Chap027.pdf

Chapter 27 - Managing International Risks

Chapter 27 Managing International Risks Multiple Choice Questions

1. A quotation in the form Yens 119.33/US$ is called: A. An Indirect quotation in USA B. A Direct quotation in USA C. A Cross rate in Japan D. None of the above

2. The most important aspect of international finance is: I) The basic principles of corporate finance do not apply II) The process of foreign exchange valuation of different currencies III) The NPV principle cannot be applied to foreign operations A. I only B. I and III only C. II only D. III only

3. If the direct quotation for the Euro is $1.3565/Euro, what is the indirect quotation? A. 0.2415 B. -1.1655 C. 0.7372 D. None of the above

4. The spot US$/BP exchange rate is US$1.99/BP. What is the indirect quote: [BP = British pound] A. BP 0.65/US$ B. BP 0.5025/US$ C. BP 1.2845/US$ D. None of the above

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5. The spot Yen/US dollar exchange rate is 119.795 Yen/US$. The 3-month forward rate is 118.397 Yen/US$. What is Yen's forward premium (or discount) on the dollar, expressed as annual percent rate? A. 6.5% discount B. 4.7% premium C. 14% discount D. none of the above

6. The spot Peso/US$ exchange rate is US$10.9892/US$. The 3-month forward rate is US$11.0408/US$. What is Peso's forward premium (or discount) on the US dollar, expressed as an annual rate? (approximately) A. 0.83% premium B. 1.9% discount C. 2.1% premium D. None of the above

7. The spot US$/Euro exchange rate is US$1.3549/US$. The 3-month forward rate is US$1.3595/Euro. What is Euro's forward premium (or discount) on the US dollar, expressed as annual rate? (approximately) A. 0.83% premium B. 1.9% discount C. 1.4% premium D. None of the above

8. A currency forward contract is described by: A. Agreeing today to buy or sell specified amount of a currency at a later date at a price set in the future B. Agreeing today to buy or sell specified amount of a currency today at its current price C. Agreeing today to buy or sell specified amount of a currency at a later date at a price set today D. None of the above

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9. Which of the following statement(s) about currency forward market is (are) true? I) In the forward market you buy or sell currency for future delivery at a rate set today. II) A forward market transaction is a made-to-measure transaction. III) Most forward transactions are for six months or less. A. I only B. I and II only C. II and III only D. I, II and III

10. An organized market for currency for future delivery that is traded on an exchange is called: A. Spot market B. Forward market C. Futures market D. Options market

11. Which of the following statement(s) about currency futures market is (are) true? I) the futures contracts are highly standardized. II) the futures contacts are made-to-measure contracts. III) the futures contracts are for specified amounts and for a limited choice of delivery dates. A. I only B. II only C. I and III only D. I, II and III

12. The spot Yen/US$ exchange rate is Yen119.795/US$ and the one year forward rate is Yen114.571/US$. If the annual interest rate on dollar CDs is 6%, what would you expect the annual interest rate to be on Yen CDs? A. 1.38% B. 5.3% C. 8.0% D. 17.14%

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13. The spot BP/$ exchange rate is 0.5025/$ and the one-year forward rate is BP 0.5048/$. If the annual interest rate on dollar CDs is 6%, what would you expect the annual interest to be on BP CDs? A. 5.52% B. 6.49% C. 3.55% D. 8.25%

14. The spot exchange rate for British pounds is 0.5025 (BP/US$). The 180-day risk-free rates in the US and Britain are 3% and 2.75%, respectively. What is the forward exchange rate in BP/US$? (Assume that the interest rates are for 180-days.) A. 0.6170 B. 0.5037 C. 0.5013 D. none of the above

15. The expectations theory of forward rates implies that: A. The forward rate is determined by government's expectations B. On average, the forward rate is equal to the future spot rate C. The forward rate is determined by expectations of the future spot interest rate D. The forward rate is equal to the future spot rate

16. The Mexican economy is predicted to average double digit inflation over the next two years of 10% per annum. The inflation forecast for the US is 4% per annum. If the current exchange rate is $0.091/peso, what will be the exchange rate two years from now? A. $0.0831 B. $0.08134 C. $0.1018 D. none of the above

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17. If a Big Mac costs $2.31 in the USA and in Japan 250 Yens, according to PPP, what is the implied exchange rate in Yens/US$? A. 106 B. 108.225 C. 119.795 D. None of the above

18. If a Big Mac costs C$3.00 in Canada and $2.31 in the USA, according to purchasing power parity, what is the implied exchange rate in C$/US$? A. 1.3793 B. 0.725 C. 1.3276 D. None of the above

19. Assume that both the law of one price and the expectations theory of forward rates hold. The spot rate for the Ruritanean doubloon is 0.455 doubloon/$, and the one-year forward rate is 0.476 doubloon/$. Suppose that next year's forecasted rate of inflation in Ruritania is now revised upward by 10%. How does this affect exchange rates? A. The current spot rate changes to 0.50 doubloon/$ B. The forward rate changes to 0.524 doubloon/$ C. Next year's expected spot rate changes to 0.501 doubloon/$ D. The forward rate changes to 0.501 doubloon/$

20. Assume that international capital markets are competitive and that the real interest rates are the same. The one-year interest rate is approximately 9% in the USA and 5% in Switzerland. If the expected inflation rate is 6% in the USA, what is the expected inflation rate in Switzerland? (Approximately) A. 16% B. 10% C. 2.1% D. None of the above

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21. Spot rate = BP 0.5024/US$; 3-month forward rate = BP 0.5040/US$. TE Company is expecting a payment of BP 100 million in 3 months. If the firm hedges this transaction in forward market what is the US$ amount it will receive in three months? (Ignore transaction costs) A. US$198.41 million B. US$199.04 million C. US $50.40 million D. None of the above

22. The spot rate = US$0.8543/A$; the one year forward rate = US$0.8475/A$. A US exporter denominates its exports to Australia in A$ and expects to receive A$600,000 in one year. What will the value of these exports in one year in US$ given that the firm executes a forward hedge? (Ignore transaction costs) A. US$508,500 B. US$512,580 C. US$707,965 D. None of the above

23. Suppose that the G Company knows that it must pay ≤7 million for goods that it will receive in Britain. The current exchange rate is $1.99/≤. The risk that the corporate treasurer faces is that: A. The pound exchange rate falls in a month's time to $1.50/≤ B. The pound exchange rate rises in a month's time to $2.10/≤ C. The pound exchange rate does not change from its current position D. The pound exchange rate falls in a month's time to $1.75/≤

24. Currency risk exposure can be categorized as: A. Transactions exposure B. Economic exposure C. Translation exposure D. All of the above

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25. An Australian firm is evaluating a proposal to build a new plant in the US. The expected cash flows in US$ (in millions) are as follows: Year 0, -100; Year 1, 40; Year 2, 50; Year 3, 65. The discount rate in A$ is 10%, while the discount rate in US$ is 12% and the spot rate is US$0.60/A$. Calculate the NPV of the project in US$. A. +36.40 B. -21.84 C. +13.10 D. +21.84

26. An Australian firm is evaluating a proposal to build a new plant in the US. The expected cash flows in US$ (in millions) are as follows: Year 0, -100; Year 1, 40; Year 2, 50; Year 3, 65. The discount rate in A$ is 10%, while the discount rate in US$ is 12% and the spot rate is US$0.85/A$. Calculate the NPV in A$: A. +25.89 B. -21.84 C. +13.10 D. +21.84

27. XJ Company from the USA is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14% and the discount rate in the US$ is 12%. The spot rate is US$1.99/BP. Calculate the NPV of the project in BP: A. +28.69 B. +25.86 C. +42.67 D. None of the above

28. XJ Company from the USA is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14% and the discount rate in the US$ is 12%. The spot rate is US$1.99/BP. Calculate the NPV in US$: A. +25.86 B. +28.69 C. +51.46 D. None of the above

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29. Political risk is defined as: A. Unanticipated changes in exchange rates B. Unanticipated actions by the host government affecting the cash flows of a project C. Unanticipated actions by the World Bank affecting the cash flows of a project D. All of the above

30. Risk associated with unanticipated actions by the host country government or the courts is called: A. Economic risk B. Transaction risk C. Political risk D. None of the above

