Chapter 9 – The Foreign Exchange Market

 

Multiple Choice Questions

 

WHAT ARE FOREIGN EXCHANGE AND THE EXCHANGE RATE?

 

1.      ______________ is money denominated in the currency of another nation or group of nations.

a.      Foreign exchange (moderate, page 266)

b.      Subsidies

c.       Tariffs

d.      Quotas

 

2.      The market in which foreign exchange transactions take place is called:

a.       the World Bank.

b.      the foreign exchange market. (easy, page 266)

c.       the federal reserve.

d.      the United Nations.

 

3.      A(n) ______________ is the price of a currency.

a.       subsidy

b.      tariff

c.       exchange rate (moderate, page 266)

d.      quota

 

4.      A(n) ______________ is the number of units of one currency that buys one unit of another currency, and this number can change daily.

a.       subsidy

b.      tariff

c.       quota

d.      exchange rate (moderate, page 266)

 

EXPLAIN THE DIFFERENCES AMONG SPOT TRANSACTIONS, FORWARD TRANSACTIONS, AND FUTURE CONTRACTS

 

5.      ______________ involve the exchange of currency the second day after the date on which the two foreign exchange traders agree to the transaction.

a.      Spot transactions (moderate, page 267)

b.      Outright forward transactions

c.       FX swaps

d.      Reverse transactions

 

6.      Outright forward transactions involve the exchange of currency beyond three days at a fixed exchange rate, known as the:

a.       spot rate.
b.      forward rate. (moderate, page 267)

c.       FX swap rate.

d.      reverse transaction rate.

 

7.      The single purchase or sale of a currency for future delivery is called:

a.       spot transactions.

b.      FX swaps.

c.       outright forward transactions. (moderate, page 267)

d.      reverse transactions.


 

FOR WHAT PURPOSES ARE U.S. DOLLARS SO WIDELY TRADED?

 

8.      The ______________ is the most widely traded currency in the world.

a.       peso

b.      yen

c.       Deutsche mark

d.      U.S. dollar (moderate, page 268)

 

9.      Which of the following is FALSE regarding the U.S. dollar? The U.S. dollar is:

a.      the third most widely traded currency in the world. (moderate, page 268)

b.      a reserve currency held by many central banks.

c.       a transaction currency in many international commodity markets.

d.      an invoice currency in many contracts.

 

10.    The ______________ is one side of seven of the top 10 currency pairs traded in the foreign exchange market.

a.       peso

b.      U.S. dollar (moderate, page 268)

c.       yen

d.      Deutsche mark

 

WHAT ARE THE THREE BIGGEST MARKETS (LOCATIONS) FOR FOREIGN EXCHANGE TRADES?

 

11.    The biggest market for foreign exchange is which of the following?

a.       New York

b.      Tokyo

c.       London (moderate, page 269)

d.      China

 

12.    Which of the following is NOT one of the four largest centers for foreign exchange trading?

a.       the United Kingdom

b.      the United States

c.       Japan

d.      China (moderate, page 269)

 

13.    ____________ is a strong international financial center where a large number of domestic and foreign financial institutions have operations.  It is also positioned in a unique way because of its time zone.

a.      London (moderate, page 269)

b.      New York

c.       Tokyo

d.      China

 

DEFINE A FOREIGN EXCHANGE BID, OFFER, AND SPREAD.

 

14.    The ______________ is the price at which the trader is willing to buy foreign currency.

a.       offer

b.      bid (moderate, page 269)

c.       spread

d.      cross rate


 

15.    Which of the following is the price at which the trader is willing to sell foreign currency?

a.       bid

b.      spread

c.       offer (moderate, page 269)

d.      cross rate

 

16.    In the spot market, the ______________ is the difference between the bid and offer rates and is the trader’s profit margin.

a.       bid

b.      offer

c.       cross rate

d.      spread (moderate, page 270)

 

HOW IS A CURRENCY CROSS-RATE CALCULATED?

 

17.    The relationship between two non-dollar currencies is known as the:

a.      cross rate (moderate, page 271)

b.      spot rate

c.       forward rate

d.      backward rate

 

18.    The ______________ is the rate quoted for transactions that call for delivery after two business days.

a.       spot rate

b.      forward rate (moderate, page 271)

c.       backward rate

d.      cross rate

 

19.    In the spot market, the ______________ is the difference between the spot and forward rate.

a.       bid

b.      offer

c.       spread (moderate, page 271)

d.      cross rate

 

WHAT IS MEANT BY A DISCOUNT OR PREMIUM BETWEEN THE SPOT AND FORWARD EXCHANGE RATES?

 

20.    If the forward rate for a foreign currency is less than the spot rate, the foreign currency is selling at a:

a.       forward premium.

b.      backward discount.

c.       backward premium.

d.      forward discount. (moderate, page 272)

 

21.    If the forward rate is greater than the spot rate, the foreign currency is selling at a:

a.      forward premium. (moderate, page 272)

b.      forward discount.

c.       backward discount.

d.      discounted premium.

 

22.    The difference between the spot and forward rates is either the ______________ or the ______________.

a.       forward discount; reverse premium

b.      forward discount; forward premium (moderate, page 272)

c.       reverse discount; forward premium

d.      reverse discount; reverse premium


 

WHAT IS MEANT BY CONVERTIFBILITY, PARTIAL CONVERTIBILITY, AND NON-CONVERTIBILITY OF CURRENCIES?

 

23.    A key aspect of exchanging one currency for another is its:

a.       strength.

b.      weakness.

c.       convertibility. (moderate, page 276)

d.      differentiation.

 

24.    _____________ currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts.

a.       Partially convertible

b.      Non-convertible

c.       Exotic

d.      Fully convertible (easy, page 276)

 

25.    When a government allows foreigners to convert their currency into the local currency and back upon departure from that country, this is known as:

a.      external convertibility. (moderate, page 276)

b.      internal convertibility.

c.       full conversation.

d.      non conversion.

 

WHAT ARE MEANT BY AN EXOTIC CURRENCY, A HARD CURRENCY, AND A SOFT OR WEAK CURRENCY?

 

26.    A ______________ is a currency that is usually fully convertible and strong or relatively stable in value in comparison with other currencies.

a.       soft currency

b.      hard currency (moderate, page 276)

c.       weak currency

d.      variable currency

 

27.    Currencies that are not fully convertible are often called:

a.       hard currencies.

b.      soft currencies. (moderate, page 277)

c.       undervalued currencies.

d.      variable currencies.

 

28.    Currencies that are not fully convertible are often called all of the following EXCEPT:

a.       soft currencies

b.      exotic currencies

c.       hard currencies  (easy, page 277)

d.      weak currencies

 

WHAT IS A MULTIPLE EXCHANGE RATE SYSTEM?

 

29.    In a ______________ system, a government sets different exchange rates for different types of transactions.

a.       variable income

b.      fixed income

c.       bonded rate

d.      multiple exchange-rate (moderate, page 277)

 

30.    Countries with ______________ often have very high exchange rate for luxury goods and financial flows, such as dividends.

a.      multiple exchange-rate (moderate, page 277)

b.      variable income

c.       fixed income

d.      bonded rate

 

31.    The government determines which kinds of transactions are to be conducted at which exchange rates in which of the following systems?

a.       single exchange rate system

b.      multiple exchange rate system (moderate, page 277)

c.       partial exchange rate system

d.      broad exchange rate system

 

WHY DO COMPANIES USE FOREIGN EXCHANGE?

 

32.    Most foreign exchange transactions stem from the international departments of commercial banks, which perform all of the following essential financial functions EXCEPT:

a.       buy and sell foreign exchange

b.      collect and pay money in transactions with foreign buyers and sellers

c.       raise interest rates among selected companies (moderate, page 278)

d.      lend money in foreign currency

 

33.    The most obvious reason companies use the foreign-exchange market is for:

a.       divestment.

b.      subsidies.

c.       privatization.

d.      import and export transactions. (moderate, page 278)

 

34.    Companies use the foreign-exchange market for all of the following reasons EXCEPT:

a.       governmental privatization (difficult, page 278)

b.      import transactions

c.       export transactions

d.      financial transactions, such as those in FDI

 

WHAT IS ARBITRAGE?

 

35.    ______________ is the purchase of foreign currency on one market for immediate resale on another market (in a different country) to profit from a price discrepancy.

a.       Cross trading

b.      Arbitrage (moderate, page 278)

c.       Forward trading

d.      Reverse trading

 

36.   Which term best describes the following situation? A trader sells U.S. dollars for Swiss francs in the United States, then Swiss francs for German marks in Switzerland, and then the German marks for U.S. dollars back in the United States, with the goal being to end up with more dollars.

a.       cross trading

b.      forward trading

c.       arbitrage (moderate, page 278)

d.      reverse trading


 

37.    Which of the following involves investing in interest-bearing instruments in foreign exchange in an effort to earn a profit due to interest-rate differentials?

a.       cross trading

b.      forward trading

c.       reverse trading

d.      interest arbitrage (moderate, page 278)

 

WHAT IS CURRENCY SPECULATION?

