Exam Preparation Questions PDF

Course Exam Preparation Questions 1. A. Describe the current state and future direction of exchange rate arrangements. It is currently a hybrid system with major currencies floating on a managed basis and other currencies have various types of pegged arrangements. In the future, we...

Course Exam Preparation Questions 1. A. Describe the current state and future direction of exchange rate arrangements. It is currently a hybrid system with major currencies floating on a managed basis and other currencies have various types of pegged arrangements. In the future, we will move towards a flexible exchange rate arrangement where there are a set of currencies floating and everyone is pegged in some form. B. Explain what fundamental factors are likely to persuade the choice of an exchange rate arrangement. Country Size (GDP) Degree of openness Degree to which trade is concentrated Inflation differential between country and main trading partner Types of shocks faced by the economy C. Discuss why a global currency (e.g., the hypothetical GLOBALL) might or might not be a viable exchange rate arrangement. In the future we may have fewer currencies such as the Triad system (dollar, euro, yen), but it might not be viable to switch to a truly global currency as it would require all countries to relinquish control over their monetary policies, leaving them unable to adjust interest rates or money supply to address local economic conditions. 2. Assume that foreign government interest rates are expected to rise above comparable U.S. government interest rates. Based on the material covered in this course, discuss what this suggests the future strength or weakness of the U.S. dollar. The US Dollar would depreciate and weaken. Higher foreign interest rates make investments in those countries more attractive, prompting investors to sell U.S. dollars to buy foreign currencies, thereby increasing demand for foreign currencies and reducing the dollar's value relative to them. 3. Suppose that you are in a meeting and an Analyst proposes the following exchange rate model of the Australian Dollar: S = 1.3(M* – M) + 0.5(Y* – Y) + 0.8(r – r*) Where: S = the % change in the spot exchange rate (A$/$) M = the money supply Y = real GDP r = a short-term real interest rate * denotes Australian variables Note: The money supply and GDP are measured in growth rates (i.e., percentage rates of change) like the interest rate. A. Does the above model have a stationarity problem? No, it does not. With the different variables, M, Y and r, are in percentage terms, used in the model to find the spot exchange rate in percentage terms as well. The model does not have any stationary problems, as the Spot exchange rate will seem to return to a mean in the long run. It would have to have a constant growth rate to have stationary problems. B. Suppose that the Australian central bank reduced the money supply by 5%, which results in a rise in short-term interest rates from 10% to 10.5% and brings down the inflation rate without slowing economic growth (i.e., Y* does not change). Also assume that the US variables all stay constant (i.e., M, Y, and r do not change). Using the model, what will happen to the A$/$ exchange rate, including both the direction of change and a numerical quantity (%) of the result? S = 1.3(-5%) + 0.8(10.5-10) = -6.1%. The Austrian dollar is appreciating towards the United States Dollar, as it takes less Austrian dollars to buy one U.S. Dollar. C. Given your growing international finance expertise, describe which additional variables you would suggest that the analyst include in this model (i.e., both technical and fundamental variables), and why they should likely be included. Inflation rate Current account balance → helpful in tracking forces pushing on exchange rates Political factors and foreign exchange reserves → changes signal pressure on currency Historical exchange rates to derive patterns to predict exchange rate movements Moving average: uses past exchange rates for a period of time to calculate the average 4. Consider the Economic and Financial Indicators section from the back pages of an Economist magazine issue (see Economist_Data_09-10-2005.Pdf on the course website). A. Consider the Yen-Euro relationship. Can you identify any deviations from relative purchasing power parity based on the past year’s data? PPP = (.111-.072)/(1+..072) = 3.6% PPP = % change in CPI B. What are the prospects for the ¥/€ exchange rate based on the latest figures for (a) money supplies and (b) wages/earnings? (a)Increasing money supply = increasing inflation, leading to depreciation, so Euro depreciates compared to Yen. (b)Rise in wages, which means increased income which means increased consumption C. Based on the three-month money market interest rates, what is the three-month ¥/€ forward rate? ( (.0002-.0213) / (1+.0213) ) = ( (F-137) / 137 ) =139.8359Y/E D. From these indicator