Chap009 IB

Chapter 09 - The Foreign Exchange Market
Chapter 09 The Foreign Exchange Market Answer Key
True / False Questions
1. (p. 312) The foreign exchange market is a market for converting the currency of one country
into that of another country.
TRUE
AACSB: Financial Theories, Analysis, Reporting, and Markets

Bloom's: Knowledge
Difficulty: Easy
Learning Objective: 09-1
2. (p. 312) Currency fluctuations can make seemingly profitable trade and investment deals
unprofitable and vice versa.
TRUE

Bloom's: Knowledge
Difficulty: Medium
9-1
3. (p. 312) The rate at which one currency is converted into another is known as the fluctuation
rate.
FALSE

Bloom's: Knowledge
Difficulty: Easy
4. (p. 313) The risk that arises from volatile changes in exchange rates is known as foreign
exchange risk.
TRUE

Bloom's: Knowledge
Difficulty: Medium
5. (p. 312) It is possible for a firm to purchase complete insurance against the risks that arise
from changes in exchange rates in the foreign exchange market.
FALSE

Bloom's: Comprehension
Difficulty: Medium
9-2
6. (p. 313) When a tourist changes one currency into another, the tourist is participating in the
foreign exchange market.
TRUE

Bloom's: Knowledge
Difficulty: Medium
7. (p. 314) Currency speculation involves the long-term movement of funds from one currency to
another in the hopes of profiting from shifts in exchange rates.
FALSE

Bloom's: Knowledge
Difficulty: Medium
8. (p. 315) When a tourist goes to a bank in a foreign country to convert money into the local
currency, the exchange rate used is the spot rate.
TRUE

Bloom's: Knowledge
Difficulty: Medium
9-3
9. (p. 315) A spot exchange rate is quoted for 30 days, 90 days, and 180 days into the future.
FALSE

Bloom's: Knowledge
Difficulty: Medium
10. (p. 315) The value of a currency is determined by the interaction between the demand and
the supply of that currency relative to the demand and supply of other currencies.
TRUE

Bloom's: Knowledge
Difficulty: Medium
11. (p. 315) If the spot exchange rate is 1 = $1.50 when the market opens, and 1 = $1.48 at the
end of the day, the pound has appreciated, and the dollar has depreciated.
FALSE

Bloom's: Application
Difficulty: Medium
12. (p. 316) When two parties agree to exchange currency and execute the deal at some specific
time in the future, a forward exchange occurs.
TRUE

Bloom's: Knowledge
Difficulty: Easy
9-4
13. (p. 316) To minimize the risk of an unanticipated change in exchange rates, a company can
protect itself by entering into a forward exchange contract.
TRUE

Bloom's: Knowledge
Difficulty: Medium
14. (p. 316) If $1 bought more yen with a spot exchange than with a 30-day forward exchange it
indicates the dollar is expected to depreciate against the yen in the next 30 days. When this
occurs, we say the dollar is selling at a premium on the 30-day forward market.
FALSE

Difficulty: Medium
15. (p. 316) Differences in the spot exchange rate and the 30-day forward rate are normal and
reflect the expectations of the foreign exchange market about future currency movements.
TRUE

Difficulty: Medium
16. (p. 316) Changes in spot exchange rates can be advantageous for an international business.
FALSE

Difficulty: Easy
9-5
17. (p. 316) If the spot rate is $1 = 120, and the 30-day forward rate is $1 = 130, the dollar is
selling at a discount in the forward market.
FALSE

Difficulty: Medium
18. (p. 317) A currency swap is the rate at which a foreign exchange dealer converts one
currency into another on a particular day.
FALSE

Bloom's: Knowledge
Difficulty: Easy
19. (p. 318) The foreign exchange market is a global network of banks, brokers, and foreign
exchange dealers connected by electronic communications systems.
TRUE
AACSB: Use of Information Technology

Bloom's: Knowledge
Difficulty: Medium
20. (p. 318) The most important trading centers for currencies are in Zurich, Frankfurt, Paris,
Hong Kong, and Sydney.
FALSE
AACSB: Domestic and Global Economic Environments

