CFC International Financial Management 5 — Questions and Answers
Question 1: When a multinational company uses 'netting' to manage intercompany cash flows, the primary benefit is:
- Eliminating all foreign exchange risk permanently
- Reducing the total volume of cross-border transfers and associated transaction costs (Correct answer)
- Increasing the number of currency conversions to capture favorable rate movements
- Avoiding tax obligations in high-tax jurisdictions
Correct answer: Reducing the total volume of cross-border transfers and associated transaction costs
Multilateral netting consolidates intercompany payables and receivables so only net amounts are transferred, reducing the number and cost of foreign exchange transactions.
Question 2: The concept of 'economic exposure' in foreign exchange risk management refers to:
- Changes in reported earnings due to exchange rate movements in financial statements
- The impact of unexpected exchange rate changes on a firm's future operating cash flows and competitive position (Correct answer)
- Short-term transaction gains and losses on foreign-currency-denominated contracts
- The risk of government-imposed restrictions on currency convertibility
Correct answer: The impact of unexpected exchange rate changes on a firm's future operating cash flows and competitive position
Economic exposure captures the long-term effect of exchange rate changes on a firm's competitive position, revenues, and operating costs — beyond what is captured in accounting statements.
Question 3: Country risk analysis for foreign direct investment typically includes which of the following components?
- Only political stability ratings from sovereign credit agencies
- Political risk, economic risk, financial risk, and sovereign risk assessed together (Correct answer)
- Internal rate of return compared to domestic investment alternatives only
- Correlation of foreign stock returns with the domestic market portfolio
Correct answer: Political risk, economic risk, financial risk, and sovereign risk assessed together
Comprehensive country risk analysis combines political stability, macroeconomic conditions, financial system soundness, and sovereign creditworthiness.
Question 4: A US firm has both a £1 million receivable and a £1 million payable due in 90 days. The most efficient hedge strategy is to:
- Hedge both the receivable and payable separately with forward contracts
- Leave both positions unhedged since they naturally offset each other (Correct answer)
- Hedge only the receivable using a currency option
- Hedge only the payable using a forward contract
Correct answer: Leave both positions unhedged since they naturally offset each other
When a firm has offsetting payables and receivables in the same currency and maturity, they naturally net to zero, eliminating the need for external hedging.
Question 5: The World Bank's Multilateral Investment Guarantee Agency (MIGA) primarily provides:
- Subsidized loans to emerging market governments for infrastructure projects
- Political risk insurance to foreign investors making investments in developing countries (Correct answer)
- Arbitration services for international commercial disputes
- Foreign exchange reserves support to countries with BOP crises
Correct answer: Political risk insurance to foreign investors making investments in developing countries
MIGA offers guarantees (insurance) against non-commercial risks such as expropriation, currency inconvertibility, war, and breach of contract for investors in developing countries.
Question 6: Under the 'foreign currency approach' to international capital budgeting, the discount rate applied to foreign cash flows should be:
- The parent company's weighted average cost of capital in home currency
- A risk-adjusted cost of capital reflecting the foreign project's risk in the foreign currency (Correct answer)
- The risk-free rate of the host country only
- The host country's sovereign bond yield plus the parent's equity risk premium
Correct answer: A risk-adjusted cost of capital reflecting the foreign project's risk in the foreign currency
The foreign currency approach discounts projected foreign-currency cash flows using a cost of capital denominated in and appropriate for the foreign currency and risk environment.
Question 7: A country adopts a currency board arrangement. This means:
- The central bank sets interest rates independently to target inflation
- The domestic currency is fully backed by foreign reserves and the exchange rate is irrevocably fixed (Correct answer)
- The government manages a dirty float by occasional intervention
- The currency is pegged within a ±2% band with periodic realignments
Correct answer: The domestic currency is fully backed by foreign reserves and the exchange rate is irrevocably fixed
A currency board commits to exchange the domestic currency for a reserve currency at a fixed rate, requiring 100% foreign reserve backing and eliminating independent monetary policy.
CFC International Financial Management 5
When a multinational company uses 'netting' to manage intercompany cash flows, the primary benefit is: