CHAPTER 3 : EXCHANGE RATES AND THE FOREIGN EXCHANGE MARKET: AN ASSET

APPROACH
1. How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing
50 British pounds if the exchange rate is 1.25 dollars per one British pound?
A. 50 dollars
B. 60 dollars
C. 70 dollars
D. 62.5 dollars
E. 40 British pounds
Answer: D
2. How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing
50 British pounds if the exchange rate is 1.50 dollars per one British pound?
A. 50 dollars
B. 60 dollars
C. 70 dollars
D. 80 dollars
E. 75 dollars
Answer: E
9. What is the exchange rate between the dollar and the British pound if a pair
of American jeans costs 50 dollars in New York and 100 pounds in London?
A. 1.5 dollars per British pound
B. 0.5 dollars per British pound
C. 2.5 dollars per British pound
D. 3.5 dollars per British pound
E. 2 dollars per British pound
Answer: B
10. What is the exchange rate between the dollar and the British pound if a pair
of American jeans costs 60 dollars in New York and 30 pounds in London?
A. 1.5 dollars per British pound
B. 0.5 dollars per British pound
C. 2.5 dollars per British pound
D. 3.5 dollars per British pound
E. 2 dollars per British pound
Answer: E
11. When a country’s currency depreciates,
A. foreigners find that its exports are more expensive, and domestic residents
find that imports from abroad are more expensive.
B. foreigners find that its exports are more expensive, and domestic residents find
that imports from abroad are cheaper.
C. foreigners find that its exports are cheaper; however, domestic residents are
not affected.
D. foreigners are not affected, but domestic residents find that imports from
abroad are more expensive.
E. None of the above.
Answer: E
12. An appreciation of a country’s currency
A. decreases the relative price of its exports and lowers the relative price of
its imports.
B. raises the relative price of its exports and raises the relative price of its imports.
C. lowers the relative price of its exports and raises the relative price of its imports.
D. raises the relative price of its exports and lowers the relative price of its imports.
E. None of the above.
Answer: D
13. Which one of the following statements is the most accurate?
A. A depreciation of a country’s currency makes its goods cheaper for foreigners.
B. A depreciation of a country’s currency makes its goods more expensive for foreigners.
C. A depreciation of a country’s currency makes its goods cheaper for its own residents.
D. A depreciation of a country’s currency makes its goods cheaper.
E. None of the above.
Answer: A
17. Which one of the following statements is the most accurate? The term spot
exchange rate is
A. misleading because even spot exchanges usually become effective only
three days after a deal is struck.
B. misleading because even spot exchanges usually become effective only four
days after a deal is struck.
C. misleading because even spot exchanges usually become effective only
five days after a deal is struck.
D. misleading because even spot exchanges usually become effective only six
days after a deal is struck.
E. misleading because even spot exchanges usually become effective only
two days after a deal is struck.
Answer: E
18. Which one of the following statements is the most accurate? Trades of U.S.
dollars for Canadian dollars in New York are executed with
A. a one-day lag.
B. a two-day lag.
C. a three-day lag.
D. a four-day lag.
E. a zero-day lag.
Answer: A
19. Forward and spot exchange rates
A. are necessarily equal
B. do not move closely together
C. The forward exchange rate is always above the spot exchange rate.
D. while not necessarily equal, do move closely together.
E. None of the above.
Answer: D
20. A foreign exchange swap
A. is a spot sale of a currency.
B. is a forward repurchase of the currency.
C. is a spot sale of a currency combined with a forward repurchase of
the currency.
D. is a spot sale of a currency combined with a forward sale of the currency.
E. None of the above.
Answer: C

21. An American put option on foreign exchange

A. gives the buyer the right to sell the foreign currency at a known exchange rate atany time during
the period of the option.
B. gives the seller the right to sell the foreign currency at a known exchange rate atany time during
the period of the option.
C. gives the buyer the right to sell the foreign currency at a known exchange rate at aspecific time in
the future.
D. obligates the buyer to sell the foreign currency at a known exchange rate at anytime during the period of
the option.
E. None of the above.
Answer: A
22. An American call option on foreign exchange
A. obligates you to buy foreign currency at a known price at any time during theperiod of the option.
B. gives you the right to buy foreign currency at a known price at any timeduring the period of the option.
C. gives you the right to buy foreign currency at a known price at a specific dayin the future.
D. gives you the right to sell foreign currency at a known price at any time duringthe period of the option.
E. None of the above.
Answer: B
23. The exchange rate between currencies depends on
A. the interest rate that can be earned on deposits of those currencies.
B. the expected future exchange rate.
C. the interest rate that can be earned on deposits of those currencies and the
expected future exchange rate.
D. national output.
E. None of the above.
Answer: B
25. Which one of the following statements is the most accurate?
A. Because dollar and DM interest rates are measured in comparable terms, they
can move quite differently over time.
B. Because dollar and DM interest rates are not measured in comparable
terms, they can move quite differently over time.
C. Because dollar and DM interest rates are measured in comparable terms, they
move quite the same over time.
D. Because dollar and DM interest rates are measured in comparable terms, they
still move quite differently over time.
E. None of the abovE

29. Which one of the following statements is the most accurate?

A. The dollar rate of return on euro deposits is the euro interest rate plus the rate
of depreciation of the dollar against the euro.
B. The dollar rate of return on euro deposits is approximately the euro interest
rate minus the rate of depreciation of the dollar against the euro.
C. The dollar rate of return on euro deposits is the euro interest rate minus the
rate of depreciation of the dollar against the euro.
D. The dollar rate of return on euro deposits is approximately the euro interest
rate plus the rate of appreciation of the dollar against the euro.
E. The dollar rate of return on euro deposits is approximately the euro
interest rate plus the rate of depreciation of the dollar against the euro.
Answer: E
30. If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. it is impossible to tell given the information.
E. All of the above.
Answer: D
31. If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and
the expected return on dollar depreciation against the euro is zero percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: A
32. If the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and
the expected return on dollar depreciation against the euro is 4 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: C

33. If the dollar interest rate is 10 percent and the euro interest rate is 6 percent, and
the expected return on dollar depreciation against the euro is 8 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: B
34. If the dollar interest rate is 10 percent, the euro interest rate is 12 percent, and the
expected return on dollar depreciation against the euro is negative 4 percent, then
A. an investor should invest only in dollars.
B. an investor should invest only in euros.
C. an investor should be indifferent between dollars and euros.
D. It is impossible to tell given the information.
E. All of the above.
Answer: A
35. Which of the following statements is the most accurate?
A. A rise in the interest rate offered by dollar deposits causes the dollar to appreciate.
B. A rise in the interest rate offered by dollar deposits causes the dollar to depreciate.
C. A rise in the interest rate offered by dollar deposits does not affect the U.S. dollar.
D. For a given euro interest rate and constant expected exchange rate, a rise in the interest rate offered
by dollar deposits causes the dollar to appreciate.
E. None of the above.
Answer: D
36. Which of the following statements is the most accurate?
A. For a given U.S. interest rate and a given expectation with regard to the
future exchange rate, a rise in the interest rate paid by euro deposits causes the
dollar
to depreciate.
B. For a given U.S. interest rate and a given expectation with regard to the future exchange rate, a rise
in the interest rate paid by euro deposits causes the dollar to appreciate.
C. A rise in the interest rate paid by euro deposits does not affect the value of the dollar.
D. A rise in the interest rate paid by euro deposits causes the dollar to depreciate.
E. None of the above.

38. Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113
per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on
dollar deposits is 10 percent and on euros it is 4 percent. Under these assumptions,
A. covered interest parity does hold.
B. covered interest parity does not hold.
C. It is hard to tell whether covered interest parity does or does not hold.
 D. Not enough information is given to answer the question.
E. None of the above.
Answer: B

Here are the explanations for the selected questions:

1. How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50
British pounds if the exchange rate is 1.25 dollars per one British pound?
Answer: D (62.5 dollars)
To calculate the cost in dollars, multiply the price in British pounds by the exchange rate:
50 GBP×1.25 USD/GBP=62.5 USD50 \, \text{GBP} \times 1.25 \, \text{USD/GBP} = 62.5 \, \
text{USD}
2. How many dollars would it cost to buy an Edinburgh Woolen Mill sweater costing 50
British pounds if the exchange rate is 1.50 dollars per one British pound?
Answer: E (75 dollars)
Similarly, multiply the price in British pounds by the exchange rate:
50 GBP×1.50 USD/GBP=75 USD50 \, \text{GBP} \times 1.50 \, \text{USD/GBP} = 75 \, \
text{USD}
9. What is the exchange rate between the dollar and the British pound if a pair of
American jeans costs 50 dollars in New York and 100 pounds in London?
Answer: B (0.5 dollars per British pound)
To find the exchange rate, divide the price of the jeans in dollars by the price in pounds:
50 USD100 GBP=0.5 USD/GBP\frac{50 \, \text{USD}}{100 \, \text{GBP}} = 0.5 \, \
text{USD/GBP}
10. What is the exchange rate between the dollar and the British pound if a pair of
American jeans costs 60 dollars in New York and 30 pounds in London?
Answer: E (2 dollars per British pound)
Again, divide the price in dollars by the price in pounds:
60 USD30 GBP=2 USD/GBP\frac{60 \, \text{USD}}{30 \, \text{GBP}} = 2 \, \text{USD/GBP}
11. When a country’s currency depreciates,
Answer: E (None of the above)
When a currency depreciates, its exports become cheaper for foreigners, and imports become
more expensive for domestic residents. None of the options perfectly reflect this scenario, so the
correct answer is E.
12. An appreciation of a country’s currency
Answer: D (raises the relative price of its exports and lowers the relative price of its
imports)
When a currency appreciates, it makes the country's exports more expensive for foreigners,
while imports become cheaper for domestic residents.
19. Forward and spot exchange rates
Answer: D (while not necessarily equal, do move closely together)
Forward exchange rates are generally based on the spot exchange rate, and while they are not
always equal, they usually move in a similar direction. This is because the forward rate reflects
the market’s expectation of the future spot rate.
20. A foreign exchange swap
Answer: C (is a spot sale of a currency combined with a forward repurchase of the
currency)
A foreign exchange swap involves the exchange of currencies at the current spot rate with an
agreement to reverse the transaction at a later date using a forward rate.
23. The exchange rate between currencies depends on
Answer: B (the expected future exchange rate)
The exchange rate is influenced by a variety of factors, but the expected future exchange rate
plays a key role in determining current rates as investors adjust their positions based on
anticipated changes in value.
25. Which one of the following statements is the most accurate?
Answer: D (Because dollar and DM interest rates are measured in comparable terms, they
still move quite differently over time.)
Despite being measured in comparable terms, interest rates in different currencies (like the U.S.
dollar and Deutsche Mark) can move independently based on factors such as inflation, economic
policy, and market expectations.
38. Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113
per euro. Further, assume that the spot exchange rate is $1.05 per euro, and the interest
rate on dollar deposits is 10 percent and on euros it is 4 percent. Under these assumptions,
Answer: A (covered interest parity does hold)
Covered interest parity (CIP) suggests that the forward exchange rate should offset the
difference in interest rates between two currencies. Here, the interest rate differential and the
spot/forward exchange rates are in line with CIP, confirming that it holds.