Financial Risk Management

Module 6 Foreign exchange and commodity risk management

Question 1
An Australian bank quotes the AUD/USD at 1.050010. This means that the bank will
a. buy USDs at 1.0500.
b. sell USDs at 1.0510.
c. buy AUDs at 1.0500.
d. sell AUDs at 1.0500.
Question 2
Assume that during the past year, the AUD/USD spot rate changed from 1.0500 to 0.9500. This means that
during this period, against the USD, the AUD has
a. appreciated by 9.5 per cent.
b. depreciated by 9.5 per cent.
c. appreciated by 10.5 per cent.
d. depreciated by 10.5 per cent.
Question 3
The following table shows the cash flows (in millions) for an Australian exporter.
* Japanese yen contracts contain a currency revaluation clause which means that the contract price is adjusted for
changesinexchangerates.
Over the one-year period, which one of the following statements is correct?
a. A net currency exposure exists for AUDs.
b. A net currency exposure exists for Japanese yen.
c. Only a timing exposure exists for USDs.
d. Only a timing exposure exists for euros.
Question 4
An Australian exporter has entered into a contract to sell goods in six months time and will receive
USD1million for thesegoods.
What type of exposure is this an example of?

Currency Quarter 1 Quarter 2 Quarter 3 Quarter 4

AUD 10 15 19 8
USD 5 13 6 2
Japanese yen* 180 260 0 180
Euro 30 15 25 40
Module 6 Foreign exchange and commodity risk management (FRM)
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a. Transaction exposure.
b. Translation exposure.
c. Competitive exposure.
d. Economic exposure.
Question 5
An Australian-based exporter wants to protect the companys profitability from large adverse currency
movements. Which of the following strategies will achieve this objective?
I. Leave the exposure unhedged.
II. Enter into a forward exchange contract (FEC).
III. Buy an AUD call option.
a. I only.
b. II only.
c. II and III only.
d. I, II and III.
Question 6
An Australian company is most likely to buy an AUD put (USD call) option as a hedge if
a. it is an importer.
b. it is an exporter.
c. it has a foreign currency receivable.
d. if it is either an importer or exporter with a foreign exchange receivable.
Question 7
What does a bought AUD call option (USD put) protect the buyer against?
a. A decline in the AUD.
b. A rise in the USD.
c. A rise in the AUD.
d. A fall in volatility.
Question 8
You are the corporate treasurer of an Australian-based importer and decide to hedge the companys
USD1million exposure by entering into a nil-premium collar with strike prices of AUD/USD 1.0600 and
AUD/USD 1.0200. At expiry of the collar, the spot AUD/USD rate is trading at AUD/USD 1.0400. What is the
cost to thecompany?
a. AUD 961 538.46.
b. AUD 1 040 000.
c. AUD 1 060 000.
d. AUD 943 396.22.

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Question 9
An Australian-based exporter enters into an AUD/USD collar transaction by buying an AUD call at 1.0500 and
selling an AUD put at 0.9500. If the AUD falls to 0.9000 at expiry, which of the following events would occur?
a. Both options would expire worthless.
b. The put option would be exercised and the exporter would receive a rate of 0.9500.
c. The put option would be exercised and the exporter would receive a rate of 0.9000.
d. Both options would be exercised and the exporter would receive the spot rate.
Question 10
You work for an Australian-based company importing goods from the United States. You have an uncommitted
exposure for USD2million in six months time and are concerned that the AUD will decline from the current level
of 1.0500. Which of the following strategies would be most appropriate?
a. Enter into a forward exchange contract.
b. Buy an AUD put option with a strike of 1.0300.
c. Buy an AUD call option with a strike of 1.0700.
d. Do nothing because the company will benefit from a falling AUD.
Question 11
Which of the following company operations involve foreign exchange risk?
I. Borrowing offshore to fund domestic operations.
II. Investing offshore.
III. Selling products or services offshore and receiving payment in a currency other than the
companysfunctionalcurrency.
a. I and II only.
b. I and III only.
c. II and III only.
d. I, II and III.
Question 12
Which of the following is/are considered appropriate risk management techniques?
I. An exporter hedging uncommitted sales by buying an AUD put option.
II. An exporter hedging committed sales with a forward exchange contract (FEC).
III. An exporter hedging uncommitted sales with an FEC.
a. I only.
b. II only.
c. I and II only.
d. I and III only.

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Question 13
An Australian gold producer with a cost of production of AUD400 per ounce decides to protect its profit
margin by hedging its goldproduction. The producer buys a gold put option for 100 000 ounces with a strike of
AUD700. The cost of the option was AUD25perounce. What is the minimum profit margin the producer will
earn on the 100000 ounces of gold?
a. AUD27 500 000.
b. AUD30 000 000.
c. AUD32 500 000.
d. AUD40 000 000.
Question 14
A gold producer has bought a gold put with a strike of AUD650 for a cost of AUD15 per ounce. At expiry the
spot AUD gold price is trading atAUD600. What will the gold producer do?
a. Allow the option to expire and achieve an effective AUD gold price of AUD635.
b. Allow the option to expire and achieve an effective AUD gold price of AUD665.
c. Exercise the option and achieve an effective AUD gold price of AUD635.
d. Exercise the option and achieve an effective AUD gold price of AUD665.
Question 15
You are the financial controller for an Australian-based importer and you want to hedge against a possible fall in
the AUD but you also want to have unlimited upside participation in any favourable AUD move. Which of the
following risk management strategies will achieve this result?
I. Bought AUD call.
II. Bought AUD put.
III. Nil-premium collar.
IV. Forward exchange contract (FEC).
a. I only.
b. II only.
c. I and II only.
d. I, II, III and IV.
Question 16
Which of the following is likely to result in a reduced profit margin for an Australian-based gold producer,
assuming all other variables remain unchanged?
I. A fall in the USD gold price.
II. A rise in the AUD/USD exchange rate.
III. A rise in the cost of gold production.
IV. A fall in the AUD/USD exchange rate.

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a. I only.
b. I and II only.
c. I, II and III only.
d. I, III and IV only.
Question 17
Steel Pty Ltd sells battleships to the Australian Department of Defence (DOD). The ships are purchased by
SteelPty Ltd in the US for USD10million each and then on-sold to the DOD. The spot rate is AUD/USD0.8000
and both US and Australian interest rates are 5 per cent per annum.
Steel Pty Ltd has been offered four alternative pricing clauses by DOD. Which should it accept?
a. Fixed price of AUD19 million payable in one year.
b. Fixed price of USD15 million payable in one year in AUD at the present spot rate of AUD/USD 0.8000.
c. AUD20 million in one year, but Steel Pty Ltd compensates DOD for unfavourable exchange rate
movements affecting DOD.
d. USD18 million, with Steel Pty Ltd subject to all exchange rate variations between now and payment in
one year.
Question 18
Dynamic Imports has very tight profit margins and a serious cash flow problem and cannot risk even a minor
weakening of the Australian dollar from its current spot level of AUD/USD 1.0500.
It should also be noted that US and Australian interest rates are both 3.00 per cent per annum.
Which of the following strategies might provide acceptable financial risk management strategies for
DynamicImports?
I. Buy an option to protect a minimum acceptable rate but also sell an option with the same premium
sonocash flow is involved.
II. Take out forward cover and lock in the outright rate.
III. Sell an AUD put/USD call exercisable at the current spot rate and receive a cash premium.
a. I only.
b. II only.
c. I and II only.
d. I, II and III.
Question 19
The CEO of Hi-Fli Enterprises has requested that, as corporate treasurer, you minimise the companys exposure
to the euro.
Currently the company has a contract to sell 2 million euros of goods next Christmas but has also a contract to
buy a limousine for delivery at Easter at a cost of 2 million euros.
Which foreign exchange instrument best meets the need to manage the total exposure?

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a. Forwards.
b. Options.
c. Swaps.
d. Spot markets.
Question 20
In the AWA Case Study, why was the actual exposure to foreign exchange volatility much lower than the
apparent exposure to foreign exchange volatility?
a. There were offsets between sales and purchases in foreign currencies.
b. The price of the companys products was sensitive to the exchange rate.
c. The majority of actual exposures were speculative and related to the apparent exposures.
d. Embedded options existed.
