Deck 10: Transaction Exposure

Question 1

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

Answer 1

gain; $4,500

Question 2

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

Answer 2

decrease; not change

Question 3

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.

Answer 3

quotation, backlog, and billing exposure.

Question 4

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 5

Each of the following is another name for operating exposure EXCEPT:

A)economic exposure.
B)strategic exposure.
C)accounting exposure.
D)competitive exposure.

Question 6

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

Question 7

________ 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 8

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 9

________ 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 10

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

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

Question 11

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 12

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 13

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

Question 14

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 15

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 16

________ 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 17

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

Question 18

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 19

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 20

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 21

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 22

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 10.2. 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

Question 23

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 24

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 25

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

Question 26

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 10.2. 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 27

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 28

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 10.2. 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 29

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 30

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

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

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 33

________ 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 34

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 10.2. 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 35

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 36

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

Question 37

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 10.2. 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 38

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 39

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 10.2. 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 40

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 10.2. 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 41

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

Question 42

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

Question 43

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

Question 44

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

Question 45

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

Question 46

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

Question 47

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

Question 48

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 49

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 50

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.