Chapter 19 Foreign Exchange Risk

Foreign
Exchange
Risk

Exchange Types of Causes of Foreign Foreign

Rate Foreign Currency Exchange Rate Currency Risk Currency
Systems Risk Fluctuations Management Derivatives

1. Fixed 1. Transactions 1. Balance of 1. Home currency 1. Futures

exchange risk payments 2. Do nothing
rate 3. Leading &
lagging

2. Freely 2. Economic 2. Capital 4. Netting & 2. Options

floating risk movements matching
exchange rate

3. Managed 3. Translation 3. Supply and 5. Forward 3. Swaps

floating risk demand contract
exchange rate 6. Money market

4. Purchasing
power parity

5. Interest rate
parity

6. Expectations
theory

7. International
Fisher
Effect
Multiple Choice Questions

1. Exporters Co is concerned that the cash received from overseas sales will not be as
expected due to exchange rate movements.

What type of risk is this?

A Translation risk
B Economic risk
C Interest rate risk
D Transaction risk

2. ‘There is a risk that the value of our foreign currency-denominated assets and liabilities
will change when we prepare our accounts.’

To which risk does the above statement refer?

A Translation risk
B Economic risk
C Transaction risk
D Interest rate risk

3. The spot exchange rate

A is the rate today for exchanging one currency for another for immediate delivery
B is the rate today for exchanging one currency for another at a specified future date
C is the rate today for exchanging one currency for another at a specific location on a
specified future date
D is the rate today for exchanging one currency for another at a specific location for
immediate delivery

4. If the US dollar weakens against the pound sterling, will UK exporters and importers
suffer or benefit?

UK exporters to US UK importers from US

A Benefit Benefit
B Suffer Suffer
C Benefit Suffer
D Suffer Benefit

5. Pechora Co is a German business that has purchased goods from a supplier, Kama Co,
which is based in the USA. Pechora Co has been invoiced in euros and payment is to be
made 30 days after the purchase. During this 30-day period, the euro strengthened against
the US$.

Assuming neither Pechora Co nor Kama Co hedge against currency risk, what would be
the currency gain or loss for each party as a result of this transaction?

Pechora Kama
A No gain or loss Gain
 B Gain No gain or loss
C No gain or loss Loss
D Loss No gain or loss

6. Sirius plc is a UK business that has recently purchased machinery from a Bulgarian
exporter. The company has been invoiced in £ sterling and the terms of sale include
payment within sixty days. During this payment period, the £ sterling weakened against
the Bulgarian lev.

If neither Sirius plc nor the Bulgarian exporter hedge against foreign exchange risk, what
would be the foreign exchange gain or loss arising from this transaction for Sirius plc and
for the Bulgarian exporter?

Sirius plc Bulgarian exporter

A No gain or loss Gain
B Gain No gain or loss
C No gain or loss Loss
D Loss No gain or loss

7. The current euro / US dollar exchange rate is €1 : $2. ABC Co, a Eurozone company,
makes a $1,000 sale to a US customer on credit. By the time the customer pays, the Euro
has strengthened by 20%.

What will the Euro receipt be?

A €416.67
B €2,400
C €600
D €400

8. The current spot rate for the Dollar /Euro is $/€ 2.0000 +/- 0.003. The dollar is quoted at
a 0.2c premium for the forward rate.

What will a $2,000 receipt be translated to at the forward rate?

A €4,002
B €999.5
C €998
D €4,008

9. The spot rate of exchange is £1 = $1·4400. Annual interest rates are 4% in the UK and
10% in the USA.

The three month forward rate of exchange should be:

A £1 = $1·4616
B £1 = $1·5264
C £1 = $1·5231
D £1 = $1·4614.
10. The home currency of ACB Co is the dollar ($) and it trades with a company in a foreign
country whose home currency is the Dinar. The following information is available:
Home country Foreign country
Spot rate 20.00 Dinar per $
Interest rate 3% per year 7% per year
Inflation rate 2% per year 5% per year

What is the six-month forward exchange rate?

