Question

1. What are the two channels by which Currency Risk affects the firm’s fundamental value?   Just name them. [2 x 2 points] What are the three main financial metrics / accounting items of a firm that get affected through those two channels? Just name them

2. How would you identify the foreign currency for a company that poses the greatest risk among a group of several currencies? Say, the group of currencies to consider is GBP, EUR, JPY, and AUD. Hint: write an equation and describe the parameter in the equation that helps us identify the source of greatest FX risk

Answer 1

Q 1. Ans; Currency Risk affects firm's fundamental value by two channels these are first through Transaction exposure and second one is Economic Exposure, The three financial metrics which are much affected by fluctuation in currency are stated below;

a.Sale value and production, b. cost of capital , c. import and export d.profitability

Q 2. Ans; To identify the foreign exchange risk on several currencies we have an equation which is stated below;

(1+RH)=(1+RF) (1+or-Rex) where

RH = Rate of return in the home or base currency

RF = Rate of return in the denominated or foreign currency

Rex = Rate of appreciation or depreciation in the exchange rate

Let say One example An indian firm is investing against dollar in in u.s.'which is planning to earn a return of 2.5% p.a. it also planning another option to ivest in british bond and get a return of 155 p.a and the exchange rate today is 1USD = 5 GBP And after 1 year the exchange rate is expected to be 1 USD = 4.5GBP.

Here. RH = 2.5%

RF = 15%

Then Rex = (5-4.5)/5 =10% ( depreciation)

By formula we will get the value of (1+ RH) = (1+15%) (1-10%) = 1.15 * 0.9 = 1.035

So RH = 3.5%

Hence british bond is givinga return of 3.5% over other and rest of return has been collapsed by foreign exchange movement. So british investment should be preferred over USD investment (3.5%>2.5%). hence justified.