AIM 1: Describe how to measure cash flow exposure to exchange rates and compute the optimal hedge ratio.

1、Judy Starks is assessing her company’s exposure to exchange rate fluctuations. Starks’ immediate concern is conserving the dollar value of receivables associated with recent sales abroad. This is an example of:

A) contractual exposure.
 
B) competitive exposure. 
 
C) transactions exposure. 
 
D) price exposure.

The correct answer is C

Transactions exposure results from having receivables from past business deals in which the firm will receive payment in a foreign currency.

2、Short-dated futures contracts are most effective for hedging which type of foreign exchange exposure?

A) Translation exposure.
 
B) Transactions exposure.
 
C) Competitive exposure.
 
D) Quantity exposure.

The correct answer is B

Transactions exposure is related to receivables and payables that are already booked. Thus, transactions exposure represents known, short-term cash flows that can be effectively hedged.

3、You are assessing your company’s exposure to exchange rate fluctuations. Your immediate concern is the impact of future exchange rate movements on future exports to Europe. This is an example of:

A) price exposure.
 
B) competitive exposure.
 
C) contractual exposure.
 
D) transactions exposure. 

The correct answer is B

Competitive exposure is the sensitivity of the firm’s cash flow to a change in the risk factor resulting from changes in the firm’s competitive position.

 4、A U.S.-based company exports consumer goods to Britain and is concerned with the U.S. dollar value of revenue from British sales. A futures hedge is unnecessary if British pound revenues:

A) have a correlation with the value of the pound of +0.5.
 
B) are perfectly negatively correlated with the value of the pound.
 
C) are perfectly positively correlated with the value of the pound. 
 
D) are uncorrelated with the value of the pound.

The correct answer is B

If pound revenues are perfectly negatively correlated with the value of the pound, there is no need to hedge, as the dollar value of pound revenues is constant.

5、XPORT Inc. exports consumer goods to Britain. The firm would like to hedge its foreign currency exposure by taking a position in a futures contract on the British pound. If British sales, denominated in pounds, are uncorrelated with changes in the value of the pound:

A) the firm cannot construct a perfect hedge.
 
B) the firm will be able to construct a perfect hedge.
 
C) the firm has no need to hedge.
 
D) any hedge will be completely ineffective.

The correct answer is A

It is impossible to construct a perfect hedge with a single futures contract when there are two uncorrelated sources of risk.

6、All of the following are methods of estimating a firm’s exposure to exchange rate risk EXCEPT:

A) estimating the slope of the demand curve.
 
B) constructing pro forma cash flow statements under various scenarios. 
 
C) simulation analysis based on exchange rate volatility.
 
D) regression of firm value changes on exchange rate changes. 

The correct answer is A

The elasticity of demand may enter into the calculations, but by itself, the slope of the demand curve does not provide an estimate of risk-factor exposure.

7、Cash flow exposure to exchange rate changes is measured as:

A) cash flow volatility times covariance.
 
B) cash flow change per unit change in the exchange rate. 
 
C) the 5% CAR based on exchange rate volatility. 
 
D) the standard deviation of cash flow.

The correct answer is B

Cash flow exposure is measured as the cash flow change per unit change in the exchange rate.

AIM 5: Describe the delta exposure of cash flow, its estimation when there are non-linear exposures to a risk factor.

1、Based on a single futures contract, which of the following cases is least likely to render a static hedge of foreign exchange exposure ineffective?

A) Exposure to uncorrelated price and quantity risks.
 
B) Multiple, perfectly correlated risk exposures. 
 
C) A nonlinear exposure to changes in the exchange rate.
 
D) Multiple, nonlinear exposures.

The correct answer is B

Nonlinear risk exposures and exposures to multiple uncorrelated risk exposures reduce the effectiveness of a static hedge based on a single futures contract.

2、Using the following regression to estimate changes in firm value, what is the marginal impact of a 10% increase in the value of the GBP?

A) - 3%.
 
B) - 10%.
 
C) - 9%.
 
D) - 30%.

The correct answer is A

(?0.3) × 0.1 = ?0.03 = ?3%

3、One approach to estimating a company’s exposures when there are multiple risk factors is to regress the return on the firm’s equity on percentage changes in risk factors. The major advantage of this approach is:

A) it incorporates nonlinearities in the relation between cash flows and risk factors.
 
B) it is robust to erroneous exclusion of potential risk factors.
 
C) regression coefficients are inherently forward-looking.
 
D) regression coefficients provide estimates of hedge ratios.

The correct answer is D

The coefficients from this type of regression are estimates of optimal hedge ratios. Weaknesses of this approach include the fact that the regression model assumes simple linear relations and that coefficient estimates are both sensitive to erroneous exclusion of risk factors and based on historical data, which makes the hedge ratios inherently backward-looking.