Foreign Exchange Risk Chapter.13 Test Questions & Answers

Chapter 13 Foreign Exchange Risk

KEY

1. An FI can eliminate its currency risk exposure by matching its foreign currency assets to its foreign currency liabilities. 

2. To a U.S. trader of foreign currencies, a direct quote indicates U.S. dollars received for each one unit of the foreign currency. 

3. As the U.S. dollar appreciates against the Japanese yen, U.S. goods become less expensive to Japanese consumers. 

4. An indirect quote of a foreign currency indicates the amount of foreign currency received for one unit of the domestic currency.

5. As the U.S. dollar appreciates against the Japanese yen, Japanese goods sold in the U.S. become less expensive to the U.S. consumer. 

6. An immediate exchange of currencies occurs in the spot foreign exchange market.

7. The exposure to foreign exchange risk by U.S. FIs has decreased with the growth of the various derivative markets. 

8. The spot foreign exchange market is where forward and futures contracts and swap agreements are transacted. 

9. Historically, to exchange Swiss francs into Chinese yuan, a trader had to first exchange the francs into U.S. dollars.

10. To transact all cross-currency trades, one must first convert both currencies into U.S. dollars.

11. The market in which foreign currency is traded for future delivery is the forward foreign exchange market. 

12. Forward contracts in FX are typically written for a period of one-, three-, or six-months. 

13. The greater the volatility of foreign exchange rates given any net exposure position, the greater the fluctuations in value of the foreign exchange portfolio. 

14. U.S. pension funds invest approximately one percent (1%) of their portfolios in foreign securities. 

15. U.S. life insurance companies generally hold less than ten percent (10%) of their portfolios in foreign securities. 

16. Most nonbank FIs have foreign exchange risk exposure that is smaller than the exposure of the large U.S. money-center banks. 

17. The underlying cause of foreign exchange volatility reflects fluctuations in the demand and supply of a country's currency. 

18. A positive net exposure position in FX implies an FI has more foreign currency assets than foreign currency liabilities. 

19. A positive net exposure position in FX implies the FI is net short in a currency. 

20. As of June 2015, U.S. banks were net short British pounds. 

21. Most profits or losses on foreign trading come from taking an open position in currencies. 

22. The FX markets of the world have become one of the largest of all financial markets. 

23. The foreign exchange market in Tokyo is the largest FX trading market. 

24. Average daily turnover in the FX market has recently been over $5 trillion. 

25. FX trading risk exposure continues into the night until all FI operations are closed. 

26. FX trading income is derived only from profit (or loss) on the FI's speculative currency positions. 

27. During 2012, the top four banks that operate in foreign currency trading comprised almost half of the market. 

28. The reason an FI receives a fee when purchasing foreign currencies that allow customers to complete international transactions is because the FI assumes some FX risk. 

29. The total FX risk for a domestic bank that is making a one-year loan in a foreign currency is that the interest income expected on the loan is exposed to a depreciation of the foreign currency. 

30. An FI can control its FX risk exposure by on-balance-sheet and off-balance-sheet hedging. 

31. Off-balance-sheet hedging involves taking a position in FX forward or other derivative securities even though no FX assets or liabilities are on the balance sheet. 

32. On-balance-sheet hedging involves making changes in the on-balance-sheet assets and liabilities to protect FI profits from FX risk without the use of derivative securities. 

33. Directly matching foreign asset and liability books in the same FX currency will allow an FI to hedge or lock in a profit spread regardless of future changes in exchange rates. 

34. The use of an exchange rate forward contract assures the FI of the opportunity to buy (or sell) the foreign currency at a future time at a known price. 

35. Since forward contracts are negotiated over-the-counter and the parties have maximum flexibility when setting the terms and conditions, credit and counterparty risk does not exist.

36. The real interest rate reflects the underlying real sector demand and supply for funds denominated in the domestic currency. 

37. Most profits and losses in foreign currency markets come from taking an open position or speculating in currencies.

38. Purchasing power parity is based on the difference in productive output (GDP) that exists between two countries. 

39. Interest rate parity implies that the discounted spread between interest rates in two currencies should equal the percentage spread between forward and spot exchange rates. 

