Exchange Rate Regimes

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Foundations of International Finance

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Foreign Exchange Rates

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Overview of Foreign Exchange Exposures

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Transaction Exposure
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Translation Exposure
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Operating Exposure
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Foreign Direct Investment

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Portfolio Investment
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Different Types of Currency Regimes

1. Hard Pegs
These are currency regimes in countries that have given up sovereignty over their monetary
policy by adopting measures such as dollarization (i.e. adopting US$ as their currency) or
utilizing currency board structures (by making a commitment to exchange domestic currency
for foreign currency such as USD at a fixed exchange rate)

2.Fixed Exchange Rates (Soft Pegs)

These are currency regimes in countries that have pegged their currencies at a fixed rate to
currency of another country or to a basket of currencies of major financial and trading
partners

3. Floating Arrangements
These are currency regimes in countries whose currencies are exchanged with currencies of
other countries at rates that are market driven.

Floating arrangements can be completely market driven with NO government influence or

intervention OR it can be floating with varying degrees of government influence and
intervention

4. Residual
These are currency regimes in countries that do not fall under any of the three categories
above.
Currency is adjusted in small amounts at a fixed rate or in response to indicators. This
is an example of Fixed Rate or Floating Rate regime?
Fixed Rate Regime

Market intervention serves to moderate the rate of change. This is an example of

a Floating Rate or Fixed Rate regime?
Floating Rate Regime
 Fixed or Floating Rate exchange rate regime?
A country's choice of exchange rate regime is a trade off between desirability for price
stability (Fixed Rate) and the desirability to have freedom to conduct monetary and fiscal
policies (Floating Rate). A country cannot have both.

This trade off manifests in a country's choice of two out of three attributes of national
economic management. What are these three attributes?
• 1
Exchange Rate Stability implies that there is no exchange rate risk to traders or investors.
Exchange rate of the country's currency is fixed relative to another currency (such as US$)
or a basket of currencies. The worrying question "What will be the exchange rate in future?"
is taken out of decision making.
• 2
Financial Integration implies complete freedom of monetary flows so that traders and
investors can move funds in and out of a country easily. They don't have to seek permission
from central banks or other authorities for such movement
• 3
Monetary independence implies that each country can pursue policies related to money
supply and interest rate that relate to national economic objectives on inflation, employment
and growth.

The USA allows free flow of funds. It sets is own monetary policy. What kind of
exchange rate regime will it have?
Floating rate

Hong Kong allows free flow of funds. Its monetary policy is restricted by its commitment
to link its inflation to that of the USA. What is the exchange rate regime likely to be in
Hong Kong?
Fixed rate
The 3 key financial decisions are: Investment, Financing and Dividend decisions

Investment: Decision on what assets to spend on now in expectation of returns in the

future
• Buying a foreign company
• Opening a bank account and depositing money in a foreign currency
• Building a new factory in a foreign country
• Building a warehouse in a foreign country and stocking inventory in it

Financing: Decisions about which sources, such as shareholders and lenders, to get
money from to spend on investment decisions
• Distribution of profits earned in a foreign country
• Decision about whether to repatriate dividends back to home country or not
Dividend: Deciding on how to distribute the returns from investment. What
proportion to be paid out as dividends to shareholders and what proportion to be
retained as reserves for future use in business
• Borrowing in a foreign currency
• Issuing stocks in a foreign stock exchange
• Reinvesting profits earned in a foreign country

1. Want to Invest 1000$ in a bicycle with expectation of return from a flower

delivery business.
2. Can finance 200$ from my savings. How to finance the rest? Bank Loan?
3. What should I do a year later when a 100$ return comes in? Give my self a
dividend? How much?
What makes finance international?
Want to buy an imported bicycle? Exchange rates will affect the price of the bicycle
Heading
There are at least 4 elements which internationalize financial decisions.

To understand these one must start with the idea of domestic currency and foreign
currency. Domestic currency is the currency of country where the decision maker
located. Any other currency is a foreign currency.

1. Exchange Rates: Financial decisions, such as investing in a foreign country with a

foreign currency, bring into play exchange rates between the domestic and foreign
currency. These rates are referred to as Forex rates

2. Inflation Rates: Exchange rates between currencies of two countries are affected by
the relation between the inflation rates in the two countries

3. Interest Rates: Exchange rates between currencies of two countries are affected by
the relation between the interest rates in the two countries.