A 20·39 Dinar per $

B 20·30 Dinar per $
C 20·59 Dinar per $
D 20·78 Dinar per $
(ACCA F9 Financial Management Pilot Paper 2014)

11. The following exchange rates of £ sterling against the Singapore dollar have been quoted
in a financial newspaper:

Spot £1 = Singapore $2·3820

Three months’ forward £1 = Singapore $2·3540

The interest rate in Singapore is 6% per year for a three-month deposit or borrowing.
What is the annual interest rate for a three-month deposit or borrowing in the UK?

A 2·71%
B 7·26%
C 8·71%
D 10·83%

12. Interest rate parity theory generally holds true in practice. However it suffers from several
limitations.

Which of the following is not a limitation of interest rate parity theory?

A Government controls on capital markets

B Controls on currency trading
C Intervention in foreign exchange markets
D Future inflation rates are only estimates

13. What does purchasing power parity refers to?

A A situation where two businesses have equal available funds to spend.

B Inflation in different locations is the same.
C Prices are the same to different customers in an economy.
D Exchange rate movements will absorb inflation differences.

14. Purchasing Power Parity Theory (PPP) refers to

A The concept that the same goods should sell for the same price across countries after
exchange rates are taken into account
 B The concept that interest rates across countries will eventually be the same
C The orderly relationship between spot and forward currency exchange rates and the
rates of interest between countries
D The natural offsetting relationship provided by costs and revenues in similar market
environments

15. An Iraqi company is expecting to receive Indian rupees in one year's time. The spot rate
is 19.68 Iraqi dinar per 1 India rupee. The company could borrow in rupees at 10% or in
dinars at 15%.

What is the expected exchange rate in one year's time?

A 18.82 Iraqi dinar = 1 Indian rupee

B 20.58 Iraqi dinar = 1 Indian rupee
C 21.65 Iraqi dinar = 1 Indian rupee
D 22.63 Iraqi dinar = 1 Indian rupee

16. What is the impact of a fall in a country’s exchange rate?

1 Exports will be given a stimulus

2 The rate of domestic inflation will rise

A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2

17. An investor plans to exchange $1,000 into euros now, invest the resulting euros for 12
months, and then exchange the euros back into dollars at the end of the 12-month period.
The spot exchange rate is €1·415 per $1 and the euro interest rate is 2% per year. The
dollar interest rate is 1·8% per year.

Compared to making a dollar investment for 12 months, at what 12-month forward

exchange rate will the investor make neither a loss nor a gain?

A €1·223 per $1
B €1·412 per $1
C €1·418 per $1
D €1·439 per $1

18. What is the purpose of hedging?

A To protect a profit already made from having undertaken a risky position

B To make a profit by accepting risk
C To reduce or eliminate exposure to risk
D To reduce costs.

19. What does the term ‘matching’ refer to?

A The coupling of two simple financial instruments to create a more complex one.
 B The mechanism whereby a company balances its foreign currency inflows and
outflows.
C The adjustment of credit terms between companies
D Contracts not yet offset by futures contracts or fulfilled by delivery.

20. ABC plc has to pay a Germany supplier 90,000 euros in three months’ time. The
company’s finance director wishes to avoid exchange rate exposure, and is looking at
four options.

1. Do nothing for three months and then buy euros at the spot rate
2. Pay in full now, buying euros at today’s spot rate
3. Buy euros now, put them on deposit for three months, and pay the debt with these
euro plus accumulated interest
4. Arrange a forward exchange contract to buy the euros in three months’ time

Which of these options would provide cover against the exchange rate exposure that ABC
plc would otherwise suffer?

