Transaction Exposure Management.docx

Multinational Business Finance Transaction Exposure Management 10.1 Types of Foreign Exchange Exposure Multiple Choice 1) ________ exposure deals with cash flows that result from existing contractual obligations. A) Operating B) Transaction C) Translation D) Economic Answer: B Topic: 10.1 Types of Foreign Exchange Exposure 2) ________ exposure measures the change in the present value of the firm resulting from unexpected changes in exchange rates. A) Operating B) Transaction C) Translation D) Accounting Answer: A Topic: 10.1 Types of Foreign Exchange Exposure 3) Each of the following is another name for operating exposure EXCEPT: A) economic exposure. B) strategic exposure. C) accounting exposure. D) competitive exposure. Answer: C Topic: 10.1 Types of Foreign Exchange Exposure 4) Transaction exposure and operating exposure exist because of unexpected changes in future cash flows. The difference between the two is that ________ exposure deals with cash flows already contracted for, while ________ exposure deals with future cash flows that might change because of changes in exchange rates. A) transaction; operating B) operating; transaction C) operating; accounting D) none of the above Answer: A Topic: 10.1 Types of Foreign Exchange Exposure 5) ________ exposure is the potential for accounting-derived changes in owner's equity to occur because of the need to translate foreign currency financial statements into a single reporting currency. A) Transaction B) Operating C) Economic D) Accounting (aka translation) Answer: D Topic: 10.1 Types of Foreign Exchange Exposure 6) Losses from ________ exposure generally reduce taxable income in the year they are realized. ________ exposure losses may reduce taxes over a series of years. A) accounting; Operating B) operating; Transaction C) transaction; Operating D) transaction; Accounting Answer: C Topic: 10.1 Types of Foreign Exchange Exposure 7) Losses from ________ exposure generally reduce taxable income in the year they are realized. ________ exposure losses are not cash losses and therefore, are not tax deductible. A) transaction; Operating B) accounting; Operating C) accounting; Transaction D) transaction; Translation Answer: D Topic: 10.1 Types of Foreign Exchange Exposure 8) MNE cash flows may be sensitive to changes in which of the following? A) exchange rates B) interest rates C) commodity prices D) all of the above Answer: D Topic: 10.1 Types of Foreign Exchange Exposure 9) Assuming no transaction costs (i.e., hedging is "free"), hedging currency exposures should ________ the variability of expected cash flows to a firm and at the same time, the expected value of the cash flows should ________. A) increase; not change B) decrease; not change C) not change; increase D) not change; not change Answer: B Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 10) Which of the following is NOT cited as a good reason for hedging currency exposures? A) Reduced risk of future cash flows is a good planning tool. B) Reduced risk of future cash flows reduces the probability that the firm may not meet required cash flows. C) Currency risk management increases the expected cash flows to the firm. D) Management is in a better position to assess firm currency risk than individual investors. Answer: C Topic: 10.1 Types of Foreign Exchange Exposure 11) Which of the following is cited as a good reason for NOT hedging currency exposures? A) Shareholders are more capable of diversifying risk than management. B) Currency risk management through hedging does not increase expected cash flows. C) Hedging activities are often of greater benefit to management than to shareholders. D) All of the above are cited as reasons NOT to hedge. Answer: D Topic: 10.1 Types of Foreign Exchange Exposure 12) The stages in the life of a transaction exposure can be broken into three distinct time periods. The first time period is the time between quoting a price and reaching an actual sale agreement or contract. The next time period is the time lag between taking an order and actually filling or delivering it. Finally, the time it takes to get paid after delivering the product. In order, these stages of transaction exposure may be identified as: A) backlog, quotation, and billing exposure. B) billing, backlog, and quotation exposure. C) quotation, backlog, and billing exposure. D) quotation, billing, and backlog exposure. Answer: C Topic: 10.1 Types of Foreign Exchange Exposure 13) A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£ , the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. The U.S. firm is at risk today of a loss if: A) the exchange rate changes to $1.52/£. B) the exchange rate changes to $1.58/£. C) the exchange rate doesn't change. D) all of the above Answer: D Topic: 10.1 Types of Foreign Exchange Exposure Skill: Analytical 14) A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£ , the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. If the exchange rate changes to $1.58/£ the U.S. firm will realize a ________ of ________. A) loss; $4,500 B) gain; $4,500 C) loss; £4,500 D) gain; £4,500 Answer: B Topic: 10.1 Types of Foreign Exchange Exposure Skill: Analytical 15) A U.S. firm sells merchandise today to a British company for £150,000. The current exchange rate is $1.55/£ , the account is payable in three months, and the firm chooses to avoid any hedging techniques designed to reduce or eliminate the risk of changes in the exchange rate. If the exchange rate changes to $1.52/£ the