Mid-term Test

Semester 3 / Year 2020

COURSE : INTERNATIONAL FINANCE

Student’s ID : B170219B
Batch No. : BAC17C1

Notes to candidates:
1) The question paper consists of 8 pages and 2 sections. Section A: 30 MCQs, and Section B:
3 Essay questions.
2) Answer all questions.
3) Submit your answer sheet including screenshots (if any) along with the question paper through
e-Learning portal.
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SECTION A:

For questions 1) to 30), please key in one answer for each question, and each question carries 1.5
marks.

1) Assume that a bank's bid rate on Malaysian RM is $4.11 and its ask rate is $4.17. Its bid-ask
percentage spread is:
A) about -1.44%.
B) about -1.46%.
C) about 1.46%.
D) about 1.44%.
Answer: ( D )

2) Assume the implied PPP rate of exchange of Malaysian RM per Singapore dollar(S$) is 3.50
according to the Big Mac Index. Further, assume the current market exchange rate is RM3.10/S$1.
Thus, according to PPP and the Law of One Price, at the current exchange rate the Singapore dollar is:
A) correctly valued.
B) undervalued.
C) overvalued.
D) There is not enough information to answer this question.
Answer: ( C )

3) Assume a two-country world: Country M and Country S. Which of the following is correct about purchasing
power parity (PPP) as related to these two countries?
  A)  If Country S's inflation rate exceeds Country M's inflation rate, Country M's currency will weaken.
  B)  If Country M's interest rate exceeds Country S's inflation rate, Country M's currency will weaken.
  C)  If Country M's interest rate exceeds Country S's inflation rate, Country M's currency will
strengthen.
  D)  If Country M's inflation rate exceeds Country S's inflation rate, Country M's currency will weaken.

Answer: ( B )

4) Kelvin Toh thinks that the U.K. pound will cost $1.63/£ in six months. A 6-month currency futures
contract is available today at a rate of $1.45/£. If Kelvin was to speculate in the currency futures market,
and his expectations are correct, which of the following strategies would earn him a profit?
A) Sell a pound currency futures contract.
B) Buy a pound currency futures contract.
C) Sell pounds today.
D) Sell pounds in six months.

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Answer: ( A )

5) The exchange rate system in which a country allows the value of the currency to be determined by
the market forces of supply and demand is known as a
A) currency board.
B) fixed exchange rate.
C) target zone.
D) floating exchange rate system.
Answer: ( D )

6) When parity conditions are not in effect in currency and money markets, traders could make
extraordinary profits from a practice known as ________.
A) covered interest rate parity
B) covered interest rate arbitrage
C) triangular arbitrage
D) forward market arbitrage
Answer: ( B )

7) The inflation rate in the United States is 5 percent while the inflation rate in Malaysia is 8 percent. The current
exchange rate for the Malaysian ringgit is $4.16. After supply and demand for the Malaysian ringgit have
adjusted in the manner suggested by purchasing power parity, the new exchange rate for the ringgit will be:
  A)  $4.2789.
  B)   $4.0073.
  C)  $4.0444.
  D)  $4.0066.
Answer: ( A )

8) In its absolute version, purchasing power parity states that price levels worldwide should be
________ when expressed in a common currency.
A) equal
B) roughly equal
C) different
D) opportunities for arbitrage
Answer: ( A )

9) Which of the following theories suggests the percentage change in spot exchange rate of a currency should be
equal to the interest rate differential between two countries?
  A)  absolute form of PPP
  B)  relative form of PPP
  C)  international Fisher effect (IFE)
  D)  interest rate parity (IRP)

Answer: ( B )

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10) The decomposition of the nominal interest rate into the sum of the expected real interest rate and the
expected rate of inflation is known as the
A) Fisher Effect.
B) purchasing power parity.
C) bid-ask spread.
D) exchange rate pass-through.
Answer: ( A )
11) A firm buys a currency futures contract, and then decides before the settlement date that it no longer wants
to maintain such a position. It can close out its position by:
  A)   buying an identical futures contract.
  B)  selling an identical futures contract.
  C)  buying a futures contract with a different settlement date.
  D)  selling a futures contract for a different amount of
currency.
 
