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Flashcards in B6-4 Deck (28):
1

The Elbow Corporation is computing the annual percentage rate of interest on its most recent borrowing of $10,000. The note carried a nominal interest rate of 10% and provided net proceeds to Elbow Corporation of $9,500 after reduction for documentary stamps and loan origination fees. The annual percentage rate of interest is:

a.

10.5%

b.

10%

c.

11%

d.

9.5%

 

Choice "a" is correct. The annual percentage rate on debt is equal to the amount of the payments required under the contract divided by the net proceeds of the debt. In this case, the amount of the payments is $1,000 ($10,000 x 10%) while the amount of net proceeds is $9,500. The annual percentage rate is $1,000 / $9,500 or 10.5%.

2

Which tool would most likely be used to determine the best course of action under conditions of uncertainty?

a.

Cost-volume-profit analysis.

b.

Scattergraph method.

c.

Program evaluation and review technique (PERT).

d.

Expected value (EV).

Choice "d" is correct. Probability and expected value formulate quantitative models to address the issue of appropriate course of action in an environment of uncertainty. The expected value is a weighted average of all values and variables. The course of action with the highest expected monetary value should be selected.

Choice "a" is incorrect. Cost-volume profit analysis is a method used to evaluate operating decisions.

Choice "c" is incorrect. PERT is a technique used in project management that focuses on the time required to complete each step in a project. It allows a project manager to monitor a project’s progress and identify potential bottlenecks or delays that will postpone the completion date.

Choice "b" is incorrect. The scattergraph method is used in statistical analysis to plot relationships between variables to determine a line function that best describes those relationships.

3

Solway International is owed £10,000 from its U.K. customer. The current exchange rate is $1.30 to the U.K. pound (£1.00). Solway has purchased a put option to sell £10,000 in 60 days time for $1.25, and Solway has paid a premium of $0.005. If 60 days from now the exchange rate is $1.20, what will be the overall result for Solway International?

a.

Solway will exercise the option and it will benefit Solway by $450.

b.

Solway will exercise the option and it will benefit Solway by $500.

c.

Solway will exercise the option and it will benefit Solway by $550.

d.

Solway will allow the option to expire unexercised.

Choice "a" is correct. The option price is $1.25 less the premium of $.005 so the net proceeds are computed at $1.245. Solway will sell the £10,000 at $1.250 and receive $12,450, net of the premium, instead of receiving $12,000 at the spot rate of $1.20, a benefit of $450. Note that the premium is not included in determining whether or not to exercise the option because the premium is a sunk cost.

Choices "d", "b", and "c" are incorrect, per the above explanation.

4

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?

a.

Futures contract on a stock.

b.

Interest rate swap agreement.

c.

Forward contract on a commodity.

d.

Structured short-term note.

Choice "b" is correct.  An interest rate swap agreement would be effective in hedging the risk associated with interest rate fluctuations. A swap agreement is a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments. In this case, the company would most likely enter into an interest rate swap in which it would pay another party a fixed rate of interest in exchange for receipt of payments of a floating rate of interest. The company would then use the floating interest payments received to pay the interest on its floating-rate bonds. In this way, the company would use the swap agreement to convert its interest payments from floating-rate to fixed-rate.

Choice "d" is incorrect. A structured short term note would not be effective in hedging the interest rate risks associated with long term floating rate bonds. Long term rates will fluctuate based on the expectations associated with the long term bond market. Short term rates at a point in time are based on different assumptions by investors and lenders.

Choice "c" is incorrect. Forward contracts on commodities have a lower likelihood of effectively hedging interest rate risk than an interest rate swap. The financial markets that impact interest rates are more directly connected to interest rates than commodities.

Choice "a" is incorrect. Futures contracts on equities have a lower likelihood of effectively hedging interest rate risk than an interest rate swap. The financial markets that impact interest rates are more directly connected to interest rates than equities.

5

An American importer expects to pay a British supplier 500,000 British pounds in three months. Which of the following hedges is best for the importer to fix the price in dollars?

a.