4. Country Risk: Financial decisions involving foreign countries also factor in the
country risk of foreign countries

All principles of basic financial management apply to international finance plus the
principles related to the 4 elements above
Foreign Currency Markets and Exchange Rates
• Larger the amount of a currency required in exchange for one USD ......... the
currency
Weaker
• Dividends and Financing are two types of financial decisions. What is the third
type of financial decision?
Investment
• In addition to factors that affect any financial decision, exchange rates affect
international financial decisions. What are the other such factors that affect
international financial decisions?

Market Participants
Banks and Non-Bank Exchange Dealers buy at bid price and sell at ask price. Many
such banks and dealers specialize in certain currencies and act as market makers in such
currencies. A market maker (MM) is a firm or individual who actively quotes two-sided
markets in a security, providing bids and offers (known as asks) along with the market
size of each. The primary goal of profiting on the bid-ask spread, which is the amount by
which the ask price exceeds the bid price a market asset.
Individuals and Companies use the foreign exchange markets to serve an underlying
commercial purpose. A company may buy foreign currency to pay for import of an
equipment. An individual tourist may buy foreign currency to go shopping in a foreign
country.
Speculators aim to make a profit from exchange rate changes in the foreign currency
markets. They have no underlying commercial needs nor do they act as market makers.
Central Banks and Treasuries trade in foreign currencies with the primary motive of
influencing the foreign exchange value of their currency in a manner that will benefit
the interests of their citizens. They can even make losses to fulfill this primary motive.
Forex Brokers facilitate trading between dealers without becoming principals in the
transaction. They know which dealers want to buy and which dealers want to sell. They
can link buyers and sellers without revealing their identities to each other. Brokers earn
commission income. One list of brokers...
 1. Spot transactions require delivery and payment on the second business day
following the transaction date.

2. Forward transactions require delivery at a future value date of a specified

amount of one currency for a specified amount of another currency. Exchange
rates are established at the time of agreement. Payment and delivery are
required at value date.

3. Swap transaction is the simultaneous purchase and sale of a given amount of

foreign exchange for two different value dates. Both purchase and sale are conducted
with the same counterparty.

EUR/USD at 1.1250
The first currency in the quotation – in this case the euro – is represented by its three-
letter symbol, EUR. This is known as the named or base currency.
The second currency – in this case the U.S. dollar, shown by its three-letter symbol, USD
– is known as the terms or quote currency.

EUR/USD at 1.1250, you would receive one unit of the euro (EUR) in exchange for a
payment of 1.1250 U.S. dollars (USD)

European terms do not limit or refer to just Europe-based currencies, but to any
currency other than the USD. European terms mean the U.S. dollar sits in the base
currency location and the other currency occupies the terms position.
USD/JPY = 110; European
For example, the Swiss franc trades in the spot market in European terms. It is quoted
in USD/CHF convention. CHF is the three-letter symbol for the Swiss franc. Most of the
world’s currencies follow European Currency Quotation for trade purposes, with the
exception of EUR, GBP, and AUD, among others.
American terms are currency pairs where the quote convention places the USD in
the term’s/quote location.
EUR/USD = 1.10; American
For example, the British pound trades in American terms in the futures market and is
shown as GBP/USD. GBP is the three-letter symbol for the British pound.
In Canada, the indirect form of this quote would be C$1 = US$0.8000 (i.e. 1/1.2500).

Cross Currency
What about cross-currency rates, which express the price of one currency in terms of a
currency other than the US dollar? A trader or investors should first ascertain which
type of quotation is being used – direct or indirect – to price the cross-rate accurately.
For example, if the Japanese yen is quoted at US$1 = JPY 100, and US$1 = C$1.2700, what
is the price of yen in Canadian dollars (both direct and indirect quotations)?
In Canada,
the indirect quotation would be: C$1 = US$0.7874 x 100 (yen per USD) = 78.74
yen.
The direct quotation would be: JPY 1 = C$1.2700/100 = C$ 0.012.

The bid price is what the dealer is willing to pay for a currency,
while the ask price is the rate at which a dealer will sell the same currency.

The bid-ask spread (or the buy-sell spread) is the difference between the amount a
dealer is willing to sell a currency for versus how much they will buy it for.
What is Foreign Exchange exposure?
Foreign exchange exposure is a measure of the potential for a firm’s profitability, net
cash flow, and market value to change because of a change in exchange rates.
There are 3 main types of Foreign exchange exposures
Transaction Exposure is the impact of settling obligations entered into before changes
in exchange rates to be settled after changes in exchange rates. This exposure has both
profit and cash flow implications. The focus of Transaction Exposure is on contracted
cash flows.
Translation Exposure is the changes in reported owners' equity in consolidated
financial statements caused by changes in exchange rates. This exposure has no cash
flow implications.
Operating Exposure is the changes in expected future cash flows arising from
unexpected changes in exchange rates. This exposure has implications for cash flows
and market value. Operating exposure focuses on expected future cash flows, not just
contracted cash flows.

