International Finance Exam 2

Gains or losses caused by translation adjustments when using the current rate method are reported separately on the: a. consolidated statement of cash flow. b. consolidated income statement. c. consolidated balance sheet. d. None of these

c. consolidated balance sheet.

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 Refer to Instruction 10.1. 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.)

$59,904

natural hedge

An offsetting operating cash flow, a payable arising from the conduct of business

foreign entity

Any distinct or separable business that prepares its financial statements in any currency other than the reporting currency of the parent company.

transaction exposure

Measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after FX change.

fundamental forecasting includes use of ________

PPP

current rate method (comparison)

assets and liabilities: current rate (as of the date of the balance sheet) income statement items: dates they were recorded or an appropriate weighted average rate for the period dividends: date of dividends payment common stock and paid in capital: historical FX rate (IPO - Par) translation gains/losses: cumulative translation adjustment (CTA), a component of other comprehensive income (OCI), Equity

A balance sheet hedge requires that the amount of exposed foreign currency assets and liabilities: a. have a 2:1 ratio of liabilities to assets. b. have a 2:1 ratio of liabilities to equity. c. have a 2:1 ratio of assets to liabilities. d. be equal.

d. be equal.

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 ________.

decrease; not change

Slow economic growth and continued unemployment problems are common reasons for central banks to hold currency values down. This can be accomplished by:

decreasing interest rates

net investment hedge

designated for the net investment in a foreign subsidiary or operation.

________ is the active buying and selling of the domestic currency against foreign currencies.

direct intervention

If the parent firm and all subsidiaries denominate all exposed assets and liabilities in the parent's reporting currency this will ____ exposure but each subsidiary would have ____ exposure a. maximize translation; no transaction b. eliminate translation; transaction c. maximize transaction; no translation d. eliminate transaction; translation

eliminate translation; transaction

Ignoring the impact of inflation of the discount factor, How would the lower Mexican Inflation Impact the Peso NPV? The Lower Inflation will reduce the amount of after-tax cost saving and ultimately Peso NPV will...

increase

________ is the alteration of economic or financial fundamentals that are thought to be drivers of capital to flow in and out of specific currencies.

indirect intervention

What parity Condition is used to compute the Mexican Discount Factor?

purchasing power parity

quotation exposure

time between quoting a price and reaching a contractual sale

backlog exposure

time it takes to fill the order after contract is signed

billing exposure

time it takes to get paid in cash after A/R is issued

purchasing and selling (transaction exposure)

transaction exposure measures gains (losses) that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency •The most common example of transaction exposure arises when a firm makes a sale and receives a promise of payment from the buyer (a receivable) or purchases an input and promises to pay in the future (a payable), and that transaction is denominated in a foreign currency •Quotation Exposure •Backlog Exposure •Billing Exposure

realized exposures

transaction exposureL changes in the recorded value of identifiable transactions of the firm like receivables and payables. Results in realized foreign exchange gains and losses in income and taxes short term to medium term to long term change operating exposure: changes in the expected future cash flows of the firm from unexpected changes in exchange rates. the firm's future cash flows are changed from realized changes in its own sales earnings and cash flows as well as changes in competitor responses to exchange rates over time

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.

transaction; translation

________ gains and losses are "realized" whereas ________ gains and losses are only "paper."

transaction; translation

__________ gains and losses are "realized" whereas __________ gains and losses are only "paper."

transaction; translation

unrealized exposures

translation exposure: changes in the periodic consolidated value of the firm; results in no change in cash flow or global tax liabilities -changes only the consolidated financial results reported to the market (if publicly traded) -often labeled accounting exposure

Will using either currency for Ariel lead to the same NPV? Why?

yes

hedging pros (CF risk reduction)

§Improves the planning capability of the firm. §Reduces default likelihood firm's CF fall below a level sufficient to make debt service payments. §Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. §Management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of single opportunities to enhance firm's value through selective hedging.

hedging cons

§Shareholders are more capable of diversifying currency risk than is the management of the firm §It does not increase the expected cash flows of the firm §Management often conducts hedging activities that benefit management at the expense of the shareholders §Managers cannot outguess the market §Management's motivation to reduce variability is sometimes for accounting reasons §Efficient market theorists believe that investors can see through the "accounting veil" and therefore have already factored the foreign exchange effect into a firm's market valuation.

transaction (accounting) exposure

•Arises because financial statements of foreign subsidiaries, stated in foreign currency, must be restated in the parent's reporting currency. •Translation purpose: to prepare consolidated financial statements •Why? •For use by investors, creditors, and governments. •Management: to assess the performance of foreign subsidiaries. •Only the income statement and balance sheet need be translated for consolidation purposes.

risk management strategies

•Avoiding Risk or Sharing Risk. •Reducing the negative effect of risk. •Accepting some or all of the consequences of a particular risk. •Transferring risk to another party. risk exposure = impact * likelihood * control

FX translation methods

•Regardless of which method is employed, a translation method must: 1)Designate at what exchange rate individual items are remeasured. 2)Where any imbalance is to be recorded (current income or an equity reserve account*).

Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in the local currency, and the local currency is the functional currency, then: a. translation is accomplished through the current rate method. b. the translation method to be used is not obvious. c. translation is accomplished through the temporal method. d. translation is not required.

a. translation is accomplished through the current rate method.

Which Currency will you use for the incremental cash flow for Ariel?

euros

A foreign subsidiary's ________ currency is the currency used in the firm's day-to-day operations.

functional

temporal method (comparison)

monetary assets and liabilities: current FX rates non-monetary assets and liabilities: historical FX rates (consistent with the timing of their creation) income statement items: the average FX for the period dividends: date of dividends payment common stock and paid in capital: historical FX rate (IPO-Par) translation gains/losses: current consolidated income

How can you forecast the FX rates?

most important: forward rates -secondary: market expectations and news

A ________ hedge refers to an offsetting operating cash flow such as a payable arising from the conduct of business.

natural

integrated foreign entity

operates as an extension of the parent company, with cash flows & general business lines highly interrelated with the parent.

How can you forecast a series of MXN/EUR exchange rates in this Case?

relative purchasing power parity

corporate FX risk exposure

resulting from accounting: -transaction exposure: impact of settling outstanding obligations entered into before change in exchange rates but to be settled after change in exchange rates -translation exposure: changes in income and owners' equity in consolidated financial statements caused by a change in exchange rates resulting from economics: -operating exposure: change in expected future cash flows arising from an unexpected change in exchange rates; changes in future cash flows arising from firm and competitor firm responses

Integrated foreign entity

subsidiary operates as an extension of the parent company's operations (Ganado China)

distinct and separable operation

subsidiary operates completely separately from the parent company (Ganado Europe). Also, known as self-sustaining.

functional currency

the currency of the primary economic environment in which the subsidiary operates and in which it generates cash flows. It is the dominant currency used by that foreign subsidiary in its day-to-day operations. (adopted by the US).

enterprise risk management (ERM)

•ERM is a process, starting by an entity's board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within overall risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. •Process: ongoing and flowing through an entity. •Starts with top management and flows across firm. •Applied across the enterprise, at every level & unit. Includes taking an entity-level portfolio view of

why hedge?

•Multinational firms possess a multitude of cash flows that are sensitive to changes in exchange rates, interest rates, and commodity prices. •Hedging involves taking a position by acquiring either an asset, a contract, or a derivative that will rise (fall) in value and offset a fall (rise) in the value of an existing position. •While hedging can protect the owner of an asset from a loss, it also eliminates any gain from an increase in the value of the asset hedged. §The value of a firm is the NPV of all expected future cash flows. §Hedging reduces the variation of the expected future cash flows.

managing translation exposure

•Some firms attempts to hedge translation exposure in forward market. •Such action amounts to speculating in the forward market in the hope that a cash profit will be realized to offset the noncash loss from translation. •Success depends on a precise prediction of future exchange rates, for such a hedge will be effective over a range of possible future spot rates. •In addition, the profit from the forward "hedge" (speculation) is taxable, but the translation loss does not reduce taxable income.

balance sheet hedge

•This requires an equal amount of exposed foreign currency assets and liabilities on a firm's consolidated balance sheet. •If this can be achieved for each currency, net translation exposure will be zero. •If a firm translates by the temporal method, a zero net exposed position is called monetary balance. •Complete monetary balance cannot be achieved under the current rate method. •Even if management chooses to follow an active policy of hedging translation exposure, it is nearly impossible to offset both transaction and translation exposure simultaneously. •If forced to choose, most managers will protect against transaction losses because they impact consolidated earnings.

current rate method

(most common): translate at the "current" FX rate with few exceptions.

hedge accounting

-Change in value is recoding in Other Comprehensive income (OCI) on the balance sheet to change in equity -Attempts to reduce volatility in earnings caused by repeated adjustments in market value -change in market value --> OCI (B/S)

mark to market accounting

-Change in value is run through to the income statement -Can cause volatility in earnings -change in market value --> profit & loss

operating exposure (economic, competitive, or strategic)

-Measures the change in the present value of the firm resulting from any change in future operating cash flows caused by an unexpected change in FX. -While transaction exposure is concerned with future cash flows already contracted for, operating exposure focuses on expected (not yet contracted for) future cash flows.

documenting designated hedging criteria

1. Identification of the forex hedge and the hedged item. 2. The risk you are hedging (changes in FX value). 3. The accounting treatment you are applying. 4. The objective of the hedge (to remove the volatility of future earnings related to changes in foreign currency exchange rates). 5. How you are going to evaluate whether you have effectively hedged that risk. 6. An assessment of the counterparty risk for the hedge provider.

