MULTINATIONAL FINANCE EVALUATING THE OPPORTUNITIES, COSTS, AND RISKS OF MULTINATIONAL OPERATIONS, 6TH EDITION BY KIRT C. BUTLER - Test Bank

Chapter 2 World Trade and the International Monetary System Notes to instructors: Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes. True/False 1. Markets are integrated when an asset sells for the same price wherever it is traded. True. 2. The world’s financial markets are becoming increasingly segmented as large international commercial banks achieve more and more economic power. False. They are becoming increasingly integrated (that is, less segmented). 3. Prices in the world’s financial markets are becoming increasingly segmented as local political forces work to erect trade barriers to protect their local industries. False. Although there remain local barriers, international markets for goods, services, and financial products are becoming more integrated (less segmented). 4. The international monetary system refers to the global network of governmental and commercial institutions within which currency exchange rates are determined. True. 5. The International Monetary Fund’s principal mission is to provide funds for economic development in developing economies. False. The IMF’s role is to help countries defend their currencies against temporary balance-of-payments imbalances and to promote cross-border trade. 6. The Basel Accord established the International Monetary Fund and the World Bank. False. These institutions were established by the Bretton Woods Agreement of 1946. 7. The financial account of the IMF’s Balance-of-Payments Statistics measures the total financial wealth of citizens in each reporting country. False. The financial account measures cross-border transactions associated with changes in ownership of financial assets and liabilities. 8. The trade balance of the IMF’s Balance-of-Payments Statistics is the net balance (exports minus imports) on merchandise trade. True. 9. The trade balance of the IMF’s Balance-of-Payments Statistics measures gross exports of goods and services. False. The trade balance is the net balance on merchandise trade. 10. In a fixed exchange rate system, governments stand ready to buy and sell currency at official exchange rates. True. 11. Decreases in currency values within a fixed rate system are called devaluations. True. 12. Decreases in currency values within a floating rate system are called devaluations. False. A decrease in a currency value in a floating rate system is called a depreciation. 13. Special drawing rights (SDRs) are distributed to commercial banks within the European Union (EU) in proportion to that member’s proportion of EU trade. False. SDRs are IMF bookkeeping units of account that are traded only between central banks. 14. Moral hazard is the risk that the existence of a contract will change the behaviors of parties to the contract. True. 15. IMF loans to troubled economies are unlikely to change the behaviors of investors, because investors can assess the risks of moral hazard for themselves. False. The expectation of an IMF bailout creates a moral hazard, in that it changes the expectations and hence the behaviors of lenders, borrowers, and governments. 16. A subprime CDO is a collateralized debt obligation with a yield (i.e., a market interest rate) that is below the prime lending rate. False. Subprime CDOs are poor credit risks, and carry higher interest rates than prime. 17. Liquidity refers to the ease with which an asset can be exchanged for another asset of equal value. True. Multiple Choice Select the BEST ANSWER 1. Factors contributing to market segmentation include each of the following EXCEPT ____. a. informational barriers b. regulatory and institutional interference c. the immobility of human labor d. transactions costs * e. All of the above contribute to market segmentation. 2. The ____ of the IMF’s Balance-of-Payments Statistics measures whether a particular country is a net importer or exporter of manufactured goods. a. current account b. financial account c. overall balance * d. trade balance e. none of the above 3. The ____ of the IMF’s Balance-of-Payments Statistics measures whether a particular country is a net importer or exporter of goods and services. * a. current account b. financial account c. overall balance d. trade balance e. none of the above 4. The ____ of the IMF’s Balance-of-Payments Statistics measures cross-border transactions associated with changes in ownership of financial assets and liabilities. a. current account * b. financial account c. overall balance d. trade balance e. none of the above 5. The ____ of the IMF’s Balance-of-Payments Statistics measures the sum of all private financial and economic transactions of the reporting economy with the rest of the world. a. current account b. financial account * c. overall balance d. trade balance e. none of the above 6. Which of the following is not related to changes in currency values under managed exchange rate systems? a. business cycles b. inflation differentials c. politics d. the balance of payments * e. Each of the above is related to changes in currency values in managed systems.   