Question 21
The board of an Australian-based airline has resolved to make the USD its functional currency as two of its
largest costs, aeroplane purchases and fuel, are priced in USDs. The airline continues to report in Australian
dollars. The airline will need to enter the following transactions next month
I the purchase of a new plane in USD;
I payment of the salaries of Australian employees in AUD;
I payment of the salaries of New Zealand employees in NZD;
I purchase fuel in USD; and
I secure retail ticket sales in AUD.
Which of the following risks is the Australian-based airline exposed to?
I. Commodity risk.
II. USD foreign exchange risk.
III. NZD foreign exchange risk.
IV. AUD foreign exchange risk.
a. I and II only.
b. I, II and III only.
c. I, III and IV only.
d. I, II, III and IV.
Question 22
A forward curve for a commodity is most likely to be in backwardation when
a. it is a non-perishable commodity.
b. the spot price falls below the forward price.
c. the forward price rises above the spot price.
d. there is a sharp increase in demand for the commodity.

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Question 23
An Australian-based aluminium producer is required to hedge its financial risk. Which of the following financial
instruments is the company most likely to use?
I. Aluminium forwards.
II. Aluminium futures on the London Metal Exchange (LME).
III. Aluminium over-the-counter (OTC) options.
IV. Foreign exchange (FX) forward exchange contracts (FECs).
a. I and II only.
b. II and III only.
c. I, III and IV only.
d. I, II, III and IV.
Question 24
An Australian-based importer with an AUD functional currency has annual revenues of AUD125 million and
costs of USD75million. The current spot rate is AUD/USD 1.0500. The company needs to hedge to ensure it
achieves a minimum profit margin (profit as a percentage of revenue) of 40 per cent. What is the worst case
exchange rate the company will need to hedge to protect its minimum profit margin?
a. AUD/USD 1.0500.
b. AUD/USD 1.0000.
c. AUD/USD 0.9500.
d. AUD/USD 0.9000.
Question 25
An Australian-based company needs to import some machinery priced in NZD in six months time and is
required to hedge the exposure. Which of the following strategies would you consider the most appropriate?
a. Entering into a six-month forward exchange contract (FEC) to buy AUD, and sell NZD.
b. Entering into a six-month AUD/NZD swap.
c. Buying an AUD call, NZD put option.
d. Buying an AUD put, NZD call option.
Question 26
With its functional currency in AUD, an Australian-based gold producers profit margin may be adversely
impacted by which of the following?
I. Rising production costs.
II. Falling USD gold price.
III. Rising AUD/USD exchange rate.
IV. Falling AUD/USD exchange rate.
a. I and II only.
b. II and III only.
c. I, II and III only.
d. I, II and IV only.
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Question 27
An Australian-based wine producer is expected to receive NZD 2 million in three months time and is concerned
about a possible sharp rise in the AUD/NZD exchange rate.
Which of the following would be considered an appropriate hedging strategy or strategies if the wine producer
still wants to benefit from a weakening AUD?
I. Buy AUD/sell NZD three months forward.
II. Buy an AUD call/NZD put expiring in three months.
III. Buy an AUD call/NZD put and sell AUD put/NZD call expiring in three months.
IV. Enter into an AUD/NZD swap expiring in three months.
a. I only.
b. I and IV only.
c. II and III only.
d. I, II and III only.









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Solutions
Question 1
Correct Answer: c
This quote says that the banks bid (buying) rate for AUDs is USD 1.0500 and its ask or offer (selling) rate for
AUDs is USD 1.0510.
Remember that this is from the point of view of the bank (not the customer). The bank is going to buy AUD/sell
USD at the rate that provides it with a margin (i.e. 1.0500). If an importer would buy USD/sell AUD at 1.0500,
thenthe bank would sell USD/buy AUD at 1.0500.
Option A is incorrect. Buying USDs is equivalent to selling AUDs, for which the rate is 1.0510.
Option B is incorrect. Selling USDs is equivalent to buying AUDs, for which the rate is 1.0500.
Option D is incorrect. The quote means that the bank is prepared to sell AUDs at 1.0510.
You can review this topic area in the study materials under the section entitled De-mystifying foreign
exchange.
Question 2
Correct Answer: b
During this period, the AUD changed from 1.0500 to 0.9500. The AUD has lost value against the USD.
