Full Test Bank Ch10 Managing Operating Exposure To Currency

Chapter 10 Managing Operating Exposure to Currency Risk

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. Economic exposure to currency risk is defined as change in the value of future cash flows due to unexpected changes in currency values.

2. Operating exposure typically is more important than translation exposure to the value of the multinational corporation.

3. Operating exposure to currency risk is easy to hedge with currency forwards.

Uncertain cash flows to real assets are difficult to hedge with currency forwards.

4. Operating exposure is defined as change in the firm’s operations in response to currency risk.

Operating exposure is change in real asset values due to currency risk.

5. In an integrated financial market, purchasing power parity holds so that equivalent assets trade for the same price regardless of where they are traded.

6. If purchasing power parity does not hold, then markets are at least partially segmented.

7. Operating exposure is defined as change in the value of contractual cash flows due to unexpected changes in currency values.

This is transaction exposure.

8. Segmented markets are markets that discriminate on the basis of race, creed, or color.

Segmented markets have barriers that prevent the free flow of capital.

9. The classic exporter manufactures goods in the local economy and sells the output in competitive global markets.

10. The classic importer buys goods in segmented foreign markets and sells them in local markets.

The classic importer buys its inputs in competitive global markets.

11. A real appreciation of the domestic currency helps importers and hurts exporters.

12. Net monetary assets is another term for shareholders’ equity.

Net monetary assets are monetary assets less monetary liabilities.

13. A multinational corporation can be exposed to more than one foreign currency.

14. Regressions based on historical data can be unsatisfactory indicators of expected future exposure to currency risk.

15. Operating hedges are zero-NPV transactions.

Because they involve the firm’s real assets, they are seldom zero-NPV transactions.

16. Real asset hedges of operating exposure to currency risk are less difficult to construct than financial market hedges.

Because they involve the firm’s real assets, they are more difficult to construct.

Multiple Choice Select the BEST ANSWER

1. Change in the value of future cash flows due to unexpected changes in exchange rates is called ____ to currency risk.

a. economic exposure

b. operating exposure

c. transaction exposure

d. translation exposure

e. none of the above

2. Change in financial accounting statements arising from unexpected changes in currency values is called ____ to currency risk.

a. economic exposure

b. operating exposure

c. transaction exposure

d. translation exposure

e. none of the above

3. Change in the value of contractual cash flows due to unexpected changes in currency values is called ____ to currency risk.

a. economic exposure

b. operating exposure

c. transaction exposure

d. translation exposure

e. none of the above

4. Change in the value of noncontractual cash flows due to unexpected changes in currency values is called ____ to currency risk.

a. economic exposure

b. operating exposure

c. transaction exposure

d. translation exposure

e. none of the above

5. Operating cash flows that are exposed to currency risk are affected primarily by ____.

a. changes in domestic inflation

b. changes in foreign inflation

c. changes in nominal exchange rates

d. changes in real exchange rates

e. none of the above

6. Monetary cash flows that are exposed to currency risk are affected primarily by ____.

a. changes in domestic unemployment

b. changes in foreign unemployment

c. changes in nominal exchange rates

d. changes in real exchange rates

e. none of the above

7. When goods markets are segmented from other markets, goods prices are determined ____.

a. in foreign markets

b. in the global market

c. in the local market

d. all of the above

e. none of the above

8. The classic exporter has ____.

a. both revenues and expenses that are determined globally

b. both revenues and expenses that are determined locally

c. revenues that are determined locally and expenses that are determined globally

d. revenues that are determined globally and expenses that are determined locally

