978-1259578113 Chapter 10 Solutions Manual

Unlock access to all the studying documents.

View Full Document

OPENING CASE: Subaru’s Sales Boom Thanks to the Weaker Yen

The opening case explores the implications of changing currency values on the U.S. sales of

Japanese automaker Subaru. Prior to 2012, the yen was relatively strong against the U.S. dollar.

Because Subaru had kept most of its production facilities in Japan, it was at a pricing

disadvantage to some of its competitors that maintained production facilities in the United States

and therefore did not have to import vehicles to the North American market. Although this

strategy initially cost Subaru business in North America, a decline in the value of the yen relative

to the dollar beginning in 2012 suddenly made Japanese exports less expensive in the United

States, and Subaru’s sales boomed. Despite the short-term improvement, Subaru decided to

expand its U.S. production facilities as a hedge against future appreciation in the value of the

yen. Discussion of the case can revolve around the following questions:

QUESTION 1: How did the relatively strong value of the yen against the dollar impact the

Japanese economy, and Subaru in particular? How does your response change when the Japanese

yen decreased in value?

ANSWER 1: A strong yen made Japanese exports more expensive for U.S. consumers, which

QUESTION 2: Why would Japan choose to keep its production facilities in Japan prior to 2012?

Was it a good decision to expand U.S. production after 2012?

ANSWER 2: Subaru sought to exploit economies of scale by keeping production local. Its

QUESTION 3: Why did the price of the yen in terms of dollars fall beginning in 2012?

CRITICAL THINKING AND DISCUSSION QUESTIONS

QUESTION 1: The interest rate on South Korean government securities with one-year maturity

is 4% and the expected inflation rate for the coming year is 2%. The U.S. interest rate on

government securities with one-year maturity is 7%, and the expected rate of inflation is 5%.

The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate

one year from today. Explain the logic of your answer.

ANSWER 1: Drawing on what we know about the Fisher effect, the real interest rate in both the

US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will

change in an equal amount but in an opposite direction to the difference in nominal interest rates.

QUESTION 2: Two countries, Great Britain and the US, produce just one good: beef. Suppose

that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound.

a. According to PPP theory, what should the $/£ spot exchange rate be?

b. Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What

should the one year forward $/£ exchange rate be?

c. Given your answers to parts a and b, and given that the current interest rate in the United

States is 10%, what would you expect current interest rate to be in Britain?

ANSWER 2:

QUESTION 3: Reread the Management Focus on Volkswagen, then answer the following

questions:

a. Why do you think management at Volkswagen decided to hedge only 30 percent of their

foreign currency exposure in 2003? What would have happened if they had hedged 70 percent

of their exposure?

b. Why do you think the value of the U.S. dollar declined against that of the euro in 2003?

c. Apart from hedging through the foreign exchange market, what else can Volkswagen do to

reduce its exposure to future declines in the value of the U.S. dollar against the euro?

ANSWER 3:

a. When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure in 2003,

it would increase its profit margin. This strategy of course, backfired.

b. The appreciation of the euro relative to the U.S. dollar took many people by surprise. Its rise

c. In addition to using forward contracts, Volkswagen could use currency swaps, and lead and lag

QUESTION 4: You manufacture wine goblets. In mid-June you receive an order for 10,000

goblets from Japan. Payment of ¥400,000 is due in mid-December. You expect the yen to rise

from its present rate of $1=¥130 to $1=¥100 by December. You can borrow yen at 6% per year.

What should you do?

ANSWER 4: The simplest solution would be to just wait until December, take the ¥400,000 and

QUESTION 5: You are the CFO of a US firm whose wholly owned subsidiary in Mexico

manufactures component parts for your U.S. assembly operations. The subsidiary has been

financed by bank borrowings in the United States. One of your analysts told you that the

Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange

markets over the next year. What actions, if any, should you take?