Answer: ( B )

12)  Assume that a currency's spot and future prices are the same, and the currency's interest rate is
higher than the U.S. rate. The actions of U.S. investors to lock in this higher foreign return would ____
the currency's spot rate and ____ the currency's futures price.
  A)  put upward pressure on; put upward pressure on
  B)  put downward pressure on; put upward pressure on
  C)  put downward pressure on; put downward pressure on
  D)  put upward pressure on; put downward pressure on

Answer: ( D )

13) Which of the following forecasting techniques is typically based on formal economic models of
exchange determination, which link exchange rates to money supply, inflation rates, productivity
growth rates, and the current account?
A) market-based forecasts
B) fundamental analysis
C) technical analysis
D) statistical analysis

Answer: ( B )

14) Unlike forward contracts, the size of currency futures contracts are ________.
A) subject to the forces of supply and demand in the currency spot market
B) based on the months in which they expire

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C) a function of the initial margin required at the open of the trade
D) a standardized amount that differs for each currency traded
Answer: ( D )

15) Assume the Singapore dollar is equal to $0.755 and the Malaysian ringgit is equal to $0.239. The
value of the Singapore dollar in Malaysian ringgits is:
A) about 3.159 Malaysian ringgits.
B) about 0.317 Malaysian ringgits.
C) about 3.397 Malaysian ringgits.
D) about 2.516 Malaysian ringgits.
Answer: ( A )

16) The international credit market primarily concentrates on:

A) long-term lending.
B) short-term lending (less than one year).
C) medium-term lending.
D) providing an exchange of foreign currencies for firms who need them.
Answer: ( B )

17) Which one of the following would be an answer to why the forward exchange rate is an unbiased
predictor of the future spot rate?
A) The forward rate is greater than the conditional expectation of the future spot rate.
B) The forward rate equals than the conditional expectation of the future spot rate.
C) The forward rate is less than the conditional expectation of the future spot rate.
D) The current spot rate is greater than the conditional expectation of the future spot rate.
Answer: ( B )

18) Assume a Japanese firm’s imports from the U.S is in U.S. dollars. Assume that the forward rate and
spot rate of the Japanese yen are equal. If the Japanese firm expects the U.S. dollar to ____ against the
yen, it would likely wish to hedge. It could hedge by ____ dollars forward.

A) depreciate; buying
B) depreciate; selling
C) appreciate; selling
D) appreciate; buying
Answer: ( B )

19) Futures contracts are typically ____; forward contracts are typically ____.

A) sold on an exchange; offered by commercial banks

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B) offered by commercial banks; sold on an exchange
C) sold on an exchange; sold on an exchange
D) offered by commercial banks; offered by commercial banks
Answer: ( A )

20) Your company expects to make a payment of 6,000,000 Japanese yen 60 days from now. You
decide to hedge your position by buying Japanese yen forward. The current spot rate of the yen is
$.0093, while the forward rate is $.0096. You expect the spot rate in 60 days to be $.0098. How many
dollars will you pay for the 6,000,000 yen 60 days from now if you buy yen forward?

A) $55,800
B) $58,800
C) $526 million
D) $57,600
Answer: ( A )

21) Investors from Germany, the United States, and the U.K. frequently invest in each other based on
prevailing interest rates. If British interest rates increase, German investors are likely to buy ____
dollar-denominated securities, and the euro is likely to ____ relative to the dollar.

A) more; depreciate
B) fewer; appreciate
C) fewer; depreciate
D) more; appreciate
Answer: ( B )

22) Currency futures contracts sold on an exchange:

A) contain a commitment to the owner, and are standardized.

23) Which of the following is the most likely strategy for a U.S. firm that will be receiving Swiss
francs in the future and desires to avoid exchange rate risk (assume the firm has no offsetting position in
francs)?
A) purchase francs spot.
B) sell a futures contract on francs.

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C) obtain a forward contract to purchase francs forward.
D) all of the above are appropriate strategies for the scenario described.
Answer: ( B )

24) The 60-day forward rate for the euro is $1.07, while the current spot rate of the euro is $1.05. What
is the annualized forward premium or discount of the euro?
  A)  1.9 percent discount
  B)  1.9 percent premium
  C)  11.4 percent premium
  D)  11.4 percent discount
Answer: ( C )

25) The purchases of goods and assets by foreign residents from domestic residents are ________
because they are a source of foreign exchange. ________ increase the supply of foreign money in the
foreign exchange market.
A) credit transactions
B) current account transactions
C) debit transactions
D) capital account transactions
Answer: ( A )

26) The accounting statement that summarizes all the economic transactions between residents of the
home country and residents of all other countries is called the
A) balance of trade.
B) current account balance.
C) balance of payments.
D) capital account balance.
Answer: ( C )

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

28) From the Malaysian perspective, which of the following would be a direct quote in the foreign
exchange market?
A) SF2.40/£

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B) $1.50/£
C) MYR4.867/€
D) €0.205/MYR
Answer: ( C )

29) The three major accounts of the ________ are the current account, the capital account and the
official settlements account.
A) balance of payments
B) balance of trade
C) trade surplus
D) trade deficit
Answer: ( A )

30) Multinational corporations most often hedge their transaction exchange rate risk using currency
________.
A) options
B) futures
C) spreads
D) forward contracts
Answer: ( D )
(Total: 45 marks)

SECTION B: Essay Questions. Please key in your answer right after each question.

