section 2C Flashcards
One United States dollar is being quoted at 120 Japanese yen on the spot market and at 123 Japanese yen on the 90-day forward market, hence the annual effect in the forward market is the:
United States dollar is at a premium of 10%.
United States dollar is at a premium of 2.5%.
United States dollar is at a discount of 10%.
Japanese yen is at a discount of 2.5%.
United States dollar is at a premium of 10%.
The difference between the spot market and 90-day forward market price of a dollar in terms of yen, is 3 yen. Over a 360-day year, this 90-day difference of 3 yen translates into 12 yen, which is 10% of the spot market quote of 120 yen.
The forward market quote is higher than that in the spot market, hence it is expected that the dollar will appreciate, and the U.S. dollar is at a premium of 10%.
FORECASTING TECHNIQUES
___forecasting involves the use of historical exchange rate data to predict future values.
___forecasting is based on the presumed relationship between exchange rates and economic variables
_____forecasting starts from the premise that financial markets provide an unbiased estimate of future events, and uses either the spot rate or the forward rate.
………….The forward rate that is quoted for a specific date in the future is commonly used as a __for the forecasted future spot rate on that date.
Technical
Fundamental
Market-based
proxy
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?
Purchase futures of the currency in which the payables will be paid.
Hold payables and receivables due in the same currency and amount.
Enter into an interest rate swap to mitigate the effects of exchange rate fluctuations.
Conduct all foreign transactions in U.S. dollars.
Hold payables and receivables due in the same currency and amount
One of the most effective methods to minimize the risk of foreign currency fluctuations is to hold payables and receivables in the same currency and amount; any fluctuations will offset each other.
TYPES OF RISK FOR FINANCIAL RISK MANAGEMENT
__risk: the risk to earnings or capital arising from changes in interest rates
__risk is an inability to convert assets to cash in a timely fashion
___risk: the uncertainty of the value of net income that would result from the variability of the market value of foreign-currency-denominated assets and liabilities due to fluctuating exchange rates
___risk: the risk that the counterparty will not meet an obligation when due and will never be able to meet the obligation at full value.
___risk: the risk that the counterparty will default on clearing obligations
___risk: the risk that payment system failures will lead to one market participant being unable to meet its obligation when due that will lead to additional participants being unable to meet commitments as well
___risk: the inability of a counterparty to meet its commitments
Interest rate
Liquidity
Foreign currency
Credit
Default
Systemic
Counterparty
Which of the following is not an exchange rate determinant?
Changes in consumer tastes
Relative interest rates
Relative income changes
Flexible exchange rates
Flexible exchange rates
Flexible exchange rates are not a determinant. It is an adjustment that eliminates balance of payment surpluses, or deficits. Exchange rates are determined by changes in consumer taste, relative interest rates, and relative income changes.
EXCHANGE RATE DETERMINANTS three determinants: Changes in \_\_\_ taste Relative \_\_\_ changes Relative \_\_\_ rates
Over time ___will adjust and eliminate balance-of-payments surpluses or deficits between two nations.. This is NOT a determinant.
Exchange rates are determined by the interaction of supply and demand for the various foreign currencies in foreign exchange markets. T/F
consumer
income
interest
flexible exchange rates
True
An example of a ____would be to use an interest rate swap to convert variable-rate interest exposure to a fixed interest rate.
……… The swap is an instrument that, in its usual form, transforms one kind of interest stream to another, such as floating to fixed or fixed to floating.T/F
Note: Swaps deal with INTEREST RATES
cash flow hedge
True
A company has several long-term floating-rate bonds outstanding. The company’s cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?
Structured short-term note
Forward contract on a commodity
Futures contract on a stock
Swap agreement
Swap Agreement
In the risk management process, a firm has the choice to do all of the following except:
accept risk.
default risk.
shift/transfer risk.
manage risk.
Default risk
A default risk assumes the counterparty will default on the obligation. It is not part of the risk management process.
The firm has a choice to accept, transfer, or manage risk.
The future value of an investment using compound interest will be ________ the same investment using simple interest.
More than
The future value using compound interest will always be more than under simple interest because it includes interest calculated on interest earned as well as on the principal amount. This is true for any interest rate used.
If a CPA’s client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments?
Precious metals
Treasury bonds
Corporate bonds
Common stock
Precious metals
An inflation hedge is an investment with intrinsic value, not tied to financial assets
___ (purchasing power risk) is the risk that inflation will result in less purchasing power for a given sum of money. Assets that are expected to rise in value during a period of inflation have a lower risk.