ANSWER 5: Your financing and operating capital are in dollars, yet many of your costs (labor)

CLOSING CASE: Embraer and the Wild Ride of the Brazilian Real

Summary

The closing case explores the implications of changing currency values on the profits of

Brazilian aircraft manufacturer Embraer, which, like all other firms in the industry, prices its

aircraft in U.S. dollars. Between 2004 and 2008, the value of the Brazilian real against the dollar

more than doubled, which negatively affected Embraer’s profit margins. In order to hedge

against future appreciation of the real, Embraer purchased forward contracts that would allow the

firm to exchange dollars for reals at a specified rate. During the financial crisis of 2008, however,

the value of the real depreciated against the dollar, and the terms of the forward contract were no

longer favorable, leading to a $121 million loss for Embraer. Since then, Embraer has not hedged

against foreign exchange risk and the real has continued to depreciate against the dollar, resulting

in a significant improvement in the firm’s finances. Discussion of the case can revolve around

the following questions.

QUESTION 1: What does the recent economic history of Brazil tell you about the relationship

between price inflation and exchange rates? What other factors might determine exchange rates

for the Brazilian real?

ANSWER 1: During periods of high inflation in Brazil, the value of the Brazilian real has

QUESTION 2: Is a decline in value of the real against the U.S. dollar good for Embraer, bad for

Embraer, or a mixed bag? Explain your answer.

ANSWER 2: In general, a decline in the value of the real against the dollar is good for Embraer.

QUESTION 3: What kind of foreign exchange rate risks is Embraer exposed to? Can Embraer

reduce these risks? How?

ANSWER 3: Embraer is vulnerable to transaction exposure because the profits it earns from

ANSWER 4: Do you think Embraer’s decision to try and hedge against further appreciation of

the real in the early 2000s was a good decision? What was the alternative?

ANSWER 4: At the time, Embraer’s decision made sense. The Brazilian government and

QUESTION 5: Since 2008 Embraer has significantly reduced its dollar hedging operations. Is

this wise?

ANSWER 5: Student answers will vary depending on their expectations for the U.S. and

QUESTION 6: Between mid-2014 and early 2015 the real depreciated significantly against the

U.S. dollar. What do you think the impact was on Embraer?

MHE INTERNATIONAL BUSINESS VIDEO LIBRARY

Please click here to visit our International Business Video Library on Pinterest, which is updated

on a monthly basis. While there, be sure to “like” the clips that work well for you, and add notes

that might be helpful to your colleagues.

INCORPORATING globalEDGE™ EXERCISES

Use the globalEDGE™ site {globaledge.msu.edu/} to complete the following exercises:

Exercise 1

One of your company’s essential suppliers is located in Japan. Your company needs to make a 1

million Japanese yen payment in six months. Considering that your company primarily operates

in U.S. dollars, you are assigned the task of deciding on a strategy to minimize your transaction

exposure. Identify the spot and forward exchange rates between the two currencies. What factors

influence your decision to use each? Which one would you choose? How many dollars must you

spend to acquire the amount of yen required?

Exercise 1 Answer

The FXStreet.com website specializes in analyzing the foreign exchange market, including news

and analysis in addition to live exchange rates. Both spot rates and forward rates can be found

under the “Rates & Charts” section.

Search phrase: forward exchange rates

Resource Name: FXStreet.com

Website: http://www.fxstreet.com/

globalEDGE Category: Finance

Exercise 2

Sometimes, analysts use the price of specific products in different locations to compare currency

valuation and purchasing power. For example, the Big Mac Index compares the

purchasing-power parity of many countries based on the price of a Big Mac. Locate the latest

edition of this index that is accessible. Identify the five countries (and their currencies) with the

lowest purchasing-power parity according to this classification. Which currencies, if any, are

overvalued?

Exercise 2 Answer

The Big Mac Index was invented by The Economist in 1986 and has been updated annually since

then to provide a light-hearted demonstration of the theory of purchasing-power-parity by

comparing the price of a Big Mac in various countries around the world.