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CHAPTER 9 Global Foreign Exchange and Capital Markets 1. _____ is money denominated in the currency of another nation or group of nations. a. Foreign exchange b. Subsidies c. Tariffs d. Quotas Answer: a. Foreign exchange 2. A(n) _____ is the number of units of one currency that buys one unit of another currency, and this number can change daily. a. subsidy b. quota c. tariff d. exchange rate Answer: d. exchange rate 3. _____ is the price of a currency. a. Tariff b. Quota c. Exchange rate d. Subsidy Answer: c. Exchange rate 4. If Andrea wanted to purchase Spanish castanets from a company in Barcelona and needed euros to complete the transaction, she would use the _____. a. NYSE b. Foreign exchange market c. Philadelphia Stock Exchange d. crab shack Answer: b. Foreign exchange market 5. Outright forward transactions involve the exchange of currency beyond three days at a fixed exchange rate, known as the _____. a. spot rate b. forward rate c. FX swap rate d. reverse transaction rate Answer: b. forward rate 6. _____ involve the exchange of currency the second day after the date on which the two foreign exchange traders agree to the transaction. a. Spot transactions b. Outright forward transactions c. FX swaps d. Reverse transactions Answer: a. Spot transactions 7. In which of the following transactions is one currency swapped for another on one date and then swapped back on a future date? a. reverse transactions b. spot transactions c. FX swaps d. outright forward transactions Answer: c. FX swaps 8. The single purchase or sale of a currency for future delivery is called a(n) _____. a. FX swap b. spot transaction c. reverse transaction d. outright forward transaction Answer: d. outright forward transaction 9. The U.S. dollar is so widely traded partially because _____. a. it is an intervention currency employed by monetary authorities in market operations to influence their own exchange rates b. iIt is the oldest currency in the world c. the Bank of International Settlements is controlled by the Federal Reserve d. the New York Stock Exchange is the biggest foreign exchange center in the world. Answer: a. it is an intervention currency employed by monetary authorities in market operations to influence their own exchange rates 10. The ______ is the most widely traded currency in the world. a. pound b. yen c. euro d. U.S. dollar Answer: d. U.S. dollar 11. One reason that the U.S. dollar is so widely traded is in part because _____. a. the New York Stock Exchange is the biggest foreign exchange in the world b. all other foreign currencies are pegged to the dollar c. it is an investment currency in many capital markets d. the U.S. has a free market economy Answer: c. it is an investment currency in many capital markets 12. The _____ is the most important currency in the foreign exchange market. a. U.S. dollar b. euro c. yen d. pound Answer: a. U.S. dollar 13. The biggest market for foreign exchange is found in which of the following cities? a. New York b. Tokyo c. London d. Singapore Answer: c. London 14. ¬¬¬¬¬¬¬¬_____ is a strong international financial center where a large number of domestic and foreign financial institutions have operations. It is also positioned in a unique way because of its time zone. a. London b. New York c. Tokyo d. Singapore Answer: a. London 15. Due to _____, London is the biggest market for foreign exchange. a. the strength of the British pound b. its location, which is close to the major capital markets in Europe c. interventions by the Central Bank of England d. the emergence of the euro Answer: b. its location, which is close to the major capital markets in Europe 16. Why is London the biggest foreign exchange market in the world? a. It is the oldest city in the world. b. English is the national language. c. The pound is the strongest currency in the world. d. Many domestic and foreign institutions have operations there. Answer: d. Many domestic and foreign institutions have operations there. 17. The _____ is the price at which the trader is willing to buy foreign currency. a. offer b. bid c. spread d. cross rate Answer: b. bid 18. In the spot market, the _____ is the difference between the bid and offer rates and is the trader's profit margin. a. bid b. offer c. cross rate d. spread Answer: d. spread 19. Which of the following is the price at which the trader is willing to sell foreign currency? a. offer b. bid c. spread d. cross rate Answer: a. offer 20. Melissa, a foreign exchange trader, wants to buy euros from Stephanie. Which of the following is the price at which Melissa is willing to buy euros? a. spread b. offer c. bid d. cross rate Answer: c. bid 21. If the forward rate for a foreign currency is less than the spot rate, the foreign currency is selling at a _____. a. forward premium b. backward discount c. backward premium d. forward discount Answer: d. forward discount 22. If the forward rate is greater than the spot rate, the foreign currency is selling at a _____. a. forward premium b. forward discount c. backward discount d. discounted premium Answer: a. forward premium 23. The yen-dollar forward rate for yen is $.00909/¥1. The spot rate is $.010/¥1. Yen are thus selling at a _____. a. forward premium b. forward discount c. discounted premium d. backward discount Answer: b. forward discount 24. The pound-dollar forward rate for pounds is $1.9068, and the spot rate is $1.9059. Pounds are selling at a _____. a. discounted premium b. backward discount c. forward premium d. forward discount Answer: c. forward premium 25. A(n) _____ is the right but not the obligation to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate. a. forward rate b. bid c. offer d. option Answer: d. option 26. Which of the following is true regarding options? a. Options can be purchased only from a commercial or investment bank. b. Options are never used with foreign currency. c. An option is a right but not an obligation to buy or sell foreign currency. d. Options do not provide firms with flexibility. Answer: c. An option is a right but not an obligation to buy or sell foreign currency. 