Global Business 4th Edition Mike Peng

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Chapter 7 Dealing with Foreign Exchange

TRUEFALSE

1. A foreign exchange rate refers to the price of buying and selling commodities for future delivery.

(A) True

(B) False

Answer : (B)

2. An appreciation is an increase in the value of the currency whereas a depreciation is a loss in the
value of the currency.

(A) True

(B) False

Answer : (A)

3. Basic economic theory suggests that the price of a commodity is most fundamentally determined
by its supply and demand.

(A) True

(B) False

Answer : (A)

4. The foreign exchange markets are influenced only by economic factors and free from the effect of
social or political pressures.

(A) True

(B) False

Answer : (B)

5. The theory of purchasing power parity suggests that in the absence of trade barriers, the price for
identical products sold in different countries will be different.

(A) True

(B) False

Answer : (B)
6. If one country's interest rate is high relative to other countries, the country will attract foreign
funds.

(A) True

(B) False

Answer : (A)

7. The rise of a country's productivity is usually accompanied by increased demand for its home
currency.

(A) True

(B) False

Answer : (A)

8. A country highly productive in manufacturing typically generates a merchandise trade deficit.

(A) True

(B) False

Answer : (B)

9. A country's current account deficit can only be financed using its savings.

(A) True

(B) False

Answer : (B)

10. Governments adopting the floating exchange rate policy tend to set the exchange rate of a
currency relative to other currencies.

(A) True

(B) False

Answer : (B)

11. Many countries with high inflation have pegged their currencies to the yuan in order to restrain
domestic inflation.

(A) True

(B) False
Answer : (B)

12. Balance of payments and exchange rate policies usually determine long-run movements of a
currency.

(A) True

(B) False

Answer : (A)

13. The effect of investors moving in the same direction at the same time leads to a bandwagon
effect.

(A) True

(B) False

Answer : (A)

14. Under the gold standard, to be able to redeem its currency in gold at a fixed price, every central
bank needed to maintain gold reserves.

(A) True

(B) False

Answer : (A)

15. The Bretton Woods system was centered on the British pound as the new common denominator.

(A) True

(B) False

Answer : (B)

16. The Bretton Woods system used the gold standard as the common denominator for all
currencies.

(A) True

(B) False

Answer : (B)

17. The Bretton Woods system had been built on the condition that the US inflation rate had to be
continuously high.
(A) True

(B) False

Answer : (B)

18. The International Monetary Fund offers free grants to countries depending on the stability and
need of the borrower.

(A) True

(B) False

Answer : (B)

19. The foreign exchange market has no central physical location and is the largest and most active
market in the world.

(A) True

(B) False

Answer : (A)

20. Forward transactions allow participants to buy and sell currencies now for future delivery.

(A) True

(B) False

Answer : (A)

21. Currency hedging is a popular way to minimize the foreign exchange risk inherent in all non-
spot transactions.

(A) True

(B) False

Answer : (A)

22. Forward discount is a condition under which the forward rate of one currency relative to
another currency is lower than the spot rate.

(A) True

(B) False

Answer : (B)
23. The primary participants of the foreign exchange market are IMF and World Bank.

(A) True

(B) False

Answer : (B)

24. Strategic hedging means spreading out activities in a number of countries in different currency
zones to offset the currency losses in certain regions through gains in other regions.

(A) True

(B) False

Answer : (A)

25. Strategic hedging focuses on using forward contracts and swaps to contain currency risks.

(A) True

(B) False

Answer : (B)

26. Proponents of fixed exchange rates argue that fixed exchange rates impose monetary discipline
by preventing governments from engaging in inflationary monetary policies.

(A) True

(B) False

Answer : (A)

27. Proponents of fixed exchange rates believe that market forces should take care of supply,
demand, and price of any currency.

(A) True

(B) False

Answer : (B)

28. A floating exchange rate allows each country to make its own monetary policy.

(A) True

(B) False
Answer : (A)

29. Floating exchange rates are less volatile than fixed rates.

(A) True

(B) False

Answer : (B)

30. The most extreme fixed rate policy is through a currency board.

(A) True

(B) False

Answer : (A)

31. In terms of international trade competitiveness, a strong dollar makes it easier for US firms to
export and to compete on price when combating imports.

