chapter 10 international finance
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.
Compare and contrast transaction exposure and economic exposure. Choose the correct statement.
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 by exchange rate movements. 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.
In this case, since the dollar value of the receivable increases as the pound appreciates
It will not hedge since it benefits from this appreciation.
Dubas Co. is a U.S.-based MNC that has a subsidiary in Germany and another subsidiary in Austria. Both subsidiaries frequently remit their earnings back to the parent company. The German subsidiary generated a net outflow of €2,000,000 this year, while the Austrian subsidiary generated a net inflow of €1,500,000. What is the net inflow or outflow as measured in U.S. dollars this year? The exchange rate for the euro is $1.05.
$525,000 outflow
Cerra Co. expects to receive 5 million euros tomorrow as a result of selling goods to the Netherlands. Cerra estimates the standard deviation of daily percentage changes of the euro to be 1 percent over the last 100 days. Assume that these percentage changes are normally distributed. Use the value-at-risk (VaR) method based on a 95 percent confidence level. What is the maximum one-day percentage loss if the expected percentage change of the euro tomorrow is 0.5 percent?
-1.15 percent
Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer a reason related to exposure to exchange rates that explain why Cieplak's earnings were reduced during the Asian crisis in 1997.
Cieplak's receivables from its exports were converted to fewer dollars due to the depreciation of the Asian currencies.
In general, the translation exposure for an MNC depends on three factors:
1.The proportion of its business conducted by foreign subsidiaries 2.The locations of its foreign subsidiaries 3.The accounting methods that it uses
Select the desirable characteristics of currency variability that would reduce transaction exposure.
A low level is desirable both for currencies that are net inflows and for currencies that are net outflows.
The Hong Kong dollar (HK$) is presently pegged to the U.S. dollar and is expected to remain pegged. Some Hong Kong firms export products to Australia that are denominated in Australian dollars and have no other business in Australia. The exports are not hedged. The Australian dollar is presently worth 0.50 U.S. dollars, but you expect that it will be worth 0.55 U.S. dollars by the end of the year. Based on your expectations, will the Hong Kong exporters be affected favorably or unfavorably? Briefly explain.
Hong Kong exporters are favorably affected. If the A$ appreciates against U.S. $, it will appreciate against the HK$, which means that the Australian importers will have to pay less for exports.
Yazoo, Inc., is a U.S. firm that has substantial international business in Japan and has cash inflows in Japanese yen. The spot rate of the yen today is $0.0095. The yen exchange rate was $0.0065 three months ago, $0.0075 two months ago, and $0.0085 one month ago. Yazoo uses today's spot rate of the yen as its forecast of the spot rate in one month. However, it wants to determine the maximum expected percentage decline in the value of the Japanese yen in one month based on the value-at-risk (VaR) method and a 95 percent probability. Use the exchange rate information provided to derive the maximum expected decline in the yen over the next month. Use a minus sign to enter a negative value, if any. Do not round intermediate calculations. Round your answer to four decimal places.
Applying an electronic spreadsheet, the standard deviation of the yen movements is about 0.018153. Maximum expected percentage decline in yen is: = Forecasted % change - (1.65 × Standard Deviation of yen movements)= 0 - (1.65 × 0.018153) = -0.0300
How should appreciation of a firm's home currency generally affect its cash inflows?
Appreciation of the firms home currency reduces inflows since the foreign demand for the firms goods is reduced and foreign competition is increased.
SP = b0 + b1e + μ 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 μ 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 fall substantially while the U.S. inflation will remain at a high level. Would you expect that Layton's value to be favorably affected, unfavorably affected, or not affected by its economic exposure over the next quarter? Explain.
Based on purchasing power parity, the relatively low inflation in Japan will place upward pressure on the yen. Since the coefficient b1 is positive, the percentage change in Layton's stock price is positively related to e. Since the percentage change in the exchange rate (e) is expected to be positive in the next quarter, the value of the stock will increase as well. Thus, Layton's value will be favorably affected.
SP = b0 + b1e + μ 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 μ 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 United Kingdom is lower than the prevailing quarterly interest rate in the United States. Would you expect that Maine's value to be favorably affected, unfavorably affected, or not affected by the pound's movement over the next quarter? Explain.
Based on the IFE, the pound's value will rise during the next quarter. Since SP is positively related to the percentage change in the British pound value per quarter, it should be favorably affected by the pound's movement over the next quarter.
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. While these firms concentrate on business in the United States, 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, and will repay the balance of an existing loan equal to 2 million euros. Company D expects zero exports and imports to cause cash outflows of 11 million euros. Company E will repay the balance of an existing loan equal to 9 million euros.
Fischer, Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would depreciation of the euro likely affect its net cash flows? Why?
Fischer Inc. should loss from the depreciation of the euro, because it should experience a weak demand for its products when the euro has less purchasing power (can obtain dollars at a high price).
Periodically, there are rumors that China will weaken its currency (the yuan) against the U.S. dollar and many European currencies. This causes investors to sell stocks in Asian countries such as Japan, Taiwan, and Singapore. Offer an intuitive explanation for such an effect. What types of Asian firms would be affected the most?
