[Level 1] Revision Phase with SAPP

Buổi 7 - Economics & FRA- Reading 18: Currency Exchange Rates & Reading 21: Understanding Income Statement

READING 18: CURRENCY EXCHANGE RATE


LOS 18.a: Define an exchange rate and distinguish between nominal and real exchange rates and spot and forward exchange rates
Question 18.1: At a base period, the CPIs of the countries of Tuolumne (currency is the TOL) and Bodee (currency is the BDE) are both 100, and the exchange rate is 0.90 BDE/TOL. One year later, the exchange rate is 0.75 BDE/TOL, and the CPI has risen to 110 in Tuolumne and 105 in Bodee. The real exchange rate is closest to:
A) 0.72 BDE/TOL.
B) 0.79 BDE/TOL.
C) 0.83 BDE/TOL.
Explanation
Step 1: Understand the question and find the right formula 
Nominal exchange rate = 0.75
CPI of base currency = 110
CPI of price currency = 105
Step 2: Calculation
The real exchange rate is calculated as 0.75 BDE/TOL × 110/105 = 0.79 BDE/TOL

Question 18.2: Three years ago, the U.S. dollar/euro exchange rate was 1.32 USD/ EUR. Over the last three years, the price level in the United States has increased by 18%, and the price level in the eurozone has increased by 12%. If the current exchange rate is 1.40 USD/EUR, the real exchange rate over the period has:
A) increased, and eurozone goods are now more expensive to U.S. consumers.
B) decreased, and eurozone goods are now more expensive to U.S. consumers.
C) increased, and U.S. goods are now more expensive to eurozone consumers.
Explanation
A is correct. 
Step 1: Suppose that the real exchange rate is the same as the nominal exchange rate, 1.32 USD/EUR for the base period three years ago
Step 2: Calculation and interpretation
The real exchange rate over the period has changed from 1.32 to 1.40 × (112 / 118) = 1.3288. This increase in the real USD/EUR exchange rate indicates that the base currency (EUR) has appreciated in real terms, so that eurozone goods are now more expensive in real terms to U.S. consumers.

LOS 18.b: Describe functions of and participants in the foreign exchange market
Question 18.3: In the foreign exchange markets, transactions by households and small institutions for tourism, cross-border investment, or speculative trading comprise the:
A) sovereign wealth market.
B) retail market.
C) real money market.
Explanation
B is correct. The retail foreign exchange market refers to transactions by households and relatively small institutions and may be for tourism, cross-border investment, or speculative trading.
Schweser note: 
Real money accounts refer to mutual funds, pension funds, insurance companies, and other
institutional accounts that do not use derivatives.
Governments and government entities, including sovereign wealth funds and pension funds, acquire foreign exchange for transactional needs, investment, or speculation. Central banks sometimes engage in FX transactions to affect exchange rates in the short term in accordance with government policy.
The retail market refers to FX transactions by households and relatively small institutions and may be for tourism, cross-border investment, or speculative trading.

LOS 18.c: Calculate and interpret the percentage change in a currency relative to another currency & LOS 18.d: LOS 18.d: Calculate and interpret currency cross-rates

Question 18.4: Assume that one year ago, the exchange rate between the Japanese yen and the euro was 100 JPY/EUR, and the exchange rate between the Japanese yen and the U.S. dollar was 80 JPY/USD. Current exchange rates are 104.2 JPY/EUR and 76.6 JPY/USD. Which of the following statements is most accurate?
A) The USD has depreciated relative to the EUR.
B) The JPY has depreciated 4.2% relative to the EUR.
C) The current U.S. dollar to euro exchange rate is approximately 1.25 USD/EUR
Explanation
Step 1: Test statement A,B,C
Statement A: We can calculate the current USD/EUR cross rate as 104.2 / 76.6 = 1.3603 USD/EUR. The original USD/EUR cross rate was 100 / 80 = 1.2500 USD/EUR. Thus, the USD has depreciated relative to the EUR. 
Statement B: The EUR has appreciated 4.2% relative to the JPY (104.2 / 100 – 1) = 4.2%, it is not correct to say that the JPY has depreciated by the same percentage.
Statement C:  The original USD/EUR cross rate was 100 / 80 = 1.2500 USD/EUR
Step 2: Conclusion
A is correct

LOS 18.e: Convert forward quotations expressed on a points basis or in percentage terms into an outright forward quotation.