sheets, describe any additional potential pressures on the exchange rate. government spending foreign exchange reserves high unemployment rate stagnant wages increasing money supply 5. Consider the following financial data for the British pound and the Thai baht: GBP THB Inflation (annual) 2.3% 5.6% Three-month Interest Rate (annualized) 4.53% ? Spot Exchange Rate (฿/£) 75.40 A. Assuming that the international parity conditions hold perfectly, what is the expected exchange rate in one year? = 75.4 x (.056 -.023 + 1) = 75.4 X 1.033 = 77.8882 B. Describe why an understanding of currency levels and movements is important. To make informed investment decisions, profitability and foreign investment are directly related, monitoring volatility 6. Using the data from the Economic and Financial Indicators section of the Economist magazine issue dated September 15, 2012 (see Economist_Data_09-15-2012.Pdf on the course website), carefully and critically discuss the prospective exchange rate pressures faced between the US Dollar and South Korean Won. Be sure to use the various concepts covered in this course along with only the given data in the above issue to address this question. Using this data, the dollar could likely face depreciation pressures. The US experiences high inflation, higher unemployment rates, lower interest rates and a decreasing account balance in terms of percent of GDP. These pressures make the USD less appealing to investors. The Won could face appreciation pressures. They have lower inflation rates, higher interest rates, lower unemployment rates, and an increasing current account balance. These factors make the SK won more appealing to investors, it will grow in value. The US does experience more industrial production than in SK, which could counteract some of the other depreciation pressures. 7. A. What are three factors that cause a bond’s price to change? What is the predicted direction of change for the bond’s price from changes in these factors? 1. Price of a “comparable” treasury bond - decrease price (all on pg 117) 2. Value of risk premium - decrease price 3. Value of any options the bondholder grants the issuer - increase price B. From a U.S. investor’s perspective, how do the risks associated with non-dollar denominated bonds impact the price of the bond and the dollar denominated return? For a U.S. investor, non-dollar-denominated bonds present several risks that affect both bond prices and dollar-denominated returns. Interest rate risk arises from fluctuations in interest rates, which can make the bond less attractive if rates rise in the bond's issuing country. Exchange rate risk is significant, as changes in the foreign currency’s value can impact the returns when converted to dollars, particularly if the foreign currency weakens. Political risk also plays a role, with government actions such as expropriation, changes in tax laws, or new regulations potentially reducing the bond's value and returns. These risks introduce volatility and can lower the returns for U.S. investors. 8. Critically discuss the nature of political risk in considering an investment, how one might go about measuring such risks, and methods for addressing and hedging such potential risks. Political risk: government intervention into the workings of the economy that affect the value of an investment. For example: expropriation, changes in tax or labor laws, regulatory restrictions We can measure it by using political, economic, subjective, and micro factors We can manage political risk by avoidance, political risk insurance, and local tie-ins and legal remedies We can hedge potential risk by geographic diversification, form joint ventures with local companies, join a consortium, and insurance. 9. A. Describe the alternative international equity investment instruments that are available to individual investors. Individual investors can invest internationally through direct purchases of foreign stocks or by buying shares in multinational corporations that conduct significant business abroad. They can also use instruments like American Depositary Receipts (ADRs), which allow for trading foreign company shares on domestic exchanges, or invest in international mutual funds and ETFs for diversified exposure. These options provide varying levels of convenience, risk, and diversification, making international equity investments accessible to a wide range of investors. B. An article from the NY Times discusses borderless investing (see Global_Investing.Pdf). Based on what you have learned in this course, explain why you agree or disagree with this approach. The primary rationale for international investing is diversification, as spreading investments across multiple markets reduces portfolio risk. Since different countries' markets often react differently to global events, their price fluctuations can offset each other, leading to a more stable overall return. 