If China weakened its currency, importers of Asian products may purchase more Chinese products, which could have enhanced the performance of the Chinese exporters, but could have adversely affected the performance of the exporters in other Asian countries. Thus, the stock prices of other exporting firms based in Asia that compete with the Chinese exporters could decline.
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.
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.
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 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 peso depreciates, interest from investments in Mexico will likely decrease . However, if the peso appreciates, interest from those investments will increase .
If the peso depreciates, the interest owed on borrowed funds from Mexico decreases . However, if the peso appreciates, the interest owed on borrowed funds from Mexico increases .
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.
Celtic Co. is a U.S. firm that exports its products to England. It faces competition from many firms in England. Its price to customers in England has generally been lower than those of the competitors, primarily because the British pound has been strong. It has priced its exports in pounds and then converts the pound receivables into dollars. All of its expenses are in the United States and are paid with dollars. It is concerned about its economic exposure. It considers a change in its pricing policy, in which it will price its products in dollars instead of pounds. Offer your opinion on why this will or will not significantly reduce its economic exposure.
If the pound weakens, demand for exports of Celtic Co. will decline as customers shift to the local competitors. Thus, this pricing policy would not significantly reduce its economic exposure.
Harz Co. (a U.S. firm) has an arrangement with a Chinese company in which it purchases products from them every week at the prevailing spot rate, and then sells the products in the United States 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.
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.
Which of the following is not true regarding economic exposure?
In general, depreciation of the firm's local currency causes a decrease in both cash inflows and outflows.
Assume that the Mexican peso and the Brazilian currency (the real) have depreciated against the U.S. dollar recently due to the high inflation rates in those countries. Assume that inflation in these two countries is expected to continue and that it will have a major effect on these currencies if they are still allowed to float. Assume that the government of Brazil decides to peg its currency to the dollar and will definitely maintain the peg for the next year. Milez Co. is based in Mexico. Its main business is to export supplies from Mexico to Brazil. It invoices its supplies in Mexican pesos. Its main competition is from firms in Brazil that produce similar supplies and sell them locally. How will the sales volume of Milez Co. be affected (if at all) by the Brazilian government's actions? Explain.
Its sales should increase because higher inflation in Mexico will cause the peso to weaken against the dollar, and therefore weaken against the real when real is pegged to $. So peso weakens against real and Brazilian customers buy more supplies from Mexico.
Lance Co. is a U.S. company that has exposure to the Swiss franc (SF) and Danish krone (DK). It has net inflows of SF100 million and net outflows of DK500 million. The present exchange rate of the SF is about $0.80 while the present exchange rate of the DK is $0.10. Lance Co. has not hedged these positions. The SF and DK are highly correlated in their movements against the dollar. Explain whether Lance will be favorably or adversely affected if the dollar strengthens against foreign currencies over time.
Lance Co. will be adversely affected because the dollar value of its SF inflows exceeds the dollar value of its DK outflows. Thus, its dollar cash inflows from SF will be reduced by a greater degree than the dollar cash outflows needed to obtain DK.
Consider two U.S.-based firms, Mason Co. and Dayton Co. Suppose that Dayton generates a large portion of sales to foreign countries via exporting, while Mason generates a large portion of sales via the international business conducted by its subsidiary in Argentina, where the value of the peso fluctuates unpredictably.
Mason is likely subject to more translation exposure than Dayton .
Suppose that, based on historical data, it has determined that the expected change in the value of the euro is -2.00% over the next quarter and that the standard deviation of these changes is 2.00%. Colorado assumes that these changes are normally distributed, such that the maximum quarterly loss lies within 1.65 standard deviations below the expected change with 95% confidence. Under this scenario, the maximum one-quarter loss due to transaction exposure is approximately -5.30% with 95% confidence.
Maximum Loss = = E(et)−(1.65×σeuro) = −2.00%−(1.65×2.00%)= −5.30% E(et)= change in standard deviation of currency Based on these results, the larger (in magnitude) the expected change in the euro, the larger the maximum loss will be.
Milwaukee Co. has an Australian subsidiary that earned 40 million Australian dollars (A$) this year. Little Rock Co. has an Australian subsidiary that earned A$30 million this year. The subsidiary of Milwaukee 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 to Australia. All three companies have the same total revenue and total earnings levels (when considering their U.S. business as well), and 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.
Milwaukee Co. has the highest degree of translation exposure because it has more earnings that must be translated. Milwaukee Co. has the highest degree of translation exposure because it has more earnings that must be translated. It does not avoid the translation exposure by reinvesting its earnings in Australia. Cincinnati Co. has transaction exposure but does not have translation exposure.
Raton Co. is a U.S. company that has net inflows of 100 million Swiss francs and net outflows of 100 million British pounds. The present exchange rate of the Swiss franc is about $0.70 while the present exchange rate of the pound is $1.90. Raton Co. has not hedged these positions. The Swiss franc and British pound are highly correlated in their movements against the dollar. Explain whether Raton will be favorably or adversely affected if the dollar strengthens against foreign currencies over time.