Buying British pound call options.

b.

Selling British pound put options.

c.

Buying British pound put options.

d.

Selling British pound call options.

 

Choice "a" is correct. To fix a price in dollars to buy British pounds, British pound call options should be purchased. Call options would allow, but not require, the purchaser of the call to acquire the currency (British pounds) for a specified price at or before a specified time in the future. If the price goes up, the purchaser (the importer) would exercise the options; if not, the purchaser (importer) would buy the British pounds in the market and let the options expire. British pound futures could also be used, but that was not one of the choices listed.

Choice "c" is incorrect. Buying British pound put options would allow, but not require, the purchaser of the put to sell the currency for a specified price at a specified time in the future. Since the importer needs British pounds, buying put options would not work. The importer needs to end up with British pounds.

Choice "b" is incorrect. Selling British pound put options would not work. The importer needs to end up with British pounds. Selling put options could work, but the option would be exercised, or not, by the purchaser and not by the importer. If the options were not exercised, the importer could end up with nothing (other than the option premium).

Choice "d" is incorrect. Selling British pound call options would not work. The importer needs to end up with British pounds; if call options are sold, the other party can exercise the options or let them expire, and if the options were exercised, the importer would have to supply the British pounds. This answer is backwards.

6

Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by development of a portfolio. Risks that cannot be eliminated through a portfolio are called:

a.

Systematic risks.

b.

Unsystematic risks.

c.

Non-market risks.

d.

Firm-specific risks.

 

Rule: Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get us DUNS.

Diversifiable

Unsystematic (non-market/firm-specific)

Non-diversifiable

Systematic (market)

Choice "a" is correct. Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Non-diversifiable risk is also referred to as market or systematic risk.

Choice "c" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed non-market risk.

Choice "b" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed unsystematic risk.

Choice "d" is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed firm-specific risk.

7

The required rate of return is generally computed as the risk-free rate of return plus a number of risk premium adjustments. All of the following risk adjustments are used to compute the required rate of return, except:

a.

Credit risk premium.

b.

Default risk premium.

c.

Maturity risk premium.

d.

Purchasing power risk premium.

 

Choice "a" is correct. Credit risk relates to the ability of a firm to obtain, not grant, credit. Require rate of return adjustments do not include a credit risk adjustment.

Choice "b" is incorrect. Default risk premium (DRP) is an appropriate risk adjustment to the risk-free rate of return and is the additional compensation demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest or fail to repay the principal.

Choice "d" is incorrect. Purchasing power risk premium, or inflation premium (IP), is an appropriate risk adjustment to the risk free-rate of return and is the compensation investors require to bear the risk that price levels may change and affect asset values or the purchasing power of invested dollars (e.g., real estate).

Choice "c" is incorrect. Maturity risk premium (MRP), or interest rate risk, is an appropriate risk adjustment to the risk-free rate of return and is the compensation investors demand for bearing risk. This risk increases with the term to maturity.

8

Hagar Company's bank requires a compensating balance of 20 percent on a $100,000 loan. If the stated interest on the loan is 7 percent, what is the effective cost of the loan?

a.

8.75 percent.

b.

8.18 percent.

c.

8.40 percent.

d.

7.00 percent.

 

Choice "a" is correct. Total interest for the loan is $100,000 × 7% or $7,000. The effective amount received is $80,000 after the 20% compensating balance. The effective interest is $7,000 / $80,000 = 8.75%.

Choices "d", "b", and "c" are incorrect, per the above calculation.

9

Each of the following financial instruments is a derivative, except:

a.

An agreement to buy a piece of equipment in six months at a price determined today.

b.

Interest rate futures.

c.

A contract to purchase a commodity in six months at a price determined today.

d.

A fixed interest, five-year note payable.

Choice "d" is correct. A derivative is a financial contract which derives its value from the performance of another asset or financial contract (interest rate, stock, asset, etc.). A fixed interest, five-year note payable is a debt instrument whose changes in value drive its own performance.