Managing Foreign Exchange exposures

Foreign exchange exposures are a source of risk for business. Managing this risk
involves
• Identification
• Measurement
• Mitigation
Hedging, as way of forex risk mitigation, is the taking of a position, acquiring either a
cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in
value and offset a fall (rise) in the value of an existing position.
To hedge or not to hedge? While hedging can protect the owner of an asset from a loss,
it also eliminates opportunities to gain from an increase in the value of the asset hedged
against.
Defining Transaction exposure
Transaction exposure measures changes in the value of outstanding financial
obligations incurred prior to a change in exchange rates but not due to be settled until
after the exchange rates change.
Note the effect of timing. Time of incurring is different from time of settlement. If they
are the same, there will be not transaction exposure

O1 Jan/xxxx
Quotation
Seller (domestic currency is Thai baht) quotes a price to the buyer in a foreign currency.
Volume 1 unit; Price 100 USD
01 Feb/xxxx
Order
Buyer places an order with the seller (domestic currency is Thai baht) at quoted price
Volume 1 unit; Price 100 USD
01 March/xxxx
Shipping
Seller ships product and bills buyer. This creates an Accounts Receivable for the seller.
Invoice: 100 USD
Accounts Receivable: 3000 Thai baht (since spot exchange rate on the date is 30 Thai
baht/USD)
01, April/xxxx
Settlement; Buyer settles the Accounts Receivable by paying in the foreign currency
Seller receives 100 USD
Amount received is 2950 Thai baht (since spot exchange rate on this date is 29.5 Thai
baht/USD
Did the seller gain or loose due to the change in spot rate from shipping to settlement?
Loss of 50 Thai Baht
Managing Transaction Exposure
Foreign exchange transaction exposure can be managed by contractual, operating, and
financial hedges.
The main contractual hedges employ the forward, money, futures, and options markets.
Operating and financial hedges employ the use of risk-sharing agreements, leads and
lags in payment terms, swaps, and other strategies.
One other way to manage transaction exposure is to remain unhedged
Translation Exposure
Translation exposure, also called accounting exposure, arises because financial
statements of foreign subsidiaries – which are stated in foreign currency – must be
restated in the parent’s reporting currency for the firm to prepare consolidated financial
statements.
Translation Exposure is a concern only for companies with foreign subsidiaries. A
subsidiary is company over which a parent has control through a number of ways, most
common of which is by holding a majority of the subsidiary's voting rights.
Financial statements of a parent and subsidiary are prepared in different currencies.
Currency in which a parent company's financial statements are prepared is called
reporting currency. Currency in which a subsidiary company's financial statements are
prepared is called foreign currency.
A parent company may have subsidiaries in different countries. In that case, the parent
will have to prepare consolidate financial statements prepared in different foreign
countries.
Methods of translating Foreign Currency financial statements
Two basic methods for the translation of foreign subsidiary financial statements are
employed worldwide
• The current rate method
• The temporal method
The current rate method is the most prevalent in the world today. Under this method
Assets and liabilities are translated at the current rate of exchange
Income statement items are translated at the exchange rate on the dates they were
recorded or an appropriately weighted average rate for the period
Dividends (distributions) are translated at the rate in effect on the date of payment
Common stock and paid-in capital accounts are translated at historical rates
Gains or losses caused by translation adjustments are reported separately and
accumulated in a separate equity reserve account (on the B/S) with a title such as
cumulative translation adjustment (CTA). Such gains and losses will have no impact on
the income statement.
Balance Sheet Hedging
The main technique to minimize translation exposure is called a balance sheet hedge.
A balance sheet hedge requires an equal amount of exposed foreign currency assets and
liabilities on a firm’s consolidated balance sheet.
If this can be achieved for each foreign currency, net translation exposure will be zero.
Under the current rate method,
assets and liabilities are translated at current rate i.e. exchange rate on the date of
balance sheet.
Paid up capital is translated using historical rate.
Profits retained for the year are translated at average rates and taken into retained
earnings
Gain or loss on translation is carried into the cumulative translation adjustment
account.
As a result, under the current rate method, translation exposure cannot be eliminated.
It can only be minimized.

