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How would you define economic exposure to exchange risk?
Economic exposure can be defined as the possibility that the firm’s cash flows and thus its market value may be affected by the unexpected changes in the exchange rate.
Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.
Competitive effect: Exchange rate changes may affect operating cash flows by altering the firm’s competitive position.
Conversion effect: A given operating cash flow in terms of a foreign currency will be converted into higher or lower home currency amounts as the exchange rate changes.
Discuss the determinants of operating exposure.
The main determinants of a firm’s exposure are:
The structure of the markets in which the firm sources its inputs, such as labour and materials, and sells its products.
The firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.
General Motors exports cars to Spain, but the strong dollar against the euro hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from Italian and French car makers, such as Fiat and Renault, whose operating currencies are the euro. What kind of measures would you recommend so that GM can maintain its market share in Spain?
Possible measures that GM can take include:
diversify the market; try to market the cars not just in Spain and other European countries but also in say, Asia;
locate production facilities in Spain and source inputs locally,
locate production facilities, say, in Mexico where production costs are low and export to Spain from Mexico.
Evaluate the following statement: “A firm can reduce its currency exposure by diversifying across different business lines.”
Conglomerate expansion may be too costly as a means of hedging exchange risk exposure. Investment in a different line of business must be made on its merit.
Exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.
A firm can have a natural hedging position due to, for example, diversified markets, flexible sourcing capabilities, etc. In addition, to the extent that PPP holds, nominal exchange rate changes do not influence firm’s competitive positions. Under these circumstances, firms do not need to worry about exchange risk exposure.
If PPP holds, does the firm face any exchange rate risk? Explain.
If PPP holds, it does not face operating exposure. However, firms may face transaction and translation exposure.
Matsushita exports about half of its TV set production to the United States under its Panasonic, Quasar, and Technics brand names. It prices its products in Yen. Suppose the Yen moves from ¥ 130 = $1 to ¥ 110 = $1. What currency risk is Matsushita facing?
As the yen rises against the dollar, Japanese producers become less competitive in the US. Matsushita might be willing to accept lower profits, by not increasing its ($) prices in line with the yen appreciation. This will prevent it from losing market share.
The impact on Matsushita will also depend on the nature of competition. It is likely to face increased competition of television manufacturers from other countries say, South Korea (Goldstar and Samsung). Its competitors might take advantage of the yen’s appreciation to sell more electronic goods. This will limit Matsushita’s ability to raise prices. This will also depend on the nature of products. Where is faces direct competition (in the case of inexpensive televisions, VCRs and microwaves) it will have little or no ability to raise prices. But, will have greater latitude in the more expensive segment where it might face little or no competition. As mentioned in the lecture, spending on R & D generally creates products, the demand for which is price inelastic. Spending on R & D is likely to result in technologically sophisticated products.
Matsushita could cut its cost by overhauling its product range and by shifting (some) production to lower cost manufacturing facilities in other Asian countries. It could consider cutting down on low volume, low margin products which might account for a low percentage of sales. Matsushita can also diversify out of consumer electronics and manufacture goods where quality and not price that matter (e.g. semiconductors and office equipment).
About two-thirds of Californian almonds are exported. The ups and downs of the US dollar cause headaches for growers. To avoid this, growers decide to concentrate on domestic sales. Does the grower bear exchange rate risk? Why and how?
A grower who sells only in the US, still faces exchange rate risk because the price at which he sells almonds will depend on exchange rate. Eg. As the US$ appreciates, foreign buyers will demand fewer almonds at the same price. This will cause the US$ price of almonds sold overseas to fall. Therefore, those who sold overseas may find it more profitable to sell in the US. This will drive down the price of almonds in the US until it equals the price of almonds in other foreign countries minus transportation costs.
In the annual results of Nestle, a large diversified Swiss-based food company with operations in more than 100 countries, management states that it does not hedge foreign exchange exposure. What might be the rationale behind this policy?
Hedging cash flows in numerous currencies might be expensive due to the transaction costs incurred.
The way it has chosen to minimise exposure is by adopting a “diversification of the market” strategy. Reduced sales in one country due to the appreciation of CHF may be offset by an increase in sales in a 2nd country due to the depreciation of the CHF against the 2nd currency.
In order to avoid speculation, Honda hedges only the sales it has clinched, not the ones it expects. Comment on Honda’s currency risk strategy.
