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Ch009 Management of Economic Exposure

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Ch009 Management of Economic Exposure

    Eun & Resnick 4e

    CHAPTER 9 Management of Economic Exposure

How to Measure Economic Exposure

    International Finance in Practice: U.S. Firms Feel the Pain of Peso’s Plunge

    Operating Exposure: Definition

    Illustration of Operating Exposure

    Determinants of Operating Exposure

    Managing Operating Exposure

    Selecting Low-Cost Production Sites

    International Finance in Practice: The Strong Yen and Toyota’s Choice

    Flexible Sourcing Policy

    Diversification of the Market

    R&D Efforts and Product Differentiation

    Financial Hedging

    International Finance in Practice: Porsche Powers Profit with Currency Plays

    CASE APPLICATION: Exchange Risk Management at Merck

    Summary

    MINI CASE: Economic Exposure of Albion Computers PLC

How to Measure Economic Exposure

    1 Suppose the U.S. dollar substantially depreciates against the Japanese yen. The change in

    exchange rate

    a) Can have a significant economic consequences for U.S. firms.

    b) Can have a significant economic consequences for Japanese firms.

    c) Can have a significant economic consequences for both U.S. and Japanese firms.

    d) None of the above

    Answer: c)

     Suppose the U.S. dollar substantially depreciates against the Japanese yen. The change in 2

    exchange rate

    a) Will tend to weaken the competitive position of import-competing U.S. car makers.

    b) Will tend to strengthen the competitive position of import-competing U.S. car makers.

    c) Will tend to strengthen the competitive position of Japanese car makers at the expense of

    U.S. makers.

    d) None of the above

    Answer: b)

3 When the Mexican peso collapsed in 1994, declining by 37 percent,

    a) U.S. firms that exported to Mexico and priced in peso were adversely affected.

    b) U.S. firms that exported to Mexico and priced in dollars were adversely affected.

    c) U.S. firms were unaffected by the peso collapse, since Mexico is such a small market.

    d) Both a) and b)

    Answer: d)

    Rationale: a) is obvious, the dollar value of revenue fell. Answer b) is less obvious, but those firm’s Mexican customers were less able to afford the imported goods.

Eun/Resnick 4e 108

4 When exchange rates change,

    a) U.S. firms that sell only to domestic customers will be unaffected.

    b) U.S. firms that sell only to domestic customers can be affected if they compete against

    imports.

    c) U.S. firms that sell only to domestic customers will be affected, but only if they borrow in

    foreign currency to finance their domestic operations.

    d) Both a) and b)

    Answer: b)

5 When exchange rates change,

    a) This can alter the operating cash flow of a domestic firm.

    b) This can alter the competitive position of a domestic firm.

    c) This can alter the home currency values of a multinational firm’s assets and liabilities.

    d) All of the above

    Answer: d)

    6 Two recent studies have found a link between exchange rates and the stock prices of U.S. firms,

    a) This suggests that exchange rate changes can systematically affect the value of the firm by

    influencing its operating cash flows.

    b) This suggests that exchange rate changes can systematically affect the value of the firm by

    influencing the domestic currency values of its assets and liabilities.

    c) a) and b)

    d) None of the above

    Answer: c)

7 Economic exposure refers to(名词解释)

    a) the sensitivity of realized domestic currency values of the firm’s contractual cash flows

    denominated in foreign currencies to unexpected exchange rate changes

    b) the extent to which the value of the firm would be affected by unanticipated changes in

    exchange rate

    c) the potential that the firm’s consolidated financial statement can be affected by changes in

    exchange rates

    d) ex post and ex ante currency exposures

    Answer: b)

    8 It is conventional to classify foreign currency exposures into the following types:

    a) economic exposure, transaction exposure, and translation exposure

    b) economic exposure, noneconomic exposure, and political exposure

    c) national exposure, international exposure, and trade exposure

    d) conversion exposure, and exchange exposure

    Answer: a)

