fin4604 ex2
If trade transactions handled on a draft basis are processed through banking channels, they may be
"Documents against payment."
An increase in the real value of a domestic currency acts as a
"tax" on exports and a "subsidy" on imports
Forward Rate Parity (FRP) states that:
(The fwd rate as an unbiased predictor of future spot) The forward exchange rate must be equal to the expected future spot exchange rate at maturity otherwise riskless arbitrage will take place.
Transaction exposure arises from:
1. Purchasing or selling, on credit, goods or services denominated in foreign currencies. 2. Borrowing or lending denominated in foreign currencies. 3. Taking long or short positions in forward markets or futures markets. 4. Acquiring assets or incurring liabilities denominated in foreign currencies.
Assume that Big Mac costs $3.06 in the US and 2505 Won in Korea. According to absolute PPP, if the actual exchange rate is 1006 Won/$, then which of the following is true?
Absolute PPP does not hold.
The ________ is also referred to as the "law of one price."
Absolute Purchasing Power Parity
If you expect the euro to depreciate, it would be appropriate to ________ for speculative purposes. And what would you do if euro were expected to appreciate?
Sell a euro call and buy a euro put.
A firm has 1,000,000-euro receivables due in 30 days, and is certain that the euro will depreciate substantially over time. Assuming that the firm is correct, the ideal strategy for the firm is to:
Sell euros forward.
Macomb Corporation is a U.S. firm that invoices some of its exports in Japanese yen. If it expects the yen to depreciate, it could ________ to hedge the exchange rate risk on those exports.
Sell futures contracts on yen.
If your firm expects the euro to substantially depreciate, it could speculate by_______ euro call options or _______euros forward in the forward exchange market.
Selling; selling
A bill of exchange requesting the bank to pay the face amount upon presentation of a document is a:
Sight draft
Under a ___________, the exporter is paid once shipment has been made and the draft is presented to the buyer for payment; under a ___________, the exporter provides instructions to the buyer's bank to release shipping documents against acceptance, by the buyer, of the draft.
Sight draft; time draft
____________ are very important in determining economic exposure, than any accounting definition.
Sources of the firm's inputs (imports, domestic traded or non-traded sectors) and real exchange rate changes
The following is not a technique used to manage transaction exposure by multinational firms
Speculation
Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year forward rate of the peso is $.10. If a U.S. firm uses covered interest arbitrage, which of the following price adjustments should result?
Spot rate of peso increases, forward rate of peso decreases.
According to the IFE, if British interest rates exceed U.S. interest rates,
The British pound will depreciate against the dollar.
What is the proximate cause in the development of financial derivative securities?
The Emergence of floating exchange rates
Temporal Method (Consistent with FASB-8)
Balance sheet items are divided into two: (a) Monetary Assets and Liabilities: • Cash, Marketable Securities, AR's, L-T Receivables • Current Liabilities (AP's), L-T Debt are translated at current market value & current exchange rate. (b) Non-monetary Assets and Liabilities: • Fixed Assets (plant & equipment) • Inventory are valued & translated at historical cost & historical exchange rate (rate at acquisition) Income statement items are translated at an average rate for the period.
Which of the following is not a typical documentation required under a letter of credit?
Banker's acceptance
Assume no transactions costs exist for any futures or forward contracts. The price of British pound futures with a settlement date 180 days from now will:
Be about the same as the 180-day forward rate.
In which case will locational arbitrage be most likely feasible? Bank A's:
Bid price for a currency is greater than Bank B's ask price for the currency.
A ________ provides a summary of freight charges and conveys title to the merchandise.
Bill of lading
Which of the following operations benefits from a continuing appreciation of a firm's local currency?
Borrowing immediately in a foreign currency and converting the funds to the local currency investment.
Which of the following best describes currency options sold through an option exchange. They grant the buyer a right:
But not the obligation, to buy or sell and are standardized.
The basic idea of arbitrage
Buy a product where its price is relatively low and sell where its price is higher - provided that the price spread more than offsets transaction costs
A firm sells a currency futures contract and then decides before the settlement date that it no longer wants to maintain such a position. It can close out its position by:
Buying an identical futures contract.
If you have acquired the right but not the obligation to buy, you are a:
Call buyer/owner/holder.
Advantages of Re-invoicing Centers
Centralization of transaction exposure management Specialized expertise and economies of scale Only residual (net) exposures are hedged.
The purchase of a Euro currency put option would be appropriate for a U.S company under which of the following?
Company expects to collect a Euro-denominated receivable in six months.
The purchase of a currency put option would be appropriate for a U.S company under which of the following?
Company expects to collect a foreign currency accounts receivable in six months.
Which of the following is not a feature of the forward market? a. OTC market traded. b. Contract sizes tailor-made. c. Delivery and settlement at maturity. d. Credit risk borne by counterparties. e. Contracts usually reversed prior to maturity (Marked to the market).
Contracts usually reversed prior to maturity (Marked to the market).
Transaction exposure can be managed by:
Contractual techniques, operating strategies, arranging swap agreements, and risk-sharing agreements.
An exchange of goods between two parties under two distinct contracts expressed in monetary terms are:
Counter purchase.
The Purchasing Power Parity (PPP) suggests that a home currency will:
Depreciate if home inflation rate exceeds foreign inflation rate.