Question 18.5: A spot exchange rate is 8.6145 and the 1-year forward quotation is +0.25%. The 1-year forward quotation on a points basis is closest to:
A) 2.
B) 25.
C) 215.
Explanation
C is correct. Convert the percentage quote to a points quote as 0.0025 × 8.6145 = 0.0215, which is 215 points (each point is 0.0001).

LOS 18.f: Explain the arbitrage relationship between spot rates, forward rates, and
interest rates.

Question 18.6: The three-month interest rate in the currency MNO is 4% and the three-month interest rate for the currency PQR is 5%. Based only on this information, the three-month forward MNO/PQR exchange rate:
A) is less than spot MNO/PQR.
B) is greater than spot MNO/PQR.
C) may be greater than or less than spot MNO/PQR.
Explanation
A is correct. Based on the no-arbitrage relationship between spot rates, forward rates, and interest rates, if the interest rate for the base currency is greater than the interest rate for the price currency, the forward exchange rate is less than the spot exchange rate.

LOS 18.h: Calculate and interpret the forward rate consistent with the spot rate and the
interest rate in each currency.

Question 18.7: Consider two currencies, the WSC and the BDR. The spot WSC/BDR exchange rate is 2.875, the 180-day riskless WSC rate is 1.5%,and the 180-day riskless BDR rate is 3.0%. The 180-day forward exchange rate that will prevent arbitrage profits is closest to:
A) 2.833 WSC/BDR.
B) 2.854 WSC/BDR.
C) 2.918 WSC/BDR
Explanation
B is correct
Step 1: Understand the question and find the right formula
For spot and forward rates expressed as price currency/base currency, the no-arbitrage relation (commonly referred to as interest rate parity) is:
Spot exchange rate = 2.875
Interest rate of price currency (180 day period) = 1.5%/2
Interest rate of base currency (180 day period) =  3%/2
Step 2: Calculation
Arbitrage-free forward = 2.875 WSC/BDR × [(1 + 0.015 / 2) / (1 + 0.03 / 2)] = 2.8538 WSC/BDR

LOS 18.i: Describe exchange rate regimes
Question 18.8: Akor is a country that has chosen to use a conventional fixed peg arrangement as the country's exchange rate regime. Under this arrangement, Akor's exchange rate against the currency to which it pegs:
A) is market-determined.
B) will be equal to the peg rate.
C) may fluctuate around the peg rate.
Explanation
In a conventional fixed peg arrangement, a country pegs its currency within a margin of ±1% versus another currency or a basket that includes the currencies of its major trading or financial partners. Market-determined exchange rates are a characteristic of an independently floating exchange rate regime.

LOS 18.j: Explain the effects of exchange rates on countries’ international trade and capital flows.

Question 18.9: Depreciation of a country's currency will be more effective in reducing its trade deficit if its:
A) imports do not have good substitutes.
B) exports are primarily luxury goods.
C) exports represent a small portion of foreign consumer expenditures
Explanation
B is correct. Under the elasticities approach, a currency depreciation will lead to a greater reduction in a trade deficit when export demand and/or import demand are more elastic. The demand for luxury goods is relatively elastic, while the demand for goods without good substitutes or for goods that represent only a small portion of consumer expenditures is relatively inelastic.

