ACCA FM Syllabus G. Risk Management - Types of foreign currency risk - Past Papers ^{1 / 2}

Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt.

Herd Co has in issue loan notes with a total nominal value of $4 million which can be redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest rates may increase in the near future.

The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.

As regards the euro receipt, what is the primary nature of the risk faced by Herd Co?

A. Transaction risk
B. Economic risk
C. Translation risk
D. Business risk

Herd Co is based in a country whose currency is the dollar ($). The company expects to receive €1,500,000 in six months’ time from Find Co, a foreign customer. The finance director of Herd Co is concerned that the euro (€) may depreciate against the dollar before the foreign customer makes payment and she is looking at hedging the receipt.

Herd Co has in issue loan notes with a total nominal value of $4 million which can be redeemed in 10 years’ time. The interest paid on the loan notes is at a variable rate linked to LIBOR. The finance director of Herd Co believes that interest rates may increase in the near future.

The spot exchange rate is €1·543 per $1. The domestic short-term interest rate is 2% per year, while the foreign short-term interest rate is 5% per year.

Which of the following hedging methods will NOT be suitable for hedging the euro receipt?

A. Forward exchange contract
B. Money market hedge
C. Currency futures
D. Currency swap

‘There is a risk that the value of our foreign currency-denominated assets and liabilities will change when we prepare our accounts’

To which risk does the above statement refer?

A. Translation risk
B. Economic risk
C. Transaction risk
D. Interest rate risk

ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. ZPS Co does not have any income in pesos. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable.

ZPS Co must pay interest on the dates set by the bank. A payment of 5,000,000 pesos is due in six months’ time. The following information is available:

Which of the following methods are possible ways for ZPS Co to hedge its existing foreign currency risk?

(1) Matching receipts and payments
(2) Currency swaps
(3) Leading or lagging
(4) Currency futures

A. 1, 2, 3 and 4
B. 1 and 3 only
C. 2 and 4 only
D. 2, 3 and 4 only

The directors of Plam Co expect that interest rates will fall over the next year and they are looking forward to paying less interest on the company’s debt finance. The dollar is the domestic currency of Plam Co. The company has a number of different kinds of debt finance, as follows:

The 7% loan notes were issued domestically while the 10% loan notes were issued in a foreign country.

The interest rate on the long-term bank loan is reset to bank base rate plus a fixed percentage at the end of each year.

The annual payment on the bank loan consists of interest on the year-end balance plus a capital repayment.

Relevant exchange rates are as follows:

Required:
(a) Evaluate the risk faced by Plam Co on its peso-denominated interest payment in six months’ time and advise how this risk might be hedged. (5 marks)

GXJ Co, whose home currency is the dollar, wishes to borrow €12 million for a period of six months in three months’ time. The lending bank will fix the interest rate for the loan period at its prevailing lending interest rate when the loan is taken out. The finance director of GXJ Co believes this lending interest rate could be a minimum of 3·5% per year or a maximum of 5·5% per year. The uncertainty regarding the future interest rate is caused by the volatile state of the economy and impending elections which could lead to a change in political leadership and direction. Interest on the euro loan would be payable at the end of the loan period.

The finance director of GXJ Co would like to hedge the interest rate risk arising from the future loan and the company’s bank has offered a 3–9, 4·5%–3·5% forward rate agreement.

The finance director is also concerned about the foreign currency risk associated with the euro interest payment which would be due in nine months’ time.

The following exchange rates are available:

Required:
(b) Analyse the foreign currency risk associated with the future interest payment of GXJ Co and briefly discuss ways that this risk might be hedged. (4 marks)

Required:
(c) Discuss whether PZK Co should avoid exchange rate risk by invoicing foreign customers in dollars. (4 marks)

‘There is a risk that the value of our foreign currency-denominated assets and liabilities will change when we prepare our accounts.’

To which risk does the above statement refer?

A. Translation risk
B. Economic risk
C. Transaction risk
D. Interest rate risk

The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:

For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit, while cost of sales was $26 million. Trade payables related to both domestic and foreign suppliers.

For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and trade receivables, and current liabilities to consist of trade payables and the company’s overdraft.

CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of March 2015:

Required:

(d)  Briefly discuss THREE internal methods which could be used by CSZ Co to manage foreign currency transaction risk arising from its continuing business activities. (6 marks)