Exam 10: Transaction Exposure

The hedge ratio,β,is an individual exposure's nominal amount covered by a financial instrument such as a forward contract or currency option.

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.If the exchange rate changes to $1.52/£ the U.S.firm will realize a ________ of ________.

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

With the use of forwards,a perfect hedge is possible.

There are as many different approaches to exposure management as there are firms and no real consensus exists regarding the best approach.Discuss the following theoretical dimensions to currency hedging: optimal hedge ratio,hedge symmetry,hedge effectiveness and hedge timing.

Like a forward market hedge,a money market hedge also involves a contract and a source of funds to fulfill that contract.In this instance,the contract is a loan agreement.

Managers CAN outguess the market.If and when markets are in equilibrium with respect to parity conditions,the expected net present value of hedging should be POSITIVE.

Hedging is accomplished by combining the exposed asset with a hedge asset to create a two asset portfolio in which the two assets react in relatively equal directions to an exchange rate change.

________ exposure is the potential for accounting-derived changes in owner's equity to occur because of the need to translate foreign currency financial statements into a single reporting currency.

A ________ hedge refers to an offsetting operating cash flow such as a payable arising from the conduct of business.

The key arguments in opposition to currency hedging such as market efficiency,agency theory,and diversification do not have financial theory at their core.

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

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 10.1.The cost of a put option to CVT would be:

Management often conducts hedging activities that benefit management at the expense of the shareholders.The field of finance called agency theory frequently argues that management is generally LESS risk averse than are shareholders.

Remaining unhedged is NOT an option when dealing with foreign exchange transaction exposure.

The effectiveness of a hedge is determined to what degree the change in spot asset's value is correlated with the equal change in the hedge asset's value to a change in the underlying spot exchange rate.

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

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/£.)

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

According to a survey by Bank of America,the type of foreign exchange risk most often hedged by firms is: