FINANCE IN A GLOBAL ENVIRONMENT

Practice set for Exam 1

1. The concept of absolute advantage's origins lie in work of Adam Smith's work published in 1776.

2. Explain the concept of comparative advantage.

See chapter 1. Make sure you understand the difference between absolute advantage and comparative
advantage. Remember the example with 2 countries (China and France) producing 2 products (T-Shirts and
wine) we used to illustrate these concepts in the first week.
Know how to calculate the opportunity cost of specializing in one good relative to other.

3. Because countries have different financial regulations and customs, it is common for MNEs to apply their
domestic rules and regulations when doing financial business in a foreign country. T/F

4. In determining why a firm becomes multinational there are many reasons. One reason is that the firm is a
resource seeker. T/F

5. The post WWII international monetary agreement that was developed in 1944 is known as the:
A) United Nations.
B) League of Nations.
C) Yalta Agreement.
D) Bretton Woods Agreement.

6. One of the innovations introduced by Bretton Woods was the creation of the Special Drawing Right or SDR.
The SDR is an international reserve asset created by the:
A) U.S. Department of the Treasury.
B) International Bank of Reconstruction and Development (IBRD).
C) World Bank (WB).
D) International Monetary Fund (IMF).

7. Since 2009 the IMF's exchange rate regime classification system uses a "de facto classification"
methodology. Under this system, a country in which exchange rate is determined by forces of supply and
demand is considered to have:
A) a residual agreement.
B) hard pegs.
C) soft pegs.
D) floating arrangements.

8. A small economy country whose GDP is heavily dependent on trade with the Italy could use a(n) ________
exchange rate regime to minimize the risk to their economy that could arise due to unfavorable changes in
the exchange rate.
A) pegged exchange rate with the United States
B) pegged exchange rate with the Euro
C) independent floating
D) managed float

9. Members of the International Monetary Fund may settle transactions among themselves by transferring
Special Drawing Rights (SDRs). T/F

10. The euro is an example of a rigidly fixed system, acting as a single currency for its member countries.
However, the euro itself is an independently floating currency against all other currencies. T/F
11. A currency board exists when a country's central bank commits to back its money supply entirely with
foreign reserves at all times. TRUE/F (Examples: Bosnia and Herzegovina, Bulgaria)

12. Which of the following is a part of the Financial Account of the BOP?
A) net foreign direct investment
B) net import/export of services
C) income
D) remittances

13. Based on the premise that, other things equal, countries would prefer a fixed exchange rate, which of the
following statements is NOT true?
A) Fixed rates provide stability in international prices for the conduct of trade.
B) Fixed exchange rate regimes necessitate that central banks maintain large quantities of
international reserves for use in the occasional defense of the fixed rate.
C) Fixed rates are inherently inflationary in that they require the country to follow loose monetary
and fiscal policies.
D) Stable prices aid in the growth of international trade and lessen exchange rate risks for
businesses.

14. 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 restriction on its capital and financial account in its balance of payments, 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) None of the above.

15. How would following transactions influence balance of payments (BOP) of each county involved?
A) A person that lives in Vienna buys Mozart balls in Salzburg.
No entry
B)
C) The U.S. subsidiary of BMW pays dividends back to its parent firm in Germany.
Current – Income part – Germany credit, USA debit
______________________________________________________________________________
D) An investor from Toronto buys 70 stocks of Tesla.
Financial – Portfolio inv. – USA credit, Canada debit
_______________________________________________________________________________
D) A worker in Google’s subsidiary in Dublin send EUR700 monthly to his retired parents in Osijek.
Current account – Transfers – HR credit, Ireland debit
_______________________________________________________________________________

16. Explain the difference between direct and portfolio investments when categorizing investments for the
financial account component of the balance of payments.