Honda is, in fact hedging its TRANSACTION exposure. It is hedging cash flows that can be viewed as being certain. However, it is leaving itself open to changes in the level of competition that it might face. In other words, it is not hedging its competitive exposure.
Black & Decker Manufacturing Co. of Towson, Md., has roughly 45% of its costs and 40% of its sales overseas. How does the soaring dollar affect its profitability, both at home and abroad?
Has a rough balance between foreign sales and costs. As the $ appreciates, both its sales revenue and its costs decline approx. in line with each other. This means that the profit will decline in line with the dollar (if revenues and costs drop by 10%, then profit must fall by 10%). Hence B&D’s profits fall in line with $ rises and vice versa. If B&D didn’t produce overseas, but instead exported from its US plants, then currency changes will lead to a greater swings in its profits. B&D’s domestic profitability will also be affected by foreign competition as the currency changes.
13. A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt at 7 percent or yen debt at 3 percent.
(a) Suppose the company is a multinational firm with sales in the United States and inputs purchased in Japan. How should this affect its financing choice?
According to the international Fisher effect, the difference in interest rates reflects expected appreciation in the value of the yen. That is, yen are not automatically less expensive to borrow just because the interest rate on yen is lower than the rate on dollars. From a risk management standpoint, the key issue is the currency risk being borne by the MNC and the effect of its borrowing decision on that currency risk. From the facts given in the question, it appears that based on its sourcing of inputs in Japan, the company is short yen1 (regardless of whether the input prices are denominated in yen or dollars). Other things being equal, therefore, it appears that the MNC should borrow dollars; borrowing yen will just exacerbate its short position in yen. However, if the company is competing with Japanese firms, then it is more likely to be long yen, in the sense that if the yen appreciates, its competitive position improves and vice versa if the yen depreciates. If this is the case, then the firm’s yen exposure is the net of its short and long exposure, which we cannot ascertain from the facts presented in the question.
(b) Suppose the company is a multinational firm with sales in Japan and inputs that are primarily determined in dollars. How should this affect its financing choice?
In this case, the firm clearly has a long economic exposure to yen. By financing in yen, the MNC can offset its economic exposure.
14. DaimlerChrysler’s Chrysler division exports vans to Europe in competition with the Japanese. Similarly, Compaq exports computers to Europe. However, its biggest competitors are all American companies–IBM, Hewlett-Packard, and Tandem. Assuming all else is equal, which of these companies–Chrysler or Digital–is likely to benefit more from a weak dollar? Explain.
Chrysler is likely to be the bigger beneficiary of a weak dollar since its primary competitors are the Japanese. The falling dollar gives Chrysler an opportunity to gain market share in Europe from the Japanese by holding its dollar prices constant, thereby lowering its prices in terms of the various European currencies. The Japanese carmakers cannot respond effectively since their costs have not changed in European currency terms. Conversely, by holding its prices constant in European currency terms, Chrysler can fatten its profit margins.
Compaq, on the other hand, will not gain a competitive advantage relative to its primary competitors from a falling dollar since all of them, being U.S. companies, share a common cost structure. Competition will likely force them to pass along lower costs (in European terms) in the form of lower European currency prices. This will probably expand the market overall, but no one company will gain a competitive advantage. By the same token, the existence of a common cost structure means that Compaq will be less affected than Chrysler by a rise in the dollar’s value.
15. Hilton International is considering investing in a new Swiss hotel. The required initial investment is $1.5 million (or SFr 2.38 million at the current exchange rate of $0.63 = SFr 1). Profits for the first ten years will be reinvested, at which time Hilton will sell out to its partner. Based on projected earnings, Hilton’s share of this hotel will be worth SFr 3.88 million in ten years.
a. What factors are relevant in evaluating this investment?
Hilton should focus on the real dollar value of future cash flows, or
where e10 is the nominal dollar value of the Swiss franc in ten years, πus is the average annual rate of U.S. inflation over the next ten years, and k is Hilton’s real required return for this project. That is, the SFr 3.88 million expected to be received in ten years should first be converted to nominal dollars, then into real dollars, and finally discounted at the real required return. This present value figure should then be compared to $1.5 million, the current cost of the investment (2,380,000 x .63).
b. How will fluctuations in the value of the Swiss franc affect this investment?
