KING FAHD UNIVERSITY OF PETROLEUM & MINERALS COLLEGE OF INDUSTRIAL MANAGEMENT DEPARTMENT OF FINANCE & ECONOMICS FIN 521–01 Mid-TermExam spring 20082 Name: _____________________________________________________ I.D:____________________________ Sec: _________ 2. Causes of devaluation. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued? Answer: The following macroeconomic variables could cause the fixed exchange rate to be devalued: • An interest rate that is too low compared to other competing currencies • A continuing balance of payments deficit • An inflation rate consistently higher than in other countries 4. The impossible trinity. Explain what is meant by concept of the “impossible trinity” and why it is accurate? Answer: • Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability. • Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the world’s capital markets. • Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy. 5. Currency board or dollarization. Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches? Answer: In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions. 4.1. Purchasing power parity. Define the following terms: (a) The law of one price. Answer: The law of one prices states that producers’ prices for goods or services of identical quality should be the same in different markets; i.e., different countries (assuming no restrictions on the sale and allowing for transportation costs). If a country has higher inflation than other countries, its currency should devalue or depreciate so that the real price remains the same as in all countries. Application of this law results in the theory of Purchasing Power Parity (PPP). (b) Absolute purchasing power parity. Answer: 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. By comparing the prices of identical products denominated in different currencies, one could determine the “real” or PPP exchange rate which should exist if markets were efficient. This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate is determined by the relative prices of similar baskets of goods. (c) Relative purchasing power parity. 1 (7) Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics—at least in the eyes of cross-border investors. 1. but also in the ease of selling those assets quickly for fair market value if desired. This more general idea is that PPP is not particularly helpful in determining what the spot rate is today. (8) Speculation can both cause a foreign exchange crisis or make an existing crisis worse.Answer: If the assumptions of the absolute version of PPP theory are relaxed a bit more. (a) Patient capitalism (b) Agency theory (c) The capital asset pricing model (d) The theory of multinational finance Topic: Agency Theory Skill: Recognition Answer: B 2 . The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country. any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. we observe what is termed relative purchasing power parity. but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. Cross-border investors are not only interested in the ease of buying assets.4. (5) Political safety is exceptionally important to both foreign portfolio and direct investors. These drivers include the following: (1) Relative real interest rates are a major consideration for investors in foreign bonds and short term money market instruments. _______________________ is the study of how shareholders can motivate management to accept prescriptions of the shareholder wealth maximization model. Explain how the asset market approach can be used to forecast future spot exchange rates. Asset market approach to forecasting. (2) Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment. (4) A country’s economic and social infrastructure is an important indicator of that country’s ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment. (6) The credibility of corporate governance practices is important to cross-border portfolio investors. Contagion can cause an ‘innocent’ country to experience capital flight with a resulting depreciation of its currency.10. if the spot exchange rate between two countries starts in equilibrium. We will observe this effect through the three illustrative cases that follow shortly. (3) Capital market liquidity is particularly important to foreign institutional investors. 5. More specifically. How does the asset market approach differ from the BOP approach to forecasting? Answer: The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers. A firm’s poor corporate governance practices can reduce foreign investors’ influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives. (d) All of the above are examples of failed corporate governance.11. Which of the following is inconsistent with long-term corporate value maximization? (a) A focus on overly generous short-term stock options. 