9 Exposure to currency risk can be measured by the sensitivities of

    a) the future home currency values of the firm’s assets and liabilities

    b) the firm’s operating cash flows to random changes in exchange rates

    c) a) and b)

    d) none of the above

    Answer: c)

    Eun/Resnick 4e 109

Eun/Resnick 4e 110

10 Currency risk

    a) is the same as currency exposure

    b) represents random changes in exchange rates

    c) measure “what the firm has at risk”

    d) a) and b)

    Answer: b)

11 Suppose a U.S.-based MNC maintains a vacation home for employees in the British

    countryside and the local price of this property is always moving together with the pound price

    of the U.S. dollar. As a result,

    a) Whenever the pound depreciates against the dollar, the local currency price of this

    property goes up by the same proportion.

    b) The firm is not exposed to currency risk even if the pound-dollar exchange rate fluctuates

    randomly.

    c) a) and b)

    d) none of the above

    Answer: c)

12 The exposure coefficient in the regression is given by: PabSe;;?;

    Cov(,) PSba) Var()S

    b) PabSe;;?;

    c) a) and b)

    d) e

    Answer: a)

    Cov(,) PSb13 The exposure coefficient in the regression is: PabSe;;?;Var()S

    a) A measure of how a change in the exchange rate affects the dollar value of a firm’s assets.

    b) Has a value of zero if the value of the firm’s assets is perfectly correlated with changes in

    the exchange rate

    c) a) and b)

    d) none of the above

    Answer: a)

    14 The link between the home currency value of a firm’s assets and liabilities and exchange rate

    fluctuations is:

    a) Asset exposure

    b) Operating exposure

    c) a) and b)

    d) none of the above

    Answer: a)

    15 The link between a firm’s future operating cash flows and exchange rate fluctuations is:

    a) Asset exposure

    b) Operating exposure

    c) a) and b)

    d) none of the above

    Answer: b)

    Eun/Resnick 4e 111

Operating Exposure: Definition

16 Operating exposure can be defined as:

    a) the future home currency values of the firm’s assets and liabilities

    b) the extent to which the firm’s operating cash flows would be affected by random changes

    in exchange rates

    c) the sensitivity of realized domestic currency values of the firm’s contractual cash flows

    denominated in foreign currencies to unexpected exchange rate changes

    d) the potential that the firm’s consolidated financial statement can be affected by changes in

    exchange rates

    Answer: b)

    17 The variability of the dollar value of an asset (invested overseas) depends on:

    a) the variability of the dollar value of the asset that is related to random changes in the

    exchange rate

    b) the dollar value variability that is independent of exchange rate movements

    c) a and b

    d) none of the above

    Answer: c)

    18 Consider a U.S. MNC who owns a foreign asset. If the foreign currency value of the asset is

    inversely related to changes in the dollar-foreign currency exchange rate:

    a) the company has a built-in hedge

    b) the dollar value variability that is independent of exchange rate movements

    c) a and b

    d) none of the above

    Answer: c)

    Eun/Resnick 4e 112

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FOUR QUESTIONS

    A U.S. firm holds an asset in Great Britain and faces the following scenario:

     State 1 State 2 State 3

    Probability 25% 50% 25%

    Spot rate $2.20/? $2.00/? $1.80/? *P ?2,000 ?2,500 ?3,000

    P $4,400 $5,000 $5,400

     where, *P = Pound sterling price of the asset held by the U.S. firm

    P = dollar price of the same asset

19 The expected value of the investment in U.S. dollars is:

    a) $4,950

    b) $3,700

    c) $2,112.50

    d) none of the above

    Answer: b)

    Rationale:

    E(P) = 0.25 × $4,400 + 0.50 × $5,000 + 0.25 × $5,400 = $4,950

    20 The variance of the exchange rate is:

    a) 0.00200

    b) 0.10

    c) 0.01

    d) none of the above

    Answer: a)

    Rationale:

    E(S) = 0.25 × $2.20 + 0.50 × $2.00 + 0.25 × $1.80 = $.55 + $1 + $.45 = $2.00 222 VAR(S) = 0.25($2.20 $2.00) + 0.50($2.00 $2.00) + 0.25($1.80 $2.00)= 0.001 + 0 +