Only fluctuations in the real value of the Swiss franc matter; fluctuations in the nominal value of the Swiss franc that are fully offset by higher U.S. inflation should not affect the investment. If the real value of the Swiss franc rises, the real dollar price of the hotel services being sold by Hilton will also rise. If demand for these services is elastic, which it seems to be given the Swiss hotel industry’s heavy dependence on tourists, real dollar revenues will decline. Inelastic demand will cause an increase in real dollar revenues. The hotel’s real dollar cost of Swiss labor and services will rise. Thus, if PPP holds, nominal currency changes shouldn’t affect Hilton’s Swiss investment; if PPP does not hold, an increase in the real exchange rate is likely to reduce the real value of Hilton’s investment.
c. How would you forecast the $:SFr exchange rate ten years ahead?
There are several ways to forecast the nominal Swiss exchange rate ten years out: (1) Rely on the international Fisher effect, using nominal interest differentials between U.S. and Swiss bonds with maturities of ten years; (2) project relative price levels changes in Switzerland and the U.S. over the next ten years and then use PPP to forecast the rate change; and (3) use the forward rate if a ten‑year swap can be found. But what really matters is what happens to the real exchange rate. The best forecast of the real rate ten years out is the current spot rate. Over the long run, PPP tends to hold, leading to a relatively constant real exchange rate.
16. A proposed foreign investment involves a plant whose entire output of 1 million units per annum is to be exported. With a selling price of $10 per unit, the yearly revenue from this investment equals $10 million. At the present rate of exchange, dollar costs of local production equal $6 per unit. A 10 percent devaluation is expected to lower unit costs by $0.30, while a 15 percent devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10 percent or 15 percent is likely, with respective probabilities of .4 and .2 (the probability of no currency change is .4). Depreciation at the current exchange rate equals $1 million annually, while the local tax rate is 40 percent.
a. What will annual dollar cash flows be if no devaluation occurs?
The cash flows associated with each exchange rate scenario are:
Cash Flow Statement (in millions of dollars)
Revenue Variable Cost Depreciation
$10.0 6.0 1.0
$10.00 5.70 0.90
$10.00 5.55 0.85
Taxable income Tax @ 40%
After-tax income Depreciation
With no devaluation, the annual cash flow will equal $2.8 million.
b. Given the currency scenario described above, what is the expected value of annual after‑tax dollar cash flows assuming no repatriation of profits to the United States?
The expected dollar cash flow will equal the sum of the cash flows under each possible devaluation percentage multiplied by the probability of that devaluation occurring or 2.8(0.4) + 2.94(0.4) + 3.01(0.2) = $2.9 million. Thus expected dollar cash flows actually increase by $100,000. If the impact of the expected devaluation of 7% (0.1 x 0.4 + 0.15 x 0.2) were calculated by reducing expected cash flows by 7%, the expected (and incorrect) result would be a loss of $196,000 (2.8 x 0.07).
17. Why should managers focus on marketing and production strategies to cope with foreign exchange risk?
Unlike transaction exposure, which is amenable to financial hedging, competitive exposures ‑- those arising from competition with firms based in other currencies ‑‑ are longer‑term, harder to quantify, and cannot be dealt with solely through financial hedging techniques. Rather, they require more strategic maneuvers involving changes in operating strategies. For this reason, the major burden of exchange risk management must fall on the shoulders of marketing and production executives. These executives deal in imperfect product and factor markets where their superior knowledge and specialized skills provide them with a comparative advantage in adjusting to the relative price changes caused by currency changes.
Market selection and market segmentation provide the basic parameters within which a company may adjust its marketing mix over time. Short‑term tactical responses include adjustments of pricing, promotional, and credit policies. Product sourcing and plant location are the principal variables companies manipulate to manage competitive risks that can’t be dealt with through marketing changes alone. This could include building plants overseas, buying more components overseas, allocating production among plants in line with their changing relative costs, and designing new facilities to provide added flexibility in making substitutions among various sources of goods so as to be better able to respond to relative price differences among domestic and imported inputs.
18. The sharp decline of the U.S. dollar between 1985 and 1995 significantly improved the profitability of U.S. firms both at home and abroad.
a. In what sense is this profit improvement false prosperity?
High profits are due to the state of the dollar, not to sustainable competitive advantage. A reversal of the dollar’s fortunes will cause these profits to disappear. In the meantime, management may mistakenly believe it has performed well; this could lower incentives for efficient production and critical innovation of sustainable competitive advantages.
b. How would you incorporate the decline in the dollar in evaluating management performance? In making investment decisions?