Operating exposure
Operating exposure, also called economic exposure, competitive exposure, and even
strategic exposure on occasion, measures any change in the present value of a firm
resulting from changes in future operating cash flows caused by an unexpected change
in exchange rates.
The analysis of longer term – where exchange rate changes are unpredictable and
therefore unexpected – is the goal of operating exposure analysis.
Note that the focus is on change in firm value. Firm value depends on all future cash
flows. The time horizon in operating exposure analysis is very long.
Change in firm value need not be only due to operation of a foreign subsidiary. However,
in this lesson we will illustrate the case of subsidiary value.
Operating exposure is subjective because it depends on estimates of future cash flow
changes over an arbitrary time horizon.
Also note that the focus is on unexpected changes in exchange rates. Analysis of
operating exposures would be based on scenarios rather than any predictable changes
in exchange rates.

How is Operating Exposure measured?

Value (of a foreign subsidiary or any asset) is discounted cash flow.
Value is to be computed in the parent company's domestic currency
Subsidiaries are intended to be long term investments. Net long term cash flows from
the subsidiary would have to be considered for valuation. Typically, considering cash
flows over a period of 8 to 10 years of cash flows should do.
The amount and nature of cash flows will depend on the subsidiary model. Reference
can be made to the Parent Subsidiary cash flow map shown above
The future cash flows of a subsidiary in foreign currency will have to be converted to
the domestic currency of the parent company using expected exchange rates between
the two currencies.
Sensitivity of value to changes in exchange rates will measure operating exposure

How can Operating Exposure be managed?

Objective
The objective of both operating exposure management is to anticipate and influence the
effect of unexpected changes in exchange rates on a firm’s future cash flows.
To meet this objective, management can
• Diversify the firm’s operating and financing base.
• Change the firm’s operating and financing policies.
• Operating Risk Management Policies
Operating (and transaction) exposures can be partially managed by adopting operating
or financing policies that offset anticipated foreign exchange exposures.
The six most commonly employed proactive policies are:
• Matching currency cash flows
• Risk-sharing agreements
• Back-to-back or parallel loans
• Currency swaps
• Leads and lags
• Re-invoicing center
Why FDI?
O-L-I

The O-L-I paradigm explains why Multinational Companies (MNCs) choose FDI rather
than serving overseas markets through alternative modes such as licensing, alliances or
exports.
Ownership advantages arise from ownership of certain competitive advantages in the
MNC's home market that cannot be easily copied and allows them to be transferred
easily to foreign subsidiaries.
Location advantages refer to certain advantages in specific locations such as low labor
cost that attract MNCs to these locations
Internationalization advantages refers to the possession of proprietary information and
control of necessary human capital by a MNC that which it can easily exploit
internationally.
Different modes of Foreign Investment

Determinants of FDI
Political Risks
Firm-specific Risks are those that affect a MNC at the project or corporate level.
Governance risk due to goal conflict between a MNC and its host government is the main
political firm-specific risk. Firm specific risks are also known as micro risks.
Country specific risks affect the MNC at the project or corporate level but originate at
the country level. Transfer risk is one kind of country risk which is the risk that a MNC
faces of having its funds blocked by the host government. Cultural and institutional risk
is another kind of country risk which arises from factors such as corruption,
protectionism, religious heritage and such.
Global-specific risks are those that affect a MNC at the project or corporate level but
originate at the global level. Sources of such risk are terrorism, cyber-attacks, anti-
globalization movement and so on.

Managing Investment Risks

Governance Risk is measured by the MNC's ability to exercise effective control over its
operations within a country's legal and political environment. Most often the risk is
linked to goal conflict between Bonafede objectives of host governments and MNCs
operating within their spheres of influence. Issues over which such conflict arises
include use of domestic vs foreign workers, impact on country's economic development,
sharing or non-sharing of ownership and control.
Investment agreements spell out specific rights and responsibilities of an MNC and its
host government. Such agreements can specify basis of fund flows, transfer pricing
methods, permitted share of ownership and provision for arbitration of disputes.
Investment Insurance and Guarantees can protect an MNC against risks of
expropriation of assets, blocking of cash flows, loss of business income due to political
conflicts. Please click on the link to see an example of an investment insurance and
guarantee scheme.
Operating Strategies of MNCs can be made supportive of local governments through
local sourcing or choice of facility location that supports development and job creation.
Control over key assets such as technology and brand can minimize the fallout of
governance risks.
Managing Transfer Risk
Transfer Risk is a country specific risk which can limit the ability of a MNC to transfer
funds in and out of the host country without restrictions. Restrictions can be imposed
by the host government for a variety of reasons and in many forms, some outright and
others partial. Such restrictions can result in blocked funds.
Management of transfer risk can be done in 3 stages:
Pre investment stage: During this stage, the impact of blocked funds on expected returns
can be assessed. Financing structures can use local borrowing rather than foreign equity
or borrowing. Sourcing and selling can be structured to minimize blocked funds.
Operations stage: There are several ways in which MNCs can transfer funds out of host
countries when faced with risk of blocked funds. One way is to obtain special
dispensation which can be used by MNCs operating in "desirable" industries such as
telecom, infrastructure or pharmaceuticals. Host governments may grant special
permissions to such companies to repatriate funds that would otherwise be blocked.
Reinvestment stage: If funds are blocked, and there is no way to take funds out of the
host country, a MNC may choose to reinvest in host country financial assets (money
market instruments, bank deposits) or in real assets (land, buildings) or to expand
capacity in the host country.

