Question 1

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.

Accepted Answer

When markets are in equilibrium with respect to parity conditions, the expected net present value of hedging is typically zero, not positive, because parity conditions imply that any potential gains from hedging or outguessing the market are already accounted for in current prices.

Question 2

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 3

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.CVT 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.

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 4

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.What is the cost of a call option hedge for CVT's euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firm's cost of capital as the appropriate interest rate for calculating future values.)
A) $57,600
B) $59,904
C) $62,208
D) $63,936

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 5

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 other options, such as using forward contracts, options or swaps to hedge against exchange rate risk. Remaining unhedged can expose the firm to potential losses if the foreign currency appreciates against the domestic currency.

Question 6

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

Accepted Answer

Hedging is a controversial topic among investors and managers, with some arguing that it is a necessary tool to mitigate risk and others arguing that it can limit potential returns and may not be worth the cost.

Question 7

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.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

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 8

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 9

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

Accepted Answer

The key arguments in opposition to currency hedging, such as market efficiency, agency theory, and diversification, do have financial theory at their core. Market efficiency suggests that attempting to outperform the market through currency hedging is futile, while agency theory argues that managers may not act in the best interest of shareholders when making hedging decisions. Diversification suggests that investors can mitigate currency risk by holding a globally diversified portfolio. These arguments are all based on financial theory.

Question 10

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.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.

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 11

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.

Accepted Answer

Agency theory often argues that management is more risk-averse than shareholders because managers have more of their personal wealth and human capital tied to the company, making them less willing to undertake risky projects that could jeopardize their employment or the stability of their compensation. Shareholders, on the other hand, can diversify their investment risk across multiple companies.

Question 12

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.CVT would be ________ by an amount equal to ________ with a forward hedge than if they had NOT hedged and their predicted exchange rate for 6 months had been correct.
A) better off; $150,000
B) better off; €150,000
C) worse off; $150,000
D) worse off; €150,000

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 13

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 that arises from settled financial obligations in foreign currencies. This means that gains or losses that occur due to changes in exchange rates during the settlement of the financial transaction will be measured.

Question 14

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.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.

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 15

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 16

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 a certain amount of money in the foreign currency and then converting that amount into the home currency using the current spot rate. The borrowed amount is then used to fulfill the contract, similar to how a forward market hedge involves a forward contract and a future obligation.

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

Managers have more information and expertise in identifying market conditions and opportunities to enhance firm value through selective hedging. This can benefit shareholders by protecting against potential losses and maximizing gains in the long run.

Question 18

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

Accepted Answer

Shareholders have the option to invest in multiple companies and assets to diversify their currency risk, while the management of a firm has more control over the currency exposure of that specific firm. Therefore, shareholders are more capable of diversifying currency risk than the management of the firm.

Question 19

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 euro 3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
∙ The spot exchange rate is $1.250/euro
∙ The six month forward rate is $1.22/euro
∙ CVT's cost of capital is 11%
∙ The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
∙ The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
∙ The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
∙ The U.S. 6-month lending rate is 6% (or 3% for 6 months)
∙ December call options for euro 750,000; strike price $1.28, premium price is 1.5%
∙ CVT's forecast for 6-month spot rates is $1.27/euro
∙ The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1.If CVT chooses to hedge its transaction exposure in the forward market,it will ________ euro 3,000,000 forward at a rate of ________.
A) buy; $1.22
B) buy; $1.25
C) sell; $1.22
D) sell; €1.25

Accepted Answer

CVT should buy euro 3,000,000 forward at a rate of $1.22/euro. This will lock in the exchange rate, ensuring that CVT pays $3,660,000 for the euro 3,000,000, which is below the budget rate of $3,900,000. The forward rate of $1.22/euro is better than the forecasted spot rate of $1.27/euro, indicating that the forward market is offering a better rate of exchange.

Question 20

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.

Quiz 10: Transaction Exposure