31. The dollar interest rate is 6%, and the Swiss franc interest rate is 4%. If the required rate of return for a project in Switzerland is 15%, calculate the required rate of return in the US for a similar project: A. 17.2% B. 12.8% C. 15% D. None of the above

32. The beta of a firm in Switzerland is 1.25. The risk-free rate is 4% and market risk premium is 8.4%. Calculate the required rate of return for this firm. A. 10.5% B. 8.4% C. 14.5% D. None of the above

33. The country with the highest score is: A. Luxembourg B. Netherlands C. Finland D. United Kingdom

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34. If a government was to seize the assets of a MNC and not provide adequate compensation to the owners, the government would be following which practice? A. Nationalization B. Expropriation C. Repatriation D. Terrorism

35. Which development in recent years has had the greatest impact on international managers? A. Capital movement B. Demographics C. Political unrest D. Information technology

36. The phrase stronger currency implies a forward premium. Given a Euro - US dollar exchange rate of 1.45, which of the following forward rates shows the strongest dollar? (remember how euros are quoted) A. 1.55 B. 1.65 C. 1.35 D. 1.25

37. If the US dollar interest rate is 4% and the peso interest rate is 7%, what is the likely 1 year forward rate if the spot dollar - peso rate is 11? A. 11.54 B. 11.32 C. 10.68 D. 10.23

True / False Questions

38. In the forward exchange market, currency is traded for future delivery. True False

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39. If the peso is traded at a forward discount relative to U.S, dollar, then the U.S. dollar is also trading at a discount relative to the peso. True False

40. Interest rate parity gives the relationship between forward rate and spot rate in terms of interest rates. True False

41. Purchasing power parity implies that any differences in inflation rates will be offset by a change in the exchange rate. True False

42. Big Mac exchange rate provides official exchange rate quotes for different currencies. True False

43. If the price of a Big Mac in the US is $2.56 and in Japan it is Yens 300, then the implied exchange rate is Yens 117.18/US$. True False

44. In general, the countries with the highest interest rates also had the highest inflation rates. True False

45. The cost of hedging foreign currency risk is the difference between the forward rate and the expected spot rate. True False

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46. The cost of hedging foreign currency risk is the difference between the forward rate and today's spot rate. True False

47. The terms "transaction exposure" and "economic exposure" are two names for the same "foreign exchange risk." True False

48. For estimating the cash flows of a foreign project, there is no need to forecast exchange rates for the life of the project. True False

49. When a firm ignores currency risk and discounts dollar cash flows using dollar cost of capital, it is implicitly assuming that the currency risk is hedged. True False

50. For a project's cost of capital measured in Swiss francs, we use Swiss interest rates and beta with respect to Swiss market. True False

51. The risk that an unfriendly government might expropriate a firm's assets is called political risk. True False

52. Project financing is often designed to reduce a foreign government's incentive to expropriate capital investment. True False

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53. When a currency gets stronger, that forward rate of the currency must have increased against all currencies. True False

54. The strength of a currency is directly related to its interest rates and inflation expectations. True False

Short Answer Questions

55. Briefly explain the foreign exchange market.

56. Briefly explain the different types of currency markets.

57. Briefly explain the concept of interest rate parity.

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58. Briefly explain the expectations theory of forward exchange rates.

59. Briefly explain the concept of purchasing power parity.

60. Briefly explain the term transaction exposure.

61. Briefly explain the term economic exposure.

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62. Briefly explain why no currency forecast is needed when estimating the cash flows from an international project?

63. Briefly show how the cost of capital is calculated for international projects using CAPM (capital asset pricing model).

64. Briefly explain the term political risk.

65. What is wrong with the following news report? "Today the dollar ended the trading session stronger."

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Chapter 27 Managing International Risks Answer Key

Multiple Choice Questions

1. A quotation in the form Yens 119.33/US$ is called: A. An Indirect quotation in USA B. A Direct quotation in USA C. A Cross rate in Japan D. None of the above

Type: Easy

2. The most important aspect of international finance is: I) The basic principles of corporate finance do not apply II) The process of foreign exchange valuation of different currencies III) The NPV principle cannot be applied to foreign operations A. I only B. I and III only C. II only D. III only

Type: Medium

3. If the direct quotation for the Euro is $1.3565/Euro, what is the indirect quotation? A. 0.2415 B. -1.1655 C. 0.7372 D. None of the above Indirect quote = 1/1.3565 = 0.7372

