IBF301 | Que Anh Nguyen

Chapter 9_Tutorial Questions

A. Eun Chap 9
1. Explain the following statement: “Exposure is the regression coefficient.” (Eun pg. 403)

Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s
future cash flows and the market value to random changes in exchange rates. Statistically, this
sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the
regression coefficient.

Students should be able to show and explain the Asset Exposure equation

2. Suppose that you hold a piece of land in the City of London that you may want to sell in one
year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if
the British economy booms in the future, the land will be worth £2,000 and one British pound
will be worth $1.40. Pg. 404

Solution: (a) Let us compute the necessary parameter values:

E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580

E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2 = .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44) = -5.28-7.92 = -13.20

➔ b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

➔ You have a negative exposure! As the pound gets stronger (weaker) against the dollar, the
dollar value of your British holding goes down (up).

(b) b2Var(S) = (-5500)2(.0024) =72,600($)2

(c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your British
asset that is due to the exchange rate volatility.

3. A U.S. firm holds an asset in France and faces the following scenario… Pg. 404
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State 1 State 2 State 3 State 4

Probability 25% 25% 25% 25%

Spot rate $1.20/€ $1.10/€ $1.00/€ $0.90/€

P* €1500 €1400 €1300 €1200

P $1,800 $1,540 $1,300 $1,080

Solution: (a)

E(S) = .25(1.20 +1.10+1.00+0.90) = $1.05/€

E(P) = .25(1,800+1,540+1,300 +1,080) = $1,430

Var(S) = .25[(1.20-1.05)2 +(1.10-1.05)2+(1.00-1.05)2+(0.90-1.05)2] = .0125

Cov(P,S) = .25[(1,800-1,430)(1.20-1.05) + (1,540-1,430)(1.10-1.05) + (1,300-1,430)(1.00-1.05) +

(1,080-1,430)(0.90-1.05)] = 30

b = Cov(P,S)/Var(S) = 30/0.0125 = €2,400.

(b) Var(P) = .25[(1,800-1,430)2+(1,540-1,430)2+(1,300-1,430)2+(1,080-1,430)2]

= 72,100($)2.

(c) Var(P) - b2Var(S) = 72,100 - (2,400)2(0.0125) = 100($)2.

This means that most of the volatility of the dollar value of the French asset can be removed by
hedging exchange risk. The hedging can be achieved by selling €2,400 forward.

4. MINI CASE: ECONOMIC EXPOSURE OF ALBION COMPUTERS PLC Pg. 405

Suggested Solution to Economic Exposure of Albion Computers PLC

a) The projected annual cash flow can be computed as follows:

______________________________________________________

Sales (40,000 units at £1,080/unit) £43,200,000

Variable costs (40,000 units at £697/unit) £27,880,000

Fixed overhead costs 4,000,000

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Depreciation allowances 1,000,000

Net profit before tax £15,315,000 WRONG HERE, THE ANSWER

HAS NOT ACCOUNT FOR THE FIXED COST

Income tax (50%) 7,657,500

Profit after tax 7,657,500

Add back depreciation 1,000,000

Operating cash flow in pounds £8,657,500

Operating cash flow in dollars $12,986,250

______________________________________________________

b) ______________________________________________________

Benchmark Current

Variables Case Case

______________________________________________________

Exchange rate ($/£) 1.60 1.50

Unit variable cost (£) 650 697

Unit sales price (£) 1,000 1,080

Sales volume (units) 50,000 40,000

Annual cash flow (£) 7,250,000 8,657,500

Annual cash flow ($) 11,600,000 12,986,250

Four-year present value ($) 33,118,000 37,076,946

Operating gains/losses ($) 3,958,946 → NO WRONG, LOSS

______________________________________________________

c) In this case, Albion actually can expect to realize exchange gains, rather than losses. This is
mainly due to the fact that while the selling price appreciates by 8% in the U.K. market, the variable
cost of imported input increased by about 6.25%. Albion may choose not to do anything about the
exposure. → WRONG ANSWER yet the action is still that you don’t have to do anything about the
currency exposure, only to deal with the loss in sales volume.

