Chapter 8 Practice Questions and Answer Keys (updated)

Lecture #7 – Practice Questions – International Financial Management 456

Chapter 8 – Management of Transaction Exposure

1.Transaction exposure is defined as

A. the sensitivity of realized domestic currency values of the firm's contractual cash flows

denominated in foreign currencies to unexpected exchange rate changes.

B. the extent to which the value of the firm would be affected by unanticipated changes in

exchange rate.

C. the potential that the firm's consolidated financial statement can be affected by changes in

exchange rates.

D. ex post and ex ante currency exposures.

2.The most direct and popular way of hedging transaction exposure is by

A. exchange-traded futures options.

B. currency forward contracts.

C. foreign currency warrants.

D. borrowing and lending in the domestic and foreign money markets.

3.If you owe a foreign currency denominated debt, you can hedge with

A. a long position in a currency forward contract.

B. a long position in an exchange-traded futures option.

C. buying the foreign currency today and investing it in the foreign county.

D. both a) and c)

4.With any hedge

A. your losses on one side should about equal your gains on the other side.

B. you should try to make money on both sides of the transaction: that way you make money

coming and going.

C. you should spend at least as much time working the hedge as working the underlying deal

itself.

D. you should agree to anything your banker puts in front of your face.

5.The choice between a forward market hedge and a money market hedge often comes down

to

A. interest rate parity.

B. option pricing.

C. flexibility and availability.

D. none of the above

6.Suppose that Boeing Corporation exported a Boeing 747 to Lufthansa and billed €10 million

payable in one year. The money market interest rates and foreign exchange rates are given as follows:

The euro zone one-year interest rate: 9.00% per annum; The U.S. one-year interest rate: 6.10% per annum; The spot exchange rate: 1.50 dollar per euro; The one-year forward exchange rate: 1.46 dollar per euro.

Assume that Boeing sells a currency forward contract of €10 million for delivery in one year, in exchange for a predetermined amount of U.S. dollar. Suppose that on the maturity date of the forwar d contract, the spot rate turns out to be $1.40/€ (i.e. less than the forward rate of $1.46/€). Which of the following is true?

A. Boeing would have received only $14.0 million, rather than €14.6 million, had it not entered into the forward contract

B. Boeing gained $0.6 million from forward hedging

C. a) and b)

D. none of the above

7.Your firm has a British customer that is willing to place a $1 million order, but wants to pay

in pounds instead of dollars. The spot exchange rate is $1.85 = ￡1.00 and the one-year

forward rate is $1.90 = ￡1.00. The lead time on the order is such that payment is due in one year. What is the fairest exchange rate to use?

A. $1.85 = ￡1.00

B. $1.8750 = ￡1.00

C. $1.90 = ￡1.00

D. none of the above

8.Your firm is a U.K.-based exporter of British bicycles. You have sold an order to an

American firm for $1,000,000 worth of bicycles. Payment from the American firm (in U.S.

dollars) is due in six months. Detail a strategy using futures contracts that will hedge your exchange rate risk.

A. Go short 12 six-month forward contracts; pay ￡555,600.

B. Go short 9 six-month forward contracts. Raise approximately ￡537,600.

C. Go long 12 six-month forward contracts. Receive approximately ￡549,500.

D. Go long 16 six-month forward contracts; raise approximately ￡537,600.

9. A U.S. firm has sold an Italian firm €1,000,000 worth of product. In one year the U.S. firm

gets paid. To hedge, the U.S. firm bought put options on the euro with a strike price of $1.65.

They paid an option premium $0.01 per euro. If at maturity, the exchange rate is $1.60,

A. the firm will realize $1,145,000 on the sale net of the cost of hedging.

B. the firm will realize $1,150,000 on the sale net of the cost of hedging.

C. the firm will realize $1,640,000 on the sale net of the cost of hedging.

D. none of the above

10.Buying a currency option provides

A. a flexible hedge against exchange exposure.

B. limits the downside risk while preserving the upside potential.

C. a right, but not an obligation, to buy or sell a currency.

D. all of the above

11.A Japanese EXPORTER has a €1,000,000 receivable due in one year.

Detail a strategy using options that will eliminate exchange rate risk.

