international finance

final revision
1. During the year, Japan had a current-account surplus of $98 billion and a financial-
account deficit of $67 billion.

a. What is the gap between Japan's national expenditure and its national income?

ANSWER. The current-account balance equals the difference between national income and
national expenditure. In Japan's case, this identity means the income-expenditure gap is $98
billion; that is, Japan's national income exceeds its spending by the equivalent of $98 billion.

b. What is the gap between Japan's savings and its domestic investment?

ANSWER. Since national savings- domestic investment equals national income - national
expenditure, the answer here is the same as the answer to part b.

c. What was Japan's net foreign investment for the year?

ANSWER. Japan's net foreign investment equals national savings minus domestic investment, or
$98 billion.

d. Suppose the Japanese government's budget ran a $22 billion surplus during the year. What
can you conclude about Japan's private savings-investment balance for the year?

ANSWER. The sum of the private savings-investment balance and the public sector surplus or
deficit must equal the national savings-investment balance. With a government surplus of $22
billion and an overall savings-investment balance of $98 billion, the private sector savings-
investment balance must equal $76 billion.

MCQ
1. In a freely floating exchange rate system, if the current account is running a deficit
a. the balance of payments must run a deficit
b. the balance of payments must be zero
c. the capital account must run a surplus
d. b and c above
2. A nation that is running a savings deficit
a. must spend more than it produces
b. will invest domestically more than it saves
c. must have a net capital outflow
d. a and b only
3. Intracompany trade represents the exporting of products by one country to other countries below
cost.
A) true.
B) false.
 4. The J curve effect is the initial worsening of the U.S. trade balance due to a weakening dollar
because of established trade relationships that are not easily changed; as the dollar weakens, the
dollar value of imports initially rises before the U.S. trade balance is improved.
A) true.
B) false.
5. A balance-of-trade surplus indicates an excess of merchandise imports over merchandise exports.
A) true.
B) False.
6. A weakening of the U.S. dollar with respect to the British pound would likely reduce the U.S. exports
to Britain and increase U.S. imports from Britain.
A) true.
B) false.
7. If the home currency begins to appreciate against other currencies, this should ____________ the
current account balance, other things equal (assume that substitutes are readily available in the
countries, and that the prices charged by firms remain the same).
A) increase
B) have no impact on
C) reduce
D) all of the above are equally possible
8. Which of the following would likely have the least direct influence on a country’s current account?
A) inflation.
B) national income.
C) exchange rates.
D) tariffs.
E) a tax on income earned from foreign stocks.
9. The “J curve” effect describes:
A) the continuous long-term inverse relationship between a country’s current account
balance and the country’s growth in gross national product.
B) the short-run tendency for a country’s balance of trade to deteriorate even while its
currency is depreciating.
C) the tendency for exporters to initially reduce the price of goods when their own currency
appreciates.
D) the reaction of a country’s currency to initially depreciate after the country’s inflation rate
declines.
10. In order to reduce its current-account deficit, the United States must do which of the following?
a. reduce the federal budget deficit
b. lower national product relative to national spending
c. reduce savings relative to domestic investment
d. reduce the federal budget surplus
11. Assume that the interest rate in the home country of Currency X is a much higher interest rate than
the U.S. interest rate. According to interest rate parity, the forward rate of Currency X:
A) should exhibit a discount.
B) should exhibit a premium.
C) should be zero (i.e., it should equal its spot rate).
D) B or C
 12. If the interest rate is higher in the U.S. than in the United Kingdom, and if the forward rate of the
British pound (in U.S. dollars) is the same as the pound’s spot rate, then:
A) U.S. investors could possibly benefit from covered interest arbitrage.
B) British investors could possibly benefit from covered interest arbitrage.
C) neither U.S. nor British investors could benefit from covered interest arbitrage.
D) A and B
13. If the interest rate is lower in the U.S. than in the United Kingdom, and if the forward rate of the
British pound is the same as its spot rate:
A) U.S. investors could possibly benefit from covered interest arbitrage.
B) British investors could possibly benefit from covered interest arbitrage.
C) neither U.S. nor British investors could benefit from covered interest arbitrage.
D) A and B
14. Assume the bid rate of a New Zealand dollar is $.33 while the ask rate is $.335 at Bank X. Assume
the bid rate of the New Zealand dollar is $.32 while the ask rate is $.325 at Bank Y. Given this
information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That
is, how much will you end up with over and above the $1,000,000 you started with?
A) $15,385.
B) $15,625.
C) $22,136.
D) $31,250.
15. Assume the following information:

You have $1,000,000 to invest

Current spot rate of pound = $1.30
90-day forward rate of pound = $1.28
3-month deposit rate in U.S. = 3%
3-month deposit rate in Great Britain = 4%

If you use covered interest arbitrage for a 90-day investment, what will be the amount of U.S. dollars
you will have after 90 days?
A) $1,024,000.
B) $1,030,000.
C) $1,040,000.
D) $1,034,000.
16. Assume the following information: exam

