IFM questions

Question 1

How do we compute cross rates?

Answer 1

Question 2

Forward rates

Answer 2

A forward rate is a contractual agreement between two parties to exchange a specific amount of one currency for another at a predetermined exchange rate, called the forward exchange rate, at a specific future date. Forward rates are primarily used by businesses and investors to hedge against fluctuations in exchange rates, which can impact their profits or the value of their investments.

Question 3

A contractual agreement between two parties to exchange a specific amount of one currency for another at a predetermined exchange rate, at a specific future date. Are primarily used by businesses and investors to hedge against fluctuations in exchange rates, which can impact their profits or the value of their investments.

Answer 3

Forward rates

Question 4

Covered Intrest Parity(CIP)

Answer 4

CIP is a financial theory that establishes a relationship between spot exchange rates, forward exchange rates, and nominal interest rates of two countries. It states that the difference between the interest rates of two countries should be equal to the percentage difference between the forward exchange rate and the spot exchange rate, assuming no arbitrage opportunities.

Question 5

A financial theory that establishes a relationship between spot exchange rates, forward exchange rates, and nominal interest rates of two countries. It states that the difference between the interest rates of two countries should be equal to the percentage difference between the forward exchange rate and the spot exchange rate, assuming no arbitrage opportunities.

Answer 5

Covered Intrest Parity (CIP)

Question 6

Uncovered Intrest Parity (UIP)

Answer 6

UIP is a hypothesis that states that the expected change in the exchange rate between two countries is equal to the difference in their nominal interest rates. In other words, it suggests that investors should expect to earn the same return when investing in two different currencies, after accounting for the expected change in the exchange rate.

Question 7

A hypothesis that states that the expected change in the exchange rate between two countries is equal to the difference in their nominal interest rates. In other words, it suggests that investors should expect to earn the same return when investing in two different currencies, after accounting for the expected change in the exchange rate.

Answer 7

Uncovered Intrest Parity (UIP)

Question 8

Continuously Compounded

Answer 8

Interest is calculated and added to the principal continuously, at every instant.

Question 9

Interest is calculated and added at every instant

Answer 9

Continuously Compounded

Question 10

Discretely compounded

Answer 10

Interest is calculated and added to the principal at specific intervals (e.g., annually, semi-annually, quarterly, or monthly)

Question 11

Interest is calculated and added to the principal at specific intervals (e.g., annually, semi-annually, quarterly, or monthly)

Answer 11

Discretely compounded

Question 12

Real interest rates

Answer 12

Real interest rates are interest rates that have been adjusted for inflation. They represent the actual purchasing power of the money you earn or pay on an investment or loan, accounting for changes in the general price level over time. Real interest rates provide a clearer picture of the true cost of borrowing or the real return on investment, as they factor in the erosion of purchasing power due to inflation.

Question 13

Rates are interest rates that have been adjusted for inflation. They represent the actual purchasing power of the money you earn or pay on an investment or loan, accounting for changes in the general price level over time. Provides a clearer picture of the true cost of borrowing or the real return on investment, as they factor in the erosion of purchasing power due to inflation.

Answer 13

Real interest rates

Question 14

Nominal exchange rates

Answer 14

Nominal exchange rates are the market rates we observe. It is the price of one currency in terms of another

Question 15

The market rates we observe. It is the price of one currency in terms of another.

Answer 15

Nominal exchange rates

Question 16

Measures the cost of foreign goods relative to domestic goods at the current market exchange rate

Answer 16

Real exchange rates

Question 17

Real exchange rates

Answer 17

Real exchange rates measures the cost of foreign goods relative to domestic goods at the current market exchange rate

Question 18

Uncovered carry trade’

Answer 18

Uncovered carry trade is an investment strategy in the foreign exchange market where an investor borrows a low-interest-rate currency to finance the purchase of a higher-interest-rate currency, aiming to profit from the difference in interest rates between the two currencies. This strategy is called “uncovered” because the investor does not hedge their foreign exchange risk using forward contracts or other derivatives, thus exposing themselves to potential exchange rate fluctuations.The main risk associated with the uncovered carry trade strategy is exchange rate risk. If the exchange rate between the two currencies moves unfavorably, it can erase the interest rate differential profit or even result in losses. Additionally, investors should also consider other risks, such as changes in interest rates, political and economic factors in the countries involved, and liquidity risk in the forex market.Uncovered carry trade can be a profitable strategy when exchange rate movements are favorable or relatively stable. However, it’s essential for investors to understand and manage the associated risks, as adverse exchange rate movements can lead to significant losses.

