Multinational Business Finance, 15e, Global Edition (Eiteman/Stonehill/Moffett)
Chapter 10 Transaction Exposure
10.1 Types of Foreign Exchange Exposure
1) ________ exposure deals with cash flows that result from existing contractual obligations.
A) Operating
B) Transaction
C) Translation
D) Economic
2) ________ exposure measures the change in the present value of the firm resulting from
unexpected changes in exchange rates.
A) Operating
B) Transaction
C) Translation
D) Accounting
3) Each of the following is another name for operating exposure EXCEPT:
A) economic exposure.
B) strategic exposure.
C) accounting exposure.
D) competitive exposure.
4) 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.
A) transaction; operating
B) operating; transaction
C) operating; accounting
D) none of the above
5) ________ 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) Transaction
B) Operating
C) Economic
D) Accounting (aka translation)
6) Losses from ________ exposure generally reduce taxable income in the year they are realized.
________ exposure losses may reduce taxes over a series of years.
A) accounting; Operating
B) operating; Transaction
C) transaction; Operating
D) transaction; Accounting
7) Losses from ________ exposure generally reduce taxable income in the year they are realized.
________ exposure losses are not cash losses and therefore, are not tax deductible.
A) transaction; Operating
B) accounting; Operating
C) accounting; Transaction
D) transaction; Translation
1) MNE cash flows may be sensitive to changes in which of the following?
A) exchange rates
B) interest rates
C) commodity prices
D) all of the above
2) 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 ________.
A) increase; not change
B) decrease; not change
C) not change; increase
D) not change; not change
3) Which of the following is NOT cited as a good reason for hedging currency exposures?
A) Reduced risk of future cash flows is a good planning tool.
B) Reduced risk of future cash flows reduces the probability that the firm may not meet required
cash flows.
C) Currency risk management increases the expected cash flows to the firm.
D) Management is in a better position to assess firm currency risk than individual investors.
4) Which of the following is cited as a good reason for NOT hedging currency exposures?
A) Shareholders are more capable of diversifying risk than management.
B) Currency risk management through hedging does not increase expected cash flows.
C) Hedging activities are often of greater benefit to management than to shareholders.
D) All of the above are cited as reasons NOT to hedge.
5) A ________ hedge refers to an offsetting operating cash flow such as a payable arising from
the conduct of business.
A) financial
B) natural
C) contractual
D) futures
6) As a generalized rule, only realized foreign exchange losses are deductible for tax purposes.
7) Many MNE s manage foreign exchange exposure centrally, thus gains or losses are always
matched with the country of origin.
8) Hedging, or reducing risk, is the same as adding value or return to the firm.
9) There is considerable question among investors and managers about whether hedging is a
good and necessary tool.
10) The key arguments in opposition to currency hedging such as market efficiency, agency
theory, and diversification do not have financial theory at their core.
11) 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.
12) 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.
13) Shareholders are LESS capable of diversifying currency risk than is the management of the
firm.
14) Hedging can be advantageous to shareholders because management is in a better position
than shareholders to recognize disequilibrium conditions and to take advantage of single
opportunities to enhance firm value through selective hedging.
15) 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.
10.3 Transaction Exposure
1) The stages in the life of a transaction exposure can be broken into three distinct time periods.
The first time period is the time between quoting a price and reaching an actual sale agreement
or contract. The next time period is the time lag between taking an order and actually filling or
delivering it. Finally, the time it takes to get paid after delivering the product. In order, these
stages of transaction exposure may be identified as:
A) backlog, quotation, and billing exposure.
B) billing, backlog, and quotation exposure.
C) quotation, backlog, and billing exposure.
D) quotation, billing, and backlog exposure.
2) 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. The U.S.
firm is at risk today of a loss if:
A) the exchange rate changes to $1.52/£.
B) the exchange rate changes to $1.58/£.
C) the exchange rate doesn’t change.
D) all of the above
3) 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 $1.58/£ the U.S. firm will realize a ________ of ________.
A) loss; $4,500
B) gain; $4,500
C) loss; £4,500
D) gain; £4,500
4) 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 ________.
A) loss; $4,500
B) gain; $4,500
C) loss; £4,500
D) gain; £4,500
5) TRANSACTION exposure measures gains or losses that arise from the settlement of existing
financial obligations whose terms are stated in a foreign currency.