27. What is the difference between a forward contract and an option? a. A forward contract is less flexible than an option. b. Options are usually cheaper than forward contracts. c. Forward contracts are not as easy to obtain as options. d. A company can walk away from a forward contract, whereas options are less flexible. Answer: a. A forward contract is less flexible than an option. 28. Why are options so attractive to companies? a. The writer of the option does not charge the company any fee for writing the option. b. Options provide companies with more flexibility than a forward contract. c. Options are usually cheaper than forward contracts. d. Options can be used for only foreign exchange deals. Answer: b. Options provide companies with more flexibility than a forward contract. 29. Which of the following is an example of a hard currency? a. Russian ruble b. Brazilian beal c. Thai baht d. British pound Answer: d. British pound 30. Hard currencies are usually _____. a. volatile in value b. undesirable assets c. strong in comparison with other currencies d. not fully convertible Answer: c. strong in comparison with other currencies 31. Soft currencies are usually _____. a. found in developing countries b. fully convertible c. relatively stable d. found in developed countries Answer: a. found in developing countries 32. Fully convertible currencies are also called _____. a. external currencies b. hard currencies c. unlimited currencies d. soft currencies Answer: b. hard currencies 33. In a multiple exchange rate system, the _____ determine(s) which kinds of transactions are to be conducted at which exchange rates. a. central bank b. government c. foreign exchange traders d. importers and exporters Answer: b. government 34. Governments use a multiple exchange rate system to _____. a. increase their budget surplus b. reduce exports c. control foreign exchange convertibility d. limit deposit requirements Answer: c. control foreign exchange convertibility 35. In countries with a multiple exchange rate system, which of the following products would have a relatively high exchange rate? a. luxury goods b. essential commodities c. semimanufactured goods d. raw materials Answer: a. luxury goods 36. In countries with a multiple exchange-rate system, _____often have a very low exchange rate. a. luxury goods b. dividends c. finished foreign products d. semimanufactured goods Answer: d. semimanufactured goods 37. Commercial banks perform three essential financial functions. Which of the following items lists those functions? a. lending money in foreign currency; buying and selling foreign exchange; and collecting and paying foreign buyers and sellers b. paying foreign buyers and sellers; lending money in foreign currency; arbitrage c. buying and selling foreign exchange; collecting money from foreign buyers; speculation on future foreign exchange rates d. advising clients on profitable foreign exchange trades; lending foreign currency; paying money in transactions with foreign sellers Answer: a. lending money in foreign currency; buying and selling foreign exchange; and collecting and paying foreign buyers and sellers 38. What is one reason that commercial banks buy and sell foreign currency? a. to engage in arbitrage and make extra profit b. for import and export transactions c. travelers going to and from foreign countries want to purchase or sell foreign currency d. to increase their bargaining power with foreign banks Answer: c. travelers going to and from foreign countries want to purchase or sell foreign currency 39. Which of the following statements best explains a reason why companies use the foreign exchange market? a. to diversify their income from other sources. b. to convert money for use in financial transactions, such as FDI c. to increase their presence on the black market d. to get currency with which to bribe foreign officials Answer: b. to convert money for use in financial transactions, such as FDI 40. Why do most companies use the foreign exchange market? a. to diversify their income from other sources b. to improve their reputation as an international firm c. to convert currency for import and export transactions d. to improve their relationship with large commercial banks Answer: c. to convert currency for import and export transactions 41. What is the goal of arbitrage? a. using foreign exchange to fund new foreign direct investments b. using foreign exchange instruments to protect against risk c. using foreign exchange instruments to speculate for profit d. purchasing foreign currency on one market for immediate resale on another market in order to make a profit Answer: d. purchasing foreign currency on one market for immediate resale on another market in order