6 Foreign Exchange & Derivatives

Question 1

What is cross currency rate?

Answer 1

When the exchange rate between two currencies is not available, a common currency is used.

Question 2

How is cross rate currency calculated?

Answer 2

(Currency A / Currency B) x (Currency B / Currency C) = Currency A / Currency C

Question 3

What is the dominant exchange rate system in use among the world’s largest economies?

Answer 3

The managed float exchange rate system

Question 4

What are the three trade-related factors that affect currency exchange rates?

Answer 4

1. relative inflation rates
2. relative income levels
3. government intervention

Question 5

What are the two financial factors that affect currency exchange rates?

Answer 5

1. relative interest rates

2. ease of capital flow

Question 6

What happens when the rate of inflation in a foreign country rises relative to the rate of inflation in a domestic country?

Answer 6

The products of the foreign country become relatively expensive and the demand for that country’s currency falls

Question 7

What are trade barriers?

Answer 7

Trade barriers decrease imports of foreign goods and increase demand for domestic goods. Thus, the domestic currency appreciates without hurting domestic producers. However, trade barriers hurt consumers because consumers pay more for goods and ultimately have access to less diverse goods.

Question 8

What are currency controls?

Answer 8

Currency controls limit exchange rate volatility by restricting the use of foreign currency or using a fixed exchange rate. As more people purchase the domestic currency, it appreciates against the foreign currency.

Question 9

What does the direct relationship between real interest rate and the currency value mean?

Answer 9

When the real interest rate increases, the currency value appreciates. When the real interest rate decreases the currency value depreciates.

Question 10

What is spot rate?

Answer 10

The number of units of a foreign currency that can be received today (“on the spot”) in exchange for a single unit of domestic currency.

Question 11

What is the forward rate?

Answer 11

The number of units of a foreign currency that can be received in exchange for a single unit of the domestic currency at some definite rate in the future.

Question 12

What is forward premium?

Answer 12

When the exchange rate for the domestic currency is higher in relation to a foreign currency in the forward market than in the spot market. The domestic currency is trading at a forward premium in relation to the foreign currency.

Question 13

What is forward discount?

Answer 13

When the exchange rate for the domestic currency is lower in relation to a foreign currency in the forward market than in the spot market. The domestic currency is trading at a forward discount in relation to the foreign currency.

Question 14

What does it mean when an entity has a long position in an asset?

Answer 14

Whenever the entity benefits from a rise in the asset’s value. Ex - stock

Question 15

What doe it mean when an entity has a short position in an asset?

Answer 15

When the entity benefits from a value decline. Typically the entity with the short position must borrow the asset from an entity that owns it before the “short sale” occurs. Ex - Fund A borrows a block of stock shares from Fund B, Fund A then sells on the appropriate stock exchange. Fund A is selling short because the fund can replace the borrowed shares later when the share value falls. If the price of the stock decreases, Fund A can repurchase the shares at the lower price and return them to Fund B, making a profit.

Question 16

What is a derivative instrument?

Answer 16

An investment whose value is based on another asset’s value, such as a option to buy shares (call option). The financial definition of a derivative instrument is a transaction in which each party’s gain or loss is derived from some other economic event. Ex - season tickets to a sports team, if the sports team is doing well the tickets to future games can be sold at a higher price. Thus, the value of tickets (derivative instrument) are based on the value of the team’s performance.

Question 17

What is a call option?

Answer 17

It gives the buyer (holder) the right to purchase (the right to call for) the underlying asset (stock, currency, commodity, etc.) at a fixed price on or before the expiration date. An option has an expiration date after which it can no longer be exercised.

Question 18

What is a put option?

Answer 18

It gives the buyer (holder) the right to sell (the right to put onto the market) the underlying asset (stock, currency, commodity, etc.) at a fixed price on or before the expiration date.

Question 19

What is an option premium?

Answer 19

The price or value of the option. Holders pay the option premium to acquire the right.

Question 20

What are the two best-known models for valuing options?

Answer 20

Black-Scholes formula and the binomial method

Question 21

What does it mean when an option is “in-the-money”?

Answer 21

A call option is “in-the-money” if, for example the price of the underlying is $20 an the strike price is less than $20.

Question 22

What is the strike price?

Answer 22

The exercise price at which the holder can purchase the (call option) or sell (put option) the underlying asset in the option contract.

Question 23

What is the intrinsic value of an option?

Answer 23

The value of the option today if it is exercised today. If the intrinsic value of an option is zero, it does not mean the market value of the option is zero because the value of an option includes the time value of money, interest rates, and market volatility in addition to the intrinsic value. Often, options trade at prices above their intrinsic value. Intrinsic value cannot be negative.

Question 24

What is the intrinsic value of a call option?

Answer 24

The amount by which the exercise price is less than the current price of the underlying. If the option has a positive intrinsic value, its in-the-money. Ex - An investor holds call options for 200 shares of stock with an exercise price of $48 per share. The share is currently trading at $50 per share. The investor’s options have an intrinsic value of $2 = $50-48.

Question 25

When is a call option out-of-the-money?

Answer 25

When the intrinsic value is $0. Ex - An investor holds call options for 200 shares of stock with an exercise price of $48. The stock is currently trading at $45 per share. The investor’s options are out-of-the-money. They have no intrinsic value.

Question 26

What is the intrinsic value of a put option?

Answer 26

The amount by which the exercise price is greater than the current price of the underlying. If an option has a positive intrinsic value it’s in-the-money. Ex - An investor holds options for 200 shares of stock with an exercise price of $48 per share. The stock is currently trading at $45 per share. The Investor’s options have an intrinsic value of $3 = $48-45. If an option has an intrinsic value of $0, it’s out-of-the-money.

Question 27

When is a put option out-of-the-money?

Answer 27

When the option has an intrinsic value of $0. Ex - An investor holds put options for 200 shares of stock with an exercise price of $48 per share. The stock is currently trading at $50 per share. The Investor’s options are out-of-the-money. They have no intrinsic value.

Question 28

What is a forward contract?

Answer 28

Two parties agree that, at a set future date, one of them will perform and the other will pay a specified amount for the performance. These are not standardized contracts. Ex - A retailer and a wholesaler agree in September on the prices and quantities of merchandise to be shipped to the retailer’s stores in time for their winter holiday season. The retailer has locked in a price and source of supply, and the wholesaler has locked in a price and a customer. Forward contracts are frequently used in transactions to exchange foreign currencies. Forward contracts are negotiated individually between the parties on a one-by-one basis.

Question 29

What is a futures contract?

Answer 29

A commitment to buy or sell an asset at a fixed price during a specific future period. In contrast with a forward contract, the counterparty to a futures contract is unknown. In contract with an options contract, a futures contract is a commitment not a choice. Futures contracts are standardized forward contracts with predetermined quantities and dates. These standardized contracts are traded actively on future exchanges. Futures contracts are essentially commodities that are traded on an exchange, making them available to more parties.

Question 30

What is an on option contract?

Answer 30

A listed option is a standardized legal contract that requires two parties to comply with its terms. A party who buys the option has bought the right to demand that the counterparty (the seller or writer of the option) buy or sell an underlying asset on or before a specified future date. The buyer holds all of the rights, and the seller has all of the obligations. The buyer pays a fee to be able to determine whether the seller buys (or sells) the underlying asset from (or to) the buyer.

Question 31

What is a market-to-market provision?

Answer 31

A provision that minimizes a futures contract’s chance of default because profits and losses on the contracts must be received or paid each day through a clearinghouse. In futures contracts the market price is posted and netted to each person’s account at the close of every business day. Each party’s gains or losses are tallied in its brokerage account. If significant losses are incurred in the brokerage account, the broker requires the funds be added to the brokerage account.

Question 32

What is a margin account?

Answer 32

A brokerage account in which the investor borrows money (obtains credit) from a broker to purchase securities, such as derivative instruments. The broker charges interest on the credit provided.

Question 33

What is a margin requirement?

Answer 33

A margin requirement, which is set by the Federal Reserve Board’s Regulation T, is the minimum down payment that the purchasers of securities must deposit in the margin account.