21. (c) Global Crossing hiding operating losses while still heavily promoting its stock. The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed ____________________.0 billion that should have been written off as operating expenses. (c) The concept of patient capitalism. (d) The avoidance of deceptive and dishonest business practices. (b) The capitalization of $7. (a) agency theory (b) the asset pricing model (c) corporate governance (d) None of the above Topic: Corporate Governance Skill: Recognition Answer: C 26. (a) strategic and operational (b) operational and financial (c) financial and hazard (d) hazard and strategic Topic: Loss of Stock Value Skill: Recognition Answer: A 20. the primary causes of lost stock value were __________________________. Which of the following is an example of failed corporate governance in the financial markets? (a) The lack of full disclosure of off-balance-sheet debt by Enron Corporation. Which of the following is NOT a realistic possible shareholder response to dissatisfaction with stock performance? (a) Move to Canada (walk away) (b) Remain quietly disgruntled (the past) (c) Change management (shareholder activism) (d) Initiate a takeover (maximum threat) Topic: Corporate Governance Skill: Recognition Answer: A 3 . Topic: Corporate Governance Skill: Recognition Answer: D 27. Topic: Wealth Maximization Skill: Recognition Answer: A According to a recent survey of 1000 global companies. (b) A focus on long-term wealth maximization. If a country chooses to have a pure float exchange rate regime. You have been hired as a consultant to the central bank for a country that has for many years suffered from repeated currency crises and depends heavily on the U.2055/$. Japanese yen. and monetary independence. (c) Full financial integration and monetary independence. (c) always changing because the price of gold was always changing.S. Russian Ruble. (b) Exchange rate stability and full financial integration.2. Topic: Special Drawing Right Skill: Recognition Answer: A 10.S. Japanese yen. British pound. (b) An exchange rate pegged to the U. Which of the following policies would have the greatest effectiveness for reducing currency volatility of the client country with the United States? (a) Dollarization.67 in U. Topic: Currency Regimes Skill: Conceptual Answer: A 4 . (d) unknown because there is not enough information to answer this question. the exchange rate of pounds per dollar under this fixed exchange regime was (a) £4. and the euro (d) None of the above. Chinese yuan. and the euro (b) US dollar. (d) An internationally floating exchange rate. Topic: Currency Regimes Skill: Conceptual Answer: C 23. and the euro (c) US dollar. an ounce of gold cost $20. Topic: Gold Standard Skill: Analytical Answer: B 20. Therefore. full financial integration. Japanese yen. SDRs currently depend on the price of crude oil. Russian Ruble. British pound. dollars and £4. A special drawing right (SDR) is the weighted average of the following currencies: (a) US dollar. Under the gold standard of currency exchange that existed from 1879 to 1914. S.2. which two of the three goals is a country most able to achieve? (a) Monetary independence and exchange rate stability. (c) An exchange rate with a fixed price per ounce of gold. British pound.8665/$. dollar. financial and product markets. (b) £0.2474 in British pounds. The authors discuss the concept of the “Impossible Trinity” or the inability to achieve simultaneously the goals of exchange rate stability. (d) A country cannot attain any of the exchange rate goals with a pure float exchange rate regime. indirect investment (d) portfolio investment. (a) direct investment. (2) the pass-through period. (d) None of the above. (d) the amount of a country’s merchandise trade deficit of surplus.1. International economic analysis characterizes the trade balance adjustment process as occurring in three stages in the following order: (a) (1) The currency contract period. (b) A devaluation of the country’s currency will result in an initial further deterioration of the trade imbalance before improvement. The balance of payments as applied to a course in international finance may be defined as (a) the amount still owed by an exporting firm after making an initial down payment. Topic: BOP Introduction Skill: Conceptual Answer: C 17. (c) the measurement of all international economic transactions between the residents of a country and foreign residents. (2) the pass-through period. and (3) the pass-through period. (b) (1) The currency contract period. Topic: The J-Curve Skill: Conceptual Answer: B 5 . (2) the currency contract period. When categorizing investments for the financial account component of the balance of payments the ________________ is an investment where the investor has no control whereas the _______________ is an investment where the investor has control over the asset. direct investment Topic: Financial Account Skill: Recognition Answer: D31. (2) the quantity adjustment period. portfolio investment (b) direct investment. indirect investment (c) portfolio investment. (c) (1) The quantity adjustment period. (b) the amount still owed by governments to the International Monetary Fund. Topic: The J-Curve Skill: Recognition Answer: A 32. and (3) the quantity adjustment period. (d) (1) The pass-through period. and (3) the currency contract period. and (3) the quantity adjustment period. (c) A devaluation of the country’s currency will result in an initial improvement of the trade imbalance before deterioration.3. The J-Curve adjustment path for adjusting trade imbalances hypothesizes that for a country with a trade balance deficit: (a) A revaluation of the country’s currency will result in an initial further deterioration of the trade imbalance before improvement. 