IBF Test 3 Short Answer Questions

Would Montana Co.'s real cost of hedging Japanese yen receivables have been positive, negative, or about zero on average over a period in which the dollar weakened consistently? Explain.

During the weak dollar period, the yen appreciated substantially against the dollar. Thus, the dollars received from hedging yen receivables would have been less than the dollars received if the yen receivables were not hedged. This implies that the real cost of hedging yen receivables would have been positive during the weak dollar period

work ch 11

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Explain how a Malaysian firm can use the forward market to hedge periodic purchases of U.S. goods denominated in U.S. dollars. Explain how a French firm can use forward contracts to hedge periodic sales of goods sold to the United States that are invoiced in dollars. Explain how a British firm can use the forward market to hedge periodic purchases of Japanese goods denominated in yen.

A Malaysian firm can purchase dollars forward with ringgit, which locks in the exchange rate at which it trades its ringgit for dollars. The French firm could purchase euros forward with dollars. The British firm can negotiate a forward contract with a bank to exchange pounds for yen at a future point in time.

Explain how a U.S. based MNC's consolidated earnings are affected when foreign currencies depreciate.

A U.S. based MNC's consolidated earnings are reduced by the translation effect when foreign currencies depreciate. Foreign earnings are translated at the average exchange rate over the fiscal year, so low values of foreign currencies result in a low level of consolidated earnings

What factors should be considered by a U.S. firm that plans to issue a floating rate bond denominated in a foreign currency?

A U.S. firm should consider the interest rate for each possible currency as well as forecasts of the exchange rate relative to the firm's home currency. The firm should also determine whether it has future cash inflows in any foreign currencies that could denominate the bond. Finally, the firm should forecast the future path of the coupon rate.

Discuss the use of specifying a break even point when financing in a foreign currency.

A break even exchange rate percentage change will indicate to a firm the amount by which a low interest rate currency must appreciate to make its financing cost the same as a domestic currency.

Once the probability distribution of effective financing rates from financing in a foreign currency is developed, how can this distribution be used in deciding whether to finance in the foreign currency or the home currency?

A distribution of effective financing rates can be used to determine the probability that foreign financing will be more costly than domestic financing. Then, the final decision will depend on the firm's degree of risk aversion.

Explain how a firm can hedge its translation exposure

A firm can hedge translation exposure by selling forward the currency of the firm's foreign subsidiary. Thus, if the foreign currency depreciates, the translation loss will be somewhat offset by the gain on the short position created by the forward contract

Lakeland, Inc., is a U.S. based MNC with a subsidiary in Mexico. Its Mexican subsidiary needs a one year loan of 10 million pesos for operating expenses. Since the Mexican interest rate is 70 percent, Lakeland is considering borrowing dollars, which it would convert to pesos to cover the operating expenses. By how much would the dollar have to appreciate against the peso to cause such a strategy to backfire? (The one year U.S. interest rate is 9%.)

((1+70%)/(1+9%)) - 1 = 55.96% The dollar would have to appreciate by more than 55.96 percent for the strategy to backfire.

Providence Co. needs dollars. Assume that the local one year loan rate is 15%, while a one year loan rate on euros is 7%. By how much must the euro appreciate to cause the loan in euros to be more costly than a U.S.-dollar loan?

((1.15)/(1.07)) -1 = 7.477% The euro must appreciate by about 7.477% over the year in order to make the loan in euros as costly as a U.S. dollar loan.

Explain why an MNC parent would consider financing from its subsidiaries.

A parent may obtain funds at a lower cost from its subsidiaries than from a bank, since a bank will maintain a spread between what it offers depositors and charges on loans

You are an exporter of goods to the United Kingdom, and you believe that today's forward rate of the British pound substantially underestimates the future spot rate. Company policy requires you to hedge your British pound receivables in some way. Would a forward hedge or a put option hedge be more appropriate? Explain.

A put option would be preferable because it gives you the flexibility to exchange pounds for dollars at the prevailing spot rate when receiving payment.

Explain how a firm's degree of risk aversion enters into its decision of whether to finance in a foreign currency or a local currency

A very risk averse firm may prefer to borrow domestically since it knows with certainty the cost of financing in advance. Yet, other firms may feel that the potential cost savings from foreign financing outweighs the risk (uncertainty); this may motivate them to consider financing in a foreign currency.

Albany Corp. is a U.S. based MNC that has a large government contract with Australia. The contract will continue for several years and generate more than half of Albany's total sales volume. The Australian government pays Albany in Australian dollars. About 10 percent of Albany's operating expenses are in Australian dollars; all other expenses are in U.S. dollars. Explain how Albany Corp. can reduce its economic exposure to exchange rate fluctuations.

Albany may ask the Australian government to provide payment in U.S. dollars. Alternatively, Albany could attempt to shift some of its expenses to Australia, by either purchasing Australian supplies or shifting part of the production process to Australia. These strategies will increase Australian dollar outflows, so that the Australian dollar inflows and outflows are more balanced.

Why should an MNC identify net exposure before hedging?

An MNC can reduce the amount of cash flow that it needs to hedge when identifying net exposure first. This can reduce the transaction costs associated with hedging

When an MNC restructures its operations to reduce its economic exposure, it may sometimes forgo economies of scale. Explain.