7. When fixed exchange rate systems collapse, government officials most frequently blame ____ for precipitating the collapse. * a. currency speculators b. foreign governments c. multinational corporations d. opposition politicians and their policies e. themselves 8. The problem with a fixed exchange rate system is that ____. a. domestic inflation is directly linked to inflation in other countries b. fixed exchange rates are hard to maintain when they diverge from market values c. labor conditions are isolated from the rest of the world d. all of the above * e. two of the above 9. The ____ established the World Bank and the International Monetary Fund in 1946. a. Basel Accord * b. Bretton Woods agreement c. Louvre Accord d. Plaza Accord e. Treaty of Maastricht 10. Which of the following currencies is currently linked to the price of gold? a. British pound b. Japanese yen c. U.S. dollar d. all of the above * e. none of the above 11. Which of the following countries is currently participating in the single-currency Eurozone? a. Denmark * b. Portugal c. Sweden d. Switzerland e. United Kingdom 12. Which of the following was least likely to have caused the Mexican peso crisis of 1995? a. a shortage of foreign currency reserves at the Mexican central bank * b. a weak economy c. an inflated value of the peso caused by pegged exchange rates d. short-term dollar borrowings by Mexican commercial banks and the government e. All of the above contributed to the crisis. 13. Which of the following was most affected by the Asian contagion of 1997? a. China * b. Korea c. Japan d. Singapore e. Taiwan 14. Which of the following was least affected by the Asian contagion of 1997? * a. China b. Korea c. Indonesia d. Thailand e. the International Monetary Fund   15. Financial aid packages provided by the IMF to countries in a currency crisis are often tied to reforms that include ____. a. a coup d’état b. changes in ruling parties * c. financial market liberalizations d. imposition of military rule to reestablish stability e. none of the above 16. Common elements in many currency crises include each of the following EXCEPT: a. a fixed exchange rate system that overvalued the local currency b. a large amount of foreign currency debt c. a precipitous drop in the value of the local currency d. IMF intervention to provide short-term assistance * e. All of the above are common during currency crises. 17. Critics of IMF lending policies during financial crises favor which of (a) through (d)? a. fiscal restraint b. immediate financial market liberalization c. monetary restraint d. temporary IMF loans * e. Critics are against each of these policies. 18. Causes of the global financial crisis of 2008 included each of the following EXCEPT ____. a. a lack of financial market liquidity b. a lack of regulatory oversight of mortgage lending c. lax credit requirements for U.S. homeowners d. subprime loans of poor credit quality * e. the divergence in economic performance between developed and emerging market economies 19. One of the first symptoms of the 2008 financial crisis was _____. a. a decrease in the default risk of collateralized debt obligations (CDOs) b. currency market volatility c. a wave of corporate bankruptcies and government bailouts d. government intervention in the currency markets * e. illiquidity in the market for collateralized debt obligations (CDOs) Chapter 4 The International Parity Conditions and Their Consequences Notes to instructors: Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes. True/False 1. The law of one price states that “Equivalent assets sell for the same price.” True. 2. Pure or riskless arbitrage is defined as a profitable position obtained with no net investment and no risk. True. 3. Speculators make their profit from situations in which they have no net investment and no risk. False. They typically have an investment at risk. 4. The actions of arbitrageurs promote the law of one price in currency markets. True. 5. Arbitrageurs pursuing covered interest arbitrage are hoping to make a profit by putting their own money at risk. False. Pure (or riskless) arbitrage involves no risk. 6. Real assets are more likely to conform to the law of one price than financial assets. False. Because market frictions are generally lower for financial assets than for real assets, financial assets are more likely to conform to the law of one price. 