(A) True

(B) False

Answer : (B)

32. A weak dollar makes it more expensive for US tourists when traveling abroad.

(A) True

(B) False

Answer : (A)

33. Majority of the largest US firms practice currency hedging.

(A) True

(B) False

Answer : (B)

34. Hedging protects firms from spot market unpredictability.

(A) True

(B) False
Answer : (A)

35. Risk analysis of any country must include its currency risks.

(A) True

(B) False

Answer : (A)

MULTICHOICE

36. A _____ is the price of one currency, such as the dollar, in terms of another, such as the euro.

(A) stock exchange index

(B) securities market rate

(C) commodities exchange rate

(D) foreign exchange rate

Answer : (D)

37. The _____ suggests the price for identical products in different countries would be the same, if
trade barriers are absent.

(A) theory of purchasing power parity

(B) fixed exchange rate policy

(C) Penn effect

(D) Bretton Woods system

Answer : (A)

38. Which of the following methods is directly derived from the theory of purchasing power parity
(PPP)?

(A) The floating exchange rate

(B) The fixed exchange rate

(C) The stock market index

(D) The Big Mac index

Answer : (D)
39. Which of the following conditions will attract foreign funds into a country?

(A) If the country has high trade deficits

(B) If the country's interest rate is relatively high compared to other countries

(C) If the country's currency is depreciated

(D) If the country is experiencing high levels of inflation

Answer : (B)

40. Which of the following will cause a country's currency to depreciate?

(A) High interest rates on the currency

(B) High inflation rates

(C) High account surplus

(D) High in-flow of foreign funds

Answer : (B)

41. Which of the following is true of quantitative easing?

(A) It depreciates the currency that is being printed.

(B) It appreciates the currency that is being printed.

(C) It increases the inflation rate in the country.

(D) It increases the exchange value of the currency.

Answer : (A)

42. _____ is a country's international transaction statement, which includes merchandise trade,
service trade, and capital movement.

(A) Capital flight

(B) Currency hedging

(C) Purchasing power parity

(D) Balance of payments

Answer : (D)

43. Which of the following characterizes a country's current account?

(A) A country's current account deficit has to be financed by both purchases and sales of assets.

(B) A country experiencing a current account deficit will see its currency appreciate.

(C) A country's current account balance consists of exports plus imports of merchandise and services
minus income on the country's assets abroad.

(D) A country experiencing a current account surplus will see its currency depreciate.

Answer : (A)

44. A clean floating exchange rate policy is a government policy to _____.

(A) set exchange rates purely on the basis of supply and demand

(B) allow a currency's value to fluctuate according to the foreign exchange rate

(C) allow selective government intervention in determining the exchange rate

(D) link the exchange rate of a currency to the gold standard

Answer : (B)

45. Which of the following types of exchange rate policies is apt for a pure free market economy?

(A) Dirty float

(B) Flexible float

(C) Clean float

(D) Target exchange rate

Answer : (C)

46. Which of the following best describes a rate where selective government intervention works
hand-in-hand, allowing markets the freedom to work themselves out?

(A) Free float rate

(B) Fixed rate

(C) Dirty float rate

(D) Target exchange rate

Answer : (C)

47. _____ have specified upper or lower bounds within which the exchange rate is allowed to
fluctuate.
(A) Fixed exchange rates

(B) Target exchange rates

(C) Free float exchange rates

(D) Dirty float exchange rates

Answer : (B)

48. The fixing of East and West Germany's currencies at a 1:1 ratio to each other during the German
unification in 1990 is an example of a _____.

(A) managed float rate policy

(B) floating rate policy

(C) target exchange rate policy

(D) fixed exchange rate policy

Answer : (D)

49. Which of the following characterizes the peg policy in foreign exchange rates?

(A) It links a developed country's currency to the gold standard.

(B) It stabilizes the import and export prices for developing countries.

(C) It is a type of floating exchange rate policy.

(D) It is primarily used by developed countries to control inflation.

Answer : (B)

50. The bandwagon effect is an example of the way _____ directly affects foreign exchange rates.

(A) exchange rate policy

(B) investor psychology

(C) purchasing power parity

(D) balance of payments

Answer : (B)

51. In foreign exchange, a(n) _____ is said to have occurred when investors move in the same
direction at the same time, like a herd.