There are several ways to insulate the manager’s performance against currency shocks. First, one could tie compensation to comparable firms who will suffer the same relative currency shocks. Second, one could construct a hedge (real or synthetic) to determine the value added based on activity outside of exchange variations. In other words, try to determine what fraction of a firm’s profits are due to the value of the dollar, and what fraction can be attributed to controllable factors.
In investment decisions, the manager should determine the market price of currency risk. Do otherwise equivalent firms that bear differing levels of currency risk earn different required rates of return? If so, then the market price of currency risk needs to be incorporated explicitly into the discount rate applied to capital projects. Also, an investment manager can develop future currency scenarios and assess profitability under these alternative scenarios. This exercise determines how robust profit projections are to changing international conditions.
c. Comment on the following statement: “The sharp appreciation of the U.S. dollar during the early 1980s might have been the best thing that ever happened to American industry.”
The resulting severe competitive pressure from foreign firms forced American industry to get “lean and mean”. This corporate restructuring raised productivity, made companies more responsive to the marketplace, led to improved product quality, shorter product cycles, and redirected capital to more productive uses. This doesn’t mean that American companies appreciated the tune‑up; most people don’t like being put on a restrictive diet and being forced to exercise.
19. Bakrie, an Indonesian conglomerate, is assessing the likely consequences of the rupiah’s precipitous decline on its different businesses. These businesses include a telecommunications company that is building a network (using mostly imported equipment) throughout Jakarta to offer wireless service to its residents, a company that sells pipe to the Western firms exploiting Indonesia’s oil and gas fields, and a big agricultural business (54% of its revenues are in dollars, compared with 40% of its costs) that owns rubber and palm plantations feeding a large refining and distribution operation.
a. Assess the likely impact of the rupiah’s depreciation on Bakrie’s three different businesses.
The telecommunications has its equipment costs in foreign currency whereas its revenues will be in devalued rupiah. Although its operating costs will be in rupiah as well, most expenses on a wireless network come from equipment costs. Hence, the net effect of rupiah devaluation on the telecommunications unit will be very negative.
The pipe business will likely benefit from rupiah devaluation since it is paid in dollars, whereas its costs are largely in rupiah. Although the agricultural business’s dollar revenues and costs are more evenly balanced, it is a net recipient of dollars. Thus, it too should benefit from rupiah devaluation.
b. Which of Bakrie’s businesses will be most hurt by the rupiah’s fall? Will any of these businesses actually benefit from rupiah depreciation?
The telecommunications business will be greatly hurt by rupiah devaluation. The other two businesses will benefit, although it is difficult to say which will benefit the most.
c. Bakrie has about $1 billion in foreign debt. Will this debt increase or decrease its currency exposure? Explain.
As it turns out, the magnitude of Bakrie’s debt is so large that it completely offsets any benefits that rupiah devaluation might have on its agricultural and pipe businesses. The net effect of this transaction exposure is to swamp Bakrie and leave it greatly exposed to adverse effects from the rupiah’s devaluation.
20. Mucho Macho is the leading beer in Patagonia, with a 65 percent share of the market. Because of trade barriers, it faces essentially no import competition. Exports account for less than 2 percent of sales. Although some of its raw material is bought overseas, the large majority of the value added is provided by locally supplied goods and services. Over the past five years, Patagonian prices have risen by 300 percent, and U.S. prices have risen by about 10 percent. During this time period, the value of the Patagonian peso has dropped from P 1 = $1.00 to P 1 = $0.50.
What has happened to the real value of the peso over the past five years?
Has it gone up or down? A little or a lot?
The real value of the Patagonian peso, relative to its value five years ago, is now $0.50 x [(1+300%)/(1+10%)] = $1.82. Thus, the real value of the peso has risen by 82 percent. As discussed in the chapter, an increase in the real value of the local currency should boost dollar profits for those firms selling locally and not subject to import competition.
b. What has the high inflation over the past five years likely done to Mucho Macho’s peso profits? Has it moved profits up or down? A lot or a little? Explain.
