BU416
Dr. J. A. Schnabel
Page 1 of 2
BU416 Quiz Practice Problems
Pertaining to Chapters 4 and 5
Note that these problems are not articulated in the multiple-choice format of the quiz. The quiz
will be composed of 40 multiple-choice problems, each of which will present you with four
alternatives. You will be asked to choose the best alternative.
Although there will be questions pertaining to all chapters covered, there will be more weight on
chapters 4 and 5.
1. The interest rate in Mexico equals 6% whereas that in the U.S. equals 4%.
A.) Which country has the higher inflation rate?
B.) Which country’s currency will appreciate?
C.) Which country’s currency exhibits a forward premium?
Answers:
A.) Mexico. Interest rates and inflation rates go together, i.e., move in tandem,
according to the Generalized Fisher Effect.
B.) U.S. The low interest rate currency will appreciate according to the International
Fisher Effect.
C.) U.S. The low interest rate currency exhibits a forward premium according to
Interest Rate Parity.
2. The interest rate in Mexico equals 6% whereas that in the U.S. equals 4%. The current
spot rate on the USD (U.S. dollar) equals MXP 5, where MXP denotes the Mexican peso.
A.) What is your forecast of the spot rate on the USD a year from now, expressed in
MXPs per USD?
B.) What do you expect the one-year forward rate on the USD to be, expressed in MXPs
per USD?
Answers:
A.) MXP 5.10 since, according to the International Fisher Effect, the future spot rate
on the USD equals 5 (1.06/1.04).
B.) MXP 5.10 since, according to Interest Rate Parity, the forward rate on the USD
equals 5 (1.06/1.04). Alternatively, one could argue that the answer to B.) should
be the same as that of A.) by invoking Unbiased Forward Rates, i.e., the forward
rate equals the expected future spot rate.
3. The British Pound Sterling (BPS) is trading at JPY 310, where JPY denotes the Japanese
Yen. The Euro, denoted EUR, is trading at JPY 250. What should the spot value of the
BPS be expressed in Euros, i.e., expressed as S(EUR/BPS)?
BU416
Dr. J. A. Schnabel
Page 2 of 2
Answer:
S(EUR/BPS) should equal 1.24, i.e., the spot value of the BPS should be EUR 1.24,
which is obtained via the calculation 310/250. The numerator of the latter is S(JPY/BPS)
whereas the denominator of the latter is S(JPY/EUR). Thus, the ratio is the desired
S(EUR/BPS).
4. The British Pound Sterling (BPS) is trading at JPY 310, where JPY denotes the Japanese
Yen. The Euro, denoted EUR, is trading at JPY 250. The BPS is trading at EUR 1.3.
Discuss how you can generate profits by trading the three currencies.
Answer:
You will generate profits if you follow the sequence of transactions: BPS to EUR to JPY
to BPS. This is indicated by the fact that the S(EUR/BPS) x S(JPY/EUR) x S(BPS/JPY)
equals 1.05. Thus profits are generated if you sell BPS for EUR then sell EUR for JPY
and finally sell JPY for BPS. The foregoing may be equivalently articulated as buy EUR
with BPS then buy JPY with EUR and finally buy BPS with JPY. The product of the
three spot rates, which equals 1.05, means that if you start with one unit of one currency
(BPS, EUR, or JPY) and then follow the indicted sequence of transactions, you will end
up with 1.05 units of that same currency (BPS, EUR, or JPY, respectively).
5.
The Bid rate on the BPS (British Pound Sterling) equals JPY 305, where JPY denotes the
Japanese Yen. The Ask rate on the BPS (British Pound Sterling) equals JPY 315. What
should the Bid and Ask rate on the JPY be expressed in BPSs, i.e., quoted as
S(BPS/JPY)?
Answer:
The Bid rate on the JPY equals 1/315 or BPS 0.00317. The Ask rate on the JPY equals
1/305 or BPS 0.00328. Note that the crisscross rule for the determination of Bid-Ask
quotes is being applied here. The crisscross rule states that the Bid rate on one currency
is the reciprocal of the Ask rate on the other currency because buying one currency
means selling the other currency.