Kirt C. Butler, Multinational Finance, 3rd edition
Chapter 4 Foreign Exchange, Eurocurrencies and Currency Risk Management
True/False
1. Eurocurrency markets are highly liquid and relatively unencumbered by government
regulation, resulting in borrowing and lending rates that are generally more favorable to customers than domestic rates.
ANS: True.
2. A bank that is making a market in lira stands ready to buy lira at its offer price and sell lira
at its bid price.
ANS: False. The bank will buy at the bid and sell at the offer price.
3. American terms state the dollar value of one unit of foreign currency, such as $0.0085/￥.
ANS: True.
4. European terms state the foreign currency price of one U.S. dollar (for example C$1.726/$).
ANS: True.
5. If the current spot rate is S0$/C$ = $0.5839/C$ and the one-year forward rate is F1$/C$ =
$0.5754/C$, then the Canadian dollar is selling at a forward premium.
ANS: False. The Canadian dollar (in the denominator of the quote) is selling at a forward discount.
6. If the current spot rate is S0$/C$ = $0.5839/C$ and the one-year forward rate is F1$/C$ =
$0.5754/C$, then the U.S. dollar is selling at a forward premium.
ANS: True. The Canadian dollar in the denominator is at a forward discount.
7. A bank offers you the following quote: “$0.5841/C$ BID and $0.5852/C$ ASK.” The bank
will buy U.S. dollars at $0.5841/C$ or sell U.S. dollars at $0.5852/C$.
ANS: False. Banks quote foreign currency in order to make a profit. The bank will buy C$ (and sell $) at $0.5841/C$ or sell C$ (and buy $) at $0.5852/C$.
8. Currency risk is the risk of unexpected changes in foreign currency values.
ANS: True.
9. For the most actively traded currencies, national credit markets are operationally more
efficient than the Eurocurrency markets.
ANS: False. Eurocurrency markets are generally more operationally efficient.
10. Volume in the foreign exchange markets averages about one billion dollars per day.
ANS: False. Interbank trading volume averages over one trillion dollars daily.
11. Eurocurrency transactions in the external credit market fall outside the jurisdiction of any
single nation.
ANS: True.
12. One basis point is equal to one percentage point (e.g., one percent of a dollar).
ANS: False. It is equal to one hundredth of a percentage point (e.g. 1/100th of a dollar). 13. The majority of the volume in the forward market for foreign exchange is conducted on the
floor of the Chicago Mercantile Exchange’s International Monetary Market.
ANS: False. Forward exchange contracts are primarily traded through commercial banks. 14. Commercial banks always quote foreign exchange rates with the domestic currency in the
denominator of the quote.
ANS: False. The domestic currency can be in the numerator or the denominator.
15. A bank’s bid price for one currency is its offer pri ce for another currency.
ANS: True.
16. Suppose S0￡/$ = ￡0.6361/$ and F1￡/$ = ￡0.6352/$. The dollar is selling at a forward premium
of 9 basis points.
ANS: False. It is selling at a forward discount of 9 bps.
17. Domestic interest rates typically lie inside the LIBID/LIBOR rate band.
ANS: False. The domestic rates lie outside the LIBID/LIBOR rate band.
18. LIBOR is the rate a Euromarket bank is willing to pay to attract a deposit.
ANS: False. It is an average offer rate at which banks are willing to loan funds in the
London Eurocurrency market.
19. Eurocurrency markets are regulated by the governments whose currencies are traded.
ANS: False. These governments have little or no jurisdiction over external credit markets. 20. MNCs and financial institutions with access to Eurocurrency markets can obtain lower cost
funds and store funds at higher interest rates than in domestic credit markets.
ANS: True.
21. Commercial banks’ lending rates in the Eurocurrency market are usually higher than their
prime lending rates in their domestic credit markets.
ANS: False. Eurocurrency markets are usually more competitive and lending rates are lower.
