CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE
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CHAPTER 10
MEASURING AND MANAGING ECONOMIC EXPOSURE
This chapter defines economic exposure as the extent to which a given currency change will change the
value of a firm. Exchange risk is just the variability of a firm’s value that is due to uncertain currency
changes. With regard to managing currency risk, the key issue is the proper role of corporate financial
management. To the extent that the firm is operating in efficient financial markets, the primary exposure
management objective of financial executives should be to arrange their firm’s finances in such a way as to
minimize the real effects of exchange rate changes. The major burden of coping with exchange risk must be
borne by the marketing and production people because they deal in imperfect product and factor markets
where their specialized knowledge provides a real advantage. Their role is to design marketing and
production strategies to deal with exchange risks. The appropriate marketing and production strategies are
similar to those that would be suitable for any firm confronted with shifting relative output or input prices
caused by any economic, political, or social factors.
KEY POINTS ON MEASURING EXCHANGE RISK
1. Because the value of a firm is equal to the present value of future cash flows, accounting measures of
2. Because currency changes are usually preceded by or accompanied by changes in relative price levels
between two countries, it is impossible to determine exposure to a given currency change without
considering simultaneously the offsetting effects of these price changes. This point is illustrated by the
examples of Apex Spain, the Brazilian shoe manufacturer, and Chile. The latter two examples show what
happens when the real exchange rate changes because inflation is not offset by exchange rate changes.
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Here are two myths concerning exchange risk.
Myth 1: Exchange rate changes always increase the riskiness of multinational corporations. It is accepted
almost as an article of faith that exchange rate changes are bad for MNCs. And yet, devaluations
(revaluations) are usually preceded by higher (lower) rates of inflation. This is PPP, the notion that an
internal appreciation or depreciation in a currency’s purchasing power will ultimately be reflected in a
Myth 2: MNCs are more subject to exchange risk than domestic companies. If exchange risk means the
degree to which a firm’s value is affected by currency changes, this proposition is not self-evident. For
example, domestic facilities that supply foreign markets normally entail much greater exchange risk than
foreign facilities supplying local markets (because material and labor used in a domestic plant are paid for in
the home currency while the products are sold in a foreign currency). Take, for instance, a Japanese company
which builds a plant to produce cars for export, primarily to the U.S. That company will incur exchange risk
CHAPTER 10: MEASURING AND MANAGING ECONOMIC EXPOSURE
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KEY POINTS ON MANAGING EXCHANGE RISK
1. Since currency risk affects all facets of a firm’s operations, it should not be the concern of financial
2. Operating managers should develop marketing and production initiatives that help to ensure
4. Managers trying to cope with actual or anticipated exchange rate changes must first determine whether
5. If real, the manager must first assess the permanence of the change. In general, real exchange rate
movements that narrow the gap between the current rate and the equilibrium rate are likely to be longer
6. The role of the financial executive in an integrated exchange risk program is fourfold: to provide local
operating management with forecasts of inflation and exchange rates; to identify and highlight the risks
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SUGGESTED ANSWERS TO “EURO APPRECIATION HURTS SOUTHERN EUROPEAN
EXPORTS”
1. Why are southern European countries particularly vulnerable to a strong euro?
2. How does the relatively high inflation rate in southern Europe add to the problems created by a
strong euro?
3. In contrast to southern Europe, northern Europe, especially Germany, exports more complex and
brand-name manufactured items, such as automobiles, machine tools, and specialty chemicals.
Would you expect German exports to be more or less sensitive to pricing pressures from a strong
euro than southern European exports? Explain.
ANSWER. German exports should be less sensitive to pricing pressures from a strong euro because these
4. It turns out that Italian companies exporting food products such as Parma ham and Parmigiano
cheese have not seen a drop in exports, nor have high-fashion exporters such as Armani and
Valentino despite the strong euro. Explain
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SUGGESTED ANSWERS TO “HOW RISING GOLD PRICES HURT HARMONY”
1. How much rand revenue per ounce was Harmony generating on September 11, 2001? Three years
later?
