in Norway by the average price of a Big Mac in the
United States gives 1.96, which suggests that the Norwegian currency was overvalued by 96
percent against the U.S. dollar.

Bloom's: Apply
Difficulty: Easy
9-69
82. (p. 323) Which of the following occurs when the quantity of money in circulation rises faster
than the stock of goods and services?
A. Liquidity crunch
B. Deflation
C. Trade surplus
D. Inflation
Inflation occurs when the quantity of money in circulation rises faster than the stock of goods
and services; that is, when the money supply increases faster than output increases.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
83. (p. 324) A government increasing the money supply is analogous to:
A. giving people more money.
B. increasing interest rates.
C. discouraging spending.
D. reducing price inflation.
A government increasing the money supply is analogous to giving people more money.

Bloom's: Understand
Difficulty: Medium
9-70
84. (p. 324) Which of the following occurs when a government increases money supply?
A. It results in an overall decrease in credit.
B. It makes it difficult for individuals and companies to borrow from banks.
C. It makes it easier for banks to borrow from the government.
D. It causes a decrease in demand for goods and services.
An increase in the money supply makes it easier for banks to borrow from the government
and for individuals and companies to borrow from banks. The resulting increase in credit
causes increases in demand for goods and services. Unless the output of goods and services is
growing at a rate similar to that of the money supply, the result will be inflation.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
85. (p. 324) The PPP theory tells us that a country with a high inflation rate will see:
A. appreciation in its currency exchange rate.
B. decrease in interest rates.
C. increase in productivity.
D. depreciation in its currency exchange rate.
The PPP theory tells us that a country with a high inflation rate will see depreciation in its
currency exchange rate.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-71
86. (p. 324) How does an increase in a country's money supply affect its currency exchange
rate?
A. It overheats the economy thereby reducing the production levels in the economy.
B. It changes the relative demand and supply conditions in the foreign exchange market.
C. It reduces the rate of inflation thus leading to an appreciation of the currency.
D. It leads to increased lending by banks thereby resulting in more savings.
An increase in a country's money supply, which increases the amount of currency available,
changes the relative demand and supply conditions in the foreign exchange market.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
87. (p. 325) Which of the following is a reasonable conclusion about the future of nation where
the government is strongly committed to controlling the rate of growth in money?
A. The country's future inflation rate may be low.
B. The country's currency will steadily depreciate in the foreign exchange market.
C. The country's economy will be marked by an abundance of liquidity.
D. The country may see a good number of populist measures not funded by taxation.
If the government seems committed to controlling the rate of growth in money supply, the
country's future inflation rate may be low (even if the current rate is high) and its currency
should not depreciate too much on the foreign exchange market.

Bloom's: Understand
Difficulty: Hard
9-72
88. (p. 325) If a country's government lacks the political will to control the rate of growth in
money supply:
A. its future inflation rate will be low.
B. its taxes are sure to increase in the future.
C. it will see reduced spending.
D. its currency could depreciate in the future.
If the government seems to lack the political will to control the rate of growth in money
supply, the future inflation rate may be high, which is likely to cause its currency to
depreciate.

