GLOBAL 2nd Edition by Mike Peng – Test Bank
Chapter 7—
Dealing with Foreign Exchange
TRUE/FALSE
1. When the United States sells products to China, US exporters often demand that they be paid in the Chinese yuan. ANS: F PTS: 1 DIF: Moderate REF: p. 95 OBJ: Intro NAT: AACSB: Tier 1 Communication | Tier 2 Environmental Influences 2. Since foreign exchange is such a unique commodity, its markets are influenced only by economic factors and are free from the effect of social or political pressures. ANS: F PTS: 1 DIF: Moderate REF: p. 97 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 3. Purchasing power parity is the price of one currency in terms of another. ANS: F PTS: 1 DIF: Moderate REF: p. 98 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 4. The rise of a country’s productivity is usually accompanied by increased demand for its home currency. ANS: T PTS: 1 DIF: Moderate REF: p. 99 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Creation of Value 5. The current account balance consists of exports, minus imports of merchandise and services, plus income on US assets abroad, minus payments on foreign assets in the United States, plus unilateral government transfers and private remittances. ANS: T PTS: 1 DIF: Moderate REF: p. 99 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Creation of Value 6. A deficit in the current account does not have to be balanced by other financial accounts. ANS: F PTS: 1 DIF: Easy REF: p. 99 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 7. Governments that believe in a free market approach usually adopt floating exchange rate policies. ANS: T PTS: 1 DIF: Moderate REF: pp. 99-100 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Legal Responsibilities 8. While theories on PPP, interest rates, and money supply give often-accurate predictions about long-term movements, investor psychology is regarded as the determinant behind short-term movements. ANS: T PTS: 1 DIF: Moderate REF: p. 101 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Creation of Value 9. A large number of individuals and companies exchanging domestic currencies for US dollars in order to exit their home country is referred to as capital flight. ANS: T PTS: 1 DIF: Moderate REF: p. 102 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 10. Under the gold standard, every central bank needed to maintain gold reserves in order to be able to redeem its currency in gold at a fixed price. ANS: T PTS: 1 DIF: Easy REF: p. 101 OBJ: 7.2 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 11. The Bretton Woods system was formed at a conference in England. ANS: F PTS: 1 DIF: Easy REF: p. 102 OBJ: 7.2 NAT: AACSB: Tier 1 Communication | Tier 2 Strategy 12. The gold standard propelled the US dollar to commanding heights in the global economy. ANS: F PTS: 1 DIF: Moderate REF: p. 101 OBJ: 7.2 NAT: AACSB: Tier 1 Communication | Tier 2 Environmental Influences 13. The International Monetary Fund offers both loans and free grants to countries depending on the stability and need of the borrower. ANS: F PTS: 1 DIF: Easy REF: pp. 102-103 OBJ: 7.2 NAT: AACSB: Tier 1 Analytic | Tier 2 Strategy 14. Currency hedging is a popular way to minimize the foreign exchange risk inherent in all nonspot transactions. ANS: T PTS: 1 DIF: Moderate REF: p. 105 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Information Technology 15. The foreign exchange market has no central physical location but operates 24/7 and is the largest and most active market in the world. ANS: T PTS: 1 DIF: Easy REF: p. 105 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Information Technology 16. 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. ANS: T PTS: 1 DIF: Moderate REF: pp. 107-108 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Information Technology 17. Only managers in financial firms have to worry about foreign exchange issues because non-financial firms are immune to risks of changing currencies. ANS: F PTS: 1 DIF: Moderate REF: p. 108 OBJ: 7.3 NAT: AACSB: Tier 1 Communication | Tier 2 Strategy 18. Smaller, internationally inexperienced firms sometimes outsource currency hedging to specialists such as currency traders. ANS: T PTS: 1 DIF: Moderate REF: p. 107 OBJ: 7.4 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 19. It is only crucial that managers pay attention to long-run movements informed by PPP, productivity changes, and balance of payments because short-run fluctuations always even out. ANS: F PTS: 1 DIF: Difficult REF: p. 108 OBJ: 7.4 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 20. Even though a country may have a high currency risk, the country