Test Bank Ch9 Managing Transaction Exposure To Currency Risk

Chapter 9 Managing Transaction 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 made up of transaction exposure and operating exposure.

2. Transaction exposure is defined as change in the value of monetary (contractual) cash flows due to an unexpected change in exchange rates.

3. Transaction exposure to currency risk is defined as change in financial accounting statements arising from unexpected changes in currency values.

Transaction exposure is the exposure of monetary assets and liabilities.

4. Every cash flow denominated in a foreign currency has a transaction exposure to currency risk.

5. To avoid influencing divisional hedging decisions, the corporate treasury should charge operating divisions the same price for a currency hedge (such as a forward contract) regardless of when the hedge is executed.

Operating divisions should be charged market prices for currency hedges.

6. Multinational netting identifies offsetting currency exposures within the corporation.

7. In multinational netting, expatriate managers are brought back to work at corporate headquarters.

Multinational netting identifies offsetting currency exposures within the firm.

8. A benefit of leading and lagging is that it does not distort the returns earned by the various affiliates.

This is one of the drawbacks of leading and lagging.

9. You have a contractual obligation denominated in a foreign currency and to be paid in six months. You can hedge this exposure by buying the foreign currency in the forward market.

10. You expect to receive a cash flow denominated in a foreign currency in six months. You can hedge this exposure by buying the foreign currency in the forward market.

Sell the foreign currency (and buy the domestic currency) at the forward rate.

11. You have a contractual cash inflow denominated in a foreign currency and to be received in six months. You will gain if the foreign currency appreciates in value over the next six months.

12. Transaction exposure to currency risk is easy to hedge with currency forwards.

13. Currency options are the most popular currency hedge.

The currency forward contract is the most popular currency hedging instrument.

14. Currency futures are like currency forwards except that they are marked-to-market daily.

15. A currency call option gives the buyer the right to buy an underlying currency at an exchange rate and on an expiration date that is determined by the option contract.

16. The seller of a currency call option has the obligation to deliver a currency at the exercise price.

17. An option premium is paid by the buyer to the seller at the time the option is purchased.

18. The option premium compensates the seller for the expected loss should the option be exercised.

19. A currency swap is an exchange of one currency for another in the spot market.

A currency swap is an agreement to exchange interest payments in two different currencies.

Multiple Choice Select the BEST ANSWER

1. The currency risk exposure given the most attention by financial managers is ____.

a. economic exposure

b. operating exposure

c. transaction exposure

d. translation exposure

e. none of the above

2. Geographically diversified operations provide a natural hedge of transaction exposure to currency risk because ____.

a. operating costs in one country are unlikely to be related to costs in another country

b. it is easy to replace sales in one country with sales from another country

c. when one currency is depreciating, another currency must be appreciating

d. two of the above

e. none of the above

3. Internal methods of reducing the MNC’s transaction exposure to currency risk include each of (a) through (c) EXCEPT ____.

a. multinational netting

b. leading and lagging of intracompany transactions

c. hedging in the currency forward markets

d. Each of the above is a way to reduce transaction exposure internally.

e. None of the above is a way of reducing transaction exposure internally.

4. The corporate treasury should charge ____ for hedging the currency risk exposures of individual business units within the firm.

a. historical cost prices

c. reservation prices

b. market prices

d. the same price regardless of when the transactions are executed

e. the most that the division can afford

5. Market prices allow the treasury to ____.

a. avoid transactions costs on internal hedges

b. benchmark the costs of internal hedges

c. use transfer prices to minimize the MNC’s tax liability

d. more than one of the above

e. none of the above

6. The preferred way to hedge transaction exposure to currency risk is ____.

a. by offsetting exposures within the firm

b. through forward currency contracts

c. through futures contracts

d. through swap contracts

e. None of the above—exposures should be left unhedged.

7. A cash management tool that minimizes intra-firm fund transfers is ____.

a. cash in advance

b. lockboxing

c. multinational netting

d. transfer pricing

e. none of the above

8. A pays B $140, A pays C $200, and B pays C $60. After netting, A will pay C ____.

a. $0

b. $200

c. $260

d. $340

e. none of the above

9. Internal hedges of currency risk are most likely to be found in ____.

a. diversified multinational corporations

b. domestic corporations

c. exporters

d. government agencies

e. importers

10. Transaction exposure to currency risk can be effectively hedged with which of the following hedging instruments or strategies?

a. currency forwards or futures

b. leading and lagging

c. international diversification

d. more than one of the above

e. none of the above

11. Financial market hedges work best for ____ exposures to currency risk.

a. accounting

b. economic

c. operating

d. transaction

e. translation

12. Which of the following is not included in financial market hedges?

a. currency futures

b. currency options

c. money market hedges

d. currency swaps

e. Each of the above can form a financial market hedge of currency risk.

13. Exposures to currency risk that are periodic, long-term, and recurring in nature are usually best hedged with ____.

a. currency compacts

b. currency futures

c. currency options

d. currency straddles

e. currency swaps

14. The most popular instrument for hedging currency risk is a ____.

a. currency forward

b. currency futures

c. money market hedge

d. currency option

e. currency swap

15. A disaster hedge against adverse currency movements can be obtained with a ____.

a. currency forward

b. currency future

c. money market hedge

d. currency option

e. currency swap

16. Bodnar, Hayt and Marston [“1998 Wharton Survey of Financial Risk Management by U.S. Non-Financial Firms,” Financial Management (1998)] found that financial derivatives users tend to be ____.

a. large firms

b. medium-size firms

c. small firms

d. private equity firms

e. privately held firms

Problems (Some of these can be converted into Multiple Choice questions.)

Exhibit T9.1

Bernd lives in Berlin and uses the euro as his currency of denomination. Bernd has an accounts payable balance of $10 million due in 3 months. The spot rate is S^€/$ = €1.20/$.

1. Refer to Exhibit T9.1. Draw each of the following:

a. Bernd’s underlying transaction on a time line.

b. Bernd’s risk profile in levels (V^€/$ versus S^€/$).

c. Bernd’s risk profile in changes (v^€/$ versus s^€/$).

2. Refer to Exhibit T9.1. How much will Bernd owe in three months at these exchange rates?

a. S^€/$ = €1.20/$.

b. S^€/$ = €1.10/$.

c. S^€/$ = €1.30/$.

3. Refer to Exhibit T9.1. Draw a risk profile (v^€/$ versus s^€/$) for each of the following:

a. Bernd’s underlying currency risk exposure

b. a currency forward hedge of Bernd’s exposure

c. the exposure of the net (or hedged) position

4. Refer to Exhibit T9.1. Show the parts of a money market hedge of Bernd’s exposure. Draw the risk exposures of the underlying position, the money market hedge, and the net position.

5. Refer to Exhibit T9.1. How can a currency option hedge reduce Bernd’s exposure to currency risk. Assume a strike price of €1.20/$ and an option premium of €0.20/$. Draw a graph of V^€/$ versus S^€/$ showing the risk exposures of the underlying position, the currency option hedge, and the net position.

6. The exchange rate between the U.S. dollar and the Mexican peso is S₀^$/peso = $16/peso.

Identify cash flows after multinational netting of the following transactions.

7. You work for an Argentinian importer and expect to pay €1 million in one year to a European supplier. You can trade at the following prices:

Spot rate, Argentinean australs per euro AA24.38/€

One-year forward rate AA24.96/€

One-year Argentinean interest rate 5.050%

One-year euro interest rate 4.050%

a. Form a forward market hedge. Identify which currency you are buying and which you are selling forward. When will currency change hands? Today? Or in one year?

b. Replicate the payoff on the forward contract with a money market hedge by using the spot currency and Eurocurrency markets. Identify each contract in the hedge.

c. Are quoted prices in these currency and Eurocurrency markets in equilibrium? If not, how would you arbitrage the disequilibrium?

8. Aphorisms Inc. has an expected cash inflow of €1 million on an accounts receivable balance due in six months. The owner, Laozi (老子), wants to hedge this exposure with an option contract at a strike price of K^CNY/€ = CNY 8.00/€ and with a due date in 6 months. At this strike price, call option and put option prices are, respectively, Call^CNY/€ = CNY 1.00/€ and Put^CNY/€ = CNY 2.00/€. Graph the following positions (a–c) on the figure below.

a. The exposure of Laozi’s underlying position

b. The payoff of Laozi’s option contract at expiration including the option premium

c. The payoff of Laozi’s combined position including the option premium

9. Payless Shoes has a shoe contract with a Taiwanese supplier. The T$30 million purchase is invoiced in new Taiwan dollars (T$) and is due in three months. The current spot and three-month forward exchange rates are T$30/$.

a. Draw Payless’ expected future cash flow in new Taiwan dollars on a timeline.

b. Draw a risk profile for Payless in terms of U.S. dollars per new Taiwan dollars.

c. If the actual spot rate in one year is T$25/$, how much gain or loss will Payless have assuming it does not hedge its currency exposure?

d. Form a forward market hedge. Indicate how the hedge eliminates foreign exchange exposure by identifying the forward contract’s cash inflows and outflows on a time line and constructing a payoff profile of the forward contract.