Bloom's: Knowledge
Difficulty: Medium
9-6
21. (p. 318) The foreign exchange market is open for only 12 hours in a day.
FALSE

Bloom's: Knowledge
Difficulty: Medium
22. (p. 319) Arbitrage opportunities abound in the foreign exchange markets and they tend to be
available for long periods of time.
FALSE

Bloom's: Knowledge
Difficulty: Easy
23. (p. 319) Although a foreign exchange transaction can involve any two currencies, most
transactions involve pounds on one side.
FALSE

Bloom's: Knowledge
Difficulty: Medium
24. (p. 320) According to the law of one price, at the most basic level, exchange rates are
determined by supply and demand.
FALSE

Bloom's: Knowledge
Difficulty: Easy
9-7
25. (p. 320) There are no impediments to the free flow of goods and services in an efficient
market.
TRUE
AACSB: Analytic Skills

Bloom's: Knowledge
Difficulty: Medium
26. (p. 320) According to a less extreme version of the PPP theory, given relatively efficient
markets, the price of a "basket of goods" should be roughly equivalent in each country.
TRUE

Bloom's: Knowledge
Difficulty: Medium
27. (p. 321) Price inflation occurs when the quantity of money in circulation rises faster than the
stock of goods and services.
TRUE

Bloom's: Knowledge
Difficulty: Medium
28. (p. 321) When the growth in a country's money supply is faster than output increases,
inflation is fueled.
TRUE

Bloom's: Knowledge
Difficulty: Medium
9-8
29. (p. 322) According to the PPP, a country with a high inflation rate will see depreciation in its
currency exchange rate.
TRUE

Bloom's: Knowledge
Difficulty: Medium
30. (p. 323) The PPP theory is a strong predictor of short-run movements in exchange rates
covering time spans of five years or less.
FALSE

Bloom's: Knowledge
Difficulty: Medium
31. (p. 324) The Fisher Effect states that a country's real interest rate is the sum of the nominal
interest rate and the expected rate of inflation over the period for which the funds are to be
lent.
FALSE

Bloom's: Knowledge
Difficulty: Medium
32. (p. 325) 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 for the two countries.
TRUE

Bloom's: Knowledge
Difficulty: Easy
9-9
33. (p. 325) The International Fisher Effect has proven to have substantial power at predicting
short-run changes in spot exchange rates.
FALSE

Bloom's: Knowledge
Difficulty: Medium
34. (p. 328) An inefficient market is one in which prices do not reflect all available information.
TRUE

Bloom's: Knowledge
Difficulty: Easy
35. (p. 330) Technical analysis draws on economic theory to construct sophisticated econometric
models for predicting exchange rate movements.
FALSE

Bloom's: Knowledge
Difficulty: Medium
36. (p. 330) If a country has an externally convertible currency, neither residents nor
nonresidents are allowed to convert it into a foreign currency.
FALSE

Bloom's: Knowledge
Difficulty: Easy
9-10
37. (p. 330) 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.
TRUE

Bloom's: Knowledge
Difficulty: Medium
38. (p. 331) Transaction exposure is the extent to which the income from individual transactions
is affected by fluctuations in foreign exchange values.
TRUE

Bloom's: Knowledge
Difficulty: Easy
39. (p. 332) The impact of currency exchange rates on the reported financial statements of a
company is translation exposure.
TRUE

Bloom's: Knowledge
Difficulty: Medium
40. (p. 332) A lag 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.
FALSE

Bloom's: Knowledge
Difficulty: Hard
9-11

Multiple Choice Questions
41. (p. 312) The rate at which one currency is converted into another is the:
A. replacement percentage.
B. resale rate.
C. exchange rate.
D. interchange ratio.
The foreign exchange market is the lubricant that enables companies based in countries that
use different currencies to trade with each other.

Bloom's: Knowledge
Difficulty: Easy
42. (p. 312) The risks that arise from volatile changes in exchange rates are commonly referred
to as:
A. interest rate risks.
B. basis risks.
C. operational risks.
D. foreign exchange risks.
Foreign exchange risk is the adverse consequences of unpredictable changes in exchange
rates.