steps to hedge accounting

1. hedging: yes or no? - assess FX risk vs cost -if yes, develop policy and educate staff 2. what to hedge? -data capture process: recorded B/S foreign currency amounts; forecasted future FX transactions 3. FX hedge plan -find FX hedge supplier -design your internal controls and processes -enter FX hedge (designated or not designated) 4. hedge accounting: -meet criteria -documentation and testings -FMV -not designated (P&L) -designated: special accounting

FX risk exposure assessment

1.Assess each currency Net flow: amount X exchange rate. 2.Assess currency trend (direction): not the forecasted value. 3.Assess each currency volatility: currency regime. 4.Assess each currency Liquidity: Bid-ask spread. 5.Repeat for highly correlated currencies (positive & negative). -risk exposure = impact * likelihood * control

temporal rate method

1.translate at FX rates consistent with the timing of those items' creation. •Temporal method assumes that a number of individual line item assets, such as inventory and net plant and equipment, are restated regularly to reflect market value. •If these items were not restated, but were instead carried at historical cost, the temporal method becomes the monetary/nonmonetary method of translation, a form of translation that is still used by a number of countries today.

self-sustaining foreign entity

1.operates in the local economic environment independent of the parent company.

foreign exchange exposure

A measure of the potential for a firm's profitability, net cash flow, & market value to change in exchange rates.

translation exposure

Accounting-derived changes in income & owner's equity to occur as we "translate" foreign currency financial statements subsidiaries into a single reporting currency consolidated financial statements

other causes of transaction exposure

Acquiring assets or incurring liabilities of any kind denominated in a foreign currency -When a firm enters into a forward exchange contract, it is deliberately creating a transaction exposure.

If the British subsidiary of a European firm has net exposed assets of £125,000, and the pound increases in value from €1.40/£ to €1.44/£, the European firm has a translation: A. loss of €5,000. B. loss of £5,000. C. gain of €5,000. D. gain of £5,000.

C. gain of €5,000.

foreign currency translation

If a foreign entity's financial statements are maintained in a functional currency, and that functional currency is different from the reporting currency of the parent company, the process for preparation of the financial statements is termed translation.

functional currency

The currency of the primary economic environment in which a distinct entity operates.

A currency board is: a. a structure, rather than a mere commitment, to limiting the growth of the money supply in the economy. b. a recipe for conservative and prudent financial management. c. designed to eliminate the power of politicians to exercise judgment by relying on an automatic and unbendable rule. d. All of these

d. All of these

US Translation Procedures

•The U.S. differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. If the financial Statements of foreign subsidiary are: 1.Maintained in U.S. dollars, then no translation is required. 2.Maintained in the local currency and the local currency is the functional currency, then they are translated using the current rate method. 3.Maintained in the local currency but the U.S. dollar is the functional currency, then they are re-measured using the temporal method. 4.Maintained the local currency and neither the local currency nor the U.S. dollar is the functional currency, then the statements must first be re-measured into the functional currency by the temporal method, and then translated into dollars using the current rate method.

when is a balance sheet hedge justified?

•The foreign subsidiary is about to be liquidated, so that the value of its CTA would be realized •The firm has debt covenants or bank agreements that state the firm's debt/equity ratios will be maintained within specific limits •Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains •The foreign subsidiary is operating in a hyper inflationary environment

foreign currency measurement (re-measurement)

•The process by which a foreign entity expresses transactions in a foreign currency in its functional currency.

goals (risk management in practice)

•The treasury function of most private firms is usually considered a cost center •It is not expected to add profit to the firm's bottom line

identifying sources of risk

•Uncertainty in the financial markets. •Uncertainty in the product market. •Project failures, Legal Liabilities. •Changing Regulatory environment. •Deliberate attacks from adversary. •Credit Risk, Accidents. Foreign Exchange Risk Exposure

financial hedge

An offsetting debt obligation or some type of financial derivative such as an interest rate swap.

does ERM slow you down?

ERM doesn't slow you down - it enables you to change, adapt, and respond faster to risk. "A company that does ERM is like race car driver that takes pit stops at just the right times. Both help ensure success over the long haul... whatever the goal."

How reasonable are the PPP-generated exchange rates?