Bloom's: Understand
Difficulty: Medium
89. (p. 325) Which of the following countries have, in the past, failed to control the rate of
growth in money supply, resulting in higher inflation rate and currency depreciation?
A. Germany
B. Argentina
C. Norway
D. Australia
Historically, many Latin American governments have failed to control the rate of growth in
money supply. These include Argentina, Bolivia, and Brazil.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-73
90. (p. 326) Studies indicate that the PPP theory seems to best predict exchange rate changes for
countries with:
A. appreciating currencies.
B. stable currencies.
C. underdeveloped capital markets.
D. small differentials in inflation rates.
Studies indicate that the PPP theory seems to best predict exchange rate changes for countries
with high rates of inflation and underdeveloped capital markets.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
91. (p. 326) The failure to find a strong link between relative inflation rates and exchange rate
movements has been referred to as the:
A. one price paradox.
B. exchange rate paradox.
C. purchasing power parity puzzle.
D. relative movement puzzle.
The failure to find a strong link between relative inflation rates and exchange rate movements
has been referred to as the purchasing power parity puzzle.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-74
92. (p. 326) Which of the following is an explanation for the failure of PPP theory to predict
exchange rates more accurately?
A. It assumes away transportation costs and trade barriers.
B. It does not take into account the law of one price.
C. It uses a small sample size of goods.
D. It assumes that the markets are not efficient.
PPP theory assumes away transportation costs and barriers to trade. It also assumes that the
markets are relatively efficient.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
93. (p. 326) Government intervention in cross-border trade, by violating the assumption of
_____, weakens the link between relative price changes and changes in exchange rates
predicted by PPP theory.
A. stable exchange rates
B. labor mobility
C. arbitrage
D. efficient markets
Governments routinely intervene in international trade, creating tariff and nontariff barriers to
cross-border trade. Government intervention in cross-border trade, by violating the
assumption of efficient markets, weakens the link between relative price changes and changes
in exchange rates predicted by PPP theory.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-75
94. (p. 326) Dominant enterprises in an industry may be able to exercise a degree of pricing
power, setting different prices in different markets to reflect varying demand conditions. This
is referred to as:
B. price fixing.
C. price war.
D. price skimming.
In the market for semiconductor equipment, Applied Materials has a commanding market
share lead in almost every important national market. Microsoft dominates the market for
personal computer operating systems and applications systems around the world, and so on. In
such cases, dominant enterprises may be able to exercise a degree of pricing power, setting
different prices in different markets to reflect varying demand conditions. This is referred to
as price discrimination.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
95. (p. 326) Identify a usual way in which a market dominating firm that practices price
discrimination prevents the arbitrage of its products across various markets.
A. Pricing its products identically despite huge differences in demand across different
markets.
B. Differentiating otherwise identical products among nations along some line, such as design
or packaging.
C. Adopting a pricing strategy of matching what competitors charge in each of the different
national markets.
D. Limiting sales of its products to only a few nations.
Enterprises with some market power may be able to control distribution channels and
therefore limit the unauthorized resale (arbitrage) of products purchased in another national
market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical
products among nations along some line, such as design or packaging.
AACSB: Analytic
Bloom's: Understand
Difficulty: Hard
9-76
96. (p. 327) According to economic theory, interest rates reflect expectations about likely:
A. population growth rates.
B. current unemployment rates.
C. current exchange rates.
D. future inflation rates.
Economic theory tells us that interest rates reflect expectations about likely future inflation
rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
97. (p. 327) In countries where inflation is expected to be high, interest rates also will be high,
because investors want compensation for the decline in the value of their money. This
relationship is referred to as the:
A. interest rate paradox.
B. Tobin effect.
C. Fisher effect.
D. Domino effect.
In countries where inflation is expected to be high, interest rates also will be high, because
investors want compensation for the decline in the value of their money. This relationship was
first formalized by economist Irvin Fisher and is referred to as the Fisher effect.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-77
98. (p. 327) The Fisher effect states that a country's "nominal" interest rate (i) is:
A. the sum of the required "real" rate of interest (r) and the expected rate of inflation over the
period for which the funds are to be lent (I).
B. the difference between the required "real" rate of interest (r) and the expected exchange
rate in the future (E).
C. the sum of the required "current" rate of interest (i) and the expected exchange rate (E).
D. the difference between the required "real" rate of interest (r) and the expected rate of
inflation over the period for which the funds are to be lent (I).
The Fisher effect states that a country's "nominal" interest rate (i) is the sum of the required
"real" rate of interest (r) and the expected rate of inflation over the period for which the funds
are to be lent (I).
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
99. (p. 327) If the real rate of interest in a country is 4 percent and annual inflation is expected to
be 9 percent, the nominal interest rate will be _____ percent.
A. 5
B. 13
C. 9
D. 7.5
The Fisher effect states that a country's "nominal" interest rate (i) is the sum of the required
"real" rate of interest (r) and the expected rate of inflation over the period for which the funds
are to be lent (I). (4% + 9%)
AACSB: Analytic
Bloom's: Apply
Difficulty: Medium
9-78
100. (p. 327) The _____ states that for any two countries, the spot exchange rate should change
in an equal amount but in the opposite direction to the difference in nominal interest rates
between the two countries.
A. carry trade effect
B. law of one price
C. international Fisher effect
D. theory of comparative advantage
The international Fisher effect states that for any two countries, the spot exchange rate should
change in an equal amount but in the opposite direction to the difference in nominal interest
rates between the two countries.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
101. (p. 327-328) Applying the international Fisher effect, if the interest rate in Brazil is 9 percent
and in Japan it is 6 percent, we would expect the value of the Brazilian real to:
A. appreciate by 3 percent against the Japanese yen.
B. depreciate by 3 percent against the Japanese yen.
C. appreciate by 1.5 percent against the Japanese yen.
D. depreciate by 1.5 percent against the Japanese yen.
The international Fisher effect states that for any two countries, the spot exchange rate should
change in an equal amount but in the opposite direction to the difference in nominal interest
rates between the two countries.

