CHAPTER 17INTERNATIONAL BANKING: RESERVES, DEBT, AND RISK

MULTIPLE CHOICE
1. Which of the following assets makes use of the basket valuation technique?
a. Swap agreements
b. Oil facility
c. Buffer stock facility
d. Special drawing rights
ANS: D

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2. Swap agreements are generally conducted by the:

a. Federal Reserve with foreign central banks
b. Federal Reserve with foreign commercial banks
c. U.S. Treasury with foreign central banks
d. U.S. Treasury with foreign commercial banks
ANS: A

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3. Which of the following is a main central bank function of the International Monetary Fund?
a. The conduct of open market operations
b. The issuance of gold certificates
c. The provision of monetary policy for member nations
d. The granting of loans to member nations
ANS: D

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4. The Federal Reserve's swap network represents:

a. Efforts to stabilize only the value of the dollar
b. Efforts to stabilize only the value of foreign currencies
c. Long-term borrowing among countries
d. Short-term borrowing among countries
ANS: D

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5. International trade and investment are most frequently financed by the U.S. dollar and the:
a. Japanese yen
b. British pound
c. Australian dollar
d. Swiss franc
ANS: B

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6. The purpose of international reserves is to finance:

a. Short-term surpluses in the balance of payments
b. Long-term surpluses in the balance of payments
c. Short-term deficits in the balance of payments
d. Long-term deficits in the balance of payments
ANS: C

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7. The currencies generally referred to as "reserve currencies" are the:

a. Japanese yen and U.S. dollar

b. Swiss franc and Japanese yen

c. British pound and U.S. dollar
d. Swiss franc and British pound
ANS: C

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8. Which of the following does not represent a form of international liquidity?

a. IMF reserve positions
b. General arrangements to borrow
c. U.S. government securities
d. Reciprocal currency arrangements
ANS: C

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9. Which of the following is not considered an "owned" reserve?

a. National currencies
b. Gold
c. Special drawing rights
d. Oil facility
ANS: D

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10. Which of the following is not considered a "borrowed" reserve?

a. Special drawing rights
b. Oil facility
c. IMF drawings
d. Reciprocal currency arrangement
ANS: A

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11. Eurodollars are:

a. Dollar-denominated deposits in overseas banks
b. European currencies used to finance transactions in the United States
c. Dollars that U.S. residents spend in Europe
d. European currencies used to finance imports from the United States
ANS: A

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12. Which of the following is not a characteristic of the Eurodollar market? It:
a. Is mainly located in the United Kingdom and continental Europe
b. Operates as a financial intermediary, bringing together lenders and borrowers
c. Deals in interest-bearing time deposits and loans to governments
d. Grew in response to the deregulation of interest rate ceilings on U.S. savings accounts
ANS: D

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13. Which of the following assets was (were) created in 1970 to provide additional international liquidity,
in the belief that increasing world trade requires more liquidity for larger expected payments
imbalances?
a. Eurodollar market
b. Special drawing rights
c. Reciprocal currency arrangements
d. General arrangements to borrow
ANS: B

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14. Which of the following constitute(s) the largest component of the world's international reserves?
a. Gold
b. Special drawing rights
c. IMF drawings
d. Foreign currencies
ANS: D

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15. With an international gold standard, if a country ended up with a deficit from the balances on its
current and capital accounts, it would:
a. Import gold to settle the balance
b. Export gold to settle the balance
c. Officially decrease the price of gold
d. Officially increase the price of gold
ANS: B

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16. Which of the following is not a condition of the international gold standard? That a nation must:
a. Convert gold into paper currency, and vice versa, at a stipulated rate
b. Permit gold to be freely imported and exported
c. Tolerate wide fluctuations in its exchange rate
d. Define its monetary unit in terms of a stipulated amount of gold
ANS: C

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17. All of the following exchange-rate systems require international reserves to finance balance-ofpayments disequilibriums except:
a. Pegged or fixed exchange rates
b. Managed floating exchange rates
c. Adjustable pegged exchange rates
d. Freely floating exchange rates
ANS: D

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18. A dollar shortage would indicate that the dollar is:

a. Undervalued in international markets
b. Overvalued in international markets
c. Overvalued in terms of gold
d. Overvalued in terms of special drawing rights
ANS: A

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19. The U.S. gold outflow that began in the late 1940s and continued through the 1960s was due in part to:
a. Crawling pegged exchange rates
b. Freely floating exchange rates
c. An undervalued dollar
d. An overvalued dollar
ANS: D

