Finquiz - Item-set Answers, Study Session 4, Reading 13

Reading 13

Currency Exchange Rates: Determination and Forecasting

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FinQuiz.com CFA Level II Item-set – Solution Study Session 4 June 2017

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Reading 13

Currency Exchange Rates: Determination and Forecasting

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FinQuiz Level II 2017 – Item-sets Solution Reading 13: Currency Exchange Rates: Determination and Forecasting 1. Question ID: 18445 Correct Answer: C C is correct. The larger the transaction, the further away from the current spot exchange rate the dealing price will be. The order placed by the client is large and will widen the bid-offer spread quoted by the dealer. A is incorrect. The type of client, individual or institutional, should not have an effect on the size of the spread quoted. B is incorrect. The trade will take place when the London FX trading center is open, that is, the interbank FX market will be relatively liquid. Thus should narrow the spread quoted by the dealer. 2. Question ID: 18446 Correct Answer: B B is correct. Smart originally purchased CAD 5 million under the original forward contract. To close out its long position in CAD, it will need to sell CAD 5 million forward to the same settlement date. Thus Smart will sell CAD, or alternatively buy USD, at the all-in offer rate of 1.0065 + (–14.1/10,000) = 1.00509. At settlement, Smart will need to purchase CAD 5 million under the original forward contract and sell CAD 5 million under the offsetting forward contract; the CAD will net to zero. However the USD will not net to zero because the forward rate has changed since contract initiation. At settlement Smart will receive CAD 5 million and pay out USD 5,022,097.23 (5,000,000/0.9956) under the original forward contract and sell CAD 5 million and receive USD 4,974,678.88 (5,000,000/1.00509) under the new contract. The difference between the USD received and paid is - USD 47,418.35 (USD 4,974,678.88 – USD 5,022,097.23). This represents an outflow because the original contract was long the CAD (or short the USD) and the CAD subsequently depreciated (or the USD appreciated, because the all-in forward rate increased from 0.9956 to 1.00509). The present value of this outflow is calculated as follows: − USD 47,418.35 =− 60 1 + 0.0026 360

47,397.81

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Reading 13

Currency Exchange Rates: Determination and Forecasting

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3. Question ID: 18447 Correct Answer: A A is correct. To determine whether arbitrage profits are possible, it is first necessary to calculate the bidoffer cross rate on the EUR/USD implied by the interbank market. = & ' % (

)*+

!"#

×

!"#

= 105.438 × 0.01222180* = 1.2886

& ' ,-. ( ×% ( ,-. )*+ )*+ = 105.440 × 0.01222210* = 1.2887

=%

*The JPY/USD rate is calculated as the inverse of the USD/JPY rate. Since the bid is the lower of the two inverse amounts, 0.01222180 and 0.01222210, the bid-offer spread is 0.01222180/0.01222210. Based on the interbank-implied cross rate of 1.2886/1.2887, the dealer is posting an offer rate to sell the USD cheaply, at a rate below the interbank market bid (1.2816 vs. 1.2886, respectively). Therefore, a triangular arbitrage would involve buying USD from the dealer selling it in the interbank market. 4. Question ID: 18448 Correct Answer: B B is correct. Arbitrage profits cannot be earned if the bid (offer) shown by the dealer is lower (higher) than the current interbank market offer (bid). Given that dealer’s bid, 1.4864, is lower than the interbank’s offer, 1.4865, and the dealer’s offer, 1.4866, is higher than the interbank’s bid, 1.4863, arbitrage profits cannot be earned. A is incorrect. The dealer’s offer of 1.4862 is lower than the interbank bid of 1.4863. It is possible to buy USD from the dealer and sell it in the interbank market and earn a profit. C is incorrect. The dealer’ bid of 1.4867 is higher than the interbank offer of 1.4865. It is possible to buy USD from the interbank and sell it to the dealer. 5. Question ID: 18449 Correct Answer: B B is least likely correct. Because Eoria is running a current account deficit, it is expected that the domestic currency will depreciate. However, a depreciation of the domestic currency should contribute to an improvement in Eoria’s trade competitiveness, in the long run, as the level of exports should increase relative to the imports. Masood’s comment with respect to trade competitiveness is incorrect. A is most likely correct. As stated in the preceding paragraph, Eoria’s domestic currency should depreciate because of its current account deficit.

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Reading 13

Currency Exchange Rates: Determination and Forecasting

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C is most likely correct. Relatively long lags can occur between changes in exchange rates, the ultimate adjustment in traded good prices and the eventual impact on import demand, export demand, and the underlying current account imbalance. 6. Question ID: 18450 Correct Answer: C C is least likely correct. The long-run equilibrium real value of Belare’s currency should increase as market participant revise upward their assessment of the domestic currency. This is because a tight fiscal policy should improve Belare’s long-run competitiveness, generate price stability, and gradually boost the real equilibrium value of its exchange rate. A is most likely correct. An improvement in long-run competitiveness and the gradual achievement of price stability policy will encourage investors to reduce the premium demanded for holding the high yield currency’s assets. Therefore the relative risk premium, ϕH ϕL, should decline. B is most likely correct. A tight fiscal policy will put downward pressure on domestic interest rates. With a decrease in Belare’s yield, the interest rate differential, iH – iL, should decline.

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