Currency Exchange Rate and International Trade and Capital Flows

CFA LEVEL 1
CURRENCY EXCHANGE RATE

[CFA LEVEL 1] CURRENCY EXCHANGE RATES
Question 1.
Spot Rate Expected Spot Rate in One Year
USD/EUR 1.3001 1.3456
USD/GBP 1.5805 1.5489
Based on the table, the appreciation of which of the following
currencies is most likely to occur?
A. The British pound against the US dollar by 2.00%
B. The US dollar against the euro by 3.38%
C. The euro against the US dollar by 3.50%
1
Answer :
C is correct.
In the exchange rate quotation, USD/EUR, the US dollar is the price currency and the
euro is the base currency. The USD/EUR is expected to increase from 1.3001 to 1.3456.
This represents a 3.5% appreciation of the euro against the dollar, i.e., a percentage
change of (1.3456/1.3001) − 1 = +3.50%.
A is incorrect because the USD/GBP is expected to decrease from 1.5805 to 1.5489. This
represents a percentage change of (1.5489/1.5805) − 1 = −2.00%. The British pound is
expected to depreciate, not appreciate, against the US dollar by 2% because the
USD/GBP exchange rate is expressed with the US dollar as the price currency.
B is incorrect because the appreciation of the euro against the US dollar can also be
expressed as a depreciation of the US dollar against the euro. Inverting the exchange
rate quote from USD/EUR to EUR/USD, so the euro is now the price currency, leads
to (1.3001/1.3456) − 1 = −3.38%. The US dollar is expected to depreciate, not
appreciate, against the euro by 3.38%.
2
Question 2.
An Australian firm purchases a patent for USD20,000 and machinery
for USD21,500 from a US firm when the exchange rates are as follows:
Exchange Rate
USD/EUR 1.29
AUD/EUR 1.24
The impact of these transactions on the capital account of Australia is
closest to:
A. AUD19,225.
B. AUD39,891.
C. AUD20,667.
3
Answer :
A is correct.
The purchase of machinery is an import and affects the current account, not the capital
account, so it is ignored. The purchase of a non-produced, non-financial asset such as a
patent affects the capital account. The impact on the capital account in AUD is:
USD20,000 ×(1EUR/1.29USD)×(AUD1.24/1EUR) = 19,225AUD
C is incorrect because it includes the machinery purchase in the capital account instead
of the patent.
USD21,500 × (1EUR/1.29USD)×(AUD1.24/1EUR) = 20,667AUD
B is incorrect because it includes both machinery and patent.
USD41,500 ×(1EUR/1.29USD) × (AUD1.24/1EUR) = 39,891AUD
4
Question 3.
A New Zealand traveler returned from Singapore with SGD7,500
(Singapore dollars). A foreign exchange dealer provided the traveler
with the following quotes:
Ratio Spot Rates
USD/SGD 1.2600
NZD/USD 0.7670
USD: US dollar; NZD: New Zealand dollar
The amount of New Zealand dollars (NZD) that the traveler would
receive for his Singapore dollars is closest to:
A. NZD7,248.
B. NZD4,565.
C. NZD7,761.
5
Answer :
A is correct.
The NZD/SGD cross-rate is NZD/USD × USD/SGD = 0.7670 × 1.2600 = 0.9664. The
traveler will receive: NZD0.9664 per SGD; NZD0.9664 × SGD7,500 = NZD7,248.
B is incorrect because it calculates NZD/SGD incorrectly by inverting USD/SGD
(0.7670 ×1/1.26 = 0.6087) and multiplying by 7,500 = 4,565 NZD.
This is equivalent to incorrectly first converting to USD (1/1.26 × 7,500 SGD) to give
5,952 USD and then converting to NZD ($5,952× 0.7670 NZD/$ = 4,565 NZD).
C is incorrect because it calculates the cross rate correctly, but divides it into 7,500:
7,500/0.9664 = 7,761.
6
Question 4.
Assume the following:
Current spot rate for the USD/EUR 0.7500
Forward rate for the EUR/AUD 1.4300
EUR/AUD forward premium to the spot rate 400 points
USD: US dollar; EUR: Euro; AUD: Australian dollar
The USD/AUD spot rate is closest to:
A. 1.0296.
B. 1.0425.
C. 1.1154.
7
Answer :
B is correct.
Step 1: Find the spot rate for the EUR/AUD
Spot = Forward Rate−Forward Points
= 1.4300−(400/10,000)
= 1.3900
Step 2: Calculate current cross rate
(USD/AUD) = (EUR/AUD)×(USD/AUD)
= 0.7500×1.39000
= 1.0425
A is incorrect because it incorrectly subtracts forward premium from 1.
(1−400/10000)×1.43 = 1.3728 1.3728×0.75
= 1.0296
C is incorrect because it incorrectly adds forward premium to 1.
(1+400/10000)×1.43 = 1.4872 1.4872×0.75 = 1.1154
8
Question 5.
The following information is available:
New Zealand dollar (NZD) to British pound (GBP) spot exchange rate:
2.0979
 Libor interest rates for the British pound: 1.6025%
 Libor interest rates for the New Zealand dollar: 3.2875%
 All Libor interest rates are quoted on a 360-day year basis
The 180-day forward points (scaled up by four decimal places) in
NZD/GBP is closest to:
A. 39.
B. 348.
C. 176.
9
Answer :
C is correct.
Covered interest arbitrage will ensure identical terminal values by investing the same
initial amounts at the respective country’s domestic interest rates:
 180 
GBP investment: £1  1  0.016025    £1.008013
 360 
NZD investment: = NZ$2.13238
 180 
NZ$2.0979   1  0.032875  
 360 
The forward rate is determined by equating these two terminal amounts:
NZD NZ$2.13238
  2.115429
GBP forward rate £1.008013
Forward points = (Forward−Spot)×10,000
= (2.1155−2.0979)×10,000
= 175.3=176 (rounded) 10
A is incorrect because it inverts the currencies.

