ACCA FM Syllabus G. Risk Management - Understanding Exchange Rates - Past Papers ^{1 / 4}

Country X uses the dollar as its currency and country Y uses the dinar.

Country X’s expected inflation rate is 5% per year, compared to 2% per year in country Y. Country Y’s nominal interest rate is 4% per year and the current spot exchange rate between the two countries is 1·5000 dinar per $1.

According to the four-way equivalence model, which of the following statements is/are true?

(1) Country X’s nominal interest rate should be 7·06% per year
(2) The future (expected) spot rate after one year should be 1·4571 dinar per $1
(3) Country X’s real interest rate should be higher than that of country Y

A. 1 only
B. 1 and 2 only
C. 2 and 3 only
D. 1, 2 and 3

Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt.

Herd Co has in issue loan notes with a total nominal value of $4 million which can be redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest rates may increase in the near future.

The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.

Which of the following statements support the finance director’s belief that the euro will depreciate against the dollar?

(1) The dollar inflation rate is greater than the euro inflation rate
(2) The dollar nominal interest rate is less than the euro nominal interest rate

A. 1 only
B. 2 only
C. Both 1 and 2
D. Neither 1 nor 2