978-1259929441 Chapter 10 Part 2

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Chapter 10 ‒ The Foreign Exchange Market

10-8

Firms can reduce economic exposure by ensuring assets are not too concentrated in

countries where likely rises in currency values will lead to damaging increases in the

foreign prices of the goods and services they produced.

Other Steps for Managing Foreign Exchange Risk

To manage foreign exchange risk:

(1) Central control of exposure is needed to protect resources efficiently and to ensure

that each subunit adopts the correct mix of tactics and strategies.

(2) Firms should distinguish between transaction and translation exposure on the one

hand and economic exposure on the other hand.

(3) The need to forecast future exchange rates cannot be overstated.

(4) Firms need to establish good reporting systems so the central finance function can

regularly monitor the firm’s exposure position.

(5) The firm should produce monthly foreign exchange exposure reports.

CRITICAL THINKING AND DISCUSSION QUESTIONS

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

maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The

interest rate on U.S. government securities with one-year maturity is 7 percent, and the

expected rate of inflation is 5 percent. The current spot exchange rate for Korean 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 U.S. and South Korea is 2 percent. The international Fisher effect suggests that

the exchange rate will change in an equal amount but in an opposite direction to the

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

Suppose that the price of beef in the U.S. 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 U.S., 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 percent, what would you expect the current interest rate to be in

Britain?

ANSWER 2:

Chapter 10 ‒ The Foreign Exchange Market

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a. According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£.

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

questions:

a. 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?

b. 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.

c. What kind of foreign exchange rate risks is Embraer exposed to? Can Embraer reduce

these risks? How?

d. 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?

e. Since 2008, Embraer has significantly reduced its dollar hedging operations. Is this

wise?

f. Between mid-2014 and early 2015, the real depreciated significantly against the U.S.

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

ANSWER 3:

a. During periods of high inflation in Brazil, the value of the Brazilian real has

depreciated, suggesting a strong inverse relationship between price inflation and

b. In general, a decline in the value of the real against the dollar is good for Embraer. As

the exchange rate of the real falls, Embraer’s revenues (which are primarily paid in

dollars) gain in value. However, a depreciating real could be a sign of larger economic

c. Embraer is vulnerable to transaction exposure because the profits it earns from each

sale are directly tied to the value of the dollar, which is the vehicle currency for most

Chapter 10 ‒ The Foreign Exchange Market

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McGraw-Hill Education.

the risks involved in forward contracts. If Embraer’s foreign exchange rate forecasting

capabilities are reliable and it has strong influence over its customers, it may also engage

in a lead strategy by attempting to collect payments from its customers before the

payments become due in cases where appreciation of the real is anticipated.

d. At the time, Embraer’s decision made sense. The Brazilian government and economic

situation was stable, and there were few signs that the real would not continue to

e. Student answers will vary depending on their expectations for the U.S. and Brazilian

economies. If students expect the real to depreciate versus the dollar (which is a good bet

f. Since Embraer has reduced its hedging activities, the firm should experience an

increase in its profit margins and may see similar increases in demand for its stock.

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 percent per year. What should you do?

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

¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100.

In this case you would have $4,000 in mid-December. If the current 180-day forward rate

is lower than 100¥/$, then a forward contract might be preferable since it both locks in

Chapter 10 ‒ The Foreign Exchange Market

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QUESTION 5: You are the CFO of a U.S. 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) must be in peso. Your hard assets are all in peso, and their value will decline. On

CLOSING CASE: Apple’s Earnings Hit by Strong Dollar

Summary

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

computer giant, Apple. Apple reported a 2016 fourth quarter loss of $5 billion in revenue

due to exchange rate changes. The impact on the company was significant, bringing its

revenues from an 8 percent increase to just 2 percent. Apple engages in hedging to

protect itself from foreign exchange fluctuations, but noted that the rise of the dollar

came more quickly than had been forecasted leaving the company exposed. Discussion of

the case can begin with the following questions.

QUESTION 1: Why did the strong U.S. dollar during 2015 have a negative impact on

Apple’s earnings?

ANSWER 1: Apple’s fourth quarter 2016 earnings showed a loss of $5 billion in revenue

due to exchange rate movements. Apple, like other companies doing business

QUESTION 2: Why did Apple not fully hedge its foreign exchange exposure to avoid a

hit on earnings?

ANSWER 2: Apple consistently tries to protect itself from exchange rate movements by

hedging in the forward market, but its strategy proved to be deficient in 2016 when the

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QUESTION 3: Why was the US dollar so strong during the 2014‒2016 period? Was the

strength in the dollar a rational response to economic fundamentals?

ANSWER 3: Most students will probably agree that the strength in the dollar in the 2014-

2016 period was indeed a response to economic fundamentals. During this time period,

QUESTION 4: Under what conditions do you think the U.S. dollar might weaken against

other major currencies (e.g. the euro, yen and yuan)?

ANSWER 4: Responses to this question will vary by student. Many will note the

uncertainty in the global economy today especially with regard to the United States and

QUESTION 5: How would a fall in the value of the US dollar against other major

currencies impact Apple?

ANSWER 5: The impact of a fall in the value of the U.S. dollar on Apple would depend

on many variables including the company’s hedging strategy, the currency of its

QUESTION 6: Some companies do not hedge their foreign exchange exposure. Do you

think Apple is correct to hedge? Why?

ANSWER 6: Most students will probably agree that Apple has an obligation to its

Another Perspective: To further explore the impact of exchange rate fluctuations on

Apple’s profitability, go to {https://www.fool.com/investing/general/2016/01/22/apple-

incs-foreign-exchange-risk-isnt-going-away-a.aspx} and

{https://www.forbes.com/sites/charlespurdy/2015/02/26/why-is-currency-crucial-to-a-

companys-bottom-line/#3587bf1392a9}.

Chapter 10 ‒ The Foreign Exchange Market

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MHE INTERNATIONAL BUSINESS VIDEO LIBRARY

Please click here to visit our International Business Video Library which provides an

ongoing stream of updated video suggestions correlated by key concept and major topic.

Every new clip posted is supported by teaching notes and discussion questions. Please

feel free to leave comments in the library that you feel 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 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?

Answers to Exercises

Exercise 1 Answer

Exercise 2 Answer

Chapter 10 ‒ The Foreign Exchange Market

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McGraw-Hill Education.

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.

Search phrase: Big Mac Index

Resource Name: Economist: The Big Mac Index

Website: http://www.economist.com/content/big-mac-index

globalEDGE™ Category: Finance