7. Prices in two currencies are related through the equation Vd = Vf Sd/f. True. 8. Prices in two currencies are related through the equation Vd = Vf / Sd/f. False. Prices are related through the equation Vd = Vf Sd/f or, equivalently, Vd / Vf = Sd/f. 9. Prices in two currencies are related through the equation Vd = Vf / Sf/d. True. Vd = Vf Sd/f = Vf / Sf/d. 10. Locational arbitrage ensures that bilateral exchange rates are in equilibrium. True. 11. Even if quoted exchange rates do not allow arbitrage, banks quoting the lowest offer prices in a currency will attract the bulk of customer purchases in that currency. True. 12. A bank is in a long euro and short yen position when it has purchased euros and sold yen. True. 13. A bank is in a short euro and long yen position when it has purchased euros and sold yen. False. Purchasing (selling) an asset creates a long (short) position in that asset. 14. A currency cross rate does not involve the domestic currency. True. 15. The following exchange rates are in equilibrium: SSFr/€ = SFr1.60/€, S€/¥ = €0.0125/¥, and S¥/SFr = ¥50.00/SFr. True. SSFr/€ S€/¥ S¥/SFr = (SFr1.60/€)(€0.0125/¥)(¥50/SFr) = 1. 16. The following exchange rates are in equilibrium: SSFr/€ = SFr1.7223/€, S€/¥ = €0.009711/¥, and S¥/SFr = ¥61.740/SFr. False. SSFr/€ S€/¥ S¥/SFr = 1.0326 > 1. Triangular arbitrage would yield a profit so long as transactions costs are less than about 3.26 percent. 17. Suppose SSFr/€ = SFr1.50/€ and S¥/€ = ¥135/€. The spot rate should be S¥/SFr = ¥90/SFr. True. SSFr/€ S€/¥ S¥/SFr = (SFr1.5000/€)(¥135/€)1(¥90/SFr) = 1. 18. Interest rate parity (IRP) holds within the bounds of transactions costs in the international currency and Eurocurrency markets. True. 19. Forward premiums and discounts depend on interest rate differentials. True. 20. Covered interest arbitrage ensures that the ratio of forward to spot exchange rates is determined by the inflation differential between two currencies. False. Forward/spot ratios are determined by interest rate differentials. 21. Empirical evidence indicates that forward parity holds in the international currency and Eurocurrency markets. False. Interest rate parity is the only reliable international parity condition. 22. Empirical evidence indicates that relative purchasing power parity holds in the international currency and Eurocurrency markets. False. Interest rate parity is the only reliable international parity condition. 23. Empirical evidence indicates that relative purchasing power parity can be used to successfully predict short-term changes in spot exchange rates. False. Inflation differentials are not good predictors of short-term changes in spot exchange rates. 24. The spot exchange rate between Swiss francs and dollars is S0SFr/$ = SFr1.7122/$. Expected inflation is 0 percent in Switzerland and 11 percent in the United States. Using relative purchasing power parity, the expected spot rate in one period is E[S1SFr/$] = SFr1.5425/$. True. E[S1SFr/$] = S0SFr/$(1 + E[pSFr])/(1 + E[p$]) = (SFr1.7122/$)(1.00/1.11) = SFr1.5425/$. 25. Deviations from purchasing power parity in real exchange rates can persist for several years. True. 26. Because currencies are standardized assets that are actively traded in international markets, real deviations from purchasing power parity are rare and fleeting. False. Real deviations from purchasing power parity can be large and persistent. 27. Real changes in currency values reflect changes in relative purchasing power. True. 28. Real exchange rate changes are determined by inflation differentials. False. Real changes equal nominal changes adjusted for inflation differentials. 29. Real (inflation adjusted) exchange rate changes have little economic significance. False. Real exchange rate changes reflect changes in purchasing power. 30. A real appreciation in the value of a currency increases the purchasing power of that currency relative to other currencies. True. 31. A nominal appreciation of the domestic currency raises the price of domestic goods relative to foreign goods. False. Only a real appreciation of the domestic currency raises the price of domestic goods relative to foreign goods. 32. For daily measurement intervals, both nominal and real exchange rates are close to a random walk. True. 33. A real appreciation of the domestic currency lowers the relative price of foreign goods. True. 34. An increase in the real value of foreign currencies helps the domestic economy as imported goods and raw materials cost less. False. Although an appreciation of a foreign currency may help domestic exporters, it will hurt importers and consumers as foreign goods will cost more. 35. An increase in the nominal exchange rate helps the domestic economy as imported goods and raw materials cost less. False. Changes in real exchange rates are much more important influences. 36. There is no correlation between annual changes in real exchange rates. False. Real exchange rates are autocorrelated (i.e., autoregressive). 37. Relative purchasing power parity holds over the short run. False. RPPP may hold in the long run, but generally does not hold in the short run. 38. Empirical tests indicate that persistent inflation differentials between two currencies eventually have an impact on nominal exchange rates. True. 39. Real exchange rates are nominal exchange rates minus the forward/spot premium or discount. False. Real exchange rates are nominal exchange rates adjusted for differential inflation. 40. International parity conditions are useful for predicting changes in the real exchange rate. False. The international parity conditions predict that nominal exchange rates change to accommodate inflation and interest rate differentials. Real exchange rates remain the same. 41. Empirical tests of forward parity over short forecasting periods suggest that forward exchange rates are poor predictors of future spot exchange rates. True. 42. Empirical tests of forward parity suggest that forward exchange rates improve as predictors of future spot exchange rates over long forecasting periods. True. 43. Empirical studies indicate that forward parity holds at each point in time. False. Deviations from forward parity are positively autocorrelated. At any point in time, the deviation from forward parity is likely to be of the same sign as in the previous period. 44. Technical analysis uses past price patterns to forecast exchange rates. True. 45. Technical analysts believe that the currency markets are weak form efficient. False. Weak form efficient markets have no memory. Technical analysts search for exchange rate patterns that would not be apparent in a weak form efficient market. 46. Fundamental analysis uses macroeconomic data to forecast exchange rates. True. 47. Fundamental analysts believe that the currency markets are semi-strong form efficient. False. Semi-strong form efficient markets are informationally efficient with respect to publicly available information. Fundamental analysts base their forecasts on relationships between exchange rate movements and publicly available macroeconomic data such as balance of payments statistic, inflation, and real and nominal interest rate movements. Multiple Choice Select the BEST ANSWER 1. The relation between interest rate differentials and expected inflation differentials is called ____. a. forward parity b. interest rate parity c. relative purchasing power parity * d. the international Fisher relation e. none of the above 2. The relation between expected future changes in the spot rate and expected inflation differentials is called ____. a. forward parity b. interest rate parity * c. relative purchasing power parity d. the international Fisher relation e. none of the above 3. The relation between the forward exchange rates and expected future spot rates is called ____. * a. forward parity b. interest rate parity c. relative purchasing power parity d. the international Fisher relation e. none of the above 4. The relation between the forward/spot ratio and interest rate differentials is called ____. a. forward parity * b. interest rate parity c. relative purchasing power parity d. the international Fisher relation e. none of the above 5. SUSD/ARS = $0.35/ARS and SARS/ZAR = ARS0.31/ZAR. What is SZAR/USD? a. ZAR 0.886/USD b. ZAR 1.129/USD c. ZAR 3.226/USD d. ZAR 3.459/USD * e. ZAR 9.217/USD 6. Annual interest rates are 6 percent in euros and 5 percent in dollars. The spot rate is S0$/€ = $1.20/€. What is the one-year forward exchange rate? a. $1.18/€ * b. $1.19/€ c. $1.20/€ d. $1.21/€ e. $1.22/€ 7. If annual interest rates are 10 percent in the U.S. and 4 percent in Switzerland with quarterly compounding and the 90-day forward rate for the Swiss franc is $0.3864/SFr, at what current spot rate will interest rate parity hold? a. $0.3910/SFr b. $0.3897/SFr * c. $0.3807/SFr d. $0.3762/SFr e. $0.3648/SFr 8. If the expected inflation rate is 5 percent and the real required return is 6 percent, then the Fisher equation says that the nominal interest rate should be exactly ____. a. 1.0% b. 6.0% c. 11.0% * d. 11.3% e. none of the above 9. If expected inflation is 10 percent and the real required return is 8 percent, then the Fisher equation says that the nominal interest rate should be exactly ____. a. 80.0% * b. 18.8% c. 18.0% d. 2.0% e. none of the above 10. Suppose annual inflation rates in the United States and Mexico are expected to be 6 percent and 80 percent, respectively, over the next several years. If the current spot rate for the Mexican peso is $0.005/Ps, then relative purchasing power parity suggests that the peso’s value in 3 years will be approximately ____. a. $0.01088/Ps b. $0.00346/Ps c. $0.00321/Ps * d. $0.00102/Ps e. $0.00024/Ps 11. Suppose that S0$/SFr = $1.27/SFr and F1$/SFr = $1.28/SFr for exchange between U.S. dollars and Swiss francs. These prices indicate that ____. * a. nominal interest rates are higher in the United States than in Switzerland b. the inflation rate in Switzerland is declining c. the Swiss franc has recently risen in relation to the dollar d. the Swiss franc is expected to fall in value relative to the dollar e. it is not possible to claim that any of the above are true without additional information 12. The current U.S. dollar value of the Hong Kong dollar is $0.1250/HK$. The 180-day forward rate is $0.12148/HK$. The difference between the two rates suggests that ____. a. inflation in the United States during the past year was lower than in Hong Kong b. interest rates are rising faster in Hong Kong than in the United States * c. prices in Hong Kong are expected to rise more rapidly than in the United States d. the Hong Kong dollar’s value is expected to rise against the U.S. dollar e. more than one of the above 13. Which of the following is an effect of a real appreciation of the domestic currency? a. It helps hold down domestic inflation. b. It helps domestic importers as imported goods and raw materials cost less. c. It shifts resources within the domestic economy from export-oriented firms toward import-oriented firms. * d. All of the above are effects of a real appreciation of the domestic currency. e. None of the above are effects of a real appreciation of the domestic currency. 14. A real depreciation of the domestic currency has which of the following consequences? a. a decrease in the domestic cost of living * b. higher domestic prices for imported goods c. higher domestic unemployment d. lower domestic inflation e. none of the above 15. Which of statements (a) through (c) is FALSE? a. Attempts to forecast short term changes in exchange rates generally fail to beat a naive guess of today’s spot exchange rate. * b. Long run forecasts of nominal exchange rates have difficulty beating the current spot rate as predictors of future spot rates of exchange. c. Prices in the interbank foreign exchange markets are difficult to predict. d. More than one of the above is true. e. All of the above are false. 16. Which of statements (a) through (c) is FALSE? * a. Real changes in exchange rates can be forecast by the international parity conditions. b. Real changes in exchange rates reflect changes in purchasing power. c. Real exchange rates vary over time. d. All of the above are false. e. More than one of the above is true. 17. Market-based exchange rate forecasts include which of (a) through (c)? a. forward/spot differentials b. inflation differentials c. interest rate differentials * d. more than one of the above e. none of the above 18. A technical analyst is likely to use which of the following in forecasting exchange rates? a. growth in gross national product (GNP) b. the federal government deficit * c. the past history of spot exchange rate movements d. the trade deficit e. balance of payments statistics 19. A fundamental analyst is likely to use which of the following in forecasting exchange rates? a. forward exchange rates b. inflation differentials c. nominal interest rate differentials d. real interest rate differentials * e. all of the above Problems (Some of these can be converted into Multiple Choice questions.) 1. Calculate the following cross exchange rates. a. If exchange rates are 1.2 dollars per euro and 1.5 dollars per pound, what is the euro per pound exchange rate? b. If the euro trades at ¥125/€ and HK$10/€, what is the yen per HK$ exchange rate? 2. How large would transactions costs have to be as a percentage of the principal to make triangular arbitrage between the exchange rates S$/€ = $0.9000/€, S$/¥ = $0.009000/¥, and S¥/€ = ¥101.00/€ unprofitable? 3. Given S0$/£ = $1.5000/£ and the one-year forward rate F1$/£ = $1.3500/£, what is the dollar forward premium or discount (a) in basis points and (b) as a percentage of the spot rate? Based on the unbiased forward expectations hypothesis, by how much is the dollar expected to appreciate or depreciate over the next year? Forecast the spot exchange rate one year into the future. 4. The euro is quoted at “€0.008300/¥ Bid and €0.008200/¥ Ask” in Tokyo. The yen is quoted at “¥121.20/€ Bid and ¥121.10/€ Ask” in Paris. Convert the Tokyo quote into a ¥/€ quote and then answer these questions. a. Calculate the bid/ask spread on the euro (in the denominator) as a percentage of the bid price from the Japanese and from the French perspectives. b. Is there an opportunity for profitable arbitrage? If so, describe the necessary transactions using a €1 million starting amount. 5. The real rate of interest on three-month government securities is 3 percent in both Switzerland and the United States. Inflation is 2 percent in Switzerland and 4 percent in the United States. In equilibrium, what are the nominal required returns on three-month government securities in Switzerland and in the United States? 6. The current spot exchange rate is S0$/€ = $1.10/€ and the one-year forward rate is F1$/€ = $1.11/€. The prime rate in the United States is 5 percent. a. What is the prime rate in euros if the international parity conditions hold? b. According to forward parity, by how much should the euro change in value during the next year? c. By how much should the dollar change in value during the next year? d. If this forward premium persists into the future, what should be the euro’s value in five years? 7. Price indices in the United States and the United Kingdom are currently V0$ = $2000 and V0£ = £10, respectively. The spot rate of exchange is S0£/$ = £0.80/$. Inflation rates are expected to be i$ = 2 percent and i£ = 3 percent per period, respectively, over the foreseeable future. a. Looking one year into the future, what are the expected levels of the price indices E[V1$] and E[V1£] and the expected nominal spot rate of exchange E[S1£/$]? b. Looking two years into the future, what are the expected price levels [V2$] and E[V2£] and the expected nominal spot rate of exchange E[S2£/$]? 8. A foreign exchange dealer provides the following quotes for the dollar against the Brazilian real. Bid (BR/$) Ask (BR/$) Spot 4.0040 4.0200 One month forward 3.9920 4.0090 Three months forward 3.9690 3.9888 Six months forward 3.9360 3.9580 a. Six-month Eurodollars yield 5 percent per year with semiannual compounding. What should be the annualized yield on six-month Brazilian real Eurocurrency interest rates with semiannual compounding? Use ask quotes for the U.S. dollar when calculating these rates from interest rate parity. b. Verify your answer to part a with a hypothetical investment of $10 million for six months in each country. Use only ask quotes for simplicity and ignore other fees, charges, and taxes. 9. Quotes for the dollar and euro are as follows: Spot contract midpoint S0€/$ = €0.8890/$ One-year forward contract midpoint F1€/$ = €0.8960/$ One-year Eurodollar interest rate i$ = 3% per year a. Your newspaper does not quote one-year Eurocurrency interest rates on EU euros. Make your own estimate of i€. b. Suppose that you can trade at the prices for S€/$, F€/$ and i$ just given and that you can also either borrow or lend at a Thai Eurocurrency interest rate of i€ = 4 percent per year. Based on a $1 million initial amount, how much profit can you generate through covered interest arbitrage? 10. Expected inflation over the next year is E[p] = 10 percent. What nominal interest rate i should investors charge on the following assets? a. Investors require a real rate of return of ʀ = 2 percent on a one-year corporate bond. b. Investors require a real return of ʀ = 6 percent on a portfolio of stocks. c. Investors require a real return of ʀ = 10 percent on an investment in an oil field. 11. Suppose the spot rate ends the year exactly where it began at S0¥/$ = S1¥/$ = ¥100/$. Inflation in Japan was 2 percent during the year. Inflation in the United States was 3 percent. Calculate the percentage change in the real exchange rate x¥/$. What does this change indicate? 12. Suppose the Japanese yen appreciates against the Indian rupee from R0.30/¥ to R0.33/¥ during a year. Inflation during the year is 5 percent in India and 3 percent in Japan. What is the real depreciation or appreciation of the yen during the year? Problem Solutions 1. a. S€/£ = S$/£ / S$/€ = ($1.50/£) / ($1.20/€) = €1.25/£ b. S¥/HK$ = S¥/€ / SHK$/€ = (¥125/€) / (HK$10/€) = ¥12.5/HK$. 