22. You have a contractual obligation denominated in a foreign currency and to be paid in six
months. You can hedge this exposure by buying the foreign currency in the forward market.
ANS: True.
23. You expect to receive a cash flow denominated in a foreign currency in six months. You can
hedge this exposure by buying the foreign currency in the forward market.
ANS: False. Sell the foreign currency (and buy the domestic currency) at the forward rate.
24. You have a contractual cash inflow denominated in a foreign currency and to be received in
six months. You will gain if the foreign currency appreciates in value over the next six
months.
ANS: True.
25. Risk exists whenever actual outcomes can deviate from expected outcomes.
ANS: True.
26. The multinational corporation is exposed to currency risk when the value of its assets and
liabilities changes with unexpected changes in currency values.
ANS: True.
27. Exposure to currency risk depends on exchange rate variability, but not on how much is at
risk.
ANS: False. Exposure to currency risk depends on how much is at risk.
28. If an investor’s wealth is dependent on foreign currency movements, then the investor is
exposed to foreign currency risk.
ANS: True.
29. Monetary contracts can be denominated either in the domestic or in a foreign currency.
ANS: True.
30. Monetary assets have contractual payoffs.
ANS: True.
31. Real assets are only exposed to currency risk if they are located in a foreign country.
ANS: False. For example, the value of an exporter depends on foreign currency values. 32. Transaction exposure to currency risk refers to changes in the value of monetary assets and
liabilities due to unexpected changes in foreign currency exchange rates.
ANS: True.
33. Operating exposure to currency risk includes transaction exposure and accounting exposure.
ANS: False. Economic exposure includes transaction exposure and operating exposure.
Accounting exposure is the exposure of financial statements to currency risk.
34. Economic exposure to currency risk refers to changes in the value of monetary assets and
liabilities due to unexpected changes in foreign currency exchange rates.
ANS: True.
35. Economic exposure refers to changes in contractual cash flows due to unexpected changes in
foreign currency exchange rates.
ANS: False. Economic exposure refers to changes in all future cash flows due to unexpected changes in foreign currency exchange rates. Transaction exposure is the exposure of
contractual cash flows.
36. Monetary contracts denominated in a foreign currency are fully exposed to changes in the
value of that currency.
ANS: True.
37. Monetary assets and liabilities denominated in a domestic currency are not exposed to
purchasing power risk.
ANS: False. The real value of monetary assets depends on realized inflation.
38. Operating exposure refers to the exposure of the firm’s real assets to currency risk.
ANS: True.
39. A parent firm has translation exposure to the extent that unexpected changes in foreign
currency values change the parent’s financial accounting statements.
ANS: True.
40. Translation exposure to currency risk necessarily reflects changes in the market value of the
firm’s assets and liabilities.
ANS: False. Accounting exposure may or may not reflect changes in market values.
41. Translation exposure to currency risk is of direct concern to equity investors in the
multinational corporation.
ANS: False. Shareholders are concerned with cash flows and values. Translation exposure may or may not be related to value.
42. Surveys reveal that financial managers believe transaction exposure is the most important
currency risk exposure.
ANS: True.
Multiple Choice
1. Which of the following is not a function of the currency and Eurocurrency markets?
a. foreign currency speculation
b. hedging foreign exchange risk
c. provision of credit
d. transfer of purchasing power
e. each of the above is a function of the foreign exchange market
ANS: E
2. When foreigners decide to purchase additional U.S. government bonds, ____.
a. the demand for dollars rises
b. the federal government budget deficit declines
c. the supply of dollars rises
d. the trade deficit declines
e. none of the above
ANS: A
3. The foreign exchange desks of commercial banks typically make their profits through ____.
a. arbitrage
b. government subsidies
c. investment banking
d. market making
e. speculation
ANS: D
4. In order to boost the value of the euro relative to the dollar, the U.S. Federal Reserve should
____.
a. sell euros for dollars and buy euros with dollars
b. sell euros for dollars and sell dollars for euros
c. sell dollars for euros and buy dollars with euros
d. sell dollars for euros and buy euros with dollars
e. more than one of the above
ANS: D
5. Electronic fund transfers between international banks are accomplished through the ____.
a. Association of International Fund Transfers
b. Clearing House Interbank Payments System
c. International Monetary Fund
d. Society for Worldwide Interbank Financial Transactions
e. World Bank
ANS: D
6. The euro depreciates 17% against the dollar. How much has the dollar appreciated against
the euro?