Question 18.10: The J-curve, in the context of trade between two countries, refers to the fact that when the domestic country has a trade deficit:
A) appreciation of the domestic currency initially leads to a decrease in the trade deficit but will increase the trade deficit in the long term.
B) an increase in domestic inflation will initially increase the trade deficit but will decrease the trade deficit in the long term.
C) appreciation of the foreign currency will initially increase the trade deficit but will decrease the trade deficit in the long term.
Explanation
The J-curve effect refers to a plot of the trade deficit over time when the domestic currency depreciates (the foreign currency appreciates). The trade deficit gets worse initially but then improves over time, either because export and import demand are more elastic in the long run or because existing contracts for future delivery are fixed in foreign currency terms in the short run.

 

READING 21: UNDERSTANDING INCOME STATEMENT

Question 21.1: On a firm's income statement, sales minus cost of goods sold, minus selling, general, and administrative expenses, is most appropriately referred to as:
A) gross profit.
B) operating profit.
C) income before tax.
Explanation
B is correct. This difference describes operating profit.
(Reading 21, LOS 21.a)
LOS 21.a: Describe the components of the income statement and alternative presentation formats of that statement
Gross profit is the amount that remains after the direct costs of producing a product or service are subtracted from revenue. Subtracting operating expenses, such as selling, general, and administrative expenses, from gross profit results in another subtotal known as operating profit or operating income

Question 21.2: A firm has undertaken a contract with an estimated total cost of $500 million at a price of $800 million. At the end of the first reporting period, the firm has devoted resources of $180 million to the project. The customer has been billed for $250 million and made payments of $160 million.The amount of revenue the firm should record for the period is closest to:
A) $180 million.
B) $250 million.
C) $290 million
Explanation
C is correct. Using the percentage of total costs incurred to date as an estimate of the portion of the performance obligations completed, revenue should be (180 / 500) × $800 million = $288 million.
(Reading 21, LOS 21.c)
LOS 21.c: Calculate revenue given information that might influence the choice of revenue recognition method.
For long-term contracts, revenue is recognized based on a firm’s progress toward completing a performance obligation. Progress toward completion can be measured from the input side (e.g., using the percentage of completion costs incurred as of the statement date).

Question 21.3: In accrual accounting, the matching principle states that:
A) an entity should recognize revenues only when received and expenses only when they are paid.
B) transactions and events producing cash flows are allocated only to time periods in which the
cash flows occur.
C) expenses incurred to generate revenue are recognized in the same time period as the revenue.
Explanation
C is correct. The matching principle holds that expenses should be accounted for in the same performance measurement period as the revenue they generate.
(Reading 21, LOS 21.d)

Question 21.4: Consider a manufacturing company and a financial services company. Interest expense is most likely classified as a non-operating component of net income for:
A) both of these companies.
B) neither of these companies.
C) only one of these companies.
Explanation
C is correct. Interest expense is shown as a non-operating component of net income for a manufacturing company but would typically be classified as an operating expense for a financial services company.
(Reading 21, LOS 21.f)
LOS 21.f: Distinguish between the operating and non-operating components of the
income statement.
For a nonfinancial firm, nonoperating transactions may result from investment income and financing expenses. For example, a nonfinancial firm may receive dividends and interest from investments in other firms. The investment income and any gains and losses from the sale of these securities are not a part of the firm’s normal business operations. Interest expense is based on the firm’s capital structure, which is also independent of the firm’s operations. Conversely, for a financial firm, investment income and financing expenses are usually considered operating activities.