2. S$/¥ S¥/€ S€/$ = S$/¥ S¥/€ / S$/€ = 1.01 > 1. Triangular arbitrage would yield a profit of about 1 percent of the starting amount. For triangular arbitrage to be profitable, transactions costs on a round turn cannot be more than this amount. 3. The one-year forward price is at a 15 basis point discount to the spot price. This is a discount of (F1$/£/S0$/£) – 1 = ($1.35/£)/($1.50/£) – 1 = –0.10, 10 percent. Forward parity suggests Ft$/£/S0$/£ = E[St$/£]/S0$/£, so the spot rate is expected to depreciate by 10 percent. 4. In Tokyo’s quote of “€0.008300/¥ Bid and €0.008200/¥ Ask,” the bid is higher than the ask. Consequently, the currency being quoted must be the euro in the numerator of the quotes. Converting the Tokyo quote yields a direct quote for the euro of “¥121.21/€ Bid and ¥121.36/€ Ask.” Similarly, the Paris quote of “¥121.20/€ Bid and ¥121.10/€ Ask” indicates that euros can be purchased at ¥121.10/€ and sold at ¥121.20/€. a. Percentage bid-ask spreads on the euro are as follows: Tokyo quote for the euro: (¥121.36/€ – ¥121.21/€)/(¥121.21/€) = 0.121% Paris quote for the euro: (¥121.20/€ – ¥121.10/€)/(¥121.10/€) = 0.083% b. The winning strategy is to buy euros from the Paris bank at the ¥121.20/€ euro ask price and sell euros to the Tokyo bank at the ¥121.21/€ bid price. Buying €1 million in Paris yields (€1 million)/(¥121.20/€) = €121.20 million. Selling €1 million in Tokyo yields (€1 million)/(¥121.21/€) = €121.21 million. Your arbitrage profit is €0.01 million, or €10,000. 5. According to the Fisher relation, iSFr = (1 + pSFr)(1 + qSFr) – 1 = (1.03)(1.02) – 1 = 5.06% and i$ = (1 + p$)(1 + q$) – 1 = (1.03)(1.04) – 1 = 7.12%. 6. a. From interest rate parity, ($1.11/€)/($1.10/€) = (1 + i¥)/(1.05)  i¥ = 0.05955, or 5.955%. b. The euro should appreciate by ($1.11/€)/($1.10/€) – 1 = 0.009091, or 0.9091%. c. (1/(1 – 0.009091)) – 1 = (1/(1 – 0.009091)) – 1 = 0.009174, or 0.9174%. d. E[S5$/€] = S0$/€ (F1$/€/S0$/€)5 = ($1.10/€) [($1.11/€)/($1.10/€)]5 = $1.1509/€. 7. a. E[V1$] = V0$(1 + p$) = $2000(1.02) = $2040 E[V1£] = V0£ (1 + p£) = £100(1.03) = £10.3 E[S1£/$] = S0£/$ (1 + p£) / (1 + p$) = (£0.80/$) (1.03/1.02) = £0.80784/$ b. E[V2$] = V0$(1 + p$)2 = $2000(1.02)2 = $2080.8 E[V2£] = V0£ (1 + p£)2 = £10(1.03)2 = £10.609 E[S2£/$] = S1£/$ [(1 + p£) / (1 + p$)]2 = (£0.80/$) [(1.03/1.02)]2 = £0.81576/$ 8. a. A 5 percent annualized rate with semiannual compounding is equivalent to 5%/2 = 2.5 percent per six months. From interest rate parity, the six-month real interest rate is (1 + iBR)/(1 + i$) = FBR/$/SBR/$  iBR = (1.025) [(BR3.9580/$)/(BR4.0200/$)] – 1 = 0.0091915, or 0.91915 percent per six months. Annualized, this is equivalent to (0.91915%)*2 = 1.83830 percent per year with semiannual compounding. Alternatively, the effective rate is (1.0091915)2 – 1 = 0.0184676, or 1.84676 percent per year. b. $10,000,000 invested at the six-month U.S. rate yields $10,250,000. Converting into BR at the six-month forward rate yields ($10,250,000)(BR3.9580/$) = BR40,569,500. You can finance this investment by borrowing ($10,000,000)(BR4.0200/$) = BR40,200,000. Your obligation on this contract will be (BR40,200,000)(1.0091915)  BR40,569,500, which is exactly offset by the proceeds from your forward contract. 9. a. Ft€/$/S0€/$ = (1 + i€)t/(1 + i$)t  i€ = (1.03)(€0.8890/$)/(€0.8960/$) – 1 = 3.81102% b. F1€/$/S0€/$ = (€0.896/$)/(€0.889/$) = 1.007874 < 1.009709 = (1 + i€)/(1 + i$) = (1.0381102)/(1.03). So, borrow at i$ and lend at i€. This leaves a net gain at time 1 of $1,031,875 – $1,030,000 = $1,875, which is worth $1,875/1.03 = $1,820 in present value. 10. Nominal interest rates are calculated from the Fisher equation (1 + i) = (1 + p)(1 + ʀ). a. (1 + i) = (1 + p)(1 + ʀ) = (1.10)(1.02) = 1.122, or i = 12.2 percent b. (1 + i) = (1 + p)(1 + ʀ) = (1.10)(1.06) = 1.166, or i = 16.6 percent c. (1 + i) = (1 + p)(1 + ʀ) = (1.10)(1.10) = 1.210, or i = 21 percent 11. x¥/$ = (S1¥/$/S0¥/$) (1 + i$)/(1 + i¥) 1 = [(¥100/$)/(¥100/$)](1.03/1.02) 1 = 0.0098, or a 0.98 percent real appreciation of the dollar in the denominator of the foreign exchange quote. Change in the real exchange rate indicates change in the purchasing power of the two currencies. In this example, the purchasing power of the dollar rose slightly less than 1 percent against the yen during the period. 