Managing Cultural and Institutional Risk

Sources of cultural and institutional risks arising from FDI are many. Some of the
important sources are:
Ownership structure requirements may be imposed by host country governments
which could require FDI investors to hold less than a majority. Joint Ventures could also
be prescribed in some host countries which might view the FDI as a way for local
businesses to learn about markets and technology. When the foreign investment does
not hold 100% or at least a majority ownership in the subsidiary, there can risks of
conflicts.
Human Resource and staffing choices must be aligned to labor laws which may not
always favor the foreign investor. Downsizing can be difficult or even impossible.
Number of foreign staff that can be employed in the subsidiary can be limited by host
country laws.
Corruption could be rampant in the host country. Local competitors could be using
bribes to gain competitive advantage. A MNC could be caught between a need to adopt
such practices and legal consequences that such business practices could entail in their
home countries. Click on the link for an example
https://www.reuters.com/article/alstom-corruption-sentencing-
idUSL1N13820V20151113

Safety of intellectual property may not be guaranteed in host countries. Laws may not
be favorable to protect IP. Even in the presence of laws, prosecution and conviction of
violators may not be easy. Click on the link to see the interesting case of auto industry
and IP protection in China. https://hbr.org/2013/01/will-our-partner-steal-our-ip

Managing Political Risk

To read an article by a former secretary of state of USA on the subject of managing
political risk, click here https://hbr.org/2018/05/managing-21st-century-political-
risk

International Capital Budgeting

Basic Inputs
Multinational capital budgeting, like traditional domestic capital budgeting, focuses on
the cash inflows and outflows associated with prospective long-term investment
projects.
The basic steps are:
• Identify the initial capital invested or put at risk
• Estimate cash flows to be derived from the project over time, including an
estimate of the terminal or salvage value of the investment
• Identify the appropriate discount rate to use in valuation
• Apply traditional capital budgeting decision criteria such as NPV and IRR

Parent vs Project Cash flows

Parent refers to the MNC making an investment. Project refers to the foreign project in
which the investment is made.
Financial evaluation of FDIs must be done both from the parent company and from the
foreign subsidiary's points of view.
Project cash flows comprise of outflows such as investment in project assets and
inflows, mainly, from operations. Project cash flows are first projected in foreign
currency and then converted to the parent company's domestic currency.
Parent cash flows will comprise of
• Project cash flows
• Additional cash flows such interest on loans provided by the parent, payments
received from subsidiary as royalty
• Discount Rates

Discount rates used at the project level are unlikely to be the same as discount rates
used at the parent level.
At the project level, the discount rate will be determined by business risk and financial
risk, the latter arising from the level of debt in the project's capital structure
At the parent level, the discount rate will account for currency risk and country risk in
addition to business and financial risk.

What are the benefits of Foreign Portfolio investment?

The primary benefit of foreign portfolio investment is risk reduction.

Risk reduction happens through increased diversification.

• An international portfolio of stocks or bonds offers greater diversification of
assets than a purely domestic portfolio.
• An international portfolio of stocks and bonds also offers an opportunity for
diversification of currencies
Risk reduction is possible as long as the assets in a portfolio are less than perfectly
positively correlated. Maximum value of correlation is +1 and minimum value is -1.
How correlated are financial markets across countries?
Three important facts
• Correlations will differ across country pairs. Correlation between Bangladesh
and India can be different from correlation between Bangladesh and Thailand
• Correlation between country pairs can change over time
• Correlation between stock markets of two countries could be different on an
exchange rate adjusted based compared to correlation between such markets
without exchange rate adjustments

What are the risks of Foreign Portfolio investment?

