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What 3 types of trade factors (economic demand for goods) influence currency exchange rate risk? What is the general rule for how the rates change?
- General: Whichever currency is in demand will increase in value.
- Inflation = if US has high inflation, it may want to purchase Euros to mitigate. The rate for the Euro will increase b/c it's in demand.
- Relative Income = if US has high income and goods from Germany are cheaper, the Euro will increase b/c the demand for Euro-based products increases.
- Government Control = tariffs artificially lower demand and thus influence exchg rates
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(1) When US income goes up, the value of the US currency goes [up/down]. (2) When inflation in the US increases, the value of the US currency goes [up/down]
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What are the 3 types of exchange rate risks a company could be subject to? Give a brief explanation of each.
- (1) Transaction = due to the settlement of individual purchases or sales.
- (2) Economic = The present value changes due to changes in exchange rates.
- (3) Translation = due to consolidations with foreign subsidiaries
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How is a money market hedge for payables different than for receivables?
- For payables, the entity deposits funds into the foreign account to gain interest to help offset costs of paying the invoice.
- For receivables, the entity factors the A/R by obtaining a loan for the discounted amount of the A/R and then using the A/R to pay it back.
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Explain the following forms of Transaction Exposure mitigating techniques (1) futures contract, (2) forward contract. What are some advantages to these types of contracts?
- (1a) If the entity agrees to buy a futures contract it will purchase the foreign currency at a specified price on a specified date.
- (1b) If the entity agrees to sell a futures contract it will sell the foreign currency at a specified price on a specified date.
- Advantages: Exchange traded (more liquid) in standard amts.
- (2) Not exchange traded, these are between 2 private parties, in larger amts, customized.
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Explain the following forms of Transaction Exposure mitigating techniques (1) options hedge, (2) currency swap, (3) currency diversification
- (1) the right, but not the obligation, to purchase a foreign currency at a specific rate in the future
- (2) an agreement between 2 parties to exchange one currency for another at set rates]
- (3) purchasing several currencies holdings over time. The loss in one should offset the gain in another.
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What is a (1) put or (2) call option?
- Put: An option to sell assets at an agreed price on or before a particular date.
- Call: An option to purchase assets at an agreed price on or before a particular date.
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What are the 2 financial factors that influence foreign currency exchange rates?
- Relative interest rates (the country will the higher interest rate will attract investors)
- Capital Flow (the country with more money will invest)
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Your company has A/R of 100 Euros, and A/P of 80 Euros. Determine the economic risk if the US Dollar (1) strengthens, (2) weakens. How would the company mitigate the risk?
- Net exposure is A/R of 20 Euros.
- (1) If US$ strengthens, Euro weakens, would result in future loss; buy put option, futures contract to sell
- (2) If US$ weakens, Euro strengthens, would result in future gain
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Your company has A/P of 100 Euros, and A/R of 80 Euros. Determine the economic risk if the US Dollar (1) strengthens, (2) weakens. How would the company mitigate the risk?
- Net exposure of A/P of 20 Euros
- (1) If US$ strengthens, Euro weakens, would result in future gain;
- (2) If US$ weakens, Euro strengthens, would result in future loss; buy call options; futures contract to buy
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Explain when a money market hedge would be used and how it works.
- If the risk is regarding an A/P and the company is concerned that the foreign rate will increase.
- (1) If the entity has extra cash available. (a) calculate the PV of the foreign amount needed in to pay the A/P in the future based on the interest rates available in the money market. Don't forget to adjust the rate for a period less than 1 year.
- (b) Purchase that amount of foreign currency and deposit into the money market fund.
- (2) If no extra cash available, the same can be accomplished by borrowing funds in the domestic currency to purchase the foreign currency today and deposit into a money market hedge.
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Explain when factoring would be used and how it works.
- Use if the risk is regarding A/R and the entity expects the foreign currency rate will decrease. If so, you'd rather have the cash today.
- (a) Determine the PV of the foreign amount that would be received today using the interest rates available. Don't forget to adjust the rate for a period less than 1 year.
- (b) Factor (get a loan) for that amount and convert to the domestic currency.
- (c) Pay the loan (factor) for the full amount when the A/R is received.
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What is the break even point formula on a call option?
BE Point = strike price + cost
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What is the break even point formula on a put option?
BE Point = strike price - cost
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Leading and Lagging only occurs when transactions are between ______. Describe Leading and Lagging.
- A subsidiary and a parent to take advantage of better exchange rates.
- Leading is when the entity that is owed bills in advance.
- Lagging is when the entity that is owed bills later than typical.
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Original exchange rate $1.14 / €1. New exchange rate $1.02/ €1. Which currency got stronger, which got weaker.
The Euro got weaker, the dollar stronger.
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Original exchange rate $1.02 / €1. New exchange rate $1.14/ €1. Which currency got stronger, which got weaker.
The Euro got stronger, the dollar weaker.
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If the foreign current appreciates compared to the dollar, what is the effect on (1) A/R, (2) A/P
- A/R suffers a loss
- A/P enjoys a gain
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If the foreign current depreciates compared to the dollar, what is the effect on (1) A/R, (2) A/P
- A/R enjoys a gain
- A/P suffers a loss
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