A 4 only
B 3 and 4 only
C 2, 3 and 4 only
D 1, 2,3 and 4

21. Consider the following statements concerning currency risk:

1. Leading and lagging is a method of hedging transaction exposure.

2. Matching receipts and payments is a method of hedging translation exposure.

Which of the above statements is/are true?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

22. A large multinational business wishes to manage its currency risk. It has been suggested
that:

1. Matching receipts and payments can be used to manage translation risk.

2. Matching assets and liabilities can be used to manage economic risk.

Which ONE of the following combinations (true/false) concerning the above statements
is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False
23. A business uses each of the hedging methods described below to protect against a
particular type of foreign exchange risk:

Hedging method used Type of foreign exchange risk

1. Matching receipts and payments Transaction risk
2. Matching assets and liabilities Economic risk
3. Leading and lagging Translation risk

Which of the hedging methods described above are suitable for their intended purpose?

A1 and 2
B 1 and 3
C 1, 2 and 3
D2 and 3

24. A forward exchange contract is

(1) an immediately firm and binding contract

(2) for the purchase or sale of a specified quantity of a stated foreign currency
(3) at a rate of exchange fixed at the time the contract is made
(4) for performance at a future time which is agreed when making the contract

A (1) and (2) only

B (1), (2) and (3) only
C (2) and (3) only
D All of the above
25. Consider the following hedging methods.

1. International diversification of operations

2. Matching receipts and payments
3. Leading and lagging
4. Forward exchange contracts

Which of the hedging methods above are suitable for hedging transaction exposure?

A 1 and 2
B 1, 2 and 3
C 2 and 3
D 2, 3 and 4

26. The following methods may be used to hedge currency risk:

1. International diversification of operations;

2. Currency swaps;
3. Leading and lagging;
4. Forward exchange contracts.

Which TWO of the above can be used to hedge currency risk arising from economic
exposure?

A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

27. A business uses the hedging methods outlined below to protect itself against the particular
types of foreign exchange risk against which they are matched.

Hedging method Type of risk

Forward exchange contracts Transaction risk
Matching receipts and payments Economic risk
Buying or selling domestic currency Translation risk

Which one of the following combinations best describes the suitability of the three
hedging methods for their intended purpose?

Suitability of hedging method for the type of risk identified

Forward exchange Matching receipts and Buying or selling in
contracts payments domestic currency
A Yes No Yes
B Yes No No
C No Yes Yes
D No No Yes

28. Which is true of forward contracts?

 1 They fix the rate for a future transaction.
2 They are a binding contract.
3 They are flexible once agreed.
4 They are traded openly.

A 1, 2 and 4 only
B 1, 2, 3 and 4
C 1 and 2 only
D 2 only

29. In comparison to forward contracts, which of the following are true in the relation to
futures contracts?

1 They are more expensive.

2 They are only available in a small amount of currencies.
3 They are less flexible.
4 They are probably an imprecise match for the underlying transaction.

A 1, 2 and 4 only
B 2 and 4 only
C 1 and 3 only
D 1, 2, 3 and 4

30. A UK company expects to receive €200,000 in three months’ time for goods sold to a
German customer and wishes to hedge the currency risk by taking out a forward contract.
The following rates have been quoted:

Spot rate 3 months forward

Euro per £ 1.4925 – 1.4985 1.4890 – 1.4897

If the forward contract is taken out, what are the sterling receipts for the UK company?

A£133,467
B £134,003
C £134,255
D£134,318

31. Polaris plc, a UK-based business, has recently exported antique furniture to a US
customer and is due to be paid $500,000 in three months’ time. To hedge against foreign
exchange risk, Polaris plc has entered into a forward contract to sell $500,000 in three
months’ time. The relevant exchange rates are as follows:

Spot £1 = $1·5535 – 1·5595

Three months’ forward 0·30 – 0·25 cents premium

How much will Polaris plc receive in £ sterling at the end of three months?

A £321,130
B £321,234
C £322,373
 D £322,477

32. Gydan plc, a UK business, is due to receive €500,000 in four months’ time for goods
supplied to a French customer. The company has decided to use a money market hedge
to manage currency risk. The following information concerning borrowing rates is
available:

Country Borrowing rate per annum

France 9%
UK 6%

The spot rate is £1 = €1·4490 – 1·4520

Using the money market approach, what is the £ sterling value of the amount that Gydan
Co will have to borrow now in order to match the receipt?