Bloom's: Knowledge
Difficulty: Easy
9-12
43. (p. 313) The foreign exchange market serves two main functions. These are:
A. collect duties on imported products and convert the currency of one country into the
currency of another.
B. insure companies against foreign exchange risk and set interest rates charged to foreign
investors.
C. collect duties on imported products and set interest rates charged to foreign investors.
D. convert the currency of one country into the currency of another and provide some
insurance against foreign exchange risk.
The first is to convert the currency of one country into the currency of another. A second
function of the foreign exchange market is to provide insurance against foreign exchange risk,
which is the possibility that unpredicted changes in future exchange rates will have adverse
consequences for the firm.

Difficulty: Medium
44. (p. 313) A pair of shoes costs 30 in Britain. The identical pair costs $45 in the United States.
The exchange rate is 1 = $1.80. In terms of cost of the shoes:
A. the U.S. offers a better deal.
B. the deal is the same in both countries.
C. Britain offers a better deal.
D. the U.S. deal is comparatively worse.
When a tourist changes one currency into another, he/she is participating in the foreign
exchange market. The exchange rate is the rate at which the market converts one currency into
another. The exchange rate allows us to compare the relative prices of goods and services in
different countries.

Difficulty: Hard
9-13
45. (p. 313) An exchange rate of 1 = $1.30 indicates that:

A. $1 is worth 1.30 euros.
B. one could sell 1.30 euros for $1.
C. one euro buys $1.30.
D. there are 1.30 euros for every dollar.
When a tourist changes one currency into another, he/she is participating in the foreign
exchange market. The exchange rate is the rate at which the market converts one currency into
another. The exchange rate allows us to compare the relative prices of goods and services in
different countries.

Difficulty: Medium
46. (p. 313) The _____ helps us to compare the relative prices of goods and services in different
countries.
A. interest rate
B. customs rate
C. exchange rate
D. tariff rate
The exchange rate is the rate at which the market converts one currency into another. The
exchange rate allows us to compare the relative prices of goods and services in different
countries.

Bloom's: Knowledge
Difficulty: Easy
9-14
47. (p. 313-314) International businesses use foreign exchange markets for all of the following
reasons except:
A. to receive payments from foreign investments that may be in foreign currencies.
B. to pay a foreign company for its products or services in its country's currency.
C. to invest for short terms in money markets when they have spare cash.
D. to cover themselves from all risks involved in currency speculation.
In general, companies should beware, because speculation by definition is a very risky
business. The company cannot know for sure what will happen to exchange rates. While
speculators may profit handsomely if future currency movements go in the direction
predicted, they can also lose vast amounts of money if they move in the other direction.

Difficulty: Hard
48. (p. 314) The short-term movement of funds from one currency to another in the hopes of
profiting from shifts in exchange rates is known as:
A. currency arbitrage.
B. currency speculation.
C. currency supposition.
D. short selling.
Currency speculation is one of the uses of foreign exchange markets.

Bloom's: Knowledge
Difficulty: Easy
9-15
49. (p. 315) One function of the foreign exchange market is to provide some insurance against
the risks that arise from changes in exchange rates, commonly referred to as:
A. foreign market hazard.
B. global jeopardy.
C. foreign exchange risk.
D. commerce uncertainty.
One of the functions of the foreign exchange market is to provide insurance against foreign
exchange risk, which is the possibility that unpredicted changes in future exchange rates will
have adverse consequences for the firm.

Bloom's: Knowledge
Difficulty: Medium
50. (p. 315) When two parties agree to exchange currency and execute the deal immediately, the
transaction is a:
A. point-in-time exchange.
B. temporal exchange.
C. spot exchange.
D. forward exchange.
Exchange rates governing "on the spot" trades are referred to as spot exchange rates.

Bloom's: Knowledge
Difficulty: Easy
9-16
51. (p. 315) If lots of people want euros and euros are in short supply, and a few people want
Japanese yen and yen are in plentiful supply, the euro is likely to _____ against the yen.
A. depreciate
B. appreciate
C. devalue
D. stabilize
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.

