CHAPTER 7 REVIEW QUESTION ANSWERS 1. Briefly summarize the six major factors that influence foreign exchange rates.

The basic factor is the supply and demand for a currency as affected by the following five factors: (1) relative price differences (the impact of purchasing power parity), (2) interest rates and monetary supply (interest rates in a country will affect demand for a currency and monetary policy affects supply of the currency), (3) productivity and balance of payments (productivity affects the cost of a countrys goods and that cost will impact exports which in turn affects the balance of payments), (4) exchange rate policies (a currency which can be freely exchanged will be more desirable than one which cannot), and (5) investor psychology - positive or negative expectations will affect the extent to which a currency is desirable. 2. How would you describe the theory of purchasing power parity (PPP)? Purchasing power parity: a theory that suggests that in the absence of trade barriers (such as tariffs), the price for identical products sold in different countries must be the same. 3. What is the relationship between a countrys current account balance and its currency? A country experiencing a current account surplus will see its currency appreciate; conversely, a country experiencing a current account deficit will see its currency depreciate. 4. What is the difference between a floating exchange rate policy and a fixed exchange rate policy? Floating (or flexible) exchange rate policy: the willingness of a government to let the demand and supply conditions determine exchange rates. Fixed exchange rate policy; fixing the exchange rate of a currency relative to other currencies. 5. How is the phenomenon of capital flight an example of the bandwagon effect or herd mentality? Capital flight: a phenomenon in which a large number of individuals and companies exchange domestic currencies for a foreign currency. Bandwagon effect: the result of investors moving as a herd in the same direction at the same time. 6. Why did the gold standard evolve to the Bretton Woods system? Then why did the Bretton Woods system evolve to the present post-Bretton Woods system? The gold standard provided predictability but placed a focus on economic adjustments and exports which were difficult to maintain during wartime and thus toward the end of

World War II the Bretton Woods system was created in which currencies were pegged to the dollar but it was difficult to maintain those pegged rates. As a result, under postBretton Woods flexible rates became more common. 7. Describe the IMFs roles and responsibilities. International Monetary Fund (IMF): an international organization of 185 member countries that was established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary financial assistance to countries to help ease balance of payments adjustment. 8. Name and describe the three primary types of foreign exchange transactions made by financial companies. There are three primary types of foreign exchange transactions: (1) spot transactions, (2) forward transactions, and (3) swaps. Spot transactions: the classic single-shot exchange of one currency for another. Forward transactions: a foreign exchange transaction in which participants buy and sell currencies now for future delivery, typically in 30, 90, or 180 days, after the date of the transaction. Swap: a foreign exchange transaction in which one currency is converted into another in Time 1, with an agreement to revert it back to the original currency at a specific Time 2 in the future. 9. Name and describe two ways nonfinancial companies can cope with currency risks. There are two primary strategies: (1) currency hedging and (2) strategic hedging. Currency hedging: a transaction that protects traders and investors from exposure to the fluctuations of the spot rate, it involves the transactions discussed in question eight in which the intent is to transfer risk from the hedgers to speculators. Strategic hedging: 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. 10. Which do you think is a better policy to adopt: a floating exchange rate or a fixed rate? The important thing is not so much the answer as the extent to which the student demonstrates thought in providing the answer. 11. Why is the strength of the American dollar important to the rest of the world?

The rest of the world holds so many greenbacks that most countries fear the capital loss they would suffer if the dollar falls too deep. Second, many countries prefer to keep the value of their currencies down to promote exports. 12. Devise your own example of a way a firm might engage in currency hedging. Currency hedging involves a transaction that protects traders and investors from exposure to the fluctuations of the spot rate. In regards to the examples, The important thing is not so much the answer as the extent to which the student demonstrates thought in providing the answer. 13. What concepts must a savvy manager understand to be considered literate about foreign exchange? First, foreign exchange literacy must be fostered. Second, risk analysis of any country must include its currency risks. Finally, a countrys high currency risks do not necessarily suggest that that country needs to be totally avoided. Instead, it calls for a prudent currency risk management strategy via currency hedging, strategic hedging, or both. 14. What skills might a manager need to develop to devise strategies for managing currency risk? Useful skills include currency hedging, strategic hedging, or both. CRITICAL DISCUSSION QUESTION ANSWERS 1. If US$1 = 0.73 in New York and US$1 = 0.75 in Paris, how can foreign exchange traders profit from these exchange rates? Which of their actions may result in the same dollar/euro exchange rate in New York and Paris? Arbitrageurs profit by buying low in one market and selling high in another. However, as they dump more of a currency into the higher priced market, they are increasing the supply of that currency in that market and as the supply increases relative to the demand the price will go down until it reaches a level in which no arbitrage profits can be obtain because the value of the currency in both markets is the same. 2. Identify the currencies of the top-three trading partners of your country in the last ten years. Find the exchange rates of these currencies, relative to your countrys currency, ten years ago and now. Explain the changes. Then predict the movement of these exchange rates ten years from now.

This is a question in which the answer is not as important as the thought process and the ability to clearly articulate. 3. As a manager, you are choosing to do business in two countries: One has a fixed exchange rate, and the other has a floating rate. Which country would you prefer? Why? The student should realize that doing business with a country that has a fixed exchange rate will result in using a currency will sometimes over valued at that rate or undervalued. 4. Should China revalue the yuan against the dollar? If so, what impact may this have on (1) US balance of payments, (2) Chinese balance of payments, (3) relative competitiveness of Mexico and Thailand, (4) firms such as Wal-Mart, and (5) US and Chinese retail consumers? The US balance of payments would improve and the Chinese balance of payments would decline. The relative competitiveness of any country with its currency tied to the dollar would also likely improve. Wal-Mart and U.S. consumers would lose but Chinese retail consumers would gain. 5. ON ETHICS: You are an IMF official going to a country whose export earnings are not able to pay for imports. The government has requested a loan from the IMF. Which areas would you recommend the government to cut: (1) education, (2) salaries for officials, (3) food subsidies, and/or (4) tax rebates for exporters? Student answers will vary but it is unlikely that any would pick number four.