International Financial Management

Exam #1 v1

The exam has 3 sections, an optional problem and an optional question. The relative worth of
each question is indicated in the section heading.
For the problems, use two significant digits (round at 0.01) and show your work for partial
credit.
You have 70 minutes. Good luck!

YOUR NAME:

Open Questions (35 points)

1. What is the Dutch Disease? (10 points)

The term was coined in 1977 by The Economist.
The Netherlands discovered natural gas fields in 1959.
The export of natural gas drove the currency so high that the other exports of the country
were hurt and economic growth, overall, suffered.
So the term refers to the situation where overabundance of natural resources prevents the
development of other industries.
One of the explanations for the natural resource curse.
A lot of countries rich in natural resources are amongst the poorest in the world, as
measured by GDP per capita.

2. Has the US current account been at a deficit or surplus over the past years? What about
the capital account? What does that mean? Choose one other country and tell me about
their current and capital accounts (we discussed China and Japan, but any other will do).
(10 points)
The US current account is running a deficit on its current account and a surplus on its
capital account. It means the US is importing more than it is exporting. But foreigners are
investing in the US more than US citizens and institutions are investing abroad.
The Japanese capital account is running a deficit while the current account has a surplus.

3. Describe two current currency exchange rate arrangements and list at least one country as
an example of each arrangement type. (One example is free floating currencies. Give
me two more). (10 points)
Free Float: market forces determine the value of a currency (Canada).
No own currency (El Salvador).
Pegged: The value of a currency depends on the value of another, reference, currency
(Syria, linked to USD).
Many other examples are possible here.

4. What is the goal of a manager or, at least, what do we assume to be the goal of a
corporate manager? (This should be VERY short and precise) (5 points)

Shareholder wealth maximization.

Multiple Choice (30 points, 5 points each)

1.
When a country's currency appreciates (gains value) against the currencies of major
trading partners,
A. the country's exports tend to rise and imports fall.
B. the country's exports tend to fall and imports rise.
C. the country's exports tend to rise and imports rise.
D. the country's exports tend to fall and imports fall.

2.

The international monetary system went through several distinct stages of evolution.

These stages are summarized, in alphabetic order, as follows:

(i)- Bimetallism
(ii)- Bretton Woods system
(iii)- Classical gold standard
(iv)- Flexible exchange rate regime
(v)- Interwar period
The chronological order that they actually occurred is:
A. (iii), (i), (iv), (ii), and (v)
B. (i), (iii), (v), (ii), and (iv)
C. (vi), (i), (iii), (ii), and (v)
D. (v), (ii), (i), (iii), and (iv)

3.

In David Ricardo's theory of comparative advantage,

A. international trade is a zero-sum game in which one trading partner's gain comes at the
expense of another's loss.
B. liberalization of international trade will enhance the welfare (or wealth) of the world's
citizens.
C. countries with no absolute advantages will not benefit from international trade.
D. international trade will create unemployment and displacement of workers permanently.

4.

Suppose that Britain pegs the pound to gold at six pounds per ounce, whereas the

exchange rate between pounds and U.S. dollars is $5 = 1. What should an ounce of gold be
worth in U.S. dollars?

A. $29.40
B. $30.00
C. $0.83
D. $1.20

5.

The "J-curve effect" shows

A. the initial improvement and the eventual depreciation of a country's trade balance following a
currency depreciation.
B. the initial deterioration and the eventual improvement of a country's trade balance following a
currency depreciation.
C. the trade balance's lack of responsiveness to the exchanges rate changes.
D. none of the above

6.

When the balance-of-payments accounts are recorded correctly, the combined balance of

the current account, the capital account, and the reserves account must be
A. equal in magnitude to the country's national debt.
B. zero.
C. equal in magnitude to the Trade Deficit or Surplus.
D. none of the above

Problems (35 points)

1. Suppose the spot ask exchange rate, Sa($/), is $1.45 = 1.00 and the spot bid exchange
rate, Sb($/), is $1.40 = 1.00. If you were to buy $10,000 worth of British pounds and
then sell them five minutes later (assume bid/ask quotes have not changed), how much of
your $10,000 would be "eaten" by the bid-ask spread? (10 points)

Buy $10,000 worth of pounds:

$10,000 (1.00/$1.45) = 6,896.55
Translate that back into dollars:
6,869.55 ($1.40/1.00) = $9,655.17
Hence, you have lost to spreads:
$10,000-$9,655.17 = $344.83

2. The current spot exchange rate is S($/) = $1.51/ and the three-month forward rate is
F90($/) = $1.50/. Based on your analysis of the exchange rate, you are confident that
the spot exchange rate will be S90($/) = $1.52/ in three months. Assume that you would
like to buy or sell 1,000,000 (three months from today). (10 points)
A) What actions do you need to take to profit in the forward market? (2.5 pts)
B) If you are right, how much money will you make? (2.5pts)
C) What if you go short at the same forward rate $1.50/ and the spot ends up being
$1.52/? (2.5pts)
D) What if you go short at the same forward rate $1.50/ and the spot ends up being
$1.50/? (2.5pts)

A) Take a long position in a forward contract on 1,000,000 at $1.50/.

B) Your profit, if you are right, is 1,000,000 [($1.52/) - ($1.50/)] = $20,000
C) You lose the same amount, $20,000.
D) No profit or loss.

3. You are a U.S.-based treasurer with $1,000,000 to invest. The dollar-euro exchange rate
is quoted as S($/) = $1.50/1.00 and the dollar-pound exchange rate is quoted at S($/)
= $2.00/1.00. If a different bank quotes you a cross rate of S(/) = 1.25/1.00 , how
can you make money? What is your profit? (10 points)
Buy euro at $1.50/: $1,000,000/ ($1.50/1.00)= 666,666.67
Buy at 1.25/: 666,666.67/(1.25/1.00)= 533,333.33
Sell at $2/: 533,333.33 * ($2.00/1.00) = $1,066,666.67
Should profit $66,667.

4. The euro-dollar exchange rate is S($/) = $1.25/1.25 = 1.00 and the dollar-yen
exchange rate is S(/$) = 100/$. What is the euro-yen cross rate? (5 points)

In other words,
S($/) = $1.25/
S(/$) = 100/$
S(/) = ?

S(/) = S($/)*S(/$) = ($1.25/)*(100/$) = 125/

Hence, S(/) = 1/[S(/)] = 0.008/
So, for one yen, we get 0.008, or 0.01, rounded to two significant digits.

Optional Problem (5 points)

A bank is quoting the following exchange rates against the dollar for the Euro () and the
Australian dollar (A$):

/$

0.750.80

A$/$ = 1.722535

An Australian firm asks the bank for a /A$ quote. What cross-rate would the bank quote?
Compute both bid and ask of the cross-rate.

bid /A$ = (bid /$)/(ask A$/$) = 0.75/1.7235 = 0.4352

ask /A$ = (ask /$)/(bid A$/$) = 0.80/1.7225 = 0.4644
The resulting quotation by the bank is
/A$ = 0.43520.4644

Optional Question (3 points)

The balance of payments identity (excluding any statistical discrepancy) is given by BCA +
BKA + BRA = 0. What is the statistical discrepancy equal to?
The statistical discrepancy = BCA + BKA + BRA = 0