International Business Chapter 10 Measuring Exposure Exchange Rate Fluctuations The Demand For Those Appliances Not Affected

Unlock access to all the studying documents.

View Full Document

Measuring Exposure to Exchange Rate Fluctuations ❖ 13

The demand for those appliances is not affected much by the local economy. Most of the firm’s

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 Missouri’s

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.

d. 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

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 VaR 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

$.4251

.4203

.4196

.4523

.4417

.4558

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

Measuring Exposure to Exchange Rate Fluctuations ❖ 15

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.

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. Although 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. It will repay the balance of an existing loan equal to 2 million euros.

Company D expects zero exports and expects 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?

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.

In contrast, 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.

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 this supplier 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.

Measuring Exposure to Exchange Rate Fluctuations ❖ 16

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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

from China. Because its competition is not affected in a similar manner, Harz Co. is at a competitive

advantage when the yuan weakens.

40. IFE and Exposure. 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.

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 in the next quarter, whereas the U.S. inflation

will remain at a low level. Would you expect Layton’s value will be favorably affected, unfavorably

affected, or not affected by its economic exposure over the next quarter? Explain.

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.

Measuring Exposure to Exchange Rate Fluctuations ❖ 18

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.

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. Milwaukee’s subsidiary 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

products to Australia. All three companies have the same total revenues and total earnings levels

(when considering their U.S. business as well), 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.

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

the coast of Argentina that are geared toward 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, and b0 and b1 are

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

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

CRITICAL THINKING

Managerial Exposure to Exchange Rate Risk The managers of many U.S.-based MNCs have heard

arguments that an MNC’s exposure to currency movements will have unfavorable effects on its cash

Measuring Exposure to Exchange Rate Fluctuations ❖ 19

flows and earnings in some periods, and favorable effects on its cash flows and earnings in other periods,

and that these effects will offset in the long run. Yet managers’ compensation (including bonuses) for the

current quarter or year is often based on the reported earnings. Thus, because the earnings are influenced

by exchange rate movements, the manager’s own compensation is influenced by exchange rate

movements. Write a short essay on how MNCs could revise their bonus structure so that bonuses are not

influenced by exchange rate movements. Alternatively, offer arguments to support leaving the bonus

structure as it is.

ANSWER

Earnings (and therefore bonuses) are enhanced by favorable exchange movements and reduced by

unfavorable exchange rate movements. If MNCs want to insulate bonuses from exchange rate

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?

2. Using a spreadsheet, perform 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

Measuring Exposure to Exchange Rate Fluctuations ❖ 20

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

(outflow) (outflow)

Thai baht

Inflow: (180,000 pairs ×

4,594 baht per pair) 826,920,000 206,712,000 620,208,000 $0.024 $14,884,992.00

Outflow: (72,000 pairs × (inflow) (inflow)

2,871 baht per pair)

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*

British pound 16,000,000.00 $1.47 to $1.53 $23,520,000 to $24,480,000

(inflow) (inflow)

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?

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

5. Assuming Blades enters into the agreement with Jogs, Ltd., how will its overall transaction exposure

be affected?

Measuring Exposure to Exchange Rate Fluctuations ❖ 21

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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

high, since the correlations between the two Asian currencies and the British pound are relatively low.

For example, a depreciation in the British pound would likely be accompanied by an appreciation in

the Thai baht and the Japanese yen. The depreciation of the pound would result in reduced dollar

revenue from Blades’ British exports. However, this reduction would be offset by increased dollar

revenue from Thailand, even though Blades’ dollar costs incurred due to Japanese imports would also

increase.

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

several Thai manufacturers located in Thailand have begun targeting the U.S. roller blade market.

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

7 127,785

8 133,492

9 122,130

Measuring Exposure to Exchange Rate Fluctuations ❖ 22

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15 160,220

Since each scenario has an equal probability of occurring, the expected value of U.S. dollar revenues

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

matrix is filled in below:

NZ$

Pound

1.00

.35

1.00

NZ$

.41

.39

1.00

Pound

.30

.17

.82

1.00

Based on this evidence, the aggregate dollar cash flows received by Whaler is more uncertain than if

the exchange rate movements were completely independent. If one currency declines in value, the

other currencies would probably decline as well, which is not accounted for by the assumption of

independent exchange rate movements.

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

use past exchange rate data to simulate those actual exchange rates, but to simulate the annual

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?

2. Logan is considering a change in the Sports Exports Company’s pricing policy such that the importer

must pay in dollars, so that Logan will not have to worry about converting pounds to dollars every

month. If implemented, would this policy eliminate the company’s transaction exposure? Would it

eliminate the company’s economic exposure? Explain.

Measuring Exposure to Exchange Rate Fluctuations ❖ 23

permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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

need to convert foreign currency into dollars. This policy would not eliminate economic exposure.

As the British importer purchases the exports each month, it would now be forced to convert its

pounds into dollars before making payment.

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 the company differ if Jim retained the 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