 180 
GBP investment : £ 2.0979   1  0.0116025    £ 21147
.
 360 
 180 
NZDinvestment : NZ$1  1  0.032875    NZ$1.0164
 360 
The forward rate is determined by equating these two terminal amounts:
NZD NZ$1.0164
  0.4806
GBP forward rate £ 2.1147
1
Inverted Spot :  0.47667
2.0979
= (0.4806−0.4767)×10,000
= 39
B is incorrect because it ignores the half-year time frame of the contract:

GBP investment: 11
£1×(1+0.016025) = £1.016025
NZD investment:
NZ$2.0979×(1+0.032875) = NZ$2.16687
NZD NZ$2 ,16687
  2.1327
GBP forward rate £1.016025
= (2.1327−2.0979)×10,000
= 347.9
12
Question 6.
If the domestic currency is trading at a forward premium, then
relative to the interest rate of the domestic country, the interest rate in
the foreign country is most likely:
A. lower.
B. higher.
C. the same.
13
Answer :
B is correct.
The currency with the higher (lower) interest rate will always trade at a discount
(premium) in the forward market. The lower interest rate in the domestic country will
be offset by the appreciation of the domestic country’s currency over the investment
horizon.
A is incorrect because the forward rate is trading at a premium and not at a discount.
C is incorrect because the forward rate does not equal the spot rate.
14
Question 7.
A country having a current account deficit most likely will still be
able to consume more output than it produces by:
A. adjusting interest rates to stimulate higher domestic savings.
B. restricting foreign direct investment.
C. increasing its net foreign liabilities.
15
Answer :
C is correct.
A current account deficit must be offset by a capital account surplus. Only by
borrowing money from foreigners can a country have a current account deficit and
consume more output than it produces. An increase in net foreign liabilities is the
result of borrowing from foreigners.
B is incorrect because restricting foreign direct investment would have a negative
effect on the capital account surplus and the country’s ability to increase its
consumption.
A is incorrect because a current account deficit is consistent with low domestic
savings. For the capital account to achieve a surplus, investments should exceed
savings.
16
Question 8.
The following international trade information is available for a
hypothetical economy:
Exports Imports
Initial Value (DCU) 4,800 6,500
Demand elasticity 0.70 0.55
DCU: domestic currency units
Following a 12% depreciation in the DCU, the trade balance will be