(A) placebo effect

(B) bandwagon effect

(C) edge effect

(D) positive correlation

Answer : (B)

52. Capital flight is a phenomenon in which a large number of individuals and companies exchange
_____.

(A) domestic goods for gold

(B) gold for domestic goods

(C) foreign currency for a domestic currency

(D) domestic currency for a foreign currency

Answer : (D)

53. Between 1870 and 1914, the value of most major currencies was maintained by fixing their
prices in terms of _____.

(A) dollar

(B) yuan

(C) gold

(D) diamonds

Answer : (C)

54. Which of the following is one of the major reasons the gold standard was abandoned?

(A) The increased flow of gold from the U.S. into foreign central banks.

(B) The competitive devaluation of currencies during the Great Depression.

(C) The strengthening of the U.S. dollar due to the rise in productivity levels in the United States.

(D) The United States unilaterally announced that the dollar would not be convertible to gold.

Answer : (B)

55. Which of the following was true of the Bretton Woods system?

(A) All currencies in the system had floating exchange rates.

(B) All currencies were pegged at a fixed rate to the dollar.

(C) All currencies were maintained by fixing their prices in terms of gold.

(D) All currencies in the system were required to be gold convertible.

Answer : (B)

56. Which of the following resulted in the abandoning of the Bretton Woods system in the 1970s?

(A) The inflation rates in the United States and other developed counties were low.

(B) The United States was not running a trade deficit.

(C) The dollar became inconvertible into gold.

(D) Most countries wanted to return to the gold standard system.

Answer : (C)

57. The post-Bretton Woods system is a system of flexible exchange rate regimes with _____.

(A) the Japanese yen as its common denominator

(B) the American dollar as its common denominator

(C) gold as its common denominator

(D) no official common denominator

Answer : (D)

58. The weight a member country carries within the IMF, which determines the amount of its
financial contribution, its capacity to borrow from the IMF, and its voting power is referred to as
a(n) _____.

(A) grant

(B) accommodation

(C) quota

(D) balance of payment

Answer : (C)

59. Which of the following is the funding source for the International Monetary Fund?

(A) Member-country quota

(B) Foreign direct investment

(C) Subsidiary investing

(D) Currency trading

Answer : (A)

60. _____ allow participants to buy and sell currencies now for future delivery.

(A) Currency Swaps

(B) Direct transactions

(C) Spot transactions

(D) Forward transactions

Answer : (D)

61. Which of the following foreign exchange transactions provide protection to traders and investors
from being exposed to fluctuations of the spot rate?

(A) Spot transactions

(B) Forward transactions

(C) Direct transactions

(D) Currency swaps

Answer : (B)

62. If the forward rate of the euro per dollar is higher than the spot rate, the euro has a _____.

(A) high spread

(B) low spread

(C) forward discount

(D) forward premium

Answer : (C)

63. _____ is defined as the conversion of one currency into another at Time 1, with an agreement to
revert it back to the original currency at a specific Time 2 in the future.

(A) Currency swap

(B) Currency hedging

(C) Spot transaction

(D) Forward transaction

Answer : (A)

64. Which of the following is true of the bid rate in foreign exchange markets?

(A) It is always higher than the offer rate.

(B) It is always lower than the offer rate.

(C) It is always equal to the offer rate.

(D) It does not affect the spread of the exchange.

Answer : (B)

65. The ____ is defined as the difference between the offer price and the bid price in a foreign
exchange.

(A) cost to serve

(B) spread

(C) forward discount

(D) forward premium

Answer : (B)

66. _____ refers to non-financial companies spreading out its activities in different currency zones in
order to offset the currency losses in certain regions through gains in other regions.

(A) Currency hedging

(B) Currency pegging

(C) Strategic hedging

(D) Currency swapping

Answer : (C)

67. A currency board is a monetary authority that issues notes and coins convertible into a key
foreign currency at a _____ exchange rate.

(A) clean floating

(B) dirty floating

(C) fixed

(D) target
Answer : (C)

68. Which of the following is an advantage of a strong US dollar?

(A) US importers will find it easier to compete with low-cost imports.