ANSWER. Harmony’s rand revenue per ounce on September 11, 2001, based on a price per ounce of $288
2. Compare Harmony’s earnings per ounce in rand terms during 2001:Q2 with the same figure in
2004:Q2.
ANSWER. With a profit per ounce in 2001:Q2 of $20 and an average exchange rate during the quarter of
3. The average exchange rate during 2001:Q2 was R8.04/$; in 2004:Q2, it was R6.60/$. By how much
would Harmony have to reduce its rand costs per ounce in 2004:Q2 in order to make the same
rand profit per ounce it was earning in 2001:Q2?
SUGGESTED ANSWERS TO “CHECK THE EURO AND SHIP THE BOXES!”
1. Why does a rise in the dollar hurt Markel? How does a falling dollar help Markel?
2. What does Markel do to hedge its currency risk? Can Markel use hedging to completely eliminate
its currency risk?
3. Comment on Markel’s policy of selective hedging. Are there any speculative elements involved in
such a policy? Would you recommend Markel continue to follow a policy of selective hedging?
Why or why not?
ANSWER. As discussed in Chapter 10, a selective hedging policy often leads to taking higher risks by
4. What are the basic elements of Markel’s pricing policy? Does this pricing policy reduce its
currency risk? Explain.
5. Does locking in Markel’s dollar costs of raw materials through multiyear dollar contracts
automatically reduce the company’s currency exposure?
SUGGESTED ANSWERS TO “PORSCHE REVS UP ITS RESULTS”
1. Why does Porsche face more operating exposure than Mercedes or BMW?
2. Is Porsche really fully hedged through July 31, 2007? Suppose that gains on all its outstanding
options were included in reported earnings for its fiscal year ended July 31, 2004.
3. Why would analysts be nervous if up to 75% of Porsche’s pretax profit for fiscal year 2004 came
from gains on foreign currency options?
SUGGESTED ANSWERS TO “A STRONG REAL HURTS EMBRAER”
1. What factors affect Embraer’s operating exposure? Why did the real‘s appreciation reduce
Embraer’s operating profit?
2. Did Embraer decrease or increase its currency risk by hedging its dollar liabilities? Explain.
3. How can Embraer use financial hedging to reduce its currency risk?
INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 6TH ED.
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4. Suppose Embraer’s $608 million in dollar receivables mentioned above were outstanding at the
beginning of the second quarter and that payment for $397 million was not received until the end
of the quarter. The remaining $211 million was still outstanding at the end of the quarter. With an
18% real appreciation during the quarter, how much of a dollar loss would Embraer take on these
receivables? In performing the calculation, consider that Embraer must first translate its dollar
receivables into reais and then convert any loss measured in reais back into dollars.
SUGGESTED ANSWERS TO “LAKER AIRWAYS CRASHES AND BURNS”
1. What were the key components of Laker Airways’ operating exposure?
ANSWER. Laker’s operating exposure stemmed from the imbalance in the currency denomination of cash
2. What options did it have to hedge its operating exposure?
3. Could Laker have hedged its “natural” dollar liability exposure?
ANSWER. The first option of indexing the sale of sterling airfare to the day–to-day exchange rate was not a
4. Should Laker have financed its purchase of DC-10 aircraft by borrowing sterling from a British
bank rather than using the dollar-denominated financing supplied by McDonnell Douglas and the
Eximbank? Consider the fact that Eximbank, a U.S. government agency, subsidized this financing
in order to promote U.S. exports.
ANSWER. Because of the interest subsidy provided by McDonnell Douglas and the Eximbank on the funds
SUGGESTED ANSWERS TO CHAPTER 10 QUESTIONS
1. Please answer the following questions.
1.a. Define exposure, differentiating between accounting and economic exposure. What role does
inflation play?