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20. The U.S. dollar glut of the 1960s was due in part to:
a. An undervalued dollar
b. An overvalued dollar
c. Freely floating exchange rates
d. Crawling pegged exchange rates

ANS: B

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21. For developing countries such as Mexico and Brazil, severe economic problems in the 1980s were
caused by:
a. A fall in the world demand for products produced by developing countries
b. High prices of basic raw materials and other commodities
c. Low real interest rates in the United States
d. High levels of income and imports for the United States
ANS: A

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22. In response to the international debt problem, the United States set up a special fund in 1986 to help
make up for lost oil revenues. Under the plan, the United States would make more money available as
world oil prices fell. This plan was designed to help:
a. Argentina
b. Saudi Arabia
c. Mexico
d. Brazil
ANS: C

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23. Which indicator of international debt burden schedules interest and principal payments on long-term
debt as a percent of export earnings?
a. Debt service ratio
b. Debt-to-export ratio
c. Ratio of external debt to gross domestic product
d. Ratio of external debt to gross national product
ANS: A

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24. Which term best describes the process in which the International Monetary Fund provides loans to
countries facing balance-of-payments difficulties provided that they initiate programs holding promise
of correcting these difficulties?
a. Conditionality
b. Debt service
c. Reciprocal currency arrangement
d. Swap agreement
ANS: A

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25. All of the following are major goals of the International Monetary Fund except:
a. Promoting international cooperation among member countries
b. Fostering a multilateral system of international payments
c. Making long-term development and reconstruction loans
d. Promoting exchange-rate stability and the elimination of exchange restrictions
ANS: C

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26. Which international reserve asset was officially phased out of the international monetary system by the
United States in the early 1970s?
a. Special drawing rights
b. Swap agreements
c. General arrangements to borrow
d. Gold
ANS: D

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27. Bilateral agreements between central banks, which provide for an exchange of currencies to help
finance temporary balance-of-payments disequilibriums, are referred to as:
a. IMF drawings
b. Special drawing rights
c. Buffer stock facility
d. Swap agreements
ANS: D

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28. Which organization is largely intended to make long-term reconstruction loans to developing nations?
a. Export-Import Bank
b. World Bank
c. International Monetary Fund
d. United Nations
ANS: B

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29. "Owned" international reserves consist of:

a. Special drawing rights
b. Oil facility
c. IMF drawings
d. Reciprocal currency arrangements
ANS: A

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30. "Borrowed" international reserves consist of:

a. IMF drawings
b. Foreign currencies
c. Gold
d. Special drawing rights
ANS: A

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31. Concerning international lending risk of commercial banks, ____ refers to the probability that part/all
of the interest/principal of a loan will not be repaid.
a. Country risk
b. Credit risk
c. Currency risk
d. Presidential risk
ANS: B

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32. Concerning international lending risk of commercial banks, ____ is closely related to political
developments in a borrowing country, especially the government's views concerning international
investments and loans.
a. Economic risk
b. Credit risk
c. Country risk
d. Currency risk
ANS: C

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33. Concerning international lending risk of commercial banks, ____ is associated with possible changes
in the exchange value of a nation's currency.
a. Political risk

b. Country risk
c. Credit risk
d. Currency risk
ANS: D

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34. To reduce their exposure to developing country debt, lending commercial banks have practiced all of
the following except:
a. Making outright loan sales to other commercial banks
b. Reducing their capital base as a cushion against losses
c. Dealing in debt-for-debt swaps with foreign governments
d. Dealing in debt/equity swaps with foreign governments
ANS: B

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35. To reduce losses on developing country loans, commercial banks sometimes sell their loans, at a
discount, to a developing country government for local currency which is then used to finance
purchases of ownership shares in developing country industries. This practice is known as:
a. Debt forgiveness
b. Debt buyback
c. Debt-for-debt swap
d. Debt/equity swap
ANS: D

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36. Concerning international debt, ____ refers to a negotiated reduction in the contractual obligations of
the debtor country and includes schemes such as markdowns and write-offs of debt.
a. Debt/equity swap
b. Debt-for-debt swap
c. Debt forgiveness
d. Debt sales
ANS: C

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37. The exchange of borrowing country debt for an ownership position in the borrowing country is known
as:
a. Debt forgiveness
b. Debt-for-debt swap
c. Debt reduction
d. Debt/equity swap
ANS: D

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38. "Country risk" analysis is concerned with all of the following except:
a. Depreciation of the borrowing country's currency
b. Political instability in the borrowing country
c. Economic growth in the borrowing country
d. External debt of the borrowing country
ANS: A