closest to:
A. −1,726.
B. −1,648.
C. −1,674.
17
Answer :
B is correct.
Impact on trade balance:
Total Trade = Exports + Imports = 4,800 + 6,500 = 11,300
ωXωX = share of exportsshare of exports
4,80011,300=0.4254,80011,300=0.425
ωMωM =share of importsshare of imports
= 6,50011,300=0.5756,50011,300=0.575
εMLεML = Marshall − Lerner trade-weighted elasticityMarshall − Lerner trade-
weighted elasticity
= ωXεX+ωM(εM−1)ωXεX+ωM(εM−1)
= (0.425×0.70)+0.575×(0.55−1)=0.039(0.425×0.70)+0.575×(0.55−1)=0.039
Change in Trade Balance using Marshall–Lerner trade-weighted elasticity:
εML× Trade Balance × Depreciation = 0.039 × 11,300 × 0.12 = 52.5 New trade balance =
4,800 − 6,500 + 52.5 = −1,647.5 = −1,648 18
Since the Marshall–Lerner condition is greater than 0, depreciation will reduce the
trade deficit. Alternatively, the change in the trade balance can be calculated from %
changes in imports and exports:
Decrease in imports: −(12% × (1 − 0.55) × 6,500) = −351.0
Increase in exports: 12% × 0.70 × 4,800 = 403.2
Difference 52.2
Change in trade balance 4,800 − 6,500 + 52.2 = −1,648
(rounded)
A is incorrect because it applies the demand elasticities on current levels, but ignores
sign of depreciation: −26
New trade balance: −1,700 − 26 = −1,726
C is incorrect because it applies the demand elasticities on current levels and uses (−)
sign for 12%.
Change in trade balance: −12% × [(4,800 × 0.70) − (6,500 × 0.55)] = 26
New trade balance: −1,700 +26 = −1,674
19
CFA LEVEL 1
INTERNATIONAL TRADE AND CAPITAL FLOWS