10. Looking at the data from the Economic and Financial Indicators section of the Economist magazine issue dated September 8, 2012 (see Economist_Data_09-08-2012.Pdf on the course website), carefully and critically discuss the local currency versus dollar equity return differences as well as the across country equity return differences.  When the country moves from local currency to dollars and their returns decrease: china, japan, euro, switzerland,india; the dollar has appreciated against these currencies, When the country moves from local currency to dollars and their returns increase: england, canada, south korea, chile; the dollar has depreciated against these currencies 11. Discuss the benefits of international portfolio diversification and why they are likely to be greater or less in the next decade than in the last decade. International portfolio diversification reduces risk by spreading investments across markets, taking advantage of low correlations between domestic and foreign markets to stabilize returns. However, increasing globalization and interconnectedness have led to higher correlations during periods of market volatility, reducing the effectiveness of diversification at times. In the coming decade, the benefits of international diversification may still grow as emerging markets expand, but these gains could be moderated by the rising integration of global economies and financial systems. 12. Formulate both a domestic and an international version of a multi-beta asset-pricing model (i.e., one equation for each). Carefully describe each of the models, and describe the key differences between these models. Domestic: Fama French 3-factor model r=Rf+B3(Km-Rf)+bs(SMB)+bv(HML)+alpha International: E(Ri) = Ro + Beta iw X Rpw + Yil X Srp1.... Ro = domestic currency, risk free interest rate Beta iw = sensitivity of asset i to domestic currency return to market movements Rpw = the world market risk premium equals E(Rw) - Ro Yi 1 to Yi K = currency exposures, the sensitivities of asset i to domestic currency returns to the exchange rate on currencies 1 to K (additional risk) Srp1 to SrpK= the foreign currency risk premiums on currency 1 to K The ICAPM differs from a domestic CAPM in two ways. First, the relevant market risk is world(global) market risk, not domestic market risk, which is obvious. Second, additional risk premiums are linked to an asset's sensitivity to currency movements. The different currency exposures of individual securities would be reflected in different expected returns. 13. Define foreign exchange and foreign political risk exposure for a firm. Discuss whether or not a domestic firm is subject to foreign exchange and foreign political risks. Foreign exchange (FX) risk arises when cash flows are denominated in a foreign currency, exposing investors to uncertainty in the value of those flows when converted to their home currency; hedging with forward or futures contracts can mitigate this risk. Political risk refers to the uncertainty over property rights due to government actions, such as nationalization, regulatory changes, or trade restrictions, that could affect the value of investments. Political risk can be assessed through factors like political stability, economic conditions, and public attitudes toward foreign investment. Domestic firms may also face these risks if they engage in activities like outsourcing, importing/exporting, or dealing with foreign buyers. To manage these risks, firms can use strategies like avoidance, risk insurance, and building local ties. 14. Discuss why firms often partake in foreign direct investment. Firms engage in foreign direct investment (FDI) to access key resources, expand into new markets, and improve operational efficiency. Resource-seeking FDI allows firms to obtain cost-effective labor, raw materials, and technology, while market-seeking FDI helps them bypass trade barriers and better cater to local consumer preferences. Additionally, strategic-seeking FDI, such as vertical integration, enables firms to protect intellectual property and secure stable supply chains, ultimately enhancing long-term competitiveness. 15. An article from the International Herald Tribune discusses homemaker foreign exchange (FX) trading in Japan (see fx_trading.pdf). Discuss important FX factors that these homemakers should consider in their FX investment decisions.  Homemaker foreign exchange (FX) traders in Japan should consider several key factors when making FX investment decisions. They need to monitor economic trends, market volatility, and indicators like interest rates, inflation, and geopolitical events, as these can drive exchange rate fluctuations. Currency forward contracts and futures are useful for short-term hedging, but may not be suitable for long-term exposure, while currency options can provide flexibility in benefiting from exchange rate movements. Additionally, understanding currency risk and how factors like monetary policy or crises (e.g., the subprime mortgage crisis) influence exchange rates is essential for managing risk. 16. In Berkshire Hathaway’s annual report to investors a few years ago, Warren Buffett discussed his investment positions. Please see the PDF file (see Buffett_2004.Pdf) that contains the relevant section of the report. Discuss why you agree or disagree with his currency investment perspectives and positions. Warren Buffett’s investment approach regarding foreign currency contracts emphasizes the potential risks and rewards of exchange rate fluctuations. He believes that the U.S. dollar cannot keep strengthening indefinitely, and that a weaker dollar may eventually be necessary to improve trade balances and exports. By purchasing foreign-denominated currency contracts, Buffett expects to benefit when the dollar weakens, as the value of these contracts would increase in dollar terms. Additionally, he notes that a significant portion of an international investment’s return is often driven by changes in exchange rates, as seen with the appreciation of the British pound over time. 17. A recent article from the Wall Street Journal discusses Japan’s yen intervention (see yen-intervention.Pdf). Critically discuss this intervention, including what effects it might have on US Exporters. If Japan intervenes to depreciate the yen, it would likely cause the U.S. dollar to appreciate relative to the yen, making U.S. exports more expensive for Japanese consumers. This would harm U.S. exporters by reducing their price competitiveness in Japan, potentially leading to lower sales and profits. On the other hand, a weaker yen would make Japanese goods cheaper for U.S. consumers, which could increase the U.S. trade deficit by boosting imports from Japan. Additionally, if Japan's intervention fails to stabilize the yen, it could negatively affect Japan’s large exporters, reducing profits, limiting investment, and potentially hindering the country's economic recovery. 18. An article from the Wall Street Journal discusses China’s call for the creation of a new currency to eventually replace the US dollar as the world’s standard (see China_Single_Currency.Pdf). At the same time, the IMF calls for a dollar alternative (see IMF_Dollar_Alternative.Pdf). Based on your foreign exchange and international investments knowledge you acquired this term, discuss your perspectives on this issue. China and the IMF's proposal for a new global currency to replace the U.S. dollar could destabilize markets, especially in developing economies reliant on dollar reserves. While it offers benefits like reduced political risk and greater stability, the shift could cause exchange rate volatility, illiquidity during crises, and economic disruption during the transition. The growing power of the IMF and changes in reserve currency demand would impact global trade and financial markets. While stable currencies might benefit, nations dependent on the dollar would face significant challenges. 19. A recent article from CNNMoney.com discusses the changing face of private equity (see Private_Equity_Investing_Strategies.Pdf), including the fact that private equity funds are increasingly looking outside of the US for opportunities. Based on your country analysis project, discuss why you would recommend that a private equity firm like Blackstone Group, the Carlyle Group, or KKR invest or not invest in your selected country. I would recommend that private equity firms, like Blackstone Group, the Carlyle Group, or KKR, invest in Ireland. The country offers an attractive business environment, with low corporate tax rates (12.5%) and consistent GDP growth. As a member of the European Union, Ireland provides access to a large market, and it has become a strategic hub for companies maintaining EU operations post-Brexit. Additionally, Ireland's strong investor protections and high FDI rankings make it an appealing destination for private equity firms seeking solid returns. 20. An article from the Economist magazine discusses social capital (see Social_Capital.Pdf on the course website). What is social capital? Is social capital important? Why or why not? Also discuss its relevance or irrelevance for finance, economics, and in a global economy. Be sure to provide a clear and complete discussion of your position. Social capital refers to the value added by trust, relationships, and community within a society. It is important because it reduces transaction costs, encourages investment, and fosters cooperation, especially in sectors like banking where trust is crucial. For countries, high social capital leads to political stability, economic freedom, and attracts foreign direct investment. While it has benefits like lower enforcement costs and better opportunities, it can also lead to groupthink, and some countries may lack access to it. In global finance and economics, social capital is relevant, but in competitive industries with tight margins, it may be less significant. 