Reading 38: Risk Management Applications of Forward and Fu exchange

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CFA Institute Area 8-11, 13: Asset Valuation
Session 13: Risk Management Applications of Derivatives
Reading 38: Risk Management Applications of Forward and Futures Strategies
LOS f, (Part 1): Discuss the three types of exposure to exchange rate risk.

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Derivatives are most often used to hedge which type of exchange-rate risk?

A) Transaction exposure.

B) Economic exposure.

C) Translation exposure.

D) Credit exposure.

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Answer and Explanation

The three types of exchange-rate risk are transaction exposure, economic exposure, and translation exposure. Futures are most often used to hedge transaction exposure, which is the risk that exchange rates will change the real value (in the domestic currency) of the contracted price.

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The risk associated with a fall in demand for a firms product caused by an appreciation of the home currency of the firm is called:

A) economic exposure.

B) transaction exposure.

C) translation exposure.

D) credit exposure.

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Answer and Explanation

Economic exposure is the loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency. That is, if the euro/dollar exchange rate increases, a U.S. exporter to Europe would see a fall in revenue as the European buyers purchase fewer U.S. exports that have effectively increased in price from the dollar appreciation.

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The exchange-rate risk associated with falling asset values in foreign subsidiaries caused by currency fluctuations is called:

A) translation exposure.

B) economic exposure.

C) transaction exposure.

D) credit exposure.

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Answer and Explanation

Translation exposure refers to the fact that multinational corporations might see a decline in the value of their assets that are denominated in foreign currencies when those foreign currencies depreciate. When the consolidated balance sheet is composed, changing exchange rates will introduce variation in account values from year to year.
  

[此贴子已经被作者于2008-9-16 16:28:37编辑过]

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With respect to the practice of using forward contracts to eliminate the exchange-rate risk associated with a receiving a future payment in a foreign currency, which of the following is correct? A firm that expects to receive a foreign-currency payment is:

A) short the currency and should go long the forward contract on the foreign currency.

B) short the currency and should short the forward contract on the foreign currency.

C) long the currency and should go long the forward contract on the foreign currency.

D) long the currency and should short the forward contract on the foreign currency.

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Answer and Explanation

In hedging foreign exchange risk, anticipating a receipt (payment) of a currency is like being long (short) the currency. To hedge the associated risk, a manager should take the opposite position in the forward contract.

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A maker of large computers has just received an order for some of its products. The agreed upon price is in British pounds: ₤8 million. The firm will receive the pounds in 60 days. The current exchange rate is $1.32/₤ and the 60-day forward rate is $1.35/₤. If the firm uses the forward contract to hedge the corresponding exchange rate risk, how many dollars will it expect to receive?

A) $10,560,000.

B) $10,800,000.

C) $5,925,926.

D) $6,060,606.

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Answer and Explanation

On the day the order comes in, the firm effectively has a long position in pounds; therefore, it should take a short position in a forward contract. This contract would obligate the firm to deliver the pounds that it will receive for dollars. The contract would be to exchange ₤8 million for:

$10,800,000 = (₤8,000,000)*$1.35/₤.

$10,800,000 = (₤8,000,000)*$1.35/₤.

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When expecting to make a future payment in a foreign currency, a firm should take a:

A) long forward position in the currency to hedge a depreciation of that currency.

B) short forward position in the currency to hedge an appreciation of that currency.

C) long forward position in the currency to hedge an appreciation of that currency.

D) short forward position in the currency to hedge a depreciation of that currency.

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Answer and Explanation

Expecting to make a payment is like being short the currency. The firm would want to take a long forward position. If the currency appreciates and there is no hedge, the firm would pay more. With the hedge, the overall cost in domestic currency is locked in (cost increases will be offset by gains on the forward contract). Of course, the forward contract will result in a loss if the foreign currency actually depreciates, but this will be offset by a decrease in the cost of the underlying transaction.