Bloom's: Knowledge
Difficulty: Medium
52. (p. 316) _____ are exchange rates governing some specific future date foreign exchange
transactions.
A. Spot exchange rates
B. Forward exchange rates
C. Future exchange rates
D. Currency swaps
Forward exchange rates represent market participants' collective predictions of likely spot
exchange rates at specified future dates.

Bloom's: Knowledge
Difficulty: Medium
9-17
53. (p. 316) Assuming the 30-day forward exchange rate were $1 = 130 and the spot exchange
rate were $1 = 120, the dollar is selling at a _____ on the 30-day forward market.
A. premium
B. margin
C. discount
D. subsidy
$1 would buy more yen with a forward exchange than with a spot exchange. In such a case,
we say the dollar is selling at a premium on the 30-day forward market.

Difficulty: Hard
54. (p. 317) The simultaneous purchase and sale of a given amount of foreign exchange for two
different value dates is referred to as a:
A. fiscal barter.
B. liquid trade.
C. currency exchange.
D. currency swap.
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.

Bloom's: Knowledge
Difficulty: Easy
9-18
55. (p. 318) Assume that the yen/dollar exchange rate quoted in London at 3:00 p.m. is 120 =
$1, and the New York yen/dollar exchange rate at the same time is 125 = $1. A dealer makes
a profit by buying a currency low and selling it high. The dealer has engaged in a(n):
A. currency swap.
B. arbitrage.
C. backwardation.
D. straddle.
Buying a currency low and selling it high is arbitrage.

Difficulty: Medium
56. (p. 319) If the demand for dollars outstrips its supply and if the supply of Japanese yen is
greater than the demand for it, what will happen?
A. The dollar will appreciate against the yen
B. The dollar will depreciate against the yen
C. The exchange rates will remain the same
D. The yen will appreciate against the dollar
At the most basic level, exchange rates are determined by the demand and supply of one
currency relative to the demand and supply of another.

Difficulty: Hard
9-19
57. (p. 320) According to the _____, 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 one price
B. principle of consistent pricing
C. model of fair pricing
D. principle of equitable pricing
The law of one price is an economic proposition to understand how prices are related to
exchange rate movements.

Bloom's: Knowledge
Difficulty: Medium
58. (p. 320) According to the law of one price, if the exchange rate between the British pound
and the dollar is 1 = $1.50, a jacket that retails for $75 in New York should sell for _____ in
London.
A. 40
B. 50
C. 60
D. 75
The law of one price states that in competitive markets free of transportation costs and
when their price is expressed in terms of the same currency.

Difficulty: Medium
9-20
59. (p. 320) The _____ suggests that given relatively efficient markets, the price of a "basket of
goods" should be roughly equivalent in each country.
A. theory of efficient markets
B. law of one price
C. theory of price inflation
D. PPP theory
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 currencies, it would be possible to determine the "real" or PPP exchange rate that
would exist if markets were efficient.

Bloom's: Knowledge
Difficulty: Medium
60. (p. 320) Suppose the price of a Big Mac in New York is $3.00 and the price of a Big Mac in
Paris is $3.75 at the prevailing euro/dollar exchange rate, then according to PPP the euro is:
A. undervalued by 25 percent against the dollar.
B. overvalued by 25 percent against the dollar.
C. appreciating relative to the dollar.
D. depreciating relative to the dollar.
To calculate the Big Mac index, The Economist converts the price of a Big Mac in a country
into dollars at current exchange rates and divides that by the average price of a Big Mac in
America. According to the PPP theorem, the prices should be the same. If they are not, it
implies that the currency is either overvalued against the dollar or undervalued.

Difficulty: Hard
9-21
61. (p. 323) Identify the incorrect statement about the PPP theory.
A. It predicts that exchange rates are determined by relative prices.
B. It yields accurate predictions in the short run.
C. It best predicts exchange rate changes for countries with high rates of inflation.
D. It assumes away transportation costs and barriers to trade.
While PPP theory seems to yield relatively accurate predictions in the long run, it does not
appear to be a strong predictor of short-run movements in exchange rates covering time spans
of five years or less.