Two main risks of foreign portfolio investments are:
• Currency risk. Gains on foreign stocks can be reduced by losses on currency
exchange and vice versa
• Country risk. These can take the form of Capital Flow Management measures
adopted by different countries.
Practice Quiz 1
A foreign exchange ________ is the price of one currency expressed in terms of another
currency. A foreign exchange ________ is a willingness to buy or sell at the announced rate.

Select one:

a. rate; rate

b. quote; rate

c. quote; quote

d. rate; quote

Feedback
The correct answer is: rate; quote

Question 2
Correct

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Question text
The following is an example of an American term foreign exchange quote:

Select one:

a. $20/£.

b. None of the above.

c. €0.85/$.

d. 100¥/€.

Feedback
The correct answer is: $20/£.
Question 3
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Question text
From the viewpoint of a British investor, which of the following would be a direct quote in
the foreign exchange market?

Select one:

a. $1.50/£

b. $0.90/€

c. SF2.40/£

d. £0.55/€

Feedback
The correct answer is: £0.55/€

Question 4
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If the direct quote for a U.S. investor for British pounds is $1.43/£, then the indirect quote
for the U.S. investor would be ________ and the direct quote for the British investor would be
________.

Select one:

a. £0.699/$; $1.43/£
b. £0.699/$; £0.699/$

c. £1.43/£; £0.699/$

d. $0.699/£; £0.699/$

Feedback
The correct answer is: £0.699/$; £0.699/$

Question 5
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Question text
"Given the following exchange rates, which of the multiple-choice choices represents a
potentially profitable intermarket arbitrage opportunity?
¥129.87/$
€1.1226/$
€0.00864/¥ _____"

Select one:

a. $0.0077/¥

b. ¥115.69/€

c. $0.8908/€

d. ¥114.96/€

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The correct answer is: ¥114.96/€

Question 6
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 Flag question

Question text
Which of the following may be participants in the foreign exchange markets?

Select one:

a. All of the above.

b. Central banks and treasuries.

c. Bank and nonbank foreign exchange dealers.

d. Speculators and arbitragers.

Feedback
The correct answer is: All of the above.

Question 7
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When the cross rate for currencies offered by two banks differs from the exchange rate
offered by a third bank, a triangular arbitrage opportunity exists.

Select one:

True

False

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The correct answer is 'True'.
Question 8
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Question text
Dealers in foreign exchange departments at large international banks act as market makers
and maintain inventories of the securities in which they specialize.

Select one:

True

False

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The correct answer is 'True'.
Quiz 1
Started on Friday, 19 June 2020, 3:04 PM

State Finished

Completed on Friday, 19 June 2020, 3:19 PM

Time taken 15 mins 2 secs

Grade 9.00 out of 10.00 (90%)

Question 1
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Question text
Most foreign exchange transactions are through the U.S. dollar. If the transaction is
expressed as the foreign currency per dollar this known as ________ whereas ________ are
expressed as dollars per foreign unit.

Select one:

a. European terms; indirect

b. American terms; European terms

c. American terms; direct

d. European terms; American terms

Feedback
The correct answer is: European terms; American terms

Question 2
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 Flag question

Question text
A/an ________ quote in the United States would be foreign units per dollar, while a/an
________ quote would be in dollars per foreign currency unit.

Select one:

a. direct; indirect

b. indirect; indirect

c. direct; direct

d. indirect; direct

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The correct answer is: indirect; direct

Question 3
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________ make money on currency exchanges by the difference between the ________ price, or
the price they offer to pay, and the ________ price, or the price at which they offer to sell the
currency.

Select one:

a. Dealers; bid; ask

b. Brokers; bid; ask

c. Dealers; ask; bid

d. Brokers; ask; bid

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The correct answer is: Dealers; bid; ask

Question 4
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The U.S. dollar suddenly changes in value against the euro moving from an exchange rate of
$0.8909/euro to $0.08709/€. Thus, the dollar has ________ by ________.

Select one:

a. appreciated; 2.24%

b. depreciated; 2.24%

c. depreciated; 2.30%

d. appreciated; 2.30%

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The correct answer is: appreciated; 2.30%

Question 5
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It is characteristic of foreign exchange dealers to
Select one:

a. trade only with clients in the retail market and never operate in the wholesale market for
foreign exchange.

b. bring buyers and sellers of currencies together but never to buy and hold an inventory of
currency for resale.

c. act as market makers, willing to buy and sell the currencies in which they specialize.

d. All of the choices here are characteristics of foreign exchange dealers.

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The correct answer is: act as market makers, willing to buy and sell the currencies in which
they specialize.

Question 6
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________ seek to profit from trading in the market itself rather than having the foreign
exchange transaction being incidental to the execution of a commercial or investment
transaction.