Type: Medium

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4. The spot US$/BP exchange rate is US$1.99/BP. What is the indirect quote: [BP = British pound] A. BP 0.65/US$ B. BP 0.5025/US$ C. BP 1.2845/US$ D. None of the above Spot rate: 1/(1.99) = BP 0.5025/US$

Type: Difficult

5. The spot Yen/US dollar exchange rate is 119.795 Yen/US$. The 3-month forward rate is 118.397 Yen/US$. What is Yen's forward premium (or discount) on the dollar, expressed as annual percent rate? A. 6.5% discount B. 4.7% premium C. 14% discount D. none of the above Forward (premium or discount) = 4[(119.795/118.397) - 1] = + 4.7% = 4.7% premium

Type: Difficult

6. The spot Peso/US$ exchange rate is US$10.9892/US$. The 3-month forward rate is US$11.0408/US$. What is Peso's forward premium (or discount) on the US dollar, expressed as an annual rate? (approximately) A. 0.83% premium B. 1.9% discount C. 2.1% premium D. None of the above Forward (premium or discount) = 4[(10.9892/11.0408) - 1] = -1.9% = 1.9% discount

Type: Difficult

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7. The spot US$/Euro exchange rate is US$1.3549/US$. The 3-month forward rate is US$1.3595/Euro. What is Euro's forward premium (or discount) on the US dollar, expressed as annual rate? (approximately) A. 0.83% premium B. 1.9% discount C. 1.4% premium D. None of the above Forward (premium or discount) = 4[(1.3595/1.3549) - 1] = 1.4% = 1.4% premium

Type: Difficult

8. A currency forward contract is described by: A. Agreeing today to buy or sell specified amount of a currency at a later date at a price set in the future B. Agreeing today to buy or sell specified amount of a currency today at its current price C. Agreeing today to buy or sell specified amount of a currency at a later date at a price set today D. None of the above

Type: Medium

9. Which of the following statement(s) about currency forward market is (are) true? I) In the forward market you buy or sell currency for future delivery at a rate set today. II) A forward market transaction is a made-to-measure transaction. III) Most forward transactions are for six months or less. A. I only B. I and II only C. II and III only D. I, II and III

Type: Medium

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10. An organized market for currency for future delivery that is traded on an exchange is called: A. Spot market B. Forward market C. Futures market D. Options market

Type: Medium

11. Which of the following statement(s) about currency futures market is (are) true? I) the futures contracts are highly standardized. II) the futures contacts are made-to-measure contracts. III) the futures contracts are for specified amounts and for a limited choice of delivery dates. A. I only B. II only C. I and III only D. I, II and III

Type: Medium

12. The spot Yen/US$ exchange rate is Yen119.795/US$ and the one year forward rate is Yen114.571/US$. If the annual interest rate on dollar CDs is 6%, what would you expect the annual interest rate to be on Yen CDs? A. 1.38% B. 5.3% C. 8.0% D. 17.14% 1 + rYen = (114.571/119.795)(1 + rUS$) = 1.01377; rYen = 1.38%

Type: Difficult

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13. The spot BP/$ exchange rate is 0.5025/$ and the one-year forward rate is BP 0.5048/$. If the annual interest rate on dollar CDs is 6%, what would you expect the annual interest to be on BP CDs? A. 5.52% B. 6.49% C. 3.55% D. 8.25% 1 + rBP = (0.5025/0.5048)(1.06) = 1.05517 or rBP = 5.52%

Type: Difficult

14. The spot exchange rate for British pounds is 0.5025 (BP/US$). The 180-day risk-free rates in the US and Britain are 3% and 2.75%, respectively. What is the forward exchange rate in BP/US$? (Assume that the interest rates are for 180-days.) A. 0.6170 B. 0.5037 C. 0.5013 D. none of the above F = (0.5025)(1.03/1.0275) = 0.5037

Type: Difficult

15. The expectations theory of forward rates implies that: A. The forward rate is determined by government's expectations B. On average, the forward rate is equal to the future spot rate C. The forward rate is determined by expectations of the future spot interest rate D. The forward rate is equal to the future spot rate