ANSWER. Accounting exposure results when exchange rate changes alter the home currency value of
1.b. Describe at least three circumstances under which economic exposure is likely to exist.
ANSWER. Circumstances in which a firm faces economic exposure include when the firm:
1.c. Of what relevance are the IFE and PPP to your answers to parts a and b?
1.d. What is exchange risk, as distinct from exposure?
1.e. Under what circumstances might MNCs be less subject to exchange risk than purely domestic
firms in the same industry?
2. 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.
2.a. In what sense is this profit improvement false prosperity?
2.b. How would you incorporate the decline in the dollar in evaluating management performance? In
making investment decisions?
ANSWER. There are several ways to insulate the manager’s performance against currency shocks. First, one
2.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.”
3. What marketing and production techniques can firms initiate to cope with exchange risk?
ANSWER. Market selection and market segmentation provide the basic parameters within which a company
4. What is the role of finance in protecting against exchange risk?
5. E&J Gallo is the largest vintner in the U.S. It gets its grapes in California (some of which it grows
itself) and sells its wines throughout the U.S. Does Gallo face currency risk? Why and how?
ANSWER. E&J Gallo faces exchange risk because its wines are competing against foreign wines and changes
6. 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.
ANSWER. Chrysler is likely to be the bigger beneficiary of a weak dollar since its primary competitors are
7. In 1994, the Singapore dollar rose by 9% in real terms against the U.S. dollar. What was the likely
impact of the strong Singapore dollar on U.S. electronics manufacturers using Singapore as an
export platform? Consider the following facts. On average, materials and components – 85% of
which are purchased abroad – account for about 60% of product costs. Labor accounts for an
additional 15%; other operating costs account for the remaining 25%.
ANSWER. The impact was less than might be expected. With 85% of materials and components coming from
8. Di Giorgio International (DGI), a subsidiary of California-based Di Giorgio Corp., processes fruit
juices and packages condiments in Turnhout, Belgium. It buys Brazilian orange concentrate in
dollars, German apples in marks, Italian peaches in lire, and cartons in Dutch guilders. At the
same time, its exports 85% of its production. Assess DGI’s currency risk and determine how it can
structure its financing to reduce this risk.
ANSWER. A key question is whether the supplies bought DGI and the products it sells are priced
domestically or internationally. The odds are that both inputs and outputs are priced at least somewhat in
9. A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt
at 7% or yen debt at 3%.
9.a. Suppose the company is an MNC with sales in the U.S. and inputs purchased in Japan. How
should this affect its financing choice?
ANSWER. According to the IFE, 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
9.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?
10. Huaneng Power International is a large Chinese company that runs coal-fired power plants in five
10.a. What currency risks does Huaneng face?
ANSWER. The biggest problem for HPI is that its debt is denominated in dollars whereas its revenues are
10.b. Do its lenders face any currency risks? Explain.
1. Suppliers of the equipment used to make semiconductors, such as Applied Materials and LAM
Research, who produce in the U.S. but are heavily dependent on sales to Asia, saw their share
prices plummet in the wake of the Asian financial crisis. Explain.
ANSWER. These firms had their costs denominated in dollars and a large portion of their revenues originating
2. Malaysian palm oil producers export more than 90% of their product for sale in dollars. Virtually
all their costs, however, are in Malaysian ringgit.
2.a. How would the 30% fall in the value of the ringgit during 1997 affect the ringgit profitability of
these producers? Explain.
2.b. How would the ringgit‘s depreciation affect the dollar profits of these producers? Explain.
3. Many business people and the business press believe that a devalued dollar offers a significant
advantage to foreign bidders for American companies and real estate. Comment on this position.
4. Saint-Gobain, a French firm, and Pilkington PLC, a British firm, are arch rivals in the European
4.a. What was the likely impact on Saint-Gobain’s profitability of the pound devaluation?
