# ECO 410 Week 5 Quiz 4 Chapter 7 and 8 – Strayer

ECO 410 Week 5 Quiz – Strayer (All Possible Questions With Answers)

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Chapter 7

International Parity Conditions

7.1 Prices and Exchange Rates

Multiple Choice

1) If an identical product can be sold in two different markets, and no restrictions exist on the sale or transportation costs, the product’s price should be the same in both markets. This is known as:
B) interest rate parity.
C) the law of one price.
D) equilibrium.

2) 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?
A) \$0.0086/¥
B) ¥124/\$
C) \$0.0081/¥
D) ¥115.75/\$

3) If the current exchange rate is 113 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is \$3.41, and the price of a Big Mac hamburger in Japan is 280 yen, then other things equal, the Big Mac hamburger in Japan is:
A) correctly priced.
B) under priced.
C) over priced.
D) There is not enough information to determine if the price is appropriate or not.

4) 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?
A) Peso 8.50/\$1
B) Peso 10.8/\$1
C) Peso 11.76/\$1
D) None of the above

5) Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 10.80/\$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is:
A) overvalued.
B) undervalued.
C) correctly valued.
D) There is not enough information to answer this question.

6) 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 ________.
A) overvalued; approximately 21%
B) overvalued; approximately 27%
C) undervalued; approximately 21%
D) undervalued; approximately 27%

7) Other things equal, and assuming efficient markets, if a Honda Accord costs \$24,682 in the U.S., then at an exchange rate of \$1.57/£, the Honda Accord should cost ________ in Great Britain.
A) £24,682
B) £38,751
C) £10,795
D) £15,721

8) 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:
A) \$0.96/C\$
B) \$1/C\$
C) \$1.04/C\$
D) Relative PPP provides no guide for this type of question.

9) ________ 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

10) Two general conclusions can be made from the empirical tests of purchasing power parity (PPP):
A) PPP holds up well over the short run but poorly for the long run, and the theory holds better for countries with relatively low rates of inflation.
B) PPP holds up well over the short run but poorly for the long run, and the theory holds better for countries with relatively high rates of inflation.
C) PPP holds up well over the long run but poorly for the short run, and the theory holds better for countries with relatively low rates of inflation.
D) PPP holds up well over the long run but poorly for the short run, and the theory holds better for countries with relatively high rates of inflation.

11) A country’s currency that strengthened relative to another country’s currency by more than that justified by the differential in inflation is said to be ________ in terms of PPP.
A) overvalued
B) over compensating
C) undervalued
D) under compensating

12) If we set the real effective exchange rate index between Canada and the United States equal to 100 in 1998, and find that the U.S. dollar has risen to a value of 112.6, then from a competitive perspective the U.S. dollar is:
A) overvalued.
B) undervalued.
C) very competitive.
D) There is not enough information to answer this question.

13) If we set the real effective exchange rate index between the United Kingdom and the United States equal to 100 in 2005, and find that the U.S. dollar has changed to a value of 91.4, then from a competitive perspective the U.S. dollar is:
A) overvalued.
B) undervalued.
C) equally valued.
D) There is not enough information to answer this question.

14) The government just released international exchange rate statistics and reported that the real effective exchange rate index for the U.S. dollar vs the Japanese yen decreased from 105 last year to 95 currently and is expected to fall still further in the coming year. Other things equal U.S. ________ to/from Japan think this is good news and U.S. ________ to/from Japan think this is bad news.
A) importers; exporters
B) importers; importers
C) exporters; exporters
D) exporters; importers

True/False

1) If a market basket of goods cost \$100 is the US and €70 in France, then the PPP exchange rate would be \$.70/€.

2) The assumptions for relative PPP are more rigid than the assumptions for absolute PPP.

3) Empirical tests prove that PPP is an accurate predictor of future exchange rates.

4) Consider the price elasticity of demand. If a product has price elasticity less than one it is considered to have relatively elastic demand.