Bloom's: Apply
Difficulty: Medium
9-79
102. (p. 328) Which of the following is said to occur when traders move like a herd, all in the
same direction and at the same time, in response to each others' perceived actions?
A. Fire-sale
B. Flight to safety
C. Bandwagon effect
D. Fisher effect
Bandwagon Effect: When traders move like a herd, all in the same direction and at the same
time, in response to each others' perceived actions.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
103. (p. 330) The _____ school of thought argues that forward exchange rates do the best
possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting
services would be a waste of money.
A. efficient market
B. inefficient market
C. quantitative
D. qualitative
The efficient market school argues that forward exchange rates do the best possible job of
forecasting future spot exchange rates, and, therefore, investing in forecasting services would
be a waste of money.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-80
104. (p. 330) Which of the following positions is adopted by the inefficient market school of
thought?
A. Forward exchange rates do the best possible job of forecasting future spot exchange rates.
B. Forward exchange rates are unbiased predictors of future spot rates.
C. Companies cannot beat the markets because forward rates reflect all available information
about likely future changes in exchange rates.
D. Companies can improve the foreign exchange market's estimate of future exchange rates
by investing in forecasting services.
The inefficient market school argues that companies can improve the foreign exchange
market's estimate of future exchange rates (as contained in the forward rate) by investing in
forecasting services. In other words, this school of thought does not believe the forward
exchange rates are the best possible predictors of future spot exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
105. (p. 331) If the foreign exchange market is efficient, forward exchange rates should be
unbiased predictors of future spot rates. This means that
A. the predictions will be accurate in any specific situation.
B. inaccuracies will not be consistently above or below future spot rates; they will be random.
C. more accurate predictions of future spot rates can be calculated from publicly available
information.
D. market participants' collective predictions about future spot rates cannot be incorrect.
If the foreign exchange market is efficient, forward exchange rates should be unbiased
predictors of future spot rates. This does not mean the predictions will be accurate in any
specific situation. It means inaccuracies will not be consistently above or below future spot
rates; they will be random.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
9-81
106. (p. 331) A(n) _____ is one in which prices do not reflect all available information.
A. inefficient market
B. primary market
C. fully priced market
D. inconsistent market
An inefficient market is one in which prices do not reflect all available information. In an
inefficient market, forward exchange rates will not be the best possible predictors of future
spot exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
107. (p. 331) Which of the following draws on economic theory to construct sophisticated
econometric models for predicting exchange rate movements?
B. SWOT analysis
C. Stochastic analysis
Fundamental analysis draws on economic theory to construct sophisticated econometric

models for predicting exchange rate movements.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-82
108. (p. 331) Which of the following is a variable used in fundamental analysis?
A. Relative strength indicator
B. Moving average
C. Inflation rate
D. Rate of change

models for predicting exchange rate movements. The variables contained in these models
typically include those we have discussed, such as relative money supply growth rates,
inflation rates, and interest rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
109. (p. 331) Which of the following is true of a country that is running a deficit on a balance-of-
payments current account?
A. It is importing more goods and services than it is exporting.
B. It will result in steady appreciation of the country's currency.
C. It will lead to very high interest rates in the country.
D. It will lead to a shortage of the country's currency in the foreign exchange market.
Running a deficit on a balance-of-payments current account (a country is importing more