 

38.    ______________ is the buying or selling of a commodity that has both an element of risk and the chance of great profit.

a.      Speculation (moderate, page 278)

b.      Arbitrage

c.       Divestment

d.      FX swapping

 

39.    All of the following are mentioned as foreign exchange instruments used to hedge risks EXCEPT:

a.       FX swaps

b.      outright backwards (moderate, page 278)

c.       options

d.      futures

 

40.    Which of the following statements is FALSE regarding the importance of speculators in the foreign exchange market?

a.       They spot trends and try to take advantage of them.

b.      They can create demand for a currency by purchasing it in the market.

c.       They have the ability to exchange an option for gold.  (moderate, page 278)

d.      They can create a supply of the currency by selling it in the market.

 

WHAT INSTITUTIONS DO COMPANIES USE FOR EXCHANGING CURRENCIES?

 

41.    Which of the following deals primarily in futures contracts for the British pound, the Canadian dollar, the German mark, the Swiss franc, the Japanese yen, and the Australian dollar?

a.       Japanese Stock Exchange

b.      London Stock Exchange

c.       Chicago Mercantile Exchange
d.      International Monetary Market (moderate, page 281)

 

42.    The International Monetary Market deals primarily in futures contracts for all of the following currencies EXCEPT:

a.      the U.S. dollar (moderate, page 281)

b.      the Canadian dollar

c.       the German mark

d.      the Japanese yen

 

43.    The ______________ is the only exchange in the United States that trades foreign-currency options.

a.       American Stock Exchange

b.      Philadelphia Stock Exchange (moderate, page 281)

c.       New York Stock Exchange

d.      Chicago Mercantile Exchange

 

Essay Questions

 

44.    What are foreign exchange and the exchange rate?

 

         Answer

         The foreign exchange market has two major segments: the “over-the-counter” market (OTC) and the exchange-traded market. The OTC market is comprised of banks, both commercial banks such as Bank of America and investment banks such as Merrill-Lynch, and other financial institutions, and is where most of the foreign exchange activity takes place. The exchange-traded market is comprised of securities exchanges, such as the Philadelphia Stock Exchange and the Chicago Mercantile Exchange, where certain types of foreign exchange instruments, such as exchange-traded options and futures, are traded. Several different types of foreign exchange instruments are traded in these markets, but the traditional foreign exchange instruments that comprise the bulk of foreign exchange trading are spot transactions, outright forwards, and FX swaps. Spot transactions involve the exchange of currency the second day after the date on which the two foreign exchange traders agree to the transaction. The rate at which the transaction is settled is the spot rate. Outright forward transactions involve the exchange of currency three or more days after the date on which the traders agree to the transaction. It is the single purchase or sale of a currency for future delivery. The rate at which the transaction is settled is the forward rate and is a contract rate between the two parties. In an FX swap, one currency is swapped for another on one data and then swapped back on a future date. Although an FX swap is both a spot and a forward transaction, it is accounted for as a single transaction.

         (difficult, page 266)

 

45.    In a short essay, discuss the characteristics of the spot market.

 

         Answer

         Most foreign-currency transactions take place between foreign exchange traders, so the traders, who work for foreign exchange brokerage houses or commercial banks, quote the rates. The traders always quote a bid and offer rate. The bid is the price at which the trader is willing to sell foreign currency. In the spot market, the spread is the difference between the bid and offer rates and is the trader’s profit margin. The method of quoting exchange rates is called the direct quote, also known in the foreign exchange industry as “American terms.” It represents a quote from the point of view of someone in the United States. The other convention for quoting foreign exchange is “European terms,” which means a direct quote from the perspective of someone in Europe. From a U.S. point of view, this means the number of units of the foreign currency per U.S. dollar. This is also sometimes called the indirect quote in the United States, although American terms and European terms are the most accurate way to describe the quotes.

         (moderate, page 267)

 

46.    In a short essay, discuss the characteristics of the forward market.

 

         Answer

         The spot market is for foreign-exchange transactions that occur within two business days, but in some transactions a seller extends credit to the buyer for a period that is longer than two days. The forward rate is the rate quoted today for future delivery. The most widely traded currencies in the forward market are the British pound, Canadian dollar, French franc, German mark, Japanese yen, and Swiss franc. Many currencies do not have a forward market due to the small size and volume of transactions it that currency. The difference between the spot and forward rates is either the forward discount or the forward premium. If the forward rate for a foreign currency is less than the spot rate, the foreign currency is selling at a forward discount. If the forward rate is greater than the spot rate, the foreign currency is selling at a forward premium.

