Chartered Financial Analyst (CFA) Practice Exam Level 2

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What is the purpose of using currency swaps in hedging?

To increase interest rates on bonds
To hedge against currency risks associated with forex transactions
To speculate on currency fluctuations
To improve liquidity in financial markets

The correct answer is: To hedge against currency risks associated with forex transactions

Using currency swaps in hedging primarily serves to mitigate the risks linked to fluctuations in exchange rates. When companies or investors are engaged in foreign operations or have exposure to foreign currency debt, they are susceptible to currency risks—changes in the value of currencies can affect cash flows, profitability, and overall financial stability. By entering into a currency swap, two parties agree to exchange principal and interest payments in different currencies. This allows the parties to convert their cash flows into the desired currency, effectively locking in exchange rates and reducing the uncertainty of future cash flows related to currency conversion. This strategic approach helps entities ensure that their financial results will be more stable, shielding them from the adverse effects of currency volatility. While other options involve aspects related to finance, they don't align with the main purpose of currency swaps in a hedging context. For instance, increasing interest rates on bonds, speculating on currency fluctuations, and improving market liquidity do not directly address the functionality or intent of using currency swaps to manage currency risk.