A£315,920
B £335,015
C £334,323
D£337,601

33. A UK based company, which has no surplus cash, is due to pay Euro 2,125,000 to a
company in Germany in three months time and wants to hedge the payment using money
markets.

The current spot rate is Euro 1·2230–1·2270 per £ sterling. The annual interest rates
available to the company in the UK and in Germany are as follows:

Country Borrow Lend

UK 5.72% 3.64%
Germany 4.52% 2.84%

What would it cost the company in UK£ if it hedges its Euro exposure?

A £1,786,190
B £1,780,367
C £1,749,953
D £1,744,248

34. If the underlying transaction gives you _____________, denominated in a foreign

currency, the general principal behind a money market hedge states that you need an
equivalent liability in the money market to provide a hedge.

A a liability
B an asset
C a forward contract
D a foreign bank account

35. A company whose home currency is the dollar ($) expects to receive 500,000 pesos in six
 months’ time from a customer in a foreign country. The following interest rates and
exchange rates are available to the company:

Spot rate 15.00 peso per $

Six-month forward rate 15.30 peso per $

Home country Foreign country

Borrowing interest rate 4% per year 8% per year
Deposit interest rate 3% per year 6% per year

Working to the nearest $100, what is the six-month dollar value of the expected receipt
using a money-market hedge?

A $32,500
B $33,700
C $31,800
D $31,900

36. Which of the following is true?

A As the majority of futures contracts are never taken to delivery a futures contract is
not legally binding
B The quantity in a futures contract is agreed between the buyer and seller
C Delivery dates on futures contracts are specified by the futures exchange and not by
the buyer and seller
D The margin requirement is a purchase cost of a future.

37. Consider the following two statements:

1. One form of hedging is where an investor buys shares in one market and sells them
immediately in another to profit from price differences between the two markets.
2. One form of financial derivative is a preference share of a business.

Which one of the following combinations relating to the above statements is correct?
Statement 1 Statement 2
A True True
B True False
C False True
D False False

38. Consider the following statements concerning derivatives.

1. Futures contracts may not be traded on an organised exchange

2. Forward contracts may be traded on an organised exchange

Which one of the following combinations (true/false) concerning the above statements is
correct?

Statement 1 Statement 2
 A True True
B True False
C False True
D False False

39. Consider the following two statements concerning futures contracts.

1. A futures contract is negotiated between a buyer and seller and can be tailored to
the buyer’s particular requirements.
2. A futures contract can be traded on a futures exchange.

Which of the following combinations (true/false) is correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

40. Consider the following statements concerning futures contracts.

1. Futures contracts are tailor-made for the needs of the client

2. Futures contracts can be traded on a futures exchange
3. A short position on a futures contract can be closed by buying an equal number of
the contracts for the same settlement date.
4. A long position on a futures contract can be closed by buying an equal number of
contracts for the same settlement date.

Which two of the above statements are correct?

A 1 and 3
B 1 and 4
C 2 and 3
D 2 and 4

41. Consider the following statements concerning financial options.

1. A European-style option gives the holder the right to exercise the option at any time
up to and including its expiry date.
2. An in-the-money option has a more favourable strike price for the option writer than
the current market price of the underlying item.

Which one of the following combinations (true/false) concerning the above statements is
correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False
42. Consider the following statements concerning options.

1. An out of-the-money call option has an intrinsic value of zero.

2. An American-style option can be exercised at any time up to, and including, the
expiry date.
Which one of the following combinations (true/false) relating to the above statements is
correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

43. The following statements have been made concerning options.

1. An out-of-the-money option has an intrinsic value of zero.

2. An American-style option can only be exercised on the expiry date of the option.
3. When an option is used to hedge currency risk, the option will be exercised only if
the market price of the underlying item is less favourable than the option strike
price.
4. An employee share option is a form of put option.

Which TWO of the above statements are correct?

A 1 and 2
B 1 and 3
C 2 and 4
D 3 and 4

44. Which of the following measures will allow a UK company to enjoy the benefits of a
favourable change in exchange rates for their euro receivables contract while protecting
them from unfavourable exchange rate movements?

