Chapter 10. Measuring Exposure to Exchange Rate Fluctuations. Lecture Outline. Is Exchange Rate Risk Relevant?

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1 Chapter 10 Measuring Exposure to Exchange Rate Fluctuations Lecture Outline Is Exchange Rate Risk Relevant? Transaction Exposure Estimating Net Cash Flows in Each Currency Measuring the Potential Impact of the Currency Exposure Assessing Transaction Exposure Based on Value-at-Risk Economic Exposure Economic Exposure to Local Currency Appreciation Economic Exposure to Local Currency Depreciation Economic Exposure of Domestic Firms Measuring Economic Exposure Translation Exposure Does Translation Exposure Matter? Determinants of Translation Exposure Examples of Translation Exposure 148

2 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 149 Chapter Theme This chapter distinguishes among three forms by which MNCs are exposed to exchange rate risk: (1) transaction exposure, (2) economic exposure, and (3) translation exposure. Each firm differs in degree of exposure. A firm should be able to measure its degree of each type of exposure as described in this chapter. Then, it can decide how to cover that exposure using methods described in the following two chapters. Topics to Stimulate Class Discussion 1. Describe in general terms how you would measure the transaction exposure of a particular MNC. 2. What is the relationship between transaction exposure and economic exposure? 3. A small firm in New York City produces various metals and sells them to local manufacturers. It has no foreign sales and purchases all supplies and materials locally. Does transaction exposure exist for this firm? Does economic exposure exist for this firm? POINT/COUNTER-POINT: Should Investors Care about an MNC s Translation Exposure? POINT: No. The present value of an MNC s cash flows is based on the cash flows that the parent receives. Any impact of the exchange rates on the financial statements is not important unless cash flows are affected. MNCs should focus their energy on assessing the exposure of their cash flows to exchange rate movements and should not be concerned with the exposure of their financial statements to exchange rate movements. Value is about cash flows, and investors focus on value. COUNTER-POINT: Investors do not have sufficient financial data to derive cash flows. They commonly use earnings as a base, and if earnings are distorted, so will be their estimates of cash flows. If they underestimate cash flows because of how exchange rates affected the reported earnings, they may underestimate the value of the MNC. Even if the value is corrected in the future once the market realizes how the earnings were distorted, some investors may have sold their stock by the time the correction occurs. Investors should be concerned about an MNC s translation exposure. They should recognize that the earnings of MNCs with large translation exposure may be more distorted than the earnings of MNCs with low translation exposure. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? ANSWER: Translation exposure affects earnings, and therefore can affect the value of the firm. If it affects the value of the MNC, translation exposure is relevant to the firm, to the investors who are affected by changing values, and to the managers whose compensation may be affected by changing values.

3 150 International Financial Management Answers to End of Chapter Questions 1. Transaction versus Economic Exposure. Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its net cash flows in each currency when assessing its transaction exposure? ANSWER: Transaction exposure is due only to international transactions by a firm. Economic exposure includes any form by which the firm s cash flow will be affected. Foreign competition may increase due to currency fluctuations. This could affect the firm s cash flow, but did not affect the value of any ongoing transactions. Thus, it represents a form of economic exposure but not transaction exposure. Transaction exposure is a subset of economic exposure. Consideration of all cash flows in a particular currency is not necessary when some inflows and outflows offset each other. Only net cash flows are necessary. 2. Assessing Transaction Exposure. Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash flows are as follows for the next year: Currency Total Inflow Total Outflow Current Exchange Rate in U.S. Dollars Danish krone (DK) DK50,000,000 DK40,000,000 $.15 British pound ( ) 2,000,000 1,000,000 $1.50 Assume that the movements in the Danish krone and the pound are highly correlated. Provide your assessment as to your firm s degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer. ANSWER: The net exposure to each currency in U.S. dollars is derived below: Foreign Currency Net Inflows in Foreign Currency Current Exchange Rate Value of Exposure Danish krone (DK) +DK10,000,000 $.15 $1,500,000 British pound ( ) + 1,000,000 $1.50 $1,500,000 The krone and pound values move in tandem against the dollar. Both the krone and the pound exposure show positive net inflows. Thus, their exposure should be magnified if their exchange rates against the U.S. dollar continue to be highly correlated. 3. Factors That Affect a Firm s Transaction Exposure. What factors affect a firm s degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure. ANSWER: Currency variability low level is desirable. Currency correlations low level is desirable for currencies that are net inflows, while a high level is desirable for pairs of currencies in which one currency shows future net inflows while the other currency shows future net outflows.

