Tutorial for CHAPTER 12
CHAPTER KEY POINTS
1. The supply of and demand for currencies in foreign exchange markets set exchange rates.
The three major force influencing exchange rates are international trade flows, capital
flows, and political flows. The concept of purchasing power parity may help explain
changes in commodity prices across the world.
2. The balance of payments can explain changes in exchange rates. If a deficit in the current
account (imports exceeding exports) is offset by the surplus in the capital account
(foreign investors buying domestic securities), then a country’s currency may not
depreciate against those of major trading partners.
3. Governments may intercede in the exchange markets or attempt to regulate private
investment and currency flows to alter domestic exchange rates.
4. Foreign exchange markets facilitate international trade. These markets represent a
network of large commercial banks trading currency around the clock. The Eurodollar
market developed, in part, because the U.S. dollar is a major trading currency that is
sometimes subjected to governmental controls. Eurodollars (and other Euro-currencies)
have grown in popularity in that they provide one way that governmental controls on
domestic currencies can be avoided. Eurodollar markets now play a major role in world
financial transactions. A combination of historical, economic, and technological factors
has contributed to the rapid internationalization of financial markets.
5. Domestic interest rates, inflation rates, and exchange rates are linked to interest rates,
inflation rates, and exchange rates of other countries through the spot and forward
exchange markets. The higher the rate of inflation in a country, the higher its short-term
interest rates are likely to be relative to foreign interest rates. However, high inflation
will also cause that country's forward exchange rates to fall below spot exchange rates
sufficiently to eliminate profits from interest rate arbitrage. Similarly, the exchange
value of the most inflationary country's currency will fall over time. The forward
exchange rates between currencies maintain interest rate parity between countries.
6. Because inflation, interest rates, and spot and forward exchange rates are linked, the
actions of other countries can have an effect on our domestic financial markets and
policies. As a result, domestic financial institutions can be affected by international
financial policies and developments.
7. Exchange rate risk is the risk that changes in exchange rates will lead to losses for
traders. It can be managed through currency forward and option contracts.
8. Commercial banks greatly facilitate international trade by providing letters of credit,
drafts, and bills of lading, among other means. They also trade currency forward
contracts, which helps manage exchange rate risk.
ANSWERS TO "DO YOU UNDERSTAND?" TEXT QUESTIONS
1. Why should purchasing power parity exist? Why might it not hold?
Answer: (a) Because of the law of one price, the same good or equivalent goods should cost the
same amount except for transportation cost differences if the goods are in different places. Thus,
exchange rates between currencies should be such that equivalent sets of goods should cost
approximately the same in different countries after converting their prices from one currency to the
other. (b) Short-term, long-term, or politically motivated capital flows can cause exchange rates to
diverge as funds flow from one country to another. Furthermore, tariffs, quotas, export and import
fees, and other non-tariff barriers may prevent goods from being transferred from one market to
another without incurring substantial costs that require that they be sold at a higher price. As a result,
prices for similar goods in different markets may never be equalized.
2. Is it always true that when a country has a deficit in its trade balance, the value of its currency will
Answer: Two types of fund flows impact foreign exchange rates: trade flows and capital flows. If,
as has been the case with the U.S. for many years, there is a deficit in the trade and current account,
foreign investors may demand the glut of dollars supplied from trade for the purchase of dollar-
denominated U.S. securities. For many years in the U.S. growing trade deficits and a strengthening
4. What types of capital flows exist between countries and what can motivate each type of flow?
Answer: Capital flows may be made in the form of direct investment (purchase of a plant), direct
financial investment (purchase of stock in a company), or from inter-governmental capital flows.
Short-term investment capital flows are usually motivated by difference in interest rates between
countries; long-term investment flows may result either from a change in perceived attractiveness of
investment in a country or from an increase in international holdings of that country’s currency.
5. Why must the balance of payments always balance?
Answer: Just as "purchase" of assets (balance sheet) must be matched by "payments" of cash or an
IOU, so the balance of payments accounts must theoretically balance.
6. What could a government do to support the value of its currency in the foreign exchange market?
Answer: It could buy its currency by selling some of its stock of reserve currencies or gold, or it
could borrow currencies from foreign countries and use the borrowed currencies to buy its domestic
currency in the exchange markets. Such interventions might only have a temporary effect, however,
unless the country addresses major problems by reducing money supply to raise interest rates to
attract foreign capital inflows and restrain domestic inflation.