goods and services than it is exporting) creates pressures that may result in the depreciation of
the country's currency on the foreign exchange market.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-83
110. (p. 332) Which of the following uses price and volume data to determine past trends, which
are expected to continue into the future?
B. SWOT analysis
C. Variable analysis
Technical analysis uses price and volume data to determine past trends, which are expected to
continue into the future. This approach does not rely on a consideration of economic
fundamentals.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
111. (p. 332) Which of the following analysis is based on the premise that there are analyzable
market trends and waves and that previous trends and waves can be used to predict future
trends and waves?
A. Variable analysis
C. SWOT analysis
Technical analysis is based on the premise that there are analyzable market trends and waves
and that previous trends and waves can be used to predict future trends and waves.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-84
112. (p. 332) Which of the following observations is true of technical analysis?
A. This approach relies on economic fundamentals.
B. The variables contained in these models typically include relative money supply growth
rates, inflation rates, and interest rates.
C. There is no theoretical rationale for the assumption of predictability underlying this
approach.
D. This approach has declined in importance over the last few years.
Technical analysis does not rely on a consideration of economic fundamentals. Technical

analysis is based on the premise that there are analyzable market trends and waves and that
previous trends and waves can be used to predict future trends and waves. Since there is no
theoretical rationale for this assumption of predictability, many economists compare technical
analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in
recent years.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
113. (p. 332) A country's currency is said to be _____ when the country's government allows
both residents and nonresidents to purchase unlimited amounts of a foreign currency with it.
B. nonconvertible
C. internally convertible
A country's currency is said to be freely convertible when the country's government allows
both residents and nonresidents to purchase unlimited amounts of a foreign currency with it.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-85
114. (p. 332) A currency is said to be _____ when only nonresidents may convert it into a
foreign currency without any limitations.
B. nonconvertible
C. part-convertible
A currency is said to be externally convertible when only nonresidents may convert it into a
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
115. (p. 332) Country A tightly controls the ability of its residents to convert its currency into
other currencies. However, all foreign businesses with deposits in banks of Country A may, at
any time, convert all their currency into foreign currency and take them out of the country.
Country A's currency is:
B. nonconvertible.
A currency is said to be externally convertible when only nonresidents may convert it into a
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-86
116. (p. 333) Which of the following is a major reason why governments limit convertibility of
their currency?
A. To encourage foreign investments.
B. To have a tight grip on fiscal policy.
C. To maintain an illusion of growth.
D. To preserve their foreign exchange reserves.
Governments limit convertibility to preserve their foreign exchange reserves.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
117. (p. 333) Which of the following happens when residents and nonresidents of a country rush
to convert their holdings of domestic currency into a foreign currency?
A. Deflation
B. Stagflation
C. Liquidity rush
D. Capital flight
Capital flight occurs when residents and nonresidents rush to convert their holdings of
domestic currency into a foreign currency.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-87
118. (p. 333) When is capital flight most likely to occur?

A. During the recovery phase post an economic depression.
B. When domestic currency depreciates rapidly because of hyperinflation.
C. When a country's economic prospects appears bright in many respects.
D. When interest rates are low for a prolonged period of time.
Capital flight is most likely to occur when the value of the domestic currency is depreciating
rapidly because of hyperinflation, or when a country's economic prospects are shaky in other
respects.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
119. (p. 334) Companies can deal with the nonconvertibility problem by engaging in:
B. countertrade.
C. cartelization.
D. price skimming.
Companies can deal with the nonconvertibility problem by engaging in countertrade.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-88
120. (p. 334) _____ refers to a range of barter-like agreements by which goods and services can
be traded for other goods and services.
A. Countertrade
B. Price discrimination
C. Cartelization
D. Dumping
Companies can deal with the nonconvertibility problem by engaging in countertrade.

Countertrade refers to a range of barter-like agreements by which goods and services can be
traded for other goods and services.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
121. (p. 334) Countertrade can make most sense when a country's currency is:
B. nonconvertible.
Countertrade refers to a range of barter-like agreements by which goods and services can be
traded for other goods and services. Countertrade can make sense when a country's currency
is nonconvertible.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-89
122. (p. 334) Which of the following refers to the extent to which the income from individual
transactions is affected by fluctuations in foreign exchange values?
A. Translation exposure
B. Economic exposure
C. Income exposure
affected by fluctuations in foreign exchange values.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
123. (p. 334) Which of the following is an example of transaction exposure?

A. Obligations for the purchase of goods at previously agreed prices.
B. Borrowing of funds in domestic currency.
C. Impact of currency exchange rate changes on the reported financial statements of a
company.
D. Long-run effect of changes in exchange rates on future prices, sales, and costs.
lending of funds in foreign currencies.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-90
124. (p. 335) ______ is the impact of currency exchange rate changes on the reported financial
statements of a company.
B. Translation exposure
C. Income exposure
Translation exposure is the impact of currency exchange rate changes on the reported
financial statements of a company.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
125. (p. 335) Which of the following is concerned with the present measurement of past events?
C. Income exposure
financial statements of a company. Translation exposure is concerned with the present
measurement of past events.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-91
126. (p. 335) In 2002-2007, the euro rose in value against the dollar. This boosted the dollar
profits of American multinationals with significant operations in Europe. Which of the
following is this an example of?
C. Translation exposure
D. Income exposure
financial statements of a company. Translation exposure is concerned with the present
measurement of past events.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
127. (p. 335) _____ is the extent to which a firm's future international earning power is affected
by changes in exchange rates.
C. Income exposure
Economic exposure is the extent to which a firm's future international earning power is
affected by changes in exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-92
128. (p. 335) Which of the following is concerned with the long-run effect of changes in
exchange rates on future prices, sales, and costs?
A. Income exposure
C. Economic exposure
future prices, sales, and costs.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
129. (p. 335) The rapid rise in the value of the dollar on the foreign exchange market in the
1990s hurt the price competitiveness of many U.S. producers in world markets. U.S.
manufacturers that relied heavily on exports saw their export volume and world market share
decline. This is an example of:
A. income exposure.
B. transaction exposure.
C. economic exposure.
D. translation exposure.
future prices, sales, and costs.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-93
130. (p. 335) A _____ strategy involves attempting to collect foreign currency receivables early
when a foreign currency is expected to depreciate and paying foreign currency payables
before they are due when a currency is expected to appreciate.
A. lag
B. forward
C. contrarian
D. lead
A lead strategy involves attempting to collect foreign currency receivables (payments from
customers) early when a foreign currency is expected to depreciate and paying foreign
currency payables (to suppliers) before they are due when a currency is expected to
appreciate.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
131. (p. 335) A _____ strategy involves delaying collection of foreign currency receivables if
that currency is expected to appreciate and delaying payables if the currency is expected to
depreciate.
A. lag
B. forward
C. contrarian
D. lead
A lag strategy involves delaying collection of foreign currency receivables if that currency is
expected to appreciate and delaying payables if the currency is expected to depreciate.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-94
132. (p. 335) Which of the following observations is true of leading and lagging strategies?
A. They involve delaying inflows from weak-currency to strong-currency countries.
B. They are used to maximize foreign exchange exposure of companies.
C. They can help firms minimize their transaction and translation exposure.
D. The involve accelerating payments from strong-currency to weak-currency countries.
Leading and lagging involve accelerating payments from weak-currency to strong-currency

countries and delaying inflows from strong-currency to weak-currency countries. They can
help firms minimize their transaction and translation exposure.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
133. (p. 336) Which of the following observations is true of leading and lagging strategies?
A. They are easy to implement.
B. They primarily protect long-term cash flows from adverse changes in exchange rates.
C. Firms need minimal bargaining power to implement them.
D. Government rules often limit leads and lags.
Lead and lag strategies can be difficult to implement. The firm must be in a position to
exercise some control over payment terms. Firms do not always have this kind of bargaining
power. Also, because lead and lag strategies can put pressure on a weak currency, many
governments limit leads and lags.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-95
134. (p. 337) Which of the following is relatively more useful to predict foreign long-term
exchange rates?
A. Forward exchange rates
C. Moving averages
No model comes close to perfectly predicting future movements in foreign exchange rates.
The best that can be said is that in the short run, forward exchange rates provide the best
predictors of exchange rate movements, and in the long run, fundamental economic factors—
particularly relative inflation rates—should be watched because they influence exchange rate
movements.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
135. (p. 337) A firm needs to develop a mechanism for ensuring it maintains an appropriate mix
of tactics and strategies for minimizing its foreign exchange exposure. Which of the following
is true of the mechanism required?
A. Firms should focus solely on managing transaction and translation exposures.
B. Forecasting future exchange rate movements should be avoided as it is speculative.
C. Firms need to develop strategies for dealing with economic exposure.
D. Firms should avoid central control of exposure.
Many companies seem to focus on reducing their transaction and translation exposure and pay
scant attention to economic exposure, which may have more profound long-term implications.
Firms need to develop strategies for dealing with economic exposure.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
Essay Questions
9-96
136. (p. 314-315) International businesses have four main uses of foreign exchange markets.
Describe them.
International businesses have four main uses of foreign exchange markets. First, the payments
a company receives for its exports, the income it receives from foreign investments, or the
income it receives from licensing agreements with foreign firms may be in foreign currencies.
To use those funds in its home country, the company must convert them to its home country's
currency. Second, international businesses use foreign exchange markets when they must pay
a foreign company for its products or services in its country's currency. Third, international
businesses also use foreign exchange markets when they have spare cash that they wish to
invest for short terms in money markets. Currency speculation is another use of foreign
exchange markets.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
137. (p. 315) What is carry trade? Is it speculative in nature? Explain with an example.
using the proceeds to invest in another currency where interest rates are high. For example, if
the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in
American banks is 6 percent, it can make sense to borrow in Japanese yen, then convert the
money into U.S. dollars and deposit it in an American bank. The trader can make a 5 percent
margin by doing so, minus the transaction costs associated with changing one currency into
another. The speculative element of this trade is that its success is based upon a belief that
there will be no adverse movement in exchange rates (or interest rates for that matter) that
will make the trade unprofitable. However, if the yen were to rapidly increase in value against
the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could
fast become unprofitable.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-97
138. (p. 315-317) Differentiate between spot exchange rates and forward exchange rates.
When two parties agree to exchange currency and execute the deal immediately, the
transaction is referred to as a spot exchange. Exchange rates governing such "on the spot"
trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a
foreign exchange dealer converts one currency into another currency on a particular day. Spot
rates change continually, often on a minute-by-minute basis. The value of a currency is
determined by the interaction between the demand and supply of that currency relative to the
demand and supply of other currencies.
A forward exchange occurs when two parties agree to exchange currency and execute the deal
at some specific date in the future. Exchange rates governing such future transactions are
referred to as forward exchange rates. For most major currencies, forward exchange rates are
quoted for 30 days, 90 days, and 180 days into the future. Differences between spot rates and
forward rates are normal; they reflect the expectations of the foreign exchange market about
future currency movements.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
Learning Objective: 09-02; 09-03
139. (p. 318) What is a currency swap?
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange
for two different value dates. Swaps are transacted between international businesses and their
banks, between banks, and between governments when it is desirable to move out of one
currency into another for a limited period without incurring foreign exchange risk. Swaps
account for a vast majority of forward exchanges.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-98
140. (p. 322) How does purchasing power parity and the law of one price relate to prices and
exchange rate movements? Describe the purchasing power parity theory and the law of one
price.
Purchasing power parity (PPP) and the law of one price help us understand how prices relate
to exchange rate movements. The law of one price states that in competitive markets free of
transportation costs and barriers to trade, identical products sold in different countries must
sell for the same price when their price is expressed in terms of the same currency. Regarding
purchasing power parity, if the law of one price were true for all goods and services, the PPP
exchange rate could be found from any individual set of prices. By comparing the prices of
identical products in different countries, it would be possible to determine the PPP exchange
rate that would exist if markets were efficient. In essence, PPP theory predicts that changes in
relative prices will result in a change in exchange rates.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
141. (p. 324) How does an increase in the money supply in an economy lead to inflation?
A government increasing the money supply is analogous to giving people more money. An
increase in the money supply makes it easier for banks to borrow from the government and
for individuals and companies to borrow from banks. The resulting increase in credit causes
increases in demand for goods and services. Unless the output of goods and services is
growing at a rate similar to that of the money supply, the result will be inflation. This
relationship has been observed time after time in country after country.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
9-99
142. (p. 326) Describe the factors that help explain the failure of PPP theory to predict exchange
rates accurately.
Several factors explain the failure of PPP theory to predict exchange rates accurately. PPP
theory assumes away transportation costs and barriers to trade. In practice, these factors are
significant and they tend to create significant price differentials between countries.
Governments routinely intervene in international trade, creating tariff and nontariff barriers to
cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize
prices for the same product in different countries, which is required for the law of one price to
hold. Government intervention in cross-border trade, by violating the assumption of efficient
markets, weakens the link between relative price changes and changes in exchange rates
predicted by PPP theory. In addition, the PPP theory may not hold if many national markets
are dominated by a handful of multinational enterprises that have sufficient market power to
be able to exercise some influence over prices, control distribution channels, and differentiate
their product offerings between nations. Another factor of some importance is that
governments also intervene in the foreign exchange market in attempting to influence the
value of their currencies.
AACSB: Analytic
Bloom's: Understand
Difficulty: Medium
143. (p. 327) What is the Fisher effect?
Economic theory tells us that interest rates reflect expectations about likely future inflation
rates. In countries where inflation is expected to be high, interest rates also will be high,
because investors want compensation for the decline in the value of their money. This
relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher
effect. The Fisher effect states that a country's "nominal" interest rate (i) is the sum of the
required "real" rate of interest (r) and the expected rate of inflation over the period for which
the funds are to be lent (I).
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-100
144. (p. 328) Explain how the psychology of investors and bandwagon effects can have an
impact on the movement in exchange rates. Do you believe that bandwagon effects really
happen? Explain your answer.
As noted in the text, empirical evidence suggests that neither the PPP theory nor the
International Fisher Effect are particularly good at explaining short-term movements in
exchange rates. One reason for this may be the impact of investor psychology on short-run
exchange rate movements. Evidence accumulated over 10 years reveals that various
psychological factors play an important role in determining the expectations of market traders
as to likely future exchange rates. In turn, expectations have a tendency to become self-
fulfilling prophecies. As a bandwagon effect builds up, the expectations of investors become a
self-fulfilling prophecy, and the market moves in the way the investors expected. According to
a number of studies, investor psychology and bandwagon effects play a major role in
determining short-run exchange rate movements. However, these effects can be hard to
predict. Student answers may vary.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
145. (p. 330-331) Describe the efficient and inefficient market schools of thought. What
conflicting theories do these schools offer?
A company's need to predict future exchange rate variations raises the issue of whether it is
worthwhile for the company to invest in exchange rate forecasting services. The efficient
market is one in which prices reflect all available market information. The inefficient market
is one in which prices do not reflect all available information. The efficient market school
argues that forward exchange rates do the best possible job of forecasting future spot
exchange rates. Therefore, investing in forecasting services is a waste of money. In contrast,
the inefficient market school argues that companies can improve the foreign exchange
market's estimate of future exchange rates by investing in forecasting services.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
9-101
146. (p. 331-332) In the context of forecasting exchange rate movements, describe the difference
between fundamental analysis and technical analysis. Which approach is preferred by
economists? Why?