The International Fisher Equation (IFE) suggests that a home currency will:
Depreciate if home interest rate exceeds foreign interest rate.
Assume that U.S. investors are benefiting from covered interest arbitrage due to high interest rate on euro. Which of the following adjustments should result from covered interest arbitrage?
Downward pressure on the euro's forward rate.
Transaction exposure reflects the exposure of a firm's:
Ongoing international transactions to exchange rate fluctuations.
Which of the following is not a trade financing method used in international trade from an exporter's perspective?
Open account
Transaction exposure manifests itself when MNCs engage in each of the following, except: a. Forward market. b. Futures market. c. Swap market. d. Options market. e. Buying/Selling on credit in foreign currency. f. Acquiring assets/Incurring liabilities in foreign currency.
Options market.
A put option on British pounds has a strike (exercise) price of $1.48. The present exchange rate is $1.55. This put option can be referred to as:
Out of the money
Under the current rate method:
Translation gains or losses are not included in the calculation of net income. They are reported in a special equity account called the "Cumulative Translation Adjustment" (CTA). This avoids exchange rate induced variations in reported earnings. When investment in the foreign affiliate is sold or liquidated, CTA account is closed, and gains or losses are reported for the time/period of liquidation.
Translation Vs. Operating (Economic) Exposure
Translation/accounting exposure is retrospective: • focus is on effects of currency changes upon results from past decisions of firm. (assets & liabilities) Operating/economic exposure is prospective: • focus is on effects of currency changes upon future cash flows of firm
Foreign exchange exposure
a measure of a change (or potential for a change) in the firm's profitability, net cash flows, and market value as a result of unexpected changes in exchange rates.
Covered Interest Arbitrage (CIA) is:
a process of capitalizing on interest rate differential between two countries while covering for exchange risk.
The stock price may be used as
a proxy for the firm's value.
A U.S. firm is bidding for a project needed by the Swiss government. The firm will not know if the bid is accepted until three months from now. The firm will need Swiss francs to cover expenses but will be paid by the Swiss government in dollars if it is hired for the project. The firm can best insulate itself against exchange rate exposure by:
buying franc call options.
The FASB identifies several factors such as ____________ to be examined to determine whether the parent's currency or the host currency is used the most, and thus is the functional currency.
cash flows, sales price, sales market, expense, finance and inter-company indicators
Only unexpected changes in exchange rates or an inefficient foreign exchange market should
cause market value of the firm to change.
Economic exposure is defined as the
variability in the firm's value caused by uncertain exchange rate changes, or the possibility that currency fluctuations may alter expected amounts/variability of the firm's future cash flows
The economic impact of changes in exchange rates depends on
whether changes in exchange rates are fully offset by differences in domestic and foreign inflation or whether, because of price controls, monetary policies, or other distortions, real exchange rates, and hence relative prices, change.
Transaction Exposure deals with
changes in cash flows that result from existing business obligations/contractual obligations.
Economic Exposure (Operating Exposure) measures:
changes in the value of the firm that result from changes in all future cash flows caused by unexpected changes in exchange rates. The changes in value depend on the effects of unexpected exchange rate changes on future sales volume, prices, and costs. Economic exposure can have a profound effect on the firm's competitive position. All business organizations are subject to economic exposure, no exceptions!
The Purchasing Power Parity (PPP) - Absolute form - states:
equilibrium exchange rate between the domestic and the foreign currencies equals the ratio between the domestic and foreign price levels.
Translation exposure measures the effect of
exchange rate changes on published financial statements of a firm.
In measuring the transaction exposure, it is also necessary to assess Currency Correlations which indicate:
he degree of linear relationship (or co-movement) between two currencies. Let r = correlation coefficient. Then -1 ≤ r ≤ 1.
When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to
hedge an existing exposure.
If the foreign exchange market is efficient,
information about expected changes in exchange rates should be widely known and be reflected in a firm's market value.
the "law of one price" is enforced by:
international arbitragers who follow the dictum of "buy low" and "sell high" to generate (riskless) profits for themselves and correct price distortions.
Managing economic exposure is a management responsibility because
it involves the interaction of strategies in Finance, Marketing, Purchasing, and Production.
All goods and financial assets obey the ____________ or free trade will equalize the price of any identical product in all countries.
law of one price
The price of identical tradable goods and financial assets must be equalized. This is the
law of one price
The main operating strategies for managing transaction exposure are
leads and lags, re-invoicing centers, etc.
Proactive Marketing strategies that manage economic exposure
market selection product strategy pricing strategy promotional options financial management
Relative price changes (changes in the real exchange rates) lead to
marketing and or production revisions
currency risk sharing
method to mitigate foreign exchange risk by quoting half the contract in US$ and the other half in the foreign currency. creation of neutral zone, the currency range in which risk is not shared, and beyond which risk is shared.
FASB-52 also includes special provision for hyper-inflation countries. (inflation of 100% or more over a 3-5 yr. period). Financial statements from such a country must be translated using:
monetary/non-monetary method. This helps to correct the distortion that occurs when depreciation at historical cost is matched against revenue at current prices.
Exposure Netting is for:
multinationals (MNC's) with positions in more than one currency.....
Diversifying financing:
multiple capital markets for funds, multiple currencies, etc.
The absolute PPP postulates
perfect commodity arbitrage, in the absence of transaction or information costs or other restrictions, ensures that PPP relationship
If International Fisher Equation holds, no _______ OR ______ are possible between countries (ignoring currency risks)
superior investments; low-cost sources of funds (Arbitrage)
Arbitrage activity will continue as long as
the difference in prices is large enough to generate a profit.
Economic exposure does not include
the effects of expected changes in foreign exchange rates.
If Forward Rate Parity holds,
the expected return from speculating in a forward contract is zero.
Key is to distribute productive assets to various locations so that
the firm is not severely affected by unexpected exchange rate changes.
Relative price changes ultimately determine
the firm's long-run exposure.
The rationale for the "unbiased hypothesis" is that:
the foreign exchange market is reasonably efficient
Equilibrium is achieved only when
the forward differential equals the expected change in the future exchange rate.
The only source of uncertainty when it comes to transaction exposure is:
the future exchange rate. The dollar value of these contractually-binding future foreign currency-denominated cash flows will change as exchange rates change between now and settlement.
According to the theory of interest rate parity (IRP), the size of the forward premium (or dis-count) should be equal to:
the interest rate differ-ential between the two countries of concern.
For a multinational corporation exposed to inflows (outflows) of a combination (a portfolio) of currencies
the lower the correlation among the component currencies, the lower the overall variability of the portfolio of cash flows.
The Fisher Equation (named after Irving Fisher) states
the nominal interest rate, i, is made up of a real required rate of return, r, and inflation premium (the expected rate of inflation). (PIE)
Interest rate risk is:
the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investment. As interest rates rise, bond prices fall, and vice versa. This means that the market price of existing bonds will drop to offset the more attractive rates of new bond issues.
Translation exposure
the potential that the firm's consolidated financial statements can be affected by unexpected changes in exchange rates. Financial statements of MNC's overseas subsidiaries must be translated from local currencies to the parent currency for consolidation with the parent company's financial statements. Changing currency values results in translation gains or losses.
For parity in the purchasing power of two currencies to hold over a period,
the rate of change of the exchange rate must equal the rate of change of relative prices.
The nominal interest rate is:
the rate quoted or observed in the market. It is the rate at which current goods are being converted into future goods.
If the forward rate is an unbiased predictor of the future spot rate,
the real cost of hedging will be zero on average.
If the forward rate is an accurate predictor of the future spot rate,
the real cost of hedging will be zero.
The real rate measures
the return after adjusting for inflation. It is the net increase in wealth that people expect to achieve when they save and invest their current income..It is the added future consumption promised by a borrower to a lender.
if changes in nominal exchange rates are fully offset by relative price level changes between two countries,
then the real exchange rate remains unchanged: i.e., Currency maintains its PPP. *IBERE*
The basic idea of a money market hedge is
to transform foreign currency assets (liabilities) to domestic currency assets (liabilities).
The cash flow implications of a forward position create
transaction exposure - Exchange rate changes are unexpected. The potential transaction gain (loss) on an account payable for example, is offset by transaction loss (gain) on the forward contract.
For two highly correlated currencies:
transaction exposure to inflows of one currency and outflows of the other has offsetting effects.
Changing currency values results in:
translation gains or losses.
Relative PPP tends to hold in the long-run especially in high inflation countries. The PPP may not hold consistently for many reasons: (EMPIRICAL EVIDENCE)
01. Other factors may be at work in exchange rate determination 02. No substitute for traded goods 03. Existence of internationally non-traded goods in the national price indexes. 04. Changes in taste. 05. Technological Progress 06. Differently constructed price indexes 07. Different "Market Baskets" 08. Different weighing formula for Market Basket 09. Relative price changes (Vs changes in general price level) 10. The "best" index cannot be a basis for a perfect representation of theoretical parity.
Lloyd's is a large bank in London. The manager of Forex department observes over the telex that the $ price of Pound ($/£) spurts up in New York compared to London. Here is a chance to make some money! To exploit the situation, this arbitrager does two things: (locational arbitrage)
> he/she contacts a broker or a correspondent bank in New York and sells, say £1m (sells high) > At the same time, he/she buys the same amount of £s in London (buys low). If the arbitrager does not buy and sell almost the same instant the spread appears, there is a risk of missing the opportunity. > The sale of pounds in New York where the price is high and its purchase in London, where the price is low, contributes to eliminating the price deferential. As other market participants take similar actions, the price difference disappears.
A banker's acceptance is a draft drawn on and accepted by ________.
A bank
Forward contracts contain:
A commitment to the owner and can be tailored to the desire of the owner.
With _____, the exporter ships the goods to the importer while still retaining actual title to the merchandise.
A consignment arrangement
change in the real exchange rate represents
A deviation from purchasing power parity
To hedge Currency Exposure,
A firm establishes a position opposite its initial foreign exchange exposure so that a firm with a long position (expects to receive foreign currency) will offset that position with a short position (expects to deliver foreign currency) in the same currency and the same maturity and vice versa. In essence, such a firm is covering/offsetting its original position in that currency (the two opposite positions cancel out each other)
Suppose a U.S. investor decides to capitalize on a relatively higher British interest rates. The spot exchange rate is known and there exists a forward market. The only uncertainty is the future spot exchange rate.
