CBE style OT case Zigto Co (6/12, amended) 18 mins

The following scenario relates to questions 292–296.

Zigto Co is a medium-sized company whose ordinary shares are all owned by the members of one family. The
domestic currency is the dollar. It has recently begun exporting to a European country and expects to receive
€500,000 in 6 months' time. The company plans to take action to hedge the exchange rate risk arising from its
European exports.
Zigto Co could put cash on deposit in the European country at an annual interest rate of 3% per year, and borrow at
5% per year. The company could put cash on deposit in its home country at an annual interest rate of 4% per year,
and borrow at 6% per year. Inflation in the European country is 3% per year, while inflation in the home country of
Zigto Co is 4.5% per year.
The following exchange rates are currently available to Zigto Co:
Current spot exchange rate 2.000 euro per $
Six-month forward exchange rate 1.990 euro per $
One-year forward exchange rate 1.981 euro per $
Zigto Co wants to hedge its future euro receipt.
Zigto Co is also trying to build an understanding of other types of currency risk and the potential impact of possible
future interest rate and inflation rate changes.
292 What is the dollar value of a forward exchange contract in six months' time (to the nearest whole number)?
$ (2 marks)
293 What is the dollar value of a money market hedge in six months' time (to the nearest whole number)?
$ (2 marks)
294 What is the one-year expected (future) spot rate predicted by purchasing power parity theory (to three dp)?

(2 marks)
295 Are the following statements true or false?
True False

1 Purchasing power parity tends to hold true in the short term.

2 Expected future spot rates are based on relative inflation rates

between two countries.
3 Current forward exchange rates are based on relative interest
rates between two countries.
(2 marks)
296 Are the following statements true or false?
True False
1 Transaction risk affects cash flows.

2 Translation risk directly affects shareholder wealth.

3 Diversification of supplier and customer base across different countries

reduces economic risk.
(2 marks)
(Total = 10 marks)

100 Questions
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CBE style OT case TGA Co 18 mins
The following scenario relates to questions 302–306.
TGA Co's sales are exported to a European country and are invoiced in euros.
TGA Co expects to receive €500,000 from export sales at the end of 3 months. A forward rate of €1.687 per $1 has
been offered by the company's bank and the spot rate is €1.675 per $1.
Other relevant financial information is as follows:
Short-term dollar borrowing rate 5% per year
Short-term dollar deposit rate 4% per year
TGA Co can borrow short term in the euro at 9% per year.
Assume there are 365 days in each year.
302 What could TGA Co do to reduce the risk of the euro value dropping relative to the dollar before the
€500,000 is received?
1 Deposit €500,000 immediately
2 Enter into a forward contract to sell €500,000 in 3 months
3 Enter into an interest rate swap for 3 months

1 or 2 only
2 only
3 only
1, 2 or 3 (2 marks)
303 What is the dollar value of a forward market hedge (to the nearest whole number)?
$ (2 marks)
304 What is the dollar value of a money market hedge?

$284,814
$292,761
$294,858
$297,770
(2 marks)
305 TGA Co is considering futures contracts.
Which of the following statements are true of futures contracts?
True False

Transactions costs are lower than other hedging methods.

They can be tailored to TGA Co's exact requirements.

(2 marks)

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 306 The following statements refer to types of foreign currency risk.
1 The risk that TGA Co will make exchange losses when the accounting results of its foreign branches
are expressed in the home currency
2 The risk that exchange rate movements will affect the international competitiveness of TGA Co
What types of risk do the statements refer to?
Economic Translation Transaction

Statement 1
Statement 2

(2 marks)
(Total = 10 marks)

104 Questions
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 Rose Co (6/15, amended) 18 mins
The following scenario relates to questions 282–286.
Rose Co expects to receive €750,000 from a credit customer in the European Union in 6 months' time. The spot
exchange rate is €2.349 per $1 and the 6-month forward rate is €2.412 per $1. The following commercial interest
rates are available to Rose Co:

Deposit rate Borrow rate

Euros 4.0% per year 8.0% per year
Dollars 2.0% per year 3.5% per year
Rose Co does not have any surplus cash to use in hedging the future euro receipt. It also has no euro payments to
make.
Rose Co is also considering using derivatives such as futures, options and swaps to manage currency risk.
In addition, Rose Co is concerned about the possibility of future interest rate changes and wants to understand how
a yield curve can be interpreted.
282 What could Rose Co do to reduce the risk of the euro value dropping relative to the dollar before the
€750,000 is received?
A Deposit €750,000 immediately
B Enter into an interest rate swap for 6 months
C Enter into a forward contract to sell €750,000 in 6 months
D Matching payments and receipts to the value of €750,000 (2 marks)
283 What is the dollar value of a forward market hedge in six months' time?
A $310,945
B $319,285
C $1,761,750
D $1,809,000 (2 marks)
284 If Rose Co used a money market hedge, what would be the percentage borrowing rate for the period?
A 1.75%
B 2.00%
C 4.00%
D 8.00% (2 marks)
285 Which of the following statements is correct?
A Once purchased, a currency futures contract has a range of settlement dates.
B Currency swaps can be used to hedge exchange rate risk over longer periods than the forward
market.
C Banks will allow forward exchange contracts to lapse if they are not used by a company.
D Currency options are paid for when they are exercised. (2 marks)

96 Questions
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CBE style OT case PGT Co 18 mins
The following scenario relates to questions 297–301.
PGT Co, whose home currency is the dollar ($), trades with both customers and suppliers in the European Union
where the local currency is the euro (€). PGT Co has the following transactions due within the next six months:

Receipts Payments
3 months 1,000,000 euros 400,000 euros
6 months 500,000 dollars 300,000 euros

The finance director at PGT Co is concerned about the exchange rate due to uncertainty in the economy. He would
like to hedge the exchange rate risk and has gathered the following information:
Spot rate (euro per $1) 1.7694 – 1.8306
Three-month forward rate (euro per $1) 1.7891 – 1.8510
PGT Co also has a 12 million loan in dollars. There is increased uncertainty in the economy regarding future interest
rates due to impending elections which could lead to a change in political leadership and direction. PGT has never
previously managed interest rate risk, but given the uncertainty the finance director is considering using a forward
rate agreement.
The following commercial interest rates are currently available to PGT Co:
Deposit rate Borrow rate
Euros 4% 8%
Dollars 2% 3.5%
Assume that PGT Co does not have any surplus cash.
297 What is the three-month dollar receipt of a forward market hedge? (to the nearest whole number)?
$ (2 marks)
298 What is the cost in six months' time of a money market hedge? (to the nearest whole number)?
$ (2 marks)
299 Which of the following statements about a forward rate agreement (FRA) is/are true?
True False
1 FRAs can be used to manage interest rate risk on borrowings but not
interest rate risk on investments.
2 FRAs are over the counter contracts.
3 The user of an FRA has the option to let the contract lapse if the rate is
unfavourable.
(2 marks)
300 Which of the following statements are true if interest rate parity theory is used to forecast the forward value
of the dollar for the transaction in six months' time (assuming interest rates stay the same)?
The value of the dollar will be forecast to rise compared to the spot rate – leading to a fall in the cost
of the transaction.
The value of the dollar will be forecast to rise compared to the spot rate – leading to a rise in the cost
of the transaction.
The value of the dollar will be forecast to fall compared to the spot rate – leading to a rise in the cost
of the transaction.
The value of the dollar will be forecast to fall compared to the spot rate – leading to a fall in the cost
of the transaction. (2 marks)

Questions 101
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 Edwen Co 18 mins
The following scenario relates to questions 287–291.