models for predicting exchange rate movements. The variables contained in these models
typically include relative money supply growth rates, inflation rates, and interest rates. In
addition, they may include variables related to countries' balance-of-payments positions. In
contrast, technical analysis uses price and volume data to determine past trends, which are
expected to continue into the future. This approach does not rely on a consideration of
economic fundamentals. Technical analysis is based on the premise that there are analyzable
market trends and waves and that previous trends and waves can be used to predict future
trends and waves.
Since there is no theoretical rationale for the assumption of predictability that underlies
technical analysis, most economists compare technical analysis to fortune-telling, and prefer
fundamental analysis. However, despite this skepticism, technical analysis has gained favor in
recent years.
AACSB: Analytic
Bloom's: Remember
Difficulty: Easy
147. (p. 334-335) Explain the concepts of (1) transaction exposure and (2) translation exposure.
lending of funds in foreign currencies. Translation exposure is the impact of currency
exchange rate changes on the reported financial statements of a company. Translation
exposure is concerned with the present measurement of past events. The resulting accounting
gains or losses are said to be unrealized—they are "paper" gains and losses—but they are still
important.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-102
148. (p. 335) Explain the concept of economic exposure. How is it different from transaction
exposure?
Economic exposure is the extent to which a firm's future international earning power is
affected by changes in exchange rates. Economic exposure is concerned with the long-run
effect of changes in exchange rates on future prices, sales, and costs. This is distinct from
transaction exposure, which is concerned with the effect of exchange rate changes on
individual transactions, most of which are short-term affairs that will be executed within a few
weeks or months.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
149. (p. 335) Differentiate between a lead strategy and a lag strategy.
A lead strategy involves attempting to collect foreign currency receivables (payments from
customers) early when a foreign currency is expected to depreciate and paying foreign
currency payables (to suppliers) before they are due when a currency is expected to
appreciate. A lag strategy involves delaying collection of foreign currency receivables if that
currency is expected to appreciate and delaying payables if the currency is expected to
depreciate. Leading and lagging involves accelerating payments from weak-currency to
strong-currency countries and delaying inflows from strong-currency to weak-currency
countries.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-103
150. (p. 337) Organizations should develop a mechanism for ensuring it maintains an appropriate
mix of tactics and strategies for minimizing foreign exchange exposure. What are some of the
accepted common themes for this mechanism?
First, central control of exposure is needed to protect resources efficiently and ensure that
each subunit adopts the correct mix of tactics and strategies. Second, firms should distinguish
between, on one hand, transaction and translation exposure and, on the other, economic
exposure. Many companies seem to focus on reducing their transaction and translation
exposure and pay scant attention to economic exposure, which may have more profound long-
term implications. Firms need to develop strategies for dealing with economic exposure.
Third, firms need to have mechanisms to forecast future exchange rate movements. Fourth,
firms need to establish good reporting systems so the central finance function can regularly
monitor the firm's exposure positions. Finally, on the basis of the information it receives from
exchange rate forecasts and its own regular reporting systems, the firm should produce
monthly foreign exchange exposure reports. These reports should identify how cash flows and
balance sheet elements might be affected by forecasted changes in exchange rates. The reports
can then be used by management as a basis for adopting tactics and strategies to hedge against
undue foreign exchange risks.
AACSB: Analytic
Bloom's: Remember
Difficulty: Medium
9-104

