978-1133947837 Chapter 10 Solution Manual Part 2

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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.

ANSWER

a. The lower interest rate in Poland will reduce capital flows to Poland, which reduces the demand for

b. The lower interest rate in Poland will reduce capital flows to Poland, which reduces the demand for

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 $.4558. 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 $.4251

2 .4203

The standard deviation is 4.09%. The maximum expected loss in the currency’s value is:

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Measuring Exposure to Exchange Rate Fluctuations  2

34. 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. 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

Zion Co. has 1,000,000 pesos that is subject to translation exposure, as these are the subsidiary

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

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

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Measuring Exposure to Exchange Rate Fluctuations  3

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

37. Assessing Translation Exposure. Assume the euro’s spot rate is presently equal to $1.00. All of

the following firms are based in New York and are the same size. While these firms concentrate on

business in the U.S., their entire foreign operations for this quarter are provided here.

Company A expects its exports to cause cash inflows of 9 million euros and imports to cause cash

outflows equal to 3 million euros.

Company B has a subsidiary in Portugal that expects revenue of 5 million euros and has expenses of 1

million euros.

Company C expects exports to cause cash inflows of 9 million euros and imports to cause cash

outflows of 3 million euros, and will repay the balance of an existing loan equal to 2 million euros.

Company D expects zero exports and imports to cause cash outflows of 11 million euros.

Company E will repay the balance of an existing loan equal to 9 million euros.

Which of the five companies described here has the highest degree of translation exposure?

ANSWER: Company B has the greatest degree of translation exposure because it has a subsidiary

38. Exchange Rates and Market Share. Minnesota Co. is a U.S. firm that exports computer parts to

Japan. Its main competition is from firms that are based in Japan, which invoice their products in yen.

Minnesota’s exports are invoiced in U.S. dollars. The prices charged by Minnesota and its

competitors will not change during the next year. Will Minnesota’s revenue increase, decrease, or be

unaffected if the spot rate of the yen appreciates over the next year? Briefly explain.

ANSWER: The revenue will increase, since the demand by Japanese customers for Minnesota’s

39. Exchange Rates and Market Share. Harz Co. (a U.S. firm) has an arrangement with a Chinese

company in which it purchases the products from them every week at the prevailing spot rate, and

then sells the products in the U.S. invoiced in dollars. All of its competition is from U.S. firms that

have no international business. The prices charged by Harz and its competitors will not change over

the next year. Will the net cash flows generated by Harz increase, decrease, or be unaffected if the

Chinese yuan depreciates over the next year? Briefly explain.

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Measuring Exposure to Exchange Rate Fluctuations  4

ANSWER: If the yuan depreciates, Harz will incur lower expenses when paying for the products

40. IFE and Exposure. Assume that Maine Co. (a U.S. firm) measures 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 Maine’s stock price per quarter, e represents the

percentage change in the British pound value per quarter, and u is an error term. Based on the

analysis, the b0 coefficient is estimated to be zero and the b1 coefficient is estimated to be 0.3 and is

statistically significant. Maine Co. believes that the movement in the value of the pound over the next

quarter will be mostly driven by the international Fisher effect. The prevailing quarterly interest rate

in the U.K. is lower than the prevailing quarterly interest rate in the U.S. Would you expect that

Maine’s value will be favorably affected, unfavorably affected, or not affected by the pound’s

movement over the next quarter? Explain.

ANSWER: Based on the IFE, the pound’s value will rise during the next quarter. Since SP is

41. PPP and Exposure. Layton Co. (a U.S. firm) attempts to determine its economic exposure to

movements in the Japanese yen, by applying regression analysis to data over the last 36 quarters:

SP = b0 + b1e + u

where SP represents the percentage change in Layton’s stock price per quarter, e represents the

percentage change in the yen value per quarter, and u is an error term. Based on the analysis, the b0

coefficient is zero and the b1 coefficient is 0.4 and is statistically significant. Layton believes that the

inflation differential has a major effect on the value of the yen (based on purchasing power parity).

The inflation in Japan is expected to rise substantially while the U.S. inflation will remain at a low

level. Would you expect that Layton’s value will be favorably affected, unfavorably affected, or not

affected by its economic exposure over the next quarter? Explain.

ANSWER: Based on purchasing power parity, the relatively high inflation in Japan will place

42. Exposure to Cash Flows. Lance Co. is a U.S. company that has exposure to the Swiss francs (SF)

and Danish kroner (DK). It has net inflows of SF100 million and net outflows of DK500 million. The

present exchange rate of the SF is about $.80 while the present exchange rate of the DK is $.10.

Lance Co. has not hedged these positions. The SF and DK are highly correlated in their movements

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

strengthens against foreign currencies over time.

ANSWER: Lance Co. will be adversely affected because the dollar value of its SF inflows exceeds

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Measuring Exposure to Exchange Rate Fluctuations  5

43. Assessing Transaction Exposure. Zebra Co. is a U.S. firm that obtains products from a U.S.

supplier and then exports them to Canadian firms. Its exports are denominated in U.S. dollars. Its

main competitor is a local company in Canada that sells similar products denominated in Canadian

dollars. Is Zebra subject to transaction exposure? Briefly explain.

ANSWER: No, because Zebra’s cash flows are denominated in home currency. They will not be

44. Assessing Translation Exposure. Quartz Co. has its entire operations in Miami, Florida, and is

an exporter of products to Eurozone countries. All of its earnings are derived from its exports. The

exports are denominated in euros. Reed Co. (of the U.S.) is about the same size as Quartz Co. and

generates about the same amount of earnings in a typical year. It has a subsidiary in Germany that

typically generates about 40 percent of its total earnings. All earnings are reinvested in Germany and

therefore not remitted. The rest of Reed’s business is in the U.S. Which company has a higher degree

of translation exposure? Briefly explain.