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39. Debt reduction

a. Refers to any voluntary scheme that lessens the burden on the debtor nation
b. May be accomplished through debt rescheduling
c. May be achieved through debt/equity swaps
d. All of the above

ANS: D

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40. Most analysts feel that the financial difficulties in East Asia were triggered by
a. Misallocation of investment
b. Unavailability of cheap foreign labor
c. Lack of alignment of the exchange rate with the dollar
d. Surpluses in the trade accounts of the Asian countries
ANS: A

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41. A nation may experience debt-servicing problems because of

a. Pursuit of improper macroeconomic policies
b. Inadequate borrowing
c. Adverse economic events
d. Both a and c
ANS: D

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42. Swap arrangements

a. Are agreements between governments
b. Require repayment within a stipulated period
c. Are usually multilateral agreements
d. Are never initiated by telephone
ANS: B

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TRUE/FALSE
1. Under a system of fixed exchange rates, international reserves are needed to bridge the gap between
monetary receipts and monetary payments.
ANS: T

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2. International reserves allow a country to finance disequilibria in its balance-of-payments position.

ANS: T

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3. An advantage of international reserves is that they allow countries to sustain temporary balance-ofpayments deficits until acceptable adjustment measures can operate to correct the disequilibrium.
ANS: T

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4. With floating exchange rates, countries require sizable amounts of international reserves for the
stabilization of exchange rates.
ANS: F

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5. When exchange rates are fixed by central bankers, the need for international reserves disappears.
ANS: F

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6. When exchange rates are fixed by central bankers, international reserves are necessary for financing
payments imbalances and the stabilization of exchange rates.

ANS: T

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7. There exists a direct relationship between the degree of exchange rate flexibility and the need for
international reserves.
ANS: F

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8. With floating exchange rates, payments imbalances tend to be corrected by market-induced

fluctuations in the exchange rate, and the need for exchange-rate stabilization and international
reserves disappears.
ANS: T

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The diagram below represents the exchange market position of the United States in trade with the
United Kingdom. Starting at the equilibrium exchange rate of $3 per pound, suppose the demand for
pounds rises from D0 to D1.
Figure 17.1 Foreign Exchange Market

9. Refer to Figure 17.1. Under a fixed exchange rate system, U.S. monetary authorities would have to
supply 8 million pounds in exchange for dollars to keep the exchange rate at $3 per pound.
ANS: T

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10. Refer to Figure 17.1. If the exchange rate was allowed to rise to $4 per pound, U.S. monetary
authorities would have to supply 6 million pounds to the foreign exchange market in exchange for
dollars to maintain this rate.
ANS: F

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11. Refer to Figure 17.1. Under a floating exchange rate system, the exchange rate would rise to $4 and
U.S. monetary authorities would have to supply 4 million pounds to the foreign exchange market in
exchange for dollars to maintain this rate.
ANS: F

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12. To the extent that adjustments in prices, interest rates, and income levels promote balance-of-payments
equilibrium, the demand for international reserves decreases.
ANS: T

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13. The greater a nation's propensity to apply tariffs and quotas to key sectors, the greater will be the need
for international reserves.
ANS: F

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14. The demand for international reserves is negatively related to the level of world prices and income.
ANS: F

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15. The demand for international reserves tend to increase with the level of world income and trade
activity.
ANS: T

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16. If a nation with a balance-of-payments deficit is willing and able to initiate quick actions to increase
export receipts and decrease import payments, the amount of international reserves needed will be
relatively large.
ANS: F

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17. The supply of international reserves consists of owned reserves and borrowed reserves.
ANS: T

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18. Foreign currencies constitute the smallest component of the world's international reserves.
ANS: F

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19. Gold constitutes the largest component of the world's international reserves.
ANS: F

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20. The U.S. dollar has been considered a reserve (key) currency because trading nations have been
willing to hold it as an international reserve asset.
ANS: T

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21. The U.S. dollar, Japanese yen, British pound, and Mexican peso are the major reserve currencies of the
international monetary system.
ANS: F

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22. By the 1990s, the British pound had replaced the U.S. dollar as the world's key currency.

ANS: F

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23. A goal of the International Monetary Fund is to make short-term loans to member nations so as to
allow them to correct balance of payments disequilibriums without resorting to measures that would
destroy national prosperity.
ANS: T

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24. When granting loans to financially troubled nations, the International Monetary Fund requires some
degree of conditionality, meaning that the borrowing nation must agree to implement economic
policies as mandated by the IMF.
ANS: T

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25. The International Monetary Fund has sometimes demanded that financially-troubled nations, that
borrow from the IMF, undergo austerity programs including slashing of public spending and private
consumption.
ANS: T

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26. The main purpose of the International Monetary Fund is to grant long-term loans to developing nations
to help them finance the development of infrastructure such as roads, dams, and bridges.
ANS: F

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27. Gold is currently the most widely used asset in the international monetary system.
ANS: F

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28. In 1974 the United States revoked a 41-year ban on U.S. citizen's ownership of gold.
ANS: T

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29. In 1975 the official price of gold was abolished as the unit of account for the international monetary
system. As a result, gold was demonetized as an international reserve asset.
ANS: T

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30. In the 1970s, the major industrial countries abandoned the managed-floating exchange rate system and
adopted a system of fixed exchange rates tied to the price of gold.
ANS: F

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31. Created by the International Monetary Fund, special drawing rights (SDRs) are unconditional rights to
draw currencies of other nations, thus enabling countries to finance their current-account deficits.
ANS: T

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32. The value of the SDR is tied to a currency basket consisting of the U.S. dollar, German mark, Japanese
yen, French franc, and British pound.
ANS: T

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33. The SDR has replaced the dollar, yen, and mark as the key asset of the international financial system.
ANS: F

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34. Because the value of the SDR is tied directly to the value of the U.S. dollar, a 10 percent dollar
depreciation would result in a 10 percent decrease in the SDR's value.
ANS: F

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35. A main purpose of the International Monetary Fund is to make loans of foreign currencies to member
countries which are experiencing current-account surpluses.
ANS: F

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36. When a deficit nation borrows from the International Monetary Fund, it purchases with its currency
the foreign currency required to help finance the payments deficit.
ANS: T

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37. The so-called General Arrangements to Borrow provide a permanent increase in the supply of
international reserves.
ANS: F

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38. Swap arrangements are bilateral agreements between central banks to allow countries to temporarily
borrow funds to ease current-account deficits and discourage speculative capital flows.
ANS: T

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39. IMF drawings, swap arrangements, buffer stock facility, and compensatory financing for exports are
classified as owned reserves rather than borrowed reserves.
ANS: F

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40. Concerning international lending risk, credit risk refers to the probability that part or all of the interest
rate or principal of a loan will not be repaid.
ANS: T

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41. Concerning international lending risk, country risk refers to the risk that part or all of the interest or
principal of a loan will not be repaid.
ANS: F

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42. Concerning international lending risk, currency risk is the risk of asset losses due to changing currency
values.
ANS: T

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43. A country with a high debt/export ratio and a high debt service/export ratio would likely be considered
as an attractive place in which to invest by foreign residents.
ANS: F

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44. A debt buyback is a debt-reduction technique in which a government of a debtor nation buys loans
from commercial banks at a discount.
ANS: T

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45. Under a debt-for-debt swap, a commercial bank sells its loans at a discount to a developing country
government for local currency which it then uses to finance an equity investment in the debtor country.
ANS: F

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46. A debt-equity swap results in a trade surplus nation forgiving the loans made to a trade-deficit nation.
ANS: F

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47. Eurocurrencies are deposits, denominated and payable in dollars and other foreign currencies, in banks
outside the United States, primarily in London, the market's center.
ANS: T

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SHORT ANSWER
1. Why do countries hold international reserves?
ANS:
The purpose of international reserves is to permit nations to bridge the gap between monetary receipts
and payments.
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2. How can a bank reduce its exposure to the debt of developing nations?
ANS:
It can reduce exposure through outright loan sales in the secondary market, debt buybacks, debt-fordebt swaps, and debt/equity swaps.
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ESSAY
1. Describe the eurocurrency market.
ANS:
Eurocurrencies are deposits, denominated and payable in dollars and other foreign currencies, such as
Swiss franc, in banks outside the United States, primarily in London, the market's center. Most
eurocurrency trading occurs in non-European centers, such as Hong Kong, and Singapore. Dollar
deposits located in banks outside the United States are known as eurodollars, and banks that conduct
trading in the markets for eurocurrencies are designated eurobanks.
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2. Are international reserve needs different for different exchange rate regimes?

ANS:
The need for international reserves tends to become less acute under a system of floating rates than
under a system of fixed rates. The more efficient the international adjustment mechanism and the
greater the extent of international policy coordination, the smaller the need for international reserves.
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