See chapter and slides

17. J-Curve suggests that when a currency is devalued the immediate impact may be an increase in a
country's trade deficit. However, this situation tends to correct itself in 2 to 5 weeks. T/ F
18. The effect of an imbalance in the BOP is the same for countries on a fixed exchange rate regime as for
those on a floating exchange rate regime. T/F (review how would a central bank intervene in case of
surplus and deficit in BoP in case of fixed exchange rate regime, what effect would that have on the foreign
reserves etc.) For example, see question 20

19. A country's overall level of interest rates should have an impact on the financial account of the BOP.
Relatively low real interest rates should normally stimulate an outflow of capital seeking higher interest
rates in other country currencies. T/F

20. Under a fixed exchange rate system, the central bank bears the responsibility to ensure that the BOP is
near zero. If the sum of the current and financial accounts is LESS THAN ZERO (deficit), an excess
demand for the foreign currency exists in the world. To preserve the fixed exchange rate, the central
bank should  ________ .
A) Buy foreign currency
B) sell foreign currency
C) sell domestic currency
D) not intervene in the foreign exchange market

21. Imports have the potential to lower a country's inflation rate because of each of the following EXCEPT:
A) the import of lower priced goods limits what domestic competitors can charge for goods.
B) the import of lower priced services limits what domestic competitors can charge for services.
C) the higher prices of foreign goods spur domestic competitors to cut prices.
D) all of the above

22. Consider the following: A foreign automobile company builds a manufacturing plant in Tennessee and
European investors buy U.S. Treasury Bonds.
A) Both activities would be considered direct investment.
B) Both activities would be considered portfolio investment.
C) The auto manufacturer in engaging in portfolio investment, and the European investors are
engaged in direct investing.
D) The auto manufacturer in engaging in direct investment, and the European investors are engaged
in portfolio investing.

23. The Glass-Steagall Act of 1933 separated commercial banking activities from investment banking. T/F

24. The process of turning an illiquid asset into a liquid saleable asset is called:
A) swapping
B) wrapping
C) securitization
D) liquidation

25. Which of the following statements concerning credit default swaps as of 2008 is FALSE?
A. As of year-end 2008, CDSs were completely outside the regulatory boundaries.
B. A CDS is a derivative security that may be used for hedging risk or for speculative purposes.
C. CDSs allowed banks to reduce their incentive to monitor the ability of borrowers to repay their
obligations.
D. In order to be a party in a credit default swap, at least one of either the buyer or seller must own
the underlying asset.

26. Mortgage loans in the U.S. marketplace were categorized as:

A. Prime, Alt-A, Sub-prime
B. Prime, Alt-A, Alt-B
C. Prime, Alt-prime, Sub-prime
D. Alt-A, Alt-B, Sub-prim
27. While trading in foreign exchange takes place worldwide, the major currency trading happen in following
three currencies:
A. US dollar, euro, pound
B. US dollar, euro, yen
C. US dollar, euro, renminbi
D. US dollar, pound, yen

28. ________ 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.
A. Speculators and arbitrageurs
B. Foreign exchange brokers
C. Central banks
D. Treasuries

29. 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.
A. European terms; indirect
B. American terms; direct
C. American terms; European terms
D. European terms; American terms

30. The following is an example of an American term foreign exchange quote:

A. $20/1£
B. €0.85/1$
C. ¥100/1€
D. none of the above

31. From the viewpoint of a British investor, which of the following would be a direct quote in the foreign
exchange market?
A. SF2.40/£
B. $1.50/£
C. £0.55/€
D. $0.90/€

32. Assume the current U.S. dollar-British spot rate is 0.6993£/$. If the current nominal one-year interest rate
in the U.S. is 5% and the comparable rate in Britain is 6%, what is the approximate forward exchange rate
for 360 days?
A) £1.42/$
B) £1.43/$ F = S x (1+UK rate) / (1+ US rate)
C) £0.6993/$ because the exchange rate is expressed as pounds per 1 dollar
D) £0.7060/$ time period is 1 year so you don’t have to use rate per period

33. Assume the current U.S. dollar-yen spot rate is 90 ¥/$. Further, the current nominal 180-day rate of return
in Japan is 1% and 2% in the United States. What is the approximate forward exchange rate for 180 days?
A) ¥89.12/$
B) ¥89.55/$ F = S x (1+Japanese semiannual rate) / (1+ US semiannual rate)
C) ¥90.89/$ because the exchange rate is expressed as 90 yen per 1 dollar
D) ¥90.45/$ time period is 6 months so you have to use rate per period

34. A German firm is attempting to determine the euro/pound exchange rate and has the following exchange
rate information: USD/pound = $1.5509/£ and the USD/euro rate = $1.2194/€. Calculate the euro/pound
cross rate.