ANSWER: Reed Co. has a higher degree of translation exposure because its foreign subsidiary’s

45. Estimating Value at Risk. Yazoo Inc. is a U.S. firm that has substantial international business in

Japan and has cash inflows in Japanese yen. The spot rate of the yen today is $.01. The yen exchange

rate was $.008 three months ago, $.0085 two months ago, and $.009 one month ago. Yazoo uses

today’s spot rate of the yen as its forecast of the spot rate in one month. However, it wants to

determine the maximum expected percentage decline in the value of the Japanese yen in one month

based on the value at risk (VaR) method and a 95 percent probability. Use the exchange rate

information provided to derive the maximum expected decline in the yen over the next month.

ANSWER: Applying an electronic spreadsheet, the standard deviation of the yen movements is about

.029185.

46. Assessing Exposure to Net Cash Flows. Reese Co. will pay 1 million British pounds for materials

imported from the U.K. in one month. Reese Co. sells some goods to Poland, and will receive 3

million zloty (the Polish currency) for those goods in one month. The spot rate of the pound is $1.50,

while the spot rate of the zloty is about $.30. Assume that the pound and zloty are both expected to

depreciate substantially against the dollar over the next month and by the same degree (percentage).

Will this have a favorable effect, unfavorable effect or no effect on Reese Co. over the next year?

Explain.

ANSWER: The dollar value of the outflow exposure to pounds is greater than the inflow exposure to

47. Impact of Translation Exposure on Stock Valuation. Spencer Co. is a U.S. firm that has a large

subsidiary in Singapore, which generates a large amount of earnings. Spencer’s stock is commonly

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Measuring Exposure to Exchange Rate Fluctuations  6

valued at about 16 times its reported earnings per share. The earnings generated by the Singapore

subsidiary in this period are the same as in the previous period. The Singapore dollar has depreciated

substantially against the U.S. dollar during this period. None of the earnings generated by the

Singapore subsidiary in this period will be remitted to the U.S. parent at this time. How will the stock

price of Spencer Co. be affected (if at all) when the earnings are reported at the end of this period?

Explain.

ANSWER: The stock price will decline because the consolidated earnings will decline as a result of

48. Assessing Translation Exposure. Milwaukee Co. has an Australian subsidiary that earned A$40

million Australian dollars (A$) this year. Little Rock Co. has an Australian subsidiary that earned

A$30 million this year. The subsidiary of Milwaukee plans to reinvest its earnings in Australia while

the subsidiary of Little Rock Co. plans to remit its earnings to the U.S. parent. Cincinnati Co. does not

have an Australian subsidiary but it received revenue of A$50 million this year from exporting to

Australia. All three companies have the same total revenue and total earnings levels (when

considering their U.S. business as well), and are the same size, and do not have any other

international business. Which company is subject to the highest degree of translation exposure?

Briefly explain.

ANSWER: Milwaukee Co. has the highest degree of translation exposure because it has more

49. Measuring Economic Exposure. Bag Company of the U.S. has a business of offering cruises along

the coast of Argentina that are solely for American tourists. The cruise ships charge American tourists

in U.S. dollars but all of their expenses such as payments to its employees are in Argentine pesos. The

cruise ships are very profitable. You want to measure Bag’s economic exposure to movements in the

peso by applying regression analysis to data over the last 60 quarters:

SP = b0 + (b1 x e) + u

where SP represents the percentage change in Bag’s stock price per quarter, e represents the

percentage change in the Argentine peso’s value per quarter, u is an error term, while b0 and b1 are

regression coefficients. Do you think the expected sign of the b1 coefficient in the model above

would be positive and significant, negative and significant, or zero (not significant)? Briefly explain.

ANSWER: The b1 coefficient would be negative and significant, because the stronger the peso, the

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Measuring Exposure to Exchange Rate Fluctuations  7

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

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 $24,000,000.00

(inflow) (inflow)

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*

(inflow) (inflow)

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Measuring Exposure to Exchange Rate Fluctuations  8

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

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

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

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

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Measuring Exposure to Exchange Rate Fluctuations  9

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 $129,010

2 153,443

b. There is some evidence of positive correlation among all currencies. The correlation coefficient

matrix is filled in below:

A$ C$ NZ$ Pound

A$ 1.00

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Measuring Exposure to Exchange Rate Fluctuations  10

c. The executive’s approach may be slightly easier to use, but is normally less reliable. Whaler does not

Small Business Dilemma

Assessment of Exchange Rate Exposure by the Sports Exports Company

1. Would you describe the exposure of the Sports Exports Company to exchange rate risk as transaction

exposure? Economic exposure? Translation exposure?

ANSWER: The Sports Exports Company is subject to transaction exposure, because the business

2. Jim Logan is considering a change in the pricing policy in which the importer must pay in dollars, so

that Jim will not have to worry about converting pounds to dollars every month. If implemented,

would this policy eliminate the transaction exposure of the Sports Exports Company? Would it

eliminate Sports Exports’ economic exposure? Explain.

ANSWER: This policy would eliminate transaction exposure, because there would no longer be any

3. If Jim decides to implement the policy described in the previous question, how would the Sports

Exports Company be affected (if at all) by appreciation of the pound? By depreciation of the pound?

Would these effects on Sports Exports differ if Jim retained his original policy of pricing the exports

in British pounds?

ANSWER: If the pound appreciates, the demand for the exports produced by the Sports Exports

Company could increase, because the importer could obtain the exports with fewer pounds. If the

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