Question 21.5: Acme Corp. purchased a new stamping machine for $100,000, paid $10,000 for shipping, and paid $5,000 to have it installed in their plant. Based on an estimated salvage value of $25,000 and an economic life of six years, the difference between straight-line depreciation and double-declining balance depreciation in the second year of the asset's life is closest to:
A) $7,220.
B) $10,556.
C) $16,666.
Explanation
B is correct. Straight line depreciation is (100,000 + 10,000 + 5,000 − 25,000) / 6 = 15,000 each year. Double-declining balance depreciation in the second year is: 115,000 (2/3)(1/3) = 25,556. The difference is $10,556. Remember that salvage value is not part of the declining balance calculation.
(Reading 21, LOS 21.d)



Question 21.6: Thunderbird Company reported net income of $500 million and the company had 100 million common shares outstanding. In addition, Thunderbird had 5 million shares of convertible preferred and 10 million outstanding warrants during the year. Each preferred share
pays a dividend of $4 per share and is convertible into three common shares. Each warrant is convertible into one common share at $25 per share. The company's stock traded at an average $50 per share. Thunderbird's diluted earnings per share for the year is closest to:
A) $4.00 per share
B) $4.20 per share.
C) $4.80 per share
Explanation
B is correct. 


(Reading 21, LOS 21.b)


Question 21.8: A company has the following sequence of events regarding its stock:
The company had 1,000,000 shares outstanding at the beginning of the year.
On June 30, the company declared and issued a 10% stock dividend.
On September 30, the company sold 400,000 shares of common stock at par.
The number of shares that should be used to compute basic earnings per share at year end is:
A) 1,000,000.
B) 1,100,000.
C) 1,200,000.
Explanation
C is correct. 

(Reading 21, LOS 21.g,21.h)
Things to know about the weighted average shares outstanding calculation:
1. The weighting system is days outstanding divided by the number of days in a year, but on the exam, the monthly approximation method will probably be used.
2. Shares issued enter into the computation from the date of issuance.
3. Reacquired shares are excluded from the computation from the date of reacquisition.
4. Shares sold or issued in a purchase of assets are included from the date of issuance.
5. A stock split or stock dividend is applied to all shares outstanding prior to the split or
dividend and to the beginning-of-period weighted average shares. A stock split or stock
dividend adjustment is not applied to any shares issued or repurchased after the split or
dividend date.

Question 21.9: Which of the following is most likely presented on a common-size balance sheet or common-size income statement?
A) Total asset turnover.
B) Operating profit margin.
C) Return on common equity
Explanation
B is correct. Operating profit margin can be read directly from a common-size income statement. Asset turnover and return on equity mix balance sheet and income statement items.
(Reading 21, LOS 21.i, 21.j)

Question 21.10: Which of the following types of items are least likely included in other comprehensive income?
A) Losses under the revaluation model.
B) Unrealized gains on equity securities.
C) Realized gains on securities classified as available-for-sale.
Explanation
 C is correct. Realized gains on investment securities are reported on the income statement under both IFRS and U.S. GAAP. The other two types of gains may be reported as other comprehensive income under certain circumstances.
(Rading 21, LOS 21.k)

Question 21.11: Items that appear in other comprehensive income, but are excluded from the income statement, include:
A) losses due to expropriation of assets.
B) gains and losses due to foreign currency translation.
C) unrealized gains and losses on trading securities.
Explanation
B is correct. Other comprehensive income includes unrealized gains and losses on available-for-sale securities, foreign currency translation gains and losses, minimum pension liability adjustments, and unrealized gains and losses on derivatives used for cash flow hedging. Unrealized gains and losses on held-for-trading securities are included in net income on the income statement. Losses due to expropriation of assets would be included in net income, most likely as an unusual or infrequent item.
(Reading 21, LOS 21.l)

Question 21.12: Which of the following items would affect owners' equity and also appear on the income statement?
A) Dividends paid to shareholders.
B) Unrealized gains and losses on trading securities.
C) Unrealized gains and losses on available-for-sale securities
Explanation
B is correct. Unrealized gains and losses from trading securities are reflected in the income statement and affect owners' equity. However, unrealized gains and losses from available-for-sale securities are included in other comprehensive income. Transactions included in other comprehensive income affect equity but not net income. Dividends paid to shareholders reduce owners' equity but not net income.
(Reading 21, LOS 21.l)