An MNC may attempt to use several production plants. The production could be increased in countries whose home currency is weak (since demand for products in those countries would be higher). However, to have such flexibility requires that production plants are scattered. Consequently, the firm forgoes the economies of scale that may be achieved by establishing one large production plant

How would an investing firm differ from a borrowing firm in the features (i.e., interest rate and currency's future exchange rates) it would prefer a floating rate foreign currency-denominated bond to exhibit?

An investing firm prefers a bond denominated in a currency that is expected to appreciate and with an interest rate that is high and expected to increase. A borrowing firm prefers a bond denominated in a currency that is expected to depreciate and with an interest rate that is low and expected to decrease

How should appreciation of a firm's home currency generally affect its cash inflows? How should depreciation of a firm's home currency generally affect its cash outflows?

Appreciation of the firm's home currency reduces inflows since the foreign demand for the firm's goods is reduced and foreign competition is increased. Depreciation of the firm's home currency should increase inflows since it will likely increase foreign demand for the firm's goods and reduce foreign competition.

Baltimore, Inc., is a U.S. based MNC that obtains 10 percent of its supplies from European manufacturers. Sixty percent of its revenues are due to exports to Europe, where its product is invoiced in euros. Explain how Baltimore can attempt to reduce its economic exposure to exchange rate fluctuations in the euro.

Baltimore Inc. could reduce its economic exposure by shifting some of its U.S. expenses to Europe. This may involve shifting its sources of materials or even part of its production process to Europe. It could also reduce its European revenue but this is probably not desirable.

Cedar Falls Co. has a subsidiary in Brazil, where local interest rates are high. It considers borrowing dollars and hedging the exchange rate risk by selling the Brazilian real forward in exchange for dollars for the periods in which it would need to make loan payments in dollars. Assume that forward contracts on the real are available. What is the limitation of this strategy?

Because of interest rate parity, the forward rate of the real will contain a discount to reflect the interest rate differential. Thus, Cedar Falls will have to exchange the real at a discount for dollars, which increases its cost of financing. This strategy will likely be as costly as borrowing the Brazilian real

Ivax Corp. (based in Miami) is a U.S. drug company that has attempted to capitalize on new opportunities to expand in Eastern Europe. The production costs in most Eastern European countries are very low, often less than one-fourth of the cost in Germany or Switzerland. Furthermore, there is a strong demand for drugs in Eastern Europe. Ivax penetrated Eastern Europe by purchasing a 60 percent stake in Galena AS, a Czech firm that produces drugs. How can borrowing koruna locally from a Czech bank reduce the exposure of Ivax to political risk caused by government regulations?

By borrowing from a local Czech bank, Ivax may be able to avoid excessive regulations that could be imposed on foreign firms by the local government. Also, there is less chance of any extreme action to be taken on a foreign firm when that firm's failure would cause defaults on loans provided by local lenders

Ivax Corp. (based in Miami) is a U.S. drug company that has attempted to capitalize on new opportunities to expand in Eastern Europe. The production costs in most Eastern European countries are very low, often less than one-fourth of the cost in Germany or Switzerland. Furthermore, there is a strong demand for drugs in Eastern Europe. Ivax penetrated Eastern Europe by purchasing a 60 percent stake in Galena AS, a Czech firm that produces drugs. How can borrowing koruna locally from a Czech bank reduce the exposure of Ivax to exchange rate risk?

By borrowing koruna, the Czech subsidiary of Ivax should make its interest payments before remitting any funds to the parent. Therefore, there are less funds that have to be remitted (less exposure) than if the funds are remitted to the U.S. before interest payments are paid to a U.S. bank.

Carlton Co. and Palmer, Inc., are U.S.-based MNCs with subsidiaries in Mexico that distribute medical supplies (produced in the United States) to customers throughout Latin America. Both subsidiaries purchase the products at cost and sell the products at 90 percent markup. The other operating costs of the subsidiaries are very low. Carlton Co. has a research and development center in the United States that focuses on improving its medical technology. Palmer, Inc., has a similar center based in Mexico. Each firm subsidizes its respective research and development center on an annual basis. Which firm is subject to a higher degree of economic exposure? Explain.

Carlton Company is subject to a higher degree of economic exposure because it does not have much offsetting cost in Mexico. Palmer Inc. incurs costs in Mexico for its research and development center

Relate the use of currency options to hedging net payables and receivables. That is, when should currency puts be purchased, and when should currency calls be purchased? Why would Cleveland, Inc., consider hedging net payables or net receivables with currency options rather than forward contracts? What are the disadvantages of hedging with currency options as opposed to forward contracts?

Currency call options should be purchased to hedge net payables. Currency put options should be purchased to hedge net receivables. Currency options not only provide a hedge, but they provide flexibility since they do not require a commitment to buy or sell a currency (whereas the forward contract does). A disadvantage of currency options is that a price (premium) is paid for the option itself. The only payment by a firm using a forward contract is the exchange of a currency as specified in the contract.

What factors affect a firm's degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure

Currency variability—low level is desirable. Currency correlations—low 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

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 Total Inflow: DK50,000,000 £2,000,000 Total Outflow: DK40,000,000 £1,000,000 Exchange Rate: DK - $.15 BP - $.10 Assume that the movements in the Danish krone and the pound are highly correlated. Provide your assessment as to your firm's degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer.

