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Exam 10: Transaction Exposure

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Question 1

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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.

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B) False

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Question 2

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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/£.)

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Question 3

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

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.

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

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

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:

________ exposure measures the change in the present value of the firm resulting from unexpected changes in exchange rates.

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

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:

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

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.

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

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

Which of the following is NOT cited as a good reason for hedging currency exposures?

________ are transactions for which there are, at present, no contracts or agreements between parties.

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

Which of the following is cited as a good reason for NOT hedging currency exposures?

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

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