clearlycanadian

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

A) economic exposure.

B) translation exposure.

C) transaction exposure.

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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.

clearlycanadian

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

A) Translation exposure.

B) Transaction exposure.

C) Economic exposure.

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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.

clearlycanadian

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.

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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.

clearlycanadian

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 short the forward contract on the foreign currency.

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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.

clearlycanadian

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) $5,925,926.

C) $10,800,000.

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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/₤.

clearlycanadian

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

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

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

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

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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.

clearlycanadian

An asset manager says he has perfectly hedged an equity portfolio that is denominated in a foreign currency by only using forward currency contracts. We know then that the:

A) number of contracts used is equal to that used on a comparable equity position.

B) asset manager is not telling the truth.

C) number of contracts used is greater than that used on a comparable equity position.

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Since the asset manager cannot know the future value of the equity position, it is impossible to perfectly hedge the position with only currency contracts.

clearlycanadian

If a manager plans to use currency forwards to hedge a long position in foreign equities, then which of the following would represent a strategy that would prevent over-hedging?

A) Short an amount that is less than the current equity position.

B) Short an amount that is more than the current equity position.

C) Go long an amount that is more than the current equity position.

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The manager would want to short the forward contracts to hedge depreciation of the foreign currency. To prevent hedging too much, over-hedging, the manager would hedge an amount less than the equity position because that position may decline in value from the equity risk.

clearlycanadian

If a manager shorts a forward currency contract to hedge the expected value of a foreign-equity portfolio in one year. The worst-case scenario is if the portfolio’s return is:

A) less than the expected value and the currency appreciates.

B) less than the expected value and the currency depreciates.

C) greater than the expected value and the currency appreciates.

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This should be obvious because a decline in the equity position is bad and the short position in a forward currency contract hurts when the foreign currency appreciates. If the equity position falls short of the contracted amount, in addition to the loss from the decline in asset prices, then the manager will suffer a loss equal to the difference in the hedged amount and the actual equity value times the difference in the spot and contracted forward rate.

clearlycanadian

When hedging the exchange-rate risk of a foreign currency-denominated equity portfolio, a manager must recognize that the position has:

A) exchange-rate risk only.

B) equity risk only.

C) both equity risk and foreign exchange risk.

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The position will have both equity and foreign exchange risk. This makes the position, in isolation, more risky than a domestic equity portfolio.