PPP's empirical track record is spotty at best

reporting currency

The currency that the reporting entity uses to prepare its financial statements.

net exposed assets

The difference between the exposed assets subtracted from exposed liabilities. These assets can refer to market values or book values. A firm is "long in currency" if its net exposed assets are positive, i.e. the exposed assets are greater than their exposed liabilities.

borrowing and lending (transaction exposure)

Transaction exposure arises when funds are borrowed or loaned, and the amount involved is denominated in a foreign currency

contractual hedges

Utilize cash flows originating from the financing activities of the firm and include specific types of debt and foreign currency derivatives

operating hedges

Utilize the cash flows originating from the operating activities of the firm and include risk-sharing agreements and payments strategies using leads and lags

Translation exposure measures: a. changes in the value of outstanding financial obligations incurred prior to a change in exchange rates. b. the potential for an increase or decrease in the parent company's net worth and reported net income caused by a change in exchange rates since the last consolidation of international operations. c. an unexpected change in exchange rates impact on short run expected cash flows. d. None of these

b. the potential for an increase or decrease in the parent company's net worth and reported net income caused by a change in exchange rates since the last consolidation of international operations.

The ________ approach argues that equilibrium exchange rates are achieved when the net inflow of foreign exchange arising from current account activities is equal to the net outflow of foreign exchange arising from financial account activities.

balance of payments

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 Refer to Instruction 10.1. 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.

better off; $150,000

Prior to July 2, 1997, the Thai government: a. allowed the Thai Bhat to float against major currencies. b. fixed the Bhat's value against the Korean won only. c. fixed the Bhat's value against major currencies especially the U.S. dollar. d. None of these

c. fixed the Bhat's value against major currencies especially the U.S. dollar.

Critics of the balance of payments approach to exchange rate determination point to the emphasis on ________ of currency and capital rather than ________ of money or financial assets. a. export; import b. import; export c. flows; stocks d. stocks; flows

c. flows; stocks

If the European subsidiary of a U.S. firm has net exposed assets of €750,000, and the euro drops in value from $1.30/euro to $1.20/€ the U.S. firm has a translation: a. gain of $75,000. b. loss of €576,923. c. loss of $75,000. d. gain of $625,000.

c. loss of $75,000.

Losses from ________ exposure generally reduce taxable income in the year they are realized. ________ exposure losses may reduce taxes over a series of years. a. operating; Transaction b. transaction; Accounting c. transaction; Operating d. accounting; Operating

c. transaction; Operating

why forecast FX?

can help MCNs decide whether to: -hedge, invest in foreign project, remit earnings from foreign subsidiaries: increase cashflow -obtain financing in foreign currencies: decrease cost of capital

monetary assets (liabilities)

cash, cash equivalents, A/R, LT receivables, current liabilities and LT debt

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 these

d. All of these

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 these

d. All of these

Which of the following did NOT contribute to the Russian currency crisis of 1998? a. an accelerated flight of capital b. generally deteriorating economic conditions c. a surprisingly healthy government surplus that was neither funding internal investment nor external debt service d. All of these

d. All of these

If a firm's subsidiary is using the local currency as the functional currency, which of the following is NOT a circumstance that could justify the use of a balance sheet hedge? a. The foreign subsidiary is about to be liquidated, so that the value of its Cumulative Translation Adjustment (CTA) would be realized. b. The firm has debt covenants or bank agreements that state the firm's debt/equity ratio will be maintained within specific limits. c. The foreign subsidiary is operating is a hyperinflationary environment. d. All of these are appropriate reasons to use a balance sheet hedge.

d. All of these are appropriate reasons to use a balance sheet hedge.

________ 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 these are contractual hedges.

d. All of these are contractual hedges.

Which of the following is NOT a technique used by governments or central banks to impact domestic currency valuation? a. Indirect Intervention b. Direct Intervention c. Capital Controls d. All of these are techniques used to control currency valuation.

d. All of these are techniques used to control currency valuation.

When there is a full forward cover with the spot rate equal to the forward rate all of the following are true EXCEPT: a. There is no uncovered exposure remaining. b. The total position is a perfect hedge. c. The currency hedge ratio is equal to 1. d. The hedge is asymmetric.

d. The hedge is asymmetric.

The "tequila effect" is a slang term used to describe a form of financial panic called: a. speculation. b. contrary investing. c. run on the market. d. contagion.

d. contagion.

The authors did NOT identify which of the following as a root of the Asian currency crisis? a. corporate socialism b. banking stability and management c. the collapse of some Asian currencies d. the rate of inflation in the United States

d. the rate of inflation in the United States

Under the U.S. method of translation procedures, if the financial statements of the foreign subsidiary of a U.S. company are maintained in U.S. dollars: a. translation is accomplished through the current rate method. b. translation is accomplished through the temporal method. c. the translation method to be used is not obvious. d. translation is not required.

d. translation is not required.

fair value hedge

designated for a firm commitment (not recorded) or foreign currency cash flows of a recognized asset or liability.

cash flow hedge

designated for a highly probable forecasted transaction, a firm commitment (a transaction not yet recorded), foreign currency cash flows of a recognized asset or liability, or a forecasted intercompany transaction.