Purchasing risk
___is an attempt to use what is believed to be relevant information to “outguess the market.”
Financial transactions in foreign exchange markets are very ___to market expectations regarding exchange rates.
Speculation
sensitive
For currency exchange rates, all of the following describe speculation except:
outguessing the market.
financial transactions in foreign exchange markets are sensitive to market expectations.
fixed-value currencies.
value determined by current expectations of the value of the currency.
speculation
Fixed currencies do not fluctuate; therefore, their value cannot be speculated.
Miller Manufacturing and Mining is facing potential translation exposure and believes that it would be desirable to use a money market hedge to reduce their risk to currency fluctuation. They have a 1.2 billion yen receivable that will come due one year from today. Current interest rates in the United States and Japan are 8% and 5% respectively. The current spot exchange rate is 120 yen = $1. If the money market hedge is structured correctly the firm would:
borrow 1.143 billion yen in Japan and invest it in a Japanese bank at 5% so that they would have 1.2 billion yen available when the receivable comes due.
borrow 1.111 billion yen and convert the proceeds into $9,259,259 and invest the money in the United States and use the proceeds of the receivable to repay the Japanese loan, collecting the proceeds $10,000,000 from the U.S. investment which would represent the guaranteed proceeds from the Japanese sale.
borrow 1.143 billion yen and convert the proceeds into $9,524,810 and invest the money in the United States and use the proceeds of the receivable to repay the Japanese loan, collecting the proceeds of $10,285,714 from the U.S. investment which would represent the guaranteed proceeds from the Japanese sale.
borrow $10,000,000 and convert the proceeds into 1.2 billion yen and invest the proceeds to have 1.26 billion yen available when the receivable comes due.
borrow 1.143 billion yen and convert the proceeds into $9,524,810 and invest the money in the United States and use the proceeds of the receivable to repay the Japanese loan, collecting the proceeds of $10,285,714 from the U.S. investment which would represent the guaranteed proceeds from the Japanese sale.
A money market hedge involves borrowing an amount equal to the discounted value of the receivable (1.2B yen ÷ 1.05 = 1.143 billion yen). The proceeds of the loan would be converted to dollars at the current spot rate (1.143B yen ÷ 120 = $9,524,810), and the proceeds would then be invested in the United States. When the receivable is paid, the firm will use the proceeds to pay off the loan balance in Japan and collect the proceeds of the U.S. investment ($9,524,810 × 1.08 = $10,285,714). This would be the guaranteed proceeds from the Japanese sale that were created by using a money market hedge.
Division A currently makes a widget. The following is information related to the production of the widgets:
Production capacity 100,000 units per year
Current sales level 80,000 units per year
Sell price 2 outside customer $20 per unit
Variable costs per unit $12 per unit
Total fixed costs $600,000
Division B wishes to purchase 15,000 widgets from Division A for $16 per unit. Division A has the capacity to handle all of Division B’s needs without changing either fixed or variable costs nor losing any sales to outside customers. Division B currently purchases widgets from the outside for $18 per unit. If Division A accepted the $16 internal price and Division B purchases the widgets from Division A, the company as a whole will be:
$30,000 better off each period.
$90,000 better off each period.
$30,000 worse off each period.
$60,000 worse off each period.
$90,000 better off each period.
Division A will have an additional
Contribution Margin of $4 per widget
sold internally ($4 x 15,000) $60,000
Division B will have an additional saving in variable cost of $2 per widget Purchased internally ($2 x 15,000) 30,000
Savings to Company if purchased Division B
purchases the widget from Division A $90,000
=======
INTERNAL PRODUCTIONS
When idle capacity exists, the selling division’s opportunity cost may be ___
Under the idle capacity condition, as long as the selling division can receive a price greater than its variable costs, it will be ___
As long as the purchasing division can purchase the product for less from the sister division than the current purchase price from the outside, it will be better off and, thus, the corporation as a whole will benefit. T/F
zero.
better off
True
Assume that a firm is able to issue 20-year fixed-rate bonds at an attractive rate. When looking at their balance sheet and cash flow position, management finds that the key interest rate risk the firm is facing is related to movements in short-term interest rates. Management decides that the rate on the 20-year bond is too attractive to pass up. They issue the bond and then choose to develop ________ to offset their interest rate risk.
an interest rate swap transaction
a collateralized debt transaction secured by subprime mortgages
a forward hedge
a technical forecast model
Interest Rate Swap
An interest rate swap in its usual form would transform one interest stream into another
A forward hedge is designed to deal with foreign exchange transactions and is a customized transaction that is usually written by a bank for a specific client.