U.S. firm will realize a ________ of ________. A) loss; $4,500 B) gain; $4,500 C) loss; £4,500 D) gain; £4,500 Answer: A Topic: 10.1 Types of Foreign Exchange Exposure Skill: Analytical 16) ________ is NOT a commonly used contractual hedge against foreign exchange transaction exposure. A) Forward market hedge B) Money market hedge C) Options market hedge D) All of the above are contractual hedges. Answer: D Topic: 10.1 Types of Foreign Exchange Exposure 17) A ________ hedge refers to an offsetting operating cash flow such as a payable arising from the conduct of business. A) financial B) natural C) contractual D) futures Answer: B Topic: 10.1 Types of Foreign Exchange Exposure True/False 1) As a generalized rule, only realized foreign exchange losses are deductible for tax purposes. Answer: TRUE Topic: 10.1 Types of Foreign Exchange Exposure 2) Many MNE s manage foreign exchange exposure centrally, thus gains or losses are always matched with the country of origin. Answer: FALSE Comment: Many MNE s manage foreign exchange exposure centrally, thus gains or losses may not always be matched with the country of origin. Topic: 10.1 Types of Foreign Exchange Exposure 3) Hedging, or reducing risk, is the same as adding value or return to the firm. Answer: FALSE Comment: Hedging is not free. Therefore, it only adds value if the increase in cash flow is greater than the cost of hedging. Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 4) There is considerable question among investors and managers about whether hedging is a good and necessary tool. Answer: TRUE Topic: 10.1 Types of Foreign Exchange Exposure 5) The key arguments in opposition to currency hedging such as market efficiency, agency theory, and diversification do not have financial theory at their core. Answer: FALSE Comment: The key arguments in opposition to currency hedging such as market efficiency, agency theory, and diversification DO have financial theory at their core. Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 6) The structure of a money market hedge is similar to a forward hedge. The difference is the cost of the money market hedge is determined by the differential interest rates, while the forward hedge is a function of the forward rates quotation. Answer: TRUE Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 7) In efficient markets, interest rate parity should assure that the costs of a forward hedge and money market hedge should be approximately the same. Answer: TRUE Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 8) Management often conducts hedging activities that benefit management at the expense of the shareholders. The field of finance called agency theory frequently argues that management is generally LESS risk averse than are shareholders. Answer: FALSE Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 9) Managers CAN outguess the market. If and when markets are in equilibrium with respect to parity conditions, the expected net present value of hedging should be POSITIVE. Answer: FALSE Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 10) Shareholders are LESS capable of diversifying currency risk than is the management of the firm. Answer: FALSE Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 11) Hedging can be advantageous to shareholders because management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of single opportunities to enhance firm value through selective hedging. Answer: TRUE Topic: 10.1 Types of Foreign Exchange Exposure Skill: Conceptual 12) TRANSACTION exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency. Answer: TRUE Topic: 10.1 Types of Foreign Exchange Exposure 13) Transaction exposure could arise when borrowing or lending funds when repayment is to be made in the firm's domestic currency. Answer: FALSE Topic: 10.1 Types of Foreign Exchange Exposure Essay 1) Does foreign currency exchange hedging both reduce risk and increase expected value? Explain, and list several arguments in favor of currency risk management and several against. Answer: Foreign exchange currency hedging can reduce the variability of foreign currency receivables or payables by locking in a specific exchange rate in the future via a forward contract, converting currency at the current spot rate using a money market hedge, or minimizing unfavorable exchange rate movement with a currency option. None of these hedging techniques, however, increases the expected value of the foreign currency exchange. In fact, expected value should fall by an amount equal to the cost of the hedge. Generally, those in favor of currency risk management find value in the reduction of variability of uncertain cash flows. Those opposed to currency risk management argue the NPV of such activities are $0 or less and that shareholders can reduce risk themselves more efficiently. For a more complete answer to this question, see page 4 where the author outlines several arguments for and against currency risk management. Topic: 10.1 Types of Foreign Exchange Exposure Skill: Analytical 2) Currency risk management techniques include forward hedges, money market hedges, and option hedges. Draw a diagram showing the possible outcomes of these hedging alternatives for a foreign currency receivable contract. In your diagram, be sure to label the X and Y-axis, the put option strike price, and show the possible results for a money market hedge, a forward hedge, a put option hedge, and an uncovered position. (Note: Assume the forward currency receivable is British pounds and the put option strike price is $1.50/£, the price of the option is $0.04 the forward rate is $1.52/£ and the current spot rate is $1.48/£.) Answer: The student should draw and label a diagram that looks similar to the one found in Exhibit 10.5. Topic: 10.1 Types of Foreign Exchange Exposure Skill: Analytical 10.2 Trident's Transaction Exposure Multiple Choice Instruction 10.2: Use the information for the following problem(s). Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information. • The spot exchange rate is $1.250/euro • The six month forward rate is $1.22/euro • CVT's cost of capital is 11% • The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) • The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months) • The U.S. 6-month borrowing rate is 8% (or 4% for 6 months) • The U.S. 6-month lending rate is 6% (or 3% for 6 months) • December call options for euro 750,000; strike price $1.28, premium price is 1.5% • CVT's forecast for 6-month spot rates is $1.27/euro • The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro 1) Refer to Instruction 10.2. If CVT chooses NOT to hedge their euro payable, the amount they pay in six months will be: A) $3,500,000. B) $3,900,000. C) €3,000,000. D) unknown today Answer: D Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 2) Refer to Instruction 10.2. If CVT chooses to hedge its transaction exposure in the forward market, it will ________ euro 3,000,000 forward at a rate of ________. A) buy; $1.22 B) buy; $1.25 C) sell; $1.22 D) sell; €1.25 Answer: A Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 3) Refer to Instruction 10.2. CVT chooses to hedge its transaction exposure in the forward market at the available forward rate. The required amount in dollars to pay off the accounts payable in 6 months will be: A) $3,000,000. B) $3,660,000. C) $3,750,000. D) $3,810,000. Answer: B Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 4) Refer to Instruction 10.2. If CVT locks in the forward hedge at $1.22/euro, and the spot rate when the transaction was recorded on the books was $1.25/euro, this will result in a "foreign exchange accounting transaction ________ of ________. A) loss; $90,000. B) loss; €90,000. C) gain; $90,000. D) gain; €90,000. Answer: C Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 5) Refer to Instruction 10.2. CVT would be ________ by an amount equal to ________ with a forward hedge than if they had NOT hedged and their predicted exchange rate for 6 months had been correct. A) better off; $150,000 B) better off; €150,000 C) worse off; $150,000 D) worse off; €150,000 Answer: A Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 6) Refer to Instruction 10.2. What is the cost of a call option hedge for CVT's euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firm's cost of capital as the appropriate interest rate for calculating future values.) A) $57,600 B) $59,904 C) $62,208 D) $63,936 Answer: B Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 7) Refer to Instruction 10.2. The cost of a put option to CVT would be: A) $52,500. B) $55,388. C) $58,275. D) There is not enough information to answer this question. Answer: D Topic: 10.2 Trident's Transaction Exposure Skill: Analytical 8) ________ are transactions for which there are, at present, no contracts or agreements between parties. A) Backlog exposure B) Quotation exposure C) Anticipated exposure D) none of the above Answer: C Topic: 10.2 Trident's Transaction Exposure 9) According to a survey by Bank of America, the type of foreign exchange risk most often hedged by firms is: A) translation exposure. B) transaction exposure. C) contingent exposure. D) economic exposure. Answer: B Topic: 10.2 Trident's Transaction Exposure True/False 1) When attempting to manage an account payable denominated in a foreign currency, the firm's only choice is to remain unhedged. Answer: FALSE Comment: A firm can bring the same set of tools available to hedge an account receivable. Topic: 10.2 Trident's Transaction Exposure 2) The treasury function of most firms, the group typically responsible for transaction exposure management, is NOT usually considered a profit center. Answer: TRUE Topic: 10.2 Trident's Transaction Exposure 3) According to the authors, firms that employ proportional hedges increase the percentage of forward-cover as the maturity of the exposure lengthens. Answer: FALSE Topic: 10.2 Trident's Transaction Exposure 4) Remaining unhedged is NOT an option when dealing with foreign exchange transaction exposure. Answer: FALSE Topic: 10.2 Trident's Transaction Exposure 5) A forward hedge involves a put or call option contract and a source of funds to fulfill that contract. Answer: FALSE Topic: 10.2 Trident's Transaction Exposure 6) Like a forward market hedge, a money market hedge also involves a contract and a source of funds to fulfill that contract. In this instance, the contract is a loan agreement. Answer: TRUE Topic: 10.2 Trident's Transaction Exposure 7) Hedging transaction exposure with option contracts allows the firm to benefit if exchange rates are favorable but protects the firm if exchange rates turn unfavorable. Answer: TRUE Topic: 10.2 Trident's Transaction Exposure 8) A firm's risk tolerance is a combination of management's philosophy toward transaction exposure and the specific goals of treasury activities. Answer: TRUE Topic: 10.2 Trident's Transaction Exposure 9) Although rarely acknowledged by the firms themselves, selective hedging is essentially speculation. Answer: TRUE Topic: 10.2 Trident's Transaction Exposure