Class 6

Question 1

Currencies with higher interest rates tend to trade at a discount or at a premium in forward contracts relative to those with lower rates?

Answer 1

Discount

Question 2

When does the FX trade at a premium or discount

Answer 2

If forward rate is higher than the spot rate it is at a premium
If forward is lower than the spot rate is at a discount

Question 3

What is transaction exposure

Answer 3

It is the risk a company faces in fluctuation in FX rate between the time the transaction is initiated and settled.

Question 4

What types of businesses are at risk of transaction exposure

Answer 4

The international ones since they deal with FX rates

Question 5

What is foreign currency denominated transactions

Answer 5

Exposure that exists if a company has accounts payable or receivable in a foreign currency

Question 6

What does timing have to do with transaction exposure

Answer 6

The risk/exposure comes because there exists a time lag between the initiation date and the settlement date

Question 7

What effect on cash flows does the transaction exposure have

Answer 7

Gains and losses due to this transaction exposure directly play on a company’s cash flow and earnings

Question 8

What are the 3 ways to hedge against future cash flows?

Answer 8

1) futures
2) options
3) natural hedge

Question 9

How can options hedge cash flows?

Answer 9

It allows you to purchase options to buy or sell currency at a set rate, meaning if it is in the money then you can exercise your option

Question 10

What is natural heding?

Answer 10

It is where you match payables and receivables in the same foreign country to offset the gains or losses.

Question 11

Why do companies hedge FX if they are publicly traded

Answer 11

Because their stock is based off of financial performance therefore they will need to eventually foreign currency back into the currency they report in which is the number that will be included in the financial performance of the company.

Question 12

Name some pros of hedging

Answer 12

-Help solidify cash flow predictability which makes your company more predictable in terms of borrowing more money and so on
-Provides protection against random events

Question 13

Name some cons of hedging?

Answer 13

-Can be costly
-Counterparty risk (ex: bank goes bankrupt)
-Limits upside gains
-Operations exposure (impact longterm vision)