Type: Medium

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16. The Mexican economy is predicted to average double digit inflation over the next two years of 10% per annum. The inflation forecast for the US is 4% per annum. If the current exchange rate is $0.091/peso, what will be the exchange rate two years from now? A. $0.0831 B. $0.08134 C. $0.1018 D. none of the above E(Spot) = (0.091)[(1.04/1.10)^2] = $0.08134/peso

Type: Difficult

17. If a Big Mac costs $2.31 in the USA and in Japan 250 Yens, according to PPP, what is the implied exchange rate in Yens/US$? A. 106 B. 108.225 C. 119.795 D. None of the above Yen/US$ = 250/2.31 = Yen 108.225/US$

Type: Medium

18. If a Big Mac costs C$3.00 in Canada and $2.31 in the USA, according to purchasing power parity, what is the implied exchange rate in C$/US$? A. 1.3793 B. 0.725 C. 1.3276 D. None of the above C$/US$ = 3/2.31 = 1.2987

Type: Medium

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19. Assume that both the law of one price and the expectations theory of forward rates hold. The spot rate for the Ruritanean doubloon is 0.455 doubloon/$, and the one-year forward rate is 0.476 doubloon/$. Suppose that next year's forecasted rate of inflation in Ruritania is now revised upward by 10%. How does this affect exchange rates? A. The current spot rate changes to 0.50 doubloon/$ B. The forward rate changes to 0.524 doubloon/$ C. Next year's expected spot rate changes to 0.501 doubloon/$ D. The forward rate changes to 0.501 doubloon/$ 0.476(1.1) = 0.524

Type: Medium

20. Assume that international capital markets are competitive and that the real interest rates are the same. The one-year interest rate is approximately 9% in the USA and 5% in Switzerland. If the expected inflation rate is 6% in the USA, what is the expected inflation rate in Switzerland? (Approximately) A. 16% B. 10% C. 2.1% D. None of the above Real interest rate = [1.09/1.06] -1 = 2.83%; Inflation rate = [1.05/1.0283] - 1 = 2.1%

Type: Medium

21. Spot rate = BP 0.5024/US$; 3-month forward rate = BP 0.5040/US$. TE Company is expecting a payment of BP 100 million in 3 months. If the firm hedges this transaction in forward market what is the US$ amount it will receive in three months? (Ignore transaction costs) A. US$198.41 million B. US$199.04 million C. US $50.40 million D. None of the above US$ Amount = 100/0.604 = 198.41

Type: Medium

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22. The spot rate = US$0.8543/A$; the one year forward rate = US$0.8475/A$. A US exporter denominates its exports to Australia in A$ and expects to receive A$600,000 in one year. What will the value of these exports in one year in US$ given that the firm executes a forward hedge? (Ignore transaction costs) A. US$508,500 B. US$512,580 C. US$707,965 D. None of the above A$600,000 * 0.8475 = US $508,500

Type: Medium

23. Suppose that the G Company knows that it must pay ≤7 million for goods that it will receive in Britain. The current exchange rate is $1.99/≤. The risk that the corporate treasurer faces is that: A. The pound exchange rate falls in a month's time to $1.50/≤ B. The pound exchange rate rises in a month's time to $2.10/≤ C. The pound exchange rate does not change from its current position D. The pound exchange rate falls in a month's time to $1.75/≤

Type: Medium

24. Currency risk exposure can be categorized as: A. Transactions exposure B. Economic exposure C. Translation exposure D. All of the above

Type: Medium

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25. An Australian firm is evaluating a proposal to build a new plant in the US. The expected cash flows in US$ (in millions) are as follows: Year 0, -100; Year 1, 40; Year 2, 50; Year 3, 65. The discount rate in A$ is 10%, while the discount rate in US$ is 12% and the spot rate is US$0.60/A$. Calculate the NPV of the project in US$. A. +36.40 B. -21.84 C. +13.10 D. +21.84 NPV = -100 + (40/1.12) + (50/1.12^2) + (65/1.12^3) = + 21.84

Type: Medium

26. An Australian firm is evaluating a proposal to build a new plant in the US. The expected cash flows in US$ (in millions) are as follows: Year 0, -100; Year 1, 40; Year 2, 50; Year 3, 65. The discount rate in A$ is 10%, while the discount rate in US$ is 12% and the spot rate is US$0.85/A$. Calculate the NPV in A$: A. +25.89 B. -21.84 C. +13.10 D. +21.84 21.84/0.85 = 25.89