21. Several recent articles discuss various issues associated with the Bitcoin, the digital currency (see Bloomberg-Businessweek_Bitcoin_04-15-2013.Pdf; Fund to Let Investors Bet on Price of Bitcoins - NYTimes.pdf). Discuss the extent to which traditional exchange rate analyses would apply to understanding digital currency price fluctuations. What other factors might you also consider? From an investments perspective, discuss digital currencies as a potential investment opportunity or not based on the topics we have covered in this course. Traditional exchange rate analyses are less relevant for Bitcoin, as it isn’t tied to any specific economy or government regulation. Its price is driven by fixed supply, speculative demand, and market acceptance, making it highly volatile. While Bitcoin offers transparency and security, it lacks interest rates and is vulnerable to risks like hacking, making it a high-risk but potentially useful investment for diversification, particularly in emerging economies. 22. While exchange rate risk is often an important factor in the competitiveness and profitability of firms among other factors, political risk is also an important consideration (see Political- pressures-a-question-of-trust.pdf). Discuss the political risks faced by your firms/investments in your country analysis project and how you might hedge those risks. Ireland offers a relatively low political risk environment, with a strong democratic government and a history of fostering foreign investment. The country is known for low corruption, robust intellectual property protections, and a stable legal framework that encourages FDI. Although the 2020 election led to a more fragmented government, political stability remains high, and such fragmentation is unlikely to disrupt international business operations. For a company like TopGolf, adhering to Ireland's corporate laws and monitoring any potential changes in policy should mitigate political risks effectively. 23. Consider the following information: Base price level 100 Current U.S. price level 105 Current South African price level 111 Base rand spot exchange rate $0.175/rand Current rand spot exchange rate $0.158/rand Expected annual U.S. inflation 7% Expected annual South African inflation 5% Expected U.S. one-year interest rate 10% Expected South African one-year interest rate 8% ZAR and USD refer to the South African rand and U.S. dollar, respectively. Calculate the following exchange rates: a. b. c. The current ZAR spot rate in USD that would have been forecast by PPP. Using IFE (Fisher Open), the expected ZAR spot rate in USD one year from now. Using PPP, the expected ZAR spot rate in USD four years from now. A. The current ZAR spot rate in USD forecasted by PPP: a. PPP Spot Rate=Base Spot Rate × [(Current Price Level (SA)) / (Current Price Level (US)​)] b. PPP Spot Rate=0.175× (111/105​)  PPP Spot Rate=0.185 USD/ZAR B. Expected ZAR spot rate in USD one year from now using Fisher Open: a. Expected Spot Rate= Current Spot Rate × [(1+iSA)​/ (1+iUS)​​] b. Expected Spot Rate=0.158 × [(1+0.10) / (1+0.08​)] c. Expected Spot Rate =.158 x (1.08/1.10) =.155 USD/ZAR C. Expected ZAR spot rate in USD four years from now using PPP a. Expected Spot Rate = Current Spot Rate x [(1+inflation SA)/(1+ inflation US)]^n b. Expected Spot Rate =.158 x [(1+.05)/(1+.07)]^4 c. Expected Spot Rate =.158 x (1.05/1.07)^4 d. Expected Spot Rate =.158 x.924 = 0.146 USD/ZAR 24. Suppose you observe that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollar and the Turkish lira? High interest rates in Turkey are likely driven by factors such as inflation, political instability, economic uncertainty, and expectations of currency depreciation. To compensate for these risks, lenders demand higher rates. Additionally, the Central Bank may maintain high rates to combat inflation. Using the Uncovered Interest Rate Parity (UIP), we can predict that the Turkish lira would depreciate by approximately 64.17% compared to the U.S. dollar, based on the interest rate differential. However, actual exchange rate movements may differ depending on other market conditions. 25. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought a year ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into euro at the exchange rate of $1.06 per euro. What is your total return on your investment in euro terms? How much of the return is due to the exchange rate movement? Initial investment: 10,000 euros, which gave you $11,500 at an exchange rate of $1.15 per euro. After selling 95.83 Microsoft shares at $135 each, you received $12,937.50, which converted to 12,205.19 euros at an exchange rate of $1.06 per euro. Your total return is 22.05%, calculated from your initial investment of 10,000 euros. The exchange rate movement contributed 955.19 euros to this return, as the value of your investment increased due to the favorable change in the exchange rate.