Foreign Exchange And Eurocurrency | Verified Test Bank Ch.3

Chapter 3 Foreign Exchange and Eurocurrency Markets

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

/

1. Liquidity refers to the ease with which you can exchange one asset for another of equal value.

2. Internal credit markets are markets for deposits and loans by local residents and hence are governed by the rules and institutional conventions of the local government.

3. External credit markets trade interest rate contracts denominated in a currency but traded outside the borders of the country issuing that currency.

4. Money markets are markets for financial assets and liabilities of short maturity, considered to be less than one year.

5. Capital markets are markets for financial assets and liabilities with maturities greater than one year.

6. Eurocurrency markets are highly liquid and relatively unencumbered by government regulation, resulting in borrowing and lending rates that are generally more favorable to large retail customers than domestic rates.

7. International commercial banks are the major market makers in the currency markets.

8. The most active market makers in the market for spot foreign exchange are the major investment banks, such as Salomon Smith Barney and Goldman Sachs.

The major market makers are the large commercial banks.

9. In the spot market, trades is conducted in a single spot or location.

Trade is conducted at commercial banks worldwide.

10. In the forward currency markets, trades are made for future delivery according to an agreed-upon delivery date, exchange rate, and amount.

11. A bank that is making a market in euros stands ready to buy euros at its euro offer price and sell euros at its euro bid price.

The bank will buy at the bid and sell at the offer price.

12. American terms state the dollar value of one unit of foreign currency, such as $0.0085/¥.

13. European terms state the foreign currency price of one U.S. dollar (e.g., C$1.1054/$).

14. If the current spot rate is S₀^$/C$ = $0.8839/C$ and the one-year forward rate is F₁^$/C$ = $0.8754/C$, then the Canadian dollar is selling at a forward premium.

The Canadian dollar (in the denominator of the quote) is selling at a forward discount.

15. If the current spot rate is S₀^$/C$ = $0.8839/C$ and the one-year forward rate is F₁^$/C$ = $0.8754/C$, then the U.S. dollar is selling at a forward premium.

Conversely, the Canadian dollar in the denominator is at a forward discount.

16. A bank offers you the following quote: “$0.8841/C$ BID and $0.8852/C$ ASK.” The bank will buy U.S. dollars at $0.8841/C$ or sell U.S. dollars at $0.8852/C$.

Banks quote foreign currency in order to make a profit. The bank will buy C$ (and sell $) at $0.8841/C$ or sell C$ (and buy $) at $0.8852/C$.

17. Currency risk is the risk of unexpected changes in foreign currency values.

18. For the most actively traded currencies, national credit markets are operationally more efficient than the Eurocurrency markets.

Eurocurrency markets are generally more operationally efficient.

19. Volume in the foreign exchange markets averages about one billion dollars per day.

In the 2014 BIS survey, daily interbank trading volume averages more than $5 trillion.

20. Eurocurrency transactions in the external credit market fall outside the jurisdiction of any single nation.

21. One basis point is equal to one percentage point (e.g., 1 percent of a dollar).

It is equal to one hundredth of a percentage point (e.g., 1/100th of a dollar).

22. The majority of the volume in the forward market for foreign exchange is conducted on the floor of the Chicago Mercantile Exchange (CME).

Forward exchange contracts are primarily traded through commercial banks.

23. Commercial banks always quote foreign exchange rates with the domestic currency in the denominator of the quote.

The domestic currency can be in the numerator or the denominator.

24. A bank’s bid price for one currency is its offer price for another currency.

25. Suppose S₀^£/$ = £0.6361/$ and F₁^£/$ = £0.6352/$. The dollar is selling at a forward premium of 9 basis points.

It is selling at a forward discount of 9 bps.

26. A LIBOR rate is quoted for all major currencies.

27. Domestic interest rates typically lie inside the LIBID/LIBOR interest rate band.

The domestic rates lie outside the LIBID/LIBOR interest rate band.

28. LIBOR is the rate that a Euromarket bank is willing to pay to attract a Eurocurrency deposit.

It is an average offer rate at which banks are willing to loan funds in the London Eurocurrency market.

29. Eurocurrency markets are regulated by the governments whose currencies are traded in the market.

These governments have little or no jurisdiction over external credit markets.

30. MNCs and financial institutions with access to Eurocurrency markets usually can obtain lower cost funds and store funds at higher interest rates than in domestic credit markets.