The AUD depreciates by (1.0500 0.9500)/1.0500 = 9.5 per cent.
You can review this topic area in the study materials under the section entitled De-mystifying foreign
exchange.
Question 3
Correct Answer: d
The cash flows for the euro all net out to zero. As such there is no currency exposure, only timing exposure.
SeeExample 6.1 in the study guide for a similar example.
As the company is an Australian exporter, there is no AUD currency exposure.
Note that there is a currency exposure to the USD, but that is not an available option.
Note that if there was no currency revaluation for JPY, then this would lead to a currency exposure for JPY
(asthe cash flows do not offset each other).
You can review this topic area in the study materials under the section entitled De-mystifying foreign
exchange.
Question 4
Correct Answer: a
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Transaction exposure arises from the conversion of foreign exchange relating to operational
contracts/commitments.
Translation exposure is the change in the statement of financial position from the revaluation of assets
orliabilities.
Competitive exposure occurs when a competitor sources goods from another country but sells into the same
market. There is nothing to advise of that in this situation.
Economic exposure occurs with unknown or uncommitted exposures and this is a committed exposure.
You can review this topic area in the study materials under the section entitled Step 2: Identify exposures
andsensitivities.
Question 5
Correct Answer: c
A forward exchange contract (FEC) or a bought AUD call will protect an exporter from adverse currency
movements (i.e. a rising AUD for an exporter).
Leaving the exposure unhedged would leave the company exposed to a rise in the AUD.
You can review this topic area in the study materials under the section entitled Risk management for exporters.
Question 6
Correct Answer: a
Only an importer would hedge against a falling AUD using an AUD put option. An exporter or a company that
has a foreign currency receivable would buy an AUD call option.
You can review this topic area in the study materials under the section entitled Step 4: OperationsImplement
strategies.
Question 7
Correct Answer: c
A bought AUD call option gives the buyer the right but not the obligation to buy AUD at an agreed rate.
Thiswould protect the buyer against a rise in the AUD.
You can review this topic area in the study materials under the section entitled Step 4: OperationsImplement
strategies.
Question 8
Correct Answer: a
If the spot rate is 1.0400, both the importers sold AUD call at 1.0600 and the bought AUD put at 1.0200 would
have no value and would not be exercised. The importer would therefore transact at the spot rate of 1.0400.
TheAUD cost will be USD 1 000 000/1.0400 = AUD 961 538.46.
Module 6 Foreign exchange and commodity risk management (FRM)
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You can review this topic area in the study materials under the section entitled Risk management for importers.
Question 9
Correct Answer: b
The bought call option would expire worthless and the put option would be exercised at 0.9500.
You can review this topic area in the study materials under the section entitled Risk management for exporters.
Question 10
Correct Answer: b
Given that this is an uncommitted exposure, the best practice strategy would be to buy an AUD put option with
a strike of1.0300. This would give the company the right but not the obligation to sell AUDs and buy USDs at
1.0300. It would therefore provide protection against a falling AUD (which would increase the AUD cost for
animporter).
A forward is inappropriate as it is an uncommitted exposure. A call option is inappropriate as the importer wants
to protect against a falling AUD, not a rising AUD. Doing nothing is inappropriate as the importer wants to
protect against a falling AUD.
You can review this topic area in the study materials under the section entitled Risk management for importers.
Question 11
Correct Answer: d
All three situations involve foreign exchange risk since movements in the exchange rate will cause variations in
the home currency cash flows of the company.
You can review this topic area in the study materials under the section entitled Step 2: Identify exposures
andsensitivities.
Question 12
Correct Answer: b
Hedging committed exposures with a forward exchange contract (FEC) is considered the most appropriate risk
management strategy.
Item I is incorrect as exporters do not hedge with a bought AUD put. An exporter would hedge an uncommitted
exposure with a bought AUD call.
Item III is incorrect as best practice risk management recommends that uncommitted exposures are not hedged
with instruments that carry delivery obligations such as forward exchange contracts (FECs).
You can review this topic area in the study materials under the section entitled Step 4: OperationsImplement
strategies.
