Unit I Exam Practice Questions

Question 1

Interest earned on foreign holdings of U.S. federal, state and local government debt are recorded in the:

a) services account.
b) merchandise account.
c) income from investment account.
d) capital account.
e) unilateral transfers account

Answer 1

c) income from investment account.

Question 2

True or false: A current account deficit must be accompanied by a corresponding deficit in the financial account.

Answer 2

False

Question 3

The balance of payments:

a) Must sum to zero in the end, by definition.
b) Records a country’s trade in goods, services, and financial assets with the rest of the world.
c) Requires two entries for each transaction.
d) (a.) and (b.) only.
e) (a.), (b.), and (c.).

Answer 3

e) (a.), (b.), and (c.).

Question 4

In terms of the balance of payments accounting, a credit:

a) is entered for exported goods
b) sends foreign exchange out of the country
c) results in a demand for foreign exchange
d) none of the above

Answer 4

a) is entered for exported goods

Question 5

A unilateral transfer is:

a) migration into or out of the country.
b) where you “draw the line”.
c) birthday money from your aunt who lives in Thailand.
d) part of the financial account but not the current account.

Answer 5

c) birthday money from your aunt who lives in Thailand.

Question 6

Use the information in the following table to answer the questions about Switzerland’s 1992 international transactions

Balance of Payments Account Amount
Merchandise imports $ 78,893
Merchandise exports $ 78,642
Services imports $ 11,526
Services exports $ 18,734
Investment income receipts $ 28,131
Investment income payments $ 18,691
Unilateral transfers $ -2,977

What is the balance of trade in merchandise? (Note: enter your answer without the dollar sign)

Answer 6

Exports - Imports, -$251

Question 7

Use the information in the following table to answer the questions about Switzerland’s 1992 international transactions

Balance of Payments Account Amount
Merchandise imports $ 78,893
Merchandise exports $ 78,642
Services imports $ 11,526
Services exports $ 18,734
Investment income receipts $ 28,131
Investment income payments $ 18,691
Unilateral transfers $ -2,977
What is the current account? (Note: enter your answer without the dollar sign)

Answer 7

Current Account = (Merchandise Exports + Services Exports + Investment Income Receipts + Unilateral Transfers) - (Merchandise Imports + Services Imports + Investment Income Payments)

$13,420

Question 8

At the last BIS survey, the average daily volume of foreign exchange trading was approximately equal to
Correct!
a) $5,100 billion.
b) $100 billion.
c) $15 billion.
d) $2,000 billion

Answer 8

a) $5,100 billion.

Question 9

Suppose that in the free market, where the supply of the foreign currency is equal to demand for that currency, the peso-dollar exchange rate is 4 pesos = $1. Assume the central bank sets an official exchange rate at 3 pesos = $1, we can say that in the official market the dollar is:

a) overvalued.
b) undervalued.
c) appreciated.
d) None of the above.

Answer 9

b) undervalued.

It takes less pesos to buy one USD, hence making the US dollar weaker.

Question 10

The essential feature of a ________ is that it immediately fixes the rate at which a specified amount of one currency is to be delivered in exchange for a specific amount of another at a future date.

a) forward contract
b) spot contract
c) money contract
d) bid contract

Answer 10

a) forward contract

Associate forward with future.

Question 11

The reduction or covering of a foreign exchange risk is called

a) hedging.
b) speculation.
c) intervention.
d) arbitrage.

Answer 11

a) hedging.

Question 12

Riskless transactions to take advantage of profit opportunities due to a price differential or a yield differential in excess of transaction costs are called

a) differential actions.
b) cash transactions.
c) arbitrage.
d) forward transactions.

Answer 12

c) arbitrage.

Question 13

Suppose an investor has 100 euros, and has a choice of: 1) buying a bond in Germany that pays 5% interest in euros; 2) buying a similar bond in the US that pays 5% interest in dollars. If the exchange rate today is 0.87 euros per dollar, what the exchange rate have to be at the maturity of the bonds for the investor to earn the same return from either bond?

a) 1 euro per dollar
b) 0.87 euro per dollar
c) 0.87 dollar per euro
d) 1.3 dollar per euro
e) none of the above

Answer 13

b) 0.87 euro per dollar

Question 14

True or false: Foreign exchange activity is dominated by the spot and swaps markets.

