10 Chapter 1 Running Head: CHAPTER 10
Chapter 10 Anastasia Cholacu FIN6605 International Financial Management
Hodges University Dr. Kest March 2, 2011 Chapter 10 Answers
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1. Transaction versus Economic Exposure.
Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its net cash flows in each currency when assessing its transaction exposure?
ANSWER: Transaction exposure is due only to international transactions by a firm. Economic exposure includes any form by which the firms cash flow will be affected. Foreign competition may increase due to currency fluctuations. This could affect the firms cash flow, but did not affect the value of any ongoing transactions. Thus, it represents a form of economic exposure but not transaction exposure. Transaction exposure is a subset of economic exposure. Consideration of all cash flows in a particular currency is not necessary when some inflows and outflows offset each other. Only net cash flows are necessary.
2. Assessing Transaction Exposure.
Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash flows are as follows for the next year: Currency Danish Krone (DK) British Pound () Total Inflow DK 50,000,000 2,000,000 Total Outflow DK 40,000,000 1,000,000 Current Exchange (U.S. $) $.15 $1.50
Assume that the movements in the Danish Krone and the pound are highly correlated. Provide your assessment as to your firms degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer.
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ANSWER: The net exposure to each currency in U.S. dollars is derived below:
Foreign Currency Danish Krone (DK) British Pound ()
Net Inflows in Foreign Currency +DK 10,000,000 + 2,000,000
Current Exchange Rate $.15 $1.50
Value to Exposure $1,500,000 $1,500,000
The Krone and Pound values move in tandem against the dollar. Both the Krone and the Pound exposure show positive net inflows. Therefore, their exposure should be magnified if their exchange rates against the U.S. dollar continue to be highly correlated.
3. Factors That Affect a Firms Transaction Exposure.
What factors affect a firms degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure.
ANSWER:
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Currency variabilitylow level is desirable. Currency correlationslow level is desirable for currencies that are net inflows, while a high level is desirable for pairs of currencies in which one currency shows future net inflows while the other currency shows future net outflows.
4. Currency Correlations.
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Kopetsky Co. has net receivables in several currencies that are highly correlated with each other. What does this imply about the firms overall degree of transaction exposure? Are currency correlations perfectly stable over time? What does your answer imply about Kopetsky Co. or any other firm using past data on correlations as an indicator for the future?
ANSWER: Its exposure is high since all currencies move in tandem and no offsetting effect is likely. If one of these currencies depreciates substantially against the firms local currency, all others will as well, and this reduces the value of these net receivables. No, it is not. As a result, past correlations will not serve as perfect forecasts of future correlations. Firms can not presume that past correlations will be perfectly accurate forecasts of future correlations. However, historical data may still be useful if the general ranking of correlations is somewhat stable.
5. Currency Effects on Cash Flows.
How should appreciation of a firms home currency generally affect its cash inflows? How should depreciation of a firms home currency generally affect its cash outflows?
ANSWER:
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Appreciation of the firms home currency reduces inflows since the foreign demand for the firms goods is reduced and foreign competition is increased. Depreciation of the firms home currency should increase inflows since it will likely increase foreign demand for the firms goods and reduce foreign competition.
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6. Transaction Exposure.
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Fischer Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash flows? Why?
ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should experience a strong demand for its products when the euro has more purchasing power.
7. Exposure of Domestic Firms.
Why are the cash flows of a purely domestic firm exposed to exchange rate fluctuations?
ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers may switch to foreign products if the local currency strengthens.
8. Measuring Economic Exposure.
Memphis Co. hires you as a consultant to assess its degree of economic exposure to exchange rate fluctuations. How would you handle this task? Be specific.
ANSWER: Regression analysis can be used to determine the relationship between the firms value and exchange rate fluctuations. Stock returns can be used as a proxy for the change in the firms value. The time period can be segmented into two sub-periods so that regression analysis can run be for each sub-period. The sign and magnitude of the regression coefficient will imply how the firms value is influenced by each currency. Also, the coefficients can be compared among sub- periods for each currency to determine how the impact of a currency is changing over time.
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9. Factors That Affect a Firms Translation Exposure.
What factors affect a firms degree of translation exposure? Explain how each factor influences translation exposure.
ANSWER: The greater the percentage of business conducted by subsidiaries, the greater is the translation exposure. The greater the variability of each relevant foreign currency relative to the headquarters home currency, the greater is the translation exposure. The type of accounting method employed can also affect translation exposure.
10. Translation Exposure.
Consider a period in which the U.S. dollar weakens against the euro. How will this affect the reported earnings of a U.S. based MNC with European subsidiaries? Consider a period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the reported earnings of a U.S.-based MNC with subsidiaries all over the world?
ANSWER: The consolidated earnings will be increased due to the strength of the subsidiaries local currency. The consolidated earnings will be reduced due to the weakness of the subsidiaries local currencies.
11. Transaction Exposure.
Aggie Co. produces chemicals. It is a major exporter to Europe, where its main competition is from other U.S. exporters. All of these companies invoice the products in U.S. dollars. Is Aggies transaction exposure likely to be significantly affected if the euro
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strengthens or weakens? Explain. If the euro weakens for several years, can you think of any change that might occur in the global chemicals market?
ANSWER:
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If the Euro strengthens, European customers can purchase Aggies goods with fewer Euros. Since Aggies competitors also invoice their exports in dollars, Aggie Company will not gain a competitive advantage. However, the overall demand for the product could increase because the chemicals are now less expensive to European customers. If the euro weakens, European customers will need to pay more Euros to purchase Aggies goods. Since Aggies competitors also invoice their exports in dollars, Aggie Company may not necessarily lose some of its market share. However, the overall European demand for chemicals could decline because the prices paid for them have increased.
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If the euro remained weak for several years, some companies in Europe may begin to produce the chemicals, so that customers could avoid purchasing dollars with weak Euros. Explicitly, the U.S. exporters could be priced out of the European market over time if the euro continually weakened.
12. Economic Exposure.
Longhorn Co. produces hospital equipment. Most of its revenues are in the United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine materials). Most of Longhorns competition is from U.S. firms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens?
ANSWER: If the Peso strengthens, Longhorn will incur higher expenses when paying for the Philippine materials. Because its competition is not affected in a similar manner, Longhorn Company is at a competitive disadvantage when the peso strengthens.
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Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in the United States. How will Lubbock, Inc., be affected if Brazils currency (the real) strengthens over time?
ANSWER: If the Brazilian Real strengthens, U.S. retail stores will likely have to pay higher prices for the furniture from Brazil, and may pass some or all of the higher cost on to customers. As a result, some customers may shift to furniture produced by Lubbock Inc. Hence, Lubbock Inc. is expected to be favorably affected by a strong Brazilian Real.
14. Economic Exposure.
Sooner Co. is a U.S. wholesale company that imports expensive high-quality luggage and sells it to retail stores around the United States. Its main competitors also import high-quality luggage and sell it to retail stores. None of these competitors hedge their exposure to exchange rate movements. The treasurer of Sooner Co. told the board of directors that the firms performance would be more volatile over time if it hedged its exchange rate exposure. How could a firms cash flows be more stable as a result of such high exposure to exchange rate fluctuations?
ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the competition when the dollar weakened and could possibly gain market share or would have a higher profit margin. It would be at a disadvantage relative to the competition when the dollar strengthened and may lose market share or be forced to accept a lower profit margin.
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If Sooner Company does not hedge, the amount paid for imports would depend on exchange rate movements, but this is also true for all of its competitors. Therefore, Sooner Company is more likely to retain its existing market share.