A forward sale can be used to lock-in the rate at which pounds can be exchanged for dollars at maturity using CIA.
Options Hedge
A hedge transacted in the options market for foreign currency The forward contract is ideal when the exposure has a straight risk-reward profile. Forward contract gains (losses) are exactly offset by losses (gains) on the underlying transaction. If, however, the transaction exposure is uncertain because of unknown volume and or foreign currency prices a forward contract will not match. Enter the options market. The options market provides an appropriate hedging tool in this situation where the quantity of foreign exchange is uncertain.
Limitations of Accounting exposure as a measure of a firm's exposure to exchange rate changes.
Accounting data focus on financial and investment decisions that have been made in the past - but ignore decisions that have implications for future cash flows. Accounting exposure is an incomplete measure of the risks that a firm faces since it ignores operating exposures (economic exposure). Accounting exposure is limited by the fact that assets are valued at historical costs. Regardless of the translation method used, the asset or liability value translated is the historical value which may not reflect current reality.
An exporter is willing to send goods to the importer, on account, without a guaranteed payment by the bank. The bank provides a loan to the exporter that is backed by the value of the exported good. This reflects:
Accounts receivable financing.
65. Which of the following is not true? a. Transaction exposure is the degree to which the dollar value of contractual transactions can be affected by exchange rate fluctuations. b. Economic exposure is the degree to which a firm's present value of future cash flows can be influenced by exchange rate fluctuations. c. Translation exposure is the exposure of an MNC's consolidated financial statements to exchange rate fluctuations. d. Economic exposure includes (is a super set of) transaction exposure. e. All the above are true.
All the above are true.
Which of the following is an example of economic exposure?
An increase in the dollar's value hurts a U.S. firm's domestic sales because foreign competitors can increase their sales to U.S. customers.
Assume U.S. and Swiss investors require a real rate of return of 3%. Assume the nominal U.S. interest rate is 6% and the nominal Swiss rate is 4%. According to the International Fisher Equation, the Swiss francs will _____ by about ______.
Appreciate; 2%
If interest rate is higher in the U.S. than in the U.K. and the forward rate of the British pound is the same as its spot rate, then:
Arbitrage flow of funds takes place from U.K. to U.S.
A critical factor in all the parity conditions we have explored is the role of: _____ Governments in trade or business; Supply and demand; the laws of nature; Arbitragers; Speculators, Hedgers, Traders.
Arbitragers
Factors influencing a MNC's decision to hedge its exposures:
Assessment of future strength/weakness of the foreign currency involved. MNC may decide not to have any currency exposure but simply focus on its core business. • McDonalds, Starbucks, Apple, Dell, and KFC may take this stand. • In contrast, a Hedge Fund, like Fidelity, Vanguard, and Charles Schwab, in a different line of business, may accept open positions in certain currencies.
explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible.
Covered interest arbitrage is based on the relation-ship between the forward rate premium and the interest rate differential. The size of the premium or discount exhibited by the forward rate of a currency should be approximately the same as the differential between the interest rates of the two countries of con-cern. In general terms, the forward rate of the foreign currency will contain a discount if the foreign coun-try's interest rate is higher than the U.S. interest rate If the forward premium deviates substantially from the interest rate differential, then covered interest arbitrage is possible. In this type of arbitrage, a short-term investment in some foreign currency is covered by a forward sale of that foreign currency in the future. In this manner, the investor is not exposed to fluctuations in the foreign currency's value.
Due to ________, market forces should realign the relationship between the interest rate differential between two countries and the forward premium or discount on the exchange rate between their two currencies
Covered interest arbitrage.
If interest rate parity holds, then ________ is not feasible.
Covered interest arbitrage.
Which of the following is not a form of exposure to exchange rate fluctuations?
Credit exposure / Interest rate exposure
Transaction exposure may also be estimated based on
Currency Variability.
If a MNC uses non-centralized approach for exposure management, then:
Each subsidiary assesses and manages its own exposure to exchange rate risk. This can cause redundancy in hedging.
Assume that the Fisher Equation holds approximately for domestic and foreign countries. If real returns are equalized by arbitrage between countries, then differences in nominal interest rates between two countries:
Equal to inflation differentials between the two countries
Assume that the interest rate for Currency X is much higher than the U.S. interest rate. According to Interest Rate Parity Theory, the forward rate of Currency X should:
Exhibit a discount.
Which of the following is not a payment method used for international trade?
Factoring
If an exporter sells his/her accounts receivables off to another firm that becomes responsible for obtaining payments from the various importers. This reflects:
Factoring.
With _____, a bank purchases an exporter's receivables at a discount without recourse to the exporter:
Factoring.
Generally, MNC with less foreign costs than foreign revenue will be _____ affected by a ---------- foreign currency.
Favorably, stronger; Adversely, weaker
Exposure is the chance of
a loss (or gain). The fact that the volatility might work in your favor does not reduce the risk.
Translation exposure reflects the exposure of a firm's:
Financial statements to exchange rate fluctuations.
Hedging Recurrent Exposure with Swaps
Firms often must deal with a sequence of accounts payable, or receivable denominated in a foreign currency. Such recurrent cash flows in a foreign currency can be best hedged using currency swap contracts.
A firm that sells products through __________ can reduce (used to be able to reduce) corporate taxes on income generated from foreign sales.