7. How can a firm reduce its risk by using forward contracts?
Answer: It can reduce its risk that foreign currency values change adversely prior to making or
receiving payments in a foreign currency by entering a forward currency contract. Foreign currency
receivables can be hedged by selling the foreign currency forward, while payables are hedged by
buying the foreign currency forward. For example, a firm that expects to receive British pounds in
the future may sell the pounds forward at a prearranged exchange rate, such as $1.98 per pound, in
order to assure itself that the dollar revenues it receives will guarantee a profit on the transaction. If
the British pound were currently trading at $2.00 per pound, some might say that the firm would lose
on the forward transaction. However, the forward exchange rate will be lower than the spot rate
primarily because British interest rates are higher than domestic rates—usually because expected
inflation is greater in Britain than in the United States. If inflation is high, the pound will be losing
purchasing power over time—thus, pounds received in the future will be worth less than pounds
received now. Consequently, it is only logical that the future receipt of pounds should be worth less
than current pound holdings— and that difference is reflected in the difference between spot and
forward exchange rates.
8. When a country has high inflation, why is it risky for a foreigner to invest in that country?
Answer: Because, over time, sustained inflation will cause the value of that country’s currency to
decline. Unless it is possible to earn returns that are higher than the possible loss in value caused by
currency devaluations, investments in that country may not earn positive net returns after accounting
for currency exchange losses. Furthermore, countries that experience balance of payments problems
often impose capital controls so people cannot take their funds out of the country easily just because
they fear the currency will be devalued. Thus, it may be easier to invest in the rapidly inflating
country than to repatriate the principal invested or earnings on the investment.
9. Why might consumer groups support government policies that maintain a “strong” U.S. dollar?
Answer: A "strong" dollar buys more foreign consumer goods (clothing) and services (travel
abroad) than a "weak" dollar, but at the same time encourages the exportation of manufacturing jobs
out of the country. Those consumers that are working want a strong dollar.
10. If the United States has a high rate of inflation, what happens to the value of the dollar? Why?
Answer: A rate of inflation higher than that of trading partners should, everything else the same,
produce a glut of dollars on the forex market and the dollar should depreciate. With higher inflation,
foreign prices are cheaper, creating a trade and service deficit, and depreciating the dollar on forex
1. (a) Which of the following is not a reason that foreign exchange markets exist?
a. to provide for efficient exchange between governments.
b. to exchange purchasing power between trading partners with different local currencies.
c. to provide a means for passing the risk associated with changes in foreign exchange rates
to professional risk-takers.
d. to accommodate credit extension and delayed payments for goods and services between
2. (d) Which of the following is not a factor associated with international trade not faced by
a. One party in the trade has to be concerned about foreign exchange risk.
b. No one legal authority has control over the transaction and legal remedies.
c. Credit information on opposite parties is often incomplete.
d. There is one currency involved.
3. (b) French importers of U.S. merchandise may be involved in foreign exchange markets
a. by demanding Euros in return for U.S. dollars.
b. by supplying Euros in return for U.S. dollars.
c. by demanding Japanese yen in return for dollars.
d. by supplying U.S. dollars in return for Euros.
e. both a and d
4. (c) A Mexican importer of computer parts from Canada would take which action in the foreign
a. supply Canadian dollars
b. demand pesos
c. demand Canadian dollars
d. demand U.S. dollars
e. none of the above
5. (e) A. U.S. importer of English china would participate in which of the following foreign
a. supply U.S. Dollars
b. demand British Pounds
c. supply British Pounds
d. demand Chinese Yuan
e. both a and b
6. (a) If a Canadian dollar costs $0.84 in U.S. dollars today and traded for $0.86 last year, the U.S.
a. has appreciated against the Canadian dollar.
b. has depreciated against the Canadian dollar.
c. has more buying power in England.
d. none of the above
7. (c) When a Balance of Payments trade balance is in a surplus position,
a. another trade or service account must balance it.
b. the entire balance of payments will be in a surplus position.
c. other accounts or capital movements offset the surplus to provide a balance.
d. a shift of capital must balance the trade surplus.
