Question

1.How does Economic exposure to exchange rate movements affect the capital budgeting of a firm? Provide an example?

2a. Give an example of how a firm might be affected by translation exposure

2b. Give an example of how a firm might be affected by transaction exposure.

3.

When the dollar strengthens, the reported consolidated earnings of U.S.-based MNCs are ____ affected by translation exposure. When the dollar weakens, the reported consolidated earnings are ____ affected.

a. favorably; favorably affected but by a smaller degree

b. favorably; favorably affected by a higher degree

c. unfavorably; favorably affected

d. favorably; unfavorably affected

4.

Dubas Co. is a U.S.-based MNC that has a subsidiary in Germany and another subsidiary in Greece. Both subsidiaries frequently remit their earnings back to the parent company. The German subsidiary generated a net outflow of €2,000,000 this year, while the Greek subsidiary generated a net inflow of €1,500,000. What is the net inflow or outflow as measured in U.S. dollars this year? The exchange rate for the euro is $1.05.

a. $3,675,000 outflow

b. $525,000 outflow

c. $525,000 inflow

d. $210,000 outflow

5.

Volusia, Inc. is a U.S.-based exporting firm that expects to receive payments denominated in both euros and Canadian dollars in one month. Based on today's spot rates, the dollar value of the funds to be received is estimated at $500,000 for the euros and $300,000 for the Canadian dollars. Based on data for the last fifty months, Volusia estimates the standard deviation of monthly percentage changes to be 8 percent for the euro and 3 percent for the Canadian dollar. The correlation coefficient between the euro and the Canadian dollar is 0.30.

What is the portfolio standard deviation?

a. 3.00%.

b. 5.44%.

c. 17.98%.

d. none of the above

6.

Consider an MNC that is exposed to the Taiwan dollar (TWD) and the Egyptian pound (EGP). 25% of the MNC's funds are Taiwan dollars and 75% are pounds. The standard deviation of exchange movements is 7% for Taiwan dollars and 5% for pounds. The correlation coefficient between movements in the value of the Taiwan dollar and the pound is .7. Based on this information, the standard deviation of this two-currency portfolio is approximately:

a. 5.13%.

b. 2.63%.

c. 4.33%.

d. 5.55%.

7.

Treck Co. expects to pay €200,000 in one month for its imports from Greece. It also expects to receive €250,000 for its exports to Italy in one month. Treck Co. estimates the standard deviation of monthly percentage changes of the euro to be 3 percent over the last 40 months. Assume that these percentage changes are normally distributed. Using the value-at-risk (VAR) method based on a 95% (z=1.65) confidence level, what is the maximum one-month loss in dollars if the expected percentage change of the euro during next month is -2%? Assume that the current spot rate of the euro (before considering the maximum one-month loss) is $1.23.

a. -$38,468

b. -$21,371

c. -$17,097

d. -$4,274

Answer 1

Ans 1.

Economic exposure is the exposure to firm's cash flow. It will affect the capital budgeting of the company for example If a company import goods from china and export them to Europe and if the Chinese Yuan were increase against Pound then import will become expensive and it will affect directly to the operations of company and its future cash flows.

Ans 2(a)

Translation exposure is the exposure to firm's financial statements.For example, If a company has foreign subsidiary and it report loss of 10,000 and the domestic company has profit of 10,000 and for suppose the exchange rate between them is 1 then it will cancel the profit from loss but if the exchange rate is 0.5 then loss of subsidiary is 5000 and the company will report profit.So the translation exposure affects the financial statement.

Ans 2(b)

Transaction exposure is the exposure to firm's international transactions. For example, If a company enter into the contract of import or export, and has to make payment or receive payment in foreign currency has the risk of exchange rate fluctuation called transaction exposure.

Ans3.

When the dollar strengthens, the reported consolidated earnings of U.S.-based MNCs are unfavorably affected  by translation exposure. When the dollar weakens, the reported consolidated earnings are favorably affected.

So correct ans is C.

Ans 4.

(Inflow - Outflow) * Exchange Rate = €(1,500,000 - 2,000,000 ) * $ 1.05 = $ 525,000 Outflow

So correct ans is B.

Ans 5.

Portfolio standard deviation =(w_A²σ_A² + w_B² σ_B² + 2w_Aw_Bσ_Aσ_Br_AB)^1/2

{(0.625)² * (0.08) ² + (0.325) ² * (0.03)² + 2 *(0.625) *(0.325) *(0.3* 0.08*0.03)}^1/2= 5.44%

So correct ans is B.

Ans 6.

Portfolio standard deviation = (w_A²σ_A² + w_B² σ_B² + 2w_Aw_Bσ_Aσ_Br_AB)^1/2

{(0.25)²* (0.07)² + (0.75)² * (0.05)² + 2 * (0.25) * (0.75) * (0.7* 0.07 *0.03)}^1/2 = 5.13%

So correct ans is A.

Ans 7.

Net exposure = €250,000 − €200,000= €50,000

Maximum one-month loss = −2 % − (1.65 *3%) = −6.95%

Maximum Loss in Euro = €50,000 * 6.95% = - € 3,475

Maximum Loss in Euro = €50,000 * 6.95% = € 3475

Maximum Loss in Dollar =  € 3,475* $ 1.23 = - $ 4,274.25 or - $ 4,274

So correct ans is D