4 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Currency Correlations. Kopetsky Co. has net receivables in several currencies that are highly correlated with each other. What does this imply about the firm s overall degree of transaction exposure? Are currency correlations perfectly stable over time? What does your answer imply about Kopetsky Co. or any other firm using past data on correlations as an indicator for the future? ANSWER: Its exposure is high since all currencies move in tandem no offsetting effect is likely. If one of these currencies depreciates substantially against the firm s local currency, all others will as well, and this reduces the value of these net receivables. No! Thus, past correlations will not serve as perfect forecasts of future correlations. Firms can not presume that past correlations will be perfectly accurate forecasts of future correlations. Yet, historical data may still be useful if the general ranking of correlations is somewhat stable. 5. Currency Effects on Cash Flows. How should appreciation of a firm s home currency generally affect its cash inflows? How should depreciation of a firm s home currency generally affect its cash outflows? ANSWER: Appreciation of the firm s home currency reduces inflows since the foreign demand for the firm s goods is reduced and foreign competition is increased. Depreciation of the firm s home currency should increase inflows since it will likely increase foreign demand for the firm s goods and reduce foreign competition. 6. Transaction Exposure. Fischer Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash flows? Why? ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should experience a strong demand for its products when the euro has more purchasing power (can obtain dollars at a low price). 7. Exposure of Domestic Firms. Why are the cash flows of a purely domestic firm exposed to exchange rate fluctuations? ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers may switch to foreign products if the local currency strengthens. 8. Measuring Economic Exposure. Memphis Co. hires you as a consultant to assess its degree of economic exposure to exchange rate fluctuations. How would you handle this task? Be specific. ANSWER: Regression analysis can be used to determine the relationship between the firm s value and exchange rate fluctuations. Stock returns can be used as a proxy for the change in the firm s value. The time period can be segmented into two subperiods so that regression analysis can be run for each subperiod. The sign and magnitude of the regression coefficient will imply how the firm s value is influenced by each currency. Also, the coefficients can be compared among subperiods for each currency to determine how the impact of a currency is changing over time.

5 152 International Financial Management 9. Factors That Affect a Firm s Translation Exposure. What factors affect a firm s degree of translation exposure? Explain how each factor influences translation exposure. ANSWER: The greater the percentage of business conducted by subsidiaries, the greater is the translation exposure. The greater the variability of each relevant foreign currency relative to the headquarters home (reporting) currency, the greater is the translation exposure. The type of accounting method employed can also affect translation exposure. 10. Translation Exposure. Consider a period in which the U.S. dollar weakens against the euro. How will this affect the reported earnings of a U.S.-based MNC with European subsidiaries? Consider a period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the reported earnings of a U.S.-based MNC with subsidiaries all over the world? ANSWER: The consolidated earnings will be increased due to the strength of the subsidiaries local currency (the euro). The consolidated earnings will be reduced due to the weakness of the subsidiaries local currencies. 11. Transaction Exposure. Aggie Co. produces chemicals. It is a major exporter to Europe, where its main competition is from other U.S. exporters. All of these companies invoice the products in U.S. dollars. Is Aggie s transaction exposure likely to be significantly affected if the euro strengthens or weakens? Explain. If the euro weakens for several years, can you think of any change that might occur in the global chemicals market? ANSWER: If the euro strengthens, European customers can purchase Aggie s goods with fewer euros. Since Aggie s competitors also invoice their exports in dollars, Aggie Company will not gain a competitive advantage. Nevertheless, the overall demand for the product could increase because the chemicals are now less expensive to European customers. If the euro weakens, European customers will need to pay more euros to purchase Aggie s goods. Since Aggie s competitors also invoice their exports in dollars, Aggie Company may not necessarily lose some of its market share. However, the overall European demand for chemicals could decline because the prices paid for them have increased. If the euro remained weak for several years, some companies in Europe may begin to produce the chemicals, so that customers could avoid purchasing dollars with weak euros. That is, the U.S. exporters could be priced out of the European market over time if the euro continually weakened. 12. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine materials). Most of Longhorn s competition is from U.S. firms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens? ANSWER: If the peso strengthens, Longhorn will incur higher expenses when paying for the Philippine materials. Because its competition is not affected in a similar manner, Longhorn Company is at a competitive disadvantage when the peso strengthens. 13. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in