8. (c) With reference to international balance of payment accounting, if a country's merchandise
imports exceed merchandise exports for a period,
a. the country has a surplus in the balance on current account.
b. the country has a deficit in the capital accounts for the period.
c. the country has a deficit in the merchandise trade account.
d. the country has a surplus in the merchandise trade account.
9. (b) Exchange rates are unlikely to change if
a. the U.S. inflation rate is twice that of other developed nations.
b. current account budget deficits/surpluses are offset by reverse capital flows.
c. the current account deficits in the U.S. are offset by capital flows much larger than the
current account deficit.
d. central banks want them stable.
10. (c) Everything else equal, significant trade deficits, imports exceeding exports, should have what
effect on a country's exchange rate?
a. Trade levels do not affect exchange rates.
b. The country's currency should appreciate in value relative to their major trading
c. The country's currency should depreciate in value relative to their major trading
d. None of the above is correct.
11. (d) The United States can import more goods that it exports without experiencing a decline in its
exchange rate if
a. foreigners are buying more long-term investments in the United States than U.S. citizens
are buying abroad.
b. foreigners wants to hold additional dollars to help them mediate their financial
c. foreign governments loan their excess dollars to the Unites States.
d. all of the above
12. (d) Exchange rates are influenced by
a. trade flows.
b. financial flows.
c. government intervention.
d. all of the above.
13. (d) A foreign exchange transaction may be motivated by
c. flight of capital.
d. all of the above
14. (d) Which of the following is not a factor that is likely to influence exchange rates?
a. trade flows of goods and services
b. financial capital flows
c. governmental intervention
d. an expansion in the number of traders of foreign exchange
15. (e) International trade flows are likely not influenced by
a. barriers to trade
b. consumer tastes
d. relative costs of factors of production
e. activity of arbitrageurs in the foreign exchange markets
16. (a) A government that wants to promote domestic exports would take which action?
a. buy assets (securities) abroad
b. sell assets (securities) abroad
c. buy dollars in foreign exchange markets
d. impose severe import restrictions
17. (b) If a government wanted to promote exports and a trade surplus, it might institute all of the
following policies except:
a. Establish import trade barriers and quotas.
b. Buy domestic currency in the foreign exchange markets.
c. Provide low cost financing for export industries.
d. Buy foreign financial assets.
18. (a) Foreign merchants often conduct transactions in U.S. dollars because
a. the dollar is a generally acceptable medium of exchange in international transactions.
b. they don't have enough money of their own.
c. interest rates on the dollar are higher than on their currency.
d. inflation is higher in the United States.
19. (b) If purchasing power parity existed in foreign exchange rates,
a. foreign exchange rates would remain constant.
b. goods and services would cost the same in terms of dollars everywhere in the world.
c. goods and services would cost the same in each local currency.
d. foreign exchange rates would be the same anywhere in the world markets.
20. (b) A major reason that exchange rates do not adjust so purchasing power parity holds precisely is
a. investors are using forward contracts when trading.
b. financial or capital flows may affect foreign exchange rates.
c. consumers and businesses of each country are not concerned about the cost of goods in
d. purchasing power parity is only a theory.
21. (a) If a country experiences inflation, generally
a. its forward exchange rate will fall relative to countries with lower inflation
b. its forward exchange rate will fall relative to countries with higher inflation
c. its exports will increase significantly.
d. its interest rates will fall.
e. the forward exchange rate will fall relative to all other countries.
22. (c) If expected inflation in the United States is below that in Britain, one would expect
a. U.S. imports from Britain to increase significantly.
b. the United States to experience balance of payments problems in the future.
c. the dollar to appreciate against the pound in the future.
d. U.S. interest rates to be above British rates.
23. (b) If the rate of inflation in the U.S. is twice the rate in Japan,
a. purchasing power parity will not be attained.
b. the yen/dollar exchange rate is likely to decrease.
c. the yen/dollar exchange rate is likely to increase.
d. the exchange rate will not change because inflation has no effect on exchange rates.
24. (d) Which of the following are largely responsible for keeping exchange rates the same in all
a. foreign exchange deals
b. forward markets
c. futures markets
e. none of the above
25. (c) The foreign exchange market
a. is an auction market with a physical exchange floor, similar to NYSE
b. has restricted trading hours
c. is composed of a group of informal markets closely interlocked through international
d. ensures that purchasing power parity holds
e. both a and b
26. (c) A U.S. commercial bank must pay 20 million Canadian dollars (C$) in 90 days. It wishes to
hedge the risk in the futures market. To do so the bank should
a. sell $20 million in Canadian dollar futures with two months maturity.
b. buy $20 million in Canadian dollar futures.
c. buy C$20 million in Canadian dollar futures.
d. sell C$20 million in Canadian dollar futures.
27. (a) The action of foreign exchange _______ tends to keep exchange rates among different
currencies consistent with each other.
28. (a) An importer who must pay yen in 60 days may hedge the foreign exchange risk
a. in the forward market.
b. in the spot market today.
c. in the spot market 60 days from now.
d. all of the above
29. (c) A payment guarantee issued by a commercial bank on behalf of an importer is a
a. sight draft.
b. time draft.
c. letter of credit.
d. documented transfer.
e. bill of lading.
30. (d) A _______ draft is paid on demand; whereas a bank would pay a _______ draft at maturity as
stated in the _______.
a. time; sight; bill of lading
b. sight; time; bill of lading
c. time; sight; letter of credit
d. sight; time; letter of credit
31. (d) Which of the following instruments are not commonly used to facilitate international
a. letters of credit
b. bills of lading
c. sight drafts
d. repurchase agreements
e. All of the above instruments are used to facilitate international transactions.
32. (c) Eurodollars are associated with
a. the use of dollar currency ($100 bills) in less-developed countries in Europe.
b. the financing of Europeans by domestic U.S. banks.
c. the holding of a dollar-denominated bank deposit outside the U. S.
d. the development of a common currency in Europe.
33. (a) Eurocurrency is
a. Any currency held in a time deposit account outside of its country of origin.
b. Any currency held in a time deposit account in Europe.
c. Any currency held in a time deposit account outside of the U.S.
d. Euros held in a time deposit account in Europe.
34. (d) Eurocurrency markets are a source of attractively priced working capital loans for
multinational firms because:
a. Lower regulatory costs allow lenders to offer lower cost loans.
b. With transactions starting at $500,000, economies of scale provide better pricing.
c. Lower credit checking costs and other processing costs lowers lending rates.
d. all of the above
1. Explain how and why the U.S. forward exchange rates are related to short-term interest rates in
the United States and Germany.
Answer: Interest rate differentials between developed countries are reflected in the forward/spot
differential, affected by covered interest arbitrage activities of investors.
2. Explain why a decline in a country's exchange rate will generally increase the demand for its
goods and reduce its demand for foreign goods.
Answer: A decline in a country’s exchange rate, the amount of a foreign currency purchased
with a unit of domestic currency, makes foreign goods more expensive to domestic customers and
a country’s exports more attractive to foreign consumers.
3. With reference to the concepts and terms related to the International Payments Flow (balance of
payments), under which conditions could a country have a sizable deficit in its trade balance and
still have an appreciating currency?
Answer: Such has been the case for the United States in the 1990s and early 2000s, which has
had an enormous trade balance deficit for years. That alone should decrease the value of the
dollar relative to trading partners, but investors’ financial flows into the U.S. financial markets
have, at times, more than offset the glut of dollars into forex markets from the trade deficit.
Always consider the possible effects on “real” as well as “financial” flows and the impact upon
4. Increased U.S. inflation, relative to other trading partner nations, should have what impact on the
value of the U.S. dollar? Explain thoroughly.
Answer: Increased U.S. inflation and higher U.S. prices relative to other trading countries should
decrease the value of the U.S. dollar as U.S. trade deficits (purchasing cheaper foreign goods)
increase. One also must consider financial flows in and out of direct and financial investment in a
country. The U.S. has had large trade deficit, but the dollar can remained strong as long as U.S.
financial markets and estimated real rates of return in the U.S. attract foreign direct and financial
5. List a number of reasons for the increased internationalization of financial markets in the last two
1) The demise of fixed exchange rates in Eastern Europe and in Asia.
2) The revitalization of Eastern Europe.
3) The extraordinary budget and trade deficits of the United States since 2001.
4) The slowdown of Japan’s growth being offset by the developing economies in Asia,
Eastern Europe and Latin America.
5) The development toward a unified European Economic Community, a common central
bank, and currency has begun to congregate a powerful economic force, especially since
6) The global trends toward financial deregulation.
7) The continuing integration of international product and service markets.
8) Improved telecommunications and computer technology leading to round the clock trading.