CFA Level 1 - Portfolio Management Session 18 - Reading 62 (Notes, Practice Questions, Sample Questions) 1.1 Gerald Santana, CFA is the president and CEO of Dartmouth Ltd., a hedge 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 todo further 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 real exchangerate between the two countries is expected to remain constant. Thesecurities are highly liquid, so he does not anticipate any problem sellingthe bonds should he decide to liquidate the position prior to hisanticipated one-year holding period. Current spot rates:U.S. Dollar ($) per Euro (€) 0.7600
U.S. Dollar ($) per British pound (₤): 0.5100 Current 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 tothe international flow of capital. Which of the following factors is leastlikely to have an impact on market efficiency? A)Psychological barriers. B)Interest rate risk. C)Legal restrictions. <Explanation>: Interest rate risk, although present across allmarkets, is not one of the six potential barriers tointernational capital mobility. The other three barriers aretransaction costs, political risks, and foreign currency risk. 1.2 Which of the following statements regarding real exchange rates and domestic 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 bythe ratio of 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 exchangerate multiplied by the ratio of the consumption basket pricelevels. 1.3 If the Euro experiences 7 percent real appreciation versus the dollar, the value of the investment in the Irish company will be impacted, allother things 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’sproducts will be 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 thecompany’s products more expensive in the U.S., which willdecrease sales. Costs will remain the same, so profitability willdecline. 1.4 According to the money demand model of equity exposure for a company, 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 indomestic currency and stock returns. <Explanation>: According to the money demand model,increased real economic activity leads to increased demandfor the domestic currency. This increase in domestic currency
demand causes the value of the domestic currency toappreciate, which in turn leads to increased stock returns. 1.5 Santana wants to quantify the additional exchange rate risk associated with the purchase of the British securities. Calculate theexpected exchange 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 inthe exchange rate is equal to the inflation differential. Thecurrent difference between the two countries rates is 2.75%(5.00% − 2.25%), so the expected depreciation of the pound is2.75%. The expected exchange rate is calculated as: $0.5100/₤× (1 − 0.0275) = $0.4960/₤ 1.6 Assume that the British pound will depreciate by 3 percent over the next year. 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 thedomestic currency is the U.S. $. The expected dollar return onthe British bond for one year is approximately equal to theBritish interest rate minus the depreciation of the pound.Therefore: 6.25% - 3.00% = 3.25% 2.1 John Swanson is an economic advisor for the international division of BMC Investments. He has been asked to gather economic data andpresent a seminar to other analysts regarding international economic
concerns. 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 growth ratesunder 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 highinvestment for growth will ultimately enter a steady state. <Explanation>: Under neoclassical theory the concept ofconvergence implies that high-growth countries that havehistorically made high investment for growth will ultimatelyenter a steady state. Absolute convergence, not conditionalconvergence, is predicted for countries with similar economicattributes, 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 muchvalue in explaining differences in growth rates internationally 2.2 The vice president of equity analysis believes that Japan is an integrated world market with few impediments to international flow ofcapital. Which of the following factors would NOT cause Swanson toquestion the international efficiency of Japan? A)The gross domestic product (GDP) is less for Japan than thelocal GDP. 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 questioningthe international efficiency of a country. In addition to theother factors mentioned in this question, there are severalother impediments to international flow of capital. The sixpotential impediments to international flow of capital arepsychological barriers, legal restrictions, transaction cost,discriminatory taxation, political risks, and foreign currencyrisk 2.3 Swanson has reason to believe that Japan will soon be making monetary policy changes that will cause the yen to suddenly depreciate1%. If the value of a Japanese firm falls when the yen depreciates, theasset return and 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 perspectivewhich exaggerates the currency movement impact <Explanation>: If the value of a Japanese firm falls when theyen depreciates, the asset return and currency movement arepositively correlated from a U.S. investor’s perspective, andthis exaggerates the currency movement impact 3. Which of the following is considered an impediment to international capital mobility? A)Foreign currency risk. B)Greek risk.C)Market risk <Explanation>: Foreign currency risk is an impediment tointernational capital mobility. The other risks listed exist in
any market, domestic or international (note: Greek risk refersto derivative securities models) 4. Which of the following is NOT an impediment to international capital mobility? A)Psychological barriers. B)Model risk. C)Discriminatory taxation <Explanation>: The impediments to international capitalmobility do not include model risk. Model risk exists in allmarkets 5. If the international markets are segmented, which of the following is most 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 withsimilar risk/return parameters will not necessarily be pricedthe same 6. Which of the following is NOT a factor that favors international market integration? A)Many institutional investors diversify internationally.B)Governments borrow and lend internationally. C)International tax laws are determined by the InternationalMonetary Fund (IMF)
<Explanation>: There is little in the way of uniforminternational tax law. Further, the IMF does not determine taxlaw. The other factors listed promote market integration 7. For the international capital asset pricing model (ICAPM), which of the following 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, internationalmarkets must be integrated. If markets are segmented, riskwill be priced differently in different national markets so theworld risk premium will not be a robust comparison measure 8. If international markets are integrated, which of the following statements is least accurate? A)The international risk-free rate will be the appropriate baserate for asset 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 “internationalrisk-free rate,” hence it cannot be used in asset pricing. Inbroad terms, both remaining answers will be correct in thepresence of well-integrated world markets 9. Paul McCormack is a U.S. investor interested in valuing a Japanese security. Which of the following regression equations would be useful toMcCormack in assessing the currency exposure of the Japanese securityto changes in the dollar/yen exchange rate?
A)Local currency return = α + β (world market return). B)Domestic currency return = α + β (exchange ratemovement). C)Domestic currency return = α + β (world market return) <Explanation>: To assess currency exposure, regress domesticcurrency returns against exchange rate movements [Domesticcurrency return = α + β (exchange rate movement)]. In thisformulation, β would be an estimate of the currency exposureand would likely be called γ if used in the international capitalasset pricing model 10. A French investor holds a U.K. security. The investor has estimated the 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 translatelocal (or FC) exposure to domestic currency exposure, we use:γ = γFC + 1. Hence, the domestic 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. security has 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 currencymovements
<Explanation>: A negative correlation means that as the valueof the dollar falls (depreciates) the value of the security rises.Hence, the security provides a natural hedge against exchangerate movements to the U.K. investor. If the correlation isnegative, the local currency γ will be less than zero 12. Suppose an analyst is assessing the currency exposure of a French firm 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 bicycleswill go up. <Explanation>: If the pound appreciates, then bicyclesimported from the U.K will be more expensive in France.Hence, the cost structure of the French bicycle importer willdeteriorate 13. 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 realimpact <Explanation>: The change in the valuation of the currency isfully explained by the inflation differential. Hence, thereshould be no impact on the valuation of the firm in real terms
14. Suppose you are an investor that holds foreign bonds. What does it mean 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 currencyfalls <Explanation>: Positive exposure implies that interest ratechanges and currency valuation changes amplify the impact ofeach other. That is, as local rates increase (bad for bondinvestors) the value of the local currency tends to fall (bad forforeign bond investors) 15.1 Sally Metford, CFA, has just accepted a position working for the Canadian 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 anappreciation in Canadian currency. C)decrease in demand for Canadian dollars causing a depreciation inCanadian currency. <Explanation>: According to money demand theory, anincrease in economic activity in Canada will most likely lead toan increase in demand for Canadian dollars causing anappreciation in Canadian currency. Therefore, the moneydemand model explains the positive short-run correlationbetween exchange rate movements and stock returns.
15.2 Metford’s supervisor has asked for recommendations regarding interest rate policies. The Canadian government is concerned that thevalue 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 mostlikely: A)induce negative currency exposure. B)ease interest rates. C)raise interest rates. <Explanation>: A strong domestic currency will lead localgovernments to ease interest rates. This is often referred to asa “leaning-against-the-wind” policy that induces positivecurrency exposure 15.3 Which of the following are most likely to occur if the Canadian real rate of 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 ofinterest will cause capital to flow into Canada from foreigninvestors. This increased demand for Canadian dollars causesan increase in the value of the Canadian dollar. This in turnwill create negative currency exposure for bond investors 16. What is the likely long-term impact of real depreciation of a nation’s currency? A)Decreased standard of living. B)Increased competitiveness of domestic industry. C)Increased budget deficits
<Explanation>: In the long run, real depreciation makes anation’s domestic industry more competitive in theinternational marketplace 17. Assume that a country has a negative trade balance. In the traditional model of the impact of currency appreciation on domestic economicactivities, what is the likely short-run impact of currency depreciation? 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 currencydepreciates in real terms, the cost of imports increasescausing a widening in the trade balance (exports – imports)and an increase in domestic inflation. Currency depreciationtends to reduce economic activity in the short run 18. According to the traditional model, a decline in the value of a country’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 thevalue of a country’s currency increases nationalcompetitiveness in the long run and increases domesticinflation in the short run. This will occur due to an increase inexports for the country whose currency is less valuable. In theshort run the cost of imports increases for the country withthe decline in currency value
19. 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 centralbank) increases real rates, capital will flow into the country.The increased demand for the nation's currency will cause thecurrency to appreciate 20. In the money demand model, what is the relationship between appreciation 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 inreal economic activity leads to an increase in the demand forthe domestic currency. The increased currency demand causesthe value of the currency to appreciate. Because stock pricesare highly correlated with gross domestic product growth, themoney demand model explains the positive short-runcorrelation between exchange rate movements and stockreturns