Currency Exchange Rate Issues

Question 1

T/F: Entities that engage in international business transactions face current exchange risks that business that only sale domestically don’t face..

Answer 1

TRUE

Question 2

There are three types of foreign currency exchange risk.. what are they?

Answer 2

1) Transaction risk
2) Translation risk
3) Economic risk

Question 3

What is transaction risk?

Answer 3

Possible unfavorable impact from changes in currency exchange rates on a transaction

• Example: Domestic firm enters in a transaction that is dominated in FC. Such transactions result in receivables or payable. Changes in exchange rates will increase or decrease the dollars received or paid.

Question 4

How can a firm mitigate transaction risk?

Answer 4

Matching- incur equal payable and receivables in the same currency for offsetting effects, a loss on one would be offset by a gain in the other

• Leading/Lagging Payment and Collections- Paying obligations or collecting receivables earlier or later otherwise to avoid exchange rate changes.
• Hedging- Using offsetting or contra transactions so that a lesson one would be offset by a gain on the other

Question 5

What is hedging, how is it used?

Answer 5

Hedging is a risk management strategy that involves offsetting contra transactions.

Question 6

What is translation risk?

Answer 6

The possible unfavorable impact on f/s of foreign operations that are covered foreign currency to the domestic currency.

Translation occurs in which the entity prepares F/S in FC and is translated to the dollar.

Question 7

Where is the risk for translation on the B/S?

Answer 7

• Asset values decrease

- Liabilities increase

Question 8

how do you mitigate translation risk?

Answer 8

Reduce amount of assets and liabilities covered using the current exchange rate

create offsetting assets or liabilities so that the gain on one is offset by a loss on the other

Borrow in the FC in an amount approximating the net asset exposure

Question 9

What is economic risk?

Answer 9

Possibility that change in FX rates will alter future revenues and costs. Changes may make future revenues convert to few dollars or expenses convert to more dollars

Such changes may make future sales or purchases in FC not economically feasible.

Mitigate the risk through:

• Distribute productive assets in different countries with different currencies
• shift resources and revenues and expenses to different locations with different currencies

Question 10

What instruments are used to hedge FX risk?

Answer 10

1) Forward contracts (forward exchange contract- contract to buy or sell a specified amount of FC at a specified date and a specified rate)
* They are legal obligations to buy or sell

2) Foreign currency option contract- RIGHT to buy or sell a specified amount, specified time, at a specified rate. It is at the discretion of the buyer or seller. If it goes adverse, they will exercise the contract, they will exercise the contract.