Question 19

An investment strategy in the foreign exchange market where an investor borrows a low-interest-rate currency to finance the purchase of a higher-interest-rate currency, aiming to profit from the difference in interest rates between the two currencies.The main risk associated with the strategy is exchange rate risk. If the exchange rate between the two currencies moves unfavorably, it can erase the interest rate differential profit or even result in losses. Additionally, investors should also consider other risks, such as changes in interest rates, political and economic factors in the countries involved, and liquidity risk in the forex market.Can be a profitable strategy when exchange rate movements are favorable or relatively stable. However, it’s essential for investors to understand and manage the associated risks, as adverse exchange rate movements can lead to significant losses.

Answer 19

Uncovered carry trade

Question 20

How do you do an uncovered carry trade strategy

Answer 20

• Borrow a low-interest-rate currency: The investor borrows a certain amount of a currency with a relatively low-interest rate, typically from a country with stable monetary policy and low inflation.* Convert to a high-interest-rate currency: The investor then converts the borrowed currency into a higher-interest-rate currency, typically from a country with higher inflation and/or higher growth prospects.* Invest in high-interest-rate currency assets: The investor uses the converted currency to invest in assets that pay interest, such as government bonds or bank deposits, in the higher-interest-rate currency.* Earn interest rate differential: The investor earns a return from the difference between the interest rates of the two currencies, assuming the exchange rate remains stable or moves in their favor.* Repay the borrowed currency: At the end of the investment period, the investor converts the higher- interest-rate currency back into the borrowed currency, repays the loan, and retains any profit from the interest rate differential.

Question 21

What is this?* Borrow a low-interest-rate currency: The investor borrows a certain amount of a currency with a relatively low-interest rate, typically from a country with stable monetary policy and low inflation.* Convert to a high-interest-rate currency: The investor then converts the borrowed currency into a higher-interest-rate currency, typically from a country with higher inflation and/or higher growth prospects.* Invest in high-interest-rate currency assets: The investor uses the converted currency to invest in assets that pay interest, such as government bonds or bank deposits, in the higher-interest-rate currency.* Earn interest rate differential: The investor earns a return from the difference between the interest rates of the two currencies, assuming the exchange rate remains stable or moves in their favor.* Repay the borrowed currency: At the end of the investment period, the investor converts the higher- interest-rate currency back into the borrowed currency, repays the loan, and retains any profit from the interest rate differential.

Answer 21

A step-by-step explanation of the uncovered carry trade strategy

Question 22

Purchasing Power Parity (PPP)

Answer 22

Purchasing Power Parity (PPP) is an economic theory that compares different countries’ currencies through a “basket of goods” approach. The concept is based on the idea that, in the absence of transaction costs and trade barriers, identical goods should have the same price when expressed in a common currency. PPP is used as a tool to determine the relative value of currencies, to compare living standards between countries, and to estimate the equilibrium exchange rate between currencies.

Question 23

An economic theory that compares different countries’ currencies through a “basket of goods” approach. The concept is based on the idea that, in the absence of transaction costs and trade barriers, identical goods should have the same price when expressed in a common currency. Is used as a tool to determine the relative value of currencies, to compare living standards between countries, and to estimate the equilibrium exchange rate between currencies.

Answer 23

Purchasing power parity (PPP)

Question 24

Absolute PPP

Answer 24

This version of PPP suggests that the exchange rate between two currencies should be equal to the ratio of the price levels of the two countries, as measured by the prices of a basket of goods in each country.

Question 25

This version of PPP suggests that the exchange rate between two currencies should be equal to the ratio of the price levels of the two countries, as measured by the prices of a basket of goods in each country.

Answer 25

Absolute PPP

Question 26

Relative PPP

Answer 26

This version of PPP is focused on the changes in price levels over time rather than the absolute price levels. Relative PPP states that the rate of change in the exchange rate between two currencies over time should be equal to the difference in the inflation rates of the two countries.

Question 27

This version of PPP is focused on the changes in price levels over time rather than the absolute price levels. It states that the rate of change in the exchange rate between two currencies over time should be equal to the difference in the inflation rates of the two countries.

Answer 27

Relative PPP

Question 28

Call option

Answer 28

A financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset (e.g., stock, bond, or commodity) at a specified price, called the strike price, on or before a predetermined expiration date. The buyer pays a premium to the seller for this right.

Question 29

A financial contract that gives the buyer the right, but not the obligation, to purchase an underlying asset (e.g., stock, bond, or commodity) at a specified price, called the strike price, on or before a predetermined expiration date. The buyer pays a premium to the seller for this right.

Answer 29

Call option

Question 30

Put option

Answer 30

A financial contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a specified price (strike price) on or before a predetermined expiration date. The buyer pays a premium to the seller for this right.

Question 31

Binomial option pricing model

Answer 31

A valuation method used to determine the theoretical value of an option by constructing a binomial tree, which represents the possible paths the underlying asset’s price may take over the option’s life. The model calculates the option’s value by working backward from the expiration date, using risk-neutral probabilities for the price movements and discounting future payoffs.

Question 32

A financial contract that gives the buyer the right, but not the obligation, to sell an underlying asset at a specified price (strike price) on or before a predetermined expiration date. The buyer pays a premium to the seller for this right.

Answer 32

Put option

Question 33

A valuation method used to determine the theoretical value of an option by constructing a tree, which represents the possible paths the underlying asset’s price may take over the option’s life. The model calculates the option’s value by working backward from the expiration date, using risk-neutral probabilities for the price movements and discounting future payoffs.

Answer 33

Binomial option pricing model

Question 34

Binomial tree

Answer 34

A graphical representation of the possible price paths an underlying asset may take over time, with each node in the tree representing a specific price level at a particular point in time. It is used in the binomial option pricing model to estimate the option’s value.

Question 35

A graphical representation of the possible price paths an underlying asset may take over time, with each node in the tree representing a specific price level at a particular point in time.

Answer 35

Binomial tree

Question 36

Replicating portfolio

Answer 36

A portfolio of assets that mimics the cash flows and risk characteristics of a specific financial instrument, such as an option. In the context of options pricing, a replicating portfolio typically consists of the underlying asset and a risk-free bond, and it is used to derive the theoretical value of the option.

Question 37

A portfolio of assets that mimics the cash flows and risk characteristics of a specific financial instrument, such as an option. In the context of options pricing, it typically consists of the underlying asset and a risk-free bond, and it is used to derive the theoretical value of the option.

Answer 37

Replicating portfolio

Question 38

European options

Answer 38

Options that can be exercised only on their expiration date, not before. European options can be valued using the Black-Scholes model or the binomial option pricing model.

Question 39

Options that can be exercised only on their expiration date, not before. Can be valued using the Black-Scholes model or the binomial option pricing model.

Answer 39

European option

Question 40

American options

Answer 40

Options that can be exercised at any time before or on their expiration date. American options require the use of the binomial option pricing model or other numerical methods for valuation, as they can’t be valued using the Black-Scholes model.

Question 41

Options that can be exercised at any time before or on their expiration date. They require the use of the binomial option pricing model or other numerical methods for valuation, as they can’t be valued using the Black-Scholes model.

Answer 41

American options

Question 42

Straddle

Answer 42

An options trading strategy that involves simultaneously buying a call and a put option with the same strike price and expiration date. This strategy is used when an investor expects a significant price movement in the underlying asset but is uncertain about the direction of the move.

Question 43

An options trading strategy that involves simultaneously buying a call and a put option with the same strike price and expiration date. This strategy is used when an investor expects a significant price movement in the underlying asset but is uncertain about the direction of the move.

Answer 43

Straddle

Question 44

Strangle

Answer 44

An options trading strategy that involves simultaneously buying a call option with a higher strike price and a put option with a lower strike price, both having the same expiration date. This strategy is used when an investor expects a substantial price movement in the underlying asset but is uncertain about the direction and wants to reduce the total premium paid compared to a straddle.