Difficulty: Medium
62. (p. 324) _____ involves dominant enterprises setting different prices in different markets to
reflect varying demand conditions.
A. Conditional pricing
B. Dual pricing
C. Price discrimination
D. Foreign market pricing
For price discrimination to work, arbitrage must be limited. Enterprises with some market
power may be able to control distribution channels and therefore limit the unauthorized resale
of products purchased in another national market.

Bloom's: Knowledge
Difficulty: Medium
9-22
63. (p. 324) The _____ states that a country's "nominal" interest rate is the sum of the required
"real" rate of interest and the expected rate of inflation over the period for which the funds are
to be lent.
A. PPP theory
B. efficient market theory
C. inefficient market theory
D. Fisher Effect
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.

Bloom's: Knowledge
Difficulty: Easy
64. (p. 324) Economic theory suggests that when inflation is expected to be high:
A. interest rates will be low.
B. exchange rates will be high.
C. the International Fisher Effect does not hold.
D. interest rates will be high.
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.

Bloom's: Knowledge
Difficulty: Medium
9-23
65. (p. 325) _____ 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. The Fisher Effect
B. The International Fisher Effect
C. The efficient market theory
D. The inefficient market theory
Since there is a link between inflation and exchange rates according to the PPP theory, and
since interest rates reflect expectations about inflation, it follows that there must also be a link
between interest rates and exchange rates. This link is known as the International Fisher
Effect.

Bloom's: Knowledge
Difficulty: Medium
66. (p. 325-326) When traders move as a herd in the same direction at the same time such as what
occurred when George Soros betted against the British pound in 1992, a(n) _____ occurs.
A. efficient market
B. inefficient market
C. bandwagon effect
D. Fisher Effect
When Soros started shorting the British pound, many foreign exchange traders, knowing
Soros's reputation, jumped on the bandwagon and did likewise. This triggered a classic
bandwagon effect.

Bloom's: Knowledge
Difficulty: Medium
9-24
67. (p. 328) The _____ argues that forward exchange rates do the best possible job of forecasting
future spot rates and therefore investing in forecasting services would be a waste of money.
A. inefficient market school
B. efficient market school
C. Fisher Effect
D. international Fisher Effect
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 to aid decision
making. Two schools of thought, the efficient market school and the inefficient market school,
address this issue.

Bloom's: Knowledge
Difficulty: Easy
68. (p. 329) _____ draws on economic theory to construct sophisticated econometric models for
predicting exchange rate movements.
A. Efficient market theory
B. Inefficient market theory
C. Fundamental analysis
D. Technical analysis
Fundamental analysis draws on economic theory to construct sophisticated econometric
models for predicting exchange rate movements. The variables contained in these models
typically include relative money supply growth rates, inflation rates, and interest rates.

Bloom's: Knowledge
Difficulty: Medium
9-25
69. (p. 330) _____ uses price and volume data to determine past trends, which are expected to
continue into the future.
A. Technical analysis
B. Fundamental analysis
C. The Fisher Effect
D. The International Fisher Effect
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.

Bloom's: Knowledge
Difficulty: Medium
70. (p. 330) A currency is said to be freely convertible when:

A. the country's government allows both residents and nonresidents to purchase unlimited
amounts of a foreign currency with it.
B. only nonresidents may convert it into a foreign currency without any limitations.
C. neither residents nor nonresidents are allowed to convert it into a foreign currency.
D. only residents may convert it internally into a foreign currency.
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.

Bloom's: Knowledge
Difficulty: Easy
9-26
71. (p. 330) A currency is said to be externally convertible when:

A currency is said to be externally convertible when only nonresidents may convert it into a
foreign currency without any limitations.

Bloom's: Knowledge
Difficulty: Easy
72. (p. 330) When a currency is nonconvertible:

A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it
into a foreign currency.