A. Buy 16 put options on euro, sell 10 call options on yen.

B. Buy 16 put options on euro, buy 10 call options on yen.

C. Sell 16 call options on euro, buy 10 put options on yen.

D. None of the above

12.To hedge a foreign currency payable,

A. buy call options on the foreign currency.

B. buy put options on the foreign currency.

C. sell call options on the foreign currency.

D. sell put options on the foreign currency.

13.To hedge a foreign currency receivable,

A. buy call options on the foreign currency with a strike in the domestic currency.

B. buy put options on the foreign currency with a strike in the domestic currency.

C. sell call options on the foreign currency with a strike in the domestic currency.

D. sell put options on the foreign currency with a strike in the domestic currency.

14.XYZ Corporation, located in the United States, has an accounts payable obligation of ￥750

million payable in one year to a bank in Tokyo. The current spot rate is ￥116/$1.00 and the one year forward rate is ￥109/$1.00. The annual interest rate is 3 percent in Japan and 6

percent in the United States. XYZ can also buy a one-year call option on yen at the strike price of $0.0086 per yen for a premium of 0.012 cent per yen. The future dollar cost of

meeting this obligation using the money market hedge is

A. $6,450,000.

B. $6,545,400.

C. $6,653,833.

D. $6,880,734.

15.A call option on ￡1,000 with a strike price of €1,250 is equivalent to

A. a put option on €1,250 with an exercise price of €1,000.

B. a portfolio of options: a put on €1,250 with a strike price in dollars plus a call on ￡1,000

with a strike price in dollars.

C. a put option on ￡1,000 with an exercise price of €1,250.

D. both a) and b)

16.A put option to sell $18,000 at a strike price of $1.80 = ￡1.00 is equivalent to

A. a call option to buy ￡10,000 at a strike price of $1.80 = ￡1.00.

B. a call option on $18,000 at a strike price of $1.80 = ￡1.00.

C. a put option on ￡10,000 at a strike price of $1.80 = ￡1.00.

D. none of the above.

17.Your U.S. firm has a ￡100,000 payable with a 3-month maturity. Which of the following will

hedge your liability?

A. Buy a call option on ￡100,000 with a strike price in euro.

B. Buy a put option on ￡100,000 with a strike price in dollars.

C. Buy a call option on ￡100,000 with a strike price in dollars.

D. None of the above

18.A minor currency is

A. anything other than the "big six": U.S. dollar, British pound, Japanese yen, euro, Canadian

dollar, and Swiss franc.

B. any currency that trades at less than one U.S. dollar.

C. any currency that is less than a $20 denomination.

D. none of the above.

19.When cross-hedging,

A. try to find one asset that has a positive correlation with another asset.

B. the main thing is to find one asset that covaries with another asset in some predictable way.

C. try to find one asset that has a negative correlation with another asset.

D. none of the above

20.Your firm is bidding on a large construction contract in a foreign country. This contingent

exposure could best be hedged

A. with put options on the foreign currency.

B. with call options on the foreign currency.

C. both a) and b), depending upon the specifics ("the rest of the story").

D. with futures contracts.

21.An exporter faced with exposure to an appreciating currency can reduce transaction exposure

with a strategy of

A. paying or collecting early.

B. paying or collecting late.

C. paying late, collecting early.

D. paying early, collecting late.

22.In evaluating the pros and cons of corporate risk management, one argument against hedging

is

A. if the corporate guys were good at forecasting exchange rates, they would make more

money on Wall Street, so only incompetent managers are left at corporations to hedge.

B. shareholders who are diversified have already managed their exchange rate risk.

C. the hedging costs go into someone else's pocket.

D. none of the above.

Answer Key (corrected):

1. A

2. B

3. D

4. A

5. A

6. B

7. C

8. B

9. C

10.D

11.B

12.A

13.B

14.C

15.A

16.A

17.C

18.A

19.B

20.C

21.D

22.B

Solutions:

Question 8: The U.K.- based exporter must sell $1,000,000 to exchange for British pounds when receive the payment from the American firm. So the exporter must enter the short position for the forward contract.

Number of forward contract is computed as follows,

$1,000,000 * 0.5376 ￡/$ / ￡62,500 = 8.6 ≈ 9 forward contracts

Question 9: Cost of Put Option = €1,000,000 * 0.01$/€ = $10,000

Based on the striking price of put option, the amount that the U.S. firm will be paid in one year equals to €1,000,000* 1.65$/€ = $1,650,000

After paying the option premium, the realized sales of euros equals to $1,650,000-$10,000 = $1,640,000.