Question 45

An options trading strategy that involves simultaneously buying a call option with a higher strike price and a put option with a lower strike price, both having the same expiration date. This strategy is used when an investor expects a substantial price movement in the underlying asset but is uncertain about the direction and wants to reduce the total premium paid compared to a straddle.

Answer 45

Strangle

Question 46

Butterfly spread

Answer 46

An options trading strategy that involves combining a bull spread and a bear spread using three different strike prices. It typically involves buying one call (or put) option with a lower strike price, selling two call (or put) options with a middle strike price, and buying one call (or put) option with a higher strike price, all with the same expiration date. This strategy is used when an investor expects the underlying asset’s price to remain within a specific range, and it aims to profit from a lack of substantial price movement.

Question 47

An options trading strategy that involves combining a bull spread and a bear spread using three different strike prices. It typically involves buying one call (or put) option with a lower strike price, selling two call (or put) options with a middle strike price, and buying one call (or put) option with a higher strike price, all with the same expiration date. This strategy is used when an investor expects the underlying asset’s price to remain within a specific range, and it aims to profit from a lack of substantial price movement.

Answer 47

Butterfly spread

Question 48

Options as insurance

Answer 48

Options can be used as a form of insurance to protect or hedge against potential losses in an investment portfolio. By purchasing options, investors can limit their downside risk while maintaining exposure to potential upside gains.Options used as insurance can help investors manage risk, protect their portfolios from significant declines in value, and generate additional income. It’s essential to understand the trade-offs between the cost of the insurance (option premium) and the level of protection it offers, as well as the potential impact on investment returns.

Question 49

Protective put

Answer 49

A protective put is a strategy that involves buying a put option on an asset you already own or have a long position in. This provides insurance against a decline in the asset’s value. The put option gives you the right to sell the underlying asset at a specified strike price on or before the option’s expiration date. If the asset’s price falls below the strike price, you can exercise the put option and sell the asset at the higher strike price, limiting your losses. The cost of this insurance is the premium you pay for the put option. If the asset’s price increases, you still benefit from the gain, but the profit will be reduced by the cost of the put option.

Question 50

A strategy that involves buying a put option on an asset you already own or have a long position in.

Answer 50

Protective put

Question 51

Covered call

Answer 51

A covered call is a strategy that involves selling a call option on an asset you already own or have a long position in. This can provide income and some downside protection in the form of the premium received from selling the call option. When you sell a call option, you receive a premium from the buyer, which can offset potential losses in your underlying asset’s value to some extent. However, in exchange for this premium, you give up potential gains if the asset’s price rises above the call option’s strike price, as the buyer has the right to purchase the asset at the strike price, effectively capping your upside.

Question 52

A strategy that involves selling a call option on an asset you already own or have a long position in.

Answer 52

Covered call

Question 53

Why use option as insurance?

Answer 53

Options used as insurance can help investors manage risk, protect their portfolios from significant declines in value, and generate additional income. It’s essential to understand the trade-offs between the cost of the insurance (option premium) and the level of protection it offers, as well as the potential impact on investment returns.

Question 54

Put-Call parity

Answer 54

Put-call parity is a fundamental principle in options pricing that establishes a relationship between the prices of European call options and put options with the same strike price, underlying asset, and expiration date. The principle is based on the concept of arbitrage-free pricing, which means that there should be no risk-free profit opportunities available from simultaneously trading different options with the same characteristics.

Question 55

A fundamental principle in options pricing that establishes a relationship between the prices of European call options and put options with the same strike price, underlying asset, and expiration date. The principle is based on the concept of arbitrage-free pricing, which means that there should be no risk-free profit opportunities available from simultaneously trading different options with the same characteristics.

Answer 55

Put-Call Parity

Question 56

What does Put-Call parity assume?

Answer 56

The put-call parity principle assumes that options are European-style, meaning they can only be exercised at expiration. The relationship does not hold exactly for American-style options, which can be exercised at any time before or on the expiration date, although it still provides a useful reference for pricing and understanding the relationship between call and put options.