31. Commercial banks’ lending rates in the Eurocurrency market are usually higher than their prime lending rates in their domestic credit markets.

Eurocurrency markets are usually more competitive and lending rates are lower.

32. Foreign currency deposits held in the United States are called Eurodollars.

Eurodollars are dollar deposits held outside the borders of the United States.

33. Eurodollar deposits typically have fixed interest rates.

Most Eurodollar deposits have floating interest rates.

34. Government regulation is nearly absent in the internal markets for long-term debt capital.

Internal markets are monitored and regulated by local authorities.

Multiple Choice Select the BEST ANSWER

1. Which of the following is not a function of the currency and Eurocurrency markets?

a. foreign currency speculation

b. hedging foreign exchange risk

c. provision of credit

d. transfer of purchasing power

e. Each of the above is a function of the foreign exchange market.

2. What happens when foreigners decide to purchase additional U.S. government bonds?

a. The demand for dollars rises.

b. The federal government budget deficit declines.

c. The supply of dollars rises.

d. The trade deficit declines.

e. None of these events happens.

3. The primary function of foreign exchange desks at major commercial banks is ____.

a. arbitrage

b. currency speculation

c. investment banking

d. market making

e. to take advantage of government subsidies in the foreign exchange market

4. In order to boost the value of the euro relative to the dollar, the U.S. Federal Reserve should ____.

a. sell dollars for euros and buy dollars with euros

b. sell dollars for euros and buy euros with dollars

c. sell euros for dollars and buy euros with dollars

d. sell euros for dollars and sell dollars for euros

e. more than one of the above

5. The euro depreciates 17 percent against the dollar. How much has the dollar appreciated against the euro?

a. 16.31%

b. 17.00%

c. 17.54%

d. 20.48%

e. 34.00%

6. A forward foreign exchange contract ____.

a. allows a transfer of purchasing power from one currency to another on a predetermined date and at a predetermined exchange rate

b. is a long (or forward) position in a foreign currency

c. is a type of option that can be used to hedge against unfavorable changes in foreign currency values at the discretion of the option holder

d. is priced to equal the spot exchange rate

e. none of the above

7. The biggest traders in the foreign exchange markets are ____.

a. commercial banks

b. corporations

c. government agencies

d. governments

e. individual investors

8. Characteristics of the Eurocurrency market include which of the following?

a. no interest rate regulations on Eurocurrency transactions

b. no regulations influencing credit allocation decisions on Eurocurrency transactions

c. no reserve requirements on Eurocurrency transactions

d. no withholding taxes on Eurocurrency transactions

e. all of the above

9. The value of the euro against the U.S. dollar when it began public trading on January 1, 2002, was $0.89139/€. Ten years later on January 1, 2012, the exchange rate was $1.29568/€. What was the average annual change in the value of the euro over this 10-year period?

a. less than or equal to 0%

b. more than 0% and less than or equal to 5%

c. more than 5% and less than or equal to 10%

d. more than 10% and less than or equal to 15%

e. more than 15%

10. The value of the euro against the U.S. dollar when it began public trading on January 1, 2002, was $0.89139/€. Ten years later on January 1, 2012, the exchange rate was $1.29568/€. What was the average annual change in the value of the U.S. dollar over this 10-year period?

a. less than or equal to 0%

b. more than 0% and less than or equal to 5%

c. more than 5% and less than or equal to 10%

d. more than 10% and less than or equal to 15%

e. more than 15%

11. The spot rate is $1.00/€ and the one-year forward rate is $1.10/€. What is the percentage forward premium (or discount) on the euro?

a. less than 0%

b. 0%

c. 10%

d. more than 10%

e. none of the above

12. The spot rate is $1.00/€ and the one-year forward rate is $1.10/€. What is the percentage forward premium (or discount) on the dollar?

a. less than 0%

b. 0%

c. 10%

d. more than 10%

e. none of the above

13. The spot rate is $1.00/€ and the one-year forward rate is $1.10/€. What is the forward premium (or discount) on the euro?

a. 0.10 basis point

b. 1 basis point

c. 10 basis points

d. 100 basis points

e. 1,000 basis points

14. A random walk has each of the following properties EXCEPT ______.

a. a constant variance

b. a positive mean

c. equally likely to rise or fall

d. independence over time

e. All of the above are properties of a random walk.