12. xR/¥ = (S1R/¥ /S0R/¥)(1 + i¥)/(1 + iR) 1 = [(R0.33/¥)/(R0.30/¥)](1.03/1.05) 1 = 0.07905, or a 7.905 percent real yen appreciation in the denominator of the quote. Appendix 4A Continuous Time Finance Multiple Choice Select the BEST ANSWER 1. The yen rises from $0.0080/¥ to $0.0100/¥. Stated in continuously compounded returns, what percentage change is this in the value of the yen? a. –22.3% b. –20% c. + 20% * d. + 22.3% e. cannot be determine from the information given 2. The yen rises from $0.0080/¥ to $0.0100/¥. Stated in continuously compounded returns, what percentage change is this in the value of the dollar? * a. –22.3% b. –20% c. + 20% d. + 22.3% e. cannot be determine from the information given Problems (Some of these can be converted into Multiple Choice questions.) 1. Suppose the spot rate starts at S0$/¥ = $0.0100/¥ and appreciates by 25.86 percent. a. What is the percentage appreciation of the yen in continuously compounded returns? b. Calculate the holding period depreciation of the dollar from the continuously compounded appreciation of the yen. 2. Suppose continuously compounded changes in the spot rate St$/¥ are independently and identically distributed (iid) as normal. The relation between the variance 2 of continuously compounded iid normal returns over a single period (e.g., one year) and the variance of return T2 over T periods is given by T2 = T2. a. If the standard deviation of continuously compounded spot rate changes is 40 percent per year, what is the standard deviation of three-month (T = 0.25) changes in the spot rate in continuously compounded returns? If the current spot rate is $0.0100/¥, find the exchange rates that are plus or minus three standard deviations from this exchange rate after one year. b. Suppose you collect 52 weeks of spot exchange rates S$/SFr. The standard deviation of continuously compounded spot rate changes is 1.5 percent per week. b-1. Assuming instantaneous (continuously compounded) spot rate changes are normally distributed with constant variance, what is the annual standard deviation of continuously compounded spot rate changes? b-2. The current spot rate is SSFr/$ = SFr1.50/$. What spot rates are ±2 after one year? b-3. What are the prices for ±2 stated in terms of the S$/SFr spot rate? Problem Solutions 1. a. s$/¥ = ln(1 + s$/¥) = ln(1.2586) = 23.00 percent appreciation b. Continuously compounded changes in exchange rates are symmetric in that an appreciation in one currency is mirrored by a depreciation of the same magnitude in another currency. The 23 percent continuously compounded yen appreciation means that the dollar depreciated 23 percent in continuous returns. The holding period depreciation of the dollar is s$/¥ = e.23 1 = 20.55%. As a check: S1¥/$ = S0¥/$ (1 + s¥/$) = (1/$0.0100/¥) (1 .2055) = (¥100/$) (0.7945) = ¥79.45/$, which yields the 25.86 percent appreciation of the yen S1$/¥ = (S1¥/$)1 = 1/(¥79.45/$) = $0.012586/¥. 2. a. T = T() = 0.25 (0.4) = 0.20, or 20 percent per quarter. From s$/¥ = ln(1 + s$/¥)  (1 + s$/¥) = es$/¥: + 3: S1$/¥ = S0$/¥(1 + s$/¥) = S0$/¥e3 = ($0.01/¥)(e3*.40) = ($0.01/¥)(3.32) = $0.0332/¥ 3: S1$/¥ = S0$/¥(1 + s$/¥) = S0$/¥e3 = ($0.01/¥)(e3*.40) = ($0.01/¥)(0.30) = $0.0030/¥ b-1. T = T() = (52)1/2 (0.015) = 10.8167% per year b-2. Plus or minus two standard deviations in the value of the dollar (in the denominator of the exchange rate) is: + 2: S1SFr/$ = S0SFr/$(1 + SSFr/$) = S0SFr/$e2 = (SFr1.5/$)(e2*0.108167) = (SFr1.5/$)(1.2415) = SFr1.8623/$ 2: S1SFr/$ = S0SFr/$(1 + sSFr/$) = S0SFr/$e2 = (SFr1.5/$)(e2*0.108167) = (SFr1.5/$)(0.8055) = SFr1.2082/$ b3. This can be done either of two ways. First, note that an appreciation of the franc against the dollar results in a depreciation of the dollar against the franc. Taking reciprocals of the time t = 1 SFr/$ spot rates yields plus or minus two standard deviations at: + 2: 1/S1SFr/$ = S1$/SFr = 1/(SFr1.2082/$) = $0.8277/SFr 2: 1/S1SFr/$ = S1$/SFr = 1/(SFr1.8623/$) = $0.5370/SFr Taking reciprocals of the SFr/$ rates yields the spot rate S0$/SFr = 1/S0SFr/$ = $0.6667/SFr. Because changes in continuously compounded returns are symmetric, 2 in the value of the SFr are at: + 2: S1$/SFr = S0$/SFr(1 + s$/SFr) = S0$/SFr e2 = ($0.6667/SFr)(e2*0.108167) = ($.6667/SFr)(1.2415) = $0.8277/SFr 2: S1$/SFr = S0$/SFr(1 + s$/SFr) = S0$/SFr) e2 = ($0.6667/SFr)(e2*0.108167) = ($.6667/SFr)(0.8055) = $0.5370/SFr These methods are equivalent. multinational finance evaluating - test banks, multinational banks and financial stability, multinational finance, multinational financial management requires that, multinational business finance, multinational financial management 11th edition, a multinational firm can be defined as,