a. 16.31%
b. 17.00%
c. 17.54%
d. 20.48%
e. 34.00%
ANS: D
7. A forward foreign exchange contract ____.
a. allows a transfer of purchasing power from one currency to another on a predetermined
date and at a predetermined exchange rate
b. is a long (or forward) position in a foreign currency
c. is a type of option that can be used to hedge against unfavorable changes in foreign
currency values at the discretion of the option holder
d. is priced to equal the spot exchange rate
e. none of the above
ANS: A
8. The biggest traders in the foreign exchange markets are ____.
a. commercial banks
b. corporations
c. government agencies
d. governments
e. individual investors
ANS: A
9. International electronic fund transfers are accomplished through the ____.
a. Association of International Fund Transfers
b. Clearing House Interbank Payments System
c. International Monetary Fund
d. Society for Worldwide Interbank Financial Transactions
e. World Bank
ANS: D
10. Characteristics of the Eurocurrency market include which of the following?
a. no interest rate regulations on Euromarket transactions
b. no regulations influencing credit allocation decisions
c. no reserve requirements on Euromarket transactions
Kirt C. Butler, Multinational Finance, 3rd edition
d. no withholding taxes on Euromarket transactions
e. all of the above
ANS: E
11. The value of the Hong Kong dollar against the U.S. dollar on December 31, 1978 was
$4.80/HK$. By year-end 1998, the exchange rate was $7.75/HK$. What was the average annual change in the value of the Hong Kong dollar over this 20-year period?
a. less than or equal to 0%
b. more than 0% and less than or equal to 5%
c. more than 5% and less than or equal to 10%
d. more than 10% and less than or equal to 15%
e. more than 15%
ANS: B
12. The value of the Hong Kong dollar against the U.S. dollar on December 31, 1978 was
$4.80/HK$. By year-end 1998, the exchange rate was $7.75/HK$. What was the average annual change in the value of the U.S. dollar over this 20-year period?
a. less than or equal to 0%
b. more than 0% and less than or equal to 5%
c. more than 5% and less than or equal to 10%
d. more than 10% and less than or equal to 15%
e. more than 15%
ANS: A
13. The spot rate is $1.00/€ and the one-year forward rate is $1.10/€. What is the percentage
forward premium (or discount) on the euro?
a. less than 0%
b. 0%
c. 10 percent
d. more than 10%
e. none of the above
ANS: C
14. The spot rate is $1.00/€ and the one-year forward rate is $1.10/€. What is the percentage
forward premium (or discount) on the dollar?
a. less than 0%
b. 0%
c. 10 percent
d. more than 10%
e. none of the above
ANS: A
15. The spot rate is $1.00/€ and the one-year forward rate is $1.10/€. What is the forward
premium (or discount) on the euro?
a. 0.10 basis point
b. 1 basis point
c. 10 basis points
d. 100 basis points
e. 1,000 basis points
Kirt C. Butler, Multinational Finance, 3rd edition
ANS: E
16. The firm’s monetary assets include each of the following except ____.
a. accounts receivable
b. cash and money market securities
c. domestic bank deposits
d. Eurocurrency deposits
e. plant and equipment
ANS: E
17. Monetary liabilities include each of the following except ____.
a. accounts payable
b. common equity
c. domestic loans
d. Eurocurrency loans
e. taxes payable
ANS: B
18. Real assets include each of a) through c) except ____.
a. inventory
b. the firm’s employees
c. the firm’s production technologies
d. real assets include all of the above
e. real assets include none of the above
ANS: D
19. A real appreciation of the domestic currency has each of the following effects except ____.
a. It helps hold down domestic inflation.