         (moderate, page 267)


 

47.    In a short essay, discuss the characteristics of the futures market.

 

         Answer

         A foreign currency future resembles a forward contract in that it specifies an exchange rate sometime in advance of the actual exchange of currency. However, a future is traded on an exchange not over-the-counter. Instead of working with a banker, companies work with exchange brokers when purchasing futures contracts. A forward contracts is tailored to the amount and timeframe that the company needs, while a futures contract is for a specific amount and specific maturity date. The futures contract is less valuable to a company than a forward contract. However, it may be useful to speculators and small companies that do not have a good enough relationship with a bank to enter into a forward contract or who need a contract for an amount that is too small for the forward market.

         (moderate, page 267)

 

48.    In a short essay, discuss the issues of foreign exchange convertibility.

 

         Answer

         A key aspect of exchanging one currency for another is its convertibility. Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts. Hard currencies, such as the U.S. dollar and Japanese yen, are currencies that are fully convertible. They are also relatively stable in value or tend to be strong in comparison with other currencies. In addition, they are desirable assets to hold. Currencies that are not fully convertible are often called soft currencies, or weak currencies. They tend to be the currencies of developing countries, also known as exotic currencies. Most countries today have nonresident, or external, convertibility, meaning that foreigners can convert their currency into the local currency and can convert back into their currency as well. Some countries limit nonresident convertibility. To conserve scarce foreign exchange, some governments impose exchange restrictions on companies or individuals who want to exchange money. The devices they use include import licensing, multiple exchange rates, import deposit requirements, and quantity controls. Governmental licenses fix the exchange rate by requiring all recipients, exporters, and others who receive foreign currency to sell it to its central bank at the official buying rate. Another way governments control foreign exchange convertibility is to establish more than one exchange rate. This restrictive measure is called the multiple exchange-rate system. Another form of foreign-exchange convertibility control is the advance import deposit. In this case, the government tightens the issue of import licenses and requires importers to make a deposit with the central bank, often for as long as one year and interest-free, covering the full price of manufactured goods they would purchase from abroad. Governments also may limit the amount of exchange through quantity controls, which often apply to tourism. A quantity control limits the amount of currency that a local resident can purchase from the bank for foreign travel.

         (moderate, page 276)

 

49.    What are meant by an exotic currency, a hard currency, and a soft or weak currency?

 

         Answer

Hard currencies, such as the U.S. dollar and Japanese yen, are currencies that are fully convertible.  They are also stable in value or tend to be strong in comparison with other currencies.  In addition, they are desirable assets to hold.  Currencies that are not fully convertible are often called soft currencies, or weak currencies.  They tend to be the currencies of developing countries, also known as exotic currencies.

         (easy, page 276)


 

50.    In a short essay, discuss how companies use foreign exchange.

 

         Answer

         Most foreign exchange transactions stem from the international department of commercial banks, which perform three essential financial functions: they buy and sell foreign exchange, they collect and pay money in transactions with foreign buyers and sellers, and they lend money in foreign currency. In performing collections, the bank serves as a vehicle for payments between its domestic and foreign customers. Lending usually takes place in the currency of the bank’s headquarters, but the bank might be able to provide loans in a foreign currency if it has a branch in that country. Commercial banks buy and sell foreign currency for many purposes. For one, travelers going abroad or returning from a foreign country will want to purchase or sell back its foreign currency. Also, residents of one country who want to invest abroad need to purchase foreign currency from a commercial bank. There are a number of reasons why companies use the foreign-exchange market. The most obvious is for import and export transactions. Companies also use the foreign-exchange market for financial transactions, such as those in FDI. Sometimes companies, but mostly traders and investors, deal in foreign exchange solely for profit. One type of profit-seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) to profit from a price discrepancy.

         (easy, page 278)

 

51.    What is arbitrage?

 

         Answer

         Interest arbitrage is the investing in debt instruments, such as bonds, in different countries.  For example, a trader might invest $1,000 in the United States for 90 days or convert $1,000 into British pounds, invest the money in the United Kingdom for 90 days, and then convert the pounds back into dollars.  The investor would try to pick the alternative that would be the highest yielding at the end of the 90 days.

         (moderate, page 278)

 

52.    What is currency speculation?

 

         Answer

        Speculation is the buying or selling of a commodity that has both an element of risk and the chance of great profit.  For example, an investor could buy euros in anticipation of the euro’s strengthening against other currencies. If it strengthens, the investor earns of profit; if it weakens, the investor incurs a loss.  Speculators are important in the foreign exchange market because they spot trends and try to take advantage of them.  They create demand for a currency by purchasing it in the market, or they can create a supply of the currency by selling it in the market.

         (moderate, page 278)