Bloom's: Knowledge
Difficulty: Easy
9-27
73. (p. 330) _____ 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.
A. The bandwagon effect
B. The Fisher Effect
C. The International Fisher Effect
D. Capital flight
Governments typically impose convertibility restrictions on their currency when they fear that
free convertibility will lead to a run on their foreign exchange reserves. This occurs when
residents and nonresidents rush to convert their holdings of domestic currency into a foreign
currencya phenomenon generally referred to as capital flight.

Bloom's: Knowledge
Difficulty: Easy
74. (p. 331) A range of barter-like agreements by which goods and services can be traded for
other goods and services is known as:
A. countertrade.
B. protracted trade.
C. intermediate sales.
D. countersale.
Companies can deal with the nonconvertibility problem by engaging in countertrade.

Bloom's: Knowledge
Difficulty: Medium
9-28
75. (p. 331) Countries might be forced to use countertrade when a currency is:
A. freely convertible.
B. externally convertible.
C. internally convertible.
D. nonconvertible.
Countertrade refers to a range of barter-like agreements by which goods and services can be
traded for other goods and services.

Bloom's: Knowledge
Difficulty: Medium
76. (p. 331) The extent to which the income from individual transactions is affected by
fluctuations in foreign exchange values is known as:
A. economic exposure.
B. financial exposure.
C. translation exposure.
D. transaction exposure.
Transaction 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.

Bloom's: Knowledge
Difficulty: Easy
9-29
77. (p. 332) _____ is the impact of currency exchange rates changes on the reported financial
statements of a company.
A. Economic exposure
B. Financial exposure
C. Translation exposure
D. Transaction exposure
Translation exposure is concerned with the present measurement of past events.

Bloom's: Knowledge
Difficulty: Easy
78. (p. 332) The extent to which a firm's future international earning power is affected by
changes in exchange rates is known as:
A. translation exposure.
B. financial exposure.
C. economic exposure.
D. transaction exposure.
Economic exposure is concerned with the long-run effect of changes in exchange rates on
future prices, sales, and costs.

Bloom's: Knowledge
Difficulty: Easy
9-30
79. (p. 332) A(n) _____ 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. follower strategy
B. interim strategy
C. lead strategy
D. lag strategy
Leading involves accelerating payments from weak-currency to strong-currency countries and
delaying inflows from strong-currency to weak-currency countries.

Bloom's: Knowledge
Difficulty: Easy
80. (p. 332) A(n) _____ 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. follower strategy
B. interim strategy
C. lead strategy
D. lag strategy
Lagging involves accelerating payments from weak-currency to strong-currency countries and
delaying inflows from strong-currency to weak-currency countries.

Bloom's: Knowledge
Difficulty: Easy
9-31

Essay Questions
81. (p. 312-313) With the help of an example explain how a tourist participates in the foreign
exchange market.
The foreign exchange market is a market for converting the currency of one country into that
of another country. When a tourist changes one currency into another, the tourist is
participating in the foreign exchange market. If the euro/dollar exchange rate is 1 = $1.30,
then one euro buys $1.30 U.S. dollars. If the tourist wants to buy a T-shirt in France that costs
20 euros, the tourist can go to a bank and exchange her $26 for 20.

Difficulty: Easy
82. (p. 313-314) What are the main uses of foreign exchange markets for international business?
The foreign exchange market serves four primary functions for international companies. First,
the market is used to convert payments a company receives in foreign currencies into the
currency of its home country. Second, the market is used to convert the currency of a
company's home country into another currency when they must pay a foreign company for its
products and services in their currency. Third, international businesses may use foreign
exchange markets when they have spare cash that they wish to invest for short terms in money
markets (of another country). Fourth, the market is used for currency speculation.

Difficulty: Medium
9-32
83. (p. 315-316) What is the difference between a spot exchange rate and a forward exchange
rate?
The spot exchange rate is the rate at which a foreign exchange dealer converts one currency
into another currency on a particular day. Spot exchange rates are reported on a real time basis
on many financial Web sites. Spot rates are continually changing, their value being
determined by supply and demand for that currency relative to others. 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 transactions are referred to as forward
exchange rates. Most major currencies are quoted 30, 90, and 120 days into the future.