15. Which of the following statements regarding nominal exchange rate forecasts is ?

a. Forward exchange rates perform better than spot exchange rates as the forecasting horizon is extended beyond one year.

b. The current spot rate is a useful forecast of future exchange rates for horizons of up to one year.

c. The variability of nominal exchange rates is large relative to forward premiums and discounts.

d. The variability of nominal exchange rates is large relative to inflation differentials.

e. The variability of forward premiums/discounts is large relative to interest rate differentials.

16. Which of the following is not a method for estimating exchange rate volatility?

a. conditional volatility

b. explicit volatility

c. historical volatility

d. implied volatility

e. realized volatility

17. Exchange rate volatility over a future period can be estimated with ____.

a. implied volatility

b. reciprocal volatility

c. virtual volatility

d. more than one of the above

e. none of the above

Problems (Some of these can be converted into Multiple Choice questions.)

1. Credit Suisse First Boston (CSFB) quotes the following rates. For each quote, state which currency CSFB is buying and which currency CSFB is selling at the quoted rates.

a. €0.8894/$ Bid and €0.8898/$ Ask

b. €0.8898/$ Bid and €0.8894/$ Ask

2. Convert to American terms. Keep the currency being bought and sold in the denominator.

a. €0.8894/$ Bid and €0.8898/$ Ask

b. €0.8898/$ Bid and €0.8894/$ Ask

3. Credit Suisse First Boston (CSFB) quotes the following rates for the U.S. dollar.

Bid (€/$) Ask (€/$)

Spot rate 0.8894 0.8898

1-month forward 0.8938 0.8942

3-month forward 0.9028 0.9032

6-month forward 0.9164 0.9168

12-month forward 0.9443 0.9447

a. Is the dollar selling at a forward premium or a forward discount? Calculate percentage premiums or discounts for each forward quote. Also state these percentage premiums or discounts on an annualized basis.

b. Convert these to $/€ quotes for the euro. Is the euro selling at a forward premium or a forward discount? Calculate percentage premiums or discounts (not annualized) for each forward quote on the euro. Also state these percentage premiums or discounts on an annualized basis.

c. Are the percentage forward premiums on the dollar equal in magnitude to the corresponding forward discounts on the euro? Why or why not?

d. What would you receive from CSFB if you sold $10 million at the 6-month forward rate?

e. What would you pay CSFB if you bought €10 million at the 12-month forward rate?

4. In what way is the quote “$1.1453/€ Bid and $1.1459/€ Ask” equivalent to “$1.1459/€ Bid and $1.1453/€ Ask”?

5. Suppose the spot rate is $1.08/€. The dollar then appreciates by 25 percent against the euro. What is the new exchange rate in dollars per euro?

6. The Czech koruna (CZK) spot rate is CZK36.02/$.

a. A 20 percent depreciation of the koruna will result in what new CZK/$ spot rate?

b. If the koruna depreciates by 20 percent, by how much does the dollar appreciate?

7. The value of the pound was €1.2022/£ when the euro began trading on January 1, 2002. Ten years later, the spot rate was €1.5725/£.

a. What was the geometric mean annual change in the value of the pound (in the denominator)?

b. What was the geometric mean change in the value of the euro (in the numerator)?

Note that a geometric mean ŝ^d/f over T periods is calculated as (1 + ŝ^d/f)^T = (S_T^d/f)/(S₀^d/f).

8. Suppose you estimate a GARCH model (with p = q = 1) of monthly volatility in the value of the dollar and arrive at the following estimates: _t² = 0.0052 + (0.30)_t–1² + (0.40)s_t–1², where the conditional variance (_t–1²) and the square of the percentage change in the spot exchange rate (s_t–1²) are from the previous period. If _t–1 = 0.04 and s_t–1 = 0.12, what is the GARCH estimate of conditional volatility?

Problem Solutions

1. a. The bid rate is below the ask rate, so CSFB is buying dollars at the bid rate and selling dollars at the offer rate.

b. The bid rate is below the ask rate. To make a profit on each round turn, CSFB is buying euros (and selling dollars) at the bid rate and selling euros (and buying dollars) at the offer rate.

2. a. Taking reciprocals yields $1.1244/€ and $1.1238/€. The euro (in the denominator) would be quoted as “$1.1238/€ and $1.1244/€.”

b. Again, the reciprocals are $1.1244/€ and $1.1238/€. The euro (in the denominator) would be quoted as “$1.1238/€ and $1.1244/€.”