e. none of the above

9. The classic importer has ____.

a. both revenues and expenses that are determined globally

b both revenues and expenses that are determined locally

c revenues that are determined locally and expenses that are determined globally

d revenues that are determined globally and expenses that are determined locally

e none of the above

10. The globally competitive multinational corporation typically has ____.

a. both revenues and expenses that are determined globally

b. both revenues and expenses that are determined locally

c. revenues that determined locally and expenses that are determined globally

d. revenues that determined globally and expenses that are determined locally

e. none of the above

11. The ____ is positively exposed to the real value of the domestic currency.

a. classic exporter

b. classic importer

c. typical domestic firm

d. globally competitive firm

e. none of the above

12. The ____ is negatively exposed to the real value of the domestic currency.

a. classic exporter

b. classic importer

c. typical domestic firm

d. globally competitive firm

e. none of the above

13. Price elasticity of demand is defined as minus the percentage change in ____.

a. interest rates for a given change in money supply

b. money supply for a given change in interest rates

c. price for a given percentage change in quantity demanded

d. quantity demanded for a given percentage change in price

e. none of the above

14. Exposure to currency risk ____.

a. can be thought of as a regression coefficient

b. cannot be measured by conventional methods

c. is equal to the price elasticity of demand

d. is equal to the variability of currency values

e. is equal for all companies

15. Operating exposure to currency risk is most effectively managed by ____.

a. hedging with currency forwards or futures

b. hedging with currency options

c. hedging with real assets

d. hedging with virtual assets

e. none of the above

16. Which of the following is a disadvantage of real asset hedges?

a. Bid-ask spreads can be large.

b. Daily marking to market can cause cash flow mismatches.

c. Option premiums can be large.

d. They are unlikely to be zero-NPV transactions.

e. They come in only a limited number of currencies and maturities.

17. The classic ____ is relatively insensitive to currency fluctuations.

a. domestic firms

b. exporters

c. importers

d. multinational corporations

e. Each of the above is sensitive to changes in foreign exchange rates.

18. Exposure to currency risk is measured as the percentage change in ____.

a. currency values given a percentage change in exchange rates

b. exchange rates given a percentage change in currency values

c. exchange rates given a percentage change in value

d. value given a percentage change in exchange rates

e. none of the above

19. The domestic currency value of a monetary cash flow denominated in a foreign currency changes ____ with a change in the value of the foreign currency.

a. disproportionately

b. the currency of denomination

c. not at all

d. one for one

e. none of the above

20. The domestic currency value of an expected future operating cash flow denominated in a foreign currency changes ____ with a change in the value of the foreign currency.

a. disproportionately

b. the currency of denomination

c. not at all

d. one for one

e. none of the above

21. Shareholders’ exposure to currency risk is equal to ____.

a. assets less liabilities

b. credits less debits

c. net monetary assets plus real assets

d. the sum of transaction exposure and operating exposure

e. none of the above

22. Which of the following is not a currency hedging alternative for a classic exporter?

a. Borrow in the foreign currency.

b. Buy a put option on the foreign currency.

c. Buy the foreign currency with long-dated forward contracts.

d. Use currency swaps to acquire financial liabilities in the foreign currency.

e. Use a rolling hedge to repeatedly sell the foreign currency.

23. Which of the following is not a currency hedging alternative for a classic importer?

a. Buy a call option on the foreign currency.

b. Invest in the foreign currency.

c. Buy the foreign currency with long-dated forward contracts.

d. Use a rolling hedge to repeatedly sell the foreign currency forward.

e. Use currency swaps to acquire financial inflows denominated in the foreign currency.

24. Managers should assess the performance of financial market hedges of operating exposures by ____.

a. assessing the interaction of operating performance with exchange rate changes

b. varying pro forma operating performance within reasonable limits

c. varying the exchange rate and assessing the resulting competitive position of the firm

d. more than one of the above

e. none of the above

25. Operational hedges can create value by ____.

a. reducing agency costs.

b. reducing expected taxes

c. reducing costs of financial distress

d. more than one of the above

e. none of the above

26. What is the main advantage of a financial market hedge of operating exposure to currency risk?

a. Financial market hedges can completely cancel operating exposures to currency risk.

b. It is relatively easy to assess the effectiveness of a financial market hedge of operating exposure.

c. The costs of buying or selling financial instruments are low compared to the costs of investing or disinvesting in real assets.

d. The uncertain cash flows of operating exposures to currency risk are exactly offset by the uncertain outcomes of a financial market hedge.

e. None of the above is an advantage.

