The Foreign Exchange Market Flashcards
Challenge Questions
A French company is set to receive 5 million GBP in three months and decides to hedge against currency risk using a forward contract at 1.18 EUR/GBP. If the spot rate at maturity is 1.22 EUR/GBP, what is the financial outcome of the hedge for the company?
A. The company loses €200,000 due to the hedge.
B. The company gains €200,000 from the hedge.
C. The company loses €100,000 due to the hedge.
D. The company gains €100,000 from the hedge.
Answer: B. The company gains €200,000 from the hedge.
Explanation: By entering into a forward contract at 1.18 EUR/GBP, the company locks in a rate where it will receive €5.9 million (5 million × 1.18) regardless of market fluctuations. If the spot rate at maturity is 1.22 EUR/GBP, the company would have received only €6.1 million at the spot rate. The difference between these two amounts (€6.1 million - €5.9 million) is a gain of €200,000 as a result of securing a better rate than the forward.
Option A is incorrect as the company gains, not loses, from the hedge.
Option C incorrectly calculates the impact of the hedge.
Option D misstates the amount gained; the correct amount is €200,000.
Suppose the nominal exchange rate between the USD and JPY changes from 110 to 100 USD/JPY, and the price level in Japan increases by 4% while the U.S. price level remains constant. How has the real USD/JPY exchange rate changed, and what does this imply about the purchasing power of the USD in Japan?
A. The real exchange rate has decreased, indicating increased purchasing power of the USD in Japan.
B. The real exchange rate has decreased, indicating decreased purchasing power of the USD in Japan.
C. The real exchange rate has increased, indicating increased purchasing power of the USD in Japan.
D. The real exchange rate has increased, indicating decreased purchasing power of the USD in Japan.
Answer: A. The real exchange rate has decreased, indicating increased purchasing power of the USD in Japan.
Explanation: The nominal exchange rate change from 110 to 100 USD/JPY means that the yen has appreciated relative to the USD. However, with Japan’s price level increasing by 4% and the U.S. price level unchanged, the real exchange rate will decrease more significantly. This reduction in the real exchange rate implies that the purchasing power of the USD has increased in Japan because the higher price level in Japan diminishes the impact of the stronger yen.
Option B is incorrect because it misinterprets the effect of increased prices on the purchasing power.
Option C is incorrect because it misidentifies the direction of change in the real exchange rate.
Option D incorrectly suggests that the purchasing power has decreased.
A U.S.-based multinational firm is deciding whether to hedge a 2 million EUR payment it expects in 60 days. If the current spot rate is 1.10 USD/EUR and the 60-day forward rate is 1.12 USD/EUR, which of the following describes the best strategy, assuming the firm wants to minimize costs?
A. Enter a forward contract to buy EUR at 1.12 USD/EUR.
B. Hedge using the spot market at the current rate of 1.10 USD/EUR.
C. Do not hedge and use the spot market at the future rate.
D. Enter a forward contract to sell EUR at 1.12 USD/EUR.
Answer: A. Enter a forward contract to buy EUR at 1.12 USD/EUR.
Explanation: The firm’s goal is to minimize costs associated with the EUR payment. Since the 60-day forward rate is higher than the current spot rate, it reflects an expectation of further depreciation of the USD against the EUR. Hedging with the forward rate locks in a rate of 1.12 USD/EUR, potentially avoiding higher costs if the EUR appreciates further.
Option B is incorrect because it assumes the company is hedging future exposure with an immediate spot rate, which doesn’t hedge forward exposure.
Option C is not ideal because it exposes the firm to potential adverse movements in the EUR/USD rate.
Option D is incorrect because the firm is paying, not receiving EUR.
Consider an exchange rate quotation of 0.85 EUR/USD, which changes to 0.82 EUR/USD. Calculate the percentage change in the value of the USD relative to the EUR and explain the result.