0081/¥ (d) 115. what is the estimated exchange rate of yen per dollar as hypothesized by the Hamburger index? (a) $.14. the Big Mac hamburger in Japan is ________. then at an exchange rate of $1. (a) correctly priced (b) under priced (c) over priced (d) not enough information to determine if the price is appropriate or not Topic: PPP Skill: Analytical Answer: B Other things equal. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore. 6 . If the current exchange rate is 124 Japanese yen per U. the price should be the same. and assuming efficient markets. (a) 26.S.183£ Topic: Law of One Price Skill: Analytical Answer: C 4.843£ (d) 9. The Economist publishes annually the “hamburger standard” by which they compare the prices of the McDonalds Corporation Big Mac hamburger around the world. the Honda Accord should cost __________ in Great Britain.365£ (c) 12.43/£. so does the demand for imports. as a country’s income increases. In general. and the price of a Big Mac hamburger in Japan is 294 yen.75¥/$ Topic: PPP Skill: Analytical Answer: D 2. In general. if a Honda Accord costs $18. dollar. the United States goods trade balance has grown increasing positive over the last 3 years. If a Big Mac costs $2.365 in the U.54 in the United States and 294 yen in Japan. (a) True (b) False Topic: Economic Theory Skill: Conceptual Answer: A 4. then other things equal. the price of a Big Mac hamburger in the United States is $2. (a) True (b) False Topic: Current Account Skill: Recognition Answer: B 15.S.262£ (b) 18.0086/¥ (b) 124¥/$ (c) $.1.54. the current spot exchange rate of U. Based on the theory of Relative PPP.S.S. What is the degree of pass through by Sony of Japan on their DVD players? (a) 95.5. and Staunton (2002) found that for the 1900–2000 period.1% Topic: Exchange Rate Pass-through Skill: Analytical Answer: C 7 . Marsh. (a) True (b) False Topic: Exchange Rate Pass-Through Skill: Conceptual Answer: B 11. Since that time the rate of inflation in the U. relative purchasing power parity did not hold. Currently the spot exchange rate is 110¥/$ and Sony is charging $170 per DVD player.2% (d) 4. dollars for Canadian dollars was $1/C$1. has been 4% greater than that in Canada. One year ago the spot rate of U.04/C$1 (d) Relative PPP provides no guide for this type of question. (a) True (b) False Topic: PPP Skill: Recognition Answer: B 10. Topic: PPP Skill: Analytical Answer: C 7. Sony of Japan produces DVD players and exports them to the United States.7% (c) 73.9% (b) 86. (a) $0. Products that are relatively price inelastic tend to also demonstrate a low degree of exchange rate passthrough. (a) True (b) False Topic: Fisher Effect Skill: Conceptual Answer: A 15. Research by Dimson. dollars for Canadian dollars should be approximately ____________.S.96/C$ (b) $1/C$1 (c) $1. Last year the exchange rate was 130¥/$ and Sony charged $150 per DVD player. Empirical tests show that the Fisher effect usually exists for short maturity government securities but less so for longer-term maturity securities. 000. (a) i = (r)(π) (b) i = r + π + (r)(π) (c) i = r + π (d) i = r + 2 π Topic: Fisher Effect Skill: Recognition Answer: C 19.587 Topic: Uncovered Interest Arbitrage Skill: Analytical Answer: D 8 . money market at an annual rate of 4.05% (c) 2. Treasury Bills of 4.S.60% and uses the proceeds to invest in the U.S. Assume a nominal interest rate on one-year U. If the spot rate today is ¥115/$ and the spot rate in 6 months is ¥113/$ Howard’s net proceeds will be: (a) ¥104. Where: i = the nominal rate of interest. over the next year? (a) 2.000 for 6 months at an annual rate of .18. (a) absolute PPP (b) the law of one price (c) relative PPP (d) the international Fisher Effect Topic: International Fisher Effect Skill: Recognition Answer: D Problem 33. what is the approximate expected rate of inflation in the U. r = the real rate of return and π = the expected rate of inflation. Using the Fisher Effect Equation. The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as ___________________.60% and a real rate of interest of 2.10% (b) 2.587 (c) $921 (d) ¥8.90% Topic: Fisher Effect Skill: Analytical Answer: A 20.00% (d) 1. Howard borrows ¥5. In its approximate form the Fisher effect may be written as ____________.S.130 (b) $8.50%.50%. (a) Contraband (b) Contagion (c) Cross-border political risk (d) Current account exposure Topic: Contagion Skill: Recognition Answer: B 9 .00% p.4375/DM 8. Which of the following is NOT part of the set of investment considerations identified by the authors for the asset market approach to forecasting? (a) relative real interest rates (b) capital market liquidity (c) political safety (d) all are considerations identified by the authors Topic: Forecasting Skill: Recognition Answer: D 3. Which of the following is NOT a forecasting technique suggested by the authors? (a) asset market approach (b) parity conditions (c) globalization process (d) balance of payments approach Topic: Forecasting Skill: Recognition Answer: C 2.a.1.a. 5.83% p. ___________________ is the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics.2909/FF 2.06% p. 11.a.a.30.a.00% p.a. France FF 3.a.00% p. Spot exchange rate Expected inflation rate One-year “t-bill” rate (a) (b) (c) (d) 4. Germany DM 0.00% p. 5. 3.00% p. calculate the One-Year “t-bill” rate for Germany. Based on the following market information for France and Germany. ?? Topic: Interest Rate Parity Skill: Analytical Answer: C 5. The ____________ provides a means to account for international cash flows in a standardized and systematic manner. interest rates. PPP (c) PPP. Which of the following statements should NOT be applied to the theory of PPP? (a) PPP is the oldest and most widely followed of the exchange rate theories. ____________________ is the most widely accepted of all exchange rate forecasting theories. (a) True (b) False Topic: Fundamental Exchange Rate Theories Skill: Conceptual Answer: B 15. (a) the Fisher effect. fundamental theories of exchange rates have proved remarkably accurate for the short. but that _________ determines long run exchange rates. interest rates.and medium-term. (a) The Balance of Payments approach (b) Purchasing Power Parity (c) The Asset Market approach (d) Sarbanes-Oxley Topic: XR Forecasting Theories Skill: Recognition Answer: B 10. Despite inadequacies in estimating long-term exchange rate values. (c) Most theories of exchange rate determination have elements of PPP imbedded in them. PPP (b) asset markets. the Fisher effect (d) the Fisher effect. asset prices. They conclude that ____________ is important in the short run. (b) PPP calculations and forecasts may be plagued with structural differences across countries. (a) parity conditions theory (b) asset approach (c) balance of payments theory (d) international Fisher effect Topic: Balance of Payments Skill: Recognition Answer: C 11.9. The authors compromise as to the key factors for exchange rate determination. (d) All of the above apply to PPP Topic: Purchasing Power Parity Skill: Conceptual Answer: D 14. and expectations Topic: Key Factors for Equilibrium in Foreign Exchange Markets Skill: Conceptual Answer: C 10 . and expectations. (b) Short-term movements longer than day-to-day.35/$) in 1997. If the exchange rate approached Ru5. Fundamentally. and evening. (c) Morning. the Russian government would intervene in the markets to stabilize the Ruble.70/$ to Ru6. (a) buy. or if the exchange rate approached Ru6. sell (b) sell. (a) True (b) False Topic: Key Factors for Equilibrium in Foreign Exchange Markets Skill: Recognition Answer: A 23.70/$ the government would _________ Rubles using foreign exchange and gold. Topic: Technical Analysis Skill: Recognition Answer: D 17. Technical analysts divide exchange rate movements into three periods. sell Topic: Russian Crisis Skill: Conceptual Answer: B 24. afternoon. When the Russian Ruble reached the limits of the bands about its managed float targets (Ru5. was not (d) rise. a country with a relatively high inflation rate should see its currency _____________ in value relative to countries with lower rates of inflation and this _______ the case for the Brazilian currency from 1994–1998. buy (c) buy. buy (d) sell. was not (b) fall. was (c) rise. Which of the following do NOT apply? (a) Random day-to-day movements. The authors claim that theoretical and empirical studies appear to show that fundamentals do apply to the long-term for foreign exchange. (a) fall. (d) Long-term trends.16.35/$ they would _________ Rubles. was Topic: Brazilian Crisis Skill: Conceptual Answer: A 11 . (a) True (b) False Topic: Forecasting Skill: Recognition Answer: B 30. (a) True (b) False Topic: Forecasting Skill: Recognition Answer: B 12 . Topic: Fundamental vs.48/£ requires more € to obtain a £ than that forecast by the cross rates. Topic: Cross Rates Skill: Analytical Answer: B 29.70/£ and €1. (d) Not enough information to determine the correct response. Are the following exchange rates are forecast for one-year hence.25. A recent London School of Economics study of fundamental versus technical trading analysis found the following with regard to currency trading: (a) Total returns to the technical portfolio were superior to the fundamental portfolio. (d) Portfolio returns were similar between the two with less variability for the technical portfolio. (c) Portfolio returns were similar between the two with less variability for the fundamental portfolio.48/£ requires fewer € to obtain a £ than that forecast by the cross rates.48/£. Exchange rates are relatively easy to forecast in the short-term but far more difficult in the long-term as currencies move away from their fundamental values. (a) Yes. (c) No because the forecast rate of €1. Are they in equilibrium? Why? Oneyear forecast are €0.90/$. (b) Total returns to the fundamental portfolio were superior to the technical portfolio. because the cross rates and forecast rates for the €/£ are equal. (b) No. $1. Technical Analysis Skill: Conceptual Answer: D 26. Overshooting in the currency market is the practice of always estimating forward rates too high to avoid more expensive undershooting errors. because the forecast rate of €1. 13 .