Select one:

a. Speculators and arbitragers

b. Treasuries

c. Foreign exchange brokers

d. Central banks

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The correct answer is: Speculators and arbitragers
Question 7
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Foreign exchange ________ earn a profit by a bid-ask spread on currencies they purchase and
sell. Foreign exchange ________, on the other hand, earn a profit by bringing together buyers
and sellers of foreign currencies and earning a commission on each sale and purchase.

Select one:

a. central banks; treasuries

b. dealers; brokers

c. brokers; dealers

d. speculators; arbitragers

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The correct answer is: dealers; brokers

Question 8
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________ exposure deals with cash flows that result from existing contractual obligations.

Select one:

a. Economic
b. Translation

c. Transaction

d. Operating

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The correct answer is: Transaction

Question 9
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________ exposure measures the change in the present value of the firm resulting from
unexpected changes in exchange rates.

Select one:

a. Transaction

b. Operating

c. Accounting

d. Translation

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The correct answer is: Operating

Question 10
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Assuming no transaction costs (i.e., hedging is "free"), hedging currency exposures should
________ the variability of expected cash flows to a firm and at the same time, the expected
value of the cash flows should ________.

Select one:

a. not change; increase

b. decrease; not change

c. not change; not change

d. increase; not change

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The correct answer is: decrease; not change
Practice Quiz 2
Question 1
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Translation gains or losses can be quite different from operating gains or losses not only in
magnitude but also in sign.

Select one:

True

False

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The correct answer is 'True'.

Question 2
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A U.S. firm sells merchandise today to a British company for £100,000. The current exchange
rate is $2.03/£, the account is payable in three months, and the firm chooses to avoid any
hedging techniques designed to reduce or eliminate the risk of changes in the exchange
rate. If the exchange rate changes to $2.05/£ the U.S. firm will realize a ________ of ________.

Select one:

a. gain; £2000
b. gain; $2000

c. loss; $2000

d. loss; £2000

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The correct answer is: gain; $2000

Question 3
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Which one of the following management techniques is likely to best offset the risk of long-
run exposure to receivables denominated in a particular foreign currency?

Select one:

a. Increase sales to that country.

b. Increase sales in this country.

c. Borrow money in the foreign currency in question.

d. Lend money in the foreign currency in question.

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The correct answer is: Borrow money in the foreign currency in question.

Question 4
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 Flag question

Question text
A British firm and a U.S. Corporation each wish to enter into a currency swap hedging
agreement. The British firm is receiving U.S. dollars from sales in the U.S. but wants pounds.
The U.S. firm is receiving pounds from sales in Britain but wants dollars. Which of the
following choices would best satisfy the desires of the firms?

Select one:

a. The British firm pays pounds to a swap dealer and receives pounds from the dealer. The
U.S. firm pays dollars to the swap dealer and receives dollars.

b. The British firm pays dollars to a swap dealer and receives dollars from the dealer. The
U.S. firm pays pounds to the swap dealer and receives pounds.

c. The U.S. firm pays dollars to a swap dealer and receives pounds from the dealer. The
British firm pays pounds to the swap dealer and receives dollars.

d. The British firm pays dollars to a swap dealer and receives pounds from the dealer. The
U.S. firm pays pounds to the swap dealer and receives dollars.

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The correct answer is: The British firm pays dollars to a swap dealer and receives pounds
from the dealer. The U.S. firm pays pounds to the swap dealer and receives dollars.

Question 5
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The Land's Beginning Company Inc. (LBC), imports extreme condition outdoor wear and
equipment from The Hudson Bay Company (HBC) located in Canada. With the steady
decline of the U.S dollar against the Canadian dollar LBC is finding a continued relationship
with HBC to be an increasingly difficult proposition. In response to LBC's request, HBC has
proposed the following risk-sharing arrangement. First, set the current spot rate as the base
rate. As long as spot rates stay within 5% (up or down) LBC will pay at the base rate. Any
rate outside of the 5% range, HBC will share equally with LBC the difference between the
spot rate and the base rate. If LBC has a payable of C$100,000 due today and the current
spot rate is C$1.17/$, how much does LBC owe in U.S. dollars?

Select one:

a. 83333

b. 117000

c. 85470

d. 85837

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The correct answer is: 83333

Question 6
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Which of the following is NOT an example of diversifying operations?

Select one:

a. Raising funds in more than one country

b. Diversifying sales.

c. Diversifying location of operations.

d. Sourcing raw materials in more than one country.

