Faculty of Foreign Languages – Department of Business English Banking & Finance

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TEST 5

 TOPIC 5: THE FOREIGN EXCHANGE MARKET 

SECTION 1: Fill in the gaps

Task 1: Fill in the gaps in the text below using the correct terms from the given table. Each
term can only be used once, and five terms will not be used.

accurate approach assets balance changes

long-term foreign fluctuations currency conditions
market influence economic demand cost
parity international factors depreciate country
price investments financial domestic crucial

Foreign exchange rates, which denote the price of one country's (1) ____ in terms of another's, play
a (2) ____ role in the global economy. They (3) ____ the cost of domestically produced goods sold
abroad and the (4) ____ of foreign goods purchased domestically. This makes them vital for both (5)
____ trade and (6) ____ stability.
The theory of purchasing power (7) ____ (PPP) posits that in the long run, exchange rate movements
between two countries' currencies are driven by (8) ____ in the relative price levels of those
countries. Essentially, if one country experiences higher inflation than another, its currency should (9)
____ relative to the other country's currency to maintain parity in the purchasing power of both
currencies. Other (10) ____ -term (11) ____ influencing exchange rates include tariffs and quotas,
import and export demands, and differences in productivity levels.
In the short term, however, exchange rates are more influenced by changes in the relative expected
returns on domestic (12) ____. These changes cause shifts in the (13) ____ curve for currencies.
Factors that can alter the expected returns on domestic assets include variations in domestic and
foreign interest rates and any changes in the factors that affect the long-term exchange rate, such as
economic policies or market expectations about future economic (14) ____.
The asset market (15) ____ to exchange rate determination provides insights into the volatility of
exchange rates. This approach can explain significant movements, such as the rise of the U.S. dollar
during the 1980-1984 period and its subsequent decline. The approach considers exchange rates as
prices that (16) ____ the supply and demand for financial assets denominated in different currencies,
making it a useful tool for understanding market dynamics.
For (17) ____ institution managers, (18) ____ forecasts of foreign exchange rates are invaluable.
These rates impact decisions on which foreign-denominated assets to hold and inform trading
strategies in the foreign exchange market. Accurate predictions help in managing risks and optimizing
returns, as (19) ____ in exchange rates can significantly affect the value of international (20) ____
and trade activities.
 Faculty of Foreign Languages – Department of Business English Banking & Finance
Task 2: Fill in the gaps in the text below using the correct terms from the given table. Each
term can only be used once, and five terms will not be used.

economic policies impact interest rates productivity foreign exchange rates

exchange rates demand higher returns competitiveness supply and demand
financial markets inflation short run price levels purchasing power parity
expectations assets foreign buyers strategies exchange rate management
domestic currency parity trade balance profitability financial institutions

Foreign exchange rates, which represent the value of one country's currency in terms of another's,
play a crucial role in the global economy. They (1) ____ the cost of domestically produced goods
sold abroad and the price of foreign goods purchased domestically. For instance, a strong domestic
currency makes imports cheaper but can make exports more expensive for (2) ____, potentially
affecting a country’s (3) ____.
The theory of (4) ____ (PPP) posits that in the long run, changes in the exchange rate between two
countries are influenced by the relative (5) ____ in those countries. If one country experiences higher
(6) ____ than another, its currency should depreciate to maintain (7) ____. Beyond price levels,
several other factors can influence long-term (8) ____. These include tariffs and quotas, which can
alter trade flows; import demand, which affects how much foreign currency is needed; export
demand, which influences how much (9) ____ is sought by foreign buyers; and (10) ____, which
impacts a country's (11) ____ and economic health.
In the (12) ____, exchange rates are primarily driven by changes in the relative expected return on
domestic (13) ____, which shift the demand curve for these assets. When investors expect (14) ____
on assets in one country compared to another, they will demand more of that country's currency,
driving up its value. Factors that influence these (15) ____ include (16) ____ changes on domestic
and foreign assets, as well as any variables affecting long-term exchange rates, like anticipated shifts
in inflation or (17) ____.
The asset market approach to exchange rate determination highlights the role of (18) ____ in
explaining both the volatility of exchange rates and significant movements, such as the rise of the US
dollar from 1980 to 1984 and its subsequent decline. This approach emphasizes that exchange rates
are influenced by the (19) ____ for financial assets, making them susceptible to market speculation
and investor sentiment.
Accurate forecasts of foreign exchange rates are invaluable for financial institutions. These rates
guide decisions on which foreign-denominated assets to hold and inform trading (20) ____ in the
foreign exchange market. Effective exchange rate management can significantly impact an
institution's profitability and risk management, making currency forecasting a critical skill for
financial managers.
 Faculty of Foreign Languages – Department of Business English Banking & Finance
SECTION 2: Read Unit 5 and circle the best option A, B, C or D:

1. What is the main function of the foreign exchange market?

A. To facilitate the exchange of one currency for another
B. To buy and sell stocks and bonds
C. To lend and borrow money
D. To trade commodities
2. What is the most widely traded currency in the world?
A. US dollar
B. Euro
C. Japanese yen
D. British pound
3. What is the term used to describe the exchange rate between two currencies?
A. Interest rate
B. Inflation rate
C. Spot rate
D. Forward rate
4. What is the difference between the bid price and the ask price in the foreign exchange market?
A. The spread
B. The premium
C. The discount
D. The volatility
5. What is the main reason why individuals and businesses participate in the foreign exchange
market?
A. To make a profit
B. To diversify their investments
C. To hedge against currency risk
D. All of the above
6. What is the primary function of the spot market in the foreign exchange market?
A. To facilitate the immediate exchange of currencies
B. To allow traders to speculate on future exchange rate movements
C. To provide forward contracts for currencies
D. To allow central banks to intervene in the market
7. What is the main difference between the spot market and the forward market in the foreign
exchange market?
A. The spot market deals with immediate exchange, while the forward market deals with
future exchange
B. The spot market is more liquid than the forward market
C. The spot market is more volatile than the forward market
D. The spot market is more regulated than the forward market
8. What is the primary reason why central banks participate in the foreign exchange market?
A. To make a profit
B. To stabilize the value of their domestic currency
C. To diversify their foreign exchange reserves
D. To speculate on currency movements
9. What is the relationship between interest rates and exchange rates, according to the theory of
interest rate parity?
A. Higher interest rates lead to a stronger domestic currency
B. Higher interest rates lead to a weaker domestic currency
C. There is no relationship between interest rates and exchange rates
Faculty of Foreign Languages – Department of Business English Banking & Finance
D. The relationship depends on other factors, such as inflation
10. What is the purpose of a forward contract in the foreign exchange market?
A. To buy or sell a currency at a predetermined price and future date
B. To speculate on future currency movements
C. To hedge against currency risk
D. All of the above
11. What is the main difference between a fixed exchange rate and a floating exchange rate
system?
A. In a fixed exchange rate system, the government sets the exchange rate, while in a floating
system, the market determines the exchange rate
B. In a fixed exchange rate system, the exchange rate is more volatile than in a floating system
C. In a fixed exchange rate system, central banks do not participate in the market, while in a
floating system, they do
D. In a fixed exchange rate system, there is no currency risk, while in a floating system, there
is
12. What is the role of speculation in the foreign exchange market?
A. Speculation helps to stabilize exchange rates
B. Speculation helps to increase market liquidity
C. Speculation helps to increase the efficiency of the market
D. Speculation can contribute to exchange rate volatility
13. What is the relationship between exchange rates and trade balances, according to the theory of
purchasing power parity?
A. A stronger domestic currency leads to a trade surplus
B. A weaker domestic currency leads to a trade surplus
C. There is no relationship between exchange rates and trade balances
D. The relationship depends on other factors, such as productivity and inflation
14. What is the main reason why businesses participate in the foreign exchange market?
A. To make a profit from currency speculation
B. To diversify their investment portfolios
C. To hedge against currency risk
D. To facilitate international trade and investment
15. What is the role of technology in the foreign exchange market?
A. Technology has made the market more efficient and liquid
B. Technology has increased the speed of transactions
C. Technology has increased the ability to access real-time information
D. All of the above
16. What are the main types of exchange rate regimes?
A. Fixed and floating
B. Managed and unmanaged
C. Both A and B
D. None of the above
17. What is the primary reason central banks participate in the foreign exchange market?
A. To make a profit
B. To stabilize exchange rates
C. To influence monetary policy
D. All of the above
18. According to the theory of interest rate parity, what is the relationship between interest rates
and exchange rates?
A. Higher interest rates lead to a stronger domestic currency
B. Higher interest rates lead to a weaker domestic currency
 Faculty of Foreign Languages – Department of Business English Banking & Finance
C. There is no relationship between interest rates and exchange rates
D. The relationship depends on other factors, such as inflation
19. What is the primary impact of speculation on the foreign exchange market?
A. It increases market efficiency and liquidity
B. It stabilizes exchange rates
C. It contributes to exchange rate volatility
D. It has no significant impact on the market
20. What is the key insight of the purchasing power parity theory regarding the relationship
between exchange rates and trade balances?
A. A stronger domestic currency leads to a trade surplus
B. A weaker domestic currency leads to a trade surplus
C. There is no relationship between exchange rates and trade balances
D. The relationship depends on other factors, such as productivity and inflation

