ACCA FM · Chapter 14
Foreign currency risk and interest rate risk MCQs with Answers
10 multiple-choice questions on Foreign currency risk and interest rate risk for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A UK company has a subsidiary in another country. When the subsidiary's statement of financial position is converted into sterling for the group accounts, a loss arises because the foreign currency has weakened. Which type of foreign currency risk is this?
- A) Translation risk
- B) Basis risk
- C) Transaction risk
- D) Economic risk
Show answer & explanation
Answer: A) Translation risk
Translation risk is the risk of gains or losses when the results and net assets of foreign operations are translated into the reporting currency. It is an accounting exposure with no immediate cash flow effect. Transaction risk affects individual foreign currency receipts and payments, and economic risk is the long-term effect of exchange rate movements on the value of the company.
Question 2
A UK company will receive $500,000 in three months. The spot rate is $1.2500 per £1 and the three-month forward rate is $1.2650 per £1. If the company hedges using a forward contract, how much sterling will it receive (to the nearest £)?
- A) £395,257
- B) £400,000
- C) £404,858
- D) £632,500
Show answer & explanation
Answer: A) £395,257
The forward contract fixes the rate at $1.2650 per £1. Sterling received = $500,000 / 1.2650 = £395,257. Dollars must be divided (not multiplied) by the rate because the rate is quoted as dollars per pound. £400,000 is the spot equivalent today, which is not available for a future receipt.
Question 3
A UK company will receive $1,000,000 in six months. The spot rate is $1.3000 per £1. The company can borrow in dollars at 5% a year and deposit in sterling at 3% a year. Using a money market hedge, how much sterling will the company have in six months (to the nearest £)?
- A) £754,579
- B) £761,726
- C) £769,231
- D) £776,809
Show answer & explanation
Answer: B) £761,726
Borrow dollars now so that the loan plus 6 months' interest equals the receipt: $1,000,000 / 1.025 = $975,610. Convert at spot: $975,610 / 1.3000 = £750,469. Deposit in sterling for 6 months at 1.5%: £750,469 x 1.015 = £761,726. The dollar receipt repays the loan. Using full annual rates instead of six-month rates gives £754,579.
Question 4
A UK company must pay €400,000 in three months. The spot rate is €1.1500 per £1. The company can deposit euros at 2% a year and borrow sterling at 6% a year. What is the sterling cost of the payment, in three months' time, using a money market hedge (to the nearest £)?
- A) £344,399
- B) £347,826
- C) £351,287
- D) £361,466
Show answer & explanation
Answer: C) £351,287
Deposit enough euros now to grow to €400,000 in three months: 400,000 / 1.005 = €398,010. Buy these euros at spot: €398,010 / 1.1500 = £346,096, borrowed in sterling. Repay the sterling loan with three months' interest at 1.5%: £346,096 x 1.015 = £351,287. Using annual rather than three-month interest rates gives £361,466.
Question 5
The current spot rate is 2.0000 dinars per $1. Expected annual inflation is 6% in the country using the dinar and 2% in the US. Using purchasing power parity theory, what is the expected spot rate in one year (dinars per $1, to 4 decimal places)?
- A) 1.9245
- B) 2.0400
- C) 2.0784
- D) 2.1200
Show answer & explanation
Answer: C) 2.0784
PPP: expected future spot = spot x (1 + inflation in the dinar country) / (1 + US inflation) = 2.0000 x 1.06 / 1.02 = 2.0784. The dinar is expected to weaken because its inflation is higher, so more dinars will be needed per dollar. 1.9245 inverts the inflation ratio.
Question 6
The spot rate is 25.00 pesos per $1. One-year interest rates are 9% for pesos and 3% for dollars. Using interest rate parity, what is the one-year forward rate (pesos per $1, to 2 decimal places)?
- A) 23.62
- B) 25.75
- C) 26.46
- D) 27.25
Show answer & explanation
Answer: C) 26.46
Interest rate parity: forward rate = spot x (1 + peso interest rate) / (1 + dollar interest rate) = 25.00 x 1.09 / 1.03 = 26.4563, which is 26.46 pesos per $1. The currency with the higher interest rate trades at a forward discount, so more pesos are needed per dollar in the forward market.
Question 7
A company plans to borrow $5m in three months' time for a period of six months. It buys a 3-9 forward rate agreement (FRA) at 4.5%. When the loan is taken out, the reference rate is 5.5%. Ignoring discounting of the settlement, what is the FRA settlement?
- A) The company receives $50,000
- B) The company pays $25,000
- C) The company receives $25,000
- D) The company receives $12,500
Show answer & explanation
Answer: C) The company receives $25,000
The reference rate (5.5%) is above the FRA rate (4.5%), so the bank compensates the company. Settlement = $5,000,000 x (5.5% - 4.5%) x 6/12 = $25,000. This offsets the higher interest on the actual loan, fixing the company's effective rate at the FRA rate plus its lending margin. The loan period is six months, so a full year's difference ($50,000) is wrong.
Question 8
A company expects to borrow a large sum in two months' time and is concerned that interest rates will rise before then. How should it use short-term interest rate futures to hedge this risk?
- A) Buy a call option on interest rate futures
- B) Take no futures position, as futures cannot hedge borrowing
- C) Buy interest rate futures now and sell them when the loan is taken out
- D) Sell interest rate futures now and buy them back when the loan is taken out
Show answer & explanation
Answer: D) Sell interest rate futures now and buy them back when the loan is taken out
Interest rate futures are priced at 100 minus the interest rate, so their price falls when interest rates rise. A borrower therefore sells futures now; if rates rise, the futures can be bought back at a lower price, and the profit offsets the higher interest cost on the loan. Buying futures (or call options on them) protects a future depositor against falling rates.
Question 9
A company with variable rate borrowing buys an interest rate cap and simultaneously sells an interest rate floor at a lower rate. What is this arrangement called and what is its main advantage?
- A) A forward rate agreement, which removes all interest rate risk
- B) An interest rate collar, which reduces the net premium cost of protection against rising rates
- C) An interest rate swap, which converts the loan to a fixed rate
- D) An interest rate collar, which allows the company to benefit fully from any fall in interest rates
Show answer & explanation
Answer: B) An interest rate collar, which reduces the net premium cost of protection against rising rates
A collar combines buying a cap (protecting against rates rising above a ceiling) with selling a floor (giving up the benefit of rates falling below a lower limit). The premium received for the floor offsets some or all of the premium paid for the cap, so protection is cheaper, but the company does not benefit from rates falling below the floor.
Question 10
A normal yield curve slopes upwards, showing that longer-term debt has higher yields than shorter-term debt. Which theory explains this by saying that investors require extra compensation for tying up their money for longer?
- A) Liquidity preference theory
- B) Expectations theory
- C) Purchasing power parity theory
- D) Market segmentation theory
Show answer & explanation
Answer: A) Liquidity preference theory
Liquidity preference theory states that investors prefer to hold liquid, short-term assets, so they demand a premium for lending long term. This produces an upward-sloping yield curve even when interest rates are not expected to change. Expectations theory explains the shape of the curve by forecast future rates, and market segmentation theory by separate supply and demand in different maturity sectors.