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KING FAHD UNIVERSITY OF PETROLEUM & MINERALS COLLEGE OF INDUSTRIAL MANAGEMENT DEPARTMENT OF FINANCE & ECONOMICS FIN 521–01 Mid-Term Exam spring 20082 Name: _____________________________________________________ I.D:____________________________ Sec: _________ 2.

Causes of devaluation. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued? Answer: The following macroeconomic variables could cause the fixed exchange rate to be devalued: • An interest rate that is too low compared to other competing currencies • A continuing balance of payments deficit • An inflation rate consistently higher than in other countries

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The impossible trinity. Explain what is meant by concept of the “impossible trinity” and why it is accurate? Answer: • Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability. • Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the world’s capital markets. • Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.

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Currency board or dollarization. Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches?

Answer: In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions. 4.1. Purchasing power parity. Define the following terms: (a) The law of one price. Answer: The law of one prices states that producers’ prices for goods or services of identical quality should be the same in different markets; i.e., different countries (assuming no restrictions on the sale and allowing for transportation costs). If a country has higher inflation than other countries, its currency should devalue or depreciate so that the real price remains the same as in all countries. Application of this law results in the theory of Purchasing Power Parity (PPP). (b) Absolute purchasing power parity. Answer: If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products denominated in different currencies, one could determine the “real” or PPP exchange rate which should exist if markets were efficient. This is the absolute version of the theory of purchasing power parity. Absolute PPP states that the spot exchange rate is determined by the relative prices of similar baskets of goods. (c) Relative purchasing power parity.

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Answer: If the assumptions of the absolute version of PPP theory are relaxed a bit more, we observe what is termed relative purchasing power parity. This more general idea is that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. More specifically, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. 5.4. Asset market approach to forecasting. Explain how the asset market approach can be used to forecast future spot exchange rates. How does the asset market approach differ from the BOP approach to forecasting? Answer: The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers. These drivers include the following: (1) Relative real interest rates are a major consideration for investors in foreign bonds and short term money market instruments. (2) Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment. (3) Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired. (4) A country’s economic and social infrastructure is an important indicator of that country’s ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment. (5) Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country. (6) The credibility of corporate governance practices is important to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors’ influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives. (7) Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an ‘innocent’ country to experience capital flight with a resulting depreciation of its currency. (8) Speculation can both cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases that follow shortly.

1.10. _______________________ is the study of how shareholders can motivate management to accept prescriptions of the shareholder wealth maximization model. (a) Patient capitalism (b) Agency theory (c) The capital asset pricing model (d) The theory of multinational finance Topic: Agency Theory Skill: Recognition Answer: B

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Which of the following is inconsistent with long-term corporate value maximization? (a) A focus on overly generous short-term stock options. (b) A focus on long-term wealth maximization. (c) The concept of patient capitalism. (d) The avoidance of deceptive and dishonest business practices. Topic: Wealth Maximization Skill: Recognition Answer: A According to a recent survey of 1000 global companies, the primary causes of lost stock value were __________________________. (a) strategic and operational (b) operational and financial (c) financial and hazard (d) hazard and strategic Topic: Loss of Stock Value Skill: Recognition Answer: A

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The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed ____________________. (a) agency theory (b) the asset pricing model (c) corporate governance (d) None of the above Topic: Corporate Governance Skill: Recognition Answer: C

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Which of the following is an example of failed corporate governance in the financial markets? (a) The lack of full disclosure of off-balance-sheet debt by Enron Corporation. (b) The capitalization of $7.0 billion that should have been written off as operating expenses. (c) Global Crossing hiding operating losses while still heavily promoting its stock. (d) All of the above are examples of failed corporate governance. Topic: Corporate Governance Skill: Recognition

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Answer: D

Which of the following is NOT a realistic possible shareholder response to dissatisfaction with stock performance? (a) Move to Canada (walk away) (b) Remain quietly disgruntled (the past) (c) Change management (shareholder activism) (d) Initiate a takeover (maximum threat) Topic: Corporate Governance Skill: Recognition Answer: A

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2.2. A special drawing right (SDR) is the weighted average of the following currencies: (a) US dollar, British pound, Japanese yen, and the euro (b) US dollar, British pound, Japanese yen, Russian Ruble, and the euro (c) US dollar, British pound, Japanese yen, Russian Ruble, Chinese yuan, and the euro (d) None of the above, SDRs currently depend on the price of crude oil. Topic: Special Drawing Right Skill: Recognition Answer: A 10.