Danish krone (DK) +DK10,000,000 $.15 $1,500,000 British pound (£) +£1,000,000 $1.50 $1,500,000

Using the following cost and revenue information shown for DeKalb, Inc., determine how the costs, revenue, and cash flow would be affected by three possible exchange rate scenarios for the New Zealand dollar (NZ$): (1) NZ$ = $.50, (2) NZ$ = $.55, and (3) NZ$ = $.60. (Assume U.S. sales will be unaffected by the exchange rate.) Assume that NZ$ earnings will be remitted to the U.S. parent at the end of the period. Ignore possible tax effects.

DeKalb Inc. is adversely affected by a weaker New Zealand dollar value. This should not be surpris¬ing since the New Zealand business has relatively high NZ$ revenue compared to NZ$ expenses. This analysis assumes that the NZ$ received are converted to U.S. dollars at the end of the period

Erie Co. has most of its business in the U.S., except that it exports to Belgium. Its exports were invoiced in euros (Belgium's currency) last year. It has no other economic exposure to exchange rate risk. Its main competition when selling to Belgium's customers is a company in Belgium that sells similar products, denominated in euros. Starting today, Erie Co. plans to adjust its pricing strategy to invoice its exports in U.S. dollars instead of euros. Based on the new strategy, will Erie Co. be subject to economic exposure to exchange rate risk in the future? Briefly explain.

Economic exposure still exists because a weak euro would encourage Belgian customers to switch to local competitors.

Columbia Corp. is a U.S. company with no foreign currency cash flows. It plans to either issue a bond denominated in euros with a fixed interest rate, or a bond denominated in U.S. dollars with a floating interest rate. It estimates its periodic dollar cash flows for each bond. Which bond do you think would have greater uncertainty surrounding these future dollar cash flows? Explain.

Exchange rates are generally more volatile than interest rates over time. Therefore the dollar payments made on euro denominated bonds would likely be more uncertain than the dollar payments made on floating rate bonds denominated in dollars. Also, the principal payment is subject to exchange rate risk but not to interest rate risk.

Connecticut Co. plans to finance its operations in the U.S. It can borrow euros on a short-term basis at a lower interest rate than if it borrowed dollars. If interest rate parity does not hold, what strategy should Connecticut Co. consider when it needs short term financing? If Connecticut Co. expects the spot rate to be a more reliable predictor of the future spot rate, what does this suggest about the feasibility of such a strategy?

If the expected spot is more reliable, the foreign financing should be less costly than domestic financing, because this implies that the expected percentage change in the euro's value is zero, so that the interest rate on euros represents the expected effective financing rate when financing with euros

If hedging is expected to be more costly than not hedging, why would a firm even consider hedging?

Firms often prefer knowing what their future cash flows will be as opposed to the uncertainty involved with an open position in a foreign currency. Thus, they may be willing to hedge even if they expect that the real cost of hedging will be positive.

Discuss the development of a probability distribution of effective financing rates when financing in a foreign currency. How is this distribution developed?

First, a probability distribution of exchange rate changes is created. Using this along with the foreign currency's quoted interest rate, the probability distribution of effective financing rates can be developed

Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two reasons related to exposure to exchange rates why Cieplak's earnings were reduced during the Asian crisis.

First, its receivables from its exports were converted to fewer dollars due to the depreciation of the Asian currencies. Second, any funds remitted by the Malaysian subsidiary converted to fewer dollars for the parent. Third, the earnings generated by the Malaysian subsidiary were translated to fewer dollars on the consolidated income statement (translation exposure) even if it did not remit any earnings to the parent.

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?

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 (can obtain dollars at a low price).

Why are the cash flows of a purely domestic firm exposed to exchange rate fluctuations?

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.

Since Obisbo Inc. conducts much business in Japan, it is likely to have cash flows in yen that will periodically be remitted by its Japanese subsidiary to the U.S. parent. What are the limitations of hedging these remittances one year in advance over each of the next 20 years? What are the limitations of creating a hedge today that will hedge these remittances over each of the next 20 years?

If Obisbo Inc. hedges one year in advance, the forward rate negotiated at the beginning of each year will be based on the spot rate of the yen (and the difference between the Japanese interest rate and U.S. interest rate) at the beginning of that year. Thus, the forward rate at which the hedge occurs each year could be quite volatile. Obisbo Inc. would remove uncertainty for one year in advance but there is still much uncertainty about 2 or 5 years in advance. The more distant the timing of remittances, the more uncertainty there is about the cash flows. It could create a hedge today (a currency swap agreement or a set of forward contract) to hedge the next 20 years, but it will have to estimate the earnings that need to be hedged in each of those years, which is very complicated and subject to much error.

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. Why might Sooner's market share be more volatile over time if it hedges its exposure?

If Sooner Company hedged its imports, then it would have an advantage over the competition when the dollar weakened (since its competitors would pay higher prices for the luggage), 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. When 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. Thus, Sooner is more likely to retain its existing market share.

Explain how a firm can use cross hedging to reduce transaction exposure.

If a firm cannot hedge a specific currency, it can use a forward contract on a currency that is highly correlated with the currency of concern.