might still be worthy of investment. ANS: T PTS: 1 DIF: Moderate REF: p. 108 OBJ: 7.4 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Strategy 21. The best practice for facing currency risk is to have a well thought-out currency management strategy and plan for both long-run movements and short-run movements. ANS: T PTS: 1 DIF: Easy REF: p. 108 OBJ: 7.4 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Strategy MULTIPLE CHOICE 1. What measure did worried Latin American governments take to restrain the value of their currencies? a. They bought foreign reserves b. They extended reserve requirements for banks’ sales of foreign exchange c. They made deposits into the Central Bank that attracted no interest d. All of the above ANS: D PTS: 1 DIF: Moderate REF: p. 96 OBJ: Opening Case NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 2. If central bankers raise interest rates to curb inflation, they risk driving currency ____. If their interventions in the foreign exchange market drive the currency ____, they may boost inflation. a. Up, up b. Up, down c. Down, down d. Down, up ANS: B PTS: 1 DIF: Difficult REF: p. 96 OBJ: Opening Case NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 3. In the trade relationship with China, why is the US dollar in more demand than the Chinese yuan? a. More people demand the yuan domestically in China, so it is not used for imports and exports. b. The dollar is the common transaction currency between the two countries. c. The yuan is pegged to the US dollar. d. Formal institutions and regulations demand the trade be conducted in the dollar. ANS: B PTS: 1 DIF: Moderate REF: p. 97 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 4. What is the “law of one price,” where the price for identical products in different countries should be the same if trade barriers are absent? a. Purchasing power parity b. Fixed exchange rate policy c. Balance of payments d. Currency swap ANS: A PTS: 1 DIF: Moderate REF: p. 98 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 5. Which of the following is the concept behind the Big Mac index? a. Purchasing power parity b. Fixed exchange rate policy c. Balance of payments d. Currency swap ANS: A PTS: 1 DIF: Moderate REF: p. 98 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 6. If a country’s interest rate is high relative to other countries, the country will: a. Develop a trade deficit. b. Attract foreign funds. c. Experience depreciation in its home currency. d. Discourage foreign investing. ANS: B PTS: 1 DIF: Moderate REF: p. 99 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 7. Which of the following is NOT one of the components of the balance of payments? a. Currency trade c. Service trade b. Merchandise trade d. Capital movement ANS: A PTS: 1 DIF: Moderate REF: p. 99 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 8. A country experiencing a current account surplus will see its currency ____, while a country experiencing a current account deficit will see its currency ____. a. Appreciate, appreciate c. Depreciate, appreciate b. Appreciate, depreciate d. Depreciate, depreciate ANS: B PTS: 1 DIF: Difficult REF: p. 99 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 9. Which of the following best describes a rate in which selective government intervention works hand-in-hand with allowing markets the freedom to work themselves out? a. Floating rate c. Dirty float rate b. Fixed rate d. Target exchange rate ANS: C PTS: 1 DIF: Moderate REF: p. 100 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences 10. What was one of the major reasons the gold standard fell apart? a. Countries fighting in World War I printed excessive amounts of money to finance their war efforts. b. Military campaigns during World War I stole much of the gold from foreign central banks. c. Gold lost its value and was no longer reliable. d. Gold became too rare and costly to maintain adequate reserves. ANS: A PTS: 1 DIF: Moderate REF: p. 101 OBJ: 7.2 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 11. Why was the US dollar chosen as the currency to which other currencies would be pegged? a. The US had high levels of productivity. b. The US was experiencing a large trade surplus. c. The US contributed approximately 70% of the global GDP. d. All of these answers ANS: D PTS: 1 DIF: Moderate REF: p. 102 OBJ: 7.2 NAT: AACSB: Tier 1 Analytic | Tier 2 Strategy 12. ____ is an international organization that was established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements. a. Bretton Woods System c. International Monetary Fund b. World Bank d. Grameen Bank ANS: C PTS: 1 DIF: Easy REF: p. 102 OBJ: 7.2 NAT: AACSB: Tier 1 Communication | Tier 2 Strategy 13. Which of the following is NOT one of the three primary activities of the International Monetary Fund? a. International monetary cooperation b. Exchange stability c. Pegging exchange rates d. Orderly exchange arrangements ANS: C PTS: 1 DIF: Moderate REF: pp. 102-103 OBJ: 7.2 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Strategy 14. Where does the International Monetary Fund receive its funds? a. Member countries quota c. Subsidiary investing b. Foreign direct investment d. Currency trading ANS: A PTS: 1 DIF: Moderate REF: p. 103 OBJ: 7.2 NAT: AACSB: Tier 1 Communication | Tier 2 Operations Management 15. Which is NOT one of the primary types of foreign exchange transactions? a. Swaps c. Spot transactions b. Direct transactions d. Forward transactions ANS: B PTS: 1 DIF: Moderate REF: p. 105 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Information Technology 16. ____ allow participants to buy and sell currencies now for future delivery. a. Swaps c. Spot transactions b. Direct transactions d. Forward transactions ANS: D PTS: 1 DIF: Moderate REF: p. 105 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Environmental Influences 17. Traders and investors trading in a forward transactions market are most concerned about: a. Political and social stability of the foreign country b. Change in the spot rate c. Regulation from the International Monetary Fund d. Currency hedging ANS: B PTS: 1 DIF: Difficult REF: p. 105 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Strategy 18. Which of the following is best defined by “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. Direct currency transaction c. Spot currency transaction d. Forward currency transaction ANS: A PTS: 1 DIF: Moderate REF: p. 106 OBJ: 7.3 NAT: AACSB: Tier 1 Technology | Tier 2 Information Technology 19. The ____ is defined as the difference between the offered price and the bid price. a. Offer rate c. Discount b. Spread d. Premium ANS: B PTS: 1 DIF: Easy REF: p. 106 OBJ: 7.3 NAT: AACSB: Tier 1 Analytic | Tier 2 Strategy 20. Which of the following is most focused on currency diversification? a. Currency hedging c. Strategic hedging b. Spot transactions d. Trading risk ANS: C PTS: 1 DIF: Moderate REF: pp. 107-108 OBJ: 7.3 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Strategy 21. Which of the following is NOT an advantage of a strong US dollar? a. US consumers benefit from low prices on imports. b. US tourists benefit from lower prices when traveling abroad. c. Lower prices on foreign goods help keep US prices level and inflation low. d. US firms in import-competing industries face more low-cost imports. ANS: D PTS: 1 DIF: Moderate REF: p. 108 OBJ: Closing Case NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences ESSAY 1. Identify the concept behind the Big Mac index and provide an example why this index should be used with caution. ANS: Student responses may vary; however, the example should closely match the example discussed in the text, using the same exchange rate concept. The theory of purchasing power parity (PPP) states that the price for identical products sold in different countries must be the same. If not, traders may buy high and sell low. One of the most fun-filled examples of an application of the PPP is the Big Mac Index, made famous by the Economist magazine. Since the McDonald’s Big Mac hamburger is produced all over the world, according to PPP, this universal hamburger should cost the same everywhere around the world. In reality, it does not! The index looks at the Big Mac price in the US (example as of July 2010): the price for the heavenly product loaded with 1,200 calories sold at $3.73 in the US. Now you arrive in China on July 3, head to McDonald’s to visit the Golden Arches and reminisce about the US and the taste of a Big Mac. In July 2010, a Big Mac cost $3.73 in the United States and $1.95 in China. But the nominal (official) rate at that time was actually 6.78 yuan to the dollar. This (and Exhibit 7.3) leads you to conclude that the yuan was 48% undervalued against the US dollar. As IB students and readers of Dr. Peng’s book, you realize it might be the time to reevaluate the numbers and dig deeper for an explanation, since your reading now tells you that some politicians argue that this proves the Chinese yuan is artificially undervalued. (The Economist disavows that assumption.) Main issues to consider when analyzing the concepts of PPP and the Big Mac Index: · First, it reveals an indication of the world’s most expensive and best valued economies. · Second, it continually