Question 57

Credit default swaps (CDS)

Answer 57

A Credit Default Swap (CDS) is a financial derivative contract that allows parties to transfer the credit risk of an underlying fixed-income security, such as a bond or a loan, from one party to another. The buyer of a CDS seeks protection against the default or decline in the creditworthiness of a specific issuer (the reference entity), while the seller of the CDS assumes the credit risk and agrees to compensate the buyer in case of a credit event, such as default or restructuring.

Question 58

A financial derivative contract that allows parties to transfer the credit risk of an underlying fixed-income security, such as a bond or a loan, from one party to another.

Answer 58

Credit default swaps (CDS)

Question 59

How do CDS work?

Answer 59

1. Two parties, the protection buyer and the protection seller, enter into a CDS contract.2. The protection buyer makes periodic payments, called CDS premiums or spreads, to the protection seller over the life of the contract.3. In return, the protection seller agrees to compensate the protection buyer for any losses incurred if a credit event, as specified in the contract, occurs involving the reference entity or the underlying debt instrument.4. If a credit event does not occur during the life of the contract, the protection seller keeps the premium payments, and the contract expires without any further obligations.

Question 60

What can CDS be used for?

Answer 60

1. Hedging: Investors holding bonds or other fixed-income securities can use CDS to hedge against the risk of default or credit deterioration. For example, a bond investor who is concerned about the creditworthiness of a specific issuer can buy a CDS to protect against potential losses in case of default.2. Speculation: Market participants can use CDS to speculate on the creditworthiness of a reference entity without owning the underlying debt instrument. For instance, an investor who believes a company’s credit quality will decline can buy a CDS on the company’s bonds to potentially profit from the widening of credit spreads.3. Arbitrage: Traders can use CDS to exploit pricing inefficiencies between the underlying debt securities and the CDS market, seeking to profit from discrepancies in perceived credit risk.

Question 61

The Black-Scholes formula

Answer 61

The Black-Scholes model, also known as the Black-Scholes-Merton model, is a widely used mathematical model for pricing European-style options on non-dividend-paying stocks. Developed by Fischer Black, Myron Scholes, and Robert Merton in the early 1970s, the model calculates the theoretical price of an option based on several factors, including the stock price, strike price, time to expiration, volatility, and risk-free interest rate.The Black-Scholes model is based on the assumption that stock prices follow a continuous-time stochastic process, specifically, a geometric Brownian motion. Under this assumption, the model derives a partial differential equation, known as the Black-Scholes equation, which can be solved to obtain the theoretical price of a European call or put option.

Question 62

A widely used mathematical model for pricing European-style options on non-dividend-paying stocks.

Answer 62

The Black-Scholes model,

Question 63

The Garman-Kohlhagen-Black-Scholes model

Answer 63

The Garman-Kohlhagen-Black-Scholes model is an extension of the original Black-Scholes model, developed by Mark Garman and Steven Kohlhagen in 1983. This model is specifically designed for pricing European- style options on foreign exchange (FX) rates, taking into account the additional complexities associated with currency markets, such as two different interest rates for each currency.The Garman-Kohlhagen model is similar to the Black-Scholes model, with some modifications to account for the unique characteristics of FX options.

Question 64

This model is specifically designed for pricing European- style options on foreign exchange (FX) rates, taking into account the additional complexities associated with currency markets, such as two different interest rates for each currency.

Answer 64

The Garman-Kohlhagen-Black-Scholes model

Question 65

FX Futures

Answer 65

Foreign exchange (FX) futures are standardized financial contracts traded on organized exchanges, which allow market participants to buy or sell a specific amount of a currency pair at a predetermined exchange rate (price) on a future settlement date. FX futures are a type of derivative instrument, as their value is derived from the underlying currency exchange rate.It’s important to note that FX futures are different from FX forwards, which are over-the-counter (OTC) contracts negotiated directly between two parties and can be customized in terms of contract size, expiration date, and other terms.

Question 66

Standardized financial contracts traded on organized exchanges, which allow market participants to buy or sell a specific amount of a currency pair at a predetermined exchange rate (price) on a future settlement date.