Explain how a firm can use currency diversification to reduce transaction exposure.

If a firm has net inflows in a variety of currencies that are not highly correlated with each other, exposure is not as great as if the equivalent amount of funds were denominated in a single currency. This is because not all currencies will depreciate against the firm's home currency simultaneously by the same degree. There may be a partial offsetting effect due to a diversified set of inflow currencies. If the firm has net outflows in a variety of currencies, the same argument would apply.

Under what conditions would Zona Co.'s subsidiary consider using a "leading" strategy to reduce transaction exposure? Under what conditions would Zona Co.'s subsidiary consider using a "lagging" strategy to reduce transaction exposure?

If a subsidiary expected its currency to depreciate against an invoice currency on goods it imported, it may "lead" its payments (make payments early). If a subsidiary expected its currency to appreciate against an invoice currency on goods it imported, it may "lag" its payments (make a late payment).

St. Louis Inc., which relies on exporting, denominates its exports in pesos and receives pesos every month. It expects the peso to weaken over time. St. Louis recognizes the limitation of monthly hedging. It also recognizes that it could remove its transaction exposure by denominating the exports in dollars but that it is still would be subject to economic exposure. The long-term hedging techniques are limited and the firm does not know how many pesos it will receive in the future, so it would have difficulty even if a long-term hedging method was available. How can this business realistically deal with this dilemma to reduce its exposure over the long-term?

If it expects that the weakness of the peso over time is attributed to high inflation in Mexico, it may be able to increase its price (in pesos) for its exports. That is, it may retain its sales at the higher peso price if its competitors have increased their prices. This strategy may offset the weakness of the peso, so that it could generate the same dollar cash flows. If it is unable to increase its price due to competitive pressure, it should consider moving some of its production to Mexico. A portion of the peso revenue could be used to cover the expenses in pesos, so that it would have less exposure.

How can a U.S. firm finance in euros and not necessarily be exposed to exchange rate risk?

If it has inflows in euros, it could use a portion of the inflows to pay its financing expenses.

Boulder, Inc., exports chairs to Europe (invoiced in U.S. dollars) and competes against local European companies. If purchasing power parity exists, why would Boulder not benefit from a stronger euro?

If purchasing power parity exists, a stronger euro would occur only because the U.S. inflation is higher than European inflation. Thus, the European demand for Boulder's chairs may not be affected much since the inflated prices of U.S. made chairs would have offset the European consumer's ability to obtain cheaper dollars. The European consumer's purchasing power of European chairs versus U.S. chairs is not affected by the change in the euro's value.

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 Brazil's currency (the real) strengthens over time?

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. Consequently, some customers may shift to furniture produced by Lubbock Inc. Thus, Lubbock Inc. is expected to be favorably affected by a strong Brazilian real.

How is it possible for a firm to incur a negative effective financing rate?

If the currency borrowed substantially depreciates against the firm's home currency (by at least the interest rate percentage as a rough approximation), the effective financing rate will be negative.

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 Aggie's transaction exposure likely to be significantly affected if the euro 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?

If the euro strengthens, European customers can purchase Aggie's goods with fewer euros. Since Aggie's competitors also invoice their exports in dollars, Aggie Company will not gain a competitive advantage. Nevertheless, 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 Aggie's goods. Since Aggie's 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. 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. That is, the U.S. exporters could be priced out of the European market over time if the euro continually weakened.

Assume that Hampshire Co. has net payables of 200,000 Mexican pesos in 180 days. The Mexican interest rate is 7% over 180 days, and the spot rate of the Mexican peso is $.10. Suggest how the U.S. firm could implement a money market hedge

If the firm deposited MXP186,916 (computed as MXP200,000/1.07) into a Mexican bank earning 7% over 6 months, the deposit would be worth 200,000 pesos at the end of the six month period. This amount would then be used to take care of the net payables. To make the initial deposit of 186,916 pesos, the firm would need about $18,692 (computed as 186,916 × $.10). It could borrow these funds

Assume the following information: 180 day U.S. interest rate = 8% 180 day British interest rate = 9% 180 day forward rate of British pound = $1.50 Spot rate of British pound = $1.48 Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge

If the firm uses a forward hedge, it will receive 400,000($1.50) = $600,000 in 180 days. If the firm uses a money market hedge, it will borrow (400,000/$1.09) = 366,972 pounds, to be converted to U.S. dollars and invested in the U.S. The 400,000 pounds received in 180 days will pay off this loan. The 366,972 pounds borrowed convert to about $543,119 (computed as 366,972 × $1.48), which when invested at 8% interest will accumulate to be worth about $586,569. In comparison, the firm will receive $600,000 in 180 days using the forward hedge, or about $586,569 in 180 days using the money market hedge. Thus, it should use the forward hedge.

Assume the following information: 90 day U.S. interest rate = 4% 90 day Malaysian interest rate = 3% 90 day forward rate of Malaysian ringgit = $.400 Spot rate of Malaysian ringgit = $.404 Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge.