Question 34

What is a margin call?

Answer 34

When a margin account falls below the margin requirement, the broker informs the investor to add funds to the account.

Question 35

What is one of the biggest financial risks firms face in the global economy?

Answer 35

currency exchange rate risk

Question 36

What is transaction exposure in currency exchange risk?

Answer 36

The exposure to fluctuations in exchange rates between the date a transaction is entered into and the settlement date.

Question 37

What is economic exposure in currency exchange risk?

Answer 37

The exposure to fluctuations in exchange rates resulting from overall economic conditions.

Question 38

What is translation exposure in currency exchange risk?

Answer 38

The exposure to fluctuations in exchange rates between the date the transaction is entered into and the date that financial statements denominated in another currency must be reported. The risk that a foreign subsidiary’s balance sheet items and results of operations, denominated in a currency different from the parent’s, will change as a result of exchange rate fluctuations.

Question 39

How do firms address transaction exposure?

Answer 39

1. estimate its net cash flows in each currency for affected transactions. If inflows and outflows in a given currency are nearly equal, transaction exposure is minimal, even if the currency itself is volatile.
2. measure the potential effect of exposure in each currency. A range of possible rates for each currency must be estimated, reflecting that currency’s volatility.
3. use hedging methods to mitigate exposure to exchange rate fluctuations.

Question 40

What happens when a firm hedges in response to transaction exposure when a debtor is to pay a foreign currency?

Answer 40

When hedging, some amount of possible gain is foregone to protect against potential loss. When a debtor is to pay a foreign currency amount at some time in the future, the risk is that the foreign currency will appreciate. If the foreign currency appreciates, more domestic currency is required to pay the debt. The hedge is to purchase the foreign currency forward to fix a definite price.

Question 41

What happens when a firm hedges in response to transaction exposure when a creditor is to receive a foreign currency?

Answer 41

When hedging, some amount of possible gain is forgone to protect against potential loss. When a creditor is to receive a foreign currency amount at tome time in the future, the risk is that the foreign currency will depreciate. If the foreign currency depreciates, the creditor receives less domestic currency in the conversion. The hedge is to sell the foreign currency forward to fix a definite price.

Question 42

What are the most common methods for addressing transaction exposure?

Answer 42

1. money market hedges
2. forward contracts
3. futures contracts
4. currency options

Question 43

What are the two approaches to estimate the degree economic exposure?

Answer 43

1. sensitivity of earnings - the entity prepares a proforma income statement for operations in each country
2. sensitivity of cash flows - the entity performs a regression analysis, weighting each net cash flow by the amount of that currency in the firm’s portfolio

Question 44

How is economic exposure estimated?

Answer 44

1. estimating the degree of exposure by one of the two approaches, sensitivity of earnings or sensitivity of cash flows
2. performing a sensitivity analysis, in which the entity constructs multiple scenarios using various estimated exchange rates and determines the ultimate effect of each scenario on accrual-basis earnings or cash flows.

Question 45

A high level of economic exposure may require the entity to do what?

Answer 45

restructure the entity’s operations

Question 46

When an entity relies on sales to foreign customers, what actions are taken due to foreign currency?

Answer 46

When foreign currency inflows are greater, the entity reduces foreign sales. When foreign currency outflows are greater they increase foreign sales.

Question 47

When an entity relies on purchases from foreign suppliers, what actions are taken due to foreign currency?

Answer 47

When foreign currency inflows are greater the entity increases foreign orders. When foreign currency outflows are greater the entity reduces foreign orders.

Question 48

What are the three factors that determine a firm’s degree of translation exposure?

Answer 48

1. proportion of total business conducted by foreign subsidiaries - a firm with half of its revenues derived from overseas subsidiaries has a high degree of exposure to translation risk. A 100% domestic firm has none.
2. locations of foreign subsidiaries - a firm with a subsidiary in a country with a volatile currency has more translation risk than a firm with a subsidiary in a country with a stable currency.
3. applicable accounting method - This can be either a cash flow hedge or fair value.