Essay

1) The authors state that empirical tests of purchasing power parity “have, for the most part, not proved PPP to be accurate in predicting future exchange rates.” The authors then state that PPP does hold up reasonably well in two situations. What are some reasons why PPP does not accurately predict future exchange rates, and under what conditions might we reasonably expect PPP to hold?

7.2 Exchange Rate Pass-Through

Multiple Choice

1) ________ states that nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation.
A) Absolute PPP
B) Relative PPP
C) The Law of One Price
D) The Fisher Effect

2) In its approximate form the Fisher effect may be written as ________. Where: i = the nominal rate of interest, r = the real rate of return and π = the expected rate of inflation.
A) i = (r)(π)
B) i = r + π + (r)(π)
C) i = r + π
D) i = r + 2π

3) Assume a nominal interest rate on one-year U.S. Treasury Bills of 2.60% and a real rate of interest of 1.00%. Using the Fisher Effect Equation, what is the approximate expected rate of inflation in the U.S. over the next year?
A) 2.10%
B) 2.05%
C) 1.60%
D) 1.00%

4) Assume a nominal interest rate on one-year U.S. Treasury Bills of 3.80% and a real rate of interest of 2.00%. Using the Fisher Effect Equation, what is the exact expected rate of inflation in the U.S. over the next year?
A) 1.84%
B) 1.80%
C) 1.76%
D) 1.72%

5) 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.

6) According to the international Fisher Effect, if an investor purchases a five-year U.S. bond that has an annual interest rate of 5% rather than a comparable British bond that has an annual interest rate of 6%, then the investor must be expecting the ________ to ________ at a rate of at least 1% per year over the next 5 years.
A) British pound; appreciate
B) British pound; revalue
C) U.S. dollar; appreciate
D) U.S. dollar; depreciate

7) ________ states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries.
A) Fisher-open
B) Fisher-closed
C) The Fisher Effect
D) none of the above

8) Exchange rate pass-through may be defined as:
B) the degree to which the prices of imported and exported goods change as a result of exchange rate changes.
C) the PPP of lesser-developed countries.
D) the practice by Great Britain of maintaining the relative strength of the currencies of the Commonwealth countries under the current floating exchange rate regime.

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

10) Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the US for \$55,000 which is the UK price multiplied by the current exchange rate of \$2.01/£. Jaguar has committed to keeping the US price at \$55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of \$2.15/£, and Jaguar has not hedged against currency changes, what is the amount the company will receive in pounds at the new exchange rate?
A) £22,803
B) £25,581
C) £27,363
D) £55,000

11) Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the US for \$55,000 which is the UK price multiplied by the current exchange rate of \$2.01/£. Jaguar has committed to keeping the US price at \$55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of \$2.15/£, and Jaguar has not hedged against currency changes, what is the percentage margin the company will realize given the new exchange rate?
A) 20.0%
B) 15.3%
C) 12.4%
D) 7.2%

12) The price elasticity of demand for DVD players manufactured by Sony of Japan is greater than one. If the Japanese yen appreciates against the U.S. dollar by 10% and the price of the Sony DVD players in the U.S also rises by 10%, then other things equal, the total dollar sales revenues of Sony DVDs would:
A) decline.
B) increase.
C) stay the same.
D) insufficient information

True/False

1) The final component of the equation for the Fisher Effect, (r)(π), where r = the real rate of return and π = the expected rate of inflation, is often dropped from the equation because the number is simply too large for most Western economies.

2) Empirical studies show that the Fisher Effect works best for short-term securities.

3) 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.

4) The premium or discount on forward currency exchange rates between any two countries is visually obvious when you plot the interest rates of each country on the same yield curve. The currency of the country with the higher yield curve should be selling at a forward discount.

5) 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.

6) Both covered and uncovered interest arbitrage are risky operations in the sense that even without default in the securities, the returns are unknown until all transactions are complete.