B. Additional MCQs
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1. Suppose the U.S. dollar substantially depreciates against the Japanese yen. The change in
exchange rate
A) will tend to weaken the competitive position of import-competing U.S. car makers.
B) will tend to strengthen the competitive position of Japanese car makers at the expense of U.S.
makers.
C) will tend to strengthen the competitive position of import-competing U.S. car makers.
D) none of the options
2. When exchange rates change,
A) U.S. firms that produce domestically and sell only to domestic customers can be affected if they
compete against imports.
B) U.S. firms that produce domestically and sell only to domestic customers will be affected, but
only if they borrow in foreign currency to finance their domestic operations.
C) U.S. firms that produce domestically and sell only to domestic customers will be unaffected.
D) U.S. firms that produce domestically and sell only to domestic customers will be unaffected, and
U.S. firms that produce domestically and sell only to domestic customers can be affected if they
compete against imports
3. Operating exposure measures
A) the extent to which the foreign currency value of the firm's assets is affected by unanticipated
changes in exchange rates.
B) the effect of changes in exchange rates will have on the consolidated financial reports of a
MNC.
C) the extent to which the firm's operating cash flows will be affected by unexpected changes in
exchange rates.
D) the effect of unanticipated changes in exchange rates on the dollar value of contractual
obligations denominated in a foreign currency.
4. Economic exposure refers to
A) ex post and ex ante currency exposures.
B) the extent to which the value of the firm would be affected by unanticipated changes in
exchange rate.
C) the sensitivity of realized domestic currency values of the firm's contractual cash flows
denominated in foreign currencies to unexpected exchange rate changes.
D) the potential that the firm's consolidated financial statement can be affected by changes in
exchange rates.
5. The exposure coefficient b = Cov(P,S)/ VAR(S) in the regression P = a + b × S + e is
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A) a measure of how a change in the exchange rate affects the dollar value of a firm's assets, and
has a value of zero if the value of the firm's assets is perfectly correlated with changes in the
exchange rate.
B) a measure of how a change in the exchange rate affects the dollar value of a firm's assets.
C) a value of zero if the value of the firm's assets is perfectly correlated with changes in the
exchange rate.
D) none of the options
6. Before you can use the hedging strategies such as a forward market hedge, options market
hedge, and so on, you should consider running a regression of the form P = a + b × S + e . When
reviewing the output, you should initially focus on
A) R2. B) the slope coefficient b.
C) mean square error, MSE. D) the intercept a.
7. From the perspective of the U.S. firm that owns an asset in Britain, the exposure that can be
measured by the coefficient b in regressing the dollar value P of the British asset on the dollar–
pound exchange rate S using regression equation P = a + b × S + e is
A) accounting exposure. B) operating exposure.
C) asset exposure. D) none of the options
8. On the basis of regression equation P = a + b × S + e, we can decompose the variability of the
dollar value of the asset, VAR(P), into two separate components: VAR(P) = b2 × VAR(S) +
VAR(e). The first term in the right-hand side of the equation, b2 × VAR(S) represents
A) the part of the variability of the dollar value of the asset that is related to random changes in the
exchange rate, as well as the residual part of the dollar value variability that is independent of
exchange rate movements.
B) the part of the variability of the dollar value of the asset that is related to random changes in the
exchange rate.
C) the residual part of the dollar value variability that is independent of exchange rate movements.
D) none of the options
9. Which of the following are identified by your text as a strategy for managing operating
exposure?
(i) Selecting low-cost production sites
(ii) Flexible sourcing policy
(iii) Diversification of the market
(iv) Product differentiation and R&D efforts
(v) Financial Hedging
A) (i), (iii), and (v) only B) (i), (iv), and (v) only
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C) (i) and (iv) only D) all of the options

