Multiple Choices (2 points each). Please write your answers below. 1-5 : B,C,A,D,A

6-10 : C,C,D,C,A

11-15: C,A,B,B,D

16-20: B,C,B,A,B

21-25: A,B,A,C,C

26-30: C,B,D,A,C

1.  The net value of flows of goods and services is described as the:

a.    financial account balance.

b.    current account balance.

c.    trade balance.

d.    official reserve balance.

2.  When a resident of Canada decreases her holdings of a foreign financial asset, this item is recorded as a:

a.    credit entry in the current account of Canada.

b.    debit entry in the current account of Canada.

c.credit entry in thefinancial account of Canada.

d.    debit entry in the financial account of Canada.

3.  A deficit in the overall balance (current account balance + financial account balance):

a.implies an increase in the official international reserves.

b.    implies a decrease in the official international reserves.

c.    does not affect the official international reserves.

d.    is the result of decreasing exports and increasing imports.

4.  A nation is called a borrower if:

a.    it provided financial assets to other countries.

b.    its net stock of foreign assets is negative.

c.    its current account is in surplus during a time period.

d.    its current account is in deficit during a time period.

5.  More flows of capital out of Canada will result in a(n) _____ foreign currency and a(n) _____ the Canadian dollars in the foreign exchange market.

a.    increase in the demand for; increase in the supply of

b.    increase in the supply of; increase in the demand for

c.    shortage of foreign currency; surplus of

d.    decrease in the supply of; decrease in the demand for

6.  As the value of the yen falls relative to the U.S. dollar in the foreign exchange market:

a. Japanese goods become more expensive to the U.S. consumers.

b. the supply of dollars will fall.

c. the demand for Japanese goods will increase in the U.S. market

d. U.S. goods become less expensive to Japanese consumers.

7.  Assume you are a Canadian exporter who will receive 500,000 euros at the end of

60 days. If you do not hedge this transaction, you face exchange-rate risk. The best way to remove the risk of loss due to currency fluctuations is to:

a.  buy 500,000 euros in the forward exchange market for delivery in 60 days.

b.  buy 500,000 euros now, hold them for 60 days, and then sell them at the spot exchange rate that exists 60 days from now.

c.sell 500,000 euros in the forward exchange market for delivery in 60 days.

d.  sell 500,000 euros now in the spot market.

8.  A _____ gives the holder the right but not the obligation to buy a foreign currency at some time in the future at a price set today.

a. forward exchange contract

b. currency Swap

c. put option

d. call option

9.  The proportionate difference between the current forward exchange rate value of a currency and its current spot value is the _____ premium.

a.  investment

b.  frequent exchanger

c.forward

d.  currency-option

10. If the expected uncovered interest differential is _____, then the expected overall

return favors uncovered investing in the foreign-denominated currency.

a.positive

b.  negative

c.  zero

d.  unchanged

11. Consider covered investments between the United States and Japan. If Japanese  interest rates decrease, interest arbitrage operations will most likely result in a(n):

a.  increase in the spot exchange price of the yen.

b.  increase in the forward exchange price of the dollar.

c.sale of dollars in the forward market.

d.  purchase of yen in the spot market.

12. When uncovered interest parity holds, it means that:

a.a currency is expected to appreciate by as much as its interest rate is lower 

than the interest rate in the other country.

b.  a currency is expected to appreciate by as much as its interest rate is higher than the interest rate in the other country

c.  exchange rate risk is unusually high

d.  the forward premium equals the interest rate differential.

13. The _____ approach to exchange rates emphasizes the role of portfolio repositioning by international financial investors.

a.   elasticity

b.asset market

c.  monetary

d.  balance of payments

14. A decrease in the foreign interest rate relative to the domestic interest rate _____ the exchange rate value of a foreign currency in the short run.

a. raises

b. lowers

c. does not affect

d. causes fluctuations in

15. Other things equal, an expected depreciation in the euro will lead to:

a. an inflow of capital to Europe.

b. an increase in official exchange market intervention by the euro area monetary authorities.

c. a lowering of exports of European goods and services.

d. a decrease in the demand for euro-denominated financial assets.

16. The law of _____ states that a product that is easily and freely traded in a perfectly competitive global market should cost the same everywhere once the prices at       different places are expressed in the same currency.

a. international trade

b. one price

c. diminishing returns

d. relative PPP

17. _____ purchasing power parity states that the difference between changes over time in product-price levels in two countries will be offset by the change in the exchange rate over this time.

a. Full

b. Partial

. Relative

d. Absolute

18. Suppose the average price of a Big Mac in Canada is $4.50 while in Japan the     average price is 400 yen. If the market exchange rate is that 1 dollar is exchanged for 100 yen, the purchasing power parity model of exchange rate determination   suggests that:

a. the yen is overvalued. b. the yen is undervalued

c. the price of a Big Mac in Japan will rise.

d. the dollar will depreciate against the yen.