Choice "b" is incorrect. An interest rate future is a derivative whose performance is driven by movement in interest rates.

Choice "a" is incorrect. Buying equipment in six months at a price defined today is an example of a derivative hedging transaction. The value of this contract will be equal to the difference between the actual price in six months and the preset price determined today, with a higher actual price benefiting the buyer (who would have locked in a lower purchase price) and a lower actual price benefiting the seller (who would have locked in a higher sale price).

Choice "c" is incorrect. Buying a commodity in six months at a price defined today is an example of a derivative hedging transaction. The value of this contract will be equal to the difference between the actual price in six months and the preset price determined today, with a higher actual price benefiting the buyer (who would have locked in a lower purchase price) and a lower actual price benefiting the seller (who would have locked in a higher sale price).

10

Hedgehog International has numerous foreign exchange transactions. Management has elected to hedge transactions as a means of mitigating transaction exposure to exchange rate risk. What is the most effective means that Hedgehog International can use to avoid overhedging?

a.

Hedgehog should acquire the minimum amount required to hedge known transactions.

b.

Hedgehog should enter into a cross hedging agreement.

c.

Hedgehog should acquire the maximum amount required to hedge known and projected transactions.

d.

Hedgehog should acquire parallel loans to provide a means for liquidating unneeded hedge securities.

Choice "a" is correct. Hedgehog should only acquire the minimum amount of hedge contracts needed to offset the effect of known transactions.

Choice "d" is incorrect. Parallel loans represent a swap contract for hedging long-term transaction exposure and are not specifically designed to mitigate the risk of overhedging.

Choice "c" is incorrect. Acquisition of the maximum number of hedge contracts for known and projected transactions exposes the organization to greater risk of overhedging since projected transactions might not materialize.

Choice "b" is incorrect. Cross hedging involves techniques related to currencies that do have hedge instruments available to mitigate risk and are not specifically designed to avoid overhedging.

11

In evaluating the impact of relative inflation rates on the demand for a foreign currency, which of the following is true?

a.

As inflation associated with a foreign economy increases in relation to a domestic economy, demand for the foreign currency falls.

b.

As inflation associated with a foreign economy decreases in relation to a domestic economy, demand for the foreign currency falls.

c.

Inflation is irrelevant to currency demand.

d.

As inflation associated with a foreign economy increases in relation to a domestic economy, demand for the foreign currency increases.

Choice "a" is correct. As inflation associated with a foreign currency increases in relation to a domestic economy, demand for the foreign currency falls. Inflation weakens the foreign currency in relation to the domestic currency and makes foreign products more expensive and reduces demand. Reduced demand for a foreign import will reduce the demand for its currency.

Choice "c" is incorrect. Inflation, along with interest rates and trade restrictions are significant determinants of exchange rates.

Choice "d" is incorrect. As inflation associated with a foreign currency increases in relation to a domestic economy, demand for the foreign currency falls. Inflation weakens the foreign currency in relation to the domestic currency and makes foreign products more expensive and reduces demand. Reduced demand for a foreign import will reduce the demand for its currency, not increase demand.

Choice "b" is incorrect. As inflation associated with a foreign currency decreases in relation to a domestic economy, demand for the foreign currency rises. Inflation weakens the domestic currency in relation to the foreign currency and makes foreign products less expensive and increases demand. Increased demand for a foreign import will increase the demand for its currency, not decrease demand.

12

Managers that anticipate greater return for greater risk are referred to as having what attitude toward risk?

a.

Risk averse.

b.

Risk indifferent.

c.

Cautious.

d.

Risk seeking.

Choice "a" is correct. Risk averse behavior describes managers who demand more return on an investment as risk increases. These managers expect to be compensated for increased risk.

Choice "b" is incorrect. Risk indifferent behavior describes a manager who is neutral with regard to the return associated with a particular investment. Typically, the amount of a risk free rate of return associated with an investment of a given amount compared to a higher return associated with higher risk is viewed as having equal value.