b. It helps domestic importers as imported goods and raw materials cost less.
c. It shifts resources within the domestic economy from export-oriented firms toward
import-oriented firms.
d. More than one of the above
e. None of the above
ANS: D
20. A real depreciation of the domestic currency has which of the following consequences for the
domestic economy?
a. a decrease in the cost of living
b. higher unemployment
c. higher prices for imported goods
d. lower inflation
e. none of the above
ANS: C
21. A random walk has each of the following properties except ____.
a. a constant variance
b. a positive mean
c. conforms to a normal distribution
d. no memory
Kirt C. Butler, Multinational Finance, 3rd edition
e. all of the above are properties of a random walk
ANS: B
22. Which of the following statements regarding nominal exchange rate forecasts is false?
a. Forward exchange rates perform better than spot exchange rates as the forecasting
horizon is extended beyond one year.
b. The current spot rate is a useful forecast of future exchange rates for horizons of up to
one year.
c. The variability of nominal exchange rates is large relative to forward premiums and
discounts.
d. The variability of nominal exchange rates is large relative to inflation differentials.
e. The variability of forward premiums/discounts is large relative to interest rate
differentials.
ANS: E
Problems
1. Expected inflation over the next year is E[p] = 10%. What nominal interest rate i should
investors charge on the following assets?
a. Investors require a real rate of return of ι = 2 percent on a one-year corporate bond.
b. Investors require a real return of ι = 6 percent on a portfolio of stocks.
c. Investors require a real return of ι = 10 percent on an investment in an oil fie l
d.
2. Credit Suisse First Boston (CSFB) quotes the following rates. For each quote, state which
currency CSFB is buying and which currency CSFB is selling at the quoted rates.
a. €0.8894/$ Bid and €0.8898/$ Ask
b. €0.8898/$ Bid and €0.8894/$ Ask
3. Convert to American terms. Keep the currency being bought and sold in the denominator.
a. €0.8894/$ Bid and €0.8898/$ Ask
b. €0.8898/$ Bid and €0.8894/$ Ask
4. Credit Suisse First Boston (CSFB) quotes the following rates for the U.S. dollar.
Bid (€/$)Ask (€/$)
Spot rate 0.8894 0.8898
1-month forward 0.8938 0.8942
3-month forward 0.9028 0.9032
6-month forward 0.9164 0.9168
12-month forward 0.9443 0.9447
a. Is the dollar selling at a forward premium or a forward discount? Calculate percentage
premiums or discounts for each forward quote. Also state these percentage premiums or discounts on an annualized basis.
b. Convert these to $/€ quotes for the euro. Is the euro selling at a forward premium or a
forward discount? Calculate percentage premiums or discounts (not annualized) for each forward quote on the euro. Also state these percentage premiums or discounts on an
annualized basis.
c. Are the percentage forward premiums on the dollar equal in magnitude to the
corresponding forward discounts on the euro? Why or why not?
d. What would you receive from CSFB if you sold $10 million at the 6-month forward rate?
e. What would you pay CSFB if you bought €10 million at the 12-month forward rate?
5. In what way is the quote “$1.1453/€ Bid and $1.1459/€ Ask” equivalent to “$1.1459/€ Bid
and $1.1453/€ Ask”?
6. Suppose the spot rate is $1.08/€. The dollar then apprec iates by 25 percent against the euro.
What is the new exchange rate in dollars per euro?
7. The Czech koruna (CZK) spot rate is CZK36.02/$.
a. A 20 percent depreciation of the koruna will result in what new CZK/$ spot rate?
b. If the koruna depreciates by 20 percent, by how much does the dollar appreciate?