SECTION 3: True/False

1. The spot market involves the immediate exchange of currencies.

2. Currency appreciation occurs when a currency increases in value relative to another currency.
3. The law of one price underlies the concept of purchasing power parity.
4. The foreign exchange market is centralized and operates through a single exchange.
5. A currency depreciates when its value rises compared to another currency.
6. Purchasing power parity (PPP) theory suggests that exchange rates are determined by interest rates.
7. The foreign exchange market operates continuously around the clock.
8. Speculators in the foreign exchange market seek to profit from currency price movements.
9. Exchange rate volatility represents the degree of variation in currency prices over time.
10. Fixed exchange rate systems allow currencies to fluctuate freely based on market forces.
11. The International Monetary Fund (IMF) does not play a role in stabilizing exchange rates.
12. Foreign exchange risk does not affect multinational corporations.
13. Devaluation refers to a deliberate reduction in a currency’s value by a government.
14. Spot exchange rates are current exchange rates for immediate currency exchange.
15. Foreign exchange reserves are held by central banks to influence exchange rates and ensure
stability.
16. The foreign exchange market operates independently of other financial markets.
17. The nominal exchange rate adjusts for differences in price levels between countries.
18. The Forex market only operates during regular business hours.
19. An appreciation of the domestic currency can hurt exporters.
20. Exchange rate expectations can influence current exchange rates.
21. Exchange rates are determined by the supply and demand for different currencies.
22. Fixed exchange rates are determined solely by market forces.
23. Forex transactions are always settled immediately.
24. There is a single global regulatory body for the Forex market.
25. Forex trading typically involves currency pairs, such as EUR/USD.
26. The Forex market facilitates international trade and investment by enabling currency conversion.
27. Currency risk, or exchange rate risk, is a major concern for Forex market participants.
28. When a country’s currency appreciates, the country’s goods abroad become cheaper and foreign
goods in that country become more expensive.
29. If a factor increases the demand for domestic goods relative to foreign goods, the
domestic currency will depreciate.
30. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its
currency to appreciate, and a fall in the country’s relative price level causes its currency to depreciate.
 Faculty of Foreign Languages – Department of Business English Banking & Finance
31. Spot transactions involve the immediate (two-day) exchange of bank deposits.
32. Forward transactions involve the exchange of bank deposits at some specified future date.
33. Exchange rates are important because they affect the relative price of domestic
and foreign goods.
34. Increasing trade barriers causes a country’s currency to depreciate in the long run.
35. Increased demand for a country’s exports causes its currency to depreciate in the long run;
conversely, increased demand for imports causes the domestic currency to appreciate.
36. In the long run, as a country becomes more productive relative to other countries, its currency
depreciates.
37. When a country’s currency appreciates (rises in value relative to other currencies), the country’s
goods abroad become more expensive and foreign goods in that country become cheaper (holding
domestic prices constant in the two countries).
38. When a country’s currency depreciates, its goods abroad become cheaper
and foreign goods in that country become more expensive.
39. The law of one price states that if two countries produce an identical good, and
transportation costs and trade barriers are very low, the price of the good should
be the same throughout the world no matter which country produces it.
40. Theory of purchasing power parity (PPP) states that exchange rates between any two currencies
will adjust to reflect changes in the price levels of the two countries.
41. The theory of PPP is simply an application of the law of one price to national price levels.
42. The theory of PPP suggests that if one country’s price level rises relative
to another’s, its currency should depreciate (the other country’s currency should appreciate).
43. If a factor increases the demand for domestic goods relative to foreign goods, the
domestic currency will appreciate; if a factor decreases the relative demand for domestic goods, the
domestic currency will depreciate.
44. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its
currency to depreciate, and a fall in the country’s relative price level causes its currency to appreciate.
45. Increasing trade barriers causes a country’s currency to appreciate in the long run.
46. Increased demand for a country’s exports causes its currency to appreciate in the long run;
conversely, increased demand for imports causes the domestic currency to depreciate.
47. In the long run, as a country becomes more productive relative to other countries, its currency
appreciates.
48. When domestic real interest rates rise, the domestic currency appreciates.
49. When domestic interest rates rise due to an expected increase in inflation, the domestic currency
depreciates.
 Faculty of Foreign Languages – Department of Business English Banking & Finance