A. The USD has depreciated by 3.53%, decreasing its purchasing power in the Eurozone.
B. The USD has appreciated by 3.53%, increasing its purchasing power in the Eurozone.
C. The USD has depreciated by 3.66%, decreasing its purchasing power in the Eurozone.
D. The USD has appreciated by 3.66%, increasing its purchasing power in the Eurozone.
Answer: D. The USD has appreciated by 3.66%, increasing its purchasing power in the Eurozone.
Explanation: The calculation of the percentage change in the USD is as follows: (0.85 - 0.82) / 0.82 = 0.0366, or 3.66%. As the EUR/USD rate decreases, the USD appreciates relative to the EUR, meaning more euros can be obtained for each dollar, hence increasing its purchasing power in the Eurozone.
Option A is incorrect as it describes depreciation, not appreciation.
Option B has the correct direction of change but incorrect magnitude.
Option C miscalculates the appreciation as a depreciation.
A Japanese firm imports goods from a U.S. supplier. The current nominal JPY/USD exchange rate is 105, and Japan’s price level increases by 2%, while the U.S. price level rises by 3%. Calculate the change in the real JPY/USD exchange rate and interpret the impact on the firm’s import costs.
A. The real exchange rate increases, raising import costs for the Japanese firm.
B. The real exchange rate decreases, lowering import costs for the Japanese firm.
C. The real exchange rate remains unchanged, leaving import costs unaffected.
D. The real exchange rate decreases, raising import costs for the Japanese firm.
Answer: B. The real exchange rate decreases, lowering import costs for the Japanese firm.
Explanation: The change in real exchange rate can be estimated by adjusting the nominal rate with the relative inflation rates:
Real exchange rate ≈ 105 × (1.02 / 1.03) = 103.88. The decrease in the real exchange rate suggests that the JPY has strengthened in real terms relative to the USD, thereby lowering import costs for the Japanese firm.
Option A misinterprets the impact on costs; a lower real rate reduces costs.
Option C incorrectly assumes no change in the real exchange rate.
Option D reverses the relationship between real rate changes and import costs.
A Canadian investment fund holds a significant position in European equities and is concerned about a potential depreciation of the euro against the Canadian dollar. The current spot rate is 1.45 CAD/EUR, and the fund considers hedging with a forward contract at 1.42 CAD/EUR for a six-month period. If the spot rate at maturity turns out to be 1.50 CAD/EUR, what is the financial impact of the hedge?
A. The fund gains 0.08 CAD per EUR hedged.
B. The fund loses 0.08 CAD per EUR hedged.
C. The fund gains 0.05 CAD per EUR hedged.
D. The fund loses 0.05 CAD per EUR hedged.
Answer: A. The fund gains 0.08 CAD per EUR hedged.
Explanation: By entering into a forward contract at 1.42 CAD/EUR, the fund locks in the ability to convert euros to Canadian dollars at this rate. With the spot rate at maturity being 1.50 CAD/EUR, the fund avoids converting at a higher cost (1.50) and instead converts at 1.42, saving 0.08 CAD per euro hedged.
Option B incorrectly states a loss rather than a gain.
Option C underestimates the impact of the hedge.
Option D incorrectly suggests a loss rather than the gain realized.
A U.S. exporter sells goods priced in euros and receives €3 million in 90 days. If the current spot rate is 1.12 USD/EUR and the exporter enters into a forward contract at 1.10 USD/EUR, which of the following best describes the outcome of the hedge if the spot rate at settlement is 1.15 USD/EUR?
A. The exporter gains $90,000 due to the hedge.
B. The exporter loses $90,000 due to the hedge.
C. The exporter gains $150,000 due to the hedge.
D. The exporter loses $150,000 due to the hedge.
Answer: B. The exporter loses $90,000 due to the hedge.
Explanation: Without the hedge, the exporter could have exchanged the euros at 1.15 USD/EUR, receiving $3.45 million. However, by locking in the forward rate of 1.10 USD/EUR, the exporter receives only $3.3 million. The difference is a loss of $150,000 due to the hedge ($3.45M - $3.3M).
