International Finance Ch 10 Questions

In using regression analysis to assess the sensitivity of cash flows to exchange rate movements, what is the purpose of breaking the database into subperiods?

Breaking the database into subperiods enables one to understand how the impact of the currency is changing over time.

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 $.01. The yen exchange rate was $.008 three months ago, $.0085 two months ago, and $.009 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.

Applying an electronic spreadsheet, the standard deviation of the yen movements is about .029185. Maximum expected percentage decline in yen is: = Forecasted % change - (1.65 x Standard Deviation of yen movements) = 0 - (1.65 x .029185) = -.048155

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

Maine Co., a U.S. firm, measures its economic exposure to movements in the British pound by applying regression analysis to data over the last 36 quarters: SP = b0 + b1e + u where SP represents the percentage change in Maine's stock price per quarter, e represents the percentage change in the British pound value per quarter, and u is an error term. Based on the analysis, the b0 coefficient is estimated to be zero and the b1 coefficient is estimated to be 0.3 and is statistically significant. Maine Co. believes that the movement in the value of the pound over the next quarter will be mostly driven by the international Fisher effect. The prevailing quarterly interest rate in the U.K. is lower than the prevailing quarterly interest rate in the U.S. Would you expect that Maine's value will be favorably affected, unfavorably affected, or not affected by the pound's movement over the next quarter? Explain.

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. Although these firms concentrate on business in the U.S., their entire foreign operations for this quarter are provided here. Company A expects its exports to cause cash inflows of 9 million euros and imports to cause cash outflows equal to 3 million euros. Company B has a subsidiary in Portugal that expects revenue of 5 million euros and has expenses of 1 million euros. Company C expects exports to cause cash inflows of 9 million euros and imports to cause cash outflows of 3 million euros. It will repay the balance of an existing loan equal to 2 million euros. Company D expects zero exports and expects imports to cause cash outflows of 11 million euros. Company E will repay the balance of an existing loan equal to 9 million euros. Which of the five companies described here has the highest degree of translation exposure?

Company B has the greatest degree of translation exposure because it has a subsidiary whose financial statements must be consolidated with the U.S. operations.

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.

Erie Co. has most of its business in the U.S.,but it exports some products 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.

Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports goods 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., a U.S.-based MNC, 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).

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 0.45 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 adversely affected. If the A$ depreciates against U.S. $, it will depreciate against the HK$, which means that the Australian importers will have to pay more for exports.

Periodically, rumors swirl 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 a reaction. 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 its exposure to exchange rate movements. Why might Sooner's market share be more volatile over time if the company 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 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 their 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.

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.

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 materials obtained in the Philippines). 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. Celtic has priced its exports in pounds, and then later converts the pound receivables into dollars. All of its expenses are in the U.S. and are paid with dollars. The firm is concerned about its economic exposure. It considers changing its pricing policy, so that it will price its products in dollars instead of pounds. Offer your opinion on why this strategy will or will not significantly reduce Celtic's 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 the products from this supplier every week at the prevailing spot rate, and then sells the products in the U.S. invoiced in dollars. All of its competition is from U.S. firms that have no international business. The prices charged by Harz and its competitors will not change over the next year. Will the net cash flows generated by Harz increase, decrease, or be unaffected if the Chinese yuan depreciates over the next year? Briefly explain.

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.

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.

Assume that the Mexican peso and the Brazilian currency (called the "real") have depreciated against the 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. Also 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. a Mexican-based MNC, exports 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 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.

Kanab Co. and Zion Co. are U.S. companies of approximately the same size that engage in much business within the U.S. They both conduct some international business as well. Kanab Co. has a subsidiary in Canada that will generate earnings of approximately C$20 million in each of the next 5 years. Kanab Co. also has a U.S. business that will also receive approximately C$1 million (after costs) in each of the next 5 years as a result of exporting products to Canada that are denominated in Canadian dollars . Zion Company has a subsidiary in Mexico that will generate earnings of approximately 1 million pesos in each of the next 5 years. Zion Co. also has a business in the U.S. that will receive approximately 300 million pesos (after costs) in each of the next 5 years as a result of exporting products to Mexico that are denominated in Mexican pesos. The salvage value of Kanab's Canadian subsidiary and Zion's Mexican subsidiary will be zero in 5 years. The spot rate of the Canadian dollar is $.60 and the spot rate of the Mexican peso is $.10. Assume the Canadian dollar could appreciate or depreciate against the U.S. dollar by approximately 8% in any given year, while the Mexican peso could appreciate or depreciate against the U.S. dollar by approximately 12% in any given year. Which company is subject to a higher degree of translation exposure? Explain.

Kanab Co. has C$20,000,000 that is subject to translation exposure, as these are the subsidiary earnings. Its cash flows from exporting are not subject to translation exposure.Zion Co. has 1,000,000 pesos that is subject to translation exposure, as these are the subsidiary earnings. Its cash flows from exporting are not subject to translation exposure.The estimated dollar value of Kanab's translated earnings is C$20,000,000 x .60 = $12,000,000. The estimated dollar value of Zion's translated earnings is 1,000,000 pesos x .10 = $100,000. Since both companies are the same size, Kanab Co. has a much higher proportion of its business that is subject to translation exposure. While the peso is more volatile than the Canadian dollar, the potential adverse effect due to translation exposure is much larger for Kanab.