Question 1

(a) If interest rate parity is in effect, there are no profitable opportunities for covered interest arbitrage.
What does this imply about the relationship between spot and forward exchange rates when the foreign
currency money market investment offers a higher return than the domestic money market investment?
(15 marks)
Answer:

Interest rate parity is a theory that says the forward rate differs from the spot rate at equilibrium
by an amount equal to the interest differential between two countries. This theory connected interest
rates, spot exchange rates and foreign exchange rates. In a simpler way, the interest rate parity (IRP)
said that the differences of interest rate between two countries is equal to the differences between the
forward exchange rate and the spot exchange rate.

When the foreign currency money market investment offers a higher return than the domestic
money market investment, then the foreign currency might be at a discount compared to the domestic

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currency in the forward market. Higher return also comes with higher risk in trading the foreign
currency. This means the domestic currency might be traded at a higher spot exchange rate than the
current domestic future spot rates which is forward discount. But when the transaction exchange risk is
offset, the forward discount will be locked in capital loss, the higher return of the foreign currency will
be reduced and back to the lower return offered in the domestic money market.

(b) If interest rate parity prevails, what is the return from a hedged foreign currency investment?

(10 mars)
Answer:

Question 2

(a) Give an example of how the balance of payments provides information concerning exchange rate
determination?
(10 marks)
Answer:

Balance of payments actually is a set of principles and statistical record of a country transaction
with other countries over a period of time which is presented in the form of double-entry system.
Balance of payment provides information in detail about the supply and demand of the currency of a
certain country. A changes in balance of payment of a country will cause fluctuations and chages in the
exchange rate between different countries.
For example if there is a consumer in France would like to buy goods and services from a firm
from United States. The US firm will not likely to accept euros as the currency for the payment as they
prefer to accept US dollars to avoid any foreign exchange risk. The French consumer will need to buy
U.S. dollar and sell the euros in the foreign exchange market in order to buy goods and services from
the US firm. After the trade is done, the transaction will be recorded in the current account under the
balance of payments.
In this situation, the capital flows between the countries will be shown clearly in the capital

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account under the balance of payments. If there is an increment in the demand of US dollars among the
foreign investors or consumers. There will be upward pressure on the price of US dollars which might
cause the US currency to increase against other currencies.

(b) Explain the double-entry system of the balance of payments. (10 marks)

Answer:

Balance of payments (BOP) is a system used to measure all financial and economic transactions
over a specified period of time. It is a summary of economic activities between the country and other
countries usually within a year. Balance of payments is governed by double entry system which is a
range of principles and conventions that helps recording the transactions systematically and coherently.
This system is consistent across the countries and over time.
Under double-entry system, a transaction or economic activity will be represented in the balance
of payment in two entries with same values. One of the value will be designated a credit, and the other
value will be debit. When there is currency inflows, a credit will be stated. This means the country had
earn in foreign exchange. When there is currency outflow, a debit for the value will be stated. This
means the foreign exchange is being expended.
There are three major accounts in BOP which are current account, capital account and official
reserves.
Current account used to record the net flow of goods and services, income and current unilateral
transfers. The main components in current account are trade in goods and services, investment incomes
and net transfer. If there is a deficit on the current account, the value of import for the country is higher
than the value of export. If there is a surplus on the current account, the value of export for the goods
and services of a country is less than the value of exports.
Capital account is used to record public and private investment and lending. In a simpler way to,
the capital account can be explained as an account in measuring the transfer in assets and liabilities. If
there is an inflow of capital, debit will be granted to the value. If there is an outflow of the capital, debit
will be given. For example, if a Japanese company wanted to build a factory in United Kingdom. This
will be counted as a credit on the UK Capital Account which is considered as income for UK.

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For Official reserves account, it is used to measure changes in international reserves owned by
central banks. It reflects the status of surplus and deficit of current account and capital account. The
official reserve account actually is a subdivision of the capital account. It shows the currency and
securities held by the government. The official reserves will increase if there is a surplus in trade
whereas it will decrease when there is a deficit. The official reserves account consist of gold and
convertible securities.

Question 3

What is the distinction between relative purchasing power parity and absolute purchasing power parity?
(10 marks)
[Total: 55 marks]
Answer:

The purchasing power parity is a theory that says the spot exchange rates between currencies
will change to the differential in inflation rates between countries. It is an economic theory that
compares currencies of different country via a approach called “basket of goods”.

There are two types of PPP which are absolute purchasing power parity and relative purchasing
power parity.

Under absolute purchasing power parity, the price levels adjusted for exchange rates should be
equal between different countries. It said that one unit of currency should have same purchasing power
globally.

For relative purchasing power parity, it states that the exchange rate of one currency against
another will adjust to reflect changes in the price levels of the two countries.

Absolute purchasing power parity is almost the same with law of one price. The absolute
purchasing power parity states the change in exchange rate should be proportional to the change in price
levels.

However the relative purchasing power parity states that the change in exchange rate should be
proportional to the relative change in the level of price for the goods and services.

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_______000______

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