Raton Co. will be favorably affected because dollar outflows and inflows will be reduced, but the dollar value of outflows is larger, and will be reduced to a greater degree than the dollar value of inflows.
Quartz Co. has its entire operations in Miami, Florida, and is an exporter of products to eurozone countries. All of its earnings are derived from its exports. The exports are denominated in euros. Reed Co. (of the United States) is about the same size as Quartz Co. and generates about the same amount of earnings in a typical year. It has a subsidiary in Germany that typically generates about 40 percent of its total earnings. All earnings are reinvested in Germany and therefore not remitted. The rest of Reed's business is in the United States. Which company has a higher degree of translation exposure? Briefly explain.
Reed Co. has a higher degree of translation exposure because its foreign subsidiary's financial statements (including earnings) must be translated into U.S. dollars. Quartz Co. does not have translation exposure.
Bag Company of the U.S. has a business of offering cruises along the coast of Argentina that are solely for American tourists. The company charges American tourists in U.S. dollars, but all of its expenses such as payments to its employees are in Argentine pesos. 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 + b1e + μ 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, μ is an error term, while b0 and b1 are regression coefficients. Do you think the expected sign of the b1 coefficient in the model would be positive and significant, negative and significant, or zero (not significant)? Briefly explain. The b1 coefficient would be negative and significant, because the stronger the peso, the more dollars that are needed to cover the expenses, and the smaller will be the cash flows to the U.S. parent.
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 reduced due to the weakness of the subsidiaries' local currencies.
Reese Co. will pay 1 million British pounds for materials imported from the United Kingdom in one month. Reese Co. sells some goods to Poland and will receive 3 million zloty (the Polish currency) for those goods in one month. The spot rate of the pound is $1.40, while the spot rate of the zloty is about $0.30. Assume that the pound and zloty are both expected to depreciate substantially against the dollar over the next month and by the same degree (percentage). Will this have a favorable effect, unfavorable effect, or no effect on Reese Co. over the next year? Explain.
The dollar value of the outflow exposure to pounds is greater than the inflow exposure to zloty. If both currencies depreciate, Reese Co. will will benefit because the favorable effect on the outflows should exceed the unfavorable effect on the inflows.
The United Kingdom still has its own currency, the pound. The pound's interest rate has historically been higher than the euro's interest rate. The United Kingdom has considered adopting the euro as its currency. There have been many arguments about whether it should do so.
The economic exposure of U.S. firms that conduct substantial business in the U.K. and have no other international business would decrease because the euro should be less volatile than the pound. The translation exposure of U.S. firms with British subsidiaries would decrease because the euro should be less volatile than the pound. The economic exposure of U.S. firms that export to the U.K. and whose only other international business is importing from firms based in the Eurozone would decrease because their euro outflows can offset some of the euro inflows.
Explain how each given factor influences a firm's degree of 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.
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. 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 or decrease if the spot rate of the yen appreciates over the next year? Briefly explain.
The revenue will increase, since the demand by Japanese customers for Minnesota's products should increase. Japanese customers can purchase dollars with fewer yen and therefore can purchase the products exported by Minnesota at a lower cost.
Spencer Co. is a U.S. firm that has a large subsidiary in Singapore that generates a large amount of earnings. Spencer's stock is commonly valued at about 16 times its reported earnings per share. The earnings generated by the Singapore subsidiary in this period are the same as in the previous period. The Singapore dollar 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.
The stock price will decline because the consolidated earnings will decline as a result of the translation effect, and the stock price tends to be a multiple of reported earnings.
____ exposure is the degree to which the value of contractual transactions can be affected by exchange rate fluctuations.
Transaction
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. Because 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 $0.81. The customers decided to oblige as 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.
Zebra Co. is a U.S. firm that obtains products from a U.S. supplier and then exports them to Canadian firms. Its exports are denominated in U.S. dollars. Its main competitor is a local company in Canada that sells similar products denominated in Canadian dollars. Is Zebra subject to transaction exposure? Briefly explain.
Yes, if the Canadian dollar weakens, the dollar amount of Zebra's inflows will be reduced, because it will convert Canadian dollars to U.S. dollars at a higher rate.
When the U.S. dollar strengthens against other currencies,
an MNC's U.S. sales will probably decrease.
Erie Co. has most of its business in the United States, 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.
Generally, MNCs with more foreign costs than foreign revenues will be ____ affected by a ____ foreign currency.
favorably; weaker
If an MNC has a net inflow in one currency and a net outflow of about the same amount in another currency, then the MNCs' transaction exposure is ____ if the two currencies are ____ correlated.
high; negatively
One argument for the irrelevance of exchange rate risk is that:
individuals can invest in a diversified set of MNCs, and can take positions in currencies on their own to offset any exchange rate exposure of MNCs
if an MNC has positive cash flows for various currencies, and those currencies are all highly correlated
it may be subject to higher transaction exposure.
The exposure of a firm's financial statements to exchange rate movements is referred to as
translation exposure.