Feedback
The correct answer is: Raising funds in more than one country

Question 7
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Purely domestic firms will be at a disadvantage to MNEs in the event of market disequilibria
because

Select one:

a. all of the domestic firm's raw materials are imported.

b. domestic firms lack comparative data from its own sources.

c. None of the above. Domestic firms are not at a disadvantage.

d. international firms are already so large.

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The correct answer is: domestic firms lack comparative data from its own sources.

Question 8
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Gains or losses caused by translation adjustments when using the current rate method are
reported separately on the ________.

Select one:
a. consolidated statement of cash flow

b. consolidated balance sheet

c. consolidated income statement

d. none of the above

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The correct answer is: consolidated balance sheet

Question 9
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If the European subsidiary of a U.S. firm has net exposed assets of €500,000, and the euro
drops in value from $1.40/euro to $1.30/€ the U.S. firm has a translation ________.

Select one:

a. gain of $450,000

b. loss of €450,000

c. loss of $50,000

d. gain of $50,000

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The correct answer is: loss of $50,000

Question 10
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 Flag question

Question text
________ exposure deals with cash flows that result from existing contractual obligations.

Select one:

a. Translation

b. Transaction

c. Operating

d. Economic

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The correct answer is: Transaction
Practice quiz 3
Question 1
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The stages in the life of a transaction exposure can be broken into three distinct time
periods. The first time period is the time between quoting a price and reaching an actual
sale agreement or contract. The next time period is the time lag between taking an order
and actually filling or delivering it. Finally, the time it takes to get paid after delivering the
product. In order, these stages of transaction exposure may be identified as

Select one:

a. quotation, backlog, and billing exposure.

b. billing, backlog, and quotation exposure.

c. quotation, billing, and backlog exposure.

d. backlog, quotation, and billing exposure.

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The correct answer is: quotation, backlog, and billing exposure.

Question 2
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Question text
A U.S. firm sells merchandise today to a British company for £100,000. The current exchange
rate is $2.03/£, the account is payable in three months, and the firm chooses to avoid any
hedging techniques designed to reduce or eliminate the risk of changes in the exchange
rate. If the exchange rate changes to $2.05/£ the U.S. firm will realize a ________ of ________.

Select one:

a. loss; £2000

b. gain; $2000

c. gain; £2000

d. loss; $2000

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The correct answer is: gain; $2000

Question 3
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________ is NOT a commonly used contractual hedge against foreign exchange transaction
exposure.

Select one:

a. Options market hedge

b. Money market hedge

c. All of the above are contractual hedges.

d. Forward market hedge

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The correct answer is: All of the above are contractual hedges.

Question 4
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The Economist publishes annually the "Big Mac Index" by which they compare the prices of
the McDonald's Corporation's 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?

Select one:

a. $0.0081/¥

b. 115.75¥/$

c. 124¥/$

d. $0.0086/¥

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The correct answer is: 115.75¥/$

Question 5
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Question text
The price of a Big Mac in the U.S. is $3.41 and the price in Mexico is Peso 29.0. What is the
implied PPP of the Peso per dollar?

Select one:

a. None of the above

b. Peso 10.8/$1

c. Peso 11.76/$1

d. Peso 8.50/$1

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The correct answer is: Peso 8.50/$1

Question 6
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"According to the Big Mac Index, the implied PPP exchange rate is Mexican peso 8.50/$1
but the actual exchange rate is peso10.80/$1. Thus, at current exchange rates the peso
appears to be ________ by ________. _____"

Select one:

a. undervalued; approximately 21%

b. overvalued; approximately 21%

c. undervalued; approximately 27%

d. overvalued; approximately 27%

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The correct answer is: undervalued; approximately 21%
Question 7
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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 ________.

Select one:

a. $1/C$1

b. $0.96/C$

c. $1.04/C$1

d. relative PPP provides no guide for this type of question

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The correct answer is: $1.04/C$1

Question 8
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The current U.S. dollar-yen spot rate is 125¥/$. If the 90-day forward exchange rate is 127
¥/$ then the yen is at a forward premium.

Select one:
 True

False

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The correct answer is 'False'.

Question 9
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Use interest rate parity to answer this question. A U.S. investor has a choice between a risk-
free one-year U.S. security with an annual return of 4%, and a comparable British security
with a return of 5%. If the spot rate is $1.43/£, the forward rate is $1.44/£, and there are no
transaction costs, the investor should invest in the U.S. security.

Select one:

True

False

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The correct answer is 'False'.

Question 10
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All that is required for a covered interest arbitrage profit is for interest rate parity to not
hold
Select one:

True

False

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The correct answer is 'True'.