Answer 14

True

Question 15

A gain can be made by the holder of a call option when the current exchange rate

a) exceeds the exercise price.
b) exceeds the forward price.
c) is less than the futures price.
d) falls to zero.

Answer 15

a) exceeds the exercise price.

Question 16

An increase in the exchange rate from $2.00 per euro to $2.20 per euro is a

a) 10% depreciation of the euro with respect to the dollar.
b) 10% depreciation of the dollar with respect to the euro.
c) 10% appreciation of the dollar with respect to the euro.
d) None of the above.

Answer 16

b) 10% depreciation of the dollar with respect to the euro.

Question 17

If the exchange rate for the Australian dollar is US$/A$=.7833 and the exchange rate for the Hong Kong dollar is US$/HK$=.1280, then the Kong Kong-Australian dollar exchange rate (or how many HK$s does it take to buy one A$), HK$/A$ equals

a) 1.2767
b) 7.8133
c) 6.1195
d) 9.9738

Answer 17

c) 6.1195

Question 18

Suppose:

1 £ = 2.435 $ in New York

1 $ = 1.07 € in Paris

1 € =0 .4 £ in London

How much could you profit per pound initially traded?

a) 0.04218 £
b) 0.1042 £
c) 0.6055 £
d) 1.6055 £

Answer 18

a) 0.04218 £

Start with 1 pound (£).

Convert it to dollars ($) in New York using the exchange rate: 1 £ = 2.435 $.
So, you get 1 £ * 2.435 $/£ = 2.435 $.

Now, take the dollars ($) and convert them to euros (€) in Paris using the exchange rate: 1 $ = 1.07 €.
So, you get 2.435 $ * 1.07 €/$ = 2.60545 €.

Finally, take the euros (€) and convert them back to pounds (£) in London using the exchange rate: 1 € = 0.4 £.
So, you get 2.60545 € * 0.4 £/€ = 1.04218 £.

Now, calculate the profit per pound by subtracting the initial amount (1 pound) from the final amount (1.04218 pounds):

Profit per pound = 1.04218 £ - 1 £ = 0.04218 £.

Question 19

Suppose:

1 £ = 2.435 $ in New York

1 $ = 1.07 € in Paris

1 € =0 .4 £ in London

Suppose New York was considering adding a transaction cost for every trade of pounds to dollars. What is the lowest transaction cost that would remove the arbitrage opportunity? Hint: a transaction cost of x means that for every 1 £ traded you receive back (2.435 - x)$ in New York.

a) 0.097 $
b) 0.098 $
c) 0.099 $
d) 0.1 $

Answer 19

c) $0.099

Arbitrage opportunity:

Buy 1 GBP in New York for 2.435 USD
Sell 1 GBP in London for 0.4 EUR
Sell 0.4 EUR in Paris for 0.4 * 1.07 = 0.428 USD
Profit = 0.428 - 2.435 = -2.007 USD
Transaction cost to remove arbitrage opportunity:

Transaction cost must be greater than 2.007 USD
The lowest transaction cost that would remove the arbitrage opportunity is 2.008 USD
Therefore, the answer is $0.099, which is the difference between 2.008 USD and 2.435 USD.

Question 19

The nominal interest rates in US and UK are 8% and 6%, correspondingly.
The corresponding national inflation rates are: 10% (US) and 4% (UK).
The spot rate is $2 for 1 pound.
What is your best estimate of the expected forward rate (dollars per pound)?

Answer 19

Calculate the real interest rate in the US and UK:

US real interest rate = 8% - 10% = -2%
UK real interest rate = 6% - 4% = 2%
Calculate the expected forward rate using the following formula:

Expected forward rate = Spot rate * (1 + Real interest rate in domestic currency) / (1 + Real interest rate in foreign currency)

Expected forward rate = $2 * (1 - 2%) / (1 + 2%) = $1.92

Therefore, the expected forward rate is $1.92.

Question 20

True or false: The U.S. dollar is the dominant international reserve currency, but rising shares are held in euros.

Answer 20

True

Question 21

Under the Maastricht Treaty, which of the following is not a requirement for a country to join the European monetary union?

a) The country’s inflation rate must not be more than 1.5 percentage points above the average of the lowest three member country rates.
b) Its interest rates on long—term government bonds must not be more than 2 percentage points above the average of the three lowest inflation members.
c) Its trade balance must not be more than +3 percent or less than 3 percent of its GDP.
d) Its government budget deficit must not exceed 3 percent of its GDP.