10. A U.S. firm holds an asset in Great Britain and faces the following scenario:
State 1 State 2 State 3
Probability 25% 50% 25%
Spot rate $ 2.20 /£ $ 2.00 /£ $ 1.80 /£
P* £ 2,000 £ 2,500 £ 3,000
P $ 4,400 $ 5,000 $ 5,400
where,
P* = Pound sterling price of the asset held by the U.S. firm
P = Dollar price of the same asset
The variance of the exchange rate is:
A) 0.10 B) 0.002
C) 0.0200 D) none of the options
11. A U.S. firm holds an asset in Great Britain and faces the following scenario:
State 1 State 2 State 3
Probability 25% 50% 25%
Spot rate $ 2.20 /£ $ 2.00 /£ $ 1.80 /£
P* £ 2,000 £ 2,500 £ 3,000
P $ 4,400 $ 5,000 $ 5,400
where,
P* = Pound sterling price of the asset held by the U.S. firm
P = Dollar price of the same asset
12. Which of the following conclusions are correct?
A) Most of the volatility of the dollar value of the British asset cannot be removed by hedging
exchange risk because b2[Var(S)] and VAR(e) are 125,000 ($)2 and -127,500 ($)2 respectively.
B) Most of the volatility of the dollar value of the British asset can be removed by hedging
exchange risk because b2[Var(S)] and VAR(e) are 125,000 ($)2 and -127,500 ($)2 respectively.
C) Most of the volatility of the dollar value of the British asset cannot be removed by hedging
exchange risk because b2[Var(S)] and VAR(e) are 236,717 ($)2 and 493,751 ($)2 respectively.
D) Most of the volatility of the dollar value of the British asset can be removed by hedging
exchange risk because b2[Var(S)] and VAR(e) are 236,717 ($)2 and 493,751 ($)2 respectively.
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13. A U.S. firm holds an asset in Great Britain and faces the following scenario:
State 1 State 2 State 3
Probability 25% 50% 25%
Spot rate $ 2.20 /£ $ 2.00 /£ $ 1.80 /£
P* £ 3,000 £ 2,500 £ 2,000
P $ 6,600 $ 5,000 $ 3,600
where,
P* = Pound sterling price of the asset held by the U.S. firm
P = Dollar price of the same asset
The variance of the exchange rate is
A) 0.0200 B) 0.002
C) 0.10 D) none of the options
14. A U.S. firm holds an asset in Israel and faces the following scenario:
State 1 State 2 State 3
Probability 25% 50% 25%
Spot rate $ 0.30 /IS $ 0.20 /IS $ 0.15 /IS
P* IS 2,000 IS 5,000 IS 3,000
P $ 600 $ 1,000 $ 4,50
where,
P* = Israeli shekel (IS) price of the asset held by the U.S. firm
P = Dollar price of the same asset
Which of the following would be an effective hedge?
A) Sell 53 Israeli shekels forward at the 1-year forward rate, F1($/IS), that prevails at time zero.
B) Sell 12,898 Israeli shekels forward at the 1-year forward rate, F1($/IS), that prevails at time
zero.
C) Buy 53 Israeli shekels forward at the 1-year forward rate, F1($/IS), that prevails at time zero.
D) none of the options Suppose a U.S. firm has an asset in Britain whose local currency price is
random.
15. For simplicity, suppose there are only three states of the world and each state is equally likely
to occur. The future local currency price of this British asset (P*) as well as the future exchange
rate (S) will be determined, depending on the realized state of the world.
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State Probability P* S S × P*
1 1/3 £ 1,000 $ 1.40 /£ $ 1,400
2 1/3 £ 1,000 $ 1.50 /£ $ 1,500
3 1/3 £ 1,000 $ 1.60 /£ $ 1,600
Which of the following statements is most correct?
A) Since randomness is involved, no hedging is possible.
B) The firm faces no exchange rate risk since the local currency price of the asset and the
exchange rate are negatively correlated.
C) The firm's exchange rate exposure can be completely hedged with derivatives written on the
British pound.
D) The firm faces substantial exchange rate risk since the local currency price of the asset and the
exchange rate are positively correlated
16. Consider a U.S. MNC with operations in Great Britain. Which of the following are potential risks
following a strengthening of the dollar?
A) A given operating cash flow in pounds will be converted into a lower dollar amount after the
pound depreciation.
B) A pound sterling depreciation may affect operating cash flow in pounds by altering the firm's
competitive position in the marketplace.
C) A pound sterling depreciation may affect operating cash flow in pounds by altering the firm's
competitive position in the marketplace, and a given operating cash flow in pounds will be
converted into a lower dollar amount after the pound depreciation.
D) none of the options
17. Generally speaking, a firm is subject to high degrees of operating exposure
A) when its prices are sensitive to exchange rate changes.
B) when either its cost or its price is sensitive to exchange rate changes.
C) when its costs are sensitive to exchange rate changes.
D) none of the options
18. What is the objective of managing operating exposure?
A) Increase the variability of cash flows in the face of fluctuating exchange rates.
B) Stabilize cash flows in the face of fluctuating exchange rates.
C) electing low cost production sites.
D) Stabilize cash flows in the face of fluctuating exchange rates, and increase the variability of
cash flows in the face of fluctuating exchange rates.
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19. Which of the following can a company use to manage operating exposure?
A) Selecting low-cost production sites, diversifying the market, as well as pursuing a flexible
sourcing policy, product differentiation, R&D efforts.
B) Pursuing a flexible sourcing policy, product differentiation, R&D efforts.
C) Selecting low-cost production sites, diversifying the market.
D) Low cost production sites, but not financial hedging.
20. Which of the following can a company use to manage operating exposure?
A) Selecting low-cost production sites, diversifying the market, as well as pursuing a flexible
sourcing policy, product differentiation, R&D efforts.
B) Pursuing a flexible sourcing policy, product differentiation, R&D efforts.
C) Selecting low-cost production sites, diversifying the market.
D) Low cost production sites, but not financial hedging.
21. A firm that is committed to keeping manufacturing facilities in only the home country (and not
developing multiple production sites in a variety of countries) can
A) not mitigate the effects of exchange rate changes.
B) lessen the effect of exchange rate changes by pursuing a strategy of selling commodity
products without product differentiation.
C) pursue a strategy of increasing its products price elasticity of demand.
D) lessen the effect of exchange rate changes by pursuing a strategy of diversifying the markets in
which the firm's products are sold
22. If the stock market of a foreign country is consistently up when the dollar value of the currency
is down,
A) then investors can ignore diversification.
B) there may not be a great deal of exchange rate risk for a U.S.-based investor.
C) there will be a great deal of exchange rate risk for a U.S.-based investor.
D) none of the options