finance data bank
Essay Questions
10.1 Types of Foreign Exchange Exposure
1) List and define the three types of foreign exchange exposure presented by your authors.
Answer: Transaction exposuremeasures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, it deals with changes in cash flows that result from existing contractual obligations.
Translation exposureis the potential for accounting-derived changes in owner's equity to occur because of the need to "translate" foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements.
Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpectedchange in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices, and costs.
10.2 Why Hedge?
1) Does foreign currency exchange hedging both reduce risk and increase expected value? Explain, and list several arguments in favor of currency risk management and several against.
Answer: Foreign exchange currency hedging can reduce the variability of foreign currency receivables or payables by locking in a specific exchange rate in the future via a forward contract, converting currency at the current spot rate using a money market hedge, or minimizing unfavorable exchange rate movement with a currency option. None of these hedging techniques, however, increases the expected value of the foreign currency exchange. In fact, expected value should fall by an amount equal to the cost of the hedge.
Generally, those in favor of currency risk management find value in the reduction of variability of uncertain cash flows. Those opposed to currency risk management argue the NPV of such activities are $0 or less and that shareholders can reduce risk themselves more efficiently. For a more complete answer to this question, see page 4 where the author outlines several arguments for and against currency risk management.
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10.3 Trident's Transaction Exposure
1) Currency risk management techniques include forward hedges, money market hedges, and option hedges. Draw a diagram showing the possible outcomes of these hedging alternatives for a foreign currency receivable contract. In your diagram, be sure to label the X and Y-axis, the put option strike price, and show the possible results for a money market hedge, a forward hedge, a put option hedge, and an uncovered position. (Note: Assume the forward currency receivable is British pounds and the put option strike price is $1.50/£, the price of the option is $0.04 the forward rate is $1.52/£ and the current spot rate is $1.48/£.)
Answer: The student should draw and label a diagram that looks similar to the one found in exhibit 10.4.
10.4 Translation Exposure
1) The two methods for the translation of foreign subsidiary financial statements are the current rate and temporal methods. Briefly, describe how each of these methods translates the foreign subsidiary financial statements into the parent company's consolidated statements. Identify when each technique should be used and the major advantage(s) of each.
Any gains or loses caused by translation adjustments are typically placed into a special reserve account (such as a CTA). Thus, gains or losses do not go through the income statement and do not increase the volatility of net income. This is perhaps the biggest advantage to using the current rate method.
By contrast, the temporal method assumes that several individual financial statement items are periodically restated to reflect their market value. The temporal method translates individual line items based on monetary/nonmonetary criteria where monetary assets such as cash and marketable securities are translated at current exchange rates, but nonmonetary assets such as fixed assets are translated at historical rates. The gains or losses that result from translation remeasurement are recorded on the consolidated income statement and impact upon the volatility of net income. The temporal method of using historical costs may be more consistent with the practice of carrying domestic items at cost on the financial statements.
10.5 Trident Corporation's Translation Exposure
1) There are no essay questions for this section.
10.6 Managerial Implications
1) Describe a balance sheet hedge and give at least two examples of when such a hedge could be justified.
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