Financial Risk Management Part 2 Flashcards
Freely fluctuating exchange rates perform which function?
They automatically correct a lack of equilibrium in the balance of payments.
The balance of payments has two major components: the current account (which is
basically imports and exports) and the capital account (which is basically investments in this country and foreign countries). The two components generally offset each other (for the most part). Freely fluctuating exchange rates will impact both of these components because the price of the currencies will fluctuate. What the examiners appear to be saying is that freely fluctuating exchange rates will affect the two components in opposite directions. Assume dollars and euros. If dollars are or become cheaper, imports will be more expensive and exports will be less expense. This condition will reduce imports and increase exports, thereby worsening the current component of the balance of payments. However, if dollars are cheaper, investments in the US will be less expensive. Thus, those in the euro zone will be able to come into the US and buy investments at a good price for them. When they do that, the capital
account balance will move in the opposite direction from the current account balance.
In evaluating the impact of relative inflation rates on the demand for a foreign currency,
which of the following is true?
A. Inflation is irrelevant to currency demand.
B. As inflation associated with a foreign economy increases in relation to a domestic
economy, demand for the foreign currency falls.
C. As inflation associated with a foreign economy increases in relation to a domestic
economy, demand for the foreign currency increases.
D. As inflation associated with a foreign economy decreases in relation to a
domestic economy, demand for the foreign currency falls.
Choice “B” is correct. Inflation in a foreign currency reduces the purchasing power of the foreign currency, which means that there is less demand for the foreign currency and more demand for the domestic currency, which has higher purchasing power due
to lower inflation.
True or False
Inflation, along with interest rates and trade restrictions are significant determinants of exchange rates.
TRUE
An importing partnership has experienced a dramatic surge in its exporting business and is looking for ways to minimize its risks from foreign currency fluctuations. The partnership’s imports and exports to European Union countries are at similar levels. Which of the following methods most effectively minimizes risk?
A. Purchase futures of the currency in which the payables will be paid.
B. Hold payables and receivables due in the same currency and amount.
C. Enter into an interest rate swap to mitigate the effects of exchange rate
fluctuations.
D. Conduct all foreign transactions in U.S. dollars
Choice “B” is correct. This strategy can be loosely viewed as currency diversification.
Even though there is a time difference between transaction initiation and settlement, this strategy is (of the choices given) the most effective way to mitigate foreign currency exposure on import and export transactions
Each of the following statements is correct regarding the impact of exchange rates on operations, except:
A. A real depreciation of the domestic currency results in higher prices for imported
goods.
B. A real depreciation of the domestic currency lowers the price for domestic goods
relative to foreign goods.
C. A real appreciation of domestic currency raises the price of domestic goods
relative to foreign goods.
D. A real appreciation of domestic currency hurts domestic importers and
consumers because imported goods cost more.
THIS ANSWER APPEARS TO BE WRONG. EMAIL BECKER
**Choice “D” is correct. When the domestic currency appreciates (relative to the foreign currency), the domestic currency becomes more expensive relative to the foreign currency. **
Exports become more expensive to purchasers overseas, which means
outflows decline. Imports become less expensive, which means inflows increase.
One euro will buy U.S. $1.48, and a British pound will buy U.S. $2.06. What is the cross rate of euros per pound?
A. 0.72
B. 1.39
C. 1.48
D. 2.06
Choice “B” is correct. The cross rate is the exchange rate between two currencies
derived by using two exchange rate quotes that have a common currency. If U.S. $1.48
converts into one euro, and U.S. $2.06 converts into one British pound, the cross rate of euros per pound is equal to 2.06 / 1.48 = 1.39 euros per pound.
This can also be looked at by stating both foreign currencies per U.S. $1.
$1.48 per one euro = $1 per 0.6756 euro.
$2.06 per one BP = $1 per 0.4854 BP
0.6756 / 0.4854 = 1.39.
What is the cross rate of currency A per currency B? (What’s the formula?)
1 unit of Currency B (in dollars) divided 1 unit of current
OR
$1 worth of currency B / $1 worth of currency A
When is it advisable to invest in an emerging market (foreign) investment that has a lower rate of return than the domestic alternative?
When management expects the US dollar to decline in relation to the foreign location’s currency.
Atlas Worldwide Industries conducts business in a number of different countries and is trying to evaluate its economic exposure to exchange rate risk. Which of the following statements is NOT correct?
A. Atlas will suffer an economic loss in the event it has net cash outflows of a
foreign currency and the foreign currency appreciates.
B. Atlas will enjoy an economic gain in the event it has net cash outflows of a
foreign currency and the foreign currency depreciates.
C. Atlas will suffer an economic loss in the event it has net cash inflows of a foreign
currency and the foreign currency appreciates.
D. Atlas will suffer an economic loss in the event it has net cash inflows of a foreign
currency and the foreign currency depreciates.
Choice “C” is correct. This is an incorrect statement. Atlas will certainly not suffer a loss in the event it has net cash inflows of a foreign currency and the foreign currency
appreciates. It will, in fact, benefit from an economic gain. Refer to the “net inflows”
column of the “Foreign Currency” section on the chart above and compare it to the line item for foreign currency appreciation. Note that when the foreign currency
appreciates, the domestic currency depreciates.
In evaluating economic exposure to exchange rate risk.
Explain the foreign currency inflow/outflow table (when foreign and domestic currencies depreciate/appreciate what happens to inflows/outflows)?
IF
Foreign currency: Depreciates OR Domestic Currency: Appreciates.
THEN
Net inflow: LOSS & Net outflow: GAIN
IF
Foreign currency: Appreciates OR Domestic Currency: Depreciates
THEN
Net inflow: GAIN & Net outflow: LOSS
___________________ is defined as the potential that an organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in exchange rates.
Transaction Exposure
________________ is defined as the potential that the present value of an organizations cash flows could increase/decrease if the exchange rate changes.
Economic Exposure
__________________ is the risk that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change due to fluctuations in the exchange rate.
Translation Exposure
Which of the following exchange rate exposures can affect a corporation that imports/exports, but has no foreign investment or subsidiary?
-Translation
-Transaction
-Economic
Transaction and Economic
Econ due to domestic expenses paid with import revenue in foreign currency.
Transaction due to settlement of export transactions.
When a foreign competitor’s currency becomes weaker compared to US dollar, what happens to them in the US market?
ADVANTAGE -
The foreign company has an advantage in the US market. When the foreign curerncy gets weaker, their products become cheaper to US consumers. This increases demand in their product.