6 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 153 the United States. How will Lubbock, Inc., be affected if Brazil s currency (the real) strengthens over time? ANSWER: If the Brazilian real strengthens, U.S. retail stores will likely have to pay higher prices for the furniture from Brazil, and may pass some or all of the higher cost on to customers. Consequently, some customers may shift to furniture produced by Lubbock Inc. Thus, Lubbock Inc. is expected to be favorably affected by a strong Brazilian real. 14. Economic Exposure. Sooner Co. is a U.S. wholesale company that imports expensive high-quality luggage and sells it to retail stores around the United States. Its main competitors also import high-quality luggage and sell it to retail stores. None of these competitors hedge their exposure to exchange rate movements. Why might Sooner s market share be more volatile over time if it hedges its exposure? ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the competition when the dollar weakened (since its competitors would pay higher prices for the luggage), and could possibly gain market share or would have a higher profit margin. It would be at a disadvantage relative to the competition when the dollar strengthened and may lose market share or be forced to accept a lower profit margin. When Sooner Company does not hedge, the amount paid for imports would depend on exchange rate movements, but this is also true for all of its competitors. Thus, Sooner is more likely to retain its existing market share. 15. PPP and Economic Exposure. Boulder, Inc., exports chairs to Europe (invoiced in U.S. dollars) and competes against local European companies. If purchasing power parity exists, why would Boulder not benefit from a stronger euro? ANSWER: If purchasing power parity exists, a stronger euro would occur only because the U.S. inflation is higher than European inflation. Thus, the European demand for Boulder s chairs may not be affected much since the inflated prices of U.S.-made chairs would have offset the European consumer s ability to obtain cheaper dollars. The European consumer s purchasing power of European chairs versus U.S. chairs is not affected by the change in the euro s value. 16. Measuring Changes in Economic Exposure. Toyota Motor Corp. measures the sensitivity of its exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could be used for such a task. Identify the expected sign of the regression coefficient if Toyota primarily exports to the United States. If Toyota established plants in the United States, how might the regression coefficient on the exchange rate variable change? ANSWER: The dependent variable is a percentage change (from one period to the next) in Toyota s export volume to the U.S. The independent variables are (1) the percentage change in the yen s value with respect to the dollar, (2) a measure of the strength of the U.S. economy, and (3) any other factors that could affect the volume of Toyota s exports. The regression coefficient related to the exchange rate variable (as defined here) would be negative, since a decrease in the yen s value is likely to cause an increase in the U.S. demand for Toyotas built in Japan. If Toyota established plants in the U.S., dealers do not need to purchase Toyotas in Japan. Thus, the demand for Toyotas is less sensitive to the exchange rate, which should cause the regression coefficient for the exchange rate variable to decrease.

7 154 International Financial Management 17. Impact of Exchange Rates on Earnings. Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two reasons related to exposure to exchange rates why Cieplak s earnings were reduced during the Asian crisis. ANSWER: First, its receivables from its exports were converted to fewer dollars due to the depreciation of the Asian currencies. Second, any funds remitted by the Malaysian subsidiary converted to fewer dollars for the parent. Third, the earnings generated by the Malaysian subsidiary were translated to fewer dollars on the consolidated income statement (translation exposure) even if it did not remit any earnings to the parent. Advanced Questions 18. Speculating Based on Exposure. During the Asian crisis in 1998, there were rumors that China would weaken its currency (the yuan) against the U.S. dollar and many European currencies. This caused investors to sell stocks in Asian countries such as Japan, Taiwan, and Singapore. Offer an intuitive explanation for such an effect. What types of Asian firms would have been affected the most? ANSWER: If China weakened its currency, importers of Asian products may purchase more Chinese products, which could have enhanced the performance of the Chinese exporters, but could have adversely affected the performance of the exporters in other Asian countries. Thus, there was concern that depreciation of the yuan would adversely affect the economies of the other countries. 19. Comparing Transaction and Economic Exposure. Erie Co. has most of its business in the U.S., except that it exports to Belgium. Its exports were invoiced in euros (Belgium s currency) last year. It has no other economic exposure to exchange rate risk. Its main competition when selling to Belgium s customers is a company in Belgium that sells similar products, denominated in euros. Starting today, Erie Co. plans to adjust its pricing strategy to invoice its exports in U.S. dollars instead of euros. Based on the new strategy, will Erie Co. be subject to economic exposure to exchange rate risk in the future? Briefly explain. ANSWER: Economic exposure still exists because a weak euro would encourage Belgian customers to switch to local competitors.

8 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations Using Regression Analysis to Measure Exposure. a. How can a U.S. company use regression analysis to assess its economic exposure to fluctuations in the British pound? ANSWER: A U.S. company could quantify its performance by measuring the percentage change in earnings, stock price, or some other variable to be used as the dependent variable. The independent variable is the percentage change in the British pound. Lagged exchange rate variables could also be included as additional independent variables to capture any lagged impact of the pound s movements on the firm. b. In using regression analysis to assess the sensitivity of cash flows to exchange rate movements, what is the purpose of breaking the database into sub periods? ANSWER: Breaking the database into sub periods enables one to understand how the impact of the currency is changing over time. c. Assume the regression coefficient based on assessing economic exposure was much higher in the second sub period than in the first sub period. What does this tell you about the firm s degree of economic exposure over time? Why might such results occur? ANSWER: The firm is more exposed to change in currency values. This could occur if the firm hedges currency positions less, or is simply increasing its degree of foreign business. 21. Transaction Exposure. Vegas Corp. is a U.S. firm that exports most of its products to Canada. It historically invoiced its products in Canadian dollars to accommodate the importers. However, it was adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas did not hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S. dollars. After a few more years of continual concern about possible exchange rate movements, Vegas called its customers and requested that they pay for future orders with U.S. dollars instead of Canadian dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to oblige, since the number of Canadian dollars to be converted into U.S. dollars when importing the goods from Vegas was still slightly smaller than the number of Canadian dollars that would be needed to buy the product from a Canadian manufacturer. Based on this situation, has transaction exposure changed for Vegas Corp.? Has economic exposure changed? Explain. ANSWER: Transaction exposure is reduced since Vegas will have less receivables in Canadian dollars. However, the economic exposure will not necessarily be reduced because a weak Canadian dollar could cause a lower demand for its exports and will still affect cash flows. 22. Measuring Economic Exposure. Using the following cost and revenue information shown for DeKalb, Inc., determine how the costs, revenue, and cash flow would be affected by three possible exchange rate scenarios for the New Zealand dollar (NZ$): (1) NZ$ = $.50, (2) NZ$ = $.55, and (3) NZ$ = $.60. (Assume U.S. sales will be unaffected by the exchange rate.) Assume that NZ$ earnings will be remitted to the U.S. parent at the end of the period. Ignore possible tax effects.

