Topic 3 Spot Forward Rates Maths

Question 1

The value of the Australian dollar (A$) today is US$0.73. Yesterday, the value of the Australian
dollar was US$0.69. The Australian dollar ____ by ____%.
a. depreciated; 5.80
b. depreciated; 4.00
c. appreciated; 5.80
d. appreciated; 4.00

Answer 1

c)

Question 2

If a currency’s spot rate market is ____, its exchange rate is likely to be ____ to a single large
purchase or sale transaction.
a. liquid; highly sensitive
b. illiquid; insensitive
c. illiquid; highly sensitive
d. none of the above.

Answer 2

c)

Question 3

. ____ is not a factor that causes currency supply and demand schedules to change.
a. Relative inflation rates
b. Relative interest rates
c. Relative income levels
d. Expectations
e. All of the above are factors that cause currency supply and demand schedules to change.

Answer 3

e)

Question 4

A large increase in the income level in Indonesia along with no growth in the Australian income level
is normally expected to cause (assuming no change in interest rates or other factors) a(n) ____ in
Indonesian demand for Australian goods, and the Indonesian Rupee should ____.
a. increase; appreciate
b. increase; depreciate
c. decrease; depreciate
d. decrease; appreciate

Answer 4

b)

Question 5

Investors from Germany, Australian, and the U.K. frequently invest in each other based on prevailing
interest rates. If British interest rates increase, German investors are likely to buy ____ Australian
dollar-denominated securities, and the euro is likely to ____ relative to the Australian dollar.
a. fewer; depreciate
b. fewer; appreciate
c. more; depreciate
d. more; appreciate

Answer 5

a)

Question 6

When the “real” interest rate is relatively low in a given country, then the currency of that country is
typically expected to be:
a. weak, since the country’s quoted interest rate would be high relative to the inflation rate.
b. strong, since the country’s quoted interest rate would be low relative to the inflation rate.
c. strong, since the country’s quoted interest rate would be high relative to the inflation rate.
d. weak, since the country’s quoted interest rate would be low relative to the inflation rate.

Answer 6

d)

Question 7

An increase in Australian interest rates relative to German interest rates would likely ____ the
Australian demand for euros and ____ the supply of euros for sale.
a. reduce; increase
b. increase; reduce
c. reduce; reduce
d. increase; increase

Answer 7

5)

Question 8

Assume that the inflation rate becomes much higher in the U.K. relative to the Australia. This will
place ____ pressure on the value of the British pound. Also, assume that interest rates in the U.K.
begin to rise relative to interest rates in Australia. The change in interest rates will place ____ pressure
on the value of the British pound.
a. upward; downward
b. upward; upward
c. downward; upward
d. downward; downward

Answer 8

c)

Question 9

In general, when speculating on exchange rate movements, the speculator will borrow the currency
that is expected to appreciate and invest in the country whose currency is expected to depreciate.
a. True
b. False

Answer 9

B)

Question 10

Baylor Bank believes the New Zealand dollar will appreciate over the next five days from A$.48 to
A$.50. The following annual interest rates apply:
Currency Lending Rate Borrowing Rate
Australian Dollars 7.10% 7.50%
New Zealand dollar (NZ$) 6.80% 7.25%
Baylor Bank has the capacity to borrow either NZ$10 million or A$5 million. If Baylor Bank’s
forecast is correct, what will its Australian dollar profit be from speculation over the five-day period
(assuming it does not use any of its existing consumer deposits to capitalize on its expectations)?
a. A$521,325.
b. A$500,520.
c. A$104,262.
d. A$413,419.
e. A$208,044

Answer 10

e)

Question 11

To force the value of the pound to appreciate against the Australian dollar, the Reserve Bank of
Australia (RBA) should:
a. sell Australian dollars for pounds in the foreign exchange market and the European Central
Bank (ECB) should sell Australian dollars for pounds in the foreign exchange market.
b. sell pounds for Australian dollars in the foreign exchange market and the European Central
Bank (ECB) should sell Australian dollars for pounds in the foreign exchange market.
c. sell pounds for Australian dollars in the foreign exchange market and the European Central
Bank (ECB) should not intervene.
d. sell Australian dollars for pounds in the foreign exchange market and the European Central
Bank (ECB) should sell pounds for Australian dollars in the foreign exchange market.

Answer 11

a)

Question 12

A weak Australian dollar is normally expected to cause:
a. high unemployment and high inflation in Australia
b. high unemployment and low inflation in Australia
c. low unemployment and low inflation in Australia
d. low unemployment and high inflation in Australia

Answer 12

D)

Question 13

A strong Australian dollar is normally expected to cause:
a. high unemployment and high inflation in Australia
b. high unemployment and low inflation in Australia
c. low unemployment and low inflation in the Australia
d. low unemployment and high inflation in the Australia

Answer 13

B)

Question 14

To force the value of the British pound to depreciate against the Australian dollar, RBA should:
a. sell Australian dollars for pounds in the foreign exchange market and the Bank of England
should sell Australian dollars for pounds in the foreign exchange market.
b. sell pounds for Australian dollars in the foreign exchange market and the Bank of England
should sell Australian dollars for pounds in the foreign exchange market.
c. sell pounds for Australian dollars in the foreign exchange market and the Bank of England
should sell pounds for Australian dollars in the foreign exchange market.
d. sell Australian dollars for pounds in the foreign exchange market and the Bank of England
should sell pounds for Australian dollars in the foreign exchange market.