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Chapter 09 - The Foreign Exchange Market

True / False Questions

7. Tourists are the major participants in the foreign exchange market.

9. Carry trade has a speculative element attached to it.

15. A common kind of swap is spot against forward.

25. For price discrimination to work, arbitrage opportunities must be unlimited.

30. Technical analysis does not rely on a consideration of economic fundamentals.

32. Borrowing or lending of funds in foreign currencies involves transaction exposure.

Multiple Choice Questions

39. Identify a main function of the foreign exchange market.

40. _____ refers to adverse consequences of unpredictable changes in exchange rates.

47. A currency carry trade takes advantage of:

56. Why do spot exchange rates and forward rates differ?

68. Which is the world's most important vehicle currency?

69. Which is the world's second most important vehicle currency?

83. A government increasing the money supply is analogous to:

93. Government intervention in cross-border trade, by violating the assumption of _____,

108. Which of the following is a variable used in fundamental analysis?

112. Which of the following observations is true of technical analysis?

118. When is capital flight most likely to occur?

123. Which of the following is an example of transaction exposure?

137. What is carry trade? Is it speculative in nature? Explain with an example.

139. What is a currency swap?

143. What is the Fisher effect?

149. Differentiate between a lead strategy and a lag strategy.

Chapter 09 The Foreign Exchange Market Answer Key

True / False Questions

AACSB: Reflective Thinking

AACSB: Reflective Thinking

Speculation by definition is a very risky business.

9. (p. 314-315) Carry trade has a speculative element attached to it.

AACSB: Reflective Thinking

AACSB: Reflective Thinking

15. (p. 318) A common kind of swap is spot against forward.

AACSB: Reflective Thinking

For price discrimination to work, arbitrage must be limited.

Leading and lagging involves accelerating payments from weak-currency to strong-currency

Multiple Choice Questions

AACSB: Reflective Thinking

By foreign exchange risk, we mean the adverse consequences of unpredictable changes in

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

47. (p. 315) A currency carry trade takes advantage of:

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

By comparing the prices of identical products in different currencies, it would be possible to

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

AACSB: Reflective Thinking

Fundamental analysis draws on economic theory to construct sophisticated econometric

Fundamental analysis draws on economic theory to construct sophisticated econometric

Running a deficit on a balance-of-payments current account (a country is importing more

Technical analysis does not rely on a consideration of economic fundamentals. Technical