3. a. The dollar (in the denominator) is selling at a forward premium.

$ Bid $ Ask Premium/discount Annualized

Spot rate 0.8894 0.8898 $ Bid $ Ask $ Bid $ Ask

One-month forward 0.8938 0.8942 0.50% 0.50% 6.00% 6.00%

One-month forward 0.9028 0.9032 1.51% 1.51% 6.03% 6.03%

One-month forward 0.9164 0.9168 3.04% 3.04% 6.08% 6.08%

One-month forward 0.9443 0.9447 6.17% 6.17% 6.17% 6.17%

b. Quotes and the associated discounts for the euro are as follows:

€ Bid € Ask Premium/discount Annualized

Spot rate 1.1238 1.1244 € Bid € Ask € Bid € Ask

One-month forward 1.1183 1.1188 –0.50% –0.50% –5.97% –5.97%

One-month forward 1.1072 1.1077 –1.49% –1.49% –5.94% –5.94%

One-month forward 1.0907 1.0912 –2.95% –2.95% –5.90% –5.90%

One-month forward 1.0586 1.0590 –5.81% –5.81% –5.81% –5.81%

c. The percentage premiums on the dollar are almost, but not quite, equal in magnitude to the corresponding percentage discounts on the euro. The difference in magnitude is because of the algebra of compound returns. Forward dollar premiums in this problem are based on a 0.5 percent per month forward premium on the dollar. Over 12 months, this compounds to (1.005)¹² – 1 = 6.17 percent dollar premium. The corresponding 12-month euro forward discount is 1/(1.0617) – 1 = –5.81 percent.

d. CSFB is buying dollars at their dollar bid price, so you will receive (€0.9028/$) × ($10 million) = €902,800.

e. CSFB is selling euros and hence buying dollars. CSFB will buy dollars at the dollar bid price, so you will pay (€10 million) / (€0.9447/$) = €1,058,558.

4. A bank quoting “$1.1453/€ Bid and $1.1459/€ Ask” is buying euros (in the denominator) at $1.1453/€ and selling euros at $1.1459/€. A bank quoting “$1.1459/€ Bid and $1.1453/€ Ask” is selling dollars (in the numerator) at $1.1453/€ and buying dollars at $1.1459/€. In each case, the bank is buying euros (and selling dollars) at $1.1453/€, and selling euros (and buying dollars) at $1.1459/€.

5. A 25 percent appreciation of the dollar in the numerator corresponds to a 20 percent depreciation of the euro in the denominator according to s^$/€ = 1/(1 + s^€/$) – 1 = 1/(1.25) – 1 = –0.20. The new spot rate must be S₁^$/€ = S₀^$/€(1 + s^$/€) = ($1.08/$)(1 – 0.20) = $86.4/€.

6. a. Since it is the Czech koruna that has depreciated, it is most convenient to place the koruna in the denominator of the foreign exchange quote; CZK36.02/$ = $0.02776/CZK. This is a direct quote for a U.S. resident. A 20% depreciation of the koruna results in: (End rate) = (Beg. rate)(1 + %Δ) = ($0.02776/CZK)(1 .2) = $0.02221/CZK, or CZK45.03/$.

b. To find the dollar appreciation, it is most convenient to use a CZK/$ quote. A 20% depreciation of the koruna is then equivalent to an appreciation in the dollar of: %Δ = (End. rate/Beg. rate) 1 = (CZK45.03/$)/(CZK36.02/$) 1 = + 25%.

Although it is more difficult, these calculations can be performed in indirect terms with the currency of interest in the numerator rather than denominator. If the CZK depreciates by 20%, the new rate is (CZK36.02/$)/(1 0.2) = CZK45.03/$, or $0.02221/CZK. The dollar would appreciate by ($0.02776/CZK $0.02221/CZK)/( $0.02221/CZK) = + 25%.

7. a. (1 + ŝ^€/£)¹⁰ = (S₁₀^€/£)/(S₀^€/£) = (€1.5725/£)/(€1.2022/£) = 1.3080 = > (1 + s^€/£) = (1.3080)^1/10 = 1.027/year.

b. If the pound rose by 2.7 percent, then the euro fell by (1 + ŝ^£/€) = 1/(1 + ŝ^€/£) = 1/1.027 ≈ –2.6%/year.

8. _t² = 0.0052 + (0.30)(0.04)² + (0.40)(0.12)² = 0.01144, or _t = 10.70 percent.