Under the gold standard of currency exchange that existed from 1879 to 1914, an ounce of gold cost $20.67 in U.S. dollars and £4.2474 in British pounds. Therefore, the exchange rate of pounds per dollar under this fixed exchange regime was (a) £4.8665/$. (b) £0.2055/$. (c) always changing because the price of gold was always changing. (d) unknown because there is not enough information to answer this question. Topic: Gold Standard Skill: Analytical Answer: B

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The authors discuss the concept of the “Impossible Trinity” or the inability to achieve simultaneously the goals of exchange rate stability, full financial integration, and monetary independence. If a country chooses to have a pure float exchange rate regime, which two of the three goals is a country most able to achieve? (a) Monetary independence and exchange rate stability. (b) Exchange rate stability and full financial integration. (c) Full financial integration and monetary independence. (d) A country cannot attain any of the exchange rate goals with a pure float exchange rate regime. Topic: Currency Regimes Skill: Conceptual Answer: C

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You have been hired as a consultant to the central bank for a country that has for many years suffered from repeated currency crises and depends heavily on the U.S. financial and product markets. Which of the following policies would have the greatest effectiveness for reducing currency volatility of the client country with the United States? (a) Dollarization. (b) An exchange rate pegged to the U. S. dollar. (c) An exchange rate with a fixed price per ounce of gold. (d) An internationally floating exchange rate. Topic: Currency Regimes Skill: Conceptual Answer: A

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3.1. The balance of payments as applied to a course in international finance may be defined as (a) the amount still owed by an exporting firm after making an initial down payment. (b) the amount still owed by governments to the International Monetary Fund. (c) the measurement of all international economic transactions between the residents of a country and foreign residents. (d) the amount of a country’s merchandise trade deficit of surplus. Topic: BOP Introduction Skill: Conceptual Answer: C 17.

When categorizing investments for the financial account component of the balance of payments the ________________ is an investment where the investor has no control whereas the _______________ is an investment where the investor has control over the asset. (a) direct investment; portfolio investment (b) direct investment; indirect investment (c) portfolio investment; indirect investment (d) portfolio investment; direct investment Topic: Financial Account Skill: Recognition

Answer: D31. International economic analysis characterizes the trade balance adjustment process as occurring in three stages in the following order: (a) (1) The currency contract period, (2) the pass-through period, and (3) the quantity adjustment period. (b) (1) The currency contract period, (2) the quantity adjustment period, and (3) the pass-through period. (c) (1) The quantity adjustment period, (2) the pass-through period, and (3) the currency contract period. (d) (1) The pass-through period, (2) the currency contract period, and (3) the quantity adjustment period. Topic: The J-Curve Skill: Recognition Answer: A 32.

The J-Curve adjustment path for adjusting trade imbalances hypothesizes that for a country with a trade balance deficit: (a) A revaluation of the country’s currency will result in an initial further deterioration of the trade imbalance before improvement. (b) A devaluation of the country’s currency will result in an initial further deterioration of the trade imbalance before improvement. (c) A devaluation of the country’s currency will result in an initial improvement of the trade imbalance before deterioration. (d) None of the above. Topic: The J-Curve Skill: Conceptual Answer: B

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In general, the United States goods trade balance has grown increasing positive over the last 3 years. (a) True (b) False Topic: Current Account Skill: Recognition Answer: B

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In general, as a country’s income increases, so does the demand for imports. (a) True (b) False Topic: Economic Theory Skill: Conceptual Answer: A

4.1. The Economist publishes annually the “hamburger standard” by which they compare the prices of the McDonalds Corporation Big Mac hamburger around the world. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore, the price should be the same. If a Big Mac costs $2.54 in the United States and 294 yen in Japan, what is the estimated exchange rate of yen per dollar as hypothesized by the Hamburger index? (a) $.0086/¥ (b) 124¥/$ (c) $.0081/¥ (d) 115.75¥/$ Topic: PPP Skill: Analytical Answer: D 2.

