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1. (7 points) Suppose the value of the Norden franc moves from NFr 1,000 = $1 at the start of

the year to NFr 1,800 = $1 at the end of the year. At the same time, the Norden price index changes from 100 on January 1 to 134 on December 31. U.S. inflation during the year was 4.5%. What happened to the real value of the Norden franc during the year? If the one-year interest rate on the franc is 44%, what was the real dollar cost of borrowing the franc during

the year?


2. (9 points) Norden pegs its currency, the Norden franc, to the U.S. dollar at an exchange rate

(SNFr,$) that rises by a pre-announced amount each month. Such an arrangement is called a crawling peg. Norden’s inflation rate exceeds that of the United States by more than the rate at which the Norden franc is devalued. If Norden maintains its commitment to the crawling

peg, what actions must Norden’s central bank take? What would speculators do?


3. (9 points)


a) Recent surveys of foreign exchange risk management practices by corporations indicate

that many firms simply do not hedge. How would you explain this result?


b) It is generally not possible to completely eliminate both translation exposure and

transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one exposure actually creates the other. Discuss which exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises.


4. (9 points) Overheard in one of the boardrooms across Canada: “The international Fisher

effect makes no sense! It predicts that a rise in the domestic interest rate will cause the domestic currency to depreciate. But when we discussed factors affecting exchange rates, we learned that a rise in the interest rate leads to a currency appreciation.” Comment.


5. (12 points) Many suggest that a practical method of measuring foreign exchange exposure is

to gather historical data for a company and then run the following regression:


DCFt = a + b × DSHC,FC,t + et


where DCFt is the change in the company’s operating cash flows for period t stated in home currency, and DSHC,FC,t is the change in the home currency value of the foreign currency during period t (i.e., amount of home currency per one unit of foreign currency).


a) Do you expect to be positive or negative for a domestic exporter? Explain. What

happens to if our firm builds a plant in the foreign market?


b) Do you expect to be positive or negative for a domestic firm that faces competition in

its domestic market from foreign suppliers? Explain.

c) A particular firm has estimated a beta (b) coefficient of 2,000,000. Assuming that this is

an accurate measure of exposure to this exchange rate, identify three methods that the firm could use to manage its foreign exchange risk. Be as specific as possible.


6. (10 points)


a) In using regression analysis to assess the sensitivity of cash flows to exchange rate

movements, what is the purpose of breaking the data into subperiods?


b) Assume the regression coefficient based on assessing economic exposure was much

higher in the second subperiod than in the first subperiod. What does this tell you about

the firm’s degree of economic exposure over time? Why might such results occur?


7. (9 points) A Canadian professional hockey team plans to play an exhibition game in

Germany next year. All expenses will be paid by the German government and the team will receive a check for 2 million euros when the game is played. In addition, the NHL must approve the deal, and approval (or disapproval) will not occur for three months. How can the team hedge its position? What is there to lose by waiting three months to see if the

exhibition game is approved before hedging?


8. (9 points) A Turkish firm produces furniture and has no international business. Its major

competitors import most of their furniture from Europe and then sell it out of retail stores in

Turkey. How will our company be affected if the Turkish lira appreciates against the euro?


9. (7 points) Bavaro Inc. expects that the British pound will depreciate from $1.70 to $1.68 in

one year. It has no money to invest, but it could borrow money to invest. A bank allows it to borrow either 1 million dollars or 1 million pounds for one year. It can borrow pounds at 6 percent or dollars at 5 percent for 1 year. It can invest in a risk-free pound deposit at 5 percent for 1 year or a risk-free dollar deposit at 4 percent for 1 year. Can Bavaro capitalize

on the expected depreciation of the pound?


10. (10 points)


a) If a currency that a company is long in threatens to weaken, many companies will sell

that currency forward. Comment on this policy.


b) Multinational firms can always reduce the foreign exchange risk faced by their foreign

affiliates by borrowing in the local currency. True or false? Why?


11. (9 points) Your bank is working with a Turkish client who wishes to hedge her Canadian

dollar payable. Suppose it is possible to invest in lira but not borrow in that currency. However, you can both borrow and lend in Canadian dollars. Also, both put and call options on lira are available. Assuming there is no forward market in lira, can you create a homemade forward contract that would allow your client to hedge her Canadian dollar



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