CFA Level 2 - Portfolio Management Session 18 - Reading 6 (Practice Questions, Sample Questions) 1. Gerald Santana, CFA is the president and CEO of Dartmouth Ltd., ahedge fund management ﬁrm located in New York. The ﬁrm has been inexistence for nearly ﬁfteen years, and has shown consistently impressivereturns since inception. Dartmouth has a wide variety of investmentsacross a broad range of asset types that are based around the world.Members of the ﬁrm have a great deal of experience in assessing thecurrency exposure associated with investing in international markets.Due to a recent inﬂux of new funds, Santana and his team have asubstantial amount of uninvested cash and are currently evaluatingseveral investment opportunities.One potential investment for the fund is a 25 percent stake in aclosely-held manufacturing company located in Ireland which producestextiles for export to the United States. Prices are set and paid for in U.S.dollars, but all costs of production are incurred in Euros. Santana issomewhat concerned about the potential currency exposure of thecompany, although he is quite familiar with the risks involved withinvesting in foreign ﬁrms with multinational operations. He intends to dofurther analysis of expected returns given various anticipated interestrate and exchange rate scenarios.Additionally, Santana is considering placing some interim funds in someBritish bonds that appear cheap and are currently yielding a premiumover other country’s comparable securities. In his opinion, inﬂation ratesshould remain reasonably stable over the next year and the realexchange rate between the two countries is expected to remainconstant. The securities are highly liquid, so he does not anticipate anyproblem selling the bonds should he decide to liquidate the position priorto his anticipated one-year holding period.Current spot rates:U.S. Dollar ($) per Euro (€) 0.7600U.S. Dollar ($) per British pound (₤): 0.5100Current 1-year interest rates:
United States 4.50%Great Britain 6.25%Expected one-year inﬂation rates:United States 2.25%Great Britain 5.00%International market eﬃciency is an effective impediment for managersfrom utilizing active asset allocation between countries to consistentlybeat the world index. However, there are six potential impediments to theinternational ﬂow of capital. Which of the following factors is least likelyto have an impact on market eﬃciency?A) Psychological barriers. B) Interest rate risk. C) Legal restrictions. Explanation: Interest rate risk, although present across all markets, is not one of the six potential barriers to international capital mobility. Theother three barriers are transaction costs, political risks, and foreigncurrency risk. (Study Session 18, LOS 62.a) Which of the following statements regarding real exchange rates anddomestic currency return is least accurate?A) Real exchange rate risk occurs if the nominal exchange rate does notchange by the amount predicted by the inﬂation differential. B) The real exchange rate is the spot exchange rate divided by the ratioof the consumption basket price levels. C) Real exchange rate movements are deﬁned as changes in the nominalexchange rate that are not explained by inﬂation differentials. Explanation: The real exchange rate is the spot exchange rate multiplied by the ratio of the consumption basket price levels. (Study Session 18,LOS 62.e) If the Euro experiences 7 percent real appreciation versus the dollar, thevalue of the investment in the Irish company will be impacted, all otherthings equal. Which of the following statements best describes theimpact on Dartmouth’s investment? The Irish company will be:
A) hurt by the appreciation of the Euro because the ﬁrm’s products willbe more expensive in the United States. B) helped by the appreciation of the Euro because its costs of productionwill decline.C) hurt by the appreciation of the Euro because its costs of productionwill increase. Explanation: The currency appreciation will make the company’s products more expensive in the U.S., which will decrease sales. Costswill remain the same, so proﬁtability will decline. (Study Session 18, LOS62.l) According to the money demand model of equity exposure for acompany, which of the following statements is most accurate? Themoney demand model:A) predicts that currency depreciation will lead to lower equity prices in adeveloped country.B) predicts that depreciation in the value of the domestic currency willcause an increase in the competitiveness of domestic industry. C) explains the positive correlation between changes in domesticcurrency and stock returns.Explanation: According to the money demand model, increased real economic activity leads to increased demand for the domestic currency.This increase in domestic currency demand causes the value of thedomestic currency to appreciate, which in turn leads to increased stockreturns. (Study Session 18, LOS 62.n) Santana wants to quantify the additional exchange rate risk associatedwith the purchase of the British securities. Calculate the expectedexchange rate change at the end of one year. A) 0.4960. B) 0.5215.C) 0.5240. Explanation: If real rates remain constant, the change in the exchange rate is equal to the inﬂation differential. The current difference betweenthe two countries rates is 2.75% (5.00% − 2.25%), so the expecteddepreciation of the pound is 2.75%. The expected exchange rate is