If the firm uses the forward hedge, it will pay out 300,000($.400) = $120,000 in 90 days. If the firm uses a money market hedge, it will invest (300,000/1.03) = 291,262 ringgit now in a Malaysian deposit that will accumulate to 300,000 ringgit in 90 days. This implies that the number of U.S. dollars to be borrowed now is (291,262 × $.404) = $117,670. If this amount is borrowed today, Santa Barbara will need $122,377 to repay the loan in 90 days (computed as $117,670 × 1.04 = $122,377). In comparison, the firm will pay out $120,000 in 90 days if it uses the forward hedge and $122,377 if it uses the money market hedge. Thus, it should use the forward hedge

Connecticut Co. plans to finance its operations in the U.S. It can borrow euros on a short-term basis at a lower interest rate than if it borrowed dollars. If interest rate parity does not hold, what strategy should Connecticut Co. consider when it needs short term financing? Assume that Connecticut Co. needs dollars. It borrows euros at a lower interest rate than that for dollars. If interest rate parity exists and if the forward rate of the euro is a reliable predictor of the future spot rate, what does this suggest about the feasibility of such a strategy?

If the forward rate is a reliable predictor, the effective financing rate on the foreign financing would be the same as the domestic financing. So, foreign financing is not feasible.

If you are a U.S. importer of Mexican goods and you believe that today's forward rate of the peso is a very accurate estimate of the future spot rate, do you think Mexican peso call options would be a more appropriate hedge than the forward hedge? Explain.

If the forward rate is close to or exceeds today's spot rate, the forward hedge would be preferable because the call option hedge would require a premium to achieve about the same locked-in exchange rate. If the forward rate was much lower than today's spot rate, the call option could be preferable because the firm could let the option expire and be better off.

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 Longhorn's competition is from U.S. firms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens?

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.

Explain how a U.S. based MNC issuing bonds denominated in euros may be able to offset a portion of its exchange rate risk.

It may offset some exchange rate risk if it has cash inflows in euros. These euros could be used to make coupon payments

If interest rate parity exists, would a forward hedge be more favorable, the same as, or less favorable than a money market hedge on euro payables? Explain.

It would be equally favorable (assuming no transactions costs). If IRP exists, the forward premium on the forward rate would reflect the interest rate differential. The hedging of future payables with a forward purchase provides the same results as borrowing at the home interest rate and investing at the foreign interest rate to hedge euro payables.

Kopetsky Co. has net receivables in several currencies that are highly correlated with each other. What does this imply about the firm's 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?

Its exposure is high since all currencies move in tandem—no offsetting effect is likely. If one of these currencies depreciates substantially against the firm's local currency, all others will as well, and this reduces the value of these net receivables. No! Thus, 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. Yet, historical data may still be useful if the general ranking of correlations is somewhat stable.

Ivax Corp. (based in Miami) is a U.S. drug company that has attempted to capitalize on new opportunities to expand in Eastern Europe. The production costs in most Eastern European countries are very low, often less than one-fourth of the cost in Germany or Switzerland. Furthermore, there is a strong demand for drugs in Eastern Europe. Ivax penetrated Eastern Europe by purchasing a 60 percent stake in Galena AS, a Czech firm that produces drugs. Should Ivax finance its investment in the Czech firm by borrowing dollars from a U.S. bank that would then be converted into koruna (the Czech currency) or by borrowing koruna from a local Czech bank? What information do you need to know to answer this question?

Ivax would need to consider the interest rate in the U.S. versus the interest rate when borrowing koruna (the Czech currency). It would also need to consider the potential change in the koruna currency against the dollar. If it finances the project in dollars, it is more exposed to exchange rate risk, because the funds would be remitted to the U.S. before paying the interest expenses on the loan. Conversely, if it finances the project in koruna, it could use some of its local funds to pay off its interest expenses before remitting any funds to the U.S. parent. Another reason for borrowing from a local Czech bank is that the bank may help Ivax avoid any excessive regulatory restrictions that could be imposed on foreign firms in the drug industry. These potential advantages of borrowing locally must be weighed against the potentially higher interest rate when borrowing locally.

Kerr, Inc., a major U.S. exporter of products to Japan, denominates its exports in dollars and has no other international business. It can borrow dollars at 9 percent to finance its operations or borrow yen at 3 percent. If it borrows yen, it will be exposed to exchange rate risk. How can Kerr borrow yen and possibly reduce its economic exposure to exchange rate risk?

Kerr could invoice its exports in yen and use the proceeds to pay back loans. Its economic exposure would be reduced because Japanese consumers would not be subjected to exchange rate swings

How can a firm hedge long term currency positions? Elaborate on each method.

Long term forward contracts are available to cover positions of five years or longer in some cases (for major currencies). Parallel loans can be used to exchange currencies and re exchange the currencies at a specified future exchange rate and date.

Cornell Co. purchases computer chips denominated in euros on a monthly basis from a Dutch supplier. To hedge its exchange rate risk, this U.S. firm negotiates a three-month forward contract three months before the next order will arrive. In other words, Cornell is always covered for the next three monthly shipments. Because Cornell consistently hedges in this manner, it is not concerned with exchange rate movements. Is Cornell insulated from exchange rate movements? Explain.

No! Cornell is exposed to exchange rate risk over time because the forward rate changes over time. If the euro appreciates, the forward rate of the euro will likely rise over time, which increases the necessary payment by Cornell.

Assume that interest rate parity exists. If a firm believes that the forward rate is an unbiased predictor of the future spot rate, will it expect to achieve lower financing costs by consistently borrowing a foreign currency with a low interest rate?

No, because a foreign currency with a relatively low interest rate exhibits a forward premium that offsets the interest rate differential. Thus, if the forward rate is the expected future spot rate, this implies that the foreign currency will appreciate over the financing period by an amount that will offset the interest rate advantage.

Can Brooklyn Co. determine whether currency options will be more or less expensive than a forward hedge when considering both hedging techniques to cover net payables in euros? Why or why not?

No. The amount paid out when using a forward contract is known with certainty. However, the amount paid out when using currency options is not known until the period is over (since the firm has the flexibility to exercise the option only if it is feasible). Thus, the MNC cannot determine whether currency options will be more or less expensive than forward contracts when hedging net payables.

Assume that the U.S. interest rate is 7 percent and the euro's interest rate is 4 percent. Assume that the euro's forward rate has a premium of 4 percent. Determine whether the following statement is true: "Interest rate parity does not hold; therefore, U.S. firms could lock in a lower financing cost by borrowing euros and purchasing euros forward for one year." Explain your answer.

No. While interest rate parity does not hold, the financing with euros would result in an effective financing rate of: (1 + 4%)(1 + 4%) - 1 = 8.16% This exceeds the U.S. rate. For a U.S. firm to be able to lock in a lower financing cost by borrowing euros and purchasing euros forward, the premium on the forward rate of the euro would have to be less than the interest rate differential.

Explain the relationship between this chapter on hedging and the previous chapter on measuring exposure

The previous chapter explains how to measure exposure, which is necessary before an MNC decides whether to hedge its 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.

Regression analysis can be used to determine the rela¬tion¬ship between the firm's value and exchange rate fluctua¬tions. Stock returns can be used as a proxy for the change in the firm's value. The time period can be segmented into two subperiods so that regression analysis can be run for each subperiod. The sign and magnitude of the regression coeffic¬ient will imply how the firm's value is influenced by each currency. Also, the coefficients can be compared among subperiods for each currency to determine how the impact of a currency is changing over time.

Kayla Co. imports products from Mexico, and it will make payment in pesos in 90 days. Interest rate parity holds. The prevailing interest rate in Mexico is very high, which reflects the high expected inflation there. Kayla expects that the Mexican peso will depreciate over the next 90 days. Yet, it plans to hedge its payables with a 90-day forward contract. Why may Kayla believe that it will pay a smaller amount of dollars when hedging than if it remains unhedged?

Since Mexico presently has a very high interest rate, the forward rate of the peso would exhibit a discount according to interest rate parity. Kayla Co. may believe that today's 90-day forward rate of the peso is lower than the expected spot rate in 90 days, which means that it will pay a smaller amount of dollar cash flows if it hedges than if it remains unhedged.

Nelson Co. is a U.S. firm with annual export sales to Singapore of about S$800 million. Its main competitor is Mez Co., also based in the United States, with a subsidiary in Singapore that generates about S$800 million in annual sales. Any earnings generated by the subsidiary are reinvested to support its operations. Based on the information provided, which firm is subject to a higher degree of translation exposure? Explain

Since Nelson Company does not have any subsidiaries, its exposure to exchange rate fluctuations would not be classified as translation exposure. Conversely, Mez Company is subject to translation exposure

Greensboro, Inc., needs $4 million for one year. It currently has no business in Japan but plans to borrow Japanese yen from a Japanese bank, because the Japanese interest rate is three percentage points lower than the U.S. rate. Assume that interest rate parity exists; also assume that Greensboro believes that the one-year forward rate of the Japanese yen will exceed the future spot rate one year from now. Will the expected effective financing rate be higher, lower, or the same as financing with dollars? Explain.

Since the forward rate is expected to overestimate the future spot rate, this implies that the yen will not appreciate to the level that would fully offset the interest rate differential. Therefore, the expected effective financing rate of the yen is lower than the U.S. financing rate.

Wedco Technology of New Jersey exports plastics products to Europe. Wedco decided to price its exports in dollars. Telematics International, Inc. (of Florida), exports computer network systems to the United Kingdom (denominated in British pounds) and other countries. Telematics decided to use hedging techniques such as forward contracts to hedge its exposure. Explain why the earnings of Telematics International, Inc., were affected by changes in the value of the pound. Why might Telematics leave its exposure unhedged sometimes?

Telematics International, Inc. has sales to European customers, which are denominated in British pounds. While Telematics' pound receivables are hedged, the forward rate changes over time and is somewhat dependent on the spot rate at the time. Telematics may consider remaining unhedged whenever it expects the pound to appreciate.

Explain how a U.S. corporation could hedge net receivables in euros with futures contracts. Explain how a U.S. corporation could hedge net payables in Japanese yen with futures contracts.