Choice "d" is incorrect. Risk seeking behavior describes managers who seek reduced return for higher risk.

Choice "c" is incorrect. The term "cautious" is a distracter. Although caution is an attitude, it is not a technical term.

13

Corbin Inc. can issue three-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs would be $1,200. The effective annualized percentage cost of the financing, based on a 360-day year, would be:

a.

8.65%

b.

2.16%

c.

8.00%

d.

8.48%

 

Choice "a" is correct. The cost to issue the commercial paper is the $20,000 original issue discount ($1 million − $980,000), plus transaction costs of $1,200 for a total of $21,200. Therefore, it costs $21,200 to borrow $980,000 for 3 months. The 3-month effective periodic percentage cost is 2.16% ($21,200 / $980,000).

The effective annualized percentage cost is approximately 8.65% (2.16% × 4).

Choices "b", "d", and "c" are incorrect, per the above calculation.

14

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?

a.

Enter into an interest rate swap contract for 30 days.

b.

Enter into a forward contract to sell 30,000 euros in 30 days.

c.

Platinum cannot effectively reduce this risk.

d.

Buy 30,000 euros now.

Choice "b" is correct. Since Platinum is going to receive euros in 30 days, it will want to lock in the price of euros now. The way to do that is to enter into a forward contract (referred to in the text as a forward hedge) to sell euros in 30 days. The price will be fixed now, but the transaction will not occur until the end of the 30 day period. A futures contract might be able to be used also. Note that, with the fixed price, Platinum will not be hurt if the price of euros in terms of dollars falls, but it will also not benefit if the price of euros in terms of dollars rises. In this question, the treasurer was concerned about the price of euros dropping. 

Choice "d" is incorrect. Buying 30,000 euros now will not reduce the risk of a drop in the value of the euro. In fact, the risk will double since the company will have 60,000 euros in 30 days.

Choice "a" is incorrect. Buying an interest rate swap will do nothing to reduce the risk of a drop in the value of the euro. Interest rate swaps might reduce the risk of changes in interest rates.

Choice "c" is incorrect. Platinum can reduce the risk of a drop in the value of the euro by using the appropriate hedge. Hedges are often used to reduce currency risk.

15

Which of the following factors is inherent in a firm's operations if it utilizes only equity financing?

a.

Business risk.

b.

Interest rate risk.

c.

Marginal risk.

d.

Financial risk.

 


Explanation

Choice "a" is correct. Business risk represents the risk associated with the unique circumstances of a particular company, as they might affect the shareholder value of that company. If an entity purely uses its own cumulative earnings in capitalizing its operations, it is exposed to the risks of its own unique circumstances.

Choice "d" is incorrect. Financial risk, also called default risk, relates to the exposure of lenders to the failure of borrowers to repay principal and interest on debt. An entity using its own cumulative earnings in capitalizing its operations is not exposed to default risk.

Choice "b" is incorrect. A business that exclusively uses equity capitalization would not be exposed to the risk that the value of its financial instruments will change as a result of changes in interest rates.

Choice "c" is incorrect. Incremental changes in risk would be limited if a firm exclusively used its own equity financing to capitalize its operations.

16

A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8%. The company is required to maintain a 20% compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?

a.

28%

b.

8%

c.

20%

d.

10%

 

Choice "d" is correct. The effective rate of interest rate is 10%. The effective interest rate represents the actual finance charges associated with a borrowing after reducing loan proceeds for charges and fees.

The above scenario indicates that finance charges are $40,000 ($500,000 x 8%), and the net proceeds or amount available under the loan is $400,000 (the face value of $500,000 net of the 20% compensating balance of $100,000 [$500,000 x 20%]).

The effective rate of interest is the finance charge of $40,000 divided by the net proceeds of $400,000:

$40,000 ÷ $400,000 = 10%

Choice "b" is incorrect. The stated rate of the loan (8%) is not the effective rate of interest.

Choice "c" is incorrect. The compensating balance (20%) percentage is not the effective rate of interest.

