CHAPTER 20
THE FOREIGN EXCHANGE MARKET
B. Multiple-Choice Questions
10. If a speculator observes that the current 3-months forward rate on Swiss francs is $1.05=
1 franc, but he/she expects that the spot rate in 3 months will be $1.10 = 1 franc, then this
speculator would now
11. Which one of the following sets of exchange rates shows “cross–rate equality” (or
“consistent cross rates”)?
a. 50 Indian rupees = $1; $2 = ₤1; 25 Indian rupees = ₤1
12. Other things equal, if exchange rates are flexible, and if U.S. consumers increase their
demand for Japanese goods at the same time that Japanese consumers increase their
demand for U.S. goods, then we would expect the dollar to
13. In a setting of flexible exchange rates, suppose that the U.S. citizens decrease their import
purchases from the United Kingdom at the same time that British citizens increase their
purchases of stocks and bonds in the United States. The first action (the U.S. imports) by
itself would lead to __________ of the dollar against the pound; the second action by
itself would __________ of the dollar against the pound.
14. The Wall Street Journal indicated, in its issue of Friday, November 9, 2012, that, in late
trading on Thursday, November 8, 2012, the spot U.K. pound was selling at a price of
$1.5983 per pound. At the same time, the six-months forward U.K. pound was selling at
a price of $1.5974 per pound. Observation of these rates indicates that the U.K. pound
was selling at a six-months forward __________ against the dollar, and, if covered
interest parity had indeed been attained at that time, the conclusion could validly be
reached that interest rates in the United Kingdom were __________ than comparable
interest rates in the United States.
15. If, in time period #1, the equilibrium value of the pound is $1.60, but then U.K. prices
double between time period #1 and time period #2 while U.S. prices rise by 60 percent,
then the (relative) purchasing power parity theory would say that the equilibrium value of
the pound in time period #2 is
16. In which of the following relationships between the expected future spot rate [E(e)] of a
foreign currency and the current forward rate (efwd) of a foreign currency would a
speculator have an incentive to sell foreign currency in the forward market?
17. A simultaneous increase in U.S. demand for German products and decrease in the desire
of German investors to send funds to the United States would, under a flexible exchange
rate system and with other things equal, lead to __________ of the U.S. dollar against the
euro and to __________ of the euro against the dollar.
a. an appreciation; a depreciation
18. Suppose that, in a system of floating or market-determined exchange rates, the
equilibrium exchange rate is 80 Japanese yen = $1. If there is then a change in
preferences of U.S. consumers such that they now prefer more Japanese goods in their
consumption bundle, then, other things equal, the equilibrium exchange rate __________,
which is __________.
d. will move toward a higher price for the dollar (e.g., 85 yen = $1); an appreciation of
the dollar relative to the yen
19. If U.K. interest rates are higher than Japanese interest rates, then the theory of covered
interest arbitrage would suggest that, in the pound/yen exchange markets, the yen would
be at a forward __________ and the pound would __________.
20. If, because of Japan’s high saving rate (in excess of domestic investment spending),
Japan invests overseas, then this investment can cause __________ of the Japanese yen
and thus a consequent trade __________ for Japan.
21. An exporter who is to receive payment in foreign currency in three months and who
wants to engage in “hedging” would __________ the foreign currency on the three-
months forward market in order to protect himself/herself from __________ of the
foreign currency.
22. Suppose that the United States trades only with Germany and Japan. Suppose also that
in 2010 the spot rates were 0.70 euro = $1 peso and ¥110 = $1, and that in 2015 the
spot rates were 0.84 euro = $1 and ¥99 = $1 peso. If United States trade is 50 percent
with Germany and 50 percent with Japan, calculation of the effective exchange rate for
the United States indicates that the dollar
23. Suppose that the one-year interest rate in the United States is 6% and that the one-year
interest rate in the United Kingdom is 3%. In the context of “uncovered” interest
arbitrage and with other things equal, funds would tend to flow out of the United States
and into the United Kingdom
a. if the British pound is expected to depreciate by 2% relative to the dollar during the
coming year.
24. Given the following partially-completed table showing the quantity demanded of euros
and the quantity supplied of dollars in exchange for the euros:
exchange rate euros demanded dollars supplied
$2.00 = €1 €600 x
$1.50 = €1 y $1,500
The missing values are __________.
25. A given exchange rate will be more or less the same in all of the world’s financial
markets because of
26. Suppose that the three-months interest rate in New York is 4 percent and the three-
months interest rate in London is 3 percent, and that the spot rate is $2.00/£1 and the
three-months forward rate is $2.10/£1. In this situation, there is an incentive for short-
term interest arbitrage funds to flow
27. If a PPP estimate of the dollar/pound exchange rate is $1.61/£ and the current spot rate is
observed to be $1.68/£, on the basis of these two rates you should, viewing the long run,
28. If ef = the forward rate on three-months Swiss francs, e = the current spot rate on Swiss
francs, and E(e) = the expected future rate of the Swiss franc in three months, then the
Swiss franc is said to be at a forward discount if __________ is negative.
d. E(e) – ef
ef
29. The “Big Mac” Index
a. is a popular example of a relative PPP index of a particular commodity.
30. If a “Big Mac” costs $4.00 in the United States and 200 yen in Japan, then the implied
“purchasing-power-parity” exchange rate using the “Big Mac Index” is __________. If
the actual exchange rate in the market is 60 yen = $1, then an economist would say that
the actual Japanese yen is __________ in comparison with its “purchasing-power-parity”
rate.
31. Suppose that a speculator notes that the current three-months forward rate on the euro is
$1.36 and the speculator expects that, in three months, the euro will have a value of
$1.40. In this situation, the speculator would __________ euros on the forward market,
and this activity __________ for the speculator.
32. If a “Big Mac” costs $4.00 in the United States and 5 francs in Switzerland, then the
implied “purchasing-power-parity” exchange rate using the “Big Mac Index” is
__________. If the actual exchange rate in the market is 1 franc = $0.90, then an
economist would say that the actual Swiss franc is __________ in comparison with its
“purchasing-power-parity” rate.
33. Suppose that, in Year 1, the price of the U.K. pound is $1.44 = £1. In year 2, the price is
$1.48 = £1. An economist would validly conclude that, from Year 1 to Year 2 and in
nominal terms, the U.K. pound __________ relative to the U.S. dollar and,
simultaneously, the U.S. dollar __________ relative to the U.K. pound.