to make a profit 42. Denise sold U.S. dollars for Ukrainian Grivna in the United States, then sold Ukrainian Grivna for euros in Ukraine, then sold euros for U.S. dollars in the United States. Which type of foreign exchange transaction does this describe? a. interest arbitrage b. speculation c. arbitrage d. FDI Answer: c. arbitrage 43. Which of the following is an example of interest arbitrage? a. investing in debt instruments b. selling U.S. dollars for Swiss francs, then selling Swiss francs for British pounds, then selling British pounds for U.S. dollars c. investigating different commercial banks to find the best exchange rate d. an American investing in a London-based company Answer: a. investing in debt instruments 44. How does arbitrage differ from speculation? a. Speculation, unlike arbitrage, is never used to protect against risk. b. A speculator buys or sells foreign currency with the hope that that currency will either weaken or strengthen in the future, resulting in a profit. c. Speculation is the purchase of foreign currency on one market for the immediate resale on another market. d. Arbitrage is another way to speculate for profit or protect against risk. Answer: b. A speculator buys or sells foreign currency with the hope that that currency will either weaken or strengthen in the future, resulting in a profit. 45. Which of the following statements is true regarding financial institutions and foreign exchange? a. Commercial banks are the only financial institutions that deal in foreign exchange. b. Brokerage houses are never used in foreign exchange trading. c. Most foreign exchange trades take place in the OTC market. d. Companies have a limited number of options when making foreign exchange trades. Answer: c. Most foreign exchange trades take place in the OTC market. 46. Which of the following statements accurately describes the current trend in currency trading? a. In the past, most foreign exchange trades took place by Internet. b. Voice trading is the latest advancement in currency trading. c. Electronic brokerage systems are used in 90 percent of all transactions for the euro, yen, and dollar. d. Internet currency trading, a recently established method of trading, provides 24-hour-a-day trading. Answer: d. Internet currency trading, a recently established method of trading, provides 24-hour-a-day trading. 47. According to Euromoney magazine, the criteria for selecting the top foreign exchange traders include the _____. a. capacity to handle weak or soft currencies b. capacity to handle major cross-trades c. capacity to engage in online trading d. length of time in the trading industry Answer: b. capacity to handle major cross-trades 48. Which of the following are two of the best-known foreign exchange instrument exchanges? a. Philadelphia Stock Exchange (PHLX) and Chicago Mercantile Exchange (CME) b. London Stock Exchange (LSE) and New York Stock Exchange (NYSE) c. New York Stock Exchange (NYSE) and Philadelphia Stock Exchange (PHLX) d. London Stock Exchange and Chicago Mercantile Exchange (CME) Answer: a. Philadelphia Stock Exchange (PHLX) and Chicago Mercantile Exchange (CME) 49. What is a Eurocurrency, as opposed to a Eurodollar? a. There is no difference between a Eurocurrency and a Eurodollar. b. A Eurocurrency is any currency banked outside its country of origin, whereas a Eurodollar is a deposit of dollars in a bank outside the United States. c. A Eurocurrency is a deposit of euros in an American bank, and a Eurodollar is a deposit of dollars in a European bank. d. A Eurocurrency is one type of Eurodollars. Answer: b. A Eurocurrency is any currency banked outside its country of origin, whereas a Eurodollar is a deposit of dollars in a bank outside the United States. 50. What are the advantages of Eurocurrencies? a. They are inconvenient to the user but very convenient to the lender. b. They provide the lender with cheaper lending rates. c. They are not very secure. d. They provide the lender with better yield. Answer: d. They provide the lender with better yield. 51. Which of the following is a characteristic of the Eurocurrency market? a. The Eurocurrency market is both short and medium term. b. Private borrowers, such as corporations and individual lenders, are the major players in the Eurocurrency market. c. The Eurocurrency market is retail, rather than a wholesale, market. d. The interest rates in the Eurocurrency market are about the same as in domestic markets. Answer: a. The Eurocurrency market is both short and medium term. 52. What is LIBOR? a. the interest rate of the National Bank of London b. the deposit rate that applies to interbank loans within London c. the interest rate of the European Union d. the deposit rate that applies to commercial loans in the European Union Answer: b. the deposit rate that applies to interbank loans within London 53. A French company floating a bond issue in Swiss francs in Switzerland would be selling a(n) _____. a. foreign bond b. eurobond c. global bond d. domestic bond Answer: a. foreign bond 54. A bond issue floated by a U.S. company in dollars in London, Luxembourg, and Switzerland is an example of a(n) _____. a. global bond b. domestic bond c. eurobond d. foreign bond Answer: c. eurobond 55. The global bond was issued by the World Bank in 1989 and is a combination of a(n) _____ and a(n) _____. a. eurobond; foreign bond b. domestic bond; eurobond c. domestic bond; foreign bond d. long-term bond; eurobond Answer: b. domestic bond; eurobond 56. Which of the following statements explains why a company may want to borrow money in the international bond market? a. The international bond market tends to be more expensive than local bond markets. b. It allows a company to diversify its funding sources. c. Because the international bond market is centered in Europe, only European countries may use it. d. Eurobonds are not readily available to the investing public. Answer: b. It allows a company to diversify its funding sources. 