EUR 1.27186 / pound

35. _______ states that differential rates of inflation between two countries tend to be offset over time by an
equal but opposite change in the spot exchange rate.
A) The Fisher Effect
B) The International Fisher Effect
C) Absolute Purchasing Power Parity
D) Relative Purchasing Power Parity

36. 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.

37. Philips NV produces DVD players and exports them to the United States. Last year the exchange rate was
$1.25/euro and Philips charged 120 euro per player in Europe and $150 per DVD player in the United
States. Currently the spot exchange rate is $1.45/euro and Philips is charging $160 per DVD player. What is
the degree of pass through by Philips NV on their DVD players?
A) 92%
B) 33.3%
C) 41.7%
D) 4.1%

38. Covered interest arbitrage moves the market ______ equilibrium because ________.
A) toward; purchasing a currency on the spot market and selling in the forward market narrows the
differential between the two
B) toward; investors are now more willing to invest in risky securities
C) away from; purchasing a currency on the spot market and selling in the forward market increases
the differential between the two
D) away from; demand for the stronger currency forces up interest rates on the weaker security

39. Explain the difference between covered and uncovered interest arbitrage.

Redo examples from class a couple of times.

The theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets and the
international money markets. The theory states, “The difference in the national interest rates for securities of
similar risk and maturity should be equal to, but opposite in sign to, the forward rate discount or premium for
the foreign currency, except for transaction costs.”

However, the spot and forward exchange rates are not constantly in the state of equilibrium described above
by interest rate parity. When the market is not in equilibrium, the potential for “risk-less” or arbitrage profit
exists.

How will investor know in which direction to go? Arbitrage Rule of Thumb states: If the difference in interest
rates is greater than the forward premium/discount (or expected change in the spot rate for UIA), invest in the
higher interest yielding currency. If the difference in interest rates is less than the forward premium (or
expected change in the spot rate), invest in the lower yielding currency. Using this rule of thumb should enable
investor to choose in which direction to go and guarantee a profit.

In the case of covered interest arbitrage, investor converts, for example, dollars to yen at the spot rate, invests
yen proceeds in a euroyen account for certain period but simultaneously sells the future yen proceeds forward
for dollars at the forward rate, “locking in” the exchange rate at which future yen proceeds will be converted
back to dollars.
In the case of uncovered interest arbitrage (UIA), investors borrow in countries and currencies exhibiting
relatively low interest rates and convert the proceed into currencies that offer much higher interest rates. The
transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward,
choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the
lower yielding currency at the end of the period at the prevailing future spot rate.

INTERNATIONAL PARITY CONDITIONS – SUMMARY:

Absolute Purchasing Power Parity – Law of one price exists, so comparing prices then, would require only a
conversion from one currency to the other

Relative Purchasing Power Parity - “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.”

For example, if we would like to see what would be the future spot rate between yen and US dollars
if relative PPP parity holds, we would use the following relationship:

S1 = S0 x (1+infl rate in Japan) / (1+inflation rate in USA)

The choice which inflation rate to put in numerator, which in denominator depends on how exchange
Rate is expressed. For example if we have spot rate of Y105/$, than we put Japanese inflation in
Numerator, and US inflation in denominator to reflect numerator and denominator for the exch. rate

Domestic Fisher effect: nominal interest rate = real interest rate + inflation rate (approximately)

International Fisher Effect (Fisher open): Percentage change in spot exchange rate should should be in an
equal amount but in the opposite direction to the difference in interest rates between two countries.

(S1 – S2)/S2 x 100 = i($) – i(Foreign)

Interest rate partity (IRP): The difference in the national interest rates for securities of similar risk and maturity
should be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency,
except for transaction costs.

Forward premium/discount = (Spot – Forward)/Forward x 360/n x 100 for quotations in European

terms

Forward premium/discount = (Forward - Spot)/Spot x 360/n x 100 for quotations in American

terms

FW ex rate for n-day period Y/$ = Spot Y/$ x (1+ rate per n-day period in yen) / (1+ rate per n-day period in
$)
 (again, like for PPP be consistent with currencies in numerator and denominator – if you have yens per 1
dollar,
then put interest rate in yen in numerator, and $ interest rate in denominator)