9 156 International Financial Management Forecasted Net Cash Flows: DeKalb Inc. (in millions of U.S. dollars and New Zealand dollars) New Zealand U.S. Business Business Sales $800 NZ$800 Cost of Materials Operating Expenses Interest Expense Cash Flow $100 NZ$700 ANSWER: (Figures are in millions) NZ$ = $.50 NZ$ = $.55 NZ$ = $.60 Sales U.S. $ 800 $ 800 $ 800 New Zealand NZ$800 = 400 NZ$800 = 440 NZ$800 = 480 Total $ 1,200 $ 1,240 $ 1,280 Cost of Materials U.S. $ 500 $ 500 $ 500 New Zealand NZ$100 = 50 NZ$100 = 55 NZ$100 = 60 Total $ 550 $ 555 $ 560 Operating expenses $300 $300 $300 Interest expenses $100 $100 $100 Cash flow $250 $285 $320 The preceding table shows that DeKalb Inc. is adversely affected by a weaker New Zealand dollar value. This should not be surprising since the New Zealand business has relatively high NZ$ revenue compared to NZ$ expenses. This analysis assumes that the NZ$ received are converted to U.S. dollars at the end of the period. 23. Changes in Economic Exposure. Walt Disney World built an amusement park in France that opened in How do you think this project has affected Disney s economic exposure to exchange rate movements? Think carefully before you give your final answer. There is more than one way in which Disney s cash flows may be affected. Explain. ANSWER: This is a good question for class discussion. The typical first reaction is that Walt Disney Company s exposure may increase, since this new park would generate revenue in French francs (now euros), which may someday be converted to dollars. If the euro weakens against the dollar, the revenue will be converted to fewer dollars. When European currencies (or the euro) weaken against the dollar, tourism by Europeans decreases and Disney s business in the U.S. declines. By having a European amusement park, it may be able to offset the declining U.S. business during strong dollar cycles, since more European

10 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 157 tourists may go to the Disney park in France during the periods. Overall, Disney may be less exposed to exchange rate movements because of the park. 24. Lagged Effects of Exchange Rate Movements. Cornhusker Co. is an exporter of products to Singapore. It wants to know how its stock price is affected by changes in the Singapore dollar s exchange rate. It believes that the impact may occur with a lag of one to three quarters. How could regression analysis be used to assess the impact? ANSWER: A possible regression model for this task is to regress percentage change in its stock price over quarter t (PSP t ) against the percentage change in the Singapore dollar (PSD) in the three previous quarters, shown as follows. where u t is an error term. PSP t = a 0 + a 1 PSD t 1 + a 2 PSD t 2 + a 3 PSD t 3 + u t 25. Potential Effects if the United Kingdom Adopted the Euro. The U.K. still has its own currency, the pound. The pound s interest rate has historically been higher than the euros interest rate. The U.K. has considered adopting the euro as its currency. There have been many arguments about whether it should do so. Use your knowledge and intuition to discuss the likely effects if the United Kingdom adopts the euro. For each of the 10 statements below, insert either INCREASE or DECREASE and complete the statement by adding a clear short explanation (perhaps one to three sentences) of why the U.K. s adoption of the euro would have that effect. To help you narrow your focus, follow these guidelines. Assume that the pound is more volatile than the euro. Do not base your answer on whether the pound would have been stronger than the euro in the future. Also, do not base your answer on an unusual change in economic growth in the U.K. or in the euro zone if the euro is adopted. ANSWERS: a. The economic exposure of British firms that are heavy exporters to the euro zone would decrease because no exchange of currencies would be needed. b. The translation exposure of firms based in the euro zone that have British subsidiaries would decrease because there would be no need to translate the British financial statements anymore. c. The economic exposure of U.S. firms that conduct substantial business in the U.K. and have no other international business would decrease because the euro should be less volatile than the pound. d. The translation exposure of U.S. firms with British subsidiaries would decrease because the euro should be less volatile than the pound. e. The economic exposure of U.S. firms that export to the U.K. and whose only other international business is importing from firms based in the euro zone would decrease because their euro outflows can offset some of the euro inflows.

