978-1133947837 Chapter 10 Solution Manual Part 1

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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

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.

Foreign Currency

Net Inflows in

Foreign Currency

Current

Exchange Rate Value of Exposure

Danish krone (DK) +DK10,000,000 $.15 $1,500,000

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.

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Measuring Exposure to Exchange Rate Fluctuations  2

4. 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

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

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

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

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

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.

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Measuring Exposure to Exchange Rate Fluctuations  3

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

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

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

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.

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

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 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

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Measuring Exposure to Exchange Rate Fluctuations  4

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

When Sooner Company does not hedge, the amount paid for imports would depend on exchange rate

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

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

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.

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Measuring Exposure to Exchange Rate Fluctuations  5

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

Advanced Questions

18. Speculating Based on Exposure. Periodically, there are rumors that China will weaken its

currency (the yuan) against the U.S. dollar and many European currencies. This causes

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 be affected the

most?

ANSWER: If China weakened its currency, importers of Asian products may purchase more Chinese

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

20. 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

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 subperiods?

ANSWER: Breaking the database into subperiods enables one to understand how the impact of the

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Measuring Exposure to Exchange Rate Fluctuations  6

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

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

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.

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 500 100

Operating Expenses 300 0

Interest Expense 100 0

Cash Flow –$100 NZ$700

ANSWER:

(Figures are in millions)

NZ$=$.50 NZ$=$.55 NZ$=$.60

Sales

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Measuring Exposure to Exchange Rate Fluctuations  7

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 1992. 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

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

where ut is an error term.

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

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Measuring Exposure to Exchange Rate Fluctuations  8

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

b. The translation exposure of firms based in the euro zone that have British subsidiaries would

c. The economic exposure of U.S. firms that conduct substantial business in the U.K. and have no

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

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

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Measuring Exposure to Exchange Rate Fluctuations  9

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

27. Exposure to Cash Flows. Raton Co. is a U.S. company that has net inflows of 100 million Swiss

francs and net outflows of 100 million British pounds. The present exchange rate of the Swiss franc

is about $.70 while the present exchange rate of the pound is $1.90. Raton Co. has not hedged these

positions. The Swiss franc and British pound are highly correlated in their movements against the

dollar. Explain whether Raton will be favorably or adversely affected if the dollar weakens against

foreign currencies over time.

ANSWER: Raton Co. will be favorably affected because dollar outflows and inflows will be

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 $0.8142 $.09334 $.29914

2 0.8176 .09437 .29829

3 0.8395 .09241 .30187

4 0.8542 .09263 .3088

5 0.8501 .09251 .30274

6 0.8556 .09448 .30312

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. [HINT: The percentage change in the

portfolio of currencies is a weighted average of the percentage change in each currency in the

portfolio.]

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

Standard

deviation

Maximum expected loss =

1.65 x Std. Dev.

Canadian $ .0123 2.03%

Mexican peso .0157 2.59%

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Measuring Exposure to Exchange Rate Fluctuations  10

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

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

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.

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.

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Measuring Exposure to Exchange Rate Fluctuations  11

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

Company Amount of Foreign Currency Net

Cash Flows (measured in $)

Sunrise $10 million

Sunrise is exposed to the most exchange rate risk.

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