40. Violation of the interest rate parity theorem would allow arbitrage profits. 

41. Long-term violations of the interest rate parity relationship may occur if imperfections in the international financial markets are allowed to exist. 

42. The law of one price is based on the theory behind purchasing power parity, in that in the long run exchange rates move toward rate that equalize the prices of identical basket of goods and services in any two countries. 

43. The law of one price is an economic rule which states that in an efficient market, identical goods and services produced in different countries should have a single price.

44. Cross-currency exchange rates for all countries are listed at Bloomberg’s website: www.bloomberg.com/markets/currencies/fxc.html. 

45. A forward exchange transaction is the exchange of currencies at a specified exchange rate which is settled at some specified date in the future. 

46. A forward market for FX is the market in which foreign currency is traded for immediate delivery. 

47. When the FI has sold more foreign currency than it has purchased, a positive net exposure position has transpired, also known as a net long in currency.

48. A forward exchange rate is the exchange rate agreed to today for future (forward) deliver of a currency. 

49. Which of the following is NOT a source of foreign exchange risk? 

A. Trading foreign currencies.

B. Making domestic-currency loans to foreign corporations.

C. Buying foreign-issued securities.

D. Issuing foreign currency-denominated debt.

E. Making foreign currency loans.

50. The market in which foreign currency is traded for immediate delivery is the 

A. spot market.

B. forward market.

C. futures market.

D. currency swap market.

E. London capital market.

51. The FI is acting as a FX market agent for its customers when it 

A. buys or sells currency to balance the FI's net exposure.

B. takes a nonzero net position in a particular currency.

C. processes an exporter's transaction in a foreign currency.

D. makes a market in its domestic currency.

E. advises customers on their international business.

52. A positive net exposure position in FX implies that the FI is 

A. net long in a currency and exposed to depreciation of the foreign currency.

B. net short in a currency and exposed to depreciation of the foreign currency.

C. net long in a currency and exposed to appreciation of the foreign currency.

D. net short in a currency and exposed to appreciation of the foreign currency.

E. neither long nor short in a currency.

53. A negative net exposure position in FX implies that the FI is 

A. net long in a currency and exposed to depreciation of the foreign currency.

B. net short in a currency and exposed to depreciation of the foreign currency.

C. net long in a currency and exposed to appreciation of the foreign currency.

D. net short in a currency and exposed to appreciation of the foreign currency.

E. neither long nor short in a currency.

54. The reasons nondepository FIs have less FX risk than major money center banks include 

A. Smaller asset sizes.

B. Prudent person concerns.

C. Regulations.

D. All of the options.

E. Smaller asset sizes and regulations.

55. U.S. pension funds hold approximately _______ of their assets in foreign securities, while British pension funds have traditionally invested over _______ of their funds in foreign assets. 

A. 20 percent; 5 percent

B. 15 percent; 20 percent

C. 0 percent; 30 percent

D. 30 percent; 10 percent

E. 20 percent; 20 percent

56. The FI is acting as a hedger when it 

A. buys or sells currency to balance the FI's net exposure.

B. takes a nonzero net position in a particular currency.

C. processes an exporter's transaction in a foreign currency.

D. makes a market in a currency.

E. advises customers on their international business.

57. FX risk exposure of an FI essentially relates to which of the following activities? 

A. Purchase and sale of foreign currencies to allow customers to participate in and complete international commercial trade transactions.

B. Purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.

C. Purchase and sale of foreign currencies for hedging purposes to offset customer exposure in any given currency.

D. Purchase and sale of foreign currencies for speculative purposes through forecasting or anticipating future movements in FX rates.

E. None of the options.

58. When purchasing and selling foreign currencies to allow customers to take positions in foreign real and financial investments, the FI 