Bloom's: Knowledge
Difficulty: Medium
84. (p. 316) What is meant by the phrases the dollar is selling at a discount' on the 30-day
forward market and the dollar is selling at a premium' on the 30-day forward market?
When a dollar is selling at a discount on the 30-day forward market, it is worth less than on
the spot market, or one dollar buys more foreign currency with a spot exchange than with a
30-day forward contract. If the dollar is selling at a premium on the 30-day forward market,
foreign exchange dealers anticipate the dollar will appreciate against the foreign currency
over the next 30 days.

Bloom's: Knowledge
Difficulty: Medium
9-33
85. (p. 317) 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.

Bloom's: Knowledge
Difficulty: Medium
86. (p. 318) Where is the foreign exchange market located? What is the nature of the market? Is
the market growing or shrinking on a global basis?
The foreign exchange market is not located in any one place. It is a global network of banks,
brokers, and foreign exchange dealers connected by electronic communications systems.
When companies wish to convert currencies, they typically go through their own banks rather
than entering the market directly. The foreign exchange market has been growing at a rapid
pace, reflecting a general growth in the volume of cross-border trade and investment.

Difficulty: Medium
87. (p. 318) Discuss the nature of the foreign exchange market. How fast has it been growing?
Where are the most important trading centers?
The foreign exchange market is a global network of banks, brokers, and foreign exchange
dealers connected by electronic communications systems. The market has been growing at a
rapid pace. In April 2007, the average total value of global foreign exchange trading was
about $3.21 trillion per day. The most important trading centers are London, New York,
Zurich, Tokyo, and Singapore.

Difficulty: Medium
9-34
88. (p. 320) What is the law of one price?

The law of one price states that in competitive markets, free of transportation costs and
when their prices is expressed in terms of the same currency. If the exchange rate is 1 =
$1.50, a bracelet that sells for $75 in New York should sell for 50 in London.

Bloom's: Knowledge
Difficulty: Medium
89. (p. 320) Explain PPP. Use an example to show how PPP can help explain exchange rates.
PPP theory states that given relatively efficient markets, the price of a "basket of goods"
should be roughly equivalent in each country. So, if a basket of goods costs $200 in the U.S.
and 20,000 in Japan, PPP predicts that the dollar/yen exchange should be $200/20,000 or
$.01 per Japanese yen.

Difficulty: Medium
9-35
90. (p. 323-324) Discuss the failure of PPP theory to predict exchange rates accurately. What is the
purchasing power puzzle?
The failure to find a strong link between inflation rates and exchange rate movements has
been referred to as the purchasing power puzzle. Several reasons contribute to the failure of
PPP as a predictive tool. First, PPP theory assumes away transportation costs and barriers to
entry, yet in practice this is not realistic. Second, 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. Third, government intervention in the
foreign exchange market influences the value of currencies. Finally, investor psychology has a
role in determining exchange rates.

Difficulty: Medium
91. (p. 324-325) Compare and contrast the Fisher Effect and the International Fisher Effect.
The Fisher Effect was put forth by Irvin Fisher who formalized the notion that in countries
where inflation is expected to be high, interest rates will also be high because investors want
compensation for the decline in the value of their money. More specifically, the Fisher Effect
states that a country's nominal interest rate is the sum of the required real rate of interest and
the expected rate of inflation over the period for which the funds are to be lent.
The Fisher Effect was extended to incorporate the link between interest rates and exchange
rates. 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.

Difficulty: Medium
9-36
92. (p. 325-326) Consider the role of investor psychology and bandwagon effects on how well
PPP and the International Fisher Effect explain short-term movements in exchange rates.
Neither PPP nor the International Fisher Effect have proven to be good at explaining shortterm movements in exchange rates. One reason for their poor explanatory power may be the
impact of investor psychology on short-run exchange movements. Studies show that
expectations about exchange rates tend to become self-fulfilling prophecies.
A bandwagon effect occurs when investors in increasing numbers start following the lead of
someone who may be pushing the value of a currency up or down due to psychological
reasons. As a bandwagon effect builds up, the expectations of investors become a selffulfilling prophecy, and the market moves in the way the investors expected.