4.b. What was the likely impact on Pilkington’s profitability of the pound devaluation?
5. 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.
5.a. Assess the likely impact of the rupiah’s depreciation on Bakrie’s three different businesses.
ANSWER. The telecommunications unit has its equipment costs in foreign currency whereas its revenues will
5.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?
5.c. Bakrie has about $1 billion in foreign debt. Will this debt increase or decrease its currency
exposure? Explain.
6. Midwestern Bank has lent $10 million to finance an equipment sale to Thailand by Lasertech, a
major exporter located in Michigan. Both the loan and the sale are priced in U.S. dollars.
6.a. Is Midwestern’s loan to Lasertech exposed to exchange risk? Explain.
6.b. Suppose Midwestern has lent money to Lasertech secured by the general credit of the company.
Are these loans exposed to exchange risk? Explain.
7. Why should managers focus on marketing and production strategies to cope with foreign exchange
risk?
8. In what sense is the boost in profits of American companies due to a falling dollar artificial?
9. How does a shorter product-cycle time help companies reduce the exchange risk they face?
10. Why do exchange rate changes bring feast or famine for Volvo, but neither feast nor famine for
Ford? Consider the distribution and concentration of their production facilities worldwide.
11. To cut costs when the dollar was at its peak, Caterpillar shifted production of small construction
equipment overseas. By contrast, Caterpillar‘s main competitors in that area, Deere & Co. and
J.I. Case, make most of their small construction equipment in the U.S. What are the most likely
competitive consequences of this restructuring?
12. When the dollar was strong and it could not earn a reasonable profit on European sales, Osmose
International gave up its government permits to sell its chemical wood preservatives in much of
Europe. “Why pay for a permit when you can’t sell anything there anyway?” said its president.
12.a. What response do you have for the president of Osmose?
12.b. How might you go about assessing the trade-offs involved for Osmose?
13. To avoid speculation, Honda hedges only the sales it has clinched, not the ones it expects.
Comment on Honda‘s currency risk strategy.
ANSWER. Honda is hedging its transaction exposure, but this leaves it with operating exposure, which is
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SUGGESTED SOLUTIONS TO CHAPTER 11 PROBLEMS
1. Hilton International is considering investing in a new Swiss hotel. The required initial investment
is $1.5 million (or SFr1.875 million at the current exchange rate of $0.8 = SFr1). 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.
1.a. What factors are relevant in evaluating this investment?
ANSWER. Hilton should focus on the real dollar value of future cash flows, or
1.b. How will fluctuations in the value of the Swiss franc affect this investment?
ANSWER. Only fluctuations in the real value of the Swiss franc matter; fluctuations in the nominal value of
1.c. How would you forecast the $:SFr exchange rate ten years ahead?
2. 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% devaluation is expected to lower unit costs by $0.30, while a 15% devaluation will
reduce these costs by an additional $0.15. Suppose a devaluation of either 10% or 15% is likely,
with respective probabilities of 0.4 and 0.2 (the probability of no currency change is 0.4).
Depreciation at the current exchange rate equals $1 million annually, while the local tax rate is 40%.
2.a. What will annual dollar cash flows be if no devaluation occurs?
ANSWER. The cash flows associated with each exchange rate scenario are:
Devaluation
0%
10%
15%
2.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 U.S.?
ANSWER. The expected dollar cash flow will equal the sum of the cash flows under each possible
3. Mucho Macho is the leading beer in Patagonia, with a 65% share of the market. Because of trade
barriers, it faces essentially no import competition. Exports account for less than 2% 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%, and U.S. prices have risen by about 10%. During this time period, the value of the
Patagonian peso has dropped from P 1 = $1.00 to P 1 = $0.50.
3.a. 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?
3.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.
3.c. Based on your answer to part a, 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.
3.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?
3.e. What foreign exchange risk would such a dollar loan face? Explain.
ANSWER. The profitability of Mucho Macho is an artifact 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