calculated as: $0.5100/₤ × (1 − 0.0275) = $0.4960/₤ (Study Session 18,LOS 62.f) Assume that the British pound will depreciate by 3 percent over the nextyear. Calculate the hedge fund’s expected return on the Britishinvestment for a one year holding period.A) 3.00%. B) 3.25%. C) 4.50%. Explanation: The hedge fund is located in New York, so the domestic currency is the U.S. $. The expected dollar return on the British bond forone year is approximately equal to the British interest rate minus thedepreciation of the pound. Therefore: 6.25% - 3.00% = 3.25% (StudySession 18, LOS 62.f) 2. John Swanson is an economic advisor for the international division ofBMC Investments. He has been asked to gather economic data andpresent a seminar to other analysts regarding international economicconcerns. The following three issues were raised in the seminar. Choosethe most reasonable statement that Swanson should make in replying tothe questions raised.The issue of growth rates across various countrieswas discussed and there was some disagreement regarding futureexpectations for growth rates across countries. Which of the followingstatements most accurately describe expectations of future growthrates under neoclassical theory?A) The best method for measuring the difference in growth ratesinternationally is using endogenous growth theory.B) Conditional convergence is predicted for countries with similareconomic attributes, including savings and population growth rates. C) High-growth countries that have historically made high investmentfor growth will ultimately enter a steady state.Explanation: Under neoclassical theory the concept of convergence implies that high-growth countries that have historically made highinvestment for growth will ultimately enter a steady state. Absoluteconvergence, not conditional convergence, is predicted for countrieswith similar economic attributes, including savings and population
growth rates. There is empirical evidence to suggest that countries thatinvest more will grow faster, but the accelerated growth is notpermanent. Endogenous (new) growth theory is not of much value inexplaining differences in growth rates internationally. The vice president of equity analysis believes that Japan is an integratedworld market with few impediments to international ﬂow of capital.Which of the following factors would NOT cause Swanson to questionthe international eﬃciency of Japan? A) The gross domestic product (GDP) is less for Japan than the localGDP. B) Foreign currency risk is not completely hedged away.C) The accounting system in Japan is not in accordance with GenerallyAccepted Accounting Principles (GAAP). Explanation: The level of GDP is not a factor in questioning the international eﬃciency of a country. In addition to the other factorsmentioned in this question, there are several other impediments tointernational ﬂow of capital. The six potential impediments tointernational ﬂow of capital are psychological barriers, legal restrictions,transaction cost, discriminatory taxation, political risks, and foreigncurrency risk. Swanson has reason to believe that Japan will soon be making monetarypolicy changes that will cause the yen to suddenly depreciate 1%. If thevalue of a Japanese ﬁrm falls when the yen depreciates, the asset returnand currency movement are:A) negatively correlated from a U.S. investor's perspective whichexaggerates the currency movement impact.B) positively correlated from a U.S. investor's perspective which lessensthe currency movement impact. C) positively correlated from a U.S. investor's perspective whichexaggerates the currency movement impact.Explanation: If the value of a Japanese ﬁrm falls when the yen depreciates, the asset return and currency movement are positivelycorrelated from a U.S. investor’s perspective, and this exaggerates thecurrency movement impact.
3. Which of the following is considered an impediment to internationalcapital mobility? A) Foreign currency risk. B) Greek risk.C) Market risk. Explanation: Foreign currency risk is an impediment to international capital mobility. The other risks listed exist in any market, domestic orinternational (note: Greek risk refers to derivative securities models). 4. Which of the following is NOT an impediment to international capitalmobility?A) Psychological barriers. B) Model risk. C) Discriminatory taxation. Explanation: The impediments to international capital mobility do not include model risk. Model risk exists in all markets. 5. If the international markets are segmented, which of the following ismost accurate? A) Risk will not be priced the same in all markets. B) The international capital asset pricing model will still be valid.C) The extended capital asset pricing model must be used to priceinternational assets. Explanation: If markets are segmented, then assets with similar risk/return parameters will not necessarily be priced the same. 6. Which of the following is NOT a factor that favors international marketintegration?A) Many institutional investors diversify internationally.B) Governments borrow and lend internationally. C) International tax laws are determined by the International MonetaryFund (IMF).Explanation: There is little in the way of uniform international tax law. Further, the IMF does not determine tax law. The other factors listedpromote market integration.
7. For the international capital asset pricing model (ICAPM), which of thefollowing statements regarding the integration of national markets ismost accurate? If international markets are:A) integrated, there is no need for the ICAPM.B) integrated, the ICAPM breaks down. C) segmented, the ICAPM breaks down.Explanation: For the ICAPM to be valid, international markets must be integrated. If markets are segmented, risk will be priced differently indifferent national markets so the world risk premium will not be a robustcomparison measure. 8. If international markets are integrated, which of the followingstatements is least accurate? A) The international risk-free rate will be the appropriate base rate forasset pricing. B) Risk will be priced similarly in all markets.C) The international capital asset pricing model will be valid. Explanation: There is no such thing as an “international risk-free rate,” hence it cannot be used in asset pricing. In broad terms, both remaininganswers will be correct in the presence of well-integrated world markets. 9. Paul McCormack is a U.S. investor interested in valuing a Japanesesecurity. Which of the following regression equations would be useful toMcCormack in assessing the currency exposure of the Japanesesecurity to changes in the dollar/yen exchange rate?A) Local currency return = α + β (world market return). B) Domestic currency return = α + β (exchange rate movement). C) Domestic currency return = α + β (world market return). Explanation: To assess currency exposure, regress domestic currency returns against exchange rate movements [Domestic currency return = α+ β (exchange rate movement)]. In this formulation, β would be anestimate of the currency exposure and would likely be called γ if used inthe international capital asset pricing model.
10. A French investor holds a U.K. security. The investor has estimatedthe currency exposure in local currency terms to be 1.3. What is thecurrency exposure in domestic currency terms? A) 2.3. B) 1.3.C) 0.3. Explanation: The investor estimated γFC = 1.3. To translate local (or FC) exposure to domestic currency exposure, we use: γ = γFC + 1. Hence, thedomestic currency exposure is: γ = γFC + 1 = 1.3 + 1 = 2.3. 11. Suppose that a U.K. investor holds a U.S. security. The U.S. securityhas a negative correlation with changes in the value of the U.S. dollar inlocal currency terms. What does the negative correlation mean for theU.K. investor? The:A) security exaggerates the impact of currency movements.B) domestic currency γ is greater than one. C) security provides a natural hedge against currency movements.Explanation: A negative correlation means that as the value of the dollar falls (depreciates) the value of the security rises. Hence, the securityprovides a natural hedge against exchange rate movements to the U.K.investor. If the correlation is negative, the local currency γ will be lessthan zero. 12. Suppose the value of the euro depreciates by 5 percent in real terms.Of the following ﬁrms, which will most likely be hurt by the change in theeuro? (The euro is used as the oﬃcial currency in France and the poundis used in the U.K.) A:A) U.K. ﬁrm that imports food from French suppliers.B) French ﬁrm that exports food to U.K. distributors. C) French ﬁrm that imports and resells computers in France.Explanation: The ﬁrm that imports and resells goods in France. 13. Suppose an analyst is assessing the currency exposure of a Frenchﬁrm that imports bicycles from the U.K. If the value of the British poundappreciates, will the French ﬁrm’s cost structure improve or deteriorate?Why?
A) Deteriorate, because the French cost of imported bicycles will godown.B) Improve, because the French cost of imported bicycles will go down. C) Deteriorate, because the French cost of imported bicycles will go up.Explanation: If the pound appreciates, then bicycles imported from the U.K will be more expensive in France. Hence, the cost structure of theFrench bicycle importer will deteriorate. 14. Consider a Canadian ﬁrm that exports hockey sticks to the U.S.Prices are set and collected in U.S. dollars. The inﬂation differentialbetween Canada and the U.S. is 2% (Canadian inﬂation minus U.S.inﬂation). What is the valuation impact on the Canadian exporter if thevalue of the Canadian dollar falls by 2% during the next year?A) The ﬁrm is helped by the falling value of the Canadian dollar.B) The ﬁrm is hurt by the falling value of the Canadian dollar. C) All currency changes are nominal, so the change has no real impact.Explanation: The change in the valuation of the currency is fully explained by the inﬂation differential. Hence, there should be no impacton the valuation of the ﬁrm in real terms. 15. Suppose you are an investor that holds foreign bonds. What does itmean if bonds have positive currency exposure to the foreign currency?A) The exposure is always a return enhance attribute of the foreign bond.B) As interest rates go up, the value of the foreign currency increases. C) As interest rates go up, the value of the foreign currency falls.Explanation: Positive exposure implies that interest rate changes and currency valuation changes amplify the impact of each other. That is, aslocal rates increase (bad for bond investors) the value of the localcurrency tends to fall (bad for foreign bond investors). 16. Sally Metford, CFA, has just accepted a position working for theCanadian government. As an economic advisor, Metford has been askedto comment on the implications of changes in domestic currency,government policy, and inﬂation expectations.According to moneydemand theory, an increase in economic activity in Canada will mostlikely lead to a(n):
A) increase in demand for Canadian dollars causing a depreciation inCanadian currency. B) increase in demand for Canadian dollars causing an appreciation inCanadian currency. C) decrease in demand for Canadian dollars causing a depreciation inCanadian currency. Explanation: According to money demand theory, an increase in economic activity in Canada will most likely lead to an increase indemand for Canadian dollars causing an appreciation in Canadiancurrency. Therefore, the money demand model explains the positiveshort-run correlation between exchange rate movements and stockreturns. Metford’s supervisor has asked for recommendations regarding interestrate policies. The Canadian government is concerned that the value ofthe Canadian dollar has approached the upper target range. Assumingthe Canadian government introduces a “leaning-against-the-wind” policy,the Canadian government will most likely:A) induce negative currency exposure. B) ease interest rates. C) raise interest rates. Explanation: 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 currencyexposure. Which of the following are most likely to occur if the Canadian real rateof interest increases? There will be a(n):A) a positive currency exposure from bond investors.B) capital ﬂow out of Canada. C) increased demand for Canadian currency from abroad.Explanation: An increase in the Canadian real rate of interest will cause capital to ﬂow into Canada from foreign investors. This increaseddemand for Canadian dollars causes an increase in the value of theCanadian dollar. This in turn will create negative currency exposure forbond investors.
17. What is the likely long-term impact of real depreciation of a nation’scurrency?A) Decreased standard of living. B) Increased competitiveness of domestic industry. C) Increased budget deﬁcits. Explanation: In the long run, real depreciation makes a nation’s domestic industry more competitive in the international marketplace. 18. Assume that a country has a negative trade balance. In thetraditional model of the impact of currency appreciation on domesticeconomic activities, what is the likely short-run impact of currencydepreciation? A) The cost of imports increases widening the trade balance. B) Domestic industry becomes more competitive narrowing the tradebalance.C) The cost of imports decreases narrowing the trade balance. Explanation: In the short run, if a country’s currency depreciates in real terms, the cost of imports increases causing a widening in the tradebalance (exports – imports) and an increase in domestic inﬂation.Currency depreciation tends to reduce economic activity in the short run. 19. According to the traditional model, a decline in the value of acountry’s currency has what effect upon national competitiveness in thelong run and domestic inﬂation in the short run? A) Both will increase. B) Both will decrease.C) Only one will increase. Explanation: Under the traditional model, a decline in the value of a country’s currency increases national competitiveness in the long runand increases domestic inﬂation in the short run. This will occur due toan increase in exports for the country whose currency is less valuable. Inthe short run the cost of imports increases for the country with thedecline in currency value.
20. Suppose a nation’s monetary authority increases real interest rates.What does economic theory tell us will happen to the value of thenation’s currency?A) Changes in the nominal rate, not the real rate, cause appreciation.B) The value of the currency will fall. C) The value of the currency will rise.Explanation: If the monetary authority (e.g., the central bank) increases real rates, capital will ﬂow into the country. The increased demand forthe nation's currency will cause the currency to appreciate. 21. In the money demand model, what is the relationship betweenappreciation in the domestic currency and the equity markets? Currencyappreciation:A) is negatively correlated with equity returns.B) hurts competitiveness and stock market returns. C) is positively correlated with equity returns.Explanation: In the money demand model, an increase in real economic activity leads to an increase in the demand for the domestic currency.The increased currency demand causes the value of the currency toappreciate. Because stock prices are highly correlated with grossdomestic product growth, the money demand model explains thepositive short-run correlation between exchange rate movements andstock returns.