SECTION A
Answer ONE question
Question 1
a) As part of their CFO Insights series, Deloitte published a report on hidden foreign exchange (FX) risk in 2016. In it, Deloitte note that, “With the US dollar’s continued strength against other major currencies, organizations are facing pressure to address related risks, such as foreign exchange (FX) exposure identification and visibility into those exposures.” Define and explain the three main different types of FX exposure multinational organizations face. (15 marks)
b) In its 2021 Annual Report, Netflix noted that, “Revenues denominated in currencies other than the U.S. dollar account for 57% of the consolidated amount [consolidated revenues] for the year ended December 31, 2021...Accordingly, changes in exchange rates, and in particular a weakening of foreign currencies relative to the U.S. dollar may negatively affect our revenue and operating income as expressed in U.S. dollars.” Explain the type or types of exposure that Netflix might be exposed to here. Should Netflix and Netflix’s shareholders be concerned about this type or these types of exposure? Explain why they should or should not be. (15 marks)
c) Netflix regularly state that as a company, they do not use financial derivatives to manage their exchange rate exposure. Explain the non-financial alternatives (alternatives that do not involve the use of derivatives or the money markets) that are available to multinational companies like Netflix to manage their exchange rate exposure, stating and briefly explaining which exposure you think is being managed for each alternative. (20 marks)
Question 2
a) In its 2021 Annual Report, Netflix noted that, “We do not use foreign exchange contracts or derivatives to hedge any foreign currency exposures. The volatility of exchange rates depends on many factors that we cannot forecast with reliable accuracy. Our continued international expansion increases our exposure to exchange rate fluctuations and as a result such fluctuations could have a significant impact on our future results of operations.” What other financial external technique that does not involve the use of derivative contracts (forwards, futures, options and swaps) could Netflix use to hedge their foreign exchange exposure? Explain how Netflix could make use of and operationalise this technique. (10 marks)
b) Suppose now that Netflix decides to use derivative contracts to hedge their foreign currency exposure. Compare and contrast the use of currency forwards and futures, and currency options to hedge foreign currency exposure. (25 marks)
c) You have been approached by a Multinational Corporation that wants to begin hedging its foreign exchange exposure and is seeking your advice on how to best organise the hedging function within the corporation. Using the evidence in Jankensgård (Jankensgård, H., 2015, Does Centralisation of FX Derivative Usage Impact Firm Value? European Financial Management 21, 309–332) to guide and inform you, explain what advice you would give to the multinational and explain why you would give that advice. (15 marks)
Question 3
a) Compare and contrast interest rate swaps and currency swaps in terms of their characteristics. Explain the differences in the types of risk that interest rate swaps and currency swaps face. What factors might motivate firms to use both types of swap? (10 marks)
b)Design an interest rate swap in which both firms share the savings from engaging in the swap equally. Assume that there is no swap bank involved in the transaction, that firm 1 wishes to borrow at the floating rate and firm 2 wishes to borrow at the fixed rate. Explain the role the Quality Spread Differential (QSD) plays in the swap. (10 marks)
c) Explain how the presence of a swap bank charging a commission through the bid-ask spread might alter your answer to part c). (5 marks) d) “In the absence of market imperfections and swap externalities, swaps are a zero-sum game such that the QSD cannot be exploited for economic gain, that is, the QSD cannot be arbitraged.”
In the light of this statement, briefly outline and explain possible reasons other than arbitrage that might explain why the QSD exists. (25 marks)
SECTION B
Answer ONE question
Question 4 “Existing evidence on foreign exchange exposure seems puzzling, with at best only a weak link between exchange rate movements and stock returns.” Critically evaluate this statement. (50 marks)
Question 5
a) “Some argue that hedging to manage foreign exchange exposure is a redundant activity that firms do not need to engage in since hedging does not add value to the firm. Others argue that hedging is valuable since it allows firms to reduce their expected tax liability and reduce the probability of financial distress.” Critically evaluate this statement. (25 marks)
b) In relation to the case study of HDG undertaken by Brown (Brown, G.W., 2001, Managing foreign exchange risk with derivatives. Journal of Financial Economics 60, 401-448), i. outline the motivations Brown identifies as to why HDG chooses to manage its foreign exchange risk; ii. outline the way in which HDG structures its hedges; iii. evaluate the extent to which the evidence in Brown provides support for more traditional motivations for risk management, such as minimising expected taxes and avoiding the costs of financial distress. (25 marks)
Question 6
a) Explain what we mean by the term Foreign Direct Investment (FDI). Explain the motivations and reasons for firms to invest overseas. (20 marks)
b) “Cross-border mergers and acquisitions can be a source of significant value creation and can provide attractive opportunities for multinational corporations (MNCs). MNCs should therefore be actively encouraged to pursue them.” Discuss. (30 marks)
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