supports the concept that prices in developing countries are cheaper. Yes, they are cheaper if the input is labor versus flour made in the US and sent to China. · Third, since the Big Mac is not traded, would you take freezer loads of Big Macs home from China? Most likely, no! · Product pricing is based on supply and demand. If you and the world choose to send freezers full of Big Macs to the US, then the price of the Big Mac might decrease in the US and increase in China. The law of supply and demand in our economic market system is at work. PTS: 1 DIF: Difficult REF: pp. 98-99 OBJ: 7.1 NAT: AACSB: Tier 1 Analytic | Tier 2 Environmental Influences 2. Describe what it means for a country to peg its currency to another, and give two benefits to this policy. ANS: When a country pegs its currency to another, the value of the currency will strengthen or weaken 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 currency to the US dollar to restrain domestic inflation (given the fact that the US has relatively low inflation). PTS: 1 DIF: Easy REF: p. 101 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Strategy 3. Identify the difference between fixed and floating exchange rates. Provide an example of a situation where the fixed and floating exchange rates are used. ANS: A fixed exchange rates involves a country that “fixes” their currency to another currency. The floating (or flexible) exchange rate rests on the idea that the supply and the demand for the currency will accurately maintain the currency’s exchange rate. This policy is often promoted by free market advocates. Few countries can adopt a truly clean (or free) float. Most countries that use the floating exchange rate adapt a variation of a dirty (or managed) float, in which the government can selectively intervene in a time of crisis or unexpected market movement. The US has been on a dirty float since the collapse of the Bretton Woods System. This has allowed the American government to intervene during times of great inflation or when other appreciating currencies force the dollar down. An example of the fixed exchange rate is when East and West Germany’s marks were fixed to each other on a 1:1 ratio. This helped East Germany’s economy act stronger than it really was, thus boosting the morale and support of the East German citizens. West Germany ended up paying more for their goods, but this additional income helped East Germany rebuild and reunite faster. PTS: 1 DIF: Difficult REF: pp. 100-102 OBJ: 7.1 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Strategy 4. Briefly explain the cause for the fall of the Bretton Woods system and identify the modern situation. ANS: The Bretton Woods system was at its peak during the late 1950s and early 1960s, and it helped bring the dollar into dominance in the global economy. However, in the late 1960s and early 1970s, the rise of productivity outside of the US and the US inflationary policies brought the Bretton Woods into question. Other countries such as West Germany exported more, and the US ran its first post-1945 trade deficit in 1971. The US also greatly increased the money supply to support more government spending of the Vietnam War and the Great Society Welfare Programs. The US government under President Lyndon increased the money supply but not additional taxation. A country cannot increase government spending without additional taxation. As the dollar faced greater inflation, it depreciated in the global exchange markets These actions led to rising inflation and strong pressure for the dollar to depreciate. Currency traders speculated on the fall of the US dollar, resulting in the purchase of more German marks. The central bank of Germany had to buy billions of dollars to maintain the dollar/mark ratio. The Bretton Woods system was structured so the US unilaterally could not adjust the exchange rate of the dollar. Therefore, as the US traded gold at a standard $35 an ounce, too much gold was going out at an undervalued price. In 1971, Nixon declared that the dollar was no longer convertible into gold. The current financial exchange environment is known as the Post-Bretton Woods system. The system allows the US to have flexibility and diversity in the exchange rate regimes. The dollar is no longer the official common denominator in the global currency exchange market. The US dollar is still relatively powerful as a key currency and has retained a significant amount of soft power. PTS: 1 DIF: Difficult REF: p. 102 OBJ: 7.2 NAT: AACSB: Tier 1 Reflective Thinking | Tier 2 Environmental Influences
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