    0.001

     = 0.002

21 The “exposure” (i.e. the regression coefficient beta) is:

    Cov(,) PSHint: Calculate the expression Var()S

    a) 25,000

    b) 25,000

    c) 25

    d) none of the above

    Answer: a)

    Rationale:

    Cov(P,S)

    = 0.25×($4,400 $4,950) × ($2.20 $2.00)

    + 0.50× ($5,000 $4,950) × ($2.00 $2.00) + 0.25($5,400 $4,950) ($1.80 $2.00)

     = 27.50 + 0 22.50

     = 50

     b = 50/0.002

    Eun/Resnick 4e 113

     = 25,000

    22 Which of the following conclusions are correct?

    a) most of the volatility of the dollar value of the British asset can be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 236,717 ($) and 493,751 ($)

    respectively

    b) most of the volatility of the dollar value of the British asset can not be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 236,717 ($) and 493,751 ($)

    respectively

    c) most of the volatility of the dollar value of the British asset can NOT be removed by 22hedging exchange risk because b[Var(S)] and Var(e) are 1,250,000 ($) and 1,122,500 2($) respectively

    d) most of the volatility of the dollar value of the British asset can be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 1,250,000 ($) and 1,122,500 ($)

    respectively

    Answer: c)

    Rationale:

    E(P) = 0.25 × $4,400 + 0.50 × $5,000 + 0.25 × $5,400

     = $4,950

     222Var(P) = 0.25($4,400 $4,950) + 0.50($5000 $4,950) + 0.25($5,400 $4,950)

     = 75,625 + 1,250 + 50,625 2 = 127,500 ($)

    From the results to earlier questions we have the values: V(S) = 0.002

     b = 25,000

    Therefore, using the Equation 9.2, we obtain

     2V(P) = b Var(S) + Var(e) 2127,500 = (25,000) × 0.002 + Var(e)

    Var(e) = 127,500 1,250,000 2 = 1,122,500 ($)

     2The expression “b Var(S)” represents the volatility of the dollar value of the asset that is related to

    random changes in the exchange rate. The expression “Var(e)” is the volatility in the dollar value of the asset that is independent of exchange rate movements. Notice that there’s a built in hedge in

    this example, when the exchange rate is down, the ?-denominated value of the asset is up and vice-

    versa.

    Eun/Resnick 4e 114

USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FOUR QUESTIONS

    A U.S. firm holds an asset in Israel and faces the following scenario:

     State 1 State 2 State 3

    Probability 25% 50% 25%

    Spot rate $0.30/IS $0.20/IS $0.15/IS *P IS2,000 IS5,000 IS3,000

    P $3,000 $2,500 $750

     where, *P = Israeli shekel (IS) price of the asset held by the U.S. firm

    P = dollar price of the same asset

    23 The expected value of the investment in U.S. dollars is:

    a) $2,083.33

    b) $2,187.50

    c) $6,250.00

    d) $6,562.50

    Answer: b)

    Rationale:

    E(P) = 0.25 × $3,000 + 0.50 × $2,500 + 0.25 × $750

     = $2,187.50

    24 The variance of the exchange rate is:

    a) 0.001968

    b) 0.002968

    c) 0.003968

    d) 0.004968

    Answer: b)

    Rationale:

    E(S) = 0.25 × $0.30 + 0.50 × $0.20 + 0.25 × $0.15

     = $0.0750 + $0.1000 + $0.0375

     = $0.2125 222VAR(S) = 0.25($0.30 $0.2125) + 0.50($0.20 $0.2125) + 0.25($0.15 $0.2125)

     = 0.001914 + 0.000078 + 0.000976

     = 0.002968

    25 The “exposure” (i.e. the regression coefficient beta) is:

    Cov(,) PSHint: Calculate the expression Var()S

    a) 128.98

    b) 1,289.80

    c) 12,898.00

    d) none of the above

    Answer: c)

    Rationale: Cov(P,S) = 0.25×($3,000.00 