57. Brook buys shares of stock in a small bakery in return for an ownership position and promised capital gains. This is an example of _____. a. equity financing b. debt financing c. playing the stock market d. investing in Euroequities Answer: a. equity financing 58. Another name for the equity capital market is the _____. a. international bond market b. London Stock Exchange c. stock market d. New York Stock Exchange Answer: c. stock market 59. Which of the following statements accurately describes the recent trend in equity markets? a. Emerging stock markets have decreased steadily since 1990. b. More and more companies are looking at equity markets as an alternative to debt financing. c. Markets in developed countries weathered the global recession of 2002 better than emerging stock markets. d. Over the past few years, investors have increasingly turned their money from emerging stock markets to the United States and other major stock markets. Answer: b. More and more companies are looking at equity markets as an alternative to debt financing. 60. The market for shares sold outside the boundaries of the issuing company's home country is the _____. a. Eurocurrency market b. international bond market c. international equity market d. Euroequity market Answer: d. Euroequity market 61. Since 1980, hundreds of companies around the world have issued stock in two or more countries. Since 2000, this trend has _____. a. increased at a more dramatic pace b. increased gradually c. declined d. stayed the same Answer: c. declined 62. Which of the following statements best explains why companies are removing their shares from foreign stock exchanges? a. The best price for stocks is usually in foreign markets. b. Market returns in foreign markets are usually stronger than in domestic markets. c. Decreased regulation has reduced the amount of information necessary to list on certain exchanges. d. If trading is light on a certain exchange, companies can save money by listing only on exchanges with heavier trading volumes. Answer: d. If trading is light on a certain exchange, companies can save money by listing only on exchanges with heavier trading volumes. 63. Following the recent corporate governance problems, the New York Stock Exchange's popularity has _____. a. decreased b. increased c. stayed the same d. increased dramatically Answer: a. decreased 64. Which of the following statements best explains the benefits to companies who list on a foreign exchange? a. Foreign listings decrease the visibility of a company, its products, and the trading of its shares. b. Listing on a foreign exchange provides a company with the opportunity to develop a wide shareholder constituency. c. A company who lists on a foreign exchange will usually receive a lower price for its stock. d. Increased regulation has made it easier for companies to list on foreign exchanges. Answer: b. Listing on a foreign exchange provides a company with the opportunity to develop a wide shareholder constituency. 65. A negotiable certificate issued by a U.S. bank to represent the underlying shares of a foreign corporation's stock is called a(n) _____. a. Euroequity b. American Depositary Receipt c. Global Depositary Receipt d. European Depositary Receipt Answer: b. American Depositary Receipt 66. The best way for a Euroequity to get a listing in the United States is to issue a(n) _____. a. Global Depositary Receipt b. European Depositary Receipt c. American Depositary Receipt d. Domestic Depositary Receipt Answer: c. American Depositary Receipt 67. The largest market for Euroequities is found in _____. a. London b. Singapore c. Japan d. the United States Answer: d. the United States 68. Which of the following statements is true regarding ADRs and the Euroequity market? a. Those companies that list on an American exchange get access to more than 50 percent of the world's market capitalization. b. The U.S. market is the only market for Euroequities. c. Companies usually list on foreign exchanges first, then they list on their home country exchange. d. The U.S. market is the second biggest market for Euroequities, second only to London. Answer: a. Those companies that list on an American exchange get access to more than 50 percent of the world's market capitalization. 69. A(n) _____ occurs when a company issues shares of its stock simultaneously in two or more countries. a. American Depositary Receipt (ADR) b. Global Depositary Receipt c. multinational IPO d. global share offering Answer: d. global share offering 70. Why is it important for MNEs to list their securities on foreign exchanges? a. As MNEs generate more of their revenues inside of their home country, it is easier to attract investors from foreign countries. b. Listing on foreign exchanges gives companies opportunities to develop a broad shareholder constituency. c. The visibility of an MNE and its products decreases when the company lists on a foreign exchange. d. Listing on a foreign exchange is not a good form of portfolio diversification. Answer: b. Listing on foreign exchanges gives companies opportunities to develop a broad shareholder constituency. 