11 158 International Financial Management f. The forward discount on the forward rate paid by U.S. firms that periodically use the forward market to hedge payables of British imports would decline (or may even be a premium) because the euro s interest rate is usually less than the pound s interest rate. g. The earnings of a foreign exchange department of a British bank that executes foreign exchange transactions desired by its European clients would decrease because there would be a reduction in the foreign exchange needed. h. Assume that the Swiss franc is more highly correlated with the British pound than with the euro. A U.S. firm has substantial monthly exports to the U.K. denominated in the British currency, and also has substantial monthly imports of Swiss supplies (denominated in Swiss francs). The economic exposure of this firm would increase because it would replace the pound with the euro. The pound effects offset the Swiss franc effects because of the high correlation. The euro effects would not have as much of an offsetting effect because it was assumed that the correlation is not as high. i. Assume that the Swiss franc is more highly correlated with the British pound. A U.S. firm has substantial monthly exports to the U.K. denominated in the British currency, and also has substantial monthly exports to Switzerland (denominated in Swiss francs). The economic exposure of this firm would decrease because the cash inflows would now come from currencies that do not move in tandem as much as before. The British government s reliance on monetary policy (as opposed to fiscal policy) as a means of fine-tuning the economy would decrease because it would no longer have control of the British money supply. The British money supply would be dictated by the European Central Bank. 26. Invoicing Policy to Reduce Exposure. Celtic Co. is a U.S. firm that exports its products to England. It faces competition from many firms in England. Its price to customers in England has generally been lower than those of the competitors, primarily because the British pound has been strong. It has priced its exports in pounds, and then converts the pound receivables into dollars. All of its expenses are in the U.S. and are paid with dollars. It is concerned about its economic exposure. It considers a change in its pricing policy, in which it will price its products in dollars instead of pounds. Offer your opinion on why this will or will not significantly reduce its economic exposure. ANSWER: If the pound weakens, demand for exports of Celtic Co. will decline as customers shift to the local competitors. Thus, this pricing policy would not significantly reduce its economic exposure. 27. Exposure of an MNC s Subsidiary. Decko Co. is a U.S. firm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan. The cell phones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to be stable against the dollar. The subsidiary s main goal is to generate profits for itself and it reinvests the profits. It does not plan to remit any funds to the U.S. parent. a. Assume that the Japanese yen strengthens against the U.S. dollar over time. How would this be expected to affect the profits earned by the Chinese subsidiary? b. If Decko Co. had established its subsidiary in Tokyo, Japan instead of China, would its subsidiary s profits be more exposed or less exposed to exchange rate risk?

12 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 159 c. Why do you think that Decko Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers. d. If the Chinese subsidiary needs to borrow money to finance its expansion and wants to reduce its exchange rate risk, should it borrow U.S. dollars, Chinese yuan, or Japanese yen? ANSWER: a. If the yen appreciates against the dollar, it appreciates against the yuan, which results in higher yuan cash flows to the Chinese subsidiary. b. If the subsidiary was established in Tokyo, Japan, it would be less exposed to exchange rate risk. c. Decko Co. may have established the subsidiary in order to take advantage of the low-cost labor in China. d. If the subsidiary needs to borrow money, it should borrow Japanese yen, because its revenue is also denominated in yen. 28. Assessing Exchange Rate Risk. Washington Co. and Vermont Co. have no domestic business. They have a similar dollar equivalent amount of international exporting business. Washington Co. exports all of its products to Canada. Vermont Co. exports its products to Poland and Mexico, with about half of its business in each of these 2 countries. Each firm receives the currency of the country where it sends its exports. You obtain the end-of-month spot exchange rates of the currencies mentioned above during the end of each of the last 6 months. End of Month Canadian Dollar Mexican Peso Polish Zloty 1 $ $ $ You want to assess the data in a logical manner to determine which firm has a higher degree of exchange rate risk. Show your work and write your conclusion. ANSWER: First, use an excel spreadsheet to determine the monthly percentage change in the exchange rate. The portfolio s movements are equal to a weighted average of the movements of each component currency. The maximum expected one-month loss is l.65 x the standard deviation. The maximum expected one-month loss is lower for the portfolio of pesos and zloty. In this problem, the peso and zloty movements have a correlation coefficient of -.44, which is why the portfolio is less volatile than the Canadian dollar. Standard Deviation Maximum Expected Loss = 1.65 Standard Deviation Canadian $ % Mexican peso % Polish zloty % Equal-weighted portfolio of pesos and zloty %