The U.S. corporation could agree to a futures contract to sell euros at a specified date in the future and at a speci¬fied price. This locks in the exchange rate at which the euros could be sold. The U.S. corporation could purchase yen futures contracts that provide for yen to be received in exchange for dollars at a specified future date and at a specified price. The firm has locked in the rate at which it will exchange dollars for yen

Explain how a U.S. corporation could hedge net receivables in Malaysian ringgit with a forward contract. Explain how a U.S. corporation could hedge payables in Canadian dollars with a forward contract

The U.S. corporation could sell ringgit forward using a forward contract. This is accomplished by negotiating with a bank to provide the bank ringgit in exchange for dollars at a specified exchange rate (the forward rate) for a specified future date. The U.S. corporation could purchase Canadian dollars forward using a forward contract. This is accomplished by negotiating with a bank to provide the bank U.S. dollars in exchange for Canadian dollars at a specified exchange rate (the forward rate) for a specified future date

Assume that Suffolk Co. negotiated a forward contract to purchase 200,000 British pounds in 90 days. The 90 day forward rate was $1.40 per British pound. The pounds to be purchased were to be used to purchase British supplies. On the day the pounds were delivered in accordance with the forward contract, the spot rate of the British pound was $1.44. What was the real cost of hedging the payables for this U.S. firm?

The U.S. dollars paid when hedging = $1.40(200,000) = $280,000. The dollars paid if unhedged = $1.44(200,000) = $288,000. The real cost of hedging payables = $280,000 - $288,000 = -$8,000. Therefore, the cash flow from hedging was better than the cash flow if the exposure had remained unhedged.

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?

The consolidated earnings will be increased due to the strength of the subsidiaries' local currency (the euro). The consolidated earnings will be reduced due to the weakness of the subsidiaries' local currencies.

Explain the difference in the cost of financing with foreign currencies during a strong-dollar period, versus a weak-dollar period for a U.S. firm.

The cost of financing with foreign currencies is low when the dollar strengthens, and high when the dollar weakens

Homewood Co. commonly finances some of its U.S. expansion by borrowing foreign currencies (such as Japanese yen) that have low interest rates. Describe how the potential return and risk of this strategy may have changed as a result of the credit crisis in 2009.

The credit crisis caused more volatile exchange rate movements and therefore may increase the risk of a firm that is attempting to reduce costs by borrowing foreign currencies

Toyota Motor Corp. measures the sensitivity of its exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could be used for such a task. Identify the expected sign of the regression coefficient if Toyota primarily exports to the United States. If Toyota established plants in the United States, how might the regression coefficient on the exchange rate variable change?

The dependent variable is a percentage change (from one period to the next) in Toyota's export volume to the U.S. The independent variables are (1) the percentage change in the yen's value with respect to the dollar, (2) a measure of the strength of the U.S. economy, and (3) any other factors that could affect the volume of Toyota's exports. The regression coefficient related to the exchange rate variable (as defined here) would be negative, since a decrease in the yen's value is likely to cause an increase in the U.S. demand for Toyotas built in Japan. If Toyota established plants in the U.S., dealers do not need to purchase Toyotas in Japan. Thus, the demand for Toyotas is less sensitive to the exchange rate, which should cause the regression coefficient for the exchange rate variable to decrease.

Assume that Stevens Point Co. has net receivables of 100,000 Singapore dollars in 90 days. The spot rate of the S$ is $.50, and the Singapore interest rate is 2% over 90 days. Suggest how the U.S. firm could implement a money market hedge. Be precise

The firm could borrow the amount of Singapore dollars so that the 100,000 Singapore dollars to be received could be used to pay off the loan. This amounts to (100,000/1.02) = about S$98,039, which could be converted to about $49,020 and invested. The borrowing of Singapore dollars has offset the transaction exposure due to the future receivables in Singapore dollars.

Connecticut Co. plans to finance its operations in the U.S. It can borrow euros on a short-term basis at a lower interest rate than if it borrowed dollars. If interest rate parity does not hold, what strategy should Connecticut Co. consider when it needs short term financing?

The firm could consider borrowing a foreign currency and purchasing the currency forward to lock in its financing cost.

Bradenton, Inc., has a foreign subsidiary in Asia that commonly obtains short-term financing from local banks. If Asian suddenly experiences a crisis, explain why Bradenton may not be able to easily obtain funds from the local banks.

The foreign subsidiary may find that the local banks do not have adequate funding from depositors any more to provide credit. Alternatively, the banks may be concerned about the credit risk given the large number of defaults by firms.

What factors affect a firm's degree of translation exposure? Explain how each factor influences translation exposure.

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 (reporting) currency, the greater is the translation exposure. The type of accounting method employed can also affect translation exposure.

Bartunek Co. is a U.S.-based MNC that has European subsidiaries and wants to hedge its translation exposure to fluctuations in the euro's value. Explain some limitations when it hedges translation exposure

The limitations are as follows. First, Bartunek Inc. needs to forecast its foreign subsidiary earnings and may forecast inaccurately. Thus, it will hedge against a level of foreign earnings that differs from actual foreign earnings. Second, forward contracts are not available for all currencies, although Bartunek will not be affected by this limitation since forward contracts in euros are available. Third, translation losses are not tax deductible, while gains on forward contracts used to hedge translation exposure are taxed. Fourth, transaction exposure may be increased as a result of hedging translation exposure.

Katina, Inc., is a U.S. firm that plans to finance with bonds denominated in euros to obtain a lower interest rate than is available on dollar-denominated bonds. What is the most critical point in time when the exchange rate will have the greatest impact?