Answer 14

c)

Question 15

Consider two countries that trade with each other, called X and Y. According to the text, inflation in
Country X will have a greater impact on inflation in Country Y under the ____ system. Now, consider
two other countries that trade with each other, called A and B. Unemployment in Country A will have
a greater impact on unemployment in Country B under the ____ system.
a. floating rate; fixed rate
b. floating rate; floating rate
c. fixed rate; fixed rate
d. fixed rate; floating rate

Answer 15

c)

Question 16

A primary result of the Bretton Woods Agreement was:
a. the establishment of the European Monetary System (EMS).
b. establishing specific rules for when tariffs and quotas could be imposed by governments.
c. establishing that exchange rates of most major currencies were to be allowed to fluctuate
1% above or below their initially set values.
d. establishing that exchange rates of most major currencies were to be allowed to fluctuate
freely without boundaries (although the central banks did have the right to intervene when
necessary).

Answer 16

c)

Question 17

A primary result of the Smithsonian Agreement was:
a. the establishment of the European Monetary System (EMS).
b. establishing that exchange rates of most major countries were to be allowed to fluctuate
2.25% above or below their initially set values.
c. establishing specific rules for when tariffs and quotas could be imposed by governments.
d. establishing that exchange rates of most major currencies were to be allowed to fluctuate
freely without boundaries (although the central banks did have the right to intervene when
necessary).

Answer 17

b)

Question 18

Under a fixed exchange rate system:
a. a foreign exchange market does not exist.
b. central bank intervention in the foreign exchange market is not necessary.
c. central bank intervention in the foreign exchange market is often necessary.
d. central bank intervention in the foreign exchange market is not allowed.

Answer 18

c)

Question 19

Under a managed float exchange rate system, the RBA may attempt to stimulate the Australian
economy by ____ the Australian dollar. Such an adjustment in the Australian dollar’s value should
____ the Australian demand for products produced by major foreign countries.
a. weakening; increase
b. weakening; decrease
c. strengthening; increase
d. strengthening; decrease

Answer 19

b)

Question 20

The value of the Canadian dollar, Japanese yen, and Australian dollar with respect to the U.S. dollar
are part of a:
a. pegged system.
b. fixed system.
c. managed float system.
d. crawling peg system.

Answer 20

c)

Question 21

Assume the spot rate of the Malaysian Ringgit is A$0.356. The expected spot rate one year from now is assumed to be A$0.205. What percentage depreciation does this reflect?

Answer 21

S = Spot rate of one year from now: A$0.205 (next year spot rate)
St-1 = Current spot rate: A$0.356 (this year spot rate)

(A$0.205 – A$0. 356)/A$0.356 = -0.4242 = -42.42%
Expected depreciation of 42.42 per cent

Question 22

If Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result), how will their currency values (relative to the Australian dollar) be affected?

Answer 22

A relative decline in Asian economic growth will reduce Asian demand for Australian products, thus places upward pressure on Asian currencies.
However, given the change in interest rates, Asian corporations with excess cash may now invest in Australia or other countries, thereby increasing the demand for Australian dollars. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies.
The overall impact depends on the magnitude of the forces that may cause Asian currencies to depreciate or appreciate.

Question 23

Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital flows?

Answer 23

Capital flows have a larger influence.
In general, crises tend to cause investors to expect that there will be less investment in the country in the future and also cause concern that any existing investments will generate poor returns (because of defaults on loans or reduced valuations of stocks).
Investors quickly liquidate their investments and convert the local currency into other currencies to invest elsewhere, so places downward pressure on the local currency and makes it weaken abruptly.

Question 24

Blue Demon Bank expects that the Mexican peso will depreciate against the US dollar from its spot rate of US$0.15 to US$0.14 in 10 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
US dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%

Assume that Blue Demon Bank has a borrowing capacity of either US$10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow. How could Blue Demon Bank attempt to capitalise on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy

Answer 24

Blue Demon Bank can capitalise on
its expectations about pesos (MXP) as follows:
1. Borrow MXP70 million
2. Convert the MXP70 million to US dollars:
MXP70,000,000 × $0.15 = $10,500,000
3. Lend the dollars through the interbank market at 8.0% annualised over a 10-day period. The amount accumulated in 10 days is:
$10,500,000 × [1 + (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333
4. Repay the peso loan. The repayment amount on the peso loan is:
MXP70,000,000 × [1 + (8.7% × 10/360)] = 70,000,000 × [1.002417]=MXP70,169,167
5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is:
MXP70,169,167 × $0.14 = $9,823,683
6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of:
$10,523,333 – $9,823,683 = $699,650

Question 25

Kurnick Co. expects that the pound will depreciate from US$1.70 to US$1.68 in one year. It has no money to invest, but it could borrow money to invest. It has been approved by a bank to borrow either US$1 million or 1 million pounds for one year. It can borrow US dollars at 6 per cent or British pounds at 5 per cent for one year. It can invest in a risk-free dollar deposit at 5 per cent for one year or a risk-free British deposit at 4 per cent for one year. Determine the expected profit or loss (in US dollars) if Kurnick Co. pursues a strategy to capitalise on the expected depreciation of the pound.

Answer 25

Initial amount borrowed = 1,000,000 pounds
US dollars received when the pounds are converted to dollars = 1,000,000 * 1.70 = US$1,700,000.
Total dollar amount (via deposits) at the end of 1 year = $1,700,000 x 1.05 = US$1,785,000.
Total owed on the pounds borrowed at the end of 1 year = 1,000,000*1.05 = 1,050,000 pounds.
Expected number of US dollars needed to repay the loan = 1,050,000 x 1.68 = US$1,764,000.
Profit = US$1,785,000 - US$1,764,000 = US$21,000.
Kurnick Co. earns profit from this strategy,