Risk Management

Which of the following are descriptions of basis risk?

(1) It is the difference between the spot exchange rate and currency futures exchange rate

(2) It is the possibility that the movements in the currency futures price and spot price will be different

(3) It is the difference between fixed and floating interest rates

(4) It is one of the reasons for an imperfect currency futures hedge.

• 1 only

• 1 and 3

• 2 and 4 only

• 2, 3 and 4

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.

What is the six-month forward exchange rate predicted by interest rate parity?

• €1·499 per $1

• €1·520 per $1

• €1·566 per $1

• €1·588 per $1

A company has annual after-tax operating cash flows of $2 million per year which are expected to continue in perpetuity. The company has a cost of equity of 10%, a before-tax cost of debt of 5% and an after-tax weighted average cost of capital of 8% per year. Corporation tax is 20%.

What is the theoretical value of the company?

• $20m

• $40m

• $50m

• $25m

Drumlin Co has $5m of $0·50 nominal value ordinary shares in issue. It recently announced a 1 for 4 rights issue at $6 per share. Its share price on the announcement of the rights issue was $8 per share.

What is the theoretical value of a right per existing share?

• $1·60

• $0·40

• $0·50

• $1·50

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.

What is the six-month forward exchange rate predicted by interest rate parity?

• €1·499 per $1

• €1·520 per $1

• €1·566 per $1

• €1·588 per $1

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?

• Transaction risk

• Economic risk

• Translation risk

• 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?

• Forward exchange contract

• Money market hedge

• Currency futures

• Currency swap

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 statements support the finance director’s belief that the euro will depreciate against the dollar?

(1) The dollar inflation rate is greater than the euro inflation rate

(2) The dollar nominal interest rate is less than the euro nominal interest rate

• 1 only

• 2 only

• Both 1 and 2

• Neither 1 nor 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 interest rate risk faced by Herd Co, which of the following statements is correct?

• In exchange for a premium, Herd Co could hedge its interest rate risk by buying interest rate options

• Buying a floor will give Herd Co a hedge against interest rate increases

• Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through matching

• Taking out a variable rate overdraft will allow Herd Co to hedge the interest rate risk through matching

Which of the following statements concerning profit are correct?

1. Accounting profit is not the same as economic profit

2. Profit takes account of risk

3. Accounting profit can be manipulated by managers.

• 1 and 3 only

• 1 and 2 only

• 2 and 3 only

• 1, 2 and 3