Current spot rate of New Zealand dollar = $.41

Forecasted spot rate of New Zealand dollar 1 year from now = $.43
One-year forward rate of the New Zealand dollar = $.42
Annual interest rate on New Zealand dollars = 8%
Annual interest rate on U.S. dollars = 9%

Given the information in this question, the return from covered interest arbitrage by U.S.
investors with $500,000 to invest is _______%.
A) about 11.97
B) about 9.63
 C) about 11.12
D) about 11.64
E) about 10.63

17. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask
Bank A $1.41 $1.42
Bank B $1.39 $1.40

As locational arbitrage occurs:

A) the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will
increase.
B) the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will
decrease.
C) the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will
decrease.
D) the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will
increase.
18. Assume the bid rate of a Singapore dollar is $.40 while the ask rate is $.41 at Bank X. Assume the
bid rate of a Singapore dollar is $.42 while the ask rate is $.425 at Bank Z. Given this information,
what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much
will you end up with over and above the $1,000,000 you started with?
A) $11,764.
B) -$11,964.
C) $36,585.
D) $24,390.
19. Assume the following exchange rates: $1 = NZ$3, NZ$1 = MXP2, and $1 = MXP5. Given this
information, as you and others perform triangular arbitrage, the exchange rate of the New Zealand
dollar (NZ) with respect to the U.S. dollar should _______, and the exchange rate of the Mexican
peso (MXP) with respect to the U.S. dollar should _______.
A) appreciate; depreciate
B) depreciate; appreciate
C) depreciate; depreciate
D) appreciate; appreciate
E) remain stable; appreciate
20. According to interest rate parity (IRP):
A) the forward rate differs from the spot rate by a sufficient amount to offset the inflation
differential between two currencies.
B) the future spot rate differs from the current spot rate by a sufficient amount to offset the
interest rate differential between two currencies.
C) the future spot rate differs from the current spot rate by a sufficient amount to offset the
inflation differential between two currencies.
D) the forward rate differs from the spot rate by a sufficient amount to offset the interest rate
differential between two currencies.
 21. Assume the British pound is worth $1.60, and the Canadian dollar is worth $.80. What is the value of
the Canadian dollar in pounds?
A) 2.0.
B) 2.40.
C) .80.
D) .50.
22. Assume that interest rate parity holds. The Mexican interest rate is 50%, and the U.S. interest rate is
8%. Subsequently, the U.S. interest rate decreases to 7%. According to interest rate parity, the peso’s
forward ___________ will __________.
A) premium; increase
B) discount; decrease
C) discount; increase
D) premium; decrease
23. Assume that interest rate parity holds, and the euro’s interest rate is 9% while the U.S. interest rate is
12%. Then the euro’s interest rate increases to 11% while the U.S. interest rate remains the same. As
a result of the increase in the interest rate on euros, the euro’s forward _______ will _______ in order
to maintain interest rate parity.
A) discount; increase
B) discount; decrease
C) premium; increase
D) premium; decrease
24. Assume the following information:

You have $300,000 to invest

The spot bid rate for the euro (€) is $1.08
The spot ask quote for the euro is $1.10
The 180-day forward rate (bid) of the euro is $1.08
The 180-day forward rate (ask) of the euro is $1.10
The 180-day interest rate in the U.S. is 6%
The 180-day interest rate in Europe is 8%

If you conduct covered interest arbitrage, what amount will you have after 180 days?

A) $318,109.10.
B) $330,000.00.
C) $312,218.20.
D) $323,888.90.
25. National Bank quotes the following for the British pound and the New Zealand dollar:

Quoted Bid Price Quoted Ask Price

Value of a British pound (£) in $ $1.61 $1.62
Value of a New Zealand dollar (NZ$) in $ $.55 $.56
Value of a British pound in
New Zealand dollars NZ$2.95 NZ$2.96
 Assume you have $10,000 to conduct triangular arbitrage. What is your profit from
implementing this strategy?
A) $77.64.
B) $197.53.
C) $15.43.
D) $111.80.
26. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask
Bank C $1.61 $1.63
Bank D $1.58 $1.60

As locational arbitrage occurs:

A) the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will
increase.
B) the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will
decrease.
C) the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will
decrease.
D) the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will
increase.

27. AS of today, you have the following information: use the differential expected inflation to
forecast the % change in Mexican peso next year.
US $ MEXICAN PESO
Real interest rate required by the investors 2% 2%
Nominal interest rate 11% 15%
Spot rate $20
One year-forward rate $0.19
Solution
Inflation = nominal – real
For USA= 9% for MEXICO=13%
Expected change in Mexican peso exchange rate =(1.09/1.13)-1= -3.5%
28. Between 1982 and 1995, the ¥/$ exchange rate moved from ¥249.05/$ to ¥116.34. During this
same 25-year period, the consumer price index (CPI) in Japan rose from 80.75 to 97.72 and the
U.S. CPI rose from 56.06 to 117.07.
a. If PPP had held over this period, what would the ¥/$ exchange rate have been in 1995?
Solution
the ¥/$ exchange rate should have been ¥144.32/$:
¥/$ PPP rate = 249.05 × (97.72/80.75)
(117.07/56.06) = ¥144.32/$
Comparing the PPP rate of ¥144.32/$ to the actual rate of ¥116.34/$, we can see that the yen has
appreciated more than PPP would suggest.
29. The current Euro interest rate is 6% per year. The yen interest rate is 8.5%. What is the implied
forward premium or discount of the Japanese yen (for a five-year forward contract? (1 point)
(1.06)5 / (1.085)5 – 1 = –11%
30. Suppose that the one-year interest rate is 5.0% in the United States and 3.5% in Germany, and that
the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. Can you find
an arbitrage opportunity? Why? (yes

31. Assume that the U.S. investors are benefiting from covered interest arbitrage due to high interest
rates on euros. Which of the following forces should result from the act of this covered interest
arbitrage?
a) downward pressure on the euro's spot rate.
b) downward pressure on the euro's forward rate.
c) downward pressure on the U.S. interest rate.
d) upward pressure on the euro's interest rate.

32. Assume the following information:

U.S. investors have $1,000,000 to invest:

1-year deposit rate offered on U.S. dollars = 12%
1-year deposit rate offered on Singapore dollars = 10%
1-year forward rate of Singapore dollars = $.412
Spot rate of Singapore dollar = $.400

Given this information:

a) interest rate parity exists and covered interest arbitrage by U.S. investors results in the
same yield as investing domestically.
b) interest rate parity doesn't exist and covered interest arbitrage by U.S. investors
results in a yield above what is possible domestically.
c) interest rate parity exists and covered interest arbitrage by U.S. investors results in a
yield above what is possible domestically.
d) interest rate parity doesn't exist and covered interest arbitrage by U.S. investors
results in a yield below what is possible domestically.
SOLUTION: $1,000,000/$.400 = S$2,500,000  (1.1)
= S$2,750,000  $.412 = $1,133,000
Yield = ($1,133,000  $1,000,000)/$1,000,000 = 13.3%
This yield exceeds what is possible domestically.

33. A currency is said to be at a forward _________ if the forward rate is below the spot rate.
a. discount
b. premium
c. position
d. forward

34. The Fisher effect states that the _________ rate is made up of a real required rate of return and an
inflation premium.
a. nominal exchange
b. real exchange
c. nominal interest rate
 d. adjusted dividend
35. Suppose annual inflation rates in the U.S. and Mexico are expected to be 6% and 80%, respectively,
over the next several years. If the current spot rate for the Mexican peso is $.005, then the best
estimate of the peso's spot value in 3 years is
a. $.00276
b. $.01190
c. $.00321
d. $.00102

36. If inflation in the U.S. is projected at 5% annually for the next 5 years and at 12% annually in Italy
for the same time period, and the lira/$ spot rate is currently at L2400 = $1, then the PPP estimate
of the spot rate for dollar five years from now is
a. 1738
b. 3314
c. 2560
d. 2250

37. If a country's freely floating currency is undervalued in terms of purchasing power parity, its capital
account is likely to be
a. in deficit or tending toward a deficit
b. in surplus or tending toward a surplus
c. Subsidized by the International Monetary Fund
d. a candidate for loans from the World Bank
38. Annual inflation rates in the U.S. and Italy are expected to be 4% and 7%, respectively. If the
current spot rate is $1 = L2,000, then the expected spot rate for the lira in three years is
a. $.0004591
b. $.0011590
c. $.0009892
d. $.0005471

39. Suppose five-year deposit rates on Eurodollars and Euromarks are 12% and 8%, respectively. If
the current spot rate for the mark is $0.50, then the spot rate for the mark five years from now
implied by these interest rates is
a. .5997
b. .4169
c. .5185
d. .4821
40. The spot rate on the Dutch guilder is $0.39 and the 180-day forward rate is $0.40. The difference
between the spot and forward rates means that
a. interest rates are higher in the U.S. than in the Netherlands
b. the guilder has risen in relation to the dollar
c. the inflation rate in the Netherlands is declining
d. the guilder is expected to fall in value relative to the dollar
there is a high inflation rate in the U.S.
41. The current five-year Euroyen rate is 6% per annum (compounded annually). The five-year
Eurodollar rate is 8.5%. What is the implied forward premium or discount of the yen (over the
current spot rate) for a five-year forward contract?
a. 4.17% premium
b. 18.46% discount
c. 11.00% discount
d. 12.36% premium
42. If annualized interest rates in the U.S. and France are 9% and 13%, respectively, and the spot
value of the franc is $.1109, then at what 180-day forward rate will interest rate parity hold?
a. $.1070
b. $.1150
c. $.1088
d. $.1130
43. The 90-day interest rates (annualized) in the U.S. and Japan are, respectively, 10% and 7%,
while the direct spot quote for the yen in New York is $.004300. At what 90-day forward rate
would interest rate parity hold?
a. .004430
b. .004271
c. .004332
d. .004176
44. Suppose inflation rates in the U.S. and France are expected to be 4% and 9%, respectively, next year
and 6% and 7%, respectively, in the following year. If the current spot rate is $.1050, then the
expected spot value of the franc in two years is
a. $.1111
b. $.1024
c. $.0992
d. $.1074