Question 13
Correct Answer: a
Module 6 Foreign exchange and commodity risk management (FRM)
Semester 2, 2013 Page 11
The minimum AUD gold price the producer will receive is AUD700 per ounce. If the AUD gold price is below
AUD700, the producer will exercise the put option and sell the 100 000 ounces of gold at AUD700perounce.
Therefore the producers profit margin would be AUD700 AUD25 (cost of the option) AUD400 (the cost of
production) =AUD275perounce. 100000 ounces AUD275/ounce = AUD27 500 000.
You can review this topic area in the study materials under the section entitled Precious metals.
Question 14
Correct Answer: c
Since the spot price is lower than the strike of the bought put, the producer will exercise the put and deliver
goldat the strike price ofAUD650. The effective gold price will be AUD635 (the strike price less the cost of
theoption).
You can review this topic area in the study materials under the section entitled Precious metals.
Question 15
Correct Answer: b
Bought AUD puts gives importers unlimited upside participation if the AUD increases.
Bought AUD calls is incorrect as they give exporters unlimited participation if the AUD falls.
A nil-premium collar only offers the importer upside participation to the level of the sold call.
Forward exchange contracts (FECs) provide no upside participation.
You can review this topic area in the study materials under the section entitled Risk management for importers.
Question 16
Correct Answer: c
Item I is correct as a fall in the USD gold price will reduce USD revenue and therefore reduce the producers
AUD revenue and reduce the profit margin.
Item II is correct as a rise in the AUD/USD exchange rate would reduce the AUD gold price and therefore reduce
the producers AUD revenue and reduce the profit.
Item III is correct as an increase in the gold production costs reduces the producers profit margin.
Item IV is incorrect as a fall in the AUD/USD exchange rate would increase the AUD gold price and would
therefore increase the producers profit margin.
You can review this topic area in the study materials under the section entitled Precious metals.
Question 17
Correct Answer: d
The key is to understand that if interest rates are identical, the forward price equals the spot price.
Module 6 Foreign exchange and commodity risk management (FRM)
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Under option D, Steel Pty Ltd sells forward the USD18 million at an outright price of AUD22.50 million, which is
superior to the next best option of AUD20 million.
Calculations
a. Fixed price of AUD19 million payable in one year.
b. Fixed price of USD15 million payable in one year in AUD at the present spot rate of AUD/USD 0.8000
equates to AUD18.75 million.
c. AUD20 million in one year, but Steel Pty Ltd compensates DOD for unfavourable exchange rate
movements affecting DOD equates to AUD20 million, as there is no exchange rate exposure to DOD
itpays in AUD.
d. USD18 million, with Steel Pty Ltd subject to all exchange rate variations between now and payment in
one year, allows Steel Pty Ltd to sell forward at the outright rate of AUD/USD 0.8000 and lock in
AUD22.50 million.
You can review this topic area in the study materials under the section entitled Step 4: OperationsImplement
strategies.
Question 18
Correct Answer: c
Item I is a zero cost collar, which first protects the downside then offsets the cost of this by giving up some
potential upside in order to receive a cash premium. To structure a collar, first, set the required floor or minimum
exchange rate required to protect the key profit level. Then, give up sufficient upside to pay for the premium on
the floor.
Item II is also acceptable as the outright rate is the same as the spot rate if interest rates are identicalsee the
forward rate calculation formula in Module 4.
Item III is unacceptable as selling an option means accepting the risk that the AUD will fall and the option would
be exercised at a cost to Dynamic Imports.
You can review this topic area in the study materials under the section entitled Step 3: Appraise risks and
implement set strategies.
Question 19
Correct Answer: c
There is no currency exposureonly a timing exposure.
A foreign exchange swap to sell 2 million at Christmas and buy 2 million at Easter neutralises the exposure.
See Example 6.1 on Removing a timing mismatch, which is a similar case of timing mismatch.
You can review this topic area in the study materials under the section entitled De-mystifying foreign
exchange.
Question 20
Correct Answer: d
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AWA had extremely large embedded options in the form of government offsets. From the Module 6 discussion
Option A is incorrect as no such offsets existed.
Option B is incorrect as the government-embedded option neutralised this exposure.
Option C is incorrect as exposures were speculative but were not related to the apparent exposures.