SECTION 4: Answer the questions

Task 1:
Question 1: How do central banks intervene in the foreign exchange market to influence their
currency’s value?
They buy/sell their own currency to influence value—buying strengthens, selling
weakens it.
Question 2: How might a central bank’s decision to change interest rates affect the foreign exchange
market and influence a company’s currency strategy?
Higher rates attract investment, boosting currency. Companies may delay/accelerate
conversions accordingly.
Question 3: "A country is always worse off when its currency is weak (falls in value)." Is this
statement true, false, or uncertain? Explain your answer.
False. It can help exports by making domestic goods cheaper, boosting jobs and growth.

Task 2:
Question 1: A U.S.-based company, TechExports Inc., sells products to European customers and
receives payments in euros. Recently, the euro has depreciated against the U.S. dollar. How does this
affect TechExports, and what can the company do to mitigate the impact?
Revenue drops in USD terms. Use hedging tools like forwards/options to manage risk.
Question 2: Alice, a currency trader, believes that the Japanese yen will appreciate against the U.S.
dollar over the next month due to anticipated economic policies in Japan. How can she profit from her
expectation?
Buy yen now, sell later at a higher rate. Or use call options.
Question 3: The central bank of Japan increases its interest rates, while Vietnam’s rates remain
unchanged. How might this interest rate differential affect the exchange rate between Yen and VND?
Yen appreciates due to higher investment appeal.
Question 4: Vietnam is experiencing high inflation compared to its trading partners. How does this
affect the value of VND in the foreign exchange market?
VND depreciates as its purchasing power drops.
Question 5: The central bank of Vietnam intervenes in the foreign exchange market by selling its own
currency and buying U.S. dollars. What is the likely goal of this intervention, and what effect does it
have on VND?
To weaken VND and boost exports. Selling VND increases its supply, causing
depreciation.
Question 6: If the Japanese price level rises by 5% relative to the price level in the United States,
what does the theory of purchasing power parity predict will happen to the value of the Japanese yen
in terms of dollars?
Yen depreciates ~5% vs USD, maintaining purchasing power parity
Question 7: The president of the United States announces that he will reduce inflation with a new
anti-inflation program. If the public believes him, predict what will happen to the exchange rate for
the U.S. dollar.
USD appreciates due to expected lower inflation and stronger confidence
Question 8: If the British central bank prints money to reduce unemployment, what will happen to the
value of the pound in the short run and the long run?
Short-run: slight depreciation. Long-run: sustained inflation causes further depreciation.
Question 9: If the Indian government unexpectedly announces that it will be imposing higher tariffs
on foreign goods one year from now, what will happen to the value of the Indian rupee today?
Rupee appreciates due to expected drop in imports and higher demand for domestic
currency.
 Faculty of Foreign Languages – Department of Business English Banking & Finance
Question 10: If nominal interest rates in America rise but real interest rates fall, predict what will
happen to the U.S. exchange rate.
USD depreciates. Real return declines, reducing currency attractiveness
Question 11: If American auto companies make a breakthrough in automobile technology and are
able to produce a car that gets 60 miles to the gallon, what will happen to the U.S. exchange rate?
USD appreciates. Exports rise, foreign demand for dollars increases
Question 12: If Mexicans go on a spending spree and buy twice as much French perfume, Japanese
TVs, English sweaters, Swiss watches, and Italian wine, what will happen to the value of the Mexican
peso?
Peso depreciates due to increased foreign currency demand and peso supply.
Question 13: If expected inflation drops in Europe so that interest rates fall there, predict what will
happen to the exchange rate for the U.S. dollar.
USD appreciates as European assets become less attractive.
Question 14: If the European central bank decides to contract the money supply to fight inflation,
what will happen to the value of the U.S. dollar?
USD depreciates as euro appreciates due to tighter EU monetary policy.
Question 15: If there is a strike in France, making it harder to buy French goods, what will happen to
the value of the euro?
Euro depreciates due to reduced export demand and investor confidence
Question 16: When the euro appreciates, are you more likely to drink California wine or French
wine?
California wine (French becomes pricier in USD).
Question 17: When the U.S. dollar depreciates, what happens to exports and imports in the United
States?
Exports rise, imports fall (US goods cheaper, foreign goods pricier).