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If the current exchange rate is 124 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is $2.54, and the price of a Big Mac hamburger in Japan is 294 yen, then other things equal, the Big Mac hamburger in Japan is ________. (a) correctly priced (b) under priced (c) over priced (d) not enough information to determine if the price is appropriate or not Topic: PPP Skill: Analytical Answer: B Other things equal, and assuming efficient markets, if a Honda Accord costs $18,365 in the U.S. then at an exchange rate of $1.43/£, the Honda Accord should cost __________ in Great Britain. (a) 26,262£ (b) 18,365£ (c) 12,843£ (d) 9,183£ Topic: Law of One Price Skill: Analytical Answer: C

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One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$1. Since that time the rate of inflation in the U.S. has been 4% greater than that in Canada. Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be approximately ____________. (a) $0.96/C$ (b) $1/C$1 (c) $1.04/C$1 (d) Relative PPP provides no guide for this type of question. Topic: PPP Skill: Analytical Answer: C

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Research by Dimson, Marsh, and Staunton (2002) found that for the 1900–2000 period, relative purchasing power parity did not hold. (a) True (b) False Topic: PPP Skill: Recognition Answer: B

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Products that are relatively price inelastic tend to also demonstrate a low degree of exchange rate passthrough. (a) True (b) False Topic: Exchange Rate Pass-Through Skill: Conceptual Answer: B

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Empirical tests show that the Fisher effect usually exists for short maturity government securities but less so for longer-term maturity securities. (a) True (b) False Topic: Fisher Effect Skill: Conceptual Answer: A

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Sony of Japan produces DVD players and exports them to the United States. Last year the exchange rate was 130¥/$ and Sony charged $150 per DVD player. Currently the spot exchange rate is 110¥/$ and Sony is charging $170 per DVD player. What is the degree of pass through by Sony of Japan on their DVD players? (a) 95.9% (b) 86.7% (c) 73.2% (d) 4.1% Topic: Exchange Rate Pass-through Skill: Analytical Answer: C

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In its approximate form the Fisher effect may be written as ____________. Where: i = the nominal rate of interest, r = the real rate of return and π = the expected rate of inflation. (a) i = (r)(π) (b) i = r + π + (r)(π) (c) i = r + π (d) i = r + 2 π Topic: Fisher Effect Skill: Recognition Answer: C

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Assume a nominal interest rate on one-year U.S. Treasury Bills of 4.60% and a real rate of interest of 2.50%. Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the U.S. over the next year? (a) 2.10% (b) 2.05% (c) 2.00% (d) 1.90% Topic: Fisher Effect Skill: Analytical Answer: A

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The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as ___________________. (a) absolute PPP (b) the law of one price (c) relative PPP (d) the international Fisher Effect Topic: International Fisher Effect Skill: Recognition Answer: D Problem

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Howard borrows ¥5,000,000 for 6 months at an annual rate of .60% and uses the proceeds to invest in the U.S. money market at an annual rate of 4.50%. If the spot rate today is ¥115/$ and the spot rate in 6 months is ¥113/$ Howard’s net proceeds will be: (a) ¥104,130 (b) $8,587 (c) $921 (d) ¥8,587 Topic: Uncovered Interest Arbitrage Skill: Analytical Answer: D

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Based on the following market information for France and Germany, calculate the One-Year “t-bill” rate for Germany. Spot exchange rate Expected inflation rate One-year “t-bill” rate (a) (b) (c) (d)

France FF 3.4375/DM 8.00% p.a. 11.00% p.a.

Germany DM 0.2909/FF 2.00% p.a. ??

4.83% p.a. 5.00% p.a. 5.06% p.a. 3.00% p.a.

Topic: Interest Rate Parity Skill: Analytical

Answer: C 5.1. Which of the following is NOT a forecasting technique suggested by the authors? (a) asset market approach (b) parity conditions (c) globalization process (d) balance of payments approach Topic: Forecasting Skill: Recognition Answer: C 2.