Problem Solutions

1. a.

b. c.

2. a. At S₀^€/$ = €1.20/$, Bernd will owe €12 million.

b. At S₁^€/$ = €1.10/$, Bernd will owe €11 million.

c. At S₁^€/$ = €1.30/$, Bernd will owe €13 million.

3. a. Bernd’s underlying currency risk exposure based on Exhibit T14.1.

b. A currency forward hedge of Bernd’s exposure

c. The exposure of the net (or hedged) position

4.

5. Bernd is short the dollar, so a long call option on the dollar can reduce Bernd’s exposure.

6. First, translate cash flows into the parent’s currency (U.S. dollars). Then, net the cash flows.

After further netting, here’s an intermediate result and an optimal solution that minimizes transfers.

7. a. You are paying €1 million to your supplier in one year, so buy €1 million and sell AA24.96 million one-year forward. In one year, you’ll receive €1 million and pay AA24.96 million on the forward contract. The €1 million receipt on the forward contract offsets the forward obligation to your supplier, leaving you with a net payment of AA24.96 million. You have eliminated your euro exposure.

b. The forward contract that you want to replicate is a forward purchase of €1 million. This can be replicated as follows:

Invest €961,169 = (€1,000,000)/(1.0405) to yield €1 million at the euro interest rate

Convert to (€961,169)(AA24.38/€) = AA23,433,295 at the spot exchange rate

Borrow AA23,433,295 to yield AA24,616,676 at the 5.05 percent Australian rate

The net result is a forward contract to purchase €1 million with astrals.

This is on more favorable terms than the forward contract, so forward prices are not in equilibrium with the interest rate differential. In this situation, it is cheaper to hedge through the money markets than through the forward market.

c. F₁^AA/€/S₀^AA/€ = (AA24.96/€)/(AA24.38/€) = 1.0238 > 1.0097 = (1.0505)/(1.0405) = (1 + i^AA)/(1 + i^€), so you should buy euros at the relatively low spot price, sell euros at the relatively high forward price, invest (or lend) euros at the relatively high euro interest rate, and borrow astrals at the relatively low astral interest rate. Based on a €1 million forward transaction, arbitrage profit will be AA24,960,000 – AA24,616,676 = AA343,324.

8.

9. a. The sale is invoiced in new Taiwan dollars, so the expected future cash flow is:

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–T$30,000,000

b. The contractual payment is a cash outflow in new Taiwan dollars, so Payless is negatively exposed to the value of the new Taiwan dollar.

c. It is convenient to place the new Taiwan dollar in the denominator. In these terms, the beginning spot and forward prices are S₀^$/T$ = F₁^$/T$ = 1/(T$30/$) = $0.0333/T$. The actual spot rate is 1/(T$25/$) = $0.04/T$, which is a 20 percent increase in the value of the new Taiwan dollar. The expected dollar payment is E[CF₁^$] = E[CF₁^T$] / E[S₁^T$/$] = (T$30,000,000) / (T$30/$) = $1,000,000. The actual payment is CF₁^$ = CF₁^T$ / S₁^T$/$ = (T$30,000,000) / (T$25/$) = $1,200,000. As the value of the new Taiwan dollar rises by 20 percent, so too does the value of Payless’ new Taiwan dollar forward obligation.

d. Buy 30 million new Taiwan dollars forward and sell $1,000,000 at the forward price of F₁^T$/$ = T$30/$, or F₁^$/T$ = $0.0333/T$.

The new Taiwan dollar is being bought forward, so Payless’s exposure to the new Taiwan dollar in this forward contract is positive. The positive exposure on the forward contract offsets the negative exposure on the underlying position. The net result is no exposure to the value of the new Taiwan dollar.