CFC International Financial Management 3 — Questions and Answers
Question 1: Covered Interest Rate Parity (CIRP) implies that:
- Forward rates are unbiased predictors of future spot rates
- The forward premium or discount on a currency equals the interest rate differential (Correct answer)
- Real interest rates are equal across all countries
- Spot exchange rates adjust instantly to news
Correct answer: The forward premium or discount on a currency equals the interest rate differential
CIRP states that the difference between forward and spot rates should equal the interest rate differential, preventing risk-free arbitrage.
Question 2: A multinational firm uses a 'leading and lagging' strategy in intercompany payments. When expecting a foreign currency to appreciate, the firm should:
- Lag payments owed in that currency and lead receipts in that currency
- Lead payments owed in that currency and lag receipts in that currency (Correct answer)
- Maintain normal payment timing to avoid counterparty risk
- Use forward contracts instead of adjusting payment timing
Correct answer: Lead payments owed in that currency and lag receipts in that currency
When a currency is expected to appreciate, accelerating (leading) payments in that currency locks in the current lower cost, while delaying (lagging) receipts awaits the higher value.
Question 3: Which political risk category refers specifically to the government's unilateral cancellation or alteration of contracts with foreign firms?
- Transfer risk
- Expropriation risk
- Creeping expropriation risk
- Breach of contract risk (Correct answer)
Correct answer: Breach of contract risk
Breach of contract risk occurs when a host government unilaterally cancels or modifies contracts, often without fair compensation.
Question 4: A US company borrows in Swiss francs at a lower interest rate than available domestically. If the Swiss franc appreciates by 3% and the interest rate advantage is 2%, the net effect is:
- Net gain of 1% due to lower interest cost
- Net loss of 1% because currency appreciation outweighs the interest savings (Correct answer)
- Break-even since both effects are roughly offsetting
- Net gain of 5% combining both benefits
Correct answer: Net loss of 1% because currency appreciation outweighs the interest savings
When the currency borrowed appreciates, the repayment cost in domestic terms rises; if appreciation (3%) exceeds the interest savings (2%), there is a net loss.
Question 5: The Balance of Payments (BOP) accounting identity states that:
- Current account + Capital account = 0
- Current account + Financial account + Capital account + Official reserves account = 0 (Correct answer)
- Trade balance equals GDP growth rate
- Current account deficit always equals fiscal deficit
Correct answer: Current account + Financial account + Capital account + Official reserves account = 0
The BOP must balance to zero; any deficit in the current account must be offset by a surplus in the financial/capital accounts or changes in official reserves.
Question 6: In international capital budgeting, the 'home currency approach' requires the analyst to:
- Discount foreign currency cash flows at the foreign country's cost of capital
- Convert all projected foreign cash flows to home currency and discount at the home currency cost of capital (Correct answer)
- Use purchasing power parity to adjust for inflation differentials only
- Apply the foreign country's risk-free rate to all cash flows
Correct answer: Convert all projected foreign cash flows to home currency and discount at the home currency cost of capital
The home currency approach converts projected foreign currency cash flows using expected future exchange rates, then discounts them using the parent's home currency cost of capital.
Question 7: Which of the following is a primary advantage of establishing a reinvoicing center in international operations?
- Eliminates the need for foreign bank accounts
- Centralizes currency risk management by having all intracompany invoices routed through a single entity (Correct answer)
- Reduces withholding taxes on intercompany dividends
- Avoids transfer pricing regulations
Correct answer: Centralizes currency risk management by having all intracompany invoices routed through a single entity
A reinvoicing center consolidates all intracompany currency risk in one entity, allowing centralized hedging and netting of exposures.
CFC International Financial Management 3
Covered Interest Rate Parity (CIRP) implies that: