Chapter 9 Foreign Exchange Markets

foreign exchange markets

Cash flows from the sale of products, services, or assets denominated in a foreign currency are transacted in

foreign exchange rate

is the price at which one currency (e.g., the U.S. dollar) can be exchanged for another currency (e.g., the Swiss franc) in the foreign exchange markets

foreign exchange risk

the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm

currency depreciation (appreciation)

occurs when a country's currency falls (rises) in value relative to other currencies

The euro is the:

European Union's single currency

The dollar remains the...

unparalleled medium of exchange because it is the world's easiest currency to buy or sell.

Dollarization

the process of aligning a country's currency with the US dollar.

advantage of dollarization

is the promotion of fiscal discipline and thus greater financial stability and lower inflation

FX rates are listed in two ways:

1.U.S. dollars received for one unit of the foreign currency exchanged (IN US$ or USD, also referred to as the direct quote)

2.Foreign currency received for each U.S. dollar exchanged (PER US$, also referred to as the indirect quote)

Two types of FX rates and FX transactions:

Spot FX transactions and Forward FX transaction

Spot FX transactions

involve the immediate exchange of currencies at the current (or spot) exchange rate

Forward FX transaction

is the exchange of currencies at a specified exchange rate (or forward exchange rate) at some specified date in the future.

FX rates and FX transactions example:

An example is an agreement today (at time 0) to exchange dollars for pounds at a given (forward) exchange rate in three months. Typically written for one-, three-, or six-month periods.

Risk involved with a Spot FX transaction

That the value of the foreign currency may change relative to the U.S. dollar over a holding period

FX risk is also introduced by

Adding foreign currency assets and liabilities to a firm's balance sheet

Who are the main participants in the FX markets?

Financial institutions and commercial banks

Managers heder to manage their exposure to currency risks,

not to eliminate it

An FI can better control the scale of its FX exposure in
either of two major ways:

On-balance sheet hedging and off-balance-sheet hedging

FX risks exposure include:

-International differentials in real prices
-Cross-country differences in the real rate of interest -Regulatory and government intervention
-Restrictions on capital movements
-Trade barriers
-Tariffs

Securities that may be used to hedge foreign exchange risk includes the following:

-Forwards
-Futures and options foreign exchange
contracts
-Foreign exchange swaps

FX market transactions are conducted among dealers mainly:

OTC using telecommunication and computer networks

FI's net exposure

is the overall FX exposure in any given currency, measured by its net book or position exposure, where i = ith country’s currency:

a positive net exposure position

implies an FI is overall net long in a currency (i.e., the FI has purchased more foreign currency than it has sold)

a negative net exposure position

implies the FI is net short (i.e., the FI has sold more foreign currency than it has purchased) in a foreign currency

Fisher effect (i=IP+RFR)

the relationship among interest rates, real interest rates, and expected inflation

on-balance-sheet hedging

Involves making changes in the on-balance-sheet assets and liabilities to protect the FI's profits from FX risk

off-balance-sheet hedging

Involves no on-balance-sheet changes, but rather involves taking a position in forward or other derivative securities to hedge FX risk

Purchasing Power Parity (PPP)

is the theory explaining the change in foreign currency exchange rates as inflation rates in the countries change

law of one price

is an economic concept that states that the price of an identical asset or commodity will have the same price globally, regardless of location, when certain factors are considered. (BIG MAC INDEX) theory behind purchasing power parity

interest rate parity theorem (IRPT)

The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency

As the U.S. dollar appreciates against the Japanese yen, U.S. become less expensive to Japanese consumers.

False

A U.S. firm has borrowed £50 million from a British firm. The borrower will need to convert dollars to pounds to repay the loan when it is due. The U.S. firm could hedge the exchange rate risk by

buying pounds forward

A U.S. bank converted $1 million to Swiss francs to make a Swiss franc loan to a valued corporate customer when the exchange rate was 1.2 francs per dollar. The borrower agreed to repay the principal plus 5 percent interest in one year. The borrower repaid Swiss francs at loan maturity and when the loan was repaid the exchange rate was 1.3 francs per dollar. What was the bank's dollar rate of return?

-3.08%

The spot rate for the Argentine peso is $0.3600 per peso. Over the year, inflation in Argentina is 10 percent and U.S. inflation is 4 percent. If purchasing power parity holds, at year-end the exchange rate should be approximately ________ dollars per peso.

0.3384

If interest rate parity holds and the annual German nominal interest rate is 3 percent and the U.S. annual nominal rate is 5 percent and real interest rates are 2 percent in both countries, then inflation in Germany is about ________ than in the United States.

2 percent lower

A current account deficit implies that

more goods and services are imported than are exported

the concept underlying purchasing power parity is the

law of one price

The value of the Euro changed from $1.15 to $1.25. We can say that the dollar has ________ and the euro has ________.

depreciated; appreciated

A U.S. investor has borrowed pounds, converted them to dollars, and invested the dollars in the United States to take advantage of interest rate differentials. To cover the currency risk, the investor should

buys pounds forward

A U.S. bank has made £12 million worth of loans and £10 million worth of deposits in Britain. The bank would benefit from a drop in the value of the pound against the dollar.

false

If a foreign currency appreciates, that country's goods and services become relatively more expensive for U.S. buyers.

true

If the United States has inflation of 3 percent and Europe has inflation of 5 percent, the value of the euro should increase, ceteris paribus.

false

A drop in value of the dollar hurts U.S. importers and helps U.S. exporters, ceteris paribus.

true

If the dollar is initially worth 120 yen and then the exchange rate changes so that the dollar is now worth 115 yen, the value of the yen has depreciated.

false

Credit Default Swap

Form of insurance pays if an issuer defaults on its bonds

The type of swap most closely linked to the subprime mortgage crisis is the ________.

credit default swap

You have agreed to deliver the underlying commodity on a futures contract in 90 days. Today the underlying commodity price rises and you get a margin call. You must have

a short position in a futures contract

An investor has unrealized gains in 100 shares of Amazin stock for which he does not wish to pay taxes. However, he is now bearish upon the stock for the short term. The stock is at $76 and he buys a put with a strike of $75 for $300. At expiration the stock is at $68. What is the net gain or loss on the entire stock/option portfolio?