Answer 21

c) Its trade balance must not be more than +3 percent or less than 3 percent of its GDP.

Question 22

Countries with floating exchange rates have certain characteristics. Indicate the one that does not apply to those countries.

a) closed economy
b) small economy
c) diversified trade
d) divergent inflation rates

Answer 22

b) small economy

Question 23

________ keeps the exchange rate fixed in the short run but then adjusts its value at regular intervals to account for supply and demand pressures.

a) The European Monetary System
b) A managed floating
c) A crawling peg
d) A crawling float

Answer 23

c) A crawling peg

Question 24

Of the following exchange rate arrangements, in which does the exchange rate fluctuate around a fixed central target rate while allowing a moderate amount of fluctuation?

a) Independently floating
b) Currency Board
c) Horizontal Bands
d) Fixed peg

Answer 24

c) Horizontal Bands

Question 25

In practice, the Bretton Woods system is best described as
a) an adjustable peg.
b) a purely fixed exchange rate
c) a gold exchange standard
d) Both A and C

Answer 25

d) Both A and C

Question 26

The interest rate in the US is 0.25%, and the interest rate in the UK is 0.5%. The spot exchange rate is 1.51 dollars for 1 pound. What are your expectations about the 12-month forward rate to be?

a) 1.513775
b) 1.1325
c) 1.506225
d) 1

Answer 26

c) 1.506225

Where:

Spot rate is the current exchange rate (1.51 dollars per pound)
Domestic interest rate is the interest rate in the US (0.25%)
Foreign interest rate is the interest rate in the UK (0.5%)
Time is the time to maturity of the forward contract (1 year)
Plugging in the numbers, we get the following:

Forward rate = 1.51 * exp((0.0025 - 0.005) * 1)
Forward rate = 1.5062297148201647

Question 27

If the 12-month interest rates for the United States and the United Kingdom are 6% and equal, and £1 = $2 in the spot market, then what do you expect the 12-month forward rate to be?

a) 2.00
b) 1.90
c) 2.10
d) 2.11

Answer 27

a) 2.00

F = 2 * (1 + 0.06) / (1 + 0.06)
F = 2 * 1.06 / 1.06
F = 2

Question 28

Supposed the domestic interest rate is 5%, the foreign interest rate is 7%, and the exchange rate is 2. According to the covered interest rate parity, what is the forward exchange rate?
a) 1.98
b) 1.96
c) 2.04
d) 12.244898

Answer 28

b) 1.96

F = 2 * (1 + 0.05) / (1 + 0.07)
F = 2 * 1.05 / 1.07
F ≈ 1.96

Question 29

True or false: The theory of uncovered interest rate parity provides a basic model of short-run exchange rate behavior.

Answer 29

True

Question 30

Which of the following is incorrect?

a) Exchange rates in the short run are much more variable than inflation differentials.
b) Deviations from PPP are much more apparent for monthly data than annual.
c) PPP holds best in the long run.
d) An assumption of MAER is that PPP holds.
e) none of the above

Answer 30

e) none of the above

Question 31

Suppose the nominal exchange rate is 2, the domestic price level is 4, and the foreign price level is 1. What is the real exchange rate equal to?
a) 0.75
b) 0.5
c) 4
d) 2
e) 8

Answer 31

Real exchange rate = Nominal exchange rate / (Domestic price level / Foreign price level)
In this case, the nominal exchange rate is 2, the domestic price level is 4, and the foreign price level is 1. Therefore, the real exchange rate is:

Real exchange rate = 2 / (4 / 1) = 0.5

Question 32

If the exchange rate is equal to the ratio of the domestic and foreign price indexes
a) absolute PPP holds
b) relative PPP holds
c) one currency is overvalued
d) one currency is undervalued
e) none of the above

Answer 32

a) absolute PPP holds

Question 33

True or false: The law of one price applies to non-traded goods because of arbitrage.

Answer 33

False

The law of one price states that in a perfectly competitive market, identical goods sold in different locations will sell for the same price when prices are expressed in a common currency.

However, non-traded goods cannot be transported to different locations, so they are not subject to the law of one price.