13 160 International Financial Management 29. Exposure to Pegged Currency System. Assume that the Mexican peso and the Brazilian currency (called the real ) have depreciated against the dollar recently, due to the high inflation rates in those countries. Assume that inflation in these two countries is expected to continue and that it will have a major effect on these currencies if they are still allowed to float. Assume that the government of Brazil decides to peg its currency to the dollar and will definitely maintain the peg for the next year. Milez Co. is based in Mexico. Its main business is to export supplies from Mexico to Brazil. It invoices its supplies in Mexican pesos. Its main competition is from firms in Brazil that produce similar supplies and sell them locally. How will the sales volume of Milez Co.be affected (if at all) by the Brazilian government s actions? Explain. ANSWER: Its sales should increase because higher inflation in Mexico will cause the peso to weaken against the dollar, and therefore weaken against the real when real is pegged to $. So peso weakens against real and Brazilian customers buy more supplies from Mexico. 30. Assessing Currency Volatility. Zemart is a U.S. firm that plans to establish international business in which it will export to Mexico (these exports will be denominated in pesos) and to Canada (these exports will be denominated in Canadian dollars) once a month and will therefore receive payments once a month. It is concerned about exchange rate risk. It wants to compare the standard deviation of exchange rate movements of these 2 currencies against the dollar on a monthly basis. For this reason, it asks you to: a. Estimate the standard deviation of the monthly movements in the Canadian dollar against the U.S. dollar over the last 12 months. b. Estimate the standard deviation of the monthly movements in the Mexican peso against the U.S. dollar over the last 12 months. c. Determine which currency is less volatile. You can use the oanda.com Web site (or any legitimate Web site that has currency data) to obtain the end of month direct exchange rate of the peso and the Canadian dollar in order to do your analysis. Show your work. You can use a calculator or a spreadsheet (like Excel) to do the actual computations. ANSWER: This problem requires students to obtain exchange rates and use an Excel spreadsheet to derive the standard deviation of exchange rate movements, and to compare results. The comparison will likely show that the Canadian dollar s movements are less volatile than the peso movements, but results vary over time. 31. Exposure of Net Cash Flows. Each of the following U.S. firms is expected to generate $40 million in net cash flows (after including the estimated cash flows from international sales if there are any) over the next year. Ignore any tax effects. Each firm has the same level of expected earnings. None of the firms have taken any positions in exchange rate derivatives to hedge their exchange rate risk. All payments for the international trade by each firm will occur one year from today. Sunrise Co. has ordered imports from Austria, and its imports are invoiced in euros. The dollar value of the payables (based on today s exchange rate) from its imports during this year is $10 million. It has no international sales.

14 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 161 Copans Co. has ordered imports from Mexico, and its imports are invoiced in U.S. dollars. The dollar value of the payables from its imports during this year is $15 million. It has no international sales. Yamato Co. ordered imports from Italy, and its imports are invoiced in euros. The dollar value of the payables (based on today s exchange rate) from its imports during this year is $12 million. In addition, Yamato exports to Portugal and its exports are denominated in euros. The dollar value of the receivables (based on today s exchange rate) from its exports during this year is $8 million. Glades Co. ordered imports from Belgium, and these imports are invoiced in euros. The dollar value of the payables (based on today s exchange rate) from its imports during this year is $7 million. Glades also ordered imports from Luxembourg and these imports are denominated in dollars. The dollar value of these payables is $30 million. Glades has no international sales. Based on this information, which firm is exposed to the most exchange rate risk? Explain. ANSWER: Amount of Foreign Currency Net Company Cash Flows (measured in $) Sunrise $10 million Copans $0 Yamato $4 million Glades $7 million Sunrise is exposed to the most exchange rate risk. 32. Cash Flow Sensitivity to Exchange Rate Movements. The Central Bank of Poland is about to engage in indirect intervention later today, in which it will lower Poland s interest rates substantially. This will have an impact on the value of the Polish currency (zloty) against most currencies because it will immediately affect capital flows. Missouri Co. has a subsidiary in Poland that sells appliances. The demand for its appliances is not affected much by the local economy. Most of its appliances produced in Poland are typically invoiced in zloty and are purchased by consumers from Germany. The subsidiary s main competition is from appliance producers in Portugal, Spain, and Italy that also export appliances to Germany. a. Explain how the impact on the zloty s value will affect the sales of appliances by the Polish subsidiary. b. The subsidiary owes a British company 1 million British pounds for some technology that the British company provided. Explain how the impact on the zloty s value will affect the cost of this technology to the subsidiary. c. The subsidiary plans to take 2 million zloty from its recent earnings, and will remit it to the U.S. parent in the near future. Explain how the impact on the zloty s value will affect the amount of dollar cash flows received by the U.S. parent due to this remittance of earnings by the subsidiary.

