Exam 10: Transaction Exposure

Does foreign currency exchange hedging both reduce risk and increase expected value? Explain,and list several arguments in favor of currency risk management and several against.

The treasury function of most firms,the group typically responsible for transaction exposure management,is NOT usually considered a profit center.

Many MNEs have established rigid transaction exposure risk management policies which mandate proportional hedging (a percentage of existing transaction exposures).Explain the pros and cons of proportional hedging.

The structure of a money market hedge is similar to a forward hedge.The difference is the cost of the money market hedge is determined by the differential interest rates,while the forward hedge is a function of the forward rates quotation.

In efficient markets,interest rate parity should assure that the costs of a forward hedge and money market hedge should be approximately the same.

A hedge constructed using puts foreign currency options would be symmetric.

MNE cash flows may be sensitive to changes in which of the following?

Shareholders are LESS capable of diversifying currency risk than is the management of the firm.

Hedging transaction exposure with option contracts allows the firm to benefit if exchange rates are favorable but protects the firm if exchange rates turn unfavorable.

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.If CVT chooses to hedge its transaction exposure in the forward market,it will ________ euro 3,000,000 forward at a rate of ________.

TRANSACTION exposure measures gains or losses that arise from the settlement of existing financial obligations whose terms are stated in a foreign currency.

A hedge constructed using a put foreign currency option would protect you against value losses,but allow,at the same time,the possibly reap value increases in the event the exchange rate moved in your favor.

Transaction exposure and operating exposure exist because of unexpected changes in future cash flows.The difference between the two is that ________ exposure deals with cash flows already contracted for,while ________ exposure deals with future cash flows that might change because of changes in exchange rates.

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.If CVT locks in the forward hedge at $1.22/euro,and the spot rate when the transaction was recorded on the books was $1.25/euro,this will result in a "foreign exchange accounting transaction ________ of ________.

Transaction exposure could arise when borrowing or lending funds when repayment is to be made in the firm's domestic currency.

Losses from ________ exposure generally reduce taxable income in the year they are realized.________ exposure losses may reduce taxes over a series of years.

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.CVT chooses to hedge its transaction exposure in the forward market at the available forward rate.The required amount in dollars to pay off the accounts payable in 6 months will be:

According to the authors,firms that employ proportional hedges increase the percentage of forward-cover as the maturity of the exposure lengthens.

Assuming no transaction costs (i.e.,hedging is "free"),hedging currency exposures should ________ the variability of expected cash flows to a firm and at the same time,the expected value of the cash flows should ________.

With a perfect hedge,there is no uncovered exposure remaining.