7) All that is required for a covered interest arbitrage profit is for interest rate parity to not hold.

1) The authors describe an application of uncovered interest arbitrage (UIA) known as “yen carry trade.” Define UIA and describe the example of yen carry trade. Why would an investor engage in the practice of yen carry trade and is there any risk of loss or lesser profit from this investment strategy?

2) The Fisher Effect is a familiar economic theory in the domestic market. In words, define the Fisher Effect and explain why you think it is also appropriately applied to international markets.

7.3 The Forward Rate

Multiple Choice

1) If the forward rate is an unbiased predictor of the expected spot rate, which of the following is NOT true?
A) The expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now.
B) The distribution of possible actual spot rates in the future is centered on the forward rate.
C) The future spot rate will actually be equal to what the forward rate predicts.
D) All of the above are true.

2) Which of the following is NOT an assumption of market efficiency?
A) Instruments denominated in other currencies are perfect substitutes for one another.
B) Transaction costs are low or nonexistent.
C) All relevant information is quickly reflected in both spot and forward exchange markets.
D) All of the above are true.

3) Empirical tests have yielded ________ evidence about market efficiency with a general consensus that developing foreign markets are ________.
A) conflicting; not efficient
B) conflicting; efficient
C) consistent; inefficient
D) none of the above

4) A ________ is an exchange rate quoted today for settlement at some time in the future.
A) spot rate
B) forward rate
C) currency rate
D) yield curve

5) 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/\$
C) £0.6993/\$
D) £0.7060/\$

6) 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/\$
C) ¥90.89/\$
D) ¥90.45/\$

7) The current U.S. dollar-yen spot rate is 125¥/\$. If the 90-day forward exchange rate is 127 ¥/\$ then the yen is selling at a per annum ________ of ________.
C) discount; 1.57%
D) discount; 6.30%

8) The theory of ________ states that 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.
A) international Fisher Effect
B) absolute PPP
C) interest rate parity
D) the law of one price

9) With covered interest arbitrage:
A) the market must be out of equilibrium.
B) a “riskless” arbitrage opportunity exists.
C) the arbitrageur trades in both the spot and future currency exchange markets.
D) all of the above

10) 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

True/False

1) If exchange markets were not efficient, it would pay for a firm to spend resources on forecasting exchange rates.

2) If the forward exchange rate is an unbiased predictor of future spot rates, then future spot rates will always be equal to current forward rates.

3) COVERED interest arbitrage (CIA), is where investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. The transaction is “covered,” because the investor does not sell the higher yielding currency proceeds forward.

7.4 Prices, Interest Rates, and Exchange Rates in Equilibrium

Multiple Choice

1) According to the International Fisher Effect, the forecast change in the spot rate between two countries is equal to:
A) the current spot rate multiplied by the ratio of the inflation rates in the respective countries.
B) but the opposite sign to the difference between nominal interest rates.
C) but the opposite sign to the difference between inflation rates.
D) but the opposite sign to the difference between real interest rates.

True/False

1) In their approximate form, PPP, IRP, and forward rates as an unbiased predictor of the future spot rate lead to similar forecasts of the future spot rate.

Chapter 8 Foreign Currency Derivatives and Swaps

8.1 Foreign Currency Futures

Multiple Choice

1) Financial derivatives are powerful tools that can be used by management for purposes of:
A) speculation.
B) hedging.
C) human resource management.
D) A and B above

2) A foreign currency ________ contract calls for the future delivery of a standard amount of foreign exchange at a fixed time, place, and price.
A) futures
B) forward
C) option
D) swap

3) Which of the following is NOT a contract specification for currency futures trading on an organized exchange?
A) size of the contract
B) maturity date
D) All of the above are specified.

4) About ________ of all futures contracts are settled by physical delivery of foreign exchange between buyer and seller.
A) 0%
B) 5%
C) 50%
D) 95%

5) Futures contracts require that the purchaser deposit an initial sum as collateral. This deposit is called a:
A) collateralized deposit.
B) marked market sum.
C) margin.
D) settlement.

6) A speculator in the futures market wishing to lock in a price at which they could ________ a foreign currency will ________ a futures contract.
D) none of the above

7) A speculator that has ________ a futures contract has taken a ________ position.
A) sold; long
B) purchased; short
C) sold; short
D) purchased; sold

8) Peter Simpson thinks that the U.K. pound will cost \$1.43/£ in six months. A 6-month currency futures contract is available today at a rate of \$1.44/£. If Peter 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.

9) Jack Hemmings bought a 3-month British pound futures contract for \$1.4400/£ only to see the dollar appreciate to a value of \$1.4250 at which time he sold the pound futures. If each pound futures contract is for an amount of £62,500, how much money did Jack gain or lose from his speculation with pound futures?
A) \$937.50 loss
B) \$937.50 gain
C) £937.50 loss
D) £937.50 gain

10) Which of the following statements regarding currency futures contracts and forward contracts is NOT true?
A) A futures contract is a standardized amount per currency whereas the forward contact is for any size desired.
B) A futures contract is for a fixed maturity whereas the forward contract is for any maturity you like up to one year.
C) Futures contracts trade on organized exchanges whereas forwards take place between individuals and banks with other banks via telecom linkages.
D) All of the above are true.

11) Which of the following is NOT a difference between a currency futures contract and a forward contract?
A) The futures contract is marked to market daily, whereas the forward contract is only due to be settled at maturity.
B) The counterparty to the futures participant is unknown with the clearinghouse stepping into each transaction, whereas the forward contract participants are in direct contact setting the forward specifications.
C) A single sales commission covers both the purchase and sale of a futures contract, whereas there is no specific sales commission with a forward contract because banks earn a profit through the bid-ask spread.
D) All of the above are true.

12) A foreign currency ________ gives the purchaser the right, not the obligation, to buy a given amount of foreign exchange at a fixed price per unit for a specified period.
A) future
B) forward
C) option
D) swap

13) A foreign currency ________ option gives the holder the right to ________ a foreign currency, whereas a foreign currency ________ option gives the holder the right to ________ an option.
C) put, hold, call, release
D) none of the above

14) The price at which an option can be exercised is called the:
B) spot rate.
C) strike price.
D) commission.

15) An ________ option can be exercised only on its expiration date, whereas a/an ________ option can be exercised anytime between the date of writing up to and including the exercise date.
A) American; European
B) American; British
C) Asian; American
D) European; American

16) An ________ option can be exercised only on its expiration date, whereas a/an ________ option can be exercised anytime between the date of writing up to and including the exercise date.
A) American; European
B) American; British
C) Asian; American
D) European; American

17) A call option whose exercise price exceeds the spot price is said to be:
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
D) over-the-spot.

18) A call option whose exercise price is less than the spot price is said to be:
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
D) under-the-spot.

19) An option whose exercise price is equal to the spot rate is said to be:
A) in-the-money.
B) at-the-money.
C) out-of-the-money.
D) on-the-spot.

20) The main advantage(s) of over-the-counter foreign currency options over exchange traded options is (are):
A) expiration dates tailored to the needs of the client.
B) amounts that are tailor made.
C) client desired expiration dates.
D) all of the above

21) As a general statement, it is safe to say that businesses generally use the ________ for foreign currency option contracts, and individuals and financial institutions typically use the ________.
A) exchange markets; over-the-counter
B) over-the-counter; exchange markets

TABLE 8.1
Use the table to answer following question(s).

April 19, 2009, British Pound Option Prices (cents per pound, 62,500 pound contracts).

22) Refer to Table 8.1. What was the closing price of the British pound on April 18, 2009?
A) \$1.448/£
B) £1.448/\$
C) \$14.48/£
D) none of the above

23) Refer to Table 8.1. The exercise price of ________ giving the purchaser the right to sell pounds in June has a cost per pound of ________ for a total price of ________.
A) 1460; 0.68 cents; \$425.00
B) 1440; 1.06 cents; \$662.50
C) 1450; 1.02 cents; \$637.50
D) 1440; 1.42 cents; \$887.50

24) Refer to Table 8.1. The May call option on pounds with a strike price of 1440 mean:
A) \$88/£ per contract.
B) \$0.88/£.
C) \$0.0088/£.
D) none of the above

25) Dash Brevenshure works for the currency trading unit of ING Bank in London. He speculates that in the coming months the dollar will rise sharply vs. the pound. What should Dash do to act on his speculation?
A) Buy a call on the pound.
B) Sell a call on the pound.
C) Buy a put on the pound.
D) Sell a put on the pound.

26) A put option on yen is written with a strike price of ¥105.00/\$. Which spot price maximizes your profit if you choose to exercise the option before maturity?
A) ¥100/\$
B) ¥105/\$
C) ¥110/\$
D) ¥115/\$

27) A call option on euros is written with a strike price of \$1.30/euro. Which spot price maximizes your profit if you choose to exercise the option before maturity?
A) \$1.20/euro
B) \$1.25/euro
C) \$1.30/euro
D) \$1.35/euro

28) A call option on UK pounds has a strike price of \$2.05/£ and a cost of \$0.02. What is the break-even price for the option?
A) \$2.03/£
B) \$2.07/£
C) \$2.05/£
D) The answer depends upon if this is a long or a short call option.

29) Your U.S firm has an accounts payable denominated in UK pounds due in 6 months. To protect yourself against unexpected changes in the dollar/pound exchange rate you should:
A) buy a pound put option.
B) sell a pound put option.
C) buy a pound call option.
D) sell a pound call option.

30) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/\$ and the 6-month forward rate is ¥128.53/\$. Jasper thinks the yen will move to ¥128.00/\$ in the next six months. Jasper should ________ at ________ to profit from changing currency values.
A) buy yen; the forward rate
B) buy dollars; the forward rate
C) sell yen; the forward rate
D) There is not enough information to answer this question.

31) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/\$ and the 6-month forward rate is ¥128.53/\$. Jasper thinks the yen will move to ¥128.00/\$ in the next six months. If Jasper buys \$100,000 worth of yen at today’s spot price and sells within the next six months at ¥128/\$, he will earn a profit of:
A) \$146.09
B) \$101,460.94
C) \$1460.94
D) nothing; he will lose money

32) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/\$ and the 6-month forward rate is ¥128.53/\$. Jasper thinks the yen will move to ¥128.00/\$ in the next six months. If Jasper buys \$100,000 worth of yen at today’s spot price her potential gain is ________ and her potential loss is ________.
A) \$100,000; unlimited
B) unlimited; unlimited
C) \$100,000; \$100,000
D) unlimited; \$100,000

33) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/\$ and the 6-month forward rate is ¥128.53/\$. Jasper thinks the yen will move to ¥128.00/\$ in the next six months. If Jasper’s expectations are correct, then he could profit in the forward market by ________ and then ________.
A) buying yen for ¥128.00/\$; selling yen at ¥128.53/\$
B) buying yen for ¥128.53/\$; selling yen at ¥128.00/\$
C) There is not enough information to answer this question
D) He could not profit in the forward market.

34) The maximum gain for the purchaser of a call option contract is ________ while the maximum loss is ________.
C) unlimited; unlimited.
D) unlimited; the value of the underlying asset.

35) The buyer of a long call option:
A) has a maximum loss equal to the premium paid.
B) has a gain equal to but opposite in sign to the writer of the option.
C) has an unlimited maximum gain potential.
D) all of the above

36) Which of the following is NOT true for the writer of a call option?
A) The maximum loss is unlimited.
B) The maximum gain is unlimited.
C) The gain or loss is equal to but of the opposite sign of the buyer of a call option.
D) All of the above are true.

