Foreign Currency Exchanges

Question 1

Define “foreign currency risk hedging”.

Answer 1

A risk management strategy that seeks to offset losses resulting from changes in exchange rates between currencies by using contracts, swaps and other instruments which will result in changes counter to (opposite of) changes in the currency exchange rate.

Question 2

Distinguish between a foreign currency exchange contract and a foreign currency option contract.

Answer 2

Under a foreign currency exchange contract, the obligation to buy or sell a foreign currency is firm; the exchange must occur. Under a foreign currency option contract, the party holding the option has the right (option) to buy (call) or sell (put), but does not have to exercise that option; the exchange will occur according to a decision made by the option holder.

Question 3

Define “currency exchange rate risk”.

Answer 3

The risk of loss or other unfavorable outcome that results from changes in exchange rates between currencies.

Question 4

Define “translation risk” as it relates to currency exchange rates.

Answer 4

The possible unfavorable impact of changes in currency exchange rates on the financial statements of an entity when those statements are converted from one currency to another currency. Exchange rates may change so that domestic (dollar) values of financial statement items are adversely impacted.

Question 5

Define “economic risk” as it relates to currency exchange rates.

Answer 5

The possible unfavorable impact of change in currency exchange rates on a firm’s future international earning power. Exchange rates may change so that future revenue, costs and prices are adversely impacted.

Question 6

Define “transaction risk” as it relates to currency exchange rates.

Answer 6

The possible unfavorable impact of changes in currency exchange rates on transactions denominated in a foreign currency. Exchange rates may change so that transactions to be settled in a foreign currency result in receiving fewer dollars or paying more dollars to settle.

Question 7

Define “foreign currency forward exchange contract”.

Answer 7

Agreement to buy or sell a specified amount of a foreign currency at a specified future date at a specified (forward) rate.

Question 8

Identify the three specific kinds of risk associated with changes in currency exchange rates.

Answer 8

Kinds of risk associated with changes in currency exchange rates:
Transaction risk;
Translation risk;
Economic risk.