You can review this topic area in the study materials under the section entitled Five key elements of foreign
exchangeand Reading 1.1: AWA and foreign exchange exposure management.
Question 21
Correct Answer: c
The airline is exposed to AUD, NZD and commodity risk for fuel.
Options A, B and D are incorrect because they included USD and there is no risk for USD when the USD is the
functional currency.
You can review this topic area in the study materials under the section entitled Step 2: Identify exposures
andsensitivities.
Question 22
Correct Answer: d
A sharp increase in demand can push the spot price above the forward price which is backwardation.
Option ANon-perishable commodities are more likely to be in contango due to the cost of carry.
Option BThis is contango.
Option CThis is contango.
You can review this topic area in the study materials under the section entitled Contango and backwardation in
commodity forward markets.
Question 23
Correct Answer: c
Producers need to hedge FX and commodity risk and mostly use OTC markets rather than exchange-traded
futures on the LME. While the study guide mentions that the LME offers exchange-traded futures, it also states
that the majority of producers ... tend to use the OTC market to hedge ... as [they] can be tailored .... As the
question is asking for the most-likely financial instruments, the LME option is deemed incorrect.
Justice Rogers stated in his judgment:
in a number of contracts with the Department of Supply, the plaintiff was held covered against
fluctuations in foreign currency in respect of the purchase of overseas components. Inthe years
19861987 the annual estimated cost of imports of the plaintiff was said to be approximately
$200million. Of this approximately $75$100 million was covered by the Departments contracts
(AWALtd v.George Richard Daniels T/AS Deloitte Haskins & Sells NSW Supreme Court
Commercial Division, No50271 of 1991, p. 2).
Module 6 Foreign exchange and commodity risk management (FRM)
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You can review this topic area in the study materials under the section entitled Base metals.
Question 24
Correct Answer: b
At AUD/USD, the USD costs will be equal to AUD 75.000m and 40 per cent profit margin.
Option A is incorrect as 1.0500 would achieve the required margin but its not the worst case rate.
Option C is incorrect as at 0.9500 the margin is only 37 per cent.
Option D is incorrect as the margin is only 33 per cent.
You can review this topic area in the study materials under the section entitled Risk management for importers.
Question 25
Correct Answer: d
The company needs to sell AUD and buy NZD. It can protect its position by buying an AUD put/NZD call.
Option A is incorrect as this FEC has the company selling NZD not buying.
Option B is incorrect as the swap only changes the timing; it does not remove the risk.
Option C is incorrect as this would have the company selling (put) NZD, not buying as required.
You can review this topic area in the study materials under the section entitled Risk management for importers.
Question 26
Correct Answer: c
Margins will decline as the costs of production rise, the gold price falls and AUD rises as the AUD receipts from
the USD denominated gold decline.
Option A does not include the adverse impact from a lower AUD/USD.
Option B does not include the impact of rising production costs.
Option D, including falling AUD/USD, is incorrect as this is a benefit to Australian gold producers and would
increase margins.
You can review this topic area in the study materials under the section entitled Precious metals.
Question 27
Correct Answer: c
AUD revenue USD cost AUD/USD AUD cost Profit Margin
125 000 000.00 75 000 000.00 1.0500 71 428 571 53 571 429 43%
125 000 000.00 75 000 000.00 1.0000 75 000 000 50 000 000 40%
125 000 000.00 75 000 000.00 0.9500 78 947 368 46 052 632 37%
125 000 000.00 75 000 000.00 0.9000 83 333 333 41 666 667 33%
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Margins will decline as the costs of production rise, or the wine price falls, or the AUD rises as the AUD receipts
from the NZD-denominated wine sales decline. The wine producer can hedge (Item II) with a bought NZD put or
hedge (Item III) with a collar. Both of these strategies protect the wine producer from a rising AUD, but allow the
wine producer to participate (either fully or partially) in the benefits of a weakening AUD. Items I and IV (i.e. the
forward and foreign exchange swap) lock the wine producer into a foreign exchange rate and therefore preclude
it from participating in any benefits if the AUD weakens.
Option A includes the forward and excludes the put option and the collar.
Option B includes the forward and excludes the collar.
Option D includes the forward.
You can review this topic area in the study materials under the section entitled Risk management for exporters.
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