Foreign Sales Corporation (FSC)
An importer issues a promissory note to pay for the imported capital goods over a period of five years. The notes are extended to an exporter who sells them at a discount to a bank. This reflects:
Forfeiting.
Any type of contractual arrangement calling for the delivery (and settlement) of a customized quantity of a good or asset at a future date, at a price agreed upon at the initiation of the contract, is a /an ________ contract.
Forward
Contractual Hedges
Forward Markets, Money Markets, or Options Markets Forward contracts can reduce translation exposure by creating an offsetting asset or liability in the foreign currency
If a contract contains a promise that a customized amount of foreign currency will be delivered on a specified date in the future at a specified price, the contract is a ____.
Forward contract
Similar to the ________; __________ are agreements embodying obligation to buy or sell an asset or commodity for future delivery and settlement.
Forwards; Futures.
Unlike the ________; __________ are traded on organized exchanges and are marked to the market.
Forwards; Futures.
Methods of Managing Translation Exposure Include:
Funds adjustment Contractual hedges Exposure netting Balance sheet hedge Swap contacts Invoicing practices
Economic exposure refers to the exposure of a firm's:
Future cash flows to exchange rate fluctuations.
If a contract contains a promise that standardized units of foreign currency will be delivered on a specified date in the future, and at a specified price, the contract is a__
Futures contract
The greater the variability of a currency, the ________ will be the premium of a call option on this currency, and the ________ will be the premium of a put option on this currency, other things equal.
Greater; greater
Call and put options premiums are affected by the level of existing spot price relative to the strike price. A ____ spot price relative to the strike price results in relatively ____ premium for a call option but a relatively ____ premium for a put option.
High; High; Low
Call and put options premiums are affected by the level of existing spot price relative to the strike price. A ____ spot price relative to the strike price results in relatively ____ premium for a call option but a relatively ____ premium for a put option.
High; High; Low
If approximate Fisher Equation holds for both domestic and foreign and real interest rates are equalized among countries by arbitrage, then:
Higher inflation country must have higher interest. Higher interest country must have higher inflation.
According to the International Fisher Equation and the Generalized Fisher Equation, if Venezuela has a much higher nominal interest rate than other countries, its inflation rate will be ______ than other countries, and its currency will _______.
Higher; weaken
Parity Conditions in International Finance are:
economic theories linking exchange rates, price levels, and interest rates.
A call option on Australian dollars has a strike (exercise) price of $.76. The current spot exchange rate is $.79. This call option can be referred to as:
In the money.
If the spot rate of the euro increased substantially over a one-month period, the futures price on euros would likely ____________over that same period.
Increase substantially
Disadvantages of Re-invoicing Centers
Increased communication costs Suspicion of tax evasion by local authorities
If interest rate parity holds and the forward rate is expected to be unbiased estimate (predictor) of the future spot rate, then which of the following is true?
International Fisher Equation holds.
If the forward rate is expected to be an unbiased estimate of the future spot rate and interest rate parity holds, then:
International Fisher Equation holds.
Transaction Exposure
Is the uncertain domestic currency value of contractual future cash flows, which are known and fixed in a foreign currency, resulting from unexpected changes in exchange rates
(a). Given that Big Mac costs $3.50 in the US and SF 7.10 in Switzerland. According to absolute PPP, if the actual exchange rate SF/$ is 1.25, then which of the following is true?
It costs more in dollar to buy Big Mac in Switzerland.
FASB-52: Superseded FASB-8 in 1982.
It differentiates between functional and reporting currency for an affiliate. It permits either of two translation methods to be used, the current-rate method or the temporal method, depending on the functional currency of the foreign operation/subsidiary. Functional Currency is the currency of primary economic environment of an affiliate. Reporting Currency is the currency in which parent prepares its own financial statements. If the functional currency is that of the host country, the MNC must use the Current-rate Method. If the functional currency is the parent's currency, and financial statements of the foreign subsidiary are maintained in local currency, the MNC must use the Temporal Method.
FASB-8 (1976-1981)
Its objectives were to measure and express in dollars, and in generally accepted principles, the assets, liabilities, revenues or expenses that are denominated in foreign currencies. Under this rule, US firms were required to translate financial statements into US dollars according to the Temporal Method. And... All exchange gains and losses were taken directly to the income statement. Income statements of US MNCs might increase (decrease) purely as the dollar weakened (strengthened). Inventory was translated primarily at historical rates. Long-term debt was translated at current rates while fixed assets (financed with long-term debt) were translated at historical rates.
Economic exposure or real operating exposure is much more important for
L-R health of a business entity than changes caused by translation or transaction exposures.
Based on interest rate parity theory, the larger the degree by which foreign interest rate exceeds domestic interest rate, the________:
Larger will be the forward discount of the foreign currency.
If a bank acknowledges that it will make payments on behalf of a beer importer after the beer is delivered to the importer. This reflects the use of:
Letter of credit.
The Advantages of options
Leverage, Risk/Reward Ratio, Unique Strategies, Low capital requirements
Due to _______, market forces should realign the spot rate of a currency among banks.
Locational arbitrage
The prices charged by different banks for foreign exchange cannot vary significantly. Prices are kept in line with one another through a process called
Locational arbitrage
explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
Locational arbitrage may occur if foreign exchange quotations differ among banks. The act of locational arbitrage should force the foreign exchange quotations of banks to become realigned, after which locational arbitrage will no longer be possible.