Which of the following is NOT part of the set of investment considerations identified by the authors for the asset market approach to forecasting? (a) relative real interest rates (b) capital market liquidity (c) political safety (d) all are considerations identified by the authors Topic: Forecasting Skill: Recognition Answer: D

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___________________ is the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics. (a) Contraband (b) Contagion (c) Cross-border political risk (d) Current account exposure Topic: Contagion Skill: Recognition Answer: B

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____________________ is the most widely accepted of all exchange rate forecasting theories. (a) The Balance of Payments approach (b) Purchasing Power Parity (c) The Asset Market approach (d) Sarbanes-Oxley Topic: XR Forecasting Theories Skill: Recognition Answer: B

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The ____________ provides a means to account for international cash flows in a standardized and systematic manner. (a) parity conditions theory (b) asset approach (c) balance of payments theory (d) international Fisher effect Topic: Balance of Payments Skill: Recognition Answer: C

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Which of the following statements should NOT be applied to the theory of PPP? (a) PPP is the oldest and most widely followed of the exchange rate theories. (b) PPP calculations and forecasts may be plagued with structural differences across countries. (c) Most theories of exchange rate determination have elements of PPP imbedded in them. (d) All of the above apply to PPP Topic: Purchasing Power Parity Skill: Conceptual Answer: D

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Despite inadequacies in estimating long-term exchange rate values, fundamental theories of exchange rates have proved remarkably accurate for the short- and medium-term. (a) True (b) False Topic: Fundamental Exchange Rate Theories Skill: Conceptual Answer: B

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The authors compromise as to the key factors for exchange rate determination. They conclude that ____________ is important in the short run, but that _________ determines long run exchange rates. (a) the Fisher effect; PPP (b) asset markets, interest rates, and expectations; PPP (c) PPP, the Fisher effect (d) the Fisher effect; asset prices, interest rates, and expectations Topic: Key Factors for Equilibrium in Foreign Exchange Markets Skill: Conceptual Answer: C

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Technical analysts divide exchange rate movements into three periods. Which of the following do NOT apply? (a) Random day-to-day movements. (b) Short-term movements longer than day-to-day. (c) Morning, afternoon, and evening. (d) Long-term trends. Topic: Technical Analysis Skill: Recognition Answer: D

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The authors claim that theoretical and empirical studies appear to show that fundamentals do apply to the long-term for foreign exchange. (a) True (b) False Topic: Key Factors for Equilibrium in Foreign Exchange Markets Skill: Recognition Answer: A

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When the Russian Ruble reached the limits of the bands about its managed float targets (Ru5.70/$ to Ru6.35/$) in 1997, the Russian government would intervene in the markets to stabilize the Ruble. If the exchange rate approached Ru5.70/$ the government would _________ Rubles using foreign exchange and gold, or if the exchange rate approached Ru6.35/$ they would _________ Rubles. (a) buy; sell (b) sell; buy (c) buy; buy (d) sell; sell Topic: Russian Crisis Skill: Conceptual Answer: B

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Fundamentally, a country with a relatively high inflation rate should see its currency _____________ in value relative to countries with lower rates of inflation and this _______ the case for the Brazilian currency from 1994–1998. (a) fall; was not (b) fall; was (c) rise; was not (d) rise; was Topic: Brazilian Crisis Skill: Conceptual Answer: A

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A recent London School of Economics study of fundamental versus technical trading analysis found the following with regard to currency trading: (a) Total returns to the technical portfolio were superior to the fundamental portfolio. (b) Total returns to the fundamental portfolio were superior to the technical portfolio. (c) Portfolio returns were similar between the two with less variability for the fundamental portfolio. (d) Portfolio returns were similar between the two with less variability for the technical portfolio. Topic: Fundamental vs. Technical Analysis Skill: Conceptual Answer: D

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Are the following exchange rates are forecast for one-year hence. Are they in equilibrium? Why? Oneyear forecast are €0.90/$, $1.70/£ and €1.48/£. (a) Yes, because the cross rates and forecast rates for the €/£ are equal. (b) No, because the forecast rate of €1.48/£ requires fewer € to obtain a £ than that forecast by the cross rates. (c) No because the forecast rate of €1.48/£ requires more € to obtain a £ than that forecast by the cross rates. (d) Not enough information to determine the correct response. Topic: Cross Rates Skill: Analytical Answer: B

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Overshooting in the currency market is the practice of always estimating forward rates too high to avoid more expensive undershooting errors. (a) True (b) False Topic: Forecasting Skill: Recognition Answer: B

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Exchange rates are relatively easy to forecast in the short-term but far more difficult in the long-term as currencies move away from their fundamental values. (a) True (b) False Topic: Forecasting Skill: Recognition Answer: B

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