Choice "a" is incorrect. The sum of the stated rate and the compensating balance (28%) is not the effective rate of interest.

17

Under frost-free conditions, Cal Cultivators expects its strawberry crop to have a $60,000 market value. An unprotected crop subject to frost has an expected market value of $40,000. If Cal protects the strawberries against frost, then the market value of the crop is still expected to be $60,000 under frost-free conditions and $90,000 if there is a frost. What must be the probability of a frost for Cal to be indifferent to spending $10,000 for frost protection?

a.

.167

b.

.250

c.

.200

d.

.333

 

Choice "c" is correct. If there is no frost, then there is no difference between Cal's income with or without the insurance; the crop is worth $60,000 either way. However, if the insurance is purchased and a frost occurs, Cal earns $50,000 more with insurance ($90,000 − $40,000) than he would without the insurance. The expected value of having the insurance is therefore:

Probability of frost × $50,000 + Probability of no frost × $0

Cal will be indifferent to spending $10,000 for frost protection when the expected value of the insurance equals the cost of the insurance:

Probability of frost × $50,000 = $10,000

Probability = 20%

Choices "a", "b", and "d" are incorrect based on the above explanation.

18

Which of the following types of risk can be reduced by diversification?

a.

Inflation.

b.

Recessions.

c.

Labor strikes.

d.

High interest rates.

 

Choice "c" is correct. The risk of labor strikes can be mitigated by diversification. Diversifiable risk, sometimes called unsystematic or firm specific risk can be mitigated by allocation of a portfolio of investments amongst various firms. Splitting a portfolio between investments in finance companies, which are less prone to strikes, vs. auto manufacturers, which have a higher percentage of organized labor, is an example of diversification to mitigate the risk of strikes.

Choice "d" is incorrect. High interest rates are a risk encountered as a result of participation in the economy and represent a nondiversifable or systematic risk. Everyone is subject to the risk of high interest rates, regardless of industry. Diversification will not mitigate this risk.

Choice "a" is incorrect. Inflation is a risk encountered as a result of participation in the economy and represents a nondiversifable or systematic risk. Everyone is subject to the risk of declining purchasing power, regardless of industry. Diversification will not mitigate this risk.

Choice "b" is incorrect. Recessions are a risk encountered as a result of participation in the economy and represent a nondiversifable or systematic risk. Everyone is subject to the risk of economic downturns, regardless of industry. Diversification will not mitigate this risk.

19

If an investor's certainty equivalent is greater than the expected value of an investment alternative, the investor is said to be:

a.

Risk seeking.

b.

Risk indifferent.

c.

Cautious.

d.

Risk averse.

 

Choice "a" is correct. If an investor's certainty equivalent, the point at which the investor is indifferent to risk, exceeds the expected return on an investment, then the investor is actually seeking lower return for higher risk. This behavior represents risk seeking behavior.

Choice "b" is incorrect. Risk indifferent behavior occurs when an investor's certainty equivalent is equal to the expected return on the investment.

Choice "d" is incorrect. Risk averse behavior occurs when an investor's certainty equivalent is less than the expected rate of return. The investor seeks higher returns for more risk.

Choice "c" is incorrect. Cautious is not a technical term used in risk behavior classifications

20

A put is an option that gives its owner the right to do which of the following?

a.

Buy a specific security at a fixed price for an indefinite time period.

b.

Sell a specific security at fixed conditions of price and time.

c.

Sell a specific security at a fixed price for an indefinite time period.

d.

Buy a specific security at fixed conditions of price and time.

Choice "b" is correct. A put option gives its owner the right to sell a specific security at fixed conditions of price and time.

Choice "c" is incorrect. A put option specifies time conditions and is not indefinite.

Choice "d" is incorrect.  An option to buy is called a call option.  A call option gives its owner the right to purchase a specific security at fixed conditions of price and time.

Choice "a" is incorrect. An option to buy is called a call option. A call option specifies time conditions and is not indefinite.