Call and put options premiums are affected by the level of the existing spot price relative to the strike price. A ____ spot price relative to the strike price results in a relatively ____ premium for a call option but a relatively ____ premium for a put option..
Low; Low; High
The Disadvantages of options
Lower Liquidity, higher spreads, higher commissions, more complicated, time decay, less information, options are not available for all stocks.
The shorter the time to the expiration date for a currency option, the _______ will be the premium of a call option, and the _______ will be the premium of a put option, other things equal
Lower; lower
Economic exposure can affect:
MNCs and purely domestic firms
competitive markets are characterized by:
Many Buyers Many Sellers Costless Access to Information Lack of Government Controls Free Transportation
Arbitrage is one of the basic forces at work in a:
Market economy
The International Fisher Equation (IFE) states that:
Nominal interest rate differential between two countries is approximately equal to the rate of change in exchange rate between their currencies.
101. Derivatives are used in the following ways except: a. To change nature of an investment or a liability b. To lock in an arbitrage profit c. To reflect a view of the future direction of the market d. To hedge risks e. To exploit relative advantages of economic agents in the marketplace f. None of the above
None of the above
Assume that Interest Rate Parity (IRP) holds. The Mexican interest rate is 5%, and the U.S. interest rate is 8%. Subsequently, the U.S. interest rate decreases to 7%. If IRP is to continue to hold, then the peso's forward ________ will ________.
Premium; decrease.
Which of the following payment terms provides the supplier with the greatest degree of protection? Letters of credit. Consignment. Prepayment. Drafts (sight/time).
Prepayment.
If a U.S. firm desired to lock in the maximum amount it would have to pay for its net payables in euros but still wanted to be able to capitalize if the euro depreciates substantially against the dollar by the time payment is to be made, the most appropriate hedge would be:
Purchasing euro call options.
Direct Funds Adjustments (In anticipation of local currency devaluation or depreciation)
Purchasing hard currency imports/inputs ahead of time, investing in hard currency securities, repaying hard currency borrowing.
Indirect Funds Adjustments (In anticipation of local currency revaluation or appreciation)
Purchasing hard currency imports/inputs ahead of time, investing in hard currency securities, repaying hard currency borrowing.
Latin American countries have historically experienced relatively high inflation rates and their currencies have weakened accordingly. This experience is consistent with the concept of:
Purchasing power parity.
If a U.S. firm desired to lock in a minimum rate at which it could sell its net receivables in Japanese yen but wanted to be able to capitalize if the yen appreciates substantially against the dollar by the time payment arrives, the most appropriate hedge would be:
Purchasing yen put options.
If you expect the British pound to appreciate, you could speculate by ________ pound call options or ________ pound put options.
Purchasing; selling
If you have acquired the right but not the obligation to sell, you are a:
Put buyer.
If you have acquired the right but not the obligation to sell, you are a:
Put buyer/owner/holder
When you purchase ________, there is no obligation on your part; however, when you purchase ________, there is an obligation on your part.
Put options, forward contracts
Assume that a currency's spot and forward rates are the same, and the currency's Interest rate is higher than U.S. interest rate. The actions U.S. investors to capitalize on this higher foreign interest rate would ____ the currency's spot rate and ____ the currency's forward rate.
Put upward pressure on, put downward pressure on
If you have a covered derivative position where you might be obligated to buy Euros, you are a
Put writer
Basic Hedging Techniques If a depreciation appears likely for a local currency
Reduce level of cash Tighten credit terms to reduce the accounts receivables Increase local currency borrowing Delay accounts payable in local currency Sell the depreciating local currency forward exposure netting balance sheet hedge swaps invoicing practices
Because there are a variety of factors in addition to inflation that affect exchange rates, this will tend to:
Reduce the probability that PPP shall hold.
Any restructuring of operations that _______ the difference between a foreign currency's inflows and outflows may ______ economic exposure.
Reduces, reduce.
Leads and Lags
Require that the time preference of one firm be imposed on the other firm. Financial obligations are paid sooner or later than required. For example: > Speed up payment to avoid appreciation of a foreign currency. > Delay payment, if foreign currency owed is expected to depreciate. > For account payables of foreign customers, i.e., local company's receivables, an inducement may be necessary before they would willingly lead their payables.
Which of the following is not an agency actively promoting international trade?
Securities and Exchange Commission (SEC)
Futures Contract Hedge
The concept is similar to the forward contracts except that forward contracts are common for large transactions while futures contracts may be more appropriate for firms hedging in smaller amounts. To hedge on future payables (receivables) in foreign currency, the firm purchases (sells) currency futures contracts in the payables (receivables) amount. By holding these contracts, the firm locks in the amount of its home currency needed to complete the transaction at maturity.
According to Interest Rate Parity (IRP), which of the following is true?
The forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two countries.
Which of the following factors is not affected when market forces resulting from covered interest arbitrage cause market realignment?
The future spot rates.
7. Which of the following is true? a. The futures market is primarily used for speculating while the forward market is primarily used for hedging. b. The futures market is primarily used for hedging while the forward market is primarily used for speculating. c. The futures and the forward markets are primarily used for speculating. d. The futures and the forward markets are primarily used for hedging.
