Question 1

________ are financial contracts whose values depend on the values of some underlying asset price.

Accepted Answer

Derivative securities are financial contracts whose values depend on the values of some underlying asset price. Margin calls are demands for additional funds or securities to be posted to an account to cover losses, which may be triggered by changes in the value of a derivative security. Tax codes and tax shields are not related to derivative securities.

Question 2

According to some research,firms with higher dividend payouts are more like to

Accepted Answer

Firms with higher dividend payouts are more likely to hedge to ensure they have sufficient cash flow to maintain their dividend payments, as hedging can reduce the volatility of cash flows.

Question 3

Tax benefits of hedging are greater in which one of the following?

Accepted Answer

Hedging benefits are greater when the tax code is more progressive because it helps to smooth income, potentially reducing the tax burden by avoiding higher tax brackets that come with higher income levels. In a progressive tax system, tax rates increase as income increases, so stabilizing income through hedging can lead to significant tax savings.

Question 4

When a firm is unprofitable it generates a ________ that allows it to offset the losses that were incurred against future income.

Accepted Answer

The tax-loss carry-forward allows companies to offset future profits with losses incurred in prior years. This reduces their tax liability and can help them become profitable again in the future.

Question 5

Because much of the equity value of a firm ________,hedging the foreign exchange risk is difficult.

Accepted Answer

The equity value of a firm depends on the indefinite future, making it challenging to hedge foreign exchange risk because future cash flows and their associated risks are uncertain and difficult to predict.

Question 6

Accountants treat many hedges as ________.

Accepted Answer

Accountants treat many hedges as off-balance sheet items because the purpose of a hedge is to offset potential losses in another asset or liability on the balance sheet. By designating a hedge as off-balance sheet, a company can reduce the volatility of its financial statements and potentially improve its financial performance metrics. Accrued expenses and deferred income are not relevant to the treatment of hedges, and although some hedges may be near liquid assets, this is not a common way that accountants think about hedges.

Question 7

Regarding the true hedging cost,if the bid-ask spread widens for more distant future contracts,the cost of forward hedging

Accepted Answer

The cost of forward hedging increases with the maturity of the contract if the bid-ask spread widens for more distant future contracts. This is because wider bid-ask spreads result in a larger cost for executing a hedge, which increases with the length of time the hedge is in place.

Question 8

What does hedging have to do with expected taxes?

Accepted Answer

Hedging allows a firm to shift income across different tax jurisdictions in the world, thereby reducing its overall tax liability.

Question 9

What does it mean when a tax code is convex?

Accepted Answer

A tax code is convex when it imposes a higher tax rate on higher incomes and a lower tax rate on lower incomes, which means that the marginal tax rate increases as taxable income rises. This is also known as a progressive tax code.

Question 10

Hedging reduces the amount of ________ in earnings data that is not due to actions of the managers.

Accepted Answer

Hedging is a strategy used to minimize or eliminate the impact of market fluctuations or other external factors on a company's financial performance, and thus reduce the amount of "noise" in earnings data that is not due to actions of the managers.

Question 11

Because only ________ tend to get reported,gathering information that reports the trends in hedging activity must be done in other ways.

Accepted Answer

Income statements and balance sheets typically do not provide detailed information on hedging activities, so other methods are needed to gather this data.

Question 12

What is the name of the accounting convention that allows a firm to offset the losses that were incurred against future income rather than receive a refund of taxes paid?

Accepted Answer

Tax-loss carry-forward is the accounting convention that allows a firm to offset the losses that were incurred against future income rather than receive a refund of taxes paid. Option A, tax credit, refers to a dollar-for-dollar reduction in tax liability, while option B, itemized deductions, refers to expenses that can be subtracted from taxable income. Option D, a write-down, refers to a reduction in the value of an asset on the balance sheet.

Question 13

According to the Wharton/CIBC Survey of 1998 on hedging,only when a firm is sufficiently large to overcome the fixed costs of hedging does the firm

Accepted Answer

The Wharton/CIBC Survey of 1998 on hedging suggests that only when a firm is large enough to overcome the fixed costs of hedging should it establish a hedging policy. This implies that the company should have a formal framework for hedging its risks in financial markets. Creating an international division or tax shelters may not be a priority for firms until they have established a successful hedging policy. Holding only the cash manager responsible for hedging is not advisable as it is a complex task that requires expertise and collaboration from various areas of the firm.

Question 14

Modigliani and Miller argued that a corporation's financial policies,such as hedging foreign exchange risk,________ unless they lowered the firm's taxes,affected its investment decisions,or could be done more cheaply than individual investors' transactions could be done.

Accepted Answer

Modigliani and Miller proposed the theory of capital structure, which states that a firm's value is not affected by its financial policies if they do not lower the firm's taxes, affect its investment decisions or can be done more cheaply than individual investors' transactions can be done. Therefore, the answer is A - the financial policies do not change the value of the firm's assets.

Question 15

A ________ tax code imposes a larger tax rate on a higher income and a smaller tax rate on lower incomes.

Accepted Answer

A convex tax code imposes a larger tax rate on a higher income and a smaller tax rate on lower incomes.

Question 16

________ are typically larger in the forward market than in the spot market for currency.

Accepted Answer

The bid-ask spreads are typically larger in the forward market than in the spot market due to the increased risk and uncertainty over a longer time horizon.

Question 17

When a firm's pretax income is more volatile,

Accepted Answer

When a firm's pretax income is more volatile, hedging currency risk can provide greater benefits by reducing the variability of cash flows and earnings, thus making income more predictable and potentially reducing the firm's risk exposure.

Question 18

It is appropriate for the costs of hedging to be borne by the ________ department of the multinational corporation.

Accepted Answer

Hedging is a financial risk management strategy that involves taking offsetting positions in order to reduce the impact of market fluctuations. It is typically the responsibility of the treasury department to manage financial risks, including currency risk. Therefore, it is appropriate for the costs of hedging to be borne by the treasury department of the multinational corporation. The other departments listed, marketing, legal, and shipping, are not directly related to financial risk management.

Question 19

How can hedging increase the value of a firm?

Accepted Answer

Hedging can stabilize a firm's cash flows, which can lead to more predictable taxable income and potentially reduce future income taxes through better tax planning and utilization of tax shields.

Question 20

________ is the use of derivative securities to take positions in financial markets that offset the underlying sources of risk that arise in a company's normal course of business.

Accepted Answer

Hedging is the use of derivative securities to take positions in financial markets that offset the underlying sources of risk that arise in a company's normal course of business. By hedging, companies can protect themselves against adverse movements in prices or interest rates, for instance, and ensure more stability in their financial outcomes. Risk management is a broader term that encompasses all the activities companies engage in to identify, measure, and control the various risks they face. Asset securitization and option premium, on the other hand, are more specific concepts related to structured finance and options trading, respectively.

Quiz 17: Risk Management and the Foreign Currency Hedging Decision