21

What is the effect when a foreign competitor's currency becomes weaker compared to the U.S. dollar?

a.

The fluctuation in the foreign currency's exchange rate has no effect on the U.S. company's sales or cost of goods sold.

b.

The foreign company will be disadvantaged in the U.S. market.

c.

It is better for the U.S. company when the value of the U.S. dollar strengthens.

d.

The foreign company will have an advantage in the U.S. market.

Choice "d" is correct. As a foreign competitor's currency becomes weaker compared to the U.S. dollar, the product becomes less expensive in U.S. dollars. The less expensive product will increase demand and result in an advantage in the U.S. market.

Choice "b" is incorrect. The opposite effect occurs, as described in choice "d" above.

Choice "a" is incorrect. Foreign currency exchange rates impact both sales and possibly cost of goods sold of a competing domestic company. Sales within U.S. markets will deteriorate as the currency of foreign competitors deteriorates and makes the domestic company's goods more expensive. As a foreign competitor's currency appreciates, sales within U.S. markets by a domestic company should also increase as goods manufactured in the U.S. become less expensive. Cost of goods sold may fluctuate if foreign suppliers are used.

Choice "c" is incorrect. It is better for a U.S. company when the value of the U.S. dollar weakens, not strengthens. A weak U.S. dollar makes domestic goods relatively less expensive than imported goods.

22

When purchasing temporary investments, which one of the following best describes the risk associated with the ability to sell the investment in a short period of time without significant price concessions?

a.

Purchasing power risk.

b.

Liquidity risk.

c.

Financial risk.

d.

Interest rate risk.

Choice "b" is correct. Liquidity risk is associated with the ability to sell the temporary investment in a short period of time without significant price concessions.

Choice "d" is incorrect. Interest rate risk is the fluctuation in the value of a "financial asset" when interest rates change.

Choice "a" is incorrect. Purchasing power risk is the risk that price levels will change and affect asset values (mostly real estate).

Choice "c" is incorrect. Financial risk is a general category of risk that includes:

Interest rate risk

Market risk

Purchasing power risk

Liquidity risk

Default risk

23

A company has an online order processing system. The company is in the process of determining the dollar amount of loss from user error. The company estimates the probability of occurrence of user error to be 90%, with evenly distributed losses ranging from $1,000 to $30,000. What is the expected annual loss from user error?

a.

$13,950

b.

$13,050

c.

$13,500

d.

$14,400

 

Choice "a" is correct. With losses evenly distributed between $1,000 and $30,000, the midpoint is calculated as $15,500. ($1,000 + $30,000) / 2 = $15,500. Applying the probability of user error at 90%, the expected annual loss is calculated as $15,000 × 90% = $13,950.

Choice "b" is incorrect. This answer choice incorrectly takes the difference between (rather than the sum of) the range end points ($29,000) and divides by 2 before applying the 90%.

Choice "c" is incorrect. This answer choice incorrectly calculates the midpoint as $15,000.

Choice "d" is incorrect. This answer choice incorrectly calculates the midpoint as $16,000.

24

Freely fluctuating exchange rates perform which of the following functions?

a.

They eliminate the need for foreign currency hedging.

b.

They impose constraints on the domestic economy.

c.

They automatically correct a lack of equilibrium in the balance of payments.

d.

They make imports cheaper and exports more expensive.

Choice "c" is correct. As we have mentioned in our explanations of other questions, sometimes questions that are released by the AICPA are released because they will never be used again or because they were test questions that didn't "make" it to be used as part of the recurring database. This may be the case with this question, but it is a good learning experience for candidates, as questions like this may appear on any exam. According to the examiners, it appears that "freely fluctuating (currency) exchange rates" correct a lack of equilibrium in the balance of payments. It is clear that none of the other choices is correct (see explanations below). It is unclear what the statement in "c" even means, but it is the correct answer, and we know that none of the others are correct. Our best explanation of the answer option follows.