The futures market is primarily used for speculating while the forward market is primarily used for hedging.
Under Purchasing Power Parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and:
The inflation differential.
Who bears the payment risk in a letter of credit?
The issuing bank. and The confirming bank.
___ is not a determinant of translation (transaction) exposure.
The local (domestic) earnings of the MNC
________ is not a determinant of translation exposure.
The local currency denominated earnings of the MNC
________ is not a determinant of transaction exposure.
The local currency denominated earnings of the MNC and The accounting methods (FASB rules) used
Which of the following is correct about a currency option, other things equal? a. The longer the time to maturity, the less the value of a call option. b. The longer the time to maturity, the less the value of a put option. c. The higher the spot rate relative to the exercise price, the greater the value of a put option. (out-of-the money put option) d. The lower the exercises price relative to the spot rate, the greater the value of a call option. (in-the-money call option) e. The higher the exercise price relative to the spot rate the smaller the value of a put option. (in-the-money put option)
The lower the exercises price relative to the spot rate, the greater the value of a call option. (in-the-money call option)
A (n) ________ allows the first beneficiary to transfer all or part of the original letter of credit (LC) to a third party; a (n) ________ allows the original beneficiary of the LC to pledge the amount in the LC to the end supplier.
Transferable LC; assignment of proceeds
According to the "law of one price,"
The price of an identical product should be equal across markets when measured in a common currency.
If interest rates on the euro are consistently below U.S. interest rates, then for the International Fisher Equation (IFE) to hold,
The value of the euro will appreciate against the dollar.
Current Rate Method
This is the simplest approach for translating financial statements. All balance sheet items are translated at the current rate. Income statement is translated at either the current rate or the average exchange rate for the reporting periods.
A bill of exchange requesting a bank to pay the face amount at a future date is a:
Time draft.
Direct Funds Adjustments (In anticipation of local currency revaluation or appreciation)
Transfer pricing between affiliates; speeding up payment of dividends, fees, and royalties; use of leads and lags (inter-subsidiary transactions).
Indirect Funds Adjustments (In anticipation of local currency devaluation or depreciation)
Transfer pricing between affiliates; speeding up payment of dividends, fees, and royalties; use of leads and lags (inter-subsidiary transactions).
explain the concept of triangular arbitrage and the scenario necessary for it to be plausible.
Triangular arbitrage is related to cross exchange rates. A cross exchange rate between two currencies is determined by the values of these two currencies with respect to a third currency. If the actual cross exchange rate of these two currencies differs from the rate that should exist, then triangular arbitrage is possible. The act of triangular arbitrage should force cross exchange rates to become realigned, so that triangular arbitrage will no longer be possible
Due to ________, market forces should realign the difference between the cross-exchange rate for a currency from, say points A and B, and the quoted rate for the same currency at point C.
Triangular arbitrage.
Which of the following is not true regarding economic exposure? a. A strong foreign currency may allow U.S.-based firms to increase their U.S. market shares at the expense of foreign exporters, who may be priced out of the U.S. market. b. A U.S. exporter whose foreign competitors are willing to reduce their profit margin during a weak-dollar period may not necessarily benefit from the exchange rate movements. c. U.S.-based MNCs can benefit from a strong dollar by increasing the volume of their exports. d. The effects of exchange rate movements on MNCs can vary with the currency involved, since exchange rates can change by varying degrees. e. All the above are true.
U.S.-based MNCs can benefit from a strong dollar by increasing the volume of their exports.
Assume the British interest rates are higher than U.S. rates, and that the spot rate for the pound equals the forward rate, then covered interest arbitrage puts______pressure on the pound's spot rate, and ______ pressure on the pound's forward rate.
Upward, downward
Cross Hedging
When hedging techniques are not available in one currency X, a multinational corporation looks for a proxy for that currency- typically a currency Y that is highly correlated with X. A cross hedge is then effected. To cross hedge a receivable in X, multinational corporation sets up a fwd. contract for the sale of Y. If Y decreases so will X and vice-versa. Also, receivables in X can be matched with payables in Y.
Under balance sheet hedge,
a company maintains the same mount of exposed assets and liabilities in a particular currency.
Since the forward premium of a currency (from a U.S. perspective) is influenced both by the interest rate of that currency and by the U.S. interest rate, and since those interest rates change over time, it follows that the forward premium changes over time. Thus,
a forward premium that is large and positive in one period, when the interest rate of that currency is relatively low, could become negative (reflecting a discount) if its interest rate rises above the U.S. level
Re-invoicing Centers
a separate corporate subsidiary that manages all transactions exposure from intra-company trade from one location. Example: Manufacturing affiliates sell goods to distribution affiliates of the same firm by selling to a re-invoicing center which in turn resells to the distribution affiliate. Title passes to the re-invoicing center, but physical movement of goods is direct from manufacturing plant to distribution affiliate. Re-invoicing center handles paperwork but does not handle any inventory. All manufacturing units and all distribution affiliates deal only in their local currency. All transaction exposure is borne by the re-invoicing center.
If the price of a currency varies from one bank to another, an arbitrager will be able to "buy low" and "sell high". Such an activity should lead to:
an increase in the rate at the low-priced bank and decrease in the rate at the high-priced bank.