-400

Bank assets tend to have ________ maturities and ________ liquidity than/as bank liabilities.

longer; lower

An example of off balance sheet activity includes:

purchasing a futures contract.

cash in the process of collection is

checks that the bank is owed but has not yet collected.

Core deposits typically include all except which one of the following?

eurodollar deposits

the ones included are below
-demand deposits
-passbook savings accounts
-NOW accounts
-MMDAs

A bank has interest income to total assets ratio of 5.45 percent and has noninterest income of $45 million and total assets of $700 million. What is the bank's asset utilization ratio?

11.88%

A bank is earning 6 percent on its $150 million in earning assets and is paying 4.75 percent on its liabilities. The bank's interest rate spread is ________.

1.25%

The First Bank of the Ozarks generates $0.0155 dollars of net income per dollar of assets and it has a profit margin of 12.25 percent. How much operating income per dollar of total assets does First Bank generate?

12.65%

Which of the following assets are used to increase a bank's liquidity position?

treasury securities because they are the most liquid and can be easily sold

Areas of commercial bank regulation dealing with preventing banks from discriminating unfairly in lending are termed ________ regulations.

consumer protection

A bank has Tier 1 capital of $90 million and Tier 2 capital of $70 million. The bank has total assets of $2,522 million and risk-weighted assets of $2,017.6 million. This bank is

undercapitalized

FDIC deposit insurance is generally limited to ________ per depositor per bank.

$250,000

QTL test

qualified thrift lender test that sets a floor on the mortgage related assets held by thrifts (currently 65 percent)

The QTL test requires that thrifts

invest at least 65 percent of their assets in mortgages or mortgage-related assets.

A finance company that makes loans to high-risk customers is called a

subprime lender

In property and casualty insurance the combined ratio is equal to ________ divided by total premiums written.

the sum of the loss ratio plus general expenses and broker's commissions

An investor has $25,000 that he can invest today. In addition to this amount, he can also invest $12,000 per year for 30 years (beginning one year from now) at which time he will retire. He plans on living for 25 years after he retires. If interest rates are 8 percent, what size annual annuity payment can he obtain for his retirement years? (All annuity payments are at year-end. Round your answer to the nearest dollar.)

150,913

Aggregate finance company profitability was poor in the late 2000s primarily due to which segment of the finance company industry?

subprime lending

Hurricane damage in a given area is an example of a ________ for which it is difficult to predict loss exposure.

high severity; low frequency event

Estimates of the cost of the September 11, 2001, terrorist attacks on the World Trade Center indicate that the cost to insurance companies was as high as

40 billion

An investment banker agrees to a firm commitment offering of two million shares of Ace stock. The offer price is set at $55 and the spread is 50 cents per share. If the stock is actually sold to the public at $53.80, however, what is the investment banker's gain or loss?

-1,400,000 loss

A company issued 5 million new shares of stock. An investment bank agrees to underwrite these shares on a best efforts basis. The investment bank is able to sell 3.7 million shares for $34.50 per share, and it charges commission of $0.52 per share sold. How much money will the company receive?

125,726,000

The risk that an unanticipated increase in liability withdrawals may cause an FI to have to sell assets at fire sale prices is an example of

liquidity risk

The terrorist attacks on the World Trade Center in 2001 are an example of ________.

event risk

The riskiest capital market security is

common stock

Which of the following are reported as liabilities on a bank's balance sheet?

checkable deposits are funds that customers have deposited in the bank, and the bank is obligated to return these funds upon demand.

eurodollars are

dollar-denominated deposits held in banks outside the U.S.

The earliest form of insurance was ________ insurance.

property and casualty

To prevent the moral hazard problem, health and life insurance companies may write policies

-All the answers below
-containing provisions which either reduce or eliminate benefits to persons who contract prespecified illnesses.
-limiting the amount the companies will pay in the event that claims are submitted by policyholders.
-for which premiums increase dramatically once the policyholder is discovered to have contracted an illness

An investment bank is a financial institution that

helps corporations raise funds.

a firm will borrow long-term

if the extra interest cost of borrowing long-term is less than the expected cost of rising interest rates before it retires its debt.

In comparison to small banks, larger banks typically have

more equity capital

If the United States has inflation of 3 percent and Europe has inflation of 5 percent, the value of the euro should increase, ceteris paribus

false

A wholesale bank is one that focuses its business activities on commercial banking relationships

true

In ratio analysis, the profit margin times the asset utilization ratio equals return on assets.

true

Banks are generally prohibited from making loans exceeding more than 15 percent of their own equity capital to any one company or borrower.

true

Of all the depository institutions, as a percentage of assets, credit unions rely the most on deposit sources of funds.

true

A 65-year-old person has saved $1,250,000 and wishes to receive 10 annual annuity payments, beginning in one year. If the annuity rate is 5.75 percent, he can expect to receive $167,829 per year.

true

Liability lawsuits related to asbestos claims are an example of long tail losses

true

An example of a national full-line investment banker that specializes in corporate finance is Goldman Sachs.

true

In a best efforts offering, the investment banker acts as an agent for the issuer rather than as a principal.

true

Risk arising from unhedged positions in securities, currencies, and derivatives is called market risk.

true

The subprime crisis is a good example of the credit risk faced by financial institutions.

true