Deck 15: Derivatives and Risk Management

Question 1

The text refers to three different sources of risk that, while not unique to MNEs, are particularly important for firms competing in the global environment and can be managed using specialized financial market instruments. What are these three sources of risk?

A) Political risk, exchange rate risk, and business risk.
B) Political risk, interest rate risk, and commodity price risk.
C) Exchange rate risk, interest rate risk, and commodity price risk.
D) Exchange rate risk, interest rate risk, and political risk.
E) Interest rate risk, commodity price risk, and business risk.

Answer 1

Exchange rate risk, interest rate risk, and commodity price risk.

Question 2

The primary types of contractual hedge include all except which of the following?

A) Money market hedge.
B) Operating hedge.
C) OTC option hedge.
D) Exchange-traded currency derivatives.
E) Forward market hedge.

Answer 2

Operating hedge.

Question 3

Commodities that are traded in futures markets are usually grouped into what three categories?

A) Agriculture products, metals, and energy.
B) Grains and oil seeds, livestock, and energy.
C) Food and fiber, crude oil and natural gas, and metals.
D) Crude oil and gas, agricultural products, and livestock.
E) None of the categories above.

Answer 3

Agriculture products, metals, and energy.

Question 4

One way to categorize risks is to divide them into two groups, one dealing with specific transactions and the other with ongoing operations. Which of the following statements is/are correct regarding these risks?

A) Continuing risks arise in connection with aggregated items in the company's financial statements whose values are affected by changing exchange rates, interest rates, or commodity prices.
B) Discrete risks, which are related to specific transactions, relate to real, economic gains and losses that must flow through the income statement when they are realized.
C) Accounting exposures, related to the effects of the different currency translation methods, create real economic gains and losses for the firm and, hence, affect its value.
D) All of the statements above are correct.
E) Only statements a and b are correct.

Question 5

Hedging, or the creation of offsetting assets and liabilities so that gains on one side offset losses on the other, is a common but controversial practice. Arguments in favor of hedging include which of the following statements?

A) Management understands the currency risk situation better than shareholders, and this creates an information asymmetry.
B) Hedging reduces the volatility of free cash flows, which leads to a lower cost of capital and a higher share price.
C) All markets are usually not in equilibrium and parity conditions do not always hold for all countries, so the NPV of hedging could easily be positive.
D) All of the statements above are arguments in favor of hedging.
E) Only statements a and c are arguments in favor of hedging.

Question 6

Hedging, or the creation of offsetting assets and liabilities so that gains on one side offset losses on the other, is a common but controversial practice. Arguments against hedging include which of the following statements?

A) Shareholders are better able to diversify currency risks and match their own risk tolerances and currency preferences.
B) When the parity conditions hold the NPV of hedging is zero; managers cannot consistently beat the market.
C) If the market is efficient, currency risk is already factored into the company's stock price.
D) All of the statements above are arguments against hedging.
E) Only statements a and b are arguments against hedging.

Question 7

Which of the following statements about currency hedging are incorrect?

A) An example of an operating hedge is a covered forward contract because the cover comes from operating cash flows.
B) An example of a natural hedge is to have monetary assets denominated in a particular foreign currency on the balance sheet offset liabilities in the same currency and same maturity.
C) An example of a contractual hedge is a money market hedge because a formal contractual relationship is established to lock in the exact terms of a future transaction.
D) None of the statements above; all are correct.

Question 8

If a company has floating-rate debt tied to dollar LIBOR and wants to eliminate the possibility that LIBOR will exceed a particular rate (but preserve the possibility the LIBOR could decline), which of the following instruments would it most likely use?

A) Interest rate future contract.
B) Forward rate agreement.
C) Interest rate cap.
D) Interest rate collar.
E) Interest rate swap.

Question 9

Which of the following statements are correct about economic exposure?

A) Transaction exposures to exchange rates, interest rates, and commodity prices over the short-to-medium run are an integral part of economic exposure.
B) Managing the strategic implications of all changing macroeconomic variables cannot be accomplished using only the financial markets.
C) Effective economic exposure management must be based on strategic operating decisions made mainly by marketing and production managers in response to expected changes in input and output prices, and the impact of changing demand for the company's products.
D) All of the statements above are correct.
E) Only statements b and c are correct.

Question 10

If a company has floating-rate debt tied to dollar LIBOR and wants to eliminate the risk associated with changes in LIBOR, it can use all except which of the following instruments?

A) Interest rate futures.
B) Forward rate agreement.
C) Coupon swap.
D) Zero width interest rate collar.
E) All of the instruments listed above eliminate the risk of changing LIBOR.

Question 11

Erwin Manufacturing Company has a floating-rate interest payment tied to LIBOR due in June 2005. The CFO wants to use interest rate futures to hedge the risk that LIBOR could increase. How would he do this?

A) Buy an interest rate futures contract (long position).
B) Buy an interest rate futures contract (short position).
C) Sell an interest rate futures contract (long position).
D) Sell an interest rate futures contract (short position).
E) None of the above-this is not what an interest rate futures contract is designed to do.