19. Suppose that prices in Canada rise 4 percent over the next year while prices in UK rise 2 percent. According to the purchasing power parity theory of exchange rates, which of the following should happen?

a.   The dollar will depreciate

b.  The pound will be worth 2 dollars in the foreign exchange market

c.   The pound will depreciate

d.  The dollar will be worth 2 pounds in the foreign exchange market

20. Based on PPP and the quantity theory of money, everything else remaining       unchanged, if Japan’s real income rises relative to real income in the U.S., there would be a(n):

a.   appreciation of the dollar.

b.appreciation of the yen.

c.  interest rate parity.

d.  decrease in the demand for yen in the foreign exchange market.

21. The _____ exchange rate is the market rate between two currencies.

a.nominal bilateral

b.  real bilateral

c.  nominal effective

d.  real effective

22. The _____ exchange rate incorporates both the market exchange rate and the product price levels for two countries.

a.  nominal bilateral

b.real bilateral

c.  nominal effective

d.  real effective

29. Which one of the following is NOT a way for a country to defend its fixed exchange rate?

a.Promote real appreciation of the country’s currency

b.  Intervene in the foreign exchange market

c.  Alter domestic interest rates

d.  Impose some form of exchange control

30. When a country defends its currency against appreciation,

a.  the monetary authority buys domestic currency and sells foreign currency.

b.  the monetary needs to have sufficient foreign reserves.

c.the country's official foreign reserves increases.

d.  the country's money supply falls.

Essay Questions (10 points each)

1.  Suppose that the dollar-yen spot exchange rate is $0.05/¥ and the 90-day       forward exchange rate is $0.052/¥. The 90-day interest rate in Canada is 5%. Assume that covered interest parity holds.

(i) What is the Japanese interest rates?

CIP equation: (1+if)*f/e-(1+id), we do not know if, so solve for and get if= 0.00961538.

Check: (1+0.009615384615)*(0.052/0.05)-(1+0.05)= 0

(ii) If Japan decreases interest rate, how would that affect international capital movement and exchange rate between dollar and yen?

As of right now the interest rates for japan are lower than the US ( this is also true as we see the forward rate ($0.052) being higher than the spot rate, indicating that the yen is in forward premium, which then concludes that the yen is a forward     premium by as much as the interest rate is LOWER than the interest rate of the    other country ( Canada).

If interest rates decreased even more, then I expect investors to move their capital towards the US as they would see a higher return there.

Furthermore, the expected FUTURE SPOT rate of the yen would decrease, as the domestic currency would appreciate.

2. The following current rates have been observed: Spot exchange rate: $1.25/SFr

Expected future spot rate in 90 days: $1.2625/SFr

Annual interest rate on 90-day U.S.-dollar-denominated bonds: 12% Annual interest rate on 90-day SFr-denominated bonds: 4%

(i) At these initial rates, does uncovered interest parity hold? Why?

F (forward premium) = (1.2625-1.25)/1.25= 0.01, this is only for a quarter, so multiply x4 to see the ANNUAL appreciation rate of the franc= 4%.

If the IUD were expected to hold, then the currency would be expected to            appreciate by as much as its interest rate is lower than the interest rate of the other country.

However, this is not the case here, as we see that the difference between the SFR and US dollar is more than the 4% appreciation rate. (8%).

(ii) What spot exchange rate will be consistent with uncovered interest parity?

A spot rate that would satisfy the IUD would be 1.237745098… derived from     solving (1.2625-x)/x= 0.02, as this is the quarterly appreciation, then we multiply by 4 to get the annual appreciation of 8%!

Using the spot rate equal to 1.237745098, we see that this holds.

3. Suppose in 1992, the average price level in UK was 100, and that in Japan was also 100. In the foreign exchange market 1 pound was exchanged for 150             Japanese yen. In 2012, the price level in UK had risen to 280 and the price level  in Japan had risen to 360.

(i) According to the relative PPP theory, what should the pound-yen exchange rate be in 2012?

According to the theory, the pound-yen exchange rate should be 280/360= 0.777778, and the yen- pound should be 360/280=1.2857.

ii) If the exchange rate on the market is 200 yen per pound, is yen overvalued or undervalued? Why?

280pound*(360yen/280pound)= 360 pound, the yen is therefore undervalued from the relative PPP equation to what it should be.

4. A country with a fixed exchange rate experiences downward pressure on the exchange rate value of its currency (the home currency tend to depreciate). The central bank chooses to intervene in the market to maintain its fixed exchange  rate.

(i)  How would the central bank go about intervening?

The central bank could intervene in the foreign exchange market by buying the      domestic currency and selling foreign currency. This will reduce the money supply, which will help reduce the risk of depreciation from inflation.