6) Transaction exposure could arise when borrowing or lending funds when repayment is to be
made in the firm’s domestic currency.
10.4 Transaction Exposure Management
1) ________ is NOT a commonly used contractual hedge against foreign exchange transaction
exposure.
A) Forward market hedge
B) Money market hedge
C) Options market hedge
D) All of the above are contractual hedges.
Instruction 10.1:
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 €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
2) Refer to Instruction 10.1. If CVT chooses NOT to hedge their euro payable, the amount they
pay in six months will be:
A) $3,500,000.
B) $3,900,000.
C) €3,000,000.
D) unknown today
3) Refer to Instruction 10.1. If CVT chooses to hedge its transaction exposure in the forward
market, it will ________ €3,000,000 forward at a rate of ________.
A) buy; $1.22
B) buy; $1.25
C) sell; $1.22
D) sell; €1.25
4) 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:
A) $3,000,000.
B) $3,660,000.
C) $3,750,000.
D) $3,810,000.
5) 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 ________.
A) loss; $90,000
B) loss; €90,000
C) gain; $90,000
D) gain; €90,000
6) Refer to Instruction 10.1. CVT would be ________ by an amount equal to ________ with a
forward hedge than if they had NOT hedged and their predicted exchange rate for 6 months had
been correct.
A) better off; $150,000
B) better off; €150,000
C) worse off; $150,000
D) worse off; €150,000
7) Refer to Instruction 10.1. What is the cost of a call option hedge for CVT’s euro receivable
contract? (Note: Calculate the cost in future value dollars and assume the firm’s cost of capital as
the appropriate interest rate for calculating future values.)
A) $57,600
B) $59,904
C) $62,208
D) $63,936
8) Refer to Instruction 10.1. The cost of a put option to CVT would be:
A) $52,500.
B) $55,388.
C) $58,275.
D) There is not enough information to answer this question.
9) When attempting to manage an account payable denominated in a foreign currency, the firm’s
only choice is to remain unhedged.
10) Remaining unhedged is NOT an option when dealing with foreign exchange transaction
exposure.
11) A forward hedge involves a put or call option contract and a source of funds to fulfill that
contract.
12) 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.
13) 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.
14) A firm’s risk tolerance is a combination of management’s philosophy toward transaction
exposure and the specific goals of treasury activities.
15) 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.
16) In efficient markets, interest rate parity should assure that the costs of a forward hedge and
money market hedge should be approximately the same.
17) 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/£.)
10.5 Transaction Exposure Management in Practice
1) ________ are transactions for which there are, at present, no contracts or agreements between
parties.
A) Backlog exposure
B) Quotation exposure
C) Anticipated exposure
D) none of the above
2) According to a survey by Bank of America, the type of foreign exchange risk most often
hedged by firms is:
A) translation exposure.
B) transaction exposure.
C) contingent exposure.
D) economic exposure.
3) The treasury function of most firms, the group typically responsible for transaction exposure
management, is NOT usually considered a profit center.
4) According to the authors, firms that employ proportional hedges increase the percentage of
forward-cover as the maturity of the exposure lengthens.
5) Although rarely acknowledged by the firms themselves, selective hedging is essentially
speculation.
6) There are as many different approaches to foreign exchange transaction exposure management
as there are firms and no real consensus exists regarding the best approach. List and discuss three
different exposures you can hedge and three different types of hedges (for example option
hedges versus non-option hedges).
7) 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.
1) When there is a full forward cover with the spot rate equal to the forward rate all of the
following are true EXCEPT:
A) The hedge is asymmetric.
B) There is no uncovered exposure remaining.
C) The total position is a perfect hedge.
D) The currency hedge ratio is equal to 1.
2) The objective of currency hedging is to eliminate the change in the value of the exposed asset
or cash flow from a change in exchange rates.
3) 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.
4) With the use of forwards, a perfect hedge is possible.
5) With a perfect hedge, there is no uncovered exposure remaining.
6) A hedge constructed using puts foreign currency options would be symmetric.
7) The commonly used 100% forward contract cover is a symmetric hedge.
8) 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.
9) The hedge ratio, β, is an individual exposure’s nominal amount covered by a financial
instrument such as a forward contract or currency option.
10) 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.
11) The various hedging alternatives explored (the forward, money market, and purchase option
hedges) only work to protect the value of the exposed asset at the time of maturity.
12) 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.