71. As global stock markets grow, companies will find it _____ to raise equity capital outside of their home markets. a. easier b. more difficult c. does not change their opportunities d. more of a challenge Answer: a. easier 72. There are a number of movements to improve stock market activity around the world, including _____. a. moving from Internet trading to voice brokerage b. increased SEC reporting requirements c. Europe's plan to introduce a unified stock exchange d. MNEs removing shares from foreign exchanges Answer: c. Europe's plan to introduce a unified stock exchange 73. Foreign exchange can be in the form of cash, traveler's checks, or bank deposits. Answer: True 74. An exchange rate is the number of units that buys one unit of another currency. Answer: True 75. A spot transaction involves the exchange of currency three or more days after the date on which the traders agree to the transaction. Answer: False 76. In an FX swap, one currency is swapped for another on one date and then swapped back on a future date. Answer: True 77. The U.S. dollar is important as a vehicle for foreign exchange transactions between two countries other than the United States. Answer: True 78. Almost every foreign exchange transaction conducted on a daily basis has the dollar as one leg of the transaction. Answer: True 79. One reason that London is the most important foreign exchange trading market is due to its unique time zone position. Answer: True 80. The emergence of the euro has helped London become one of the biggest foreign exchange trading markets. Answer: False 81. The bid is the price at which the trader is willing to sell foreign currency. Answer: False 82. The bid price is usually higher than the offer price. Answer: False 83. If the forward rate for yen is $.00909/¥1, and the spot rate is $.010/¥1, yen are selling at a forward premium. Answer: True 84. If the forward rate for a foreign currency is less than the spot rate, the foreign currency is selling at a forward premium Answer: False 85. Options are more flexible than forward contracts. Answer: True 86. On the date when an option to buy euros is set to expire, if the spot rate is less than the option rate, a company will not exercise the option. Answer: True 87. The Japanese yen is an example of a soft currency. Answer: False 88. Soft currencies are usually the currencies of developing countries. Answer: True 89. In a multiple exchange rate system, the central bank determines which kinds of transactions are to be conducted at which exchange rate. Answer: False 90. A multiple exchange rate system is another way for governments to control foreign exchange convertibility. Answer: True 91. Most companies use foreign exchange for import and export transactions. Answer: True 92. Commercial banks buy and sell foreign exchange, collect and pay money in foreign transactions, and lend foreign currency. Answer: True 93. Using foreign exchange transactions to speculate for profit or to protect against risk is called arbitrage. Answer: False 94. Arbitrage is the purchase of foreign currency on one market for immediate resale on a foreign market in order to profit from a price discrepancy. Answer: True 95. Although most foreign currency trades in the past took place by telephone, the use of electronic brokerages is increasing. Answer: True 96. The OTC market is the only market in which foreign exchange instruments are traded. Answer: False 97. A Eurocurrency is any currency that is banked outside its country of origin. Answer: True 98. The Eurocurrency market is so large because it is a retail market, and the major players are public borrowers, such as governments and central banks. Answer: False 99. A French company floating a bond issue in Swiss francs in Switzerland would be selling a foreign bond. Answer: True 100. A global bond is a combination of a domestic bond and a foreign bond. Answer: False 101. Another source of financing, in which an investor takes an ownership position in return for shares of stock in the company and the promises of capital gains is called debt financing. Answer: False 102. Two forms of equity financing are private placement with a venture capital firm and the equity capital market, otherwise known as the stock market. Answer: True 103. More and more companies are removing their shares from foreign exchanges, in part because of weak market returns and increased regulation. Answer: True 104. The trend of listing on more than one exchange, which was popular in the 1990s, is beginning to increase even more dramatically. Answer: False 105. An ADR is a negotiable certificate issued by a U.S. bank in the United States to represent the underlying shares of a foreign corporation's stock held at a custodian bank in the foreign country. Answer: True 106. Unlike normal shares of stock, ADRs cannot be traded on an exchange. Answer: False 107. A global share offering occurs when a company issues shares of its stock simultaneously in two or more countries. Answer: That statement accurately describes a global share offering. In such an offering, a company seeks to raise capital by issuing shares of its stock not only in its home market but also in multiple international markets simultaneously. This approach allows the company to access a broader investor base and potentially attract more capital by tapping into different geographical regions and investor preferences. 108. As global stock markets grow, companies will find it easier to raise equity capital outside of their home markets. Answer: This statement is generally true. With the expansion and integration of global stock markets, companies have increasingly diverse options for raising equity capital beyond their domestic markets. As international financial markets become more interconnected and accessible, companies can explore opportunities to issue shares in multiple jurisdictions through mechanisms like global depository receipts (GDRs) or American depository receipts (ADRs). This trend facilitates capital raising on a global scale, offering companies greater flexibility and potentially lower costs of capital as they tap into the depth and liquidity of international markets. 109. What are foreign exchange and the exchange rate? Answer: The foreign exchange market has two major segments: the over-the-counter market (OTC) and the exchange-traded market. The OTC market is comprised of banks, both commercial banks such as Bank of America and investment banks such as Merrill-Lynch, and other financial institutions, and is where most of the foreign exchange activity takes place. The exchange-traded market is comprised of securities exchanges, such as the Philadelphia Stock Exchange and the Chicago Mercantile Exchange, where certain types of foreign exchange instruments, such as exchange-traded options and futures, are traded. Several different types of foreign exchange instruments are traded in these markets, but the traditional foreign exchange instruments that comprise the bulk of foreign exchange trading are spot transactions, outright forwards, and FX swaps. Spot transactions involve the exchange of currency the second day after the date on which the two foreign exchange traders agree to the transaction. The rate at which the transaction is settled is the spot rate. Outright forward transactions involve the exchange of currency three or more days after the date on which the traders agree to the transaction. It is the single purchase or sale of a currency for future delivery. The rate at which the transaction is settled is the forward rate and is a contract rate between the two parties. In an FX swap, one currency is swapped for another on one date and then swapped back on a future date. Although an FX swap is both a spot and a forward transaction, it is accounted for as a single transaction. 110. In a short essay, discuss the characteristics of the spot market. Answer: Most foreign currency transactions take place between foreign exchange traders, so the traders, who work for foreign exchange brokerage houses or commercial banks, quote the rates. The traders always quote a bid and offer rate. The bid is the price at which the trader is willing to sell foreign currency. In the spot market, the spread is the difference between the bid and offer rates and is the trader's profit margin. The method of quoting exchange rates is called the direct quote, also known in the foreign exchange industry as "American terms." It represents a quote from the point of view of someone in the United States. The other convention for quoting foreign exchange is "European terms," which means a direct quote from the perspective of someone in Europe. From a U.S. point of view, this means the number of units of the foreign currency per U.S. dollar. This is also sometimes called the indirect quote in the United States, although American terms and European terms are the most accurate way to describe the quotes. 111. In a short essay, discuss the characteristics of the forward market. Answer: The spot market is for foreign exchange transactions that occur within two business days, but in some transactions a seller extends credit to the buyer for a period that is longer than two days. The forward rate is the rate quoted today for future delivery. The most widely traded currencies in the forward market are the British pound, Canadian dollar, French franc, German mark, Japanese yen, and Swiss franc. Many currencies do not have a forward market due to the small size and volume of transactions it that currency. The difference between the spot and forward rates is either the forward discount or the forward premium. If the forward rate for a foreign currency is less than the spot rate, the foreign currency is selling at a forward discount. If the forward rate is greater than the spot rate, the foreign currency is selling at a forward premium. 112. In a short essay, discuss the characteristics of the futures market. Answer: A foreign currency future resembles a forward contract in that it specifies an exchange rate sometime in advance of the actual exchange of currency. However, a future is traded on an exchange not over-the-counter. Instead of working with a banker, companies work with exchange brokers when purchasing futures contracts. A forward contract is tailored to the amount and timeframe that the company needs, while a futures contract is for a specific amount and specific maturity date. The futures contract is less valuable to a company than a forward contract. However, it may be useful to speculators and small companies who do not have a good enough relationship with a bank to enter into a forward contract or who need a contract for an amount that is too small for the forward market. 113. In a short essay, discuss the issues of foreign exchange convertibility. Answer: A key aspect of exchanging one currency for another is its convertibility. Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts. Hard currencies, such as the U.S. dollar and Japanese yen, are currencies that are fully convertible. They are also relatively stable in value or tend to be strong in comparison with other currencies. In addition, they are desirable assets to hold. Currencies that are not fully convertible are often called soft currencies, or weak currencies. They tend to be the currencies of developing countries, also known as exotic currencies. Most countries today have nonresident, or external, convertibility, meaning that foreigners can convert their currency into the local currency and can convert back into their currency as well. Some countries limit nonresident convertibility. To conserve scarce foreign exchange, some governments impose exchange restrictions on companies or individuals who want to exchange money. The devices they use include import licensing, multiple exchange rates, import deposit requirements, and quantity controls. Governmental licenses fix the exchange rate by requiring all recipients, exporters, and others who receive foreign currency to sell it to its central bank at the official buying rate. Another way governments control foreign exchange convertibility is to establish more than one exchange rate. This restrictive measure is called the multiple exchange rate system. Another form of foreign exchange convertibility control is the advance import deposit. In this case, the government tightens the issue of import licenses and requires importers to make a deposit with the central bank, often for as long as one year and interest-free, covering the full price of manufactured goods they would purchase from abroad. Governments also may limit the amount of exchange through quantity controls, which often apply to tourism. A quantity control limits the amount of currency that a local resident can purchase from the bank for foreign travel. 114. What are meant by a hard currency and a soft or weak currency? Answer: Hard currencies, such as the U.S. dollar and Japanese yen, are currencies that are fully convertible. They are also stable in value or tend to be strong in comparison with other currencies. In addition, they are desirable assets to hold. Currencies that are not fully convertible are often called soft currencies, or weak currencies. They tend to be the currencies of developing countries, also known as exotic currencies. 115. In a short essay, discuss how companies use foreign exchange. Answer: Most foreign exchange transactions stem from the international department of commercial banks, which perform three essential financial functions: they buy and sell foreign exchange, they collect and pay money in transactions with foreign buyers and sellers, and they lend money in foreign currency. In performing collections, the bank serves as a vehicle for payments between its domestic and foreign customers. Lending usually takes place in the currency of the bank's headquarters, but the bank might be able to provide loans in a foreign currency if it has a branch in that country. Commercial banks buy and sell foreign currency for many purposes. For one, travelers going abroad or returning from a foreign country will want to purchase or sell back its foreign currency. Also, residents of one country who want to invest abroad need to purchase foreign currency from a commercial bank. There are a number of reasons why companies use the foreign exchange market. The most obvious is for import and export transactions. Companies also use the foreign exchange market for financial transactions, such as those in FDI. Sometimes companies, but mostly traders and investors, deal in foreign exchange solely for profit. One type of profit-seeking activity is arbitrage, which is the purchase of foreign currency on one market for immediate resale on another market (in a different country) to profit from a price discrepancy. 116. What is arbitrage? Answer: Interest arbitrage is investing in debt instruments, such as bonds, in different countries. For example, a trader might invest $1,000 in the United States for 90 days or convert $1,000 into British pounds, invest the money in the United Kingdom for 90 days, and then convert the pounds back into dollars. The investor would try to pick the alternative that would provide the highest yield at the end of the 90 days. 117. What is currency speculation? Answer: Speculation is the buying or selling of a commodity that has both an element of risk and the chance of great profit. For example, an investor could buy euros in anticipation of the euro's strengthening against other currencies. If it strengthens, the investor earns profit; if it weakens, the investor incurs a loss. Speculators are important in the foreign exchange market because they spot trends and try to take advantage of them. They create demand for a currency by purchasing it in the market, or they can create a supply of the currency by selling it in the market. Test Bank for International Business: Environments and Operations John D. Daniels, Lee H. Radebaugh, Daniel P. Sullivan 9780131869424, 9780201846188, 9780130308016, 9780201566260, 9780201107135, 9780132668668