Question 12

Cosgrove Manufacturing Company just sold products to a German company for €1,275,000. The account receivable was booked as $1,568,250 at the current spot rate of $1.2300/€. Cosgrove is worried that the dollar might strengthen against the euro in the 30 days until the account will be collected, so it decides to hedge the transaction at the 30-day forward rate of $1.2310/€. By hedging, Cosgrove will lock in a ______ of _______?

A) Gain; $1,275
B) Loss; $926
C) Loss; $1,275
D) Gain; $926
E) None of the above.

Question 13

Lakewood Products, Inc. just bought €2,650,000 in products from a French supplier with payment due in 30 days. The spot exchange rate today is $1.2300/€ and the 30-day forward rate is $1.2310/€. If Lakewood decides to hedge the transaction, they will have to book a ______ of _______ at the end of 30 days.

A) Gain; $1,750
B) Loss; $2,650
C) Loss; $1,750
D) Gain; $2,650
E) None of the above.

Question 14

An investor has purchased both a call option and a put option on the same stock. The call option has a strike price of $20 and the put option has a strike price of $25. If the current stock price is $23, what payoff (per share) will the investor receive if the options were exercised?

A) -$2.00
B) $2.00
C) $3.00
D) $5.00
E) $7.00

Question 15

An investor has purchased both a call option and a put option on the same stock. The call option has a strike price of $30 and the put option has a strike price of $40. If the current stock price is $28, what payoff (per share) will the investor receive if the options were exercised?

A) $8.00
B) $10.00
C) $12.00
D) $14.00
E) $18.00

Question 16

Milton Mining is a U.S. multinational that just purchased €1,100,000 of goods on account, due in 30 days from a German supplier. The spot exchange rate is $1.225/€. Milton wants to hedge the account payable with an OTC call option with a strike price of $1.250/€. The option premium is 0.50 percent. What is the U.S. dollar cost of the option?

A) $5,500.00
B) $6,442.36
C) $6,737.50
D) $6,777.93
E) $6,850.00

Question 17

Cosgrove Manufacturing Company just sold products to a German company for €1,275,000 on terms of net 30 days. Cosgrove is worried that the dollar might strengthen against the euro in the 30 days the credit is outstanding, so it has decided to hedge the receivable with a money market hedge. Current euro interest rates are 4.42 percent per annum or 0.3684 percent per month and U.S. interest rates are 5.40 percent per annum or 0.45 percent per month. The current spot rate is $1.2300/€ and the forward rate is $1.2310/€. How much does Cosgrove have to borrow today in euros to hedge this transaction, and will the transaction lead to a transaction gain or loss?

A) €1,270,320; gain
B) €1,279,697; loss
C) €1,270,320; loss
D) €1,279,697; gain
E) None of the above.

Question 18

Lakewood Products, Inc. just bought €2,650,000 in products from a French supplier with payment due in 30 days. The spot exchange rate today is $1.2300/€ and the 30-day forward rate is $1.2310/€, but Lakewood is apprehensive that the dollar might fall even more during the 30-day period. The company has decided to use a money market hedge for this transaction. The French interest rate is 4.42 percent per annum or 0.3684 percent per month, and the U.S. interest rate is 5.40 percent per annum or 0.45 percent per month. How many dollars must Lakewood invest today to hedge this transaction with a money market hedge?

A) $3,271,508
B) $3,247,536
C) $3,212,478
D) $3,197,295
E) None of the above.

Question 19

Adams Systems is a U.S. multinational that just purchased €1 million of goods on account, due in 30 days from a French supplier. The spot exchange rate is $1.235/€, while the 30-day forward rate is $1.201/€. Adams is interested in hedging this account payable by using a money market hedge. If the 30-day periodic investment rate in France is 0.15 percent, how many U.S. dollars does Adams need to invest to properly hedge the account payable?

A) $1,199,201
B) $1,233,150
C) $1,236,853
D) $1,301,984
E) $1,314,923

Question 20

Cullen Pharmaceuticals is a U.S. multinational that just sold ¥70 million of goods to a Japanese customer on account, due in 30 days. The spot exchange rate is $0.008987/¥, while the 30-day forward rate is 0.008671/¥. Cullen is interested in hedging this account receivable by using a forward market hedge. If the 30-day periodic investment rate in Japan is 0.10 percent, how many U.S. dollars does Adams need to invest to properly hedge the account receivable?

A) $574,672
B) $588,535
C) $590,344
D) $606,970
E) $629,090

Question 21

Lakewood Products, Inc. just bought €2,650,000 in products from a French supplier with payment due in 30 days. The spot exchange rate today is $1.2300/€ and the 30-day forward rate is $1.2310/€. Lakewood is afraid that the dollar will depreciate significantly more than the amount implied in the forward rate, but some of its economics staff are predicting that the dollar will strengthen. The Lakewood CFO thinks that this may be a good time to consider OTC currency options. Both puts and calls on euros are available for 30 days at a strike price of $1.2310/€ and a 0.25 percent premium. If the U.S. 30-day interest rate is 0.45 percent per month (5.4 percent per annum), what is the breakeven future spot rate at which the OTC option costs the same as remaining unhedged?