The objective of economic exposure management is to
anticipate and influence the effects of unexpected changes in exchange rates on a firm's future cash flows.
Essentially, IFE says:
arbitrage between financial markets in the form of capital flows should ensure that nominal interest rate differential, (id - if ), is an unbiased predictor of the future change in spot exchange rate between domestic and foreign currencies i.e. (nominal interest rate differential is a predictor of future changes in spot exchange rates)
Other strategies for managing transaction exposure include
back-to-back loans, parallel loans and currency swaps.
An unbiased forward rate needs not
be a very good predictor in terms of accuracy. Just that it is unbiased!
An unbiased predictor is one that is
correct on average, i.e., it is just as likely to guess too high as it is to guess too low.
The Standard Deviation is a measure of
currency variability. - Currencies with higher standard deviations imply that the potential for them to deviate from their projected values is greater than those with smaller standard deviations. standard deviations of currencies do not remain constant. They change over time.
A number of translation rules set by Financial Accounting Standard Board (FASB) include the
current rate method and the temporal method.
A regression analysis of economic exposure can help firms to:
develop forecasts of costs, prices, sales volume (and hence cash flows) and exchange rates for several periods ahead under various scenarios. Firms can apply regression analysis to historical data on cash flows and exchange rates
Which of the following is not true concerning regulation of derivatives in the U.S.? a. The SEC regulates OTC, Exchanges, and Brokers/Dealers. b. The FED sets margin requirements on stocks and options. c. The Commodity Futures Trading Commission regulates futures trading. d. The National Association of Securities Dealers regulates OTC markets. e. None of the above (Dept of Treasury regulates fwd. mkt)
e. None of the above (Dept of Treasury regulates fwd. mkt)
Economic exposure is derived from
economic analysis
an appreciating domestic currency hurts firms that
export (exports are less competitive) or firms that compete with imports (imports are more affordable).
domestic currency depreciation promotes
exports and makes import-competing goods more competitive.
The main contractual techniques for managing transaction exposure are
forward, futures, options, money market hedges, etc...
The law of one price states:
free trade will equalize the price of any identical good (or asset) in all countries/markets.
Translation exposure exists when
functional currency assets of a subsidiary exceed its liabilities.
Since virtually all financial contracts are stated in nominal terms,
nominal interest rates always to incorporate inflation expectation in order to provide lenders with a real return.
. A firm produces goods for which substitute goods are produced in other countries. A depreciation of the firm's local currency should: a. Decrease local sales as it decreases competition in local markets. b. Decrease the firm's exports denominated in the local currency. c. Decrease the returns earned on the firm's foreign currency bank deposits. d. Decrease the firm's cash outflow required to pay for imported supplies denominated in foreign currency. e. None of the above.
none of the above
A firm produces goods for which substitute goods are produced in other countries. An appreciation of the firm's local currency should: a. Increase local sales as it reduces competition in local markets. b. Increase the firm's exports denominated in the local currency. c. Increase the returns earned on the firm's foreign currency bank deposits. d. Increase the firm's cash outflow required to pay for imported supplies denominated in a foreign currency. e. None of the above.
none of the above
If IRP holds, then covered interest arbitrage is
not feasible, because any interest rate advantage in the foreign country will be offset by the discount on the for-ward rate. Thus, covered interest arbitrage would not generate higher returns than would be generated by a domestic investment.
Most MNCs use
operational hedging techniques known as strategic (operational) methods such as diversification in production, marketing, and financing.
Translation (Accounting) Exposure measures
potential accounting-derived changes in owner's equity that result from the need to translate foreign currency financial statements of affiliates into a single reporting currency in order to prepare consolidated financial statements. The changes are due to unexpected changes in exchange rates. (Assets, liabilities, revenues, and expenses originally measured in a foreign currency are reported and valued in the home currency in order to be consolidated in the accounts)
Proactive Production strategies that manage economic exposure
product sourcing input mix plant location production management restructuring operations
Centralized exposure management requires:
projection of the consolidated net amount of currency inflows and outflows for all subsidiaries categorized by currency.
PPP-determined exchange rates:
provide a valuable benchmark especially for policy makers.
The effect of arbitrage is to
reduce or eliminate price differentials on identical products market-wide.
a portfolio of currencies with negative or very low correlation can even
reduce overall risk
The sensitivity of revenues and costs to changes in exchange rates can be examined in a
regression analysis
Arbitragers partake in _______ profit
riskless
speculators partake in _____ profit.
risky
Diversifying operations:
sales, location of production facilities, raw material sources, etc.
Proponents of hedging give the following reasons
• Reduction in the risk of future cash flows improves the planning capability of the firm. • Reduction of risk in future cash flows reduces the likelihood that the firm's cash flows will fall below a necessary minimum - avoiding bankruptcy costs. • Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm. • Markets are usually in disequilibrium because of structural and institutional imperfections • Reduction in variability of income reduces (uncertainties in) a firm's overall tax burden.
Opponents of hedging give the following reasons:
• Shareholders are more capable of diversifying risk than the management of a firm. • Currency risk management does not increase the expected cash flows of a firm. • Management often conducts hedging activities that benefit management at the expense of shareholders. • Managers cannot outguess the market • Management's motivation to reduce variability is sometimes driven by 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.
