Foreign exchange Question 1 Explain the differences between the following types of foreign exchange exposure and provide an example of each to demonstrate how the foreign exchange risk will impact in each example. (a) transaction exposure (b) translation exposure (c) economic exposure Hint: Be sure to refer to the following reading: Jeff Madura, (2014) “International Financial Management”, Cengage Learning US, Chapter 10 “Measuring exposure to exchange rate fluctuations” Question 2 Explain the concept of foreign exchange risk and discuss how foreign exchange risk may impact a corporate’s free cash flow and its profit & Loss statement and Balance Sheet financial statements. Hint: be sure to refer to the following reading: Michael Papaioannou (2006) “Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms”, IMF Working Paper, WP/06/255, November 2006 Question 3 Recommend alternative internal hedging approaches that a company can be used to reduce its exposure to transaction and translation risk. Question 4 Identify and discuss the relative strengths and weaknesses of alternative approaches to managing foreign exchange risk. In your answer be sure to identify and discuss both internal and external approaches. Question 5 Explain the concept of a money market hedge and discuss how such a hedge can be used to manage accounts payable and recievable in foreign currencies. Question 6 Differentiate between interest rate parity and purchasing power parity. With the use of examples, show how both can be used to estimate implied forward rates for foreign exchange. Question 7 In each of the following cases, state the type of exchange rate risk, the company is facing and whether the risk is beneficial or harful to the company. (a) A UK power generating company imports coal from Germany, paying for the coal in Euros (€). The importing company expects Pounds Sterling (£) to weaken against the euro during the next six months. (b) A UK toy company supplies only the domestic market with stores in London, Manchester and Liverpool. Its only major competitor in the UK is a US toy company. The Pounds sterling is expected to weaken against the US Dollar over the next 12 months. (c) A UK company has bought a factory in france, financing the purchase with a Pounds sterling borrowing. Over the next year the Pound Sterling is expected to appreciate against the Euro. (d) a French company operates a subsidiary company in Germany. Both company’s financial statements are reported in Euros. In six months time, the French subsidiary company profit & loss statement and balance sheet are expected to be consolidated with the German parent company’s accounts. During the time Euro is expected to appreciate relative to both Pound Sterling and US Dollars. Question 8 Brexit LLC is a UK company that engages in export and import trade with the USA. The following transactions, in the currency specified, are due to occur within the next six months: Purchases of goods, cash payment due in 3 months £ 116,000 Sale of goods, cash payment due in 3 months £ 197,000 Purchases of goods, cash payment due in 6 months £ 447,000 Data relating to the exchange rates are as follows: Exchange rates $/£ (USD/GBP) Spot 1.7106-1.7140 Three months forward 1.7024-1.7063 Six Months forward 1.6967-1.7006 Data relating to the interest rates are as follows: Interest rates Borrow Deposit Pounds Sterling (GBP) 12.50% 9.50% US dollars 9.00% 6.00% (a) Identify and explain four techniques that Brexit LLC could use to hedge against the foreign exchange risk involved in foreign trade. (b) Calculate the net sterling receipts/payments that Brexit LLC might expect for both its three month and its six month transactions, if the company hedges foreign exchange risk using i. the forward market ii. the money market (i.e. a money market hedge) Interest rates Question 9 What are the primary sources of interest rate risk for a bank ? Question 10 What is Gap analysis and how is it applied by banks to manage a bank’s net interest income? Question 11 In relation to gap analysis, explain the difference between rate sensitive assets and rate sensitive liabilities Question 12 Discuss the impact on NII if: (a) a company is a rate sensitive asset company and interest rates increase (b) a company is a rate sensitive asset company and interest rates decrease (c) a company is a rate sensitive liability company and interest rates increase (d) a company is a rate sensitive liability company and interest rates decrease Question 13 Identify strategies that a company can introduce to (a) reduce a negative gap (b) increase a positive gap (Hint – refer to slide 30 and 32 from the week 11 lecture) Question 14 Identify problems encountered in using gap analysis to manage a bank’s interest rate gap. Question 15 Explain the concept of duration, modified duration and duration gap. Question 16 Explain the concept of positive duration gap and negative gap and discuss the impact of each of the following on net worth: (a) positive interest rate gap when interest rates are expected to rise (b) positive interest rate gap when interest rates are expected to fall (c) negative interest rate gap when interest rates are expected to rise (d) negative interest rate gap when interest rates are expected to fall Question 17 Is a non- financial corporate more likely to have a positive or negative duration rate gap? why? Hint – consider the interest rate sensitive assets and liabilities of a corporate – think again about the items that are subject to interest rate sensitivity including rollover risk. Eg. cash, marketable securities, short term and long term borrowing, accounts receivable, accounts payable. Question 18 Identify problems in the use of duration Question 19 What are the differences between a microhedge and a macrohedge for an FI? Why is it generally more efficient for FIs to employ a macrohedge than a series of microhedges? Question 20 Differentiate between forward rate agreements and interest rate swaps and explain with the use of an example as to how each can be used to: (a) reduce exposure to interest rate risk for a borrower (b) reduce the exposure to interest rate risk for an investor Question 21 (a) Explain the similarity between a swap and a forward contract. (b) Why does the duration of an interest rate swap reflect the difference between the duration on a fixed rate and a floating rate and why is the floating leg typically less than one? (c) Explain how derivatives such as forward contracts (futures and forward rate agreements) and interest rate swaps can be used to manage a duration gap in order to immunize a balance sheet. Group Question for consideration by Group members. Question 22 Explain the alternative sources of foreign exchange rate risk and discuss how foreign exchange risk may impact the profit and loss and balance sheet of (a) a bank (b) a manufacturing company (c) a service based company (d) a government owned corporation Question 23 Explain the alternative sources of interest rate risk and discuss how interest rate risk may impact the profit and loss and balance sheet of (a) a bank (b) a manufacturing company (c) a service based company (d) a government owned corporation

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