Question

If the NZ dollar (base currency) is trading at a discount in the forward market relative to UK pounds (term currency),

Select one:

a. then NZ interest rates are higher than UK interest rates

b. then for NZ dollars in terms of UK pounds, the forward rates are lower than the spot rate.

If the forward exchange rate of the yen in terms of the New Zealand dollar is greater than the spot exchange rate: A. Japanese interest rates must be higher than New Zealand interest rates. B. New Zealand interest rates must be lower than Japanese interest rates. C. market participants must be expecting the New Zealand dollar to appreciate against the yen. D. market participants must be expecting the New Zealand dollar to depreciate against the yen. E. the New Zealand inflation rate is lower than the Japanese inflation rate.

If exchange rates adjust to reflect inflation differentials across countries, then: A. The law of one price will always hold. B. No one will use forward currency markets. C. Interest rates will be equal across countries. D. Purchasing Power Parity (PPP) is said to hold. E. Interest Rate Parity theory will always hold

If a New Zealand firm will receive an payment for an account receivable in euros in two months, to hedge against foreign exchange rate risk, the firm should: A. sell foreign exchange futures. B. buy foreign exchange futures. C. stay out of the foreign exchange futures markets. D. enter into a contract to sell NZ dollars two months forward. E. do none of the above.

c. then UK interest rates are higher than NZ's interest rates

d. both A and B are correct.

e. then for UK punds in terms of NZ dollars, forward rates are lower than the spot rate

Answer 1

I believe the questions and options have been jumbled up and the first question along with the options is as follows:

If the NZ dollar (base currency) is trading at a discount in the forward market relative to UK pounds (term currency),

Select one:

a. then NZ interest rates are higher than UK interest rates

b. then for NZ dollars in terms of UK pounds, the forward rates are lower than the spot rate.

c. then UK interest rates are higher than NZ's interest rates

d. both A and B are correct.

e. then for UK pounds in terms of NZ dollars, forward rates are lower than the spot rate

Solution to question 1

If the NZD is trading at a discount in the forward market against the UK pounds, it means that it will take less UK pounds in the future to purchase the same amount of NZ dollars.

As an example, if today the price to purchase 1 NZD is 0.51 UK pounds, and three months forward rate to purchase 1 NZD is 0.49 UK pounds, it means the NZD has weakened, as it now takes less UK pounds to purchase the same 1 NZD. Similarly, UK pound has strengthened over the period.

Some of the reasons contributing to forward rate differences are differences in inflation rates and interest rates.

Because of interest rates, money loses its value over time. For example, if the interest rates are 5%, and you have $1000 today, your money has the potential to grow to $1050 one year from now. If you do not invest your money at those rates, you would remain with $1000, which would purchase less than what it did one year back.

This means that the country with higher interest rates loses value of its currency more quickly.

Thus we can draw the conclusion that the currency which is trading at a discount in the future will have higher interest rates.In this case, NZ will have higher interest rates than UK.

So, option D (both A and B are correct) is the most appropriate option.

Solution to question 2

Forward exchange rate of yen in terms of NZD is greater than spot, which means that yen is trading at a premium against NZD.

This means that the Japanese interest/inflation rates are lower than the NZD interest rates, for the same logic as explained above.

Option A, B and E all speak about the same thing. But they are all wrong because they describe the NZD rates to be lower than the Japanese rates.

Option C speaks about NZD rising in the future, which is the opposite of what is happening.

In reality, the NZD is depreciating against Yen (as yen is trading at a premium against NZD in forwards market)

So, Option D (market participants must be expecting the New Zealand dollar to depreciate against the yen.) is correct.

Solution to question 3

If exchange rates adjust to inflation differentials, we will have currency rates fluctuating.

Purchasing Power Parity is the theory that the price to purchase a commodity irrespective of its location will eventually be the same as currency exchange rates will adjust themselves to not allow any arbitrage opportunities. This means that any differences in prices caused due to different inflation rates will be cancelled out by currency exchange rates adjusting.

Thus, the correct option here is PPP is said to hold. It is worth noting that the Law of one price is the basis for Purchasing Price Parity, but the question is specifically pointing in direction to PPP. Therefore option D is deemed much more appropriate.

Forward markets will be used heavily in case of fluctuating currency rates, therefore Option B is incorrect.

Different inflation rates generally assure different interest rates, therefore Option C is incorrect too.

Option E is also incorrect as question is focusing on inflation rates.

So, Option D (Purchasing Power Parity (PPP) is said to hold.) is most appropriate.

Solution to question 4

NZ Firm will receive payment in Euros in 2 months from now.

The risk faced by the firm will be that the final realization of money will reduce because of changing exchange rates.

The firm would want Euros to strengthen against the NZD, so that it realizes more amount, considering its receipts are in Euros.

Ideally, the firm should buy a NZD forward now. This will help them fix the price at which they can sell their Euros.

Option D is thus incorrect, as it is asking us to do the opposite.

Since there is a forex risk involved, Option C is also incorrect.

The firm should sell foreign exchange futures, as this will help them fix a price at which they can sell their foreign commodity (Euro) and hedge the risk of foreign exchange fluctuations.

So, Option A (sell foreign exchange futures) is correct.