Lance Co. is a U.S. company that has exposure to the Swiss francs (SF) and Danish kroner (DK). It has net inflows of SF100 million and net outflows of DK500 million. The present exchange rate of the SF is about $.80 while the present exchange rate of the DK is $.10. Lance Co. has not hedged these positions. The SF and DK are highly correlated in their movements against the dollar. Explain whether Lance will be favorably or adversely affected if the dollar strengthens against foreign currencies over time.

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.

Milwaukee Co. has an Australian subsidiary that earned A$40 million Australian dollars (A$) this year. Little Rock Co. has an Australian subsidiary that earned A$30 million this year. Milwaukee's subsidiary plans to reinvest its earnings in Australia while the subsidiary of Little Rock Co. plans to remit its earnings to the U.S. parent. Cincinnati Co. does not have an Australian subsidiary, but it received revenue of A$50 million this year from exporting products to Australia. All three companies have the same total revenues and total earnings levels (when considering their U.S. business as well), are the same size, and do not have any other international business. Which company is subject to the highest degree of translation exposure? Briefly explain.

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.

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.

No, because Zebra's cash flows are denominated in home currency. They will not be affected by exchange rate fluctuations.

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 approximately $.70 and 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 weakens 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. (a U.S.-based firm) is approximately 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 40 percent of its total earnings. All earnings are reinvested in Germany and therefore are not remitted. The rest of Reed's business is in the U.S. 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 does not have translation 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 relationship between the firm's value and exchange rate fluctuations. 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 coefficient 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.

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.

Reese Co. will pay 1 million British pounds for materials imported from the U.K. in one month. This firm also 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 $1.50, while the spot rate of the zloty is $.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 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 benefit because the favorable effect on the outflows should exceed the unfavorable effect on the inflows.

Assume the regression coefficient based on assessing economic exposure was much higher in the second sub period than in the first sub period. What does this tell you about the firm's degree of economic exposure over time? Why might such results occur?

The firm is more exposed to change in currency values. This could occur if the firm hedges currency positions less or is simply increasing its degree of foreign business.

Minnesota Co. is a U.S. firm that exports computer parts to Japan. Its main competition is from firms that are based in Japan, which invoice their products in yen. In contrast, Minnesota's exports are invoiced in U.S. dollars. The prices charged by Minnesota and its competitors will not change during the next year. Will Minnesota's revenue increase, decrease, or be unaffected if the spot rate of the yen appreciates over the next year? Briefly explain.

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.

You use today's spot rate of the Brazilian real to forecast the spot rate of the real for one month ahead. Today's spot rate is $.4558. Use the VaR method to determine the maximum percentage loss of the Brazilian real over the next month based on a 95 percent confidence level. Use the spot exchange rates at the end of each of the last 6 months as shown below to conduct your analysis. Forecast the exchange rate that would exist under these conditions.

The standard deviation is 4.09%. The maximum expected loss in the currency's value is:1.65 x 4.09% = 6.75%. If this loss occurs, the exchange rate of the real in one month would be: $.4558 x (1 - .0675) = $.4250.

Spencer Co., a U.S. firm, has a large subsidiary in Singapore, which generates a large amount of earnings. Spencer's stock is usually valued at approximately 16 times its reported earnings per share. The earnings generated by the Singapore subsidiary in this period are the same as those 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.

Vegas Corp. is a U.S. firm that exports most of its products to Canada. Historically, the firm 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 ongoing 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 Vegas, since the number of Canadian dollars to be converted into U.S. dollars when importing the goods from Vegas would still be 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 its 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.

How can a U.S. company use regression analysis to assess its economic exposure to fluctuations in the British pound?

U.S. company could quantify its performance by measuring the percentage change in earnings, stock price, or some other variable to be used as the dependent variable. The independent variable is the percentage change in the British pound. Lagged exchange rate variables could also be included as additional independent variables to capture any lagged impact of the pound's movements on the firm.

The Central Bank of Poland is about to engage in indirect intervention later today, in which it will lower Poland's interest rates substantially. This will have an impact on the value of the Polish currency (zloty) against most currencies because it will immediately affect capital flows. Missouri Co. has a subsidiary in Poland that sells appliances. The demand for those appliances is not affected much by the local economy. Most of the firm's appliances produced in Poland are typically invoiced in zloty and are purchased by consumers from Germany. The subsidiary's main competition is from appliance producers in Portugal, Spain, and Italy that also export appliances to Germany. a. Explain how the impact on the zloty's value will affect the sales of appliances by Missouri's Polish subsidiary. b. The subsidiary owes a British company 1 million British pounds for some technology that the British company provided. Explain how the impact on the zloty's value will affect the cost of this technology to the subsidiary. c. The subsidiary plans to take 2 million zloty from its recent earnings, and will remit it to the U.S. parent in the near future. Explain how the impact on the zloty's value will affect the amount of dollar cash flows received by the U.S. parent due to this remittance of earnings by the subsidiary.

a. The lower interest rate in Poland will reduce capital flows to Poland, which reduces the demand for zloty, which weakens the value of the zloty. Thus, sales of appliances by the Polish subsidiary to Germany should increase because German consumers can purchase appliances from the subsidiary at a lower price. b. The lower interest rate in Poland will reduce capital flows to Poland, which reduces the demand for zloty, which weakens the value of the zloty. The subsidiary's cost will increase because it will take more zloty to purchase technology. c. The earnings will convert to less dollars because of the zloty's depreciation against the dollar.