(B) US exporters will find it easier to compete on price abroad.

(C) US firms will experience less competitive pressure to keep prices low.

(D) US tourists will find it more expensive when traveling abroad.

Answer : (B)

69. Which of the following is an advantage of a weak US dollar?

(A) US consumers benefit from low prices on imports.

(B) US tourists enjoy lower prices abroad.

(C) Foreign firms find it harder to acquire US targets.

(D) Foreign tourists enjoy lower prices in the US.

Answer : (D)

70. A manager arguing against currency hedging would most likely argue that _____.

(A) currency hedging eats into company profits

(B) currency hedging leaves firms at the mercy of the spot market

(C) currency hedging decreases stability of cash flows and earnings

(D) currency hedging is mainly a practice of very large MNEs

Answer : (A)

ESSAY

71. List the five underlying building blocks that determine the supply and demand of foreign
exchange.

Graders Info :

The five underlying building blocks in foreign exchange are (1) relative price differences, (2) interest
rates and monetary supply, (3) productivity and balance of payments, (4) exchange rate policies, and
(5) investor psychology.

72. Identify the difference between fixed and floating exchange rates. Provide an example of a
situation where the fixed and floating exchange rates were used.

Graders Info :

There are two major exchange rate policies: (1) floating rate and (2) fixed rate. Governments
adopting the floating (or flexible) exchange rate policy tend to be free market believers, willing to let
the demand-and-supply conditions determine exchange rates-usually on a daily basis via the foreign
exchange market. Another major exchange rate policy is the fixed exchange rate policy-countries fix
the exchange rate of their currencies relative to other currencies. Both political and economic
rationales may be at play. During the German reunification in 1990, the West German government,
for political considerations, fixed the exchange rate between West and East German mark as 1:1.
Economically, the East German mark was not worth that much. Politically, this exchange rate
reduced the feeling of alienation and resentment among East Germans, thus facilitating a smoother
unification process.

73. Describe what it means for a country to peg its currency to another, and give two benefits to
adopting this policy.

Graders Info :

Pegging is a stabilizing policy of linking a developing country's currency to a key currency. When a
country pegs its currency to another, the value of the currency strengthens or weakens according to
the currency it is pegged to. Most countries that choose to peg their currency choose the US dollar.
A country that pegs its currency takes advantage of two benefits. First, a peg stabilizes the import
and export prices for developing countries. Second, many countries with high inflation have pegged
their currencies to the US dollar to restrain domestic inflation (given the fact that the US has
relatively low inflation).

74. Briefly explain the cause for the fall of the Bretton Woods System.

Graders Info :

​ By the late 1960s and early 1970s, a combination of rising productivity elsewhere and US
inflationary policies led to the demise of the Bretton Woods system. First, (West) Germany and other
countries caught up in productivity and exported more, and the United States ran its first post-1945
trade deficit in 1971. Second, in the 1960s, in order to finance both the Vietnam War and Great
Society welfare programs, President Lyndon Johnson increased government spending, not by
additional taxation, but by increasing money supply. These actions led to rising inflation levels and
strong pressures for the dollar to depreciate. The Bretton Woods system also became a pain in the
neck for the United States, because the exchange rate of the dollar was not allowed to unilaterally
change. Consequently, there was a hemorrhage of US gold flowing into the coffers of foreign central
banks. In August 1971, in order to stop such hemorrhage, President Richard Nixon unilaterally
announced that the dollar was no longer convertible into gold. In retrospect, the Bretton Woods
system had been built on two conditions: (1) the US inflation rate had to be low and (2) the US could
not run a trade deficit. When both these conditions were violated, the demise of the system was
inevitable.
​

75. Explain, with the help of examples, the three primary types of foreign exchange transactions.

Graders Info :

There are three primary types of foreign exchange transactions: (1) spot transactions, (2) forward
transactions, and (3) swaps. Spot transactions are the classic single-shot exchange of one currency
for another. For example, Canadian tourists buying several thousand euros in Italy with Canadian
dollars will get their euros from a bank right away. Forward transactions allow participants to buy
and sell currencies now for future delivery, typically in 30, 90, or 180 days, after the date of the
transaction. The primary benefit of forward transactions is to protect traders and investors from
being exposed to the fluctuations of the spot rate, an act known as currency hedging. Currency
hedging is a way to minimize the foreign exchange risk inherent in all non-spot transactions, which
characterize most trade and FDI deals. Traders and investors expecting to make or receive payments
in a foreign currency in the future are concerned whether they will have to make a greater payment
or receive less in terms of the domestic currency, should the spot rate changes. For example, if the
forward rate of the euro (€/US$) is exactly the same as the spot rate, the euro is "flat." If the forward
rate of the euro per dollar is higher than the spot rate, the euro has a forward discount.
A third major type of foreign exchange transactions is swap. A currency swap is the conversion of
one currency into another in Time 1, with an agreement to revert it back to the original currency at
a specific Time 2 in the future. Deutsche Bank may have an excess balance of British pounds but
need dollars. At the same time, Union Bank of Switzerland (UBS) may have more dollars than it
needs at the moment but is looking for more British pounds. They can negotiate a swap agreement
in which Deutsche Bank agrees to exchange with UBS pounds for dollars today and dollars for
pounds at a specific point in the future.

76. Compare and contrast the three primary strategies companies use to cope with currency risks.

Graders Info :

There are three primary strategies: (1) invoicing in their own currencies, (2) currency hedging (as
discussed earlier), and (3) strategic hedging. The most basic way is to invoice customers in your own
currency. By invoicing in dollars, many US firms have enjoyed such protection from unfavorable
foreign exchange movements. Currency hedging is risky in case of wrong bets of currency
movements. Strategic hedging means spreading out activities in different currency zones in order to
offset the currency losses in certain regions through gains in other regions. Therefore, strategic
hedging can be considered as currency diversification. It reduces exposure to unfavorable foreign
exchange movements. Strategic hedging is conceptually different from currency hedging. Currency
hedging focuses on using forward contracts and swaps to contain currency risks, a financial
management activity that can be performed by in-house financial specialists or outside experts (such
as currency traders). Strategic hedging refers to geographically dispersing operations-through
sourcing or FDI-in multiple currency zones. By definition, this is more strategic, involving managers
from many functional areas (such as production, marketing, and sourcing) in addition to those from
finance.

77. Compare and contrast the advantages and disadvantages of a strong and a weak dollar.

Graders Info :

A strong (appreciating) dollar:

Advantages:
• US consumers benefit from low prices on imports.
• Lower prices on foreign goods help keep US price level and inflation level low.
• US tourists enjoy lower prices abroad.
• US firms find it easier to acquire foreign targets.

Disadvantages:
• US exporters have a hard time to compete on price abroad.
• US firms in import-competing industries have a hard time competing with low-cost imports.
• Foreign tourists find it more expensive when visiting the US.

A weak (depreciating) dollar:

Advantages:
• US exporters find it easier to compete on price abroad.
• US firms face less competitive pressure to keep prices low.
• Foreign tourists enjoy lower prices in the US.
• Foreign firms find it easier to acquire US targets.
• The US can print more dollars to export its problems to the rest of the world.

Disadvantages:
• US consumers face higher prices on imports.
• Higher prices on imports contribute to higher price level and inflation level in the US.
• US tourists find it more expensive when traveling abroad.
• Governments, firms, and individuals outside the US holding dollar-denominated assets suffer from
value loss of their assets.

78. What determines the success and failure of currency management around the globe?

Graders Info :

From an institution-based standpoint, the "rules of the game"-economic, political, and psychological-
enable or constrain firms. From a resource-based perspective, how firms develop valuable, unique,
and hard-to-imitate capabilities in currency management may make or break them. As a result, three
implications for action emerge. First, foreign exchange literacy must be fostered. Savvy managers
need to not only pay attention to the broad long-run movements informed by PPP, productivity
changes, and balance of payments, but also to the fickle short-run fluctuations triggered by interest
rate changes and investor mood swings. Second, risk analysis of any country must include its
currency risks. Finally, a country's high currency risks do not necessarily suggest that this country
needs to be totally avoided. Instead, they call for a prudent currency risk management strategy-via
currency hedging, strategic hedging, or both.