Important Terms and Concepts

Chapter 2: The International Monetary Environment



Short questions:

What is the gold standard?  How did it work?

What are the arguments for and against fixed exchange rates?

What is the function of the European Central Bank?  How does it differ from a conventional central bank?

What are the advantages and disadvantages of a monetary union?

What is the difference between fiscal and monetary policy?

What happened at Bretton Woods?


Chapter 3: Foreign Exchange Rate Determination


Chapter 4: The Foreign Exchange Market


Short Questions: 

What are the functions of the Foreign Exchange Market?

 What are the classes of participants in the Foreign Exchange Market?

 What is the purpose of computing a cross rate?

 How is forward quotation expressed in points?

It is not the foreign exchange rate itself; rather it is the difference between the forward rate and the spot rate.  Thus, if the outright forward bid for the 3-month forward yen is 116.84/$, and the spot rate were 118.27 yen/$, it would be described as [100*(forward-spot)] or 100*(116.84-118.27) = -143 bid, since in this case, two decimal points are used.

 Why are longer-term forward rates called swap rates? 

They are called swap rates because longer-term forwards (more than 2 years) are often used in conjunction with a spot against forward swap.  If a trader buys a foreign currency in the spot market and simultaneously sells it two years forward, he has effectively borrowed the currency for two years, while giving up the use of the domestic currency for the same amount of time.  The party holding the currency with the higher interest rate will simply pay the net interest differential to the other party.  The swap rate expresses this net interest differential on a points basis rather than as an interest rate.  

How are forward quotations expressed in percentage terms?

If the spot rate is expressed in foreign currency terms (indirect quotation) and is 105.65 yen/$, while the forward rate is 105.04 yen/$, in percentage terms, it is quoted as (spot-forward)/forward or 100*[(105.65-105.04)/105.04] = 0.58073%.  However, it is usually annualized; hence if the forward contract is for 90 days, it would be quoted as (360/90)* -58073% = 2.32%.  If the quotation is a direct quotation (i.e. 1/105.04 = 0.0095202 for the forward and 1/105.65 or 0.0094652 for the spot), the quote in percentage terms is computed as (forward-spot)/spot, which works out to 2.32% again. 

How is a change in spot exchange rates measured?

If the quotation is a direct one, it is measured as (Ending rate Beginning rate)/Beginning rate; if it is an indirect one, it is measured as (Beginning rate Ending rate)/Ending rate, which will then come out to the same percentage value. 

What are some of the specifications of a foreign currency futures contract? 

How would you use foreign currency futures to speculate on the movement of a foreign currency?

What is the difference between a forward and a futures contract?

Chapter 5: Foreign Currency Options 



Short Questions:

 How would you speculate on the spot market?

How would you speculate on the forward market?

How would you speculate on the options market?

Draw payoff diagrams for the buyer of a call, the writer of a call, the buyer of a put, and the writer of a put.

What are the factors that affect the valuation of a currency option?

Chapter 6: Transaction Exposure



Short Questions:

What are the arguments for hedging?

What are the arguments against hedging?

What are the sources of transaction exposure?

Transaction exposure arises from 1) purchasing or selling on credit, goods or services whose prices are stated in foreign currencies; 2) borrowing or lending funds when repayment is to be made in a foreign currency; 3) being a party to an unperformed forward foreign exchange contract; and 4) otherwise acquiring assets or liabilities denominated in foreign currencies. 

What are the different kinds of transaction exposure management?

Transaction exposure can be managed by contractual hedging techniques, financial hedging techniques, and by using different operating strategies.

 What are the main contractual hedges?

The main contractual hedges employ the forward, money , futures and options markets. 

What are the main operating and financial hedges?

The main operating and financial hedges employ risk-sharing agreements, leads and lags in payment terms, swaps and other operating exposure management strategies.

 What is a forward hedge?

A forward hedge involves a forward (or futures) contract and a source of funds to fulfill that contract.

 What is a money market hedge?

A money market hedge involves a loan agreement and a source of funds to fulfill that contract.  For example, if a US company had sales denominated in UK pounds payable in three months, it could borrow UK pounds today and convert them into dollars at the current exchange rate.  When the loan came due, it would be repaid by the proceeds from the sale. 

How would you use the options market to hedge?


How would you decide which hedging strategy to use?  What factors have to be taken into account?


According to FAS 52, when is a foreign currency transaction considered a hedge of a foreign currency commitment?


What are anticipated exposures?


Chapter 7: Operating Exposure

How can a firm diversify its operating base?

What are the advantages of diversifying operations, aside from its implications for foreign exchange risk management?

How can a firm diversify its financing base?

What are the advantages of diversifying financing sources, aside from its implications for foreign exchange risk management?

When would a firm lead payments and when would it lag them?

Why would governments put restrictions on firms' use of leads and lags?

How does a reinvoicing center works?  What are its advantages?

Chapter 8: Accounting Exposure



Short Questions:

What are some of the economic indicators used to determine the functional currency of a foreign affiliate?

What is the fundamental problem that translation causes?

Why would a different exchange rate be used in remeasuring different line items in a financial statement, during translation?

Where can you find current US translation practices?

What are the two basic translation methods employed world-wide?

What are the main features of the current rate method of translation?

What are the main features of the temporal method of translation?

Which translation method causes greater variability in reported earnings, and why?

How are imbalances generated by translation dealt with in the temporal and current-rate methods?

How does FAS 52 deal with affiliates in countries undergoing hyperinflation?

Is it appropriate for management to change real decisions about financing and investment to minimize translation exposure?  Why or why not?

When is a balance sheet hedge justified?

There are two situations that could justify the use of a balance sheet hedge: one, if the firm has debt covenants or bank agreements that state the firm's debt/equity ratios will be maintained within specific limits; two, if management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains.  In this latter case, it would be more appropriate, however, to modify the method by which management is evaluated.

How would resolve the tension between accounting exposure and transaction exposure?

Chapter 9: Interest Rate Exposure and Swaps


Short Questions:

What are some different categories of financial risks?

What are the sources of interest rate risk for the multinational firm?

How would you decide whether treasury operations should be run as a profit center or a cost center?

Give examples of credit risk and repricing risk.

What is the difference between forward and futures contracts?

How does an FRA help to hedge interest rate risk?

How are interest rate futures used to hedge interest rate risk?

Under what circumstances would you use a pay floating/ receive fixed swap?

Under what circumstances would you use a pay fixed/ receive floating swap?

Compare and contrast an FRA and an interest-rate swap.

Why would a firm want to unwind a swap?

How are the payments determined when a swap is unwound?

Chapter 10: Global Cost of Capital and Financial Structure


Short Questions:

What are the advantages of being able to access global capital markets?

Why might a security market be segmented instead of being integrated into global capital markets?

Would a MNE with access to global capital markets always have a lower cost of capital?

When is a market considered to be segmented?

When is a market considered to be informationally efficient?

Can access to global capital markets change a firm's choice of project?  How?

Can access to global capital markets change a firm's choice of capital structure?  How?

What can a firm do to reduce its cost of capital, if it does not have access to global capital markets?

Among other things, it can access global markets by proxy by acquiring a firm that does have such access.

One of the advantages of being listed and traded in a global securities market is that the firm would be valued in those markets, using the discount rate applicable to those markets.  How can a firm achieve such pricing if it does not have such access?

If foreigners may purchase the firm's securities in its local securities market and hold them, and if they are desirous of so doing, the firm's marginal shareholders may well be foreigners.  In this case, it would be priced as if it were traded abroad (to the extent that there are not additional costs imposed on foreign holders of the securities).

How can a firm make its securities attractive to foreign investors?

It can be transparent in its accounting and reporting practices.  It can be responsive to inquiries from potential investors.  Beyond that, investors might prefer to hold its securities if they are interested in the diversification possibilities that the firm's projects offer -- however, this would be, generally, beyond the control of the firm, itself.

Under what conditions would investors achieve additional diversification by holding securities issued and traded abroad?

Where the correlation between returns on those securities and those of the home country is small.

Chapter 11: Sourcing Equity Globally


Short Questions:

What are the advantages of using ADRs for a foreign company?

What are the obligations of a specialist?

How do markets react when foreign firms crosslist their shares on a US exchange?  Why?

What is the advantage of a Rule 144A issue?

What is a potential financial  advantage in a strategic alliance?


Chapter 12: Sourcing Debt Globally


Short Questions:

Why is currency matching desirable in issuing debt?

What are some of the unique characteristics of Eurobond markets that make them desirable for issuers?

What is the genesis of Brady bonds, and what problem did their creation resolve?




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