Managing international risk

Chapter 27

Answers to questions

Short Answer Questions

1. Briefly explain the different types of currency markets.
There are several types of currency markets. A spot market is for trading currencies
immediately. Forward markets are used for delivery of a currency at a future date at a price
agreed upon today. There are also currency futures, currency options, and currency swaps.
2. Explain the concept of interest rate parity.
Interest rate parity provides the theoretical relationship between interest rates in two countries
and the differences between the forward and the spot rates. Interest rate parity is ensured
through arbitrage. The theory explains how forward rates are determined in the marketplace.
Forward rates serve to determine interest rate parity between two countries, for investors
involved in covered interest arbitrage.
3. Briefly explain the expectations theory of forward exchange rates.
The expectations theory of exchange rates states that the forward rate equals the expected
future spot rate.
4. Explain the concept of purchasing power parity.
Purchasing power parity is based on the law of one price. It implies that the expected difference
in inflation rates equals the expected change in the spot rate. The Economist publishes Big Mac
prices in different countries. By implication, the ratio of these prices should provide a guide for
exchange rates among currencies of these countries. Of course, the statistical errors associated
with the estimates are large.
Multiple Choice Questions
5. The expectations theory of forward rates implies that:
A. The forward rate is determined by government's expectations
B. On average, the forward rate is equal to the future spot rate
C. The forward rate is determined by expectations of the future spot interest rate
D. The forward rate is equal to the future spot rate

6. If the direct quotation for the Euro is $1.3565/Euro, what is the indirect quotation?
A. 0.2415
B. -1.1655
C. 0.7372
D. None of the above
Indirect quote = 1/1.3565 = 0.7372
7. The spot Peso/US$ exchange rate is Peso10.9892/US$. The 3-month forward rate is
Peso11.0408/US$. What is the Peso's forward premium (or discount) on the US dollar,
expressed as an annual rate? (approximately)
A. 0.83% premium
B. 1.9% discount
C. 2.1% premium
D. None of the above
Peso forward (premium or discount) = 4[(10.9892/11.0408) - 1] = -1.9% = 1.9% discount
8. Which of the following statement(s) about the foreign exchange forward market is (are) true?
I) In the forward market you buy or sell currency for future delivery at a rate set today.
II) A forward market transaction is a made-to-measure transaction.
III) Most forward transactions are for six months or less.
A. I only
B. I and II only
C. II and III only
D. I, II and III
9. The dollar interest rate is 6%, and the Swiss franc interest rate is 4%. If the required rate of
return for a project in Switzerland is 15%, calculate the required rate of return in the US for a
similar project:
A. 17.2%
B. 12.8%
C. 15%
D. None of the above
(1 + dollar return) = (1.15)(1.06)/1.04 = 1.172 = 17.2%

10. If the US dollar interest rate is 4% and the peso interest rate is 7%, what is the likely 1-year
forward rate if the spot dollar-peso rate is 11?
A. 11.54
B. 11.32
C. 10.68
D. 10.23
(1.07/1.04) x 11 = 11.32
11. Risk associated with unanticipated actions by a countrys government or law courts is
called:
A. Economic risk
B. Political risk
C. Transaction risk
D. None of the above
12. The spot rate = US$0.8543/A$; the one year forward rate = US$0.8475/A$. A US exporter
denominates its exports to Australia in A$ and expects to receive A$600,000 in one year. What
will the value of these exports in one year in US$ given that the firm executes a forward hedge?
(Ignore transaction costs)
A. US$508,500
B. US$512,580
C. US$707,965
D. None of the above
A$600,000 * 0.8475 = US $508,500
13. An Australian firm is evaluating a proposal to build a new plant in the US. The expected
cash flows in US$ (in millions) are as follows: Year 0, -100; Year 1, 40; Year 2, 50; Year 3, 65.
The discount rate in A$ is 10%, while the discount rate in US$ is 12% and the spot rate is
US$0.85/A$. Calculate the NPV in A$.
A. +25.69
B. -21.84
C. +13.10
D. +21.84
NPV = $21.84; $21.84/0.85 = A$25.69

14. The Mexican economy is predicted to average double digit inflation over the next two years
of 10% per annum. The inflation forecast for the US is 4% per annum. If the current exchange
rate is $0.19/peso, what will be the exchange rate two years from now?
A. $0.0831
B. $0.1698
C. $0.1018
D. none of the above
E(Spot) = (0.19)[(1.04/1.10)^2] = $0.17/peso
15. The spot US$/Euro exchange rate is USD1.3549/EUR. The 3-month forward rate is
USD1.3595/EUR. What is the Euro's forward premium (or discount) on the US dollar, expressed
as an annual rate? (approximately)
A. 0.83% premium
B. 1.9% discount
C. 1.4% premium
D. None of the above
Forward (premium or discount) = 4[(1.3595/1.3549) - 1] = 1.4% = 1.4% premium
16. A currency forward contract is described by:
A. Agreeing today to buy or sell a specified amount of currency at a later date at a price set in
the future
B. Agreeing today to buy or sell a specified amount of currency today at its current price
C. Agreeing today to buy or sell a specified amount of currency at a later date at a price set
today
D. None of the above
Calculation questions
17. The spot Yen/USD exchange rate is Yen119.795/USD and the one-year forward rate is
Yen114.571/USD. If the annual interest rate on dollar CDs is 6%, what would you expect the
annual interest rate to be on Yen CDs?
1 + rYen = (114.571/119.795)(1 + rUS$) = 1.01377; rYen = 1.38%
18. The XJ Company from the USA is evaluating a proposal to build a new plant in the United
Kingdom. The expected cash flows in GBP are as follows: Year_0, -50; Year_1, 25; Year_2, 35;
Year_3, 40. The discount rate in GBP is 14% and the discount rate in the USD is 12%. The spot
rate is USD1.5/GBP. Calculate the NPV in USD.
NPV = GBP25.86; GBP25.86 * 1.5 = $38.79