Answer 66

FX future

Question 67

Future contracts

Answer 67

Futures contracts are standardized financial agreements traded on organized exchanges that allow market participants to buy or sell an underlying asset at a predetermined price on a specific future date. These contracts are a type of derivative instrument, as their value is derived from the underlying asset, which can be a commodity (such as oil, gold, or agricultural products), a financial instrument (such as bonds, interest rates, or currencies), or an index (such as a stock index or a commodity index).

Question 68

Standardized financial agreements traded on organized exchanges that allow market participants to buy or sell an underlying asset at a predetermined price on a specific future date. These contracts are a type of derivative instrument, as their value is derived from the underlying asset, which can be a commodity (such as oil, gold, or agricultural products), a financial instrument (such as bonds, interest rates, or currencies), or an index (such as a stock index or a commodity index).

Answer 68

Futures contract

Question 69

Currency futures markets

Answer 69

The currency futures market is a specialized segment of the futures market where participants trade stan- dardized futures contracts based on currency exchange rates. Currency futures are financial contracts that obligate the buyer and seller to exchange a specific amount of one currency for another at a predetermined exchange rate (price) on a specified future date. These contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE).

Question 70

Specialized segment of the futures market where participants trade stan- dardized futures contracts based on currency exchange rates.

Answer 70

Currency futures markets

Question 71

Swaps

Answer 71

Swaps are financial derivative instruments that involve the exchange of cash flows between two parties based on a specified notional amount and a predetermined set of terms. Swaps allow market participants to manage various types of risk, such as interest rate risk, currency risk, or commodity price risk, and are typically traded over-the-counter (OTC) rather than on organized exchanges.There are several types of swaps, but the most common are interest rate swaps and currency swaps.Swaps can be customized to meet the specific needs of the counterparties and can involve multiple types of risk or cash flows. However, it’s important to note that swaps carry counterparty risk, which is the risk that one party may not fulfill its contractual obligations. To mitigate this risk, swaps are often cleared through a central counterparty (CCP), which guarantees the performance of both parties in the transaction.

Question 72

Dinancial derivative instruments that involve the exchange of cash flows between two parties based on a specified notional amount and a predetermined set of terms.

Answer 72

Swaps

Question 73

Intrest rate swaps

Answer 73

These are agreements between two parties to exchange interest payments based on a notional principal amount. Typically, one party agrees to pay a fixed interest rate, while the other party pays a floating interest rate, which is often tied to a reference rate like the London Interbank Offered Rate (LIBOR) or the Euro Interbank Offered Rate (EURIBOR). Interest rate swaps allow participants to manage their interest rate risk exposure, either by converting fixed-rate payments to floating-rate payments or vice versa.

Question 74

These are agreements between two parties to exchange interest payments based on a notional principal amount.

Answer 74

Intrest rate swaps

Question 75

Currency swaps

Answer 75

These involve the exchange of principal and interest payments in different currencies between two parties. In a currency swap, the parties agree to exchange specified amounts of two different currencies at the start of the contract and then exchange interest payments periodically throughout the life of the contract. At the end of the contract, the principal amounts are exchanged back at either the original or a predetermined exchange rate. Currency swaps are used to manage currency risk exposure and to obtain financing in a foreign currency at more favorable terms.A currency swap can be represented as a series of cash flows between two parties, similar to the cash flows generated by bonds.

Question 76

How does a Currency swap as forwards work?

Answer 76

Question 77

How does a currency swap as a bond work?

Answer 77

Question 78

These involve the exchange of principal and interest payments in different currencies between two parties.

Answer 78

Currency swaps

Question 79

Exchange rate exposure of firms

Answer 79

Exchange rate exposure refers to the sensitivity of a firm’s financial position, cash flows, and overall value to fluctuations in foreign exchange rates. Companies involved in international trade, operations, or investments are particularly vulnerable to exchange rate risk. There are three main types of exchange rate exposure that a firm may face.

Question 80

This type of exposure arises from the effect of exchange rate fluctuations on a firm’s short-term transactions, such as accounts receivable and accounts payable, which are denominated in foreign currencies. For example, if a U.S. company sells goods to a European customer and agrees to receive payment in euros, the U.S. company faces transaction exposure because changes in the EUR/USD exchange rate can impact the value of the payment in U.S. dollars.

