Question & Answer

Consider the prevailing conditions for inflation (including oil prices), the economy, interest rates, and any other factors that could affect exchange rates. Based on these conditions, do you think the euro’s value will likely appreciate or depreciate against the dollar for the remainder of this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on the euro’s exchange rate? (LO2)

Assume a horizontal yield curve exists. How do you think the yield curve would be affected if foreign investors in short-term securities and long-term securities suddenly anticipate that the value of the dollar will strengthen? (You may find it helpful to refer to the discussion of the yield curve in Chapter 3.) (LO2, LO3)

Explain how U.S. speculators could use foreign exchange derivatives to speculate on the expected appreciation of the Japanese yen. (LO4)

How does a weak dollar affect U.S. inflation? Explain. (LO2)

Seattle Bank just took speculative positions by borrowing Canadian dollars and converting the funds to invest in Australian dollars. Explain a possible future scenario that could adversely affect the bank’s performance. (LO2, LO3)

Explain the conditions under which a speculator would like to invest in a foreign currency today even when the speculator has no use for that currency in the future. (LO2, LO3)

The Bank of Japan desires to decrease the value of the Japanese yen against the U.S. dollar. How could it use direct intervention to achieve this goal? (LO2)

Assume that Switzerland has a very strong economy, putting upward pressure on both its inflation and interest rates. Explain how these conditions could place pressure on the value of the Swiss franc, and determine whether the franc’s value will rise or fall. (LO2)

Assume that Mexico suddenly experiences high and unexpected inflation. How could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory? (LO2)

Assume that stocks in the United Kingdom become very attractive to U.S. investors. How could this affect the value of the British pound? Explain. (LO2)

Assume that European countries impose a quota on goods imported from the United States and that the United States does not plan to retaliate. How could this affect the value of the euro? Explain. (LO2)

Explain the difference between a freely floating system and a dirty float. Which type is more representative of the U.S. system? (LO1)

Explain the exchange rate system that existed during the 1950s and 1960s. How did the Smithsonian Agreement in 1971 revise it? How does today’s exchange rate system differ from the earlier system? (LO1)

A critic recently stated that the creation of credit default swaps caused the credit crisis in the 2008–2009 period. Write a short essay that supports or refutes this statement. 

Explain how the Financial Reform Act of 2010 and the rules issued to implement it attempted to reduce the risk in the financial system resulting from the use of credit default swaps. (LO7) 

Explain why the failure of Lehman Brothers caused prices on credit default swap contracts to increase. (LO7)

Credit default swaps were once viewed as a great innovation that could make mortgage markets more stable. However, these swaps have been criticized for making the credit crisis worse. Why? (LO7)

Back Bay Insurance Company negotiated a callable swap involving fixed payments in exchange for floating payments. Assume that interest rates decline consistently up until the swap maturity date. Do you think Back Bay might terminate the swap prior to maturity? Explain. (LO2)

Explain the advantage of a swap option to a financial institution that wants to swap fixed payments for floating payments. (LO2)

Rider Company negotiates a forward swap, to begin two years from now, in which it will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates rise substantially over the next two years? That is, would Rider be better off by using this forward swap than if it had simply waited two years before negotiating the swap? Explain. (LO2)

Bull and Finch Company wants a fixed-for-floating swap. It expects interest rates to rise far above the fixed rate that it would pay and remain very high until the swap maturity date. Should it consider negotiating for a rate-capped swap with the cap set at 2 percentage points above the fixed rate? Explain. (LO6)

Explain why some companies that issue bonds engage in currency swaps. Why do they not simply issue bonds in the currency that they would prefer to use for making payments? (LO8)

Explain why some companies that issue bonds engage in interest rate swaps in financial markets. Why do they not simply issue bonds that require the type of payments (fixed or variable) that they prefer to make? (LO1)

Give an example of how sovereign risk is related to currency swaps. (LO8)

Explain basis risk as it relates to a currency swap. (LO8)