A. acts defensively as a hedger.

B. acts aggressively as a speculator.

C. assumes the FX risk itself.

D. acts as an agent.

E. acts as a market maker.

59. Foreign exchange trading has been called the fairest market in the world because

A. no single institution can control the direction of the market.

B. trading may take place at any time during a 24-hour period.

C. the volume of trading is very large and liquid.

D. trading may take place anywhere as there is no central location for foreign exchange trading.

E. all of the options are correct.

60. The FI is acting as a speculator when it 

A. buys or sells currency to balance the FI's net exposure.

B. takes a nonzero net position in a particular currency.

C. processes an exporter's transaction in a foreign currency.

D. makes a market in a currency.

E. advises customers on their international business.

61. The decrease in European FX volatility during the last decade has occurred because of 

A. the stabilizing force of the euro.

B. reduction in inflation rates in European countries.

C. the reduced volatility in many emerging-market countries.

D. the greater volatilities of Asian currencies.

E. the stabilizing force of the euro and reduction in inflation rates in European countries.

62. The decline in European FX volatility during the last decade has been offset in part by 

A. the greater volatilities of Asian currencies.

B. a reduction in inflation rates in European countries.

C. the fixing of exchange rates among European countries.

D. the replacement of domestic currencies with the euro.

E. None of the options.

63. If foreign currency exchange rates are highly positively correlated, how can a FI reduce its exchange rate risk exposure? 

A. By taking net long positions in all currencies.

B. By taking net short positions in all currencies.

C. By taking opposing net short and net long positions in different currencies.

D. By maximizing net FX exposure in each currency, independently.

E. By minimizing net FX exposure in each currency, independently.

64. Which of the following FX trading activities is used to hedge FX risk? 

A. The purchase and sale of foreign currencies for the purpose of profiting from forecasting or anticipating future movements in FX rates.

B. The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.

C. The purchase and sale of foreign currencies for the purpose of offsetting customer exposure in any given currency.

D. The purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.

E. None of the options.

65. Which of the following FX trading activities is used for purposes of speculation? 

A. The purchase and sale of foreign currencies for the purpose of profiting from forecasting or anticipating future movements in FX rates.

B. The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.

C. The purchase and sale of foreign currencies for the purpose of offsetting customer exposure in any given currency.

D. The purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.

E. None of the options.

66. In which of the following FX trading activities does the FI not assume FX risk? 

A. The purchase and sale of foreign currencies for the purpose of profiting from forecasting or anticipating future movements in FX rates.

B. The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.

C. The purchase and sale of foreign currencies for the purpose of offsetting customer exposure in any given currency.

D. The purchase and sale of foreign currencies to allow customers to take positions in foreign real and financial investments.

E. The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions and to take positions in foreign real and financial investments.

67. As of 2015, which of the following FX "markets" is the largest? 

A. London.

B. New York.

C. Tokyo.

D. Hong Kong.

E. Zurich.

68. In recent years, average daily trading volume at foreign exchange markets has been ______ the average daily trading volume of the NYSE?

A. one-half

B. 20 times

C. 40 times

D. 70 times

E. 85 times

69. In 2011, during the financial crisis, which country was viewed as a safe haven and saw its currency appreciate in value relative to other currencies because of the demand for the currency?

A. Australia.

B. Dubai.

C. Canada.

D. Argentina.

E. Switzerland.

70. In 2015, approximately _______ of the daily foreign exchange transactions occurred outside of the spot market?

A. 35 percent

B. 60 percent

C. 15 percent

D. 75 percent

E. 90 percent

71. The Federal Reserve estimates that _______ financial institutions are active market makers in foreign currencies in the U.S., of which _______ are commercial and investment banks.

A. 200; 50

B. 60; 15

C. 100; 10

D. 200; 25

E. 300; 20

72. Most profits or losses on foreign trading for FIs come from 

A. open positions or speculation.

B. market making.

C. acting as agents for retail customers.

D. acting as agents for wholesale customers.

E. hedging activities.

73. Deviations from the international currency parity relationships may occur because of 

A. free capital movements across national boundaries.

B. barriers to cross-border financial flows.

C. perfect rationality of market participants.

D. differences in each country's productive capacity.

E. Basel capital regulations.

74. The nominal interest rate is equal to the 

A. real interest rate minus the inflation premium.

B. real interest rate minus the trailing inflation rate.

C. real interest rate plus the expected interest rate increase.

D. real interest rate plus the expected inflation rate.

E. real interest rate plus the interest rate volatility.

75. Which of the following is an example of interest rate parity? 

A. The Japanese yen trades at the same exchange rate as the Swiss franc.

B. U.S. dollar rates on one year U.S. Treasury securities equal 1 year Japanese government bond rates.

C. U.S. dollar rates on one year U.S. Treasury securities equal 1 year Japanese government bond rates, restated in dollars.

D. British pound 2 year forward rates equal 2 year Swiss franc forward rates.

E. All currency exchange rates and interest rates move in unison.

76. According to purchasing power parity (PPP), foreign currency exchange rates between two countries adjust to reflect changes in each country's 

A. unemployment rates.

B. export competitiveness.

C. inflation rates.

D. foreign exchange reserves.

E. reserve requirements.

77. On May 31, 2016, the exchange rate of U.S. dollars for Bitcoins was Ƀ535.592. Three months later on August 31, 2016, the exchange rate was Ƀ572.187. If a Learjet 85 carries a price of $21 million, what is the difference in price a purchaser would pay in Bitcoins if the jet were purchased on August 31 rather than May 31, 2016?

A. $2,508,000

B. (Ƀ2,508)

C. ($2,508,000)

D. (Ƀ36.6)

E. Ƀ19,581

Feedback:

(Ƀ36,701 – Ƀ39,509) = -Ƀ2,508

78. On January 1, 2016, the exchange rate of U.S. dollars for Australian dollars was 0.730 USD/AUD. On January 15, 2016, the exchange rate was 0.6863 USD/AUD. If a mining company had a net exposure to Australian dollars of 9,750,000 AUD, what is the company’s U.S. dollar gain or loss during this two week period?

A. Gain of 620,829 USD

B. Loss of 620,829 USD

C. Loss of 426,075 AUD

D. Gain of 426,075 AUD

E. Loss of 426,075 USD

Feedback:

79. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

  

What is the FI's net exposure in British pounds? 

A. -45,400.

B. -150,600.

C. -196,000.

D. +105,200.

E. +196,000.

Feedback: Net Exposurei = (FX assetsi - FX liabilitiesi) + (FX boughti - FX soldi)
NEi = (FXAi - FXLi) + (FXCBi - FXCSi)
NE(pound) = (24,600 - 70,000)+(170,400 - 321,000) = −45,400 - 151,600 = −196,000

80. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

  

What is the FI's net exposure in the Japanese yen? 

A. +30,000.

B. +40,600.

C. -19,400.

D. -40,600.

E. +20,600.

Feedback: NEi = (FXAi - FXLi) + (FXCBi - FXCSi)
NE(yen) = (31,000 - 20,400) + (250,000 - 220,000) = 10,600 + 30,000 = +40,600

81. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

  

What is the FI's net exposure in the Swiss franc? 

A. +2,400.

B. +400.

C. -2,800.

D. -2,400.

E. +3,200.

Feedback: NEi = (FXAi - FXLi) + (FXCBi - FXCSi)
NE(franc) = (10,200 - 9,800) + (8,000 - 10,800) = 400 - 2,800 = −2,400

82. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

  

How would you characterize the FI's risk exposure to fluctuations in the British pound to dollar exchange rate? 

A. The FI is net short in the British pound and therefore faces the risk that the British pound will rise in value against the U.S. dollar.

B. The FI is net short in the British pound and therefore faces the risk that the British pound will fall in value against the U.S. dollar.

C. The FI is net long in the British pound and therefore faces the risk that the British pound will fall in value against the U.S. dollar.

D. The FI is net long in the British pound and therefore faces the risk that the British pound will rise in value against the U.S. dollar.

E. The FI has a balanced position in the British pound.

83. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

  

How would you characterize the FI's risk exposure to fluctuations in the yen/dollar exchange rate? 

A. The FI is net short in the yen and therefore faces the risk that the yen will rise in value against the U.S. dollar.

B. The FI is net short in the yen and therefore faces the risk that the yen will fall in value against the U.S. dollar.

C. The FI is net long in the yen and therefore faces the risk that the yen will fall in value against the U.S. dollar.

D. The FI is net long in the yen and therefore faces the risk that the yen will rise in value against the U.S. dollar.

E. The FI has a balanced position in the Japanese yen.

84. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

  

How would you characterize the FI's risk exposure to fluctuations in the Swiss franc/dollar exchange rate? 

A. The FI is net short in the franc and therefore faces the risk that the franc will rise in value against the U.S. dollar.

B. The FI is net short in the franc and therefore faces the risk that the franc will fall in value against the U.S. dollar.

C. The FI is net long in the franc and therefore faces the risk that the franc will fall in value against the U.S. dollar.

D. The FI is net long in the franc and therefore faces the risk that the franc will rise in value against the U.S. dollar.

E. The FI has a balanced position in the Swiss franc.

85. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

Note: Net currency positions are foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms.

  

What is the FI's total FX investment? 

A. US $671,500.

B. US $1,236,700.

C. -US $671,500.

D. -US $1,236,700.

E. 0

Feedback: Net position is sum of all FX
PP = (1,200 - 245,900 + 505,000 - 36,700 + 447,900) = $671,500 US

86. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

Note: Net currency positions are foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms.

  

How would you characterize the FI's risk exposure to fluctuations in the Euro to dollar exchange rate? 

A. The FI is net short in the Euro and therefore faces the risk that the Euro will rise in value against the U.S. dollar.

B. The FI is net short in the Euro and therefore faces the risk that the Euro will fall in value against the U.S. dollar.

C. The FI is net long in the Euro and therefore faces the risk that the Euro will fall in value against the U.S. dollar.

D. The FI is net long in the Euro and therefore faces the risk that the Euro will rise in value against the U.S. dollar.

E. The FI has a balanced position in the Euro.

87. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

Note: Net currency positions are foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms.

  

What is the portfolio weight of the Euro in this FI's portfolio of foreign currency? 

A. +0.18 percent.

B. -36.62 percent.

C. +75.20 percent.

D. -5.47 percent.

E. +66.70 percent.

Feedback: Portfolio weight of Euro = $US in Euro/total FX exposure
−245,900/671,500 = −0.3662

88. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

Note: Net currency positions are foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms.

  

How would you characterize the FI's risk exposure to fluctuations in the yen/dollar exchange rate? 

A. The FI is net short in the yen and therefore faces the risk that the yen will rise in value against the U.S. dollar.

B. The FI is net short in the yen and therefore faces the risk that the yen will fall in value against the U.S. dollar.

C. The FI is net long in the yen and therefore faces the risk that the yen will fall in value against the U.S. dollar.

D. The FI is net long in the yen and therefore faces the risk that the yen will rise in value against the U.S. dollar.

E. The FI has a balanced position in the Japanese yen.

89. The following are the net currency positions of a U.S. FI (stated in U.S. dollars).

Note: Net currency positions are foreign exchange bought minus foreign exchange sold restated in U.S. dollar terms.

  

What is the portfolio weight of the Japanese yen in this FI's portfolio of foreign currency? 

A. +0.18 percent.

B. -36.62 percent.

C. +75.20 percent.

D. -5.47 percent.

E. +66.70 percent.

Feedback: Portfolio weight of yen = $US in yeno/total FX exposure
−505,000/671,500 = 0.7520

90.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

What amount, in sterling, will the FI have to repatriate back to the U.S. after one year if the exchange rate remains constant at $1.60 to ≤1. 

A. ≤6.25 million.

B. ≤7.875 million.

C. ≤7.25 million.

D. ≤6.625 million.

E. ≤11.26 million.

Feedback: End of year ₤ Loan balance = [₤loan amount × 1U.K. loan rate] = [$10,000,000 × (₤1/$1.60)] × 1.16 = ₤6,250,000 × 1.16 = ₤7,250,000

91.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

If the spot foreign exchange rate remains constant at $1.60 to ≤1 throughout the year, the return from the U.K. investment will be 

A. 15%.

B. 12%.

C. 16%.

D. 13%.

E. 7%.

Feedback: The return will be the promised 16%.

92.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

The weighted return on the bank's portfolio of investments would be 

A. 15%.

B. 12%.

C. 16%.

D. 13%.

E. 7%.

Feedback: Return on portfolio = (weight of U.S. investment × U.S. rate earned) + (weight U.K investment × U.K. rate earned)
[(10/20) × 0.10] + [(10/20) × 0.16] = 0.13

93.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year when the FI needed to repatriate the principal and interest on the loan. What would be the dollar loan amount repatriated at the end of the year? 

A. $6.25 million.

B. $11.6 million.

C. $7.25 million.

D. $6.625 million.

E. $10.875 million.

Feedback: ₤ year-end amount × ($1.50/1₤) = 7,250,000 × 1.50 = $10,875,000

94.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year when the FI needed to repatriate the principal and interest on the loan. What would the dollar loan revenues at the end of the year be as a return on the original dollar investment? 

A. 13%.

B. 12.55%.

C. 16%.

D. 8.75%.

E. 7.25%.

Feedback: ($10,845,000 - $10,000,000)/$10,000,000 = $875,000/$10,000,000 = 0.0875

95.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year, the weighted return on the FI's asset portfolio would be 

A. 13.29%.

B. 12.56%.

C. 16%.

D. 8.75%.

E. 9.375%.

Feedback: [(10/20) × 0.10] + [(10/20) × 0.0875] = 0.09375

96.  

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.

If the exchange rate had fallen from $1.60/≤1 at the beginning of the year to $1.50/≤1 at the end of the year, the net interest margin for the FI on its balance sheet investments is 

A. 3.2875%.

B. -3.2875%.

C. 4%.

D. 8.75%.

E. 0.375%.

Feedback: Net interest margin = rate earned on assets - cost of funds
NIM = 0.09375 - 0.09 = 0.375

97. Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar.

Your position is exposed to 

A. interest rate risk only.

B. credit risk only.

C. exchange rate risk only.

D. interest rate and exchange rate risk only.

E. interest rate risk, exchange rate risk, and credit risk.

98. Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar.

If you wanted to hedge your bank's risk exposure, what hedge position would you take? 

A. A short interest rate hedge to protect against interest rate declines and a short currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S. dollar.

B. A short interest rate hedge to protect against interest rate increases and a short currency hedge to protect against declines in the value of the Canadian dollar with respect to the U.S. dollar.

C. A long interest rate hedge to protect against interest rate increases and a long currency hedge to protect against declines in the value of the Canadian dollar with respect to the U.S. dollar.

D. A long interest rate hedge to protect against interest rate declines and a long currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S. dollar.

E. A long interest rate hedge to protect against interest rate declines and a short currency hedge to protect against increases in the value of the Canadian dollar with respect to the U.S. dollar.

99. Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar.

If in one year there is no change to either interest rates or exchange rates, what is the end-of-year profit or loss for the bank? (Hint: Annual interest is paid on both the Canadian bonds and the CD on the date of liquidation in exactly one year.) 

A. Profit of US $20,000.

B. Loss of C $224,000.

C. Profit of US $50,000.

D. Profit of C $63,700.

E. Profit of US $313,000.

Feedback: Profit (loss) = ($ income earned on loan) - ($ cost of funds)
US Dollar amount of CD issued to fund Canadian loan = [C $1,274,000 × (US $0.78493/C $1)] = US $1,000,000
US Dollar amount of loan and loan revenue = [(C $1,274,000 × 1.07) × (US $0.78493/C $1)] = C $1,363,180 × US $0.78493 = US $1,070,000
Profit (loss) = (US $1,070,000) - (US $1,000,000 × 1.05) = US $20,000

100. Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar.

What is the end-of-year profit or loss to the bank if in one year the exchange rate falls to US $0.765 per Canadian dollar? (Assume that there is no change in interest rates.) 

A. Loss of US $75,000.

B. Profit of C $274,000.

C. Loss of US $7,000.

D. Profit of C $9,000.

E. Loss of US $5,000.

Feedback:

101. Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar.

What is the end-of-year profit or loss to the bank if in one year Canadian bond rates increase to 7.538 percent? (Assume no change in either current U.S. interest rates or current exchange rates, US $0.78493/C $1.) 

A. Loss of US $5,000.

B. Profit of US $15,000.

C. Loss of C $119,000.

D. Profit of C $50,000.

E. Loss of C $50,000.

Feedback: Value of Canadian bond at year end



Change in bond value = (C $1,267,607 - C $1,274,000) × 0.78493 = −C $6,392 × 0.78493 = Approx. −$5,000
Previously established
Profit (loss) = (US $1,070,000) - (US $1,000,000 × 1.05) = US $20,000 less approximate change in bond value (−US $5000)
Overall profit (loss) = US $15,000

102. Your U.S. bank issues a one-year U.S. CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in one year. Currently, spot exchange rates are US $0.78493 per Canadian dollar.

What is the end of year profit or loss on the bank's cash position if in one year both Canadian bond rates increase to 7.538 percent and the exchange rate falls to US $0.765 per Canadian dollar? (Assume no change in U.S. interest rates.) 

A. Loss of US $12,000.

B. Loss of US $75,000.

C. Profit of C $9,000.

D. Profit of US $50,000.

E. Loss of C $119,800.

Feedback:

103. The one-year CD rates for financial institutions with AA ratings are 5 percent in the U.S. and 8 percent in France. An AA-rated U.S. financial institution can borrow by issuing CDs or lend by purchasing CDs at these rates in either market. The current spot rate is $0.20/Euro.

If the bank receives a quote of $0.1975/€ for one-year forward rates for the Euro (to buy and to sell), what is the arbitrage profit for the bank if it uses $1,000,000 as the notional amount? 

A. $5,000.

B. $16,500.

C. $19,350.

D. $22,000.

E. $25,675.

Feedback: Issue $1,000,000 in US at 5%. Amount to repay at year-end: (1,000,000 × 0.05) = 1,050,000
Purchase [$1,000,000 × (5 €/$1)] = 5,000,000 € at 8%. Receive at year end 5,000,000€ × (1.08)
5,400,000€
Repatriate the 5,400,000€ at the one-year forward rate of $0.1975/1€ = $1,066,500

Revenue - cost of funds = $1,066,500 - $1,050,000 = $16,500

104. The one-year CD rates for financial institutions with AA ratings are 5 percent in the U.S. and 8 percent in France. An AA-rated U.S. financial institution can borrow by issuing CDs or lend by purchasing CDs at these rates in either market. The current spot rate is $0.20/Euro.

What should be the one-year forward rate in order to prevent any arbitrage? 

A. $0.1944/€.

B. $0.1975/€.

C. $0.2000/€.

D. $0.2025/€.

E. $0.2031/€.

Feedback: US $ Repatriation amount = $1,050,000
$1,050,000/5,400,000€ = $0.1944/1€

105. The one-year CD rates for financial institutions with AA ratings are 5 percent in the U.S. and 8 percent in France. An AA-rated U.S. financial institution can borrow by issuing CDs or lend by purchasing CDs at these rates in either market. The current spot rate is $0.20/Euro.

What should be the spot rate in order for no arbitrage to take place, assuming the one-year forward rate is $0.1975/€? 

A. $0.1944/€.

B. $0.1975/€.

C. $0.2000/€.

D. $0.2025/€.

E. $0.2031/€.

Feedback: (dollar amount cost of funds/US $ forward rate)
$1,050,000/($0.1975/1€) = 5,316,456€
Repatriation amount/(CD principal + CD principal × rate)
5,316,456€/(1.08) = 4,922,644€
Amount to exchange/investment amount
$1,000,000/4,922,644€ = $0.2031/1€

106. Suppose that the current spot exchange rate of U.S. dollars for Russian rubles is $0.15/1ruble. The price of Russian-produced goods increases by 8 percent, and the U.S. price index increases by 3 percent.

According to PPP, the 8 percent rise in the price of Russian goods relative to the 3 percent rise in the price of U.S. goods results in a(n) 

A. depreciation of the Russian ruble by 5 percent.

B. depreciation of the Russian ruble by 6 percent.

C. appreciation of the Russian ruble by 5 percent.

D. appreciation of the Russian ruble by 6 percent.

E. depreciation of the Russian ruble by 7 percent.

Feedback:

107. Suppose that the current spot exchange rate of U.S. dollars for Russian rubles is $0.15/1ruble. The price of Russian-produced goods increases by 8 percent, and the U.S. price index increases by 3 percent.

According to PPP, the new exchange rate of Russian rubles to U.S. dollars is 

A. 0.15.

B. 0.1425.

C. 0.141.

D. 0.1605.

E. 0.159.

Feedback: According to PPP, the exchange rate should depreciate the ruble by 5%



Or 0.15 - 0.0075 = $0.1425/ruble

108. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

What is the spread earned by the bank at the end of the year if the exchange rate remains at €1.75/$? 

A. 0.50 percent.

B. 1.00 percent.

C. 1.5 percent.

D. 2.0 percent.

E. 2.5 percent.

Feedback:

109. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

What is the spread earned by the bank if the end-of-year exchange rate is €1.77/$? 

A. -1.00 percent.

B. -0.70 percent.

C. -0.25 percent.

D. 0.00 percent.

E. 0.20 percent.

Feedback:

110. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

What is the spread earned if the bank can sell one-year forward Euros at €1.755/$? 

A. -0.70 percent.

B. -0.25 percent.

C. 0.00 percent.

D. 0.20 percent.

E. 0.50 percent.

Feedback:

111. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

At what one-year forward rate will the bank earn a 1 percent spread? 

A. €1.7344/$.

B. €1.7418/$.

C. €1.7478/$.

D. €1.7750/$.

E. €1.7842/$.

Feedback: To earn a 1 percent spread, the dollar equivalent conversion should be $10,700,000
US Dollar spread = (10,700,000 - 10,600,000)/10,000,000 = 0.01
Forward rate needs to be €18,637,500/$10,700,000 = €1.7418/$1.

112. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent, it invests them in variable rates of LIBOR + 1.5 percent, reset every six months. The current LIBOR rate is 5 percent. What is the annual spread earned by the bank if LIBOR at the end of six months is 5.5 percent? Assume both interest and principal will be reinvested in six months. Assume the exchange rate remains at €1.75/$ at the end of the year. 

A. 0.50 percent.

B. 0.68 percent.

C. 0.86 percent.

D. 0.90 percent.

E. 0.95 percent.

Feedback:

113. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent, the FI invests them in variable rates of LIBOR + 1.5 percent, reset every six months. The current LIBOR rate is 5 percent. Assume both interest and principal will be reinvested in six months. Assume the exchange rate remains at €1.75/$ at the end of the year. What should be the LIBOR rates in six months in order for the bank to earn a 1 percent spread? 

A. 5.25 percent.

B. 5.48 percent.

C. 5.76 percent.

D. 5.86 percent.

E. 5.94 percent.

Feedback:

107. An FI has purchased (borrowed) a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent. It has invested these proceeds in one-year Euro (€) bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$. Both interest and principal are paid at the end of the year.

Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent, the FI invests them in variable rates of LIBOR + 1.5 percent, reset every six months. The current LIBOR rate is 5 percent. LIBOR at the end of six months is 5.5 percent. Assume both interest and principal will be reinvested in six months. Assume the spot exchange rate is €1.75/$. What should be the one-year forward rate in order for the bank to earn a spread of 1 percent? 

A. €1.7344/$.

B. €1.7418/$.

C. €1.7478/$.

D. €1.7750/$.

E. €1.7842/$.

Feedback:

114. Yen Bank wishes to invest in Yen loans at a rate of 10 percent. The bank will fund the loans in the domestic CD market at a rate of 6.3 percent. This on-balance-sheet FX risk will be hedged in the spot market at a forward rate of $0.62/×. The spot rate on yen is $0.60/×.

What must be the forward exchange rate to eliminate the preference for the yen loans? 

A. $0.6416/×.

B. $0.5798/×.

C. $0.6118/×.

D. $0.5991/×.

E. Insufficient information.

Feedback: Cost of funds = Income from loan
(1 + domestic CD rate) = [spot indirect × quote × (1 + × loan rate)] × forward $/×
(1.063) = [1.6667×/$ × (1.10)] × ($/×)
(1.063)/(1.83334) = ($/×) = $0.5798/×

115. Yen Bank wishes to invest in Yen loans at a rate of 10 percent. The bank will fund the loans in the domestic CD market at a rate of 6.3 percent. This on-balance-sheet FX risk will be hedged in the spot market at a forward rate of $0.62/×. The spot rate on yen is $0.60/×.

What must be the spot exchange rate to eliminate the preference for the yen loans if the forward rate remains $0.62/×? 

A. $0.6416/×.

B. $0.5798/×.

C. $0.6118/×.

D. $0.5991/×.

E. Insufficient information.

Feedback: Cost of funds = Income from loan
(1 + domestic CD rate) = [spot indirect × quote × (1 + × loan rate)] × forward $/×
(1.063) = ×/$ × (1.10) × ($0.62/×)
(1.063)/(0.682) = (×/$) = 1.55865 or $/× = $0.6416/×