A) $1.234089/€
B) $1.233089/€
C) $1.227911/€
D) $1.226911/€
E) None of the above.

Question 22

Cosgrove Manufacturing Company just sold products to a German company for €1,275,000 on terms of net 30 days. Cosgrove is worried that the dollar might strengthen against the euro in the 30 days the credit is outstanding, so it has decided to hedge the receivable with an OTC option hedge. The spot exchange rate today is $1.2300/€ and the 30-day forward rate is $1.2310/€. Both puts and calls are available at a strike price of $1.2310/€ and a 0.25 percent premium. If the U.S. interest rate is 5.4 percent per annum (0.45 percent per month), what is the breakeven future spot rate at which the OTC option costs the same as remaining unhedged?

A) $1.234075/€
B) $1.226925/€
C) $1.233075/€
D) $1.227911/€
E) None of the above.

Question 23

The CFO of Rijkens Radio, NV, can borrow dollars at a fixed rate of 8.5 percent per annum or floating at LIBOR + 2%. He prefers to borrow at a floating rate, but considers the rate too high. Rothwell Resources, plc, can borrow dollars at a fixed rate of 7.75 percent per annum and at a floating rate of LIBOR + 0.5%. The CFO of Rothwell wants to borrow at a fixed rate, but considers 7.75 percent to be too high. A broker offers to arrange a swap for the two companies for a fee of 0.25 percent. If the two companies split any gains from the swap equally, what type of loan debt service (fixed or floating) will the two companies end up with and at what rate?

A) Rijkens pays floating at LIBOR + 1.625%; Rothwell pays fixed at 7.375%
B) Rijkens pays floating at LIBOR + 1.75%; Rothwell pays fixed at 7.5%
C) Rijkens pays fixed at 7.375%; Rothwell pays floating at LIBOR + 1.625%
D) Rijkens pays fixed at 7.5%; Rothwell pays floating at LIBOR + 1.75%
E) None of the above.

Question 24

Carson Printing is a U.S. multinational that just purchased £600,000 of goods on account, due in 30 days from a British supplier. The spot exchange rate is $1.775/£. Carson wants to hedge the account payable with an OTC call option with a strike price of $1.800/£. The option premium is 0.50 percent, and the 30-day periodic rate in the U.S. is 0.40 percent. If the spot exchange rate in 30 days is $1.825/£, what is the total cost of the account payable (including the cost of the option)?

A) $996,324
B) $998,589
C) $1,010,089
D) $1,083,000
E) $1,085,346

Question 25

Plummer Tech is a U.S. multinational that just purchased C$800,000 of goods on account, due in 30 days from a Canadian supplier. The spot exchange rate is $0.793/C$. Plummer wants to hedge the account payable with an OTC call option with a strike price of $0.800/C$. The option premium is 0.50 percent, and the 30-day periodic rate in the U.S. is 0.40 percent. If the spot exchange rate in 30 days is $0.776/C$, what is the total cost of the account payable (including the cost of the option)?

A) $623,984.69
B) $637,584.69
C) $643,184.69
D) $662,484.69
E) $663,424.69

Question 26

Differentiate between discrete and continuing risks.

Question 27

If a firm performs an analysis comparing forward market, money market, and OTC option hedges, how should it choose its hedging technique?

Question 28

Explain how risk is defined in a risk management context.

Question 29

Identify some reasons that firms should use hedging techniques.

Question 30

Identify some reasons that firms should not use hedging technique

Question 31

Muller Industries is a U.S. multinational that just sold C$1.1 million of goods on account, due in 30 days to a Canadian customer. The spot exchange rate is $0.792/C$, while the 30-day forward rate is $0.813/C$. Muller is interested in hedging this account receivable by using a money market hedge. If the 30-day periodic investment rate in Canada is 0.20 percent, how many U.S. dollars does Muller need to borrow to properly hedge the account receivable?

Question 32

Foster Autos is a U.S. multinational that just purchased £1,300,000 of goods on account, due in 30 days from a British supplier. The spot exchange rate is $1.715/£. Foster wants to hedge the account payable with an OTC call option with a strike price of $1.750/£. The option premium is 0.60 percent, and the 30-day periodic rate in the U.S. is 0.30 percent. If the spot exchange rate in 30 days is $1.696/£, what is the total cost of the account payable (including the cost of the option)?

Question 33

Fieldman National is a U.S. multinational that just sold C$1,000,000 of goods on account, due in 30 days to a Canadian customer. The spot exchange rate is $0.755/C$. Fieldman wants to hedge the account receivable with an OTC call option with a strike price of $0.750/C$. The option premium is 0.40 percent, and the 30-day periodic rate in the U.S. is 0.30 percent. If the spot exchange rate in 30 days is $0.766/C$, what is the total receipt from the account receivable (including the cost of the option)?