FINS3616 International Business Finance - Week 4

A. Conceptual questions
1. What is a forward exchange rate?

2. If the yen is selling at a premium relative to the euro in the forward market, is the forward
price of EUR per JPY larger or smaller than the spot price of EUR per JPY?

3. If you are a U.S. firm and owe someone 10,000,000 in 180 days, what is your
transaction exchange risk?

4. If the spot exchange rate of the yen relative to the dollar is 105.75, and the 90-day
forward rate is 103.25/$, is the dollar at a forward premium or discount? Express the
premium or discount as a percentage per annum for a 360-day year?

5. Intel is scheduled to receive a payment of 100,000,000 in 90 days from Sony in

connection with a shipment of computer chips that Sony is purchasing from Intel.
Suppose that the current exchange rate is 103/$, that analysts are forecasting that the
dollar will weaken by 1% over the next 90 days.
(1) Provide a qualitative description of Intels transaction exchange risk.

(2) If Intel chooses not to hedge its transaction exchange risk, what is Intels expected
dollar revenue?

6. A firm based in the United Kingdom has promised to pay bondholders 10,000 in one
year. The firm will be worth either 9,000 or 19,000 with equal probability at that time
depending on the value of the dollar. The firm will be worth 14,000 if it hedges against
currency risk.
a.Identify the values of debt and equity under unhedged and hedged scenarios assuming
there are no costs of financial distress.
b.Suppose the firm will incur direct bankruptcy costs of 1,000 in bankruptcy. Identify
the value of debt and of equity under both unhedged and hedged scenarios.

c.In addition to the 1,000 direct bankruptcy cost, suppose indirect costs reduce the asset
value of the firm to either 6,000 or 18,000 (before the 1,000 direct bankruptcy cost)
with equal probability. Hedging results in firm value of 12,000 with certainty. Identify
the value of debt and of equity under both unhedged and hedged scenarios.
d.Can hedging add value to shareholders in this problem?

B. True or False questions

1.

A major problem with a currency forward contract is that one party always has an incentive
to default when the actual spot rate diverges from the contract price.

2.

If the closing spot rate is $0.5800/C$ at the expiration of a forward contract, a party that has
sold dollars at a forward rate of $0.5754/C$ has an incentive to default.

3.

In a forward contract, an exchange clearinghouse takes one side of every transaction.

4.

The majority of forward contracts are settled at maturity.

5.

In perfect financial markets, corporate hedging policy has no value.

6.

If financial markets are informationally efficient, then corporate financial policy is

irrelevant.

7.

In the real world, corporate hedging policy can change expected future cash flows but is
unlikely to reduce the cost of debt.

8. One important purpose of the forward markets for foreign exchange allows global traders to
protect themselves by speculating

C. MCQ
1. What is the name of the exchange rate specified in the forward contract?
a. spot rate
b. forward rate
c. future exchange rate
d. cross-rate
e. none of the above
2. If you want to hedge the risk from paying a firm foreign currency in the future, you would
a. buy the foreign currency forward.
b. sell the foreign currency forward.
c. speculate on the possibility to not hedge.
d. buy the currency now and deposit into a bank account until needed.
e. do nothing
3. If the forward price of a currency contract is higher than the spot rate, the currency is said to be at a
a. forward discount.
b. forward premium.
c. future expected exchange rate.
d. forward swap rate.
e. none of the above
4. If the euro is selling at a premium relative to the USD in the forward market, is the forward price of
USD /EUR larger or smaller than the spot price of the USD /EUR?
a. larger
b. smaller
c. indeterminate
d. the same
e. none of the above
5. Why are the bid-ask spreads larger in the forward market than in the spot market?
a. because the forward market is less liquid than the spot market
b. because the spot market is more volatile than the forward market
c. because the forward market is more volatile than the spot market
d. because the spot market is less liquid than the forward market
e. none of the above
6. One of the major reasons for the existence of the forward market is to ________.
a. provide a location for all currency traders to assemble and trade
b. manage currency risk especially risk associated with a transaction
c. hedge transactions involving foreign currency that occurred in the past
d. prevent default in the transaction
e. none of the above
7. The perfect market assumptions include each of the following except ____.
a. equal access to market prices
b. equal access to costless information
c. frictionless markets
d. rational investors
e. stable governments