Question 1

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:

Accepted Answer

CVT will use the forward market to hedge its transaction exposure, thus locking in the forward rate of $1.22/euro. Therefore, the required amount in dollars to pay off the accounts payable in 6 months will be:

€3,000,000 x $1.22/euro = $3,660,000

Option A is incorrect because it does not consider the exchange rate risk.
Option C is incorrect because it assumes that CVT will not hedge its transaction exposure and will pay the invoice at the spot rate in December.
Option D is incorrect because it assumes that CVT will borrow euros in the Euro zone and lend dollars in the US, which is not necessary in this case.

Question 2

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

Accepted Answer

The firm has several options to hedge against foreign currency risk such as using forward contracts, options or currency swaps. Remaining unhedged is not the only choice available to manage account payable denominated in a foreign currency.

Question 3

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:

Accepted Answer

The U.S. firm is at risk today of a loss if the exchange rate changes in either direction, or if it doesn't change.

Question 4

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 ________.

Accepted Answer

If the exchange rate changes from $1.55/£ to $1.52/£, then the British company will only have to pay $228,000 ($1.52/£ x £150,000). However, because the U.S. firm will receive payment in British pounds, the value of the payment in U.S. dollars will depend on the exchange rate at the time of payment, which is three months from now. If the exchange rate remains the same, the U.S. firm will receive $232,500 ($1.55/£ x £150,000). If the exchange rate changes to $1.52/£, then the U.S. firm will only receive $228,000 ($1.52/£ x £150,000). This represents a loss of $4,500 for the U.S. firm. Therefore, the correct answer is A.

Question 5

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

Accepted Answer

Remaining unhedged is indeed an option when dealing with foreign exchange transaction exposure; companies may choose to accept the risk of currency fluctuations.

Question 6

________ is NOT a commonly used contractual hedge against foreign exchange transaction exposure.

Accepted Answer

All the options listed (Forward market hedge, Money market hedge, Options market hedge) are indeed commonly used contractual hedges against foreign exchange transaction exposure.

Question 7

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.

Accepted Answer

The answer of Does foreign currency exchange hedging both reduce...

Question 8

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 ________.

Accepted Answer

CVT should buy €3,000,000 forward at a rate of $1.22. This will lock in a known exchange rate and eliminate exchange rate risk. The forward rate of $1.22/euro is lower than the budget rate of $1.30/euro, which means that CVT will save money by hedging in the forward market. The other hedging alternatives, such as borrowing euros or buying options, would have a higher cost than the forward market hedge. Therefore, hedging with a forward contract is the best choice for CVT.

Question 9

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

Accepted Answer

A forward hedge involves a contract to buy or sell an asset at a specified price on a future date, not options contracts which are rights to buy (call) or sell (put) an asset.

Question 10

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:

Accepted Answer

The first time period, between quoting a price and reaching a sale agreement, is quotation exposure. The next time period, between taking an order and delivering it, is backlog exposure. Finally, the time it takes to get paid after delivering the product is billing exposure. Therefore, the stages of transaction exposure are quotation, backlog, and billing exposure. Choice C lists these stages in the correct order.

Question 11

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

Accepted Answer

Transaction exposure refers to the risk of gains or losses resulting from the settlement of existing financial obligations that are denominated in a foreign currency. This can include things like accounts payable, receivables, loans, and other financial instruments with fixed payment terms that are not subject to change.

Question 12

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.

Accepted Answer

A money market hedge involves borrowing the amount of foreign currency needed to fulfill a future payment obligation and investing that borrowed amount in the foreign currency to earn enough interest to cover the future payment. This process involves a loan agreement, which is the source of funds to fulfill the contract, similar to a forward market hedge.

Question 13

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 ________.

Accepted Answer

Explanation: By locking in the forward hedge at $1.22/euro when the spot rate was $1.25/euro, CVT effectively secures a lower exchange rate for the future payment. This means they will pay less in dollars for the euros needed to settle the contract than they would have at the spot rate at the time of the transaction. The difference in rates ($1.25 - $1.22 = $0.03/euro) applied to the €3,000,000 contract results in a savings or "gain" of $90,000 (€3,000,000 * $0.03 = $90,000).

Question 14

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.)

Accepted Answer

To calculate the cost of a call option hedge, we need to first calculate the premium paid for the option:
Premium = Option price x Option size = 1.5% x €750,000 = €11,250
Next, we need to convert the premium cost into future value dollars:
FV = PV x (1 + r)^n
PV = €11,250
r = CVT's cost of capital = 11%
n = 6/12 (since the payment is due in 6 months)
FV = €11,250 x (1 + 11%)^0.5 = $59,904
Therefore, the cost of a call option hedge is $59,904. Since the forecasted spot rate of $1.27/euro is lower than the budget rate of $1.30/euro, a hedging strategy is recommended. The best choice for CVT would be to purchase call options, as it provides protection against a potential appreciation of the euro while allowing CVT to benefit from a favorable exchange rate if the spot rate is lower than the strike price.

Question 15

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:

Accepted Answer

The question does not provide information on the strike price or the premium for a put option, which are necessary to calculate the cost of a put option for CVT.

Question 16

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.

Accepted Answer

$150,000If CVT uses a forward hedge, they lock in a rate of $1.22/euro, making the cost of €3,000,000 equal to $3,660,000. Without hedging, and if their predicted exchange rate of $1.27/euro is correct, the cost would be €3,000,000 * $1.27/euro = $3,810,000. Therefore, by hedging, CVT is better off by the difference, which is $3,810,000 - $3,660,000 = $150,000.

Question 17

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.

Accepted Answer

Hedging can help protect shareholders from losses, but it can also limit potential gains. However, management has access to more information and expertise than individual shareholders, making them better equipped to identify and seize profitable hedging opportunities that can increase firm value.

Question 18

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

Accepted Answer

Transaction exposure arises from the possibility of exchange rate fluctuations affecting the value of a company's financial transactions, but if repayment is in the firm's domestic currency, there is no currency exchange risk involved in the transaction.

Question 19

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:

Accepted Answer

Without hedging, the future payment in dollars depends on the exchange rate at the time of payment, which is uncertain and cannot be determined today.

Question 20

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 ________.

Accepted Answer

The U.S. firm will realize a gain because the value of the pound increases from $1.55 to $1.58. Initially, £150,000 would convert to $232,500 (150,000 * 1.55). With the new exchange rate, the same amount converts to $237,000 (150,000 * 1.58). The difference, or gain, is $4,500 ($237,000 - $232,500).

Quiz 10: Transaction Exposure