The risk management process includes both internal and external controls and involves the following:
Identifying and ___risks and understanding their relevance
Understanding the stakeholder’s objectives and their ___for risk
Developing and implementing appropriate ___in the context of a risk management policy
prioritizing
tolerance
strategies
In the modern world economy, balance-of-payments deficits and surpluses can be eliminated:
through the market mechanism of flexible exchange rates.
if all nations adopt tight monetary policies.
when the opportunity costs of production are made the same in all countries.
if nations trade inputs instead of outputs.
through the market mechanism of flexible exchange rates.
Flexible exchange rates automatically adjust so as to eliminate balance of payments surpluses and deficits
The dominant reason why countries devalue their currencies is to:
improve the balance of trade.
discourage exports without having to impose controls.
curb inflation by increasing imports.
slow what is regarded as too rapid an accumulation of international reserves.
improve the balance of trade.
Countries devalue their currencies so as to lower the prices of their domestic goods relative to those of foreign imports.
Devaluation of one’s currency makes foreign goods more expensive, and demand for the goods denominated in the devalued currency become more attractiv
FIXED EXCHANGE RATE SYSTEM
The advantage of a fixed rate system is that ___) would be able to engage in international trade without worrying about exchange risk.
A key disadvantage of the fixed exchange rate system is that a government, faced by economic pressures, will choose to ____the value of its currency. While the exchange rate does not fluctuate on a regular basis, it may be revalued or devalued by a significant amount unexpectedly
multinational companies (MNCs
alter
If an institution is developing a capital position that is designed to cover risk beyond what is considered necessary for its best estimate reserves, the institution would be creating what would be called:
____is generally defined as the level of reserves established in addition to the best estimate level of reserves.
Risk MArgin
____ reserves tend to create a cushion to cover any fluctuations or misestimation of errors in best estimate liabilities (reserves) and to cover risk of fluctuations under “normal situations” with required capital serving as a buffer against more extreme black swan events
The risk margin covers risks linked to the ____cash flows over their whole time horizon.
The goal is to have the concept of risk margin be made applicable to determining ___in the more broadly defined financial risk areas as well as to insurance.
Risk margin
Future liability
potential losses
Which of the following is not part of the control cycle approach to risk management?
Doing a profit test to determine whether a product provides a positive contribution margin
Developing the hedges necessary to mitigate interest rate risk
Determining, in both quantitative and qualitative terms, an understandable explanation of the differences between expected and actual results
Using the feedback loops in the modeling of expected results to update the assumptions and determine what adjustments in reserves might be necessary
Developing the hedges necessary to mitigate interest rate risk
RANDOM
A “___” event has a high impact, is hard to predict, and is a rare event that is beyond the realm of normal expectations in history, science, finance, and technology.
A ____is a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets.
\_\_\_is an action undertaken to capitalize on inefficiencies in financial markets. It is a response to the belief in the “law of one price” that states that a product should sell for the same price in all markets, less the cost of transfer between markets
black swan
collateral debt obligation (CDO)
Arbitrage
The control cycle used by actuaries includes the following:
a. Modeling ___results using a set of initial assumptions
b. Doing a __to determine if the product provides a positive contribution margin
c. Measurement of ___results
d. Determination in both ___terms, an understandable
explanation of the differences between expected and actual results, and
determining what actions need to be taken with respect to the product, including
adjusting the reserves that might need to be held
e. Use of the ___to strengthen the model and update the assumptions as
necessary with a feedback into the profit test (item b. above)
expected profit test actual quantitative and qualitative findings
Which of the following best describes arbitrage?
Buying in a low-price market and selling in a high-price market
Arbitrage states that a product should sell for different prices in all markets.
Arbitrage profits are not available until the two prices are equal.
Arbitrage is only transferred between two markets.
Buying in a low-price market and selling in a high-price market
Arbitrage involves buying in a low-price market and selling in a high-price market. Arbitrage profits are available until the two prices are equal. Arbitrage states the law of one price—that products should sell for the same price in all markets.
Which of the following describes the hedging approach to financing?
Maturity dates of financing instruments are staggered so that they mature in a steady, predictable fashion when it is expected that funds will be needed.
The firm takes out insurance to protect itself against uneven cash flows.
Each asset is offset with a financing instrument of the same approximate maturity or duration.
Each asset is offset with either a put or a call.
Each asset is offset with a financing instrument of the same approximate maturity or duration.
Under the hedging approach the length of the financing term is matched to the maturity or duration of assets financed. Long-term debt is used to finance long-term assets and short-term debt is used to finance short-term assets.
Thus, each asset is offset with a financing instrument of the same approximate maturity.
RANDOM
The main reasons for ___include reducing the volatility in cash flow, avoiding financial distress, or providing predictability
\_\_\_risk is the risk of holding fixed interest-bearing instruments such as a bond when interest rates are changing.
____hedges: A firm buys a currency futures contract that gives the firm the right to receive a specified amount of a specified currency for a given price on a specific date.
___hedge: A forward hedge is very similar to a futures hedge except that it is designed to be used by large corporations who have relatively large positions to hedge.
___hedge: This type of hedge involves the firm taking a position in domestic or foreign money markets to hedge a payables or receivables position.
___hedge: This type of hedge ideally would insulate the firm from adverse foreign exchange movements, but also allow the firm to benefit from favorable exchange rate movements if the currency does not move in the expected manner during the hedging period
hedging
Interest rate
Future
Forward
Money market
Currency option
Caroline Brown, the product manager for a U.S. computer manufacturer, is being asked to quote prices of desktop computers to be used in Kuwait. The Kuwaiti government wants the price quoted in British pounds, for delivery next year. Brown knows that the general price level in the United States is expected to increase by 3%. Her banker forecasts that the British pound will depreciate about 5% this year with respect to the U.S. dollar. If Brown is able to quote 700 pounds for immediate delivery, the price that should be quoted for delivery to Kuwait next year is:
757 pounds
If the price of a desktop computer is presently 700 British pounds, a 3% increase in price will increase it to 721 pounds. If the pound is expected to depreciate by 5%, that is losing 5% of its value against the dollar, the cost of the computer in terms of British pounds will increase further. In this case, it rises by an additional 36 British pounds (5% of 721). The quoted price for delivery to Kuwait next year should be 757 pounds.
Financial risk management is one component of the concept of enterprise risk management of the firm, which includes items such as the following:
\_\_\_: the uncertainty associated with the ability to forecast EBIT due to factors such as sales variability and operating leverage
____risk: the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events
____risk: the potential disruptions to continued manufacturing production and thereby commercial financial exposure
___risk: the responsibility of the firm or vendor of goods to compensate for injury caused by defective merchandise that it has provided for sale
____risk: the risk that a government buyer or a country prevents a transaction from being completed, or fails to meets its payment obligations; and/or the risk associated with the overall health of the economy
Business risk
Operations
Supply-Chain
Propduct Liability
Politcal and Economic
A significant decline in the exchange rate of the U.S. dollar generally will have which of the following effects?
It will hurt all U.S. business.
It will benefit U.S. importers.
It will benefit U.S. exporters.
It will make foreign goods cheaper for U.S. consumers.
It will benefit U.S. exporters.
“It will benefit U.S. exporters” is correct because a decline in the exchange rate of the U.S. dollar will make goods produced in the U.S. less expensive in foreign currencies, improving the competitiveness of U.S. exporters.
Platinum Co. has a receivable due in 30 days for 30,000 euros. The treasurer is concerned that the value of the euro relative to the dollar will drop before the payment is received. What should Platinum do to reduce this risk?
Buy 30,000 euros now
Enter into an interest rate swap contract for 30 days
Enter into a forward contract to sell 30,000 euros in 30 days
Platinum cannot effectively reduce this risk.
Enter into a forward contract to sell 30,000 euros in 30 days
A forward contract is an arrangement between two parties to exchange currencies at a specified exchange rate sometime in the future. This allows a company to reduce the exchange rate risk. In this situation, the Platinum Co. enters into a forward contract to sell 30,000 euros in 30 days. If the value of the euro declines in the next 30 days, the Platinum Co. will lose (exchange rate loss) on the receipt of the 30,000 euro receivable; however, it will recover that loss on the sale of the 30,000 euros based upon the forward contract at a specified exchange rate.
XYZ Company gets a $100,000 revolving credit agreement from the Last National Bank. The 10% interest is to be paid on a discount basis and XYZ is required to maintain $10,000 more in its non-interest bearing account than it ordinarily would. The effective annual interest cost is:
12.5%
With a compensating balance of $10,000 for a loan of $100,000 at 10%, discounted:
Effective interest = Interest paid / Usable funds
= (10% x $100,000) / ($100,000 - $10,000 - $10,000)
= $10,000 / $80,000
= .125 or 12.5%
Usable funds = Loan amount - discounted interest - compensating balance