Edwen Co is based in Country C, where the currency is the C$. Edwen is expecting the following transactions with
suppliers and customers who are based in Europe.
One month: Expected receipt of 240,000 euros
One month: Expected payment of 140,000 euros
Three months: Expected receipts of 300,000 euros
A one-month forward rate of 1.7832 euros per $1 has been offered by the company's bank and the spot rate is
1.7822 euros per $1.
Other relevant financial information is as follows:
Three-month European borrowing rate 1.35%
Three-month Country C deposit rate 1.15%
Assume that it is now 1 April.
287 What are the expected dollar receipts in one month using a forward hedge (to the nearest whole number)?
A $56,079
B $56,110
C $178,220
D $178,330 (2 marks)
288 What are the expected dollar receipts in three months using a money market hedge (to the nearest whole
number)?
A $167,999
B $296,004
C $166,089
D $164,201 (2 marks)
289 Edwen Co is expecting a fall in the value of the C$.
What is the impact of a fall in a country's exchange rate?
1 Exports will be given a stimulus.
2 The rate of domestic inflation will rise.
A 1 only
B 2 only
C Both 1 and 2
D Neither 1 nor 2 (2 marks)
290 Edwen Co is considering a currency futures contract.
Which of the following statements about currency futures contracts are true?
1 The contracts can be tailored to the user's exact requirements.
2 The exact date of receipt or payment of the currency does not have to be known.
3 Transaction costs are generally higher than other hedging methods.
A 1 and 2 only
B 1 and 3 only
C 2 only
D 3 only (2 marks)

98 Questions
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291 Do the following features apply to forward contracts or currency futures?
1 Contract price is in any currency offered by the bank
2 Traded over the counter
A Both features relate to forward contracts.
B Both features relate to currency futures.
C Feature 1 relates to forward contracts and feature 2 relates to currency futures.
D Feature 2 relates to forward contracts and feature 1 relates to currency futures. (2 marks)
(Total = 10 marks)

Questions 99
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CBE style OT case DFE Co 18 mins
The following scenario relates to questions 262–266.
DFE Co is hoping to invest in a new project. DFE Co's gearing is slightly above the industry average, so when
seeking finance for the new project DFE Co opts for equity finance.
The board of DFE Co recently appointed a media liaison officer as they believe the timing and method of public
announcements (such as the investment in a large project) is important in managing the value of DFE Co's shares.
DFE Co has 8% convertible loan notes in issue which are redeemable in 5 years' time at their nominal value of $100
per loan note. Alternatively, each loan note could be converted after 5 years into 70 equity shares with a nominal
value of $1 each.
The equity shares of DFE Co are currently trading at $1.25 per share and this share price is expected to grow by 4%
per year. The before-tax cost of debt of DFE Co is 10% and the after-tax cost of debt of DFE Co is 7%.
262 What is the capital structure theory that DFE Co appears to subscribe to?

Traditional view
Modigliani-Miller (no tax)
Modigliani-Miller (with tax)
Residual view (2 marks)
263 How efficient does the DFE Co board believe the markets to be?

Completely inefficient
Weak form efficient
Semi-strong form efficient
Strong form efficient (2 marks)
264 What is the current market value of each convertible loan note (to 2 dp)?
$ (2 marks)
265 In relation to DFE Co hedging interest rate risk, which of the following statements is correct?

The flexible nature of interest rate futures means that they can always be matched with a specific
interest rate exposure.
Interest rate options carry an obligation to the holder to complete the contract at maturity.
Forward rate agreements are the interest rate equivalent of forward exchange contracts.
Matching is where a balance is maintained between fixed rate and floating rate debt. (2 marks)
266 Which of the following could cause the interest yield curve to steepen?
1 Increased uncertainty about the future
2 Heightened expectations of an increase in interest rates
3 The expectation that interest rate decreases will happen earlier than previously thought

1 and 2 only
1, 2 and 3
2 and 3 only
1 only (2 marks)

(Total = 10 marks)

Questions 91
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