Deck 10: Transaction Exposure

Question 1

________ exposure deals with cash flows that result from existing contractual obligations.

A) Operating
B) Transaction
C) Translation
D) Economic

Answer 1

Transaction

Question 2

Hedging, or reducing risk, is the same as adding value or return to the firm.

Answer 2

False

Question 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 3

accounting exposure.

Question 4

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

Question 5

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

Question 6

As a generalized rule, only realized foreign exchange losses are deductible for tax purposes.

Question 7

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.

Question 8

Many MNE s manage foreign exchange exposure centrally, thus gains or losses are always matched with the country of origin.

Question 9

There is considerable question among investors and managers about whether hedging is a good and necessary tool.

Question 10

________ 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

Question 11

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.

Question 12

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

Question 13

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.

Question 14

________ 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)

Question 15

Shareholders are LESS capable of diversifying currency risk than is the management of the firm.

Question 16

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.

Question 17

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

Question 18

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

Question 19

The key arguments in opposition to currency hedging such as market efficiency, agency theory, and diversification do not have financial theory at their core.

Question 20

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

Question 21

Instruction 10.1:
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 €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 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.

Question 22

When attempting to manage an account payable denominated in a foreign currency, the firm's only choice is to remain unhedged.

Question 23

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

Question 24

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

Question 25

Remaining unhedged is NOT an option when dealing with foreign exchange transaction exposure.

Question 26

________ 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.

Question 27

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.

Question 28

Instruction 10.1:
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 €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. If CVT chooses to hedge its transaction exposure in the forward market, it will ________ €3,000,000 forward at a rate of ________.

A) buy; $1.22
B) buy; $1.25
C) sell; $1.22
D) sell; €1.25

Question 29

A forward hedge involves a put or call option contract and a source of funds to fulfill that contract.

Question 30

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.

Question 31

TRANSACTION exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.

Question 32

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.

Question 33

Instruction 10.1:
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 €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. 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

Question 34

Instruction 10.1:
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 €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.)

A) $57,600
B) $59,904
C) $62,208
D) $63,936

Question 35

Instruction 10.1:
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 €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. 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.

Question 36

Instruction 10.1:
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 €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.

A) better off; $150,000
B) better off; €150,000
C) worse off; $150,000
D) worse off; €150,000

Question 37

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.

Question 38

Transaction exposure could arise when borrowing or lending funds when repayment is to be made in the firm's domestic currency.

Question 39

Instruction 10.1:
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 €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. 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

Question 40

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

Question 41

With a perfect hedge, there is no uncovered exposure remaining.

Question 42

The objective of currency hedging is to eliminate the change in the value of the exposed asset or cash flow from a change in exchange rates.

Question 43

In efficient markets, interest rate parity should assure that the costs of a forward hedge and money market hedge should be approximately the same.

Question 44

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/£.)

Question 45

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.

Question 46

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.

Question 47

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.

Question 48

The treasury function of most firms, the group typically responsible for transaction exposure management, is NOT usually considered a profit center.

Question 49

________ 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

Question 50

According to the authors, firms that employ proportional hedges increase the percentage of forward-cover as the maturity of the exposure lengthens.

Question 51

Many MNEs have established rigid transaction exposure risk management policies which mandate proportional hedging (a percentage of existing transaction exposures). Explain the pros and cons of proportional hedging.

Question 52

Although rarely acknowledged by the firms themselves, selective hedging is essentially speculation.

Question 53

When there is a full forward cover with the spot rate equal to the forward rate all of the following are true EXCEPT:

A) The hedge is asymmetric.
B) There is no uncovered exposure remaining.
C) The total position is a perfect hedge.
D) The currency hedge ratio is equal to 1.

Question 54

There are as many different approaches to foreign exchange transaction exposure management as there are firms and no real consensus exists regarding the best approach. List and discuss three different exposures you can hedge and three different types of hedges (for example option hedges versus non-option hedges).

Question 55

Hedging is accomplished by combining the exposed asset with a hedge asset to create a two-asset portfolio in which the two assets react in relatively equal directions to an exchange rate change.

Question 56

The commonly used 100% forward contract cover is a symmetric hedge.

Question 57

The effectiveness of a hedge is determined to what degree the change in spot asset's value is correlated with the equal change in the hedge asset's value to a change in the underlying spot exchange rate.

Question 58

A hedge constructed using puts foreign currency options would be symmetric.

Question 59

With the use of forwards, a perfect hedge is possible.

Question 60

A firm's risk tolerance is a combination of management's philosophy toward transaction exposure and the specific goals of treasury activities.

Question 61

A hedge constructed using a put foreign currency option would protect you against value losses, but allow, at the same time, the possibly reap value increases in the event the exchange rate moved in your favor.

Question 62

The hedge ratio, ?, is an individual exposure's nominal amount covered by a financial instrument such as a forward contract or currency option.

Question 63

The various hedging alternatives explored (the forward, money market, and purchase option hedges) only work to protect the value of the exposed asset at the time of maturity.

Question 64

There are as many different approaches to exposure management as there are firms and no real consensus exists regarding the best approach. Discuss the following theoretical dimensions to currency hedging: optimal hedge ratio, hedge symmetry, hedge effectiveness and hedge timing.