The most critical time is maturity, since the principal will be paid back at that time

Would Oregon Co.'s real cost of hedging Australian dollar payables every 90 days have been positive, negative, or about zero on average over a period in which the dollar weakened consistently? What does this imply about the forward rate as an unbiased predictor of the future spot rate? Explain.

The nominal cost when hedging Australian dollar payables would have been below the nominal cost of payables on an unhedged basis during the weak dollar period, because the Australian dollar substantially appreciated during this period. Thus, the real cost of hedging would have been negative during the period. This implies that the Australian dollar's forward rate consistently underestimated the Australian dollar's future spot rate during the period and was therefore biased.

Is the risk of issuing a floating rate bond higher or lower than the risk of issuing a fixed rate Eurobond? Explain

The risk from issuing a floating rate bond is that the interest rate may rise over time. The risk from issuing a fixed rate bond is that the firm is obligated to pay that coupon rate even if interest rates decline. Some firms may feel that a fixed rate bond is less risky since at least they know with certainty the coupon rate they must pay in the future. This question is somewhat open ended.

Describe how a crisis in Asia could reduce the cash flows of a U.S. firm that exports products (denominated in U.S. dollars) to Asian countries. How could a U.S. firm that exported products (denominated in U.S. dollars) to Asia and anticipates an Asian crisis before it began insulate itself from any currency effects while continuing to export to Asia?

The weakness of the Asian currencies would cause the Asian importers to reduce their demand for U.S. products, because these imports from the U.S. would have cost more due to the Asian currency depreciation. It might have invoiced the exports in the Asian currencies so that the Asian customers would not be subjected to higher costs when their currencies depreciated, but it would also have hedged its receivables over the Asian crisis period to insulate against the expected depreciation of the Asian currencies.

Walt Disney World built an amusement park in France that opened in 1992. How do you think this project has affected Disney's economic exposure to exchange rate movements? Think carefully before you give your final answer. There is more than one way in which Disney's cash flows may be affected. Explain.

This is a good question for class discussion. The typical first reaction is that Walt Disney Company's exposure may increase, since this new park would generate revenue in French francs (now euros), which may someday be converted to dollars. If the euro weakens against the dollar, the revenue will be converted to fewer dollars. When European currencies (or the euro) weakens against the dollar, tourism by Europeans decreases and Disney's business in the U.S. declines. By having a European amusement park, it may be able to offset the declining U.S. business during strong dollar cycles, since more European tourists may go to the Disney park in France during the periods. Overall, Disney may be less exposed to exchange rate movements because of the park.

Would a more established MNC or a less established MNC be better able to effectively hedge its given level of translation exposure? Why?

This question is intended to stimulate class discussion. There is no perfect answer. One opinion is that a more established MNC can better predict its level of foreign earnings, because its foreign business is stabilized. There¬fore, it is more able to hedge the appropriate amount of foreign earnings.

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?

Transaction exposure is due only to international transactions by a firm. Economic exposure includes any form by which the firm's cash flow will be affected. Foreign competition may increase due to currency fluctuations. This could affect the firm's 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.

Vegas Corp. is a U.S. firm that exports most of its products to Canada. It historically invoiced its products in Canadian dollars to accommodate the importers. However, it was adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas did not hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S. dollars. After a few more years of continual concern about possible exchange rate movements, Vegas called its customers and requested that they pay for future orders with U.S. dollars instead of Canadian dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to oblige, since the number of Canadian dollars to be converted into U.S. dollars when importing the goods from Vegas was still slightly smaller than the number of Canadian dollars that would be needed to buy the product from a Canadian manufacturer. Based on this situation, has transaction exposure changed for Vegas Corp.? Has economic exposure changed? Explain.

Transaction exposure is reduced since Vegas will have less receivables in Canadian dollars. However, the economic exposure will not necessarily be reduced because a weak Canadian dollar could cause a lower demand for its exports and will still affect cash flows.

UVA Co. is a U.S. based MNC that obtains 40 percent of its foreign supplies from Thailand. It also borrows Thailand's currency (the baht) from Thai banks and converts the baht to dollars to support U.S. operations. It currently receives about 10 percent of its revenue from Thai customers. Its sales to Thai customers are denominated in baht. Explain how UVA Co. can reduce its economic exposure to exchange rate fluctuations.

UVA Company has periodic outflow payments in Thai baht that are substantially more than its Thai baht inflow payments. UVA could reduce its economic exposure by attempt¬ing to increase sales in Thailand, which would generate additional Thai baht inflows.

What is the advantage of using simulation to assess the bond financing position?

Unlike point forecasts, simulation provides a distribution of possible outcomes. Thus, the firm can determine the probability that a particular foreign issued bond will be a less expensive source of funds than a locally issued bond.

Wedco Technology of New Jersey exports plastics products to Europe. Wedco decided to price its exports in dollars. Telematics International, Inc. (of Florida), exports computer network systems to the United Kingdom (denominated in British pounds) and other countries. Telematics decided to use hedging techniques such as forward contracts to hedge its exposure. Does Wedco's strategy of pricing its materials for European customers in dollars avoid economic exposure? Explain.

Wedco avoids transaction exposure but not economic exposure. If the euro weakens against the dollar, European customers would have to pay more for Wedco's materials. This may encourage the customers to purchase their materials from other firms.