The balance of payments has two major components: the current account (which is basically imports and exports) and the capital account (which is basically investments in this country and foreign countries). The two components generally offset each other (for the most part). Freely fluctuating exchange rates will impact both of these components because the price of the currencies will fluctuate. What the examiners appear to be saying is that freely fluctuating exchange rates will affect the two components in opposite directions. Assume dollars and euros. If dollars are or become cheaper, imports will be more expensive and exports will be less expense. This condition will reduce imports and increase exports, thereby worsening the current component of the balance of payments. However, if dollars are cheaper, investments in the US will be less expensive. Thus, those in the euro zone will be able to come into the US and buy investments at a good price for them. When they do that, the capital account balance will move in the opposite direction from the current account balance.

Choice "d" is incorrect. Freely fluctuating (currency) exchange rates do not necessarily make imports cheaper and exports more expensive. It depends on the direction of the exchange rate movements.

Choice "b" is incorrect. Freely fluctuating exchange rates do not impose constraints on the domestic economy. Exchange rates will have an effect on the domestic economy, but the effect will be indirect over a period of time.

Choice "a" is incorrect. Freely fluctuating (currency) exchange rates may actually increase (not eliminate) the need for foreign currency hedging because the exchange rates will change on a continuous basis and may change in either direction.

Note: The balance of payments is not currently covered on point in the course, which is why this detailed explanation is provided with this question.

25

The marketable securities with the least amount of default risk are:

a.

Federal government agency securities.

b.

Repurchase agreements.

c.

Bankers' acceptances.

d.

U.S. Treasury securities.

Choice "d" is correct. Default risk is the risk that the security will not be repaid because the issuing entity is insolvent or illiquid. U.S. Treasury securities are issued by the Treasury Department, which has virtually no risk of being insolvent or illiquid.

Choice "a" is incorrect. Securities issued by certain federal government agencies carry slightly more default risk than U.S. Treasuries because these agencies are (usually) not as large or liquid as the U.S. Treasury.

Choice "b" is incorrect. Repurchase agreements are sales by dealers in government securities who agree to repurchase these securities at a specific time and price. The risk of default is high because it is based upon the ability of the dealer to repurchase the securities.

Choice "c" is incorrect. Bankers' acceptances are drafts drawn on a bank, which guarantees payment at maturity. The default risk is higher because the execution of the acceptance is based upon the solvency of the bank.

26

Universal Industries limits its operations to exports to foreign countries. What can be said about Universal's exposures to exchange rate risk?

a.

Universal is subject to potential transaction and economic exposures to exchange rate risk.

b.

Universal is subject to economic and translation exposures to exchange rate risk.

c.

Universal is subject to transaction and translation exposures to exchange rate risk.

d.

Universal is subject to potential transaction, economic and translation exposures to exchange rate risk.

Choice "a" is correct. Universal is subject to transaction risks associated with settlement of export transactions and is subject to economic risks associated with the satisfaction of domestic expenses denominated in domestic currencies with imported revenues denominated in a foreign currency. No translation exposure exists since there is no foreign investment or subsidiary.

Choices "d", "b", and "c" are incorrect, per the above explanation.

27

If the dollar price of the euro rises, which of the following will occur?

a.

The euro will buy fewer European goods.

b.

The dollar depreciates against the euro.

c.

The euro depreciates against the dollar.

d.

The euro will buy fewer U.S. goods.

Choice "b" is correct. Foreign currencies are like anything else: their value can go up or down. If the dollar price of the euro rises, then the euro is getting more expensive. That means that the dollar is getting less expensive. Another way to say the same thing is that the dollar is depreciating against the euro.

Choice "c" is incorrect. This choice is backwards.

Choice "a" is incorrect. The euro is the currency of Europe (or at least a large portion of Europe). If the price of the euro increases relative to the U.S. dollar, it will not buy fewer European goods. When the price of the euro rises, the price of European goods will also increase, and the euro will buy the same amount of European goods, but more U.S. goods.

Choice "d" is incorrect. When the price of the euro rises, the euro will buy more, not fewer, U.S. goods.

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