[CFA LEVEL 1] INTERNATIONAL TRADE AND CAPITAL FLOWS
Question 1.
Which of the following statements is most accurate? For a country to
gain from trade, it must have:
A. economies of scale or lower labor costs.
B. an absolute advantage.
C. a comparative advantage.
20
Answer :
C is correct.
A comparative advantage arises if one entity can produce an item at a lower
opportunity cost than another. An absolute advantage in producing a good (or service)
arises if one entity can produce that good at a lower cost or use fewer resources in its
production than its trading partner. Even if a country does not have an absolute
advantage in producing any of its goods, it can still gain from trade by exporting the
goods in which it has a comparative advantage. The country with the lower
opportunity cost (with the comparative advantage) should specialize and produce its
low opportunity cost item, and the other country should produce the high opportunity
cost item, trading the goods between each other to make both better off.
A is incorrect because economies of scale or lower labor costs will likely result in a lower
cost of production, but only a comparative advantage is necessary to benefit from trade.
B is incorrect because an absolute advantage in producing a good (or service) arises if one
country is able to produce that good at a lower cost or use fewer resources in its production
than its trading partner. It is the lower opportunity cost that one country has that is the
reason that one country should specialize in order to gain from trade. 21
Question 2.
The production capabilities of two countries for computers and
phones is as follows:
Output per Worker per Year
Country Computers Phones
X 600 900
Y 400 800
Country X is best described as having a comparative advantage over
Country Y for producing:
A. computers.
B. phones.
C. phones and computers.
22
Answer :
A is correct.
A country has a comparative advantage if its opportunity cost for producing a product
is less than its trading partners: the cost of a computer in units of phones is lowest for
Country X.
Country Computers Phones Opportunity Cost of Opportunity Cost of
Computers (Phones per Phones (Computer
Computer) per Phones)
X 600 900 1.5 0.67
Y 400 800 2.0 0.5
Country X has an absolute advantage over country Y in producing both computers
and phones.
B is incorrect because country Y has the higher opportunity cost in making phones.
C is incorrect because country Y has a comparative advantage in making phones.
23
Question 3.
Consider two countries, A and B. Country A, a closed country with a
relative abundance of labor, holds a comparative advantage in the
production of textiles. Country B has a relative abundance of capital.
When the textile trade is opened between the two countries, Country
A will most likely experience a favorable impact on:
A. labor.
B. both capital and labor.
C. capital.
24
Answer :
A is correct.
As a country opens up to trade, the benefit accrues to the abundant
factor, which is labor in Country A.
B is incorrect because the favorable impact goes to the factor in relative
abundance, which includes labor and excludes capital in Country A.
C is incorrect because country B has an abundance of capital, therefore
the favorable benefit to capital lies in Country B, not in Country A.
25
Question 4.
The diagram below shows the domestic demand and supply curves for a
country that imports a commodity, where PW is its world price and PT is its
domestic price after the imposition of a tariff.
26
The gain in government revenues arising from the imposition of the tariff is
best described by area(s):
A. L.
B. J.
C. K + M.
27
Answer :
A is correct.
With the imposition of the tariff, domestic supply will increase from Q1 to Q2, but
domestic demand will fall from Q4 to Q3. The net amount imported will be Q3 − Q2.
The change in government revenues is Area L, which is the rectangle (Q3 − Q2) × (PT
− PW).
B is incorrect because it is the gain in producer surplus.
C is incorrect because it is deadweight loss.
28
Question 5.
During the last month, a food company located in the United States had the
following transactions:
Transaction Amount (US$ millions)
Bought raw material from Indonesia 50.0
Sold food products to France 65.0
Received royalty fees from its branch in the United Kingdom 0.5
Donated to a charitable institution in Africa 0.1
Borrowed from a bank in Singapore 2.0
Paid legal fees to its German legal consultant company 1.2
Received interest coupon from its investment in Eurobonds 0.8
issued in Luxembourg
These transactions will most likely increase the US current account by:
A. $15.0 million.
B. $14.5 million.
C. $17.0 million. 29
Answer :
A is correct.
Note that the borrowing from a bank in Singapore is not a current account transaction.
Transaction Current Account
(US$ millions)
Bought raw material from Indonesia −50.0
Sold food products to France 65
Received royalty fees from its branch in the United Kingdom 0.5
Donated to charitable institution in Africa −0.1
Borrowed from a bank in Singapore Omit
Paid legal fees to its German legal consultant company −1.2
Received interest coupon from its investment in Eurobonds issued 0.8
in Luxembourg
Total 15
B is incorrect because the royalty fee is not included.
C is incorrect because the bank loan is included. 30
Question 6.
A country’s international transactions accounts data for last year are presented in its
domestic currency:
Transaction Amount
Exports of goods and services 10,000
Import of goods and services 14,216
Investment income payments made to foreigners 2,519
Investment income received from foreigners 3,409
Net change in assets owned abroad 1,548
Net change in foreign-owned assets domestically 4,989
Unilateral current transfers received 346
Unilateral current transfers paid 1,107
Statistical discrepancy 646
The current account balance is closest to:
A. −4,087.
B. −4,216.
C. −4,345. 31
Answer :
A is correct.
Current Account Amounts with Signs and Grouped Appropriately:
Transaction Amount Totals
Export of goods and services and income receipts 13,409
Export of goods and services 10,000
Investment income received from foreigners 3,409
Import of goods and services and income payments −16,735
Import of goods and services −14,216
Investment income payments made to foreigners −2,519
Net unilateral current transfers −761
Unilateral current transfers received 346
Unilateral current transfers paid −1,107
Current account balance −4,087
32
C is incorrect because it mixes up the direction of flow for the income payments and
receipts and the unilateral transfers
Exports + Income payments made + Unilateral transfers paid = 10,000 + 1,107 + 2,519 +
1,107 = 13,626
Imports + Income payments received + Unilateral transfers received = 14,216 + 3,409 +
346 = 17,971
13,626 − 17,971 = −4,345
B is incorrect because it is simply Exports − Imports: 10,000 − 14,216 = −4,216
33
Question 7.
A country implements policies that are expected to increase taxes by
€100 million, increase government spending by €50 million, and
reduce investments and private sector savings by €25 million each. As
a result, the country’s current account balance is most likely to:
A. decrease by €50 million.
B. increase by €100 million.
C. increase by €50 million.
34
Answer :
C is correct.
CA = SP − I + (T − G − R)
where
CA = current account balance
Sp = private sector savings
I = investments
T = taxes
G = government spending
R = transfers
∆CA = −25 − (−25) + (100 − 50 − 0) = 50
A in incorrect because it uses the wrong sign before the parenthesis for government
sector: ∆CA = −25 − (−25) − (100 − 50 − 0) = −50.
B is incorrect because it uses the wrong sign on savings:
∆CA = 25 − (−25) + (100 − 50 − 0) = 100. 35
Question 8.
Which of the following best describes a function of the International
Bank for Reconstruction and Development?
A. Lending foreign currencies on a temporary basis to address
balance of payment issues
B. Regulating cross-border trade relationships on a global scale
C. Providing low interest rate loans to developing countries
36
Answer :
C is correct.
Closely affiliated with The World Bank Group, the International Bank
for Reconstruction and Development (IBRD) provides low or no-interest
loans and grants to developing countries that have unfavorable credit or
no access to international credit markets.
A is incorrect because this is a function of the IMF.
B is incorrect because this is a function of the World Trade Organization.
37

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Currency Exchange Rate and International Trade and Capital Flows

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CFA LEVEL 1

CURRENCY EXCHANGE RATE

A is incorrect because it inverts the currencies.

B is incorrect because it ignores the half-year time frame of the contract:

Following a 12% depreciation in the DCU, the trade balance will be

INTERNATIONAL TRADE AND CAPITAL FLOWS

B is incorrect because it is simply Exports − Imports: 10,000 − 14,216 = −4,216

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