15 162 International Financial Management ANSWER: a. The lower interest rate in Poland will reduce capital flows to Poland, which reduces the demand for zloty, which weakens the value of the zloty. Thus, sales of appliances by the Polish subsidiary to Germany should increase because German consumers can purchase appliances from the subsidiary at a lower price. b. The lower interest rate in Poland will reduce capital flows to Poland, which reduces the demand for zloty, which weakens the value of the zloty. The subsidiary s cost will increase because it will take more zloty to purchase technology. c. The earnings will convert to less dollars because of the zloty s depreciation against the dollar. 33. Applying the Value-at-Risk Method. You use today s spot rate of the Brazilian real to forecast the spot rate of the real for one month ahead. Today s spot rate is $ Use the value-at-risk method to determine the maximum percentage loss of the Brazilian real over the next month based on a 95 percent confidence level. Use the spot exchange rates at the end of each of the last 6 months as shown below to conduct your analysis. Forecast the exchange rate that would exist under these conditions. ANSWER: End of Month Value of Brazilian Real 1 $ The standard deviation is 4.09%. The maximum expected loss in the currency s value is: % = 6.75%. If this loss occurs, the exchange rate of the real in one month would be: $.4558 (1.0675) = $ Assessing Translation Exposure. Kanab Co. and Zion Co. are U.S. companies that engage in much business within the U.S. and are about the same size. They both conduct some international business as well. Kanab Co. has a subsidiary in Canada that will generate earnings of about C$20 million in each of the next 5 years. Kanab Co. also has a U.S. business that will also receive about C$1 million (after costs) in each of the next 5 years as a result of exporting products to Canada that are denominated in Canadian dollars. Zion Company has a subsidiary in Mexico that will generate earnings of about 1 million pesos in each of the next 5 years. Zion Co. also has a business in the U.S. that will receive about 300 million pesos (after costs) in each of the next 5 years as a result of exporting products to Mexico that are denominated in Mexican pesos. The salvage value of Kanab s Canadian subsidiary and Zion s Mexican subsidiary will be zero in 5 years. The spot rate of the Canadian dollar is $.60 while the spot rate of the Mexican peso is $.10. Assume the Canadian dollar could appreciate or depreciate against the U.S. dollar by about 8% in any given year, while the Mexican peso could appreciate or depreciate against the U.S.

16 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 163 dollar by about 12% in any given year. Which company is subject to a higher degree of translation exposure? Explain. ANSWER: Kanab Co. has C$20,000,000 that is subject to translation exposure, as these are the subsidiary earnings. Its cash flows from exporting are not subject to translation exposure. Zion Co. has 1,000,000 pesos that is subject to translation exposure, as these are the subsidiary earnings. Its cash flows from exporting are not subject to translation exposure. The estimated dollar value of Kanab s translated earnings is C$20,000, = $12,000,000. The estimated dollar value of Zion s translated earnings is 1,000,000 pesos.10 = $100,000. Since both companies are the same size, Kanab Co. has a much higher proportion of its business that is subject to translation exposure. While the peso is more volatile than the Canadian dollar, the potential adverse effect due to translation exposure is much larger for Kanab. 35. Cross-Currency Relationships. The Hong Kong dollar (HK$) is presently pegged to the U.S. dollar and is expected to remain pegged. Some Hong Kong firms export products to Australia that are denominated in Australian dollars and have no other business in Australia. The exports are not hedged. The Australian dollar is presently worth 0.50 U.S. dollars but you expect that it will be worth 0.45 U.S. dollars by the end of the year. Based on your expectations, will the Hong Kong exporters be affected favorably or unfavorably? Briefly explain. ANSWER: Hong Kong exporters are adversely affected. If the A$ depreciates against U.S. $, it will depreciate against the HK$, which means that the Australian importers will have to pay more for exports. 36. Interpreting Economic Exposure. Spratt Co. (a U.S. firm) attempts to determine its economic exposure to movements in the British pound, by applying regression analysis to data over the last 36 quarters: SP = b0 + b1e + u where SP represents the percentage change in Alabama s stock price per quarter, e represents the percentage change in the pound value per quarter, and u is an error term. Based on the analysis, the b0 coefficient is zero and the b1 coefficient is.4 and is statistically significant. Assume that interest rate parity exists. Today, the spot rate of the pound is $1.80, the 90-day British interest rate is 3%, and the 90-day U.S. interest rate is 2%. Assume that the 90-day forward rate is expected to be an accurate forecast of the future spot rate. Would you expect that Spratt s value will be favorably affected, unfavorably affected, or not affected by its economic exposure over the next quarter? Explain. ANSWER: The forecast based on the forward rate (assuming interest rate parity) is depreciation of the pound, and Spratt value moves inversely with the movement in pound, so it will be favorably affected.

17 164 International Financial Management Solution to Continuing Case Problem: Blades, Inc. 1. What type(s) of exposure (i.e., transaction, economic, or translation exposure) is Blades subject to? Why? ANSWER: Blades is subject to transaction and economic exposure, but is not subject to translation exposure. Transaction exposure is the degree to which the value of future cash transactions can be affected by exchange rate fluctuations. Economic exposure is the degree to which a firm s present value of future cash flows can be influenced by exchange rate fluctuations. Translation exposure is the exposure of an MNC s consolidated financial statements to exchange rate fluctuations. 2. Using a spreadsheet, conduct a consolidated net cash flow assessment of Blades, Inc., and estimate the range of net inflows and outflows for Blades for the coming year. Assume that Blades enters into the agreement with Jogs, Ltd. ANSWER: Consolidated Net Cash Flow Assessment of Blades, Inc. Net Inflow or Net Inflow Expected Outflow as Total Total or Exchange Measured in Currency Inflow Outflow Outflow Rate U.S. Dollars British pound Inflow: (200,000 pairs 80 pounds per pair) 16,000,000 16,000,000 $1.50 $24,000, (inflow) (inflow) Japanese yen Outflow: (1,700 pairs 7,440 yen per pair) 12,648,000 12,648,000 $ $104, (outflow) (outflow) Thai baht Inflow: (180,000 pairs 4,594 baht per pair) 826,920, ,712, ,208,000 $0.024 $14,884, Outflow: (72,000 pairs (inflow) (inflow) 2,871 baht per pair)