Difficulty: Medium
93. (p. 328) Discuss the two schools of thought on exchange rate forecasting.
There are two schools of thought on whether it is worthwhile for a firm to invest in exchange
rate forecasting services. The efficient market school argues that forward exchange rates do
the best possible job of forecasting exchange rates and therefore, it is not necessary to invest
in forecasting services. The inefficient market, however, suggests that forward exchange rates
are not the best predictors of future spot rates and that consequently there is value in
forecasting services.

Difficulty: Medium
9-37
94. (p. 329-330) Explain the difference between fundamental analysis and technical analysis.
Fundamental analysis draws on economic theory to construct sophisticated econometric
models for predicting exchange rate movements. Technical analysis uses price and volume
data to determine past trends that are expected to continue into the future. Both schools of
thought are used to forecast exchange rate movements.

Bloom's: Knowledge
Difficulty: Medium
95. (p. 330) Compare and contrast currencies that are freely convertible, externally convertible,
and nonconvertible.
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.
In contrast, a currency is said to be externally convertible if only nonresidents may convert it
into a foreign currency without limitations. Finally, a currency is nonconvertible when neither
residents nor nonresidents are allowed to convert it into a foreign currency.

Bloom's: Knowledge
Difficulty: Medium
96. (p. 331) What is countertrade? Why would a firm engage in countertrade?
Countertrade refers to a range of barter-like agreements by which goods and services can be
traded for other goods and services. When a country's currency is nonconvertible, a firm may
turn to countertrade. The number of countertrade deals has been falling in recent years as
more governments make their currencies freely convertible.

Bloom's: Knowledge
Difficulty: Medium
9-38
97. (p. 331-332) What is transaction exposure? How can transaction exposure be minimized?
Transaction exposure is the extent to which the income from various transactions is affected
by fluctuations in foreign exchange values. Transaction 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. Transaction exposure can be minimized by entering
into forward contracts or swaps, or by leading and lagging payables and receivables.

Bloom's: Knowledge
Difficulty: Medium
98. (p. 332) Describe translation exposure. How can translation exposure be minimized?
Translation exposure is the impact of currency exchange rate changes on the reported
financial statements of a company. Translation exposure is basically concerned with the
present measurement of past events. Like transaction exposure, translation exposure can be
minimized by entering into forward contracts or swaps, or by leading and lagging payables
and receivables.

Bloom's: Knowledge
Difficulty: Medium
99. (p. 332-333) Explain the notion of economic exposure. How can economic exposure be
minimized?
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. To reduce economic
exposure, a firm must distribute the firm's productive assets to various locations so the firm's
long-run financial well-being is not severely affected by adverse changes in exchange rates.

Bloom's: Knowledge
Difficulty: Medium
9-39
100. (p. 334) How can a firm minimize its foreign exchange exposure?
There are several strategies a firm can follow to minimize foreign exchange exposure. First,
central control of exposure is needed to protect resources and ensure that each subunit adopts
the correct mix of tactics and strategies. Second, firms should distinguish between transaction
and translation exposure as compared to economic exposure. Third, the firm needs to forecast
future exchange rate movements. Fourth, the firm needs to establish a good reporting system
to monitor the firm's exposure positions. Finally, the firm should produce monthly foreign
exchange exposure report forms.

Bloom's: Knowledge
Difficulty: Medium
9-40

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Chapter 09 - The Foreign Exchange Market

Chapter 09 The Foreign Exchange Market Answer Key

True / False Questions

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Use of Information Technology

AACSB: Domestic and Global Economic Environments

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Analytic Skills

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Analytic Skills

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market

45. (p. 313) An exchange rate of 1 = $1.30 indicates that:

AACSB: Financial Theories, Analysis, Reporting, and Markets

AACSB: Financial Theories, Analysis, Reporting, and Markets

Chapter 09 - The Foreign Exchange Market