8. Payless Shoes has a shoe contract with a Taiwanese supplier. The T$30 million purchase is
invoiced in new Taiwan dollars (T$) and is due in three months. The current spot and 3-
month forward exchange rates are T$30/$.
a. Draw Payless’ expected future cash flow in new Taiwan dollars on a time line.
b. Draw a risk profile for Payless in terms of U.S. dollars per new Taiwan dollars.
c. If the actual spot rate in one year is T$25/$, how much gain or loss will Payless have
assuming it does not hedge its currency exposure?
d. Form a forward market hedg
e. Indicate how the hedge eliminates foreign exchange
exposure by identifying the forward contract’s cash inflows and outflows on a time line
and constructing a payoff profile of the forward contract.
9. Is translation exposure important to shareholders?
10. Suppose you estimate a GARCH model (with p = q = 1) of monthly volatility in the value of
the dollar and arrive at the following estimates: σt2= 0.0052 + (0.30)σt-12+ (0.40)s t-12, where the conditional variance (σt-12) and the square of the percentage change in the spot exchange rate (s t-12) are from the previous period. If σt-1 = 0.04 and s t-1 = 0.12, what is the GARCH estimate of conditional volatility?
Problem Solutions
1 Nominal interest rates are calculated from the Fisher equation (1+i) = (1+p)(1+ι).
a. (1+i) = (1+p)(1+ι) = (1.10)(1.02) = 1.122, or i = 12.2 percent
b. (1+i) = (1+p)(1+ι) = (1.10)(1.06) = 1.166, or i = 16.6 percent
c. (1+i) = (1+p)(1+ι) = (1.10)(1.10) = 1.21, or i = 21 percent
2. a. The bid rate is below the ask rate, so CSFB is buying dollars at the bid rate and selling
dollars at the offer rate.
b. The bid rate is below the ask rate. To make a profit on each round turn, CSFB is buying
euros (and selling dollars) at the bid rate and selling euros (and buying dollars) at the
offer rate.
3. a. Taking reciprocals yields $1.1244/€ and $1.1238/€. The euro (in the denominator)
would be quoted as “$1.1238/€ and $1.1244/€.”
b. Again, the reciprocals are $1.1244/€ and $1.1238/€. The euro (in the denominator)
would be quoted as “$1.1238/€ and $1.1244/€.”
4. a. The dollar (in the denominator) is selling at a forward premium.
$ Bid $ Ask Premium/discount Annualized
Spot rate 0.8894 0.8898 $ Bid $ Ask $ Bid $ Ask
One-month forward 0.8938 0.8942 0.50% 0.50% 6.00% 6.00%
One-month forward 0.9028 0.9032 1.51% 1.51% 6.03% 6.03%
One-month forward 0.9164 0.9168 3.04% 3.04% 6.08% 6.08%
One-month forward 0.9443 0.9447 6.17% 6.17% 6.17% 6.17%
b. Quotes and the associated discounts for the euro are as follows:
€ Bid€ Ask Premium/discount Annualized
Spot rate 1.1238 1.1244 € Bid€ Ask€ Bid€ Ask
One-month forward 1.1183 1.1188 -0.50% -0.50% -5.97% -5.97%
One-month forward 1.1072 1.1077 -1.49% -1.49% -5.94% -5.94%
One-month forward 1.0907 1.0912 -2.95% -2.95% -5.90% -5.90%
One-month forward 1.0586 1.0590 -5.81% -5.81% -5.81% -5.81%
c. The percentage premiums on the dollar are almost, but not quite, equal in magnitude to
the corresponding percentage discounts on the euro. The difference in magnitude is
because of the algebra of compound returns. Forward dollar premiums in this problem
are based on a 0.5 percent per month forward premium on the dollar. Over 12 months,
this compounds to (1.005)12 - 1 = 6.17 percent dollar premium. The corresponding 12-
month euro forward discount is 1/(1.0617) - 1 = -5.81 percent.
d. CSFB is buying dollars at their dollar bid price, so you will receive (€0.9028/$) x ($10
million) = €902,800.
e. CSFB is selling euros and hence buying dollars. CSFB will buy dollars at the dollar bid
price, so you will pay (€10 million) / (€0.9447/$) = €1,058,558.