27. Multinational corporations have an advantage over domestic firms in their ____.

a. market selection and promotion strategies

b. plant location decisions

c. product sourcing decisions

d. more than one of the above

e. none of the above

28. A Dutch exporter has dollar revenues and euro expenses. The company’s competitors are U.S. firms that have revenues and expenses denominated in dollars. Sensible pricing strategies that the Dutch exporter can pursue in response to an appreciation of the dollar include which of (a) through (c)?

a. Maintain the current euro price for their goods, try to sell the same quantity in the U.S. market, and capture a bigger contribution margin per unit.

b. Maintain the current dollar price for their goods and try to increase profits by increasing sales volume at the current contribution margin.

c. Follow the lead of the price leader in the U.S. market.

d. more than one of the above

e. none of the above

29. The percent of the variation in asset value that is explained by variation in a currency value is called the ____.

a. beta

b. price elasticity of demand

c r-square

d. slope coefficient

e. none of the above

Problems

1. Copper Kettle, Inc. of the United States manufactures (what else?) copper kettles. Copper Kettle imports its raw materials from Chile, and sells most of its goods in the domestic United States. Accounts that are denominated in Chilean pesos are indicated in the balance sheet below. Inventory is not exposed to the peso. The spot rate is $0.0020/peso.

Value Value Value Value

in pesos in dollars in pesos in dollars

Cash (pesos) P20,000,000 $40,000 Payables (pesos) P100,000,000 $200,000

Cash ($) $40,000 Payables ($) $40,000

Receivables($) $40,000

Inventory ($) $40,000

Current assets $160,000 Current liabilities $240,000

Real assets $240,000 Debt (pesos) P20,000,000 $40,000

Debt ($) $80,000

Net worth $40,000

Total assets $400,000 Total liabilities $400,000

a. What is the value of monetary assets and of monetary liabilities that are exposed to the Chilean peso? What is the value of exposed monetary assets net of exposed monetary liabilities?

b. If the peso depreciates by 10 percent, by how much will monetary assets change in value? By how much will monetary liabilities change in value? What are the r-squares of the relations between change in value and change in the exchange rate?

c. Suppose the exposure of real assets to the Chilean peso is ^Peso = _R,s(_R/_s), where _R,s = –0.30, _R = 0.15, and _s = 0.15. If the peso depreciates by 10 percent, by how much are Copper Kettle’s real assets likely to change in value? What is the r-square of this relation? Do you have much confidence in this estimate of the change in value? Why or why not.

d. Given your results in parts b and c, by how much is Copper Kettle’s equity likely to change in value with a 10 percent depreciation of the Chilean peso?

e. Does Copper Kettle’s peso-denominated debt make sense given their operating exposure?

An advanced problem on pricing strategy that is similar to problem 10.5 in the text

2. U.K.-based OSA has an expected expense of €20 million due in one year. Actual expenses might be as low as €15 million or as high as €25 million. The expected future spot rate is E[S₁^£/€] = $0.6000/€. OSA wants to hedge the expected euro expense with a one-year €20 million euro forward contract.

a. Draw OSA’s underlying transaction on a timeline using a minus sign (–) to indicate a cash outflow and a plus sign ( + ) to indicate a cash inflow.

b. Draw OSA’s risk profile in levels (V^£/€ versus S^£/€) and in percentage changes (v^£/€ versus s^£/€).

c. How much does OSA expect to owe in one year at each of the following exchange rates?

S^£/€ = £0.50/€

S^£/€ = £0.70/€

d. Complete the following table assuming an exchange rate of £0.60/€ and uncertain expenses. Use a minus sign (–) to indicate a cash outflow and a plus sign ( + ) to indicate a cash inflow.

Volume uncertainty at an expected spot rate of £0.60/€

Underlying euro cash flows –€15 million –€20 million –€25 million

Cash flows of the forward hedge

Pound cash flows

Euro cash flows

Net position

Pound cash flows

Euro cash flows

e. Complete the following table assuming actual expenses of €15 million and an uncertain exchange rate. Use a minus sign (–) to indicate a cash outflow and a plus sign ( + ) to indicate a cash inflow.

Exchange rate uncertainty at expenses of €15 million

Actual euro cash flows –€15 million –€15 million –€15 million

Cash flows of the forward hedge

Pound cash flows

Euro cash flows

Net position

Pound cash flows

Euro cash flows

Actual exchange rate £0.50/€ £0.60/€ £0.70/€

Actual revenues in pounds

f. Complete the following table assuming actual expenses of €25 million and an uncertain exchange rate. Use a minus sign (–) to indicate a cash outflow and a plus sign ( + ) to indicate a cash inflow.

Exchange rate uncertainty at expenses of €25 million

Actual euro cash flows –€25 million –€25 million –€25 million

Cash flows of the forward hedge

Pound cash flows

Euro cash flows

Net position

Pound cash flows

Euro cash flows

Actual exchange rate £0.50/€ £0.60/€ £0.70/€

Actual revenues in pounds

Problem Solutions

1. a. U.S.-based Copper Kettle has exposed monetary assets of Peso20 million and exposed monetary liabilities of (Peso100 million) + (Peso20 million) = Peso120 million. The net exposure of is Copper Kettle –100 million pesos.

b. A 10 percent depreciation of the Chilean peso will decrease the dollar value of peso-denominated monetary assets and liabilities by $4,000 and $24,000, respectively, for a net increase in the dollar value of Copper Kettle of $20,000. Exposed monetary assets and liabilities are derivative accounts that change one-for-one with changes in exchange rates, so the r-square of this relation is + 1.00, or 100 percent.

c. The sensitivity of real assets to the value of the peso is ^Peso = _R,s(_R/_s) = (–0.30)(0.15/0.15) = –0.30. A 10 percent depreciation of the peso is likely to increase the dollar value of Copper Kettle’s real assets by (–0.10)(–0.30) = + 0.03, or 3 percent. This translates into an $8,400 increase, from $280,000 to $288,400. The r-square is (–0.30)² = 0.09, so 9 percent of the variation in the dollar value of real assets is explained by variation in the value of the peso.

d. Equity exposure is equal to the exposure of net monetary assets plus the exposure of real assets. A 10 percent depreciation of the Chilean peso should change Copper Kettle’s equity value by ( + $20,000) + ($8,400) = $28,400.

e. Foreign currency debt does not make sense for an importer such as Copper Kettle. If the peso appreciates, Copper Kettle will owe more on its peso-denominated liabilities at the same time that its real assets fall in value. Copper Kettle probably could swap its peso-denominated debt for dollar debt, so that its financial obligations are in the same currency as its revenues.

2. An advanced problem on pricing strategy that is similar to problem 10.5 in the text

a. ──────────────────────┤

€20 million

b. Draw OSA’s risk profile in levels (V^$/€ versus S^$/€) and in percentage changes (v^$/€ versus s^$/€).

c. At S^£/€ = £0.50/€, OSA owes (€20,000,000)(£0.50/€) = £10,000,000

At S^£/€ = £0.70/€, OSA owes (€20,000,000)(£0.70/€) = £14,000,000

d. Volume uncertainty at an expected spot rate of £0.60/€

Underlying euro cash flows –€15 million –€20 million –€25 million

Cash flows of the forward hedge

Pound cash flows –£12,000,000 –£12,000,000 –£12,000,000

Euro cash flows €20,000,000 €20,000,000 €20,000,000

Net position

Pound cash flows –£12,000,000 –£12,000,000 –£12,000,000

Euro cash flows €5,000,000 €0 –€5,000,000

e. Exchange rate uncertainty at expenses of €15 million

Actual euro cash flows –€15 million –€15 million –€15 million

Cash flows of the forward hedge

Pound cash flows –£12,000,000 –£12,000,000 –£12,000,000

Euro cash flows €20,000,000 €20,000,000 €20,000,000

Net position

Pound cash flows –£12,000,000 –£12,000,000 –£12,000,000

Euro cash flows €5,000,000 €5,000,000 €5,000,000

Actual exchange rate £0.50/€ £0.60/€ £0.70/€

Actual revenues in pounds –£9,500,000 –£9,000,000 –£8,500,000

f. Exchange rate uncertainty at expenses of €25 million

Actual euro cash flows –€25 million –€25 million –€25 million

Cash flows of the forward hedge

Pound cash flows –£12,000,000 –£12,000,000 –£12,000,000

Euro cash flows €20,000,000 €20,000,000 €20,000,000

Net position

Pound cash flows –£12,000,000 –£12,000,000 –£12,000,000

Euro cash flows –€5,000,000 –€5,000,000 –€5,000,000

Actual exchange rate £0.50/€ £0.60/€ £0.70/€

Actual revenues in pounds –£14,500,000 –£15,000,000 –£15,500,000