A reasonable assumption is that both Mucho Macho’s sales and costs have risen at least at the rate of Patagonian inflation. This means that its peso profits, which equal the difference between the two, have risen at least 300% over the past five years. In fact, sales have probably risen by more than the rate of inflation, while costs have risen at less than the rate of inflation because some of the inputs are bought overseas.
c. Based on your above answers, what has been the likely effect of the change in the peso’s real value on Mucho Macho’s peso profits converted into dollars? Have dollar‑equivalent profits gone up or down? A lot or a little? Explain.
Given the answers to items a and b, each peso of profits five years ago should now have grown to at least four pesos. Converting these profits into dollars at the lower exchange rate ($.50 vs. $1) yields at least two dollars of profit today for every dollar of profit five years ago.
d. Mucho Macho has applied for a dollar loan to finance its expansion. Were you to look solely at its past financial statements in judging its creditworthiness, what would be your likely response to Mucho Macho’s dollar loan request?
The real appreciation of the Patagonian peso should have boosted Mucho Macho’s dollar profits dramatically. Thus, any analysis of creditworthiness based solely on its financial statements would show a very profitable and successful company and one deserving of a loan.
e. What foreign exchange risk would such a dollar loan face? Explain.
The profitability of Mucho Macho is an artefact of the real peso appreciation. Thus it is artificial and not sustainable. The odds are that the government will be unable to maintain such an overvalued exchange rate for long. Once the peso devalues, the dollar value of Mucho Macho’s peso cash flow will plummet and so will its ability to repay its dollar loan.
21. Question: Goodwear-Gorkiy is the Russian subsidiary of an American tyre company. Goodwear-Gorkiy manufactures tyres in Russia to sell to members of the Commonwealth of Independent States. Its projected income statement is as follows:
Sales (1,000,000 tyres @ Ruble 120,000/tyre) 120,000,000,000 rubles
Direct costs (1,000,000 tyres @ Ruble 80,000/tyre) 80,000,000,000
Cash fixed overhead 4,000,000,000
Profit before Russian income taxes 20,000,000,000
Income taxes — none due to tax holiday _____________
Profit after Russian income taxes 20,000,000,000
Add back depreciation 16,000,000,000
Cash flow from operations — in rubles 36,000,000,000 rubles
Current exchange rate: Rubles 3,000 = $1.00
Cash flow from operations — in dollars $12,000,000
Suppose that the ruble drops in value from 3,000/$ to 4,000/$.
What is the resulting operating exposure if
(i) Goodwear-Gorkiy does not raise its ruble sales price, but
Goodwear-Gorkiy’s Czech competitor, which had been importing into Russia, drops out, and Goodwear-Gorkiy’s unit sales increase 10% as a result.
Also, Goodwear-Gorkiy’s direct costs and cash fixed overheads increase by an unknown percent and this is given by %.
Hint: Assume that the costs increase by an unknown percent given by %.
Past exam question
21. Answer: It depends on what happens to costs! Assuming an unknown cost-increase of ( x 100)%, the operating exposure can be found as follows:
120,000,000,000×1.1 (no price increase, 10% volume increase)
-80,,000,000,000×1.1x(1+) ((x100)% cost-increase, 10% volume increase)
-4,,000,000,000x(1+) (( x 100)% cost-increase)
40,,000,000,000 – 92,000,000,000 x
Evaluated at -devaluation exchange rate ruble 4,000/$:
$10,000,000 – $23,000,000x
So, the resulting exposure is:
$12,000,000 – ($10,000,000 – $23,000,000x) = $2,000,000 + $23,000,000x
For example, at a cost-increase of 25%, the operating exposure would be:
$2,000,000 + $23,000,000×0.25 = $7,750,000
Goodwear-Gorkiy benefits from the fact that its competitor drops out when the ruble depreciates. Goodwear-Gorkiy could do even better if they manage to increase the ruble price of their tires.
Note:An NPV calculation would be more realistic, but there was not enough information in the question for such an analysis
22. A recent article in the New York Times mentioned that PSA Peugeot Citroën of France “said it might lose 600 million euros ($744 million) this year because of the strong euro.” Discuss at least two ways that European carmakers can use to respond as the US dollar weakens? Past exam question
European car makers can respond by either raising the dollar price of their cars to compensate for the weak exchange rate (dollar) OR absorb the difference in the form of lower profits. Hedging techniques include: Build assembly plants overseas, say in the US.
1 Short Yen just means that a company would be in an adverse situation if Yen appreciates in the future. For example, a company would need to pay more if yen appreciates.
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