Chapter 8 Flashcards
(9 cards)
How is transaction exposure defined, and how does it differ from economic exposure?
Transaction exposure is the sensitivity of domestic currency values of contractual foreign currency cash flows to unexpected exchange rate changes. It is short-term and well-defined, unlike economic exposure, which is broader and longer-term.
Compare hedging transaction exposure using forward contracts vs. money market instruments. When do they yield the same result?
Forward contracts lock in rates for future transactions. Money market hedging involves borrowing/lending to offset FX exposure. If interest rate parity holds, both methods yield the same outcome.
How do the costs of forward contracts compare with those of options for hedging?
Forwards have no upfront cost but may lead to regret if rates move favorably. Options require a premium but provide flexibility, limiting downside without giving up upside.
What is the main advantage of currency options over forward contracts for hedging?
Options provide flexibility—hedgers can benefit from favorable exchange rate movements while being protected against unfavorable ones, avoiding ex post regret.
Why is a purchased euro put option on an A/R like an ‘insurance policy’?
It guarantees a minimum dollar amount from the euro receivable, while still allowing gains if the euro appreciates—similar to how insurance limits downside but allows favorable outcomes.
Why do many U.S. firms choose not to hedge exchange rate risk?
Reasons include
- perceived lack of exposure,
- natural hedging via diversification,
- internal risk management or belief that shareholders can hedge themselves.
Should a firm hedge exchange rate risk? Why or why not?
Yes, in imperfect markets.
Hedging can reduce default risk,
lower taxes via income smoothing, and be more cost-effective than shareholder-level hedging, especially if management knows exposure better.
What is contingent exposure, and why are currency options useful for managing it?
Contingent exposure arises when a firm might or might not have FX exposure. Options are ideal since they provide the right, not the obligation, to hedge uncertain future cash flows.
What is cross-hedging and what determines its effectiveness?
Cross-hedging involves hedging one currency exposure with another related currency. Its effectiveness depends on how closely correlated the two currencies are.