Answer 80

Constractual exposure / Transactions exposure

Question 81

Constractual exposure / Transactions exposure

Answer 81

This type of exposure arises from the effect of exchange rate fluctuations on a firm’s short-term transactions, such as accounts receivable and accounts payable, which are denominated in foreign currencies. For example, if a U.S. company sells goods to a European customer and agrees to receive payment in euros, the U.S. company faces transaction exposure because changes in the EUR/USD exchange rate can impact the value of the payment in U.S. dollars.

Question 82

This type of exposure refers to the effect of exchange rate fluctuations on a firm’s future cash flows and overall value. It is broader and more long-term than transaction and translation exposure, as it considers the impact of exchange rate changes on the competitive position, market share, and profitability of the firm. For example, a U.S. company that sources raw materials from Europe may face increased production costs if the EUR/USD exchange rate appreciates, which could lead to reduced competitiveness and lower future cash flows.

Answer 82

Operation exposure / Economic exposure

Question 83

Operation exposure / Economic exposure

Answer 83

Also known as operating exposure, this type of exposure refers to the effect of exchange rate fluctuations on a firm’s future cash flows and overall value. Economic exposure is broader and more long-term than transaction and translation exposure, as it considers the impact of exchange rate changes on the competitive position, market share, and profitability of the firm. For example, a U.S. company that sources raw materials from Europe may face increased production costs if the EUR/USD exchange rate appreciates, which could lead to reduced competitiveness and lower future cash flows.

Question 84

This type of exposure arises from the effect of exchange rate fluctuations on a firm’s consolidated financial statements when foreign subsidiaries’ financials are translated into the parent company’s reporting currency. For example, if a U.S. company has a subsidiary in Japan, the subsidiary’s financials must be converted from Japanese yen to U.S. dollars for consolidation purposes. Changes in the USD/JPY exchange rate can impact the reported assets, liabilities, and equity of the parent company, affecting its balance sheet and income statement.

Answer 84

Translation exposure / Accounting exposure

Question 85

Translation exposure / Accounting exposure

Answer 85

Also known as accounting exposure, this type of exposure arises from the effect of exchange rate fluctuations on a firm’s consolidated financial statements when foreign subsidiaries’ financials are translated into the parent company’s reporting currency. For example, if a U.S. company has a subsidiary in Japan, the subsidiary’s financials must be converted from Japanese yen to U.S. dollars for consolidation purposes. Changes in the USD/JPY exchange rate can impact the reported assets, liabilities, and equity of the parent company, affecting its balance sheet and income statement.Firms can manage their exchange rate exposure through various financial instruments and strategies, such as forward contracts, options, futures, currency swaps, and natural hedging (e.g., matching foreign currency assets and liabilities or sourcing inputs and financing in the same currency as revenues). By effectively managing exchange rate risk, firms can protect their financial position, cash flows, and overall value from adverse exchange rate movements.

Question 86

Modigliani and Miller (M&M) propositions

Answer 86

Modigliani and Miller (M&M) propositions are fundamental principles in corporate finance developed by Franco Modigliani and Merton Miller in their groundbreaking 1958 paper, “The Cost of Capital, Corporation Finance, and the Theory of Investment.” M&M propositions provide insights into the relationship between a firm’s capital structure (the mix of debt and equity financing) and its overall value. The propositions are presented under two scenarios: with no taxes (Propositions 1 and 2) and with taxes (Propositions 1 and 2 with taxes).

Question 87

This proposition states that the value of a firm is unaffected by its capital structure in a frictionless market with no taxes, bankruptcy costs, or asymmetric information. In other words, the total value of a leveraged firm (i.e., a firm with debt in its capital structure) is equal to the total value of an unleveraged firm (i.e., a firm with no debt) with the same operating income and risk profile. This implies that the choice of financing – whether debt or equity – does not impact the firm’s value, and the firm’s management should focus on making investment decisions that maximize the value of the firm’s assets.