Option A miscalculates the financial impact.
Option C incorrectly identifies a gain rather than a loss.
Option D overestimates the loss amount.
A German manufacturer is exposed to USD fluctuations as it imports raw materials priced in dollars. The current spot rate is 1.05 USD/EUR, and the company forecasts a depreciation of the euro to 1.15 USD/EUR in the next quarter. What hedging strategy should the company consider to minimize currency risk, and what would be the impact if the forecast materializes?
A. Enter a forward contract to sell USD at 1.05 USD/EUR; the company would gain from the hedge.
B. Enter a forward contract to buy USD at 1.05 USD/EUR; the company would gain from the hedge.
C. Enter a forward contract to buy EUR at 1.05 USD/EUR; the company would lose from the hedge.
D. Enter a forward contract to sell EUR at 1.05 USD/EUR; the company would lose from the hedge.
Answer: B. Enter a forward contract to buy USD at 1.05 USD/EUR; the company would gain from the hedge.
Explanation: By entering a forward contract to buy USD at 1.05, the company hedges against the expected depreciation of the euro. If the euro depreciates to 1.15 USD/EUR, the company avoids paying the higher rate and secures dollars at the favorable forward rate of 1.05, gaining on the hedge.
Option A is incorrect because it involves selling USD, which would not hedge the manufacturer’s USD liabilities.
Option C misstates the direction of the transaction and its impact.
Option D is incorrect as it involves selling EUR, which is not relevant to the company’s exposure.
Assume a real estate investment trust (REIT) based in the UK has extensive assets in the U.S. and anticipates cash flows in USD. The current exchange rate is 1.30 USD/GBP, but with increasing inflation in the UK, the rate is projected to move to 1.25 USD/GBP. What is the impact on the REIT’s cash flows, and how can it mitigate this risk?
A. The GBP will appreciate, decreasing the GBP value of USD cash flows; hedge by selling USD forward.
B. The GBP will depreciate, increasing the GBP value of USD cash flows; hedge by buying USD forward.
C. The GBP will appreciate, increasing the GBP value of USD cash flows; no hedge is needed.
D. The GBP will depreciate, decreasing the GBP value of USD cash flows; hedge by buying USD forward.
Answer: A. The GBP will appreciate, decreasing the GBP value of USD cash flows; hedge by selling USD forward.
Explanation: If the GBP appreciates to 1.25 USD/GBP, the value of the USD cash flows in GBP terms will decline. To protect against this, the REIT should hedge by selling USD forward, locking in a rate that prevents the adverse impact of GBP appreciation.
Option B incorrectly states the direction of currency movement and hedging strategy.
Option C misidentifies the impact on cash flows.
Option D incorrectly describes the currency appreciation and misstates the strategy.
A Brazilian company with significant USD-denominated debt is concerned about currency risk as the BRL/USD rate rises from 5.00 to 5.50. What would be the impact on the company’s debt servicing costs, and what action can mitigate this risk?
A. The company’s debt servicing costs in BRL would decrease; hedge by selling USD forward.
B. The company’s debt servicing costs in BRL would increase; hedge by buying USD forward.
C. The company’s debt servicing costs in BRL would remain the same; no hedge is necessary.
D. The company’s debt servicing costs in BRL would decrease; no hedge is necessary.
Answer: B. The company’s debt servicing costs in BRL would increase; hedge by buying USD forward.
Explanation: As the BRL depreciates against the USD, the cost of servicing USD-denominated debt in BRL terms increases. To mitigate this risk, the company should hedge by buying USD forward, locking in a lower rate and securing the funds needed to service its debt at a predictable cost.
Option A incorrectly describes the impact and hedging action.
Option C ignores the impact of exchange rate movements on debt costs.
Option D inaccurately states that no hedge is necessary, missing the depreciation effect.
