Exchange Rate and Investment Quiz

Company A is a manufacturer in U.S. and its raw materials need to be imported from China. It is deeply concerned with the exchange rate fluctuations of yuan. To protect this, it enters into a contract which would allow the company to buy yuan at a specific price at a given future date. This is an example of:

• hedging.

• speculation.

• investment.

• profit maximization.

_____ is the act of taking a net asset position or a net liability position in some asset class.

• buying

• investing

• hedging

• speculating

Assume you are an Chinese importer who must pay 100,000 dollars at the end of 90 days when you receive 50,000 computers from the U.S. exporter. If you do not hedge this transaction, you face exchange-rate risk. The best way to remove the risk of loss due to currency fluctuations is to:

• buy 100,000 dollars now, hold them for 60 days, and then sell them at the spot exchange rate that exists 60 days from now.

• sell 100,000 dollars in the forward exchange market for delivery after 60 days.

• buy 100,000 dollars in the forward exchange market for delivery in 60 days.

• sell 100,000 dollars now in the spot market.

A _____ gives the holder the right but not the obligation to buy a foreign currency at some time in the future at a price set today.

• forward exchange contract

• currency Swap

• put option

• call option

An investment exposed to exchange-rate risk is a(n) _____ international investment. An investment is fully hedged against exchange-rate risk is a(n) _____ international investment.

• covered, uncovered

• uncovered, covered

• covered, hedged

• arbitrage, risk neutral

If the spot price of the pounds is $2.10 per pound and the 90-day forward rate is $2.00 per pound, and you believe that the spot rate in 90 days will be $2.05 per pound, then you can try to maximize speculative gains by:

• buying pounds in the current spot market and selling pounds in 90 days at the future spot rate.

• signing a forward foreign exchange contract to sell pounds in 90 days.

• signing a forward foreign exchange contract to sell dollars in 90 days.

• buying dollars in the spot market and selling the dollars in 90 days at the future spot rate.

For an investor who starts with yuan and wants to end up with yuan in the future, which of the following choices is an example of a covered international investment?

• Sell yuan at the spot rate, invest the proceeds in foreign currency-denominated financial instruments, and then buy yuan at the future spot rate

• Buy a yuan-denominated financial asset

• Sell yuan at the spot rate, invest the proceeds in foreign currency-denominated financial instruments, and sign a forward exchange contract to buy the foreign currency

• Sell yuan at the spot rate, invest the proceeds in foreign currency-denominated financial instruments, and sign a forward exchange contract to buy yuan

Suppose the interest rate on 6-month treasury bills is 11% per year in the United Kingdom and 7% per year in the United States. Also, today’s spot exchange price of the pound is $2.00 while the 6-month forward exchange price of the pound is $1.98. By investing in U.K. treasury bills rather than U.S. treasury bills, and covering exchange-rate risk, U.S. investors earn an approximate extra return for 6 months of:

• 0.5%

• 1%.

• 2%

• 3%

Answer explanation

Consider covered investments between the China and United States. If Chinese interest rates decrease, interest arbitrage operations will most likely result in a(n):

• sale of dollars in the forward market.

• purchase of yuan in the spot market.

• increase in the spot exchange price of the yuan.

• increase in the forward exchange price of the dollar.

Suppose that the dollar-yen spot exchange rate is $0.05/¥ and the 90-day forward exchange rate is $0.06/¥. Assuming that covered interest parity holds, are Japanese interest rates higher or lower than U.S. interest rates? Explain why.

Answer explanation

Let us assume, i_JP = Interest rate in Japan, i_US = Interest rate in the U.S., e = Spot exchange rate, and f = Forward exchange rate.

Now for the covered interest parity to holds, covered interest differential must equal to zero.

Therefore, CD = (1 + i_JP) * f / e – (1 + i_US)

=> 0 = (1 + i_JP) * 0.06 / 0.05 – (1 + i_US)

=> (1 + i_JP) * 0.06 / 0.05 = (1 + i_US)

=> 0.06 / 0.05 = (1 + i_US) / (1 + i_JP)

For this equation to hold, the numerator has to be greater than the denominator.

Thus, the U.S. interest rates must be higher than Japan’s.