Answer 87

M&M 1

Question 88

M&M Proposition 1 (No Taxes)

Answer 88

This proposition states that the value of a firm is unaffected by its capital structure in a frictionless market with no taxes, bankruptcy costs, or asymmetric information. In other words, the total value of a leveraged firm (i.e., a firm with debt in its capital structure) is equal to the total value of an unleveraged firm (i.e., a firm with no debt) with the same operating income and risk profile. This implies that the choice of financing – whether debt or equity – does not impact the firm’s value, and the firm’s management should focus on making investment decisions that maximize the value of the firm’s assets.

Question 89

This proposition states that the cost of equity for a leveraged firm increases linearly with the firm’s debt-to-equity ratio. As a firm takes on more debt, the risk to equity holders increases, leading to a higher required return on equity. However, the overall weighted average cost of capital (WACC) remains constant, as the increase in the cost of equity is offset by the lower cost of debt. In other words, the firm’s capital structure influences the required returns on debt and equity but does not affect the firm’s overall WACC and value.

Answer 89

M&M 2

Question 90

M&M Proposition 2 (No Taxes)

Answer 90

This proposition states that the cost of equity for a leveraged firm increases linearly with the firm’s debt-to-equity ratio. As a firm takes on more debt, the risk to equity holders increases, leading to a higher required return on equity. However, the overall weighted average cost of capital (WACC) remains constant, as the increase in the cost of equity is offset by the lower cost of debt. In other words, the firm’s capital structure influences the required returns on debt and equity but does not affect the firm’s overall WACC and value.

Question 91

Reasons for hedging

Answer 91

1. Risk reduction: Hedging helps to reduce the uncertainty and volatility associated with future cash flows, earnings, and asset values. By reducing risk, a company can better plan and manage its financial and operational activities.2. Competitive advantage: Hedging can provide a company with a competitive advantage, especially if its competitors do not hedge. A well-executed hedging strategy can lead to cost savings, improved profit margins, and more predictable financial results, which can enhance the company’s market position and attractiveness to investors.3. Access to financing: A company with lower risk exposure may find it easier to obtain financing at favorable terms, as lenders and investors generally prefer more predictable cash flows and lower risk levels.4. Budgeting and forecasting: Hedging allows a company to lock in prices or exchange rates for future transactions, which can improve the accuracy of budgeting and forecasting, and facilitate long-term planning.5. Legal or contractual requirements: In some cases, companies may be required by law or contract to hedge certain risks, such as foreign exchange exposure or interest rate risk.

Question 92

Reasons against hedging

Answer 92

1. Costs: Hedging can be costly, as companies need to pay for financial instruments, such as options, futures, or swaps, to hedge their risks. Additionally, there may be transaction costs and fees associated with implementing and maintaining a hedging strategy.2. Profit potential: By hedging, a company may give up the potential to benefit from favorable market movements. For example, a company that hedges its foreign exchange risk may miss out on profits if the exchange rate moves in its favor.3. Complexity: Hedging strategies can be complex, requiring specialized expertise and resources to design, implement, and monitor. Smaller companies or those without the necessary expertise may find it challenging to manage a hedging program effectively.4. Counterparty risk: Hedging typically involves entering into contracts with counterparties, such as banks or financial institutions. If a counterparty fails to fulfill its obligations under a hedging contract, the company may still be exposed to the underlying risk.5. Regulatory and accounting considerations: Hedging activities may be subject to regulatory require- ments and can have accounting implications, such as affecting reported earnings or balance sheet items. Companies need to be aware of these issues and manage them appropriately.

Question 93

Net present value

Answer 93

Net Present Value (NPV) is a financial metric used in capital budgeting to evaluate the profitability and feasibility of an investment or project. It represents the difference between the present value of cash inflows generated by the investment and the present value of cash outflows, including the initial investment cost. In other words, NPV measures the net value created by the investment, adjusted for the time value of money.The time value of money concept acknowledges that a dollar received today is worth more than a dollar received in the future, as money can be invested today to earn returns over time. To account for this, future cash flows are discounted to their present value using a discount rate, which reflects the opportunity cost of capital or the required rate of return on the investment.

Question 94

How does a currency swap as a bond work?

Answer 94

Question 95

How do we calculate gains for diversification?

Answer 95

Question 96

How do we find the foreign currency cost or capital?

Answer 96