A A forward exchange contract

B A put option for euros
C A call option for euros
D A money market hedge

45. The following European-style options are held at their expiry date by an investor:

1. A call option of 20,000 shares in Peterhouse plc with an exercise price of 860p. The
market price of the shares at the expiry date is 880p.
2. A put option of £600,000 in exchange for euros at a strike rate of £1 = €1·5. The
exchange rate at the expiry date is £1 = €1·45.

Which one of the above combinations (exercise/lapse) concerning the options should be
undertaken by the investor?
 Option 1 Option 2
A Exercise Exercise
B Exercise Lapse
C Lapse Exercise
D Lapse Lapse

46. Musat plc holds the following OTC options at their expiry date:

1. A put option on dollars at an exchange rate of £1 = $1·92. The exchange rate is £1

= $1·95 at the expiry date of the option.
2. A call option on 5,000 ordinary shares in Spitzer plc at an exercise price of 575p.
The share price is 562p at the expiry date of the option.

Which of the above options should be exercised and which should be allowed to lapse at
their expiry date?

Put option Call option

A Exercise Exercise
B Lapse Exercise
C Exercise Lapse
D Lapse Lapse

47. A US company has just purchased goods from a UK supplier for £500,000. Payment is
due in three months’ time and the US company wishes to hedge its exposure to exchange
rate risk. The following ways of dealing with the exchange rate risk have been suggested:

1. Buy sterling futures now and sell sterling futures in three months’ time
2. Buy sterling call options now.
3. Sell sterling futures now and buy sterling futures in three months’ time
4. Buy sterling put options now

Which two of the above suggestions would provide a hedge against exchange rate risk?
A 1 and 2
B 1 and 3
C 2 and 3
D 3 and 4

48. A UK business expects to receive euros in five months’ time. Assume that the business
wishes to hedge against exchange rate risk.

Which one of the following methods should be employed?

A Take out a forward contract to sell euros in five months’ time

B Take out a forward contract to buy euros in five months’ time
C Buy euros now at the prevailing spot rate
D Take out a call option on euros.

49. A company based in Farland (with the Splot as its currency) is expecting its US customer
to pay $1,000,000 in 3 month’s time and wants to hedge this transaction using currency
 options.

What is the option they require?

1 A Splot put option purchased in America

2 A US dollar put option purchased in Farland
3 A Splot call option purchased in America
4 A US dollar call option purchased in Farland.

A 2 or 3 only
B 2 only
C 1 or 4 only
D 4 only

50. A UK company has just provided a service to a US company for $750,000. Settlement is
due in two months’ time and the UK company wants to hedge the risk of a fall in the
value of the US dollar over the next two months. The following methods of hedging this
risk have been suggested:

1. Buy sterling put options now

2. Buy sterling futures now
3. Buy sterling call options now
4. Sell sterling futures now

Which two of the above suggestions would provide a hedge against the exchange rate
risk?

A 1 and 3
B 1 and 4
C 2 and 3
D 2 and 4

Which one of the following actions should the company take NOW to hedge the risk?

A Buy euro futures

B Buy US dollar options
C Sell euro futures
D Sell US dollar futures

52. Three derivatives that may be used to manage financial risk are as follows:

1. Futures contracts
2. Forward contracts
3. Swaps

Which of the above may be traded on an organised exchange?

A 1 only
B 1 and 2
 C 2 only
D 2 and 3

53. Consider the following statements concerning currency risk hedges:

1. A currency swap may be used to hedge for a longer period than that offered by
forward exchange contracts.
2. A futures contract can be customised to fit the particular needs of the client.

Which one of the following combinations (true/false) concerning the above statements is
correct?

Statement 1 Statement 2
A True True
B True False
C False True
D False False

54. Which of the following statements is correct?

A Once purchased, currency futures have a range of close-out dates

B Currency swaps can be used to hedge exchange rate risk over longer periods than
the forward market
C Banks will allow forward exchange contracts to lapse if they are not used by a
company
D Currency options are paid for when they are exercised