18 Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 165 Estimating the Range of Net Inflows or Outflows for Blades, Inc. Range of Possible Net Inflows or Outflows in Range of Possible U.S. Dollars (Based on Net Inflow or Exchange Rates at Range of Possible Net Outflow End of Period Exchange Rate* British pound 16,000, $1.47 to $1.53 $23,520,000 to $24,480,000 (inflow) (inflow) Japanese yen 12,648, $ to $ $99, to $110, (outflow) (outflow) Thai baht 620,208, $0.020 to $0.028 $12,404,160 to $17,365,824 (inflow) (inflow) *Ranges are calculated by multiplying the net inflow or outflow and the exchange rates in the range. 3. If Blades does not enter into the agreement with the British firm and continues to export to Thailand and import from Thailand and Japan, do you think the increased correlations between the Japanese yen and the Thai baht will increase or decrease Blades transaction exposure? ANSWER: If Blades does not enter into the agreement with the British firm but continues its current importing and exporting practices in Asia, the increased correlations between the Japanese yen and the Thai baht will reduce Blades level of transaction exposure. This is because Blades generates net inflows denominated in Thai baht but net outflows denominated in Japanese yen. For example, if the Thai baht depreciates, resulting in reduced dollar revenue, the Japanese yen will also depreciate, resulting in reduced dollar costs. 4. Do you think Blades should import components from Japan to reduce its net transaction exposure in the long run? Why or why not? ANSWER: Importing components from Japan would probably not be a good way to reduce Blades transaction exposure in the long run. Although the correlation between the Thai baht and the Japanese yen is currently quite high, it has been low and unstable in the past. Once the current economic problems that caused the currently high correlation subside, the correlation between the two currencies will probably return to its normal level. Since Blades only reduces its net transaction exposure by importing from Japan because of the high correlation between the two currencies, Blades net transaction exposure may actually increase once the correlation between the baht and the yen returns to normal levels. 5. Assuming Blades enters into the agreement with Jogs, Ltd., how will its overall transaction exposure be affected? ANSWER: If Blades enters into the agreement with Jogs Ltd., its overall level of transaction exposure would increase because the resulting transactions would increase Blades net cash inflows denominated in foreign currencies. However, the increase in transaction exposure is probably not too high, since the correlations between the two Asian currencies and the British pound are relatively low. For example, a depreciation in the British pound would likely be accompanied by an appreciation in the Thai baht and the Japanese yen. The depreciation of the pound would result in reduced dollar revenue from Blades British exports. However, this

19 166 International Financial Management reduction would be offset by increased dollar revenue from Thailand, even though Blades dollar costs incurred due to Japanese imports would also increase. 6. Given that Thai roller blade manufacturers located in Thailand have begun targeting the U.S. roller blade market, how do you think Blades U.S. sales were affected by the depreciation of the Thai baht? How do you think its exports to Thailand and its imports from Thailand and Japan were affected by the depreciation? ANSWER: Blades U.S. sales were likely negatively affected by the depreciation of the baht since several Thai manufacturers located in Thailand have begun targeting the U.S. roller blade market. This is because Blades U.S. customers can obtain foreign roller blades more cheaply with a strengthened dollar. Blades exports to Thailand were affected negatively by the depreciation, as the baht it received were converted into fewer dollars. Blades imports from Thailand were probably affected positively by a depreciation of the baht, as fewer dollars were needed to obtain the baht to pay for the imports. Since the correlation between the baht and the yen has been high, the yen probably also depreciated, leading to reduced dollar costs for Blades to pay for the Japanese imports. Solution to Supplemental Case: Whaler Publishing Company a. Using the exchange rate data from the case problem in the previous chapter, scenarios for the percentage change in each exchange rate and the forecasted spot rate in one year are determined. Then, for each scenario, the forecasted spot rate is multiplied by the number of foreign currency units to be received; estimate the U.S. dollar revenues to be generated from each country. These revenues are then aggregated across the four countries to estimate total dollar revenues. U.S. Dollar Revenues Year Used to from All Countries in Create a Scenario Aggregate (in thousands) 1 $129, , , , , , , , , , , , , , ,220 Since each scenario has an equal probability of occurring, the expected value of U.S. dollar revenues from all countries in aggregate is the average of these numbers, $143,982,000. The standard deviation of the U.S. dollar revenues from all countries in aggregate is $14,018,000.