Type: Medium

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27. XJ Company from the USA is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14% and the discount rate in the US$ is 12%. The spot rate is US$1.99/BP. Calculate the NPV of the project in BP: A. +28.69 B. +25.86 C. +42.67 D. None of the above NPV = -50 + (25/1.14) + (35/1.14^2) + (40/1.14^3) = 25.86

Type: Medium

28. XJ Company from the USA is evaluating a proposal to build a new plant in the United Kingdom. The expected cash flows in pounds are as follows: Year 0, -50; Year 1, 25; Year 2, 35; Year 3, 40. The discount rate in BP is 14% and the discount rate in the US$ is 12%. The spot rate is US$1.99/BP. Calculate the NPV in US$: A. +25.86 B. +28.69 C. +51.46 D. None of the above (25.86)(1.99) = 51.46

Type: Medium

29. Political risk is defined as: A. Unanticipated changes in exchange rates B. Unanticipated actions by the host government affecting the cash flows of a project C. Unanticipated actions by the World Bank affecting the cash flows of a project D. All of the above

Type: Medium

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30. Risk associated with unanticipated actions by the host country government or the courts is called: A. Economic risk B. Transaction risk C. Political risk D. None of the above

Type: Medium

31. The dollar interest rate is 6%, and the Swiss franc interest rate is 4%. If the required rate of return for a project in Switzerland is 15%, calculate the required rate of return in the US for a similar project: A. 17.2% B. 12.8% C. 15% D. None of the above (1 + dollar return) = ((1.15)(1.06))/1.04) = 1.172 = 17.2%

Type: Medium

32. The beta of a firm in Switzerland is 1.25. The risk-free rate is 4% and market risk premium is 8.4%. Calculate the required rate of return for this firm. A. 10.5% B. 8.4% C. 14.5% D. None of the above Required return = 4 + (1.25)(8.4) = 14.5%

Type: Medium

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33. The country with the highest score is: A. Luxembourg B. Netherlands C. Finland D. United Kingdom

Type: Easy

34. If a government was to seize the assets of a MNC and not provide adequate compensation to the owners, the government would be following which practice? A. Nationalization B. Expropriation C. Repatriation D. Terrorism

Type: Medium

35. Which development in recent years has had the greatest impact on international managers? A. Capital movement B. Demographics C. Political unrest D. Information technology

Type: Easy

36. The phrase stronger currency implies a forward premium. Given a Euro - US dollar exchange rate of 1.45, which of the following forward rates shows the strongest dollar? (remember how euros are quoted) A. 1.55 B. 1.65 C. 1.35 D. 1.25

Type: Medium

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37. If the US dollar interest rate is 4% and the peso interest rate is 7%, what is the likely 1 year forward rate if the spot dollar - peso rate is 11? A. 11.54 B. 11.32 C. 10.68 D. 10.23 (1.07/1.04) x 11 = 11.32

Type: Medium

True / False Questions

38. In the forward exchange market, currency is traded for future delivery. TRUE

Type: Medium

39. If the peso is traded at a forward discount relative to U.S, dollar, then the U.S. dollar is also trading at a discount relative to the peso. FALSE

Type: Medium

40. Interest rate parity gives the relationship between forward rate and spot rate in terms of interest rates. TRUE

Type: Medium

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41. Purchasing power parity implies that any differences in inflation rates will be offset by a change in the exchange rate. TRUE

Type: Medium

42. Big Mac exchange rate provides official exchange rate quotes for different currencies. FALSE

Type: Easy

43. If the price of a Big Mac in the US is $2.56 and in Japan it is Yens 300, then the implied exchange rate is Yens 117.18/US$. TRUE

Type: Easy

44. In general, the countries with the highest interest rates also had the highest inflation rates. TRUE

Type: Medium

45. The cost of hedging foreign currency risk is the difference between the forward rate and the expected spot rate. TRUE

Type: Medium

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46. The cost of hedging foreign currency risk is the difference between the forward rate and today's spot rate. FALSE

