Exam 2

Question 1

Law of 1 price

Answer 1

A freely traded asset with no trade restrictions should have same price in foreign and domestic markets

Question 2

Assumptions of 1 Price

Answer 2

• Free Trade/No trade restrictions
• Perfect substitutions of goods and services
• No transaction costs

Question 3

Absolute Purchasing Power Parity

Answer 3

• Exchange rates between countries is the ratio of price levels between those countries
• Based on a basket of goods
• Must have the same or similar basket of essential goods and the goods have similar weights

Question 4

Relative Purchasing Power Parity

Answer 4

The change in ER over a period is the relative change in prices between the two countries over that same period

Question 5

International Fischer Effect

Answer 5

○ Change in foreign currency exchange rates are based on interest rate differentials between countries
○ Spot rates should change in an equal amount and in an opposite direction to the interest rate differential between coutnries

Question 6

Interest Rate Parity

Answer 6

• The interest rate differentials between counties is equal to and inversely related to the differential between the forward and spot exchange rates.
• Interest rates are quoted on an annual basis, and must be changed to the time frame you care about

Question 7

Covered Interest Arbitrage

Answer 7

Created when forward contract exploits interest rate differentials between countries

Question 8

CIA Process

Answer 8

1. Calculate Forward Discount or Premium
2. Calulate Delta IR
3. Determine which rule
4. Calculate Investment returns

Question 9

CIA Rules

Answer 9

1. IF F is premium and F∆IR, Invest in lower IR
2. IF F is discount and -F>∆IR, Invest in Higher IR
3. IF F is discount and -F

Question 10

Transaction Exposure:

Answer 10

The risk of loss arising from the effect of changes in foreign exchange rates on the settlement of a contract which originated prior to the change

Question 11

Sources of Transaction Exposure

Answer 11

○ Commercial Activity - trading of goods and services on account or on credit where price quotes or settlements are required in a foreign country
○ Credit Financing Arrangement - Borrowing or lending in a foreign currency or requiring repayment in a foreign currency
○ Financial Position - Acquiring assets or liabilities that are denominated in a foreign currency

Question 12

Types of Hedging for Transaction Exposure

Answer 12

○ Risk management tool to manage FX exposure
○ Utilizing a position to offset the risk of loss likely to arise from realization of an exposure
○ The risk of loss relating to the FX transaction exposure and the hedging transaction are negatively correlated

Question 13

Translation Exposure

Answer 13

○ The risk exposure to consolidated earnings and capital from changes in exchange rates since translation, all else equal
○ Converting/ restating the financial statements of a subsidiary which is denominated in a foreign currency to the parent’s company reporting currency
§ To produce a set of consolidated financial statements
§ Performance assessment and comparison of subsidiaries.

Question 14

Functional Currencie

Answer 14

is the primary currency used in the entity’s operations or the environment in which it operates

Question 15

Reporting Currency

Answer 15

is the currency in which the financial statements are prepared

Question 16

Current Exchange Rate

Answer 16

is the spot exchange rate at balance sheet reporting date

Question 17

Historical Exchange Rate

Answer 17

Is the spot exchange rate at transaction date

Question 18

Restatement Process:

Answer 18

1. Determine the functional currency
   2. Convert financial statements from functional currency to reporting currency
   3. Record gains and losses on the translation o currencies

Question 19

Methods of restatement - Income Statement

Answer 19

○ Revenues and expenses - Spot rate @ incurrence or weighted average rate
○ Gains/Losses - Spot Rate @ incurrence or weighted average rate
○ Difference - None

Question 20

• Methods of restatement - Balance Sheet

Answer 20

○ Monetary Assets - Spot rate at the balance sheet date
○ Nonmonetary assets - Spot rate at the balance sheet date
○ Liabilities - Spot rate at the balance sheet date
○ Equity - Historical cost
○ Difference - included in other comprehensive income

Question 21

Balance sheet hedge

Answer 21

requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet
§ Net translation exposure will be zero
§ Cost of balance sheet hedge depends on relative borrowing costs
§ Are a compromise in which the denomination of balance sheet accounts is altered, sometimes at a cost in terms of interest expense or operating efficiency, to achieve some degree of foreign exchange protection.

Question 22

Operating Exposure

Answer 22

• The sensitivity and impact on firm value resulting from unexpected changes in foreign exchange rates

Question 23

General Process to Calculate Operating exposure decisions

Answer 23

• Calculate the Value of the firm in USD at the current ER
  
  • Calculate the value of the firm in USD at the “new” ER
  • Calculate the operating loss or gain

Question 24

NOPAT

Answer 24

EBIT x (1-t)

Question 25

OCF

Answer 25

NOPAT + Depreciation

Question 26

Matching cash flows

Answer 26

○ Match CF, same amount, same currency, for same period of time
○ MM or balance sheet hedge

Question 27

Risk-Sharing Agreements

Answer 27

○ Both parties agree to share their foreign exchange gains and losses

Question 28

Back-to-Back loans

Answer 28

MNE in different countries borrow from each other in their respective currencies.

Question 29

Currency Swap

Answer 29

MNEs in different countries exchange cash flows in their respective currencies.

Question 30

Contractual hedge

Answer 30

MNEs can utilize currency options to manage their operating exposure.