37) Which of the following is NOT true for the writer of a put option?
A) The maximum loss is limited to the strike price of the underlying asset less the premium.
B) The gain or loss is equal to but of the opposite sign of the buyer of a put option.
C) The maximum gain is the amount of the premium.
D) All of the above are true.

38) The buyer of a long put option:
A) has a maximum loss equal to the premium paid.
B) has a gain equal to but opposite in sign to the writer of the option.
C) has maximum gain potential limited to the difference between the strike price and the premium paid.
D) all of the above

39) The value of a European style call option is the sum of two components:
A) the present value plus the intrinsic value.
B) the time value plus the present value.
C) the intrinsic value plus the time value.
D) the intrinsic value plus the standard deviation.

True/False

1) Currency futures contracts have become standard fare and trade readily in the world money centers.

2) The major difference between currency futures and forward contracts is that futures contracts are standardized for ease of trading on an exchange market whereas forward contracts are specialized and tailored to meet the needs of clients.

3) The writer of the option is referred to as the seller, and the buyer of the option is referred to as the holder.

4) Foreign currency options are available both over-the-counter and on organized exchanges.

5) Jasper Pernik is a currency speculator who enjoys “betting” on changes in the foreign currency exchange market. Currently the spot price for the Japanese yen is ¥129.87/\$ and the 6-month forward rate is ¥128.53/\$. Jasper would earn a higher rate of return by buying yen and a forward contract than if he had invested her money in 6-month US Treasury securities at an annual rate of 2.50%.

6) Most option profits and losses are realized through taking actual delivery of the currency rather than offsetting contracts.

Essay

1) Why are foreign currency futures contracts more popular with individuals and banks while foreign currency forwards are more popular with businesses?

2) Compare and contrast foreign currency options and futures. Identify situations when you may prefer one vs. the other when speculating on foreign exchange.

8.2 Option Pricing and Valuation

Multiple Choice

1) Which of the following is NOT a factor in determining the premium price of a currency option?
A) the present spot rate
B) the time to maturity
C) the standard deviation of the daily spot price movement
D) All of the above are factors in determining the premium price.

2) The ________ of an option is the value if the option were to be exercised immediately. It is the option’s ________ value.
A) intrinsic value; maximum
B) intrinsic value; minimum
C) time value; maximum
D) time value; minimum

3) Assume that a call option has an exercise price of \$1.50/£. At a spot price of \$1.45/£, the call option has:
A) a time value of \$0.04.
B) a time value of \$0.00.
C) an intrinsic value of \$0.00.
D) an intrinsic value of -\$0.04.

4) The single largest interest rate risk of a firm is:
A) interest sensitive securities.
B) debt service.
C) dividend payments.
D) accounts payable.

5) ________ is the possibility that the borrower’s creditworthiness is reclassified by the lender at the time of renewing credit. ________ is the risk of changes in interest rates charged at the time a financial contract rate is set.
A) Credit risk; Interest rate risk
B) Repricing risk; Credit risk
C) Interest rate risk; Credit risk
D) Credit risk; Repricing risk

Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide \$1,000,000 in financing for a three-year period.

• Strategy #1: Borrow \$1,000,000 for three years at a fixed rate of interest of 7%.
• Strategy #2: Borrow \$1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50%
• Strategy #3: Borrow \$1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.

6) Refer to Instruction 8.1. Choosing strategy #1 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

7) Refer to Instruction 8.1. Choosing strategy #2 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

8) Refer to Instruction 8.1. Choosing strategy #3 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.

9) Refer to Instruction 8.1. Which strategy (strategies) will eliminate credit risk?
A) Strategy #1
B) Strategy #2
C) Strategy #3
D) Strategies #1 and #2

10) Refer to Instruction 8.1. If your firm felt very confident that interest rates would fall or, at worst, remain at current levels, and were very confident about the firm’s credit rating for the next 10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)
A) Strategy #3
B) Strategy #2
C) Strategy #1
D) Strategy #1, #2, or #3; you are indifferent among the choices.

11) Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #2 is: (Assume your firm is borrowing money.)
A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above

12) Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that your credit rating might improve. The risk of strategy #3 is: (Assume your firm is borrowing money.)
A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above

13) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #1? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

14) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #2? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

15) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #3? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.

True/False

1) The time value is asymmetric in value as you move away from the strike price (i.e., the time value at two cents above the strike price is not necessarily the same as the time value two cents below the strike price).

8.3 Interest Rate Derivatives

Multiple Choice

1) An interbank-traded contract to buy or sell interest rate payments on a notional principal is called a/an:
A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above

2) A/an ________ is a contract to lock in today interest rates over a given period of time.
A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above

3) An agreement to exchange interest payments based on a fixed payment for those based on a variable rate (or vice versa) is known as a/an:
A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above

4) The financial manager of a firm has a variable rate loan outstanding. If she wishes to protect the firm against an unfavorable increase in interest rates she could:
A) sell an interest rate futures contract of a similar maturity to the loan.
B) buy an interest rate futures contract of a similar maturity to the loan.
C) swap the adjustable rate loan for another of a different maturity.
D) none of the above

5) An agreement to swap a fixed interest payment for a floating interest payment would be considered a/an:
A) currency swap.
B) forward swap.
C) interest rate swap.
D) none of the above

6) An agreement to swap the currencies of a debt service obligation would be termed a/an:
A) currency swap.
B) forward swap.
C) interest rate swap.
D) none of the above

7) Which of the following would be considered an example of a currency swap?
A) exchanging a dollar interest obligation for a British pound obligation
B) exchanging a eurodollar interest obligation for a dollar obligation
C) exchanging a eurodollar interest obligation for a British pound obligation
D) All of the above are examples of a currency swap.

8) A firm with fixed-rate debt that expects interest rates to fall may engage in a swap agreement to:
A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

9) A firm with variable-rate debt that expects interest rates to rise may engage in a swap agreement to:
A) pay fixed-rate interest and receive floating rate interest.
B) pay floating rate and receive fixed rate.
C) pay fixed rate and receive fixed rate.
D) pay floating rate and receive floating rate.

10) The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to:
A) do nothing.
B) pay floating and receive fixed.
C) receive floating and pay fixed.
D) none of the above

11) The potential exposure that any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract is called:
A) interest rate risk.
B) credit risk.
C) counterparty risk.
D) clearinghouse risk.

12) Which of the following is an unlikely reason for firms to participate in the swap market?
A) To replace cash flows scheduled in an undesired currency with cash flows in a desired currency.
B) Firms may raise capital in one currency but desire to repay it in another currency.
C) Firms desire to swap fixed and variable payment or receipt of funds.
D) All of the above are likely reasons for a firm to enter the swap market.

True/False

1) Historically, interest rate movements have shown less variability and greater stability than exchange rate movements.

2) Unlike the situation with exchange rate risk, there is no uncertainty on the part of management for shareholder preferences regarding interest rate risk. Shareholders prefer that managers hedge interest rate risk rather than having shareholders diversify away such risk through portfolio diversification.

3) Interest rate futures are relatively unpopular among financial managers because of their relative illiquidity and their difficulty of use.

4) A basis point is one-tenth of one percent.

5) A swap agreement may involve currencies or interest rates, but never both.

6) Some of the world’s largest and most financially sound firms may borrow at variable rates less than LIBOR.

7) Counterparty risk is greater for exchange-traded derivatives than for over-the-counter derivatives.

8) Swap rates are derived from the yield curves in each major currency.

Essay

1) Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

2) How does counterparty risk influence a firm’s decision to trade exchange-traded derivatives rather than over-the-counter derivatives?
Answer: With exchange-traded derivatives, the exchange is the clearinghouse. Thus, firms do not need to worry about the other party making good on its obligations and it is easier to trade the derivative products.