CIMA F3 Financial risks: practice questions with answers

Question 1

Pinecrest Inc, a US company, owns a subsidiary in Brazil. At each year end the subsidiary's net assets are translated into US dollars at the closing rate for the group's consolidated financial statements. This year the Brazilian real weakened against the dollar, reducing reported group equity, although no cash flows were affected. Which type of exposure does this illustrate?

1. A Transaction exposure
2. B Economic exposure
3. C Political risk
4. D Translation exposure

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Answer: D. Transaction exposure affects specific foreign currency cash flows. Translation exposure affects reported values when foreign subsidiaries are consolidated; it is an accounting exposure with no immediate cash effect. Economic exposure is the long-term effect on the present value of future cash flows. The fall in reported equity with no cash effect is translation exposure.

Question 2

The spot rate is EUR 1 = USD 1.1000. Expected annual inflation is 3.5% in the US and 2.0% in the eurozone for the next two years. Using purchasing power parity, what is the expected spot rate in two years' time (USD per EUR 1)?

1. A USD 1.1552
2. B USD 1.1326
3. C USD 1.1162
4. D USD 1.0683

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Answer: B. PPP: expected spot = current spot x [(1 + US inflation) / (1 + euro inflation)]^n

= 1.1000 x (1.035 / 1.020)^2 = USD 1.1326 per EUR 1

The dollar is expected to weaken against the euro because US inflation is higher.

Question 3

Halvard Inc, a US company, is setting up a subsidiary in Germany. It decides to finance the subsidiary's assets with a long-term loan denominated in euros rather than in US dollars. What is the main risk management purpose of this decision?

1. A To eliminate the economic exposure arising from competitors' costs in other currencies
2. B To fix the dollar value of future dividends remitted by the subsidiary
3. C To obtain a lower overall cost of borrowing through interest rate parity
4. D To reduce translation exposure by matching euro assets with euro liabilities

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Answer: D. Financing foreign assets with borrowings in the same currency is matching (asset and liability hedging). When the euro weakens, the dollar value of the German assets falls but so does the dollar value of the euro loan, so the net translation effect on group equity is reduced. The euro interest and repayments can also be paid from the subsidiary's euro cash flows.

Question 4

Wenlock Inc, a US company, needs CHF 50 million for five years to fund a Swiss subsidiary but can borrow more cheaply in US dollars. It borrows in USD and enters a currency swap with a bank. Which statement describes the usual cash flows under the swap?

1. A Only interest payments are exchanged, and the principal amounts are never exchanged
2. B The principal is re-exchanged at maturity at the spot exchange rate on that date
3. C The parties exchange principal at the start, pay each other's interest in the swapped currencies, and re-exchange the principal at maturity at the original rate
4. D The parties exchange fixed-rate interest for floating-rate interest in the same currency

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Answer: C. In a currency swap, Wenlock Inc gives USD to the bank and receives CHF 50m at the start. Over the five years it pays CHF interest (which the subsidiary can fund from its CHF income) and receives USD interest to service its USD loan. At maturity the principal amounts are re-exchanged at the original rate. This gives Wenlock Inc the benefit of its cheaper USD borrowing while matching the CHF asset with a CHF liability, reducing translation and long-term economic exposure.

Question 5

Ardent Inc is concerned that the government of a country in which it has a subsidiary may expropriate (seize) the subsidiary's assets. Which action would most directly reduce Ardent Inc's potential loss from expropriation?

1. A Hedging the subsidiary's export receipts with forward currency contracts
2. B Increasing the proportion of the subsidiary's profits that are reinvested locally
3. C Translating the subsidiary's net assets at the average exchange rate rather than the closing rate
4. D Financing the subsidiary as far as possible with borrowing raised from banks in the host country

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Answer: D. Political risk is the risk that government actions (expropriation, exchange controls, discriminatory taxes) reduce the value of an overseas investment. Ways to manage it include: local financing (so less of the parent's own capital is exposed), joint ventures with local partners, political risk insurance, negotiating agreements with the host government before investing, and structuring operations so that key technology, brands or supply chains stay outside the country.