Reading 70: LOS L ～ Q1- 5

1.What is the likely long-term impact of real depreciation of a nation’s currency?

A)   Decreased standard of living.

B)   Increased budget deficits.

C)   Increased competitiveness of domestic industry.

D)   Lower cost of imported goods.

The correct answer was C)     

In the long run, real depreciation makes a nation’s domestic industry more competitive in the international marketplace.

2.Sally Metford, CFA, has just accepted a position working for the Canadian government. As an economic advisor, Metford has been asked to comment on the implications of changes in domestic currency, government policy, and inflation expectations.

According to money demand theory, an increase in economic activity in Canada will most likely lead to a(n):

A)   increase in demand for Canadian dollars causing an appreciation in Canadian currency.

B)   decrease in demand for Canadian dollars causing a depreciation in Canadian currency.

C)   increase in demand for Canadian dollars causing a depreciation in Canadian currency.

D)   decrease in demand for Canadian dollars causing an appreciation in Canadian currency.

The correct answer was A)

According to money demand theory, an increase in economic activity in Canada will most likely lead to an increase in demand for Canadian dollars causing an appreciation in Canadian currency. Therefore, the money demand model explains the positive short-run correlation between exchange rate movements and stock returns.

3.Metford’s supervisor has asked for recommendations regarding interest rate policies. The Canadian government is concerned that the value of the Canadian dollar has approached the upper target range. Assuming the Canadian government introduces a “leaning-against-the-wind” policy, the Canadian government will most likely:

A)   raise interest rates.

B)   induce negative currency exposure.

C)   ease interest rates.

D)   increase the real rate of return.

The correct answer was C)

A strong domestic currency will lead local governments to ease interest rates. This is often referred to as a “leaning-against-the-wind” policy that induces positive currency exposure.

4.Which of the following are most likely to occur if the Canadian real rate of interest increases? There will be a(n):

A)   capital flow out of Canada.

B)   a positive currency exposure from bond investors.

C)   decrease in the value of Canadian currency.

D)   increased demand for Canadian currency from abroad.

The correct answer was D)

An increase in the Canadian real rate of interest will cause capital to flow into Canada from foreign investors. This increased demand for Canadian dollars causes an increase in the value of the Canadian dollar. This in turn will create negative currency exposure for bond investors.

5.Suppose you are an investor that holds foreign bonds. What does it mean if bonds have positive currency exposure to the foreign currency?

A)   As interest rates go up, the value of the foreign currency increases.

B)   The exposure is always a return enhance attribute of the foreign bond.

C)   All exchange rate movements are beneficial to the investor.

D)   As interest rates go up, the value of the foreign currency falls.

The correct answer was D)

Positive exposure implies that interest rate changes and currency valuation changes amplify the impact of each other. That is, as local rates increase (bad for bond investors) the value of the local currency tends to fall (bad for foreign bond investors).