5. A bank quoting “$1.1453/€ Bid and $1.1459/€ Ask” is buying euros (in the denominator) at
$1.1453/€ and selling euros at $1.1459/€. A bank quoting “$1.1459/€ Bid and $1.1453/€Ask” is selling dollars (in the numerator) at $1.1453/€ and buying dollars at $1.1459/€. In each case, the bank is buying euros (and selling dollars) at $1.1453/€, and selling euros (and buying dollars) at $1.1459/€.
6. Let’s put the dollar in the denom inator: S0€/$ = 1/S0$/€= 1/($1.1111/€) = €0.9000/$. A 25%
appreciation of the dollar yields: S1€/$= (€0.9000/$)(1.25) = €1.1250/$, or S0$/€ =
1/(€1.1250/$) = $0.8888/€. Alternatively, S1€/$= ($1.1111/€)(1.00/1.25) = $0.8888/€.
7. a. Since it is the Czech koruna that has depreciated, it is most convenient to place the
koruna in the denominator of the foreign exchange quote; CZK36.02/$ = $0.02776/CZK.
This is a direct quote for a U.S. resident. A 20% depreciation of the koruna results in:
(End rate) = (Beg. rate)(1+%?) = ($0.02776/CZK)(1-0.2) = $0.02221/CZK, or
CZK45.03/$.
b. To find the dollar appreciation, it is most convenient to use a CZK/$ quote. A 20%
depreciation of the koruna is then equivalent to an appreciation in the dollar of: %? =
(End. rate/Beg. rate)-1 = (CZK45.03/$)/(CZK36.02/$)-1 = +25%.
Although it is more difficult, these calculations can be performed in indirect terms with
the currency of interest in the numerator rather than denominator. If the CZK
depreciates by 20%, the new rate is (CZK36.02/$)/(1-0.2) = CZK45.03/$, or
$0.02221/CZK. The dollar would appreciate by
($0.02776/CZK-$0.02221/CZK)/( $0.02221/CZK) = +25%.
8. a. The sale is invoiced in new Taiwan dollars, so the expected future cash flow is:
-T$30,000,000
b. The contractual payment is a cash outflow in new Taiwan dollars, so Payless is
negatively exposed to the value of the new Taiwan dollar.
Payless’s underlying exposure
?S$/T$
c. It is convenient to place the new Taiwan dollar in the denominator. In these terms, the
beginning spot and forward prices are S0$/T$ = F1$/T$ = 1/(T$30/$) = $0.0333/T$. The
actual spot rate is 1/(T$25/$) = $0.04/T$, which is a 20 percent increase in the value of
the new Taiwan dollar. The expected dollar payment is E[CF1$] = E[CF1T$] / E[S1T$/$] =
(T$30,000,000) / (T$30/$) = $1,000,000. The actual payment is CF1$ = CF1T$ / S1T$/$ =
(T$30,000,000) / (T$25/$) = $1,200,000. As the value of the new Taiwan dollar rises by
20 percent, so too does the value of Payless’ new Taiwan dollar forward obligation.
Kirt C. Butler, Multinational Finance , 3rd edition
d. Buy 30 million new Taiwan dollars forward and sell $1,000,000 at the forward price of F 1T$/$ = T$30/$, or F 1$/T$ = $0.0333/T$.
-$1,000,000
+T$30,000,000
The new Taiwan dollar is being bought forward, so Payless’ exposure to the new Taiwan dollar in this forward contract is positive. The positive exposure on the forward contract offsets the negative exposure on the underlying position. The net result is no exposure to the value of the new Taiwan dollar.
$/T$
exposure
?S $/T$