Type: Medium

47. The terms "transaction exposure" and "economic exposure" are two names for the same "foreign exchange risk." FALSE

Type: Difficult

48. For estimating the cash flows of a foreign project, there is no need to forecast exchange rates for the life of the project. TRUE

Type: Difficult

49. When a firm ignores currency risk and discounts dollar cash flows using dollar cost of capital, it is implicitly assuming that the currency risk is hedged. TRUE

Type: Difficult

50. For a project's cost of capital measured in Swiss francs, we use Swiss interest rates and beta with respect to Swiss market. TRUE

Type: Difficult

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51. The risk that an unfriendly government might expropriate a firm's assets is called political risk. TRUE

Type: Easy

52. Project financing is often designed to reduce a foreign government's incentive to expropriate capital investment. TRUE

Type: Medium

53. When a currency gets stronger, that forward rate of the currency must have increased against all currencies. FALSE

Type: Medium

54. The strength of a currency is directly related to its interest rates and inflation expectations. TRUE

Type: Medium

Short Answer Questions

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55. Briefly explain the foreign exchange market. The foreign exchange market is an over the counter market where the business is conducted electronically. The principal dealers in the foreign exchange market are the large commercial banks and investment banks. A firm that wants to buy or sell currency usually conducts transactions through a commercial bank. London, New York and Tokyo are the largest foreign exchange trading centers.

Type: Medium

56. Briefly explain the different types of currency markets. There are several types of currency markets. A spot market is for trading currencies immediately. Forward markets are used for delivery of a currency at a future date at a price agreed upon today. There are also futures, options, and swaps.

Type: Medium

57. Briefly explain the concept of interest rate parity. Interest rate parity provides the relationship between interest rates in two countries and the differences between the forward and the spot rates. Interest rate parity is ensured through arbitrage. This explains how forward rates are determined in the marketplace. Forward rates serve to determine interest rate parity between two countries, for investors involved in covered interest arbitrage.

Type: Medium

58. Briefly explain the expectations theory of forward exchange rates. The expectations theory of exchange rate states that the forward rate equals the expected future spot rate.

Type: Medium

27-31


59. Briefly explain the concept of purchasing power parity. Purchasing power parity is based on the law of one price. It implies that the expected difference in inflation rates is equals the expected change in the spot rate. [The Economist publishes Big Mac prices in different countries. By implication, the ratio of these prices should provide a guide for exchange rates among currencies of these countries. Of course, the statistical errors associated with these estimations would be very large.]

Type: Medium

60. Briefly explain the term transaction exposure. This is the risk that exchange rate movements would change the amount received or payment to be made in a foreign currency between the time a transaction is contracted and the time it is fulfilled. Transaction exposure can easily be identified and hedged using the forward market, options market or the money market.

Type: Medium

61. Briefly explain the term economic exposure. Economic exposure is the risk that an unexpected change in the exchange rate might change the cash flows from a project and hence the value of the project. The same idea holds good for firms also. This is minimized by diversification.

Type: Medium

27-32


62. Briefly explain why no currency forecast is needed when estimating the cash flows from an international project? If the firm can hedge its foreign currency exposure from the cash flows generated from an international project then there is no need to forecast exchange rates for future cash flows. The project NPV can be calculated using the appropriate discount rate and the NPV in a different currency can be found by converting the NPV using the spot rate. This assumes that there is an active forward market in the currency.

Type: Medium

63. Briefly show how the cost of capital is calculated for international projects using CAPM (capital asset pricing model). Required rate of return = foreign risk-free rate + (beta)(foreign market risk premium). Here beta can be calculated relative to the domestic market. For international projects beta may be calculated using a world market index. The choice depends on how well diversified the investors are.

Type: Medium

64. Briefly explain the term political risk. Political risk is the risk that foreign governments might appropriate a firm's assets at the worst, or change the terms of the contracts agreed upon, because of a change in the government.

Type: Medium

27-33


65. What is wrong with the following news report? "Today the dollar ended the trading session stronger." The phrase is incomplete. The dollar cannot end stronger if we do not know against which currencies. It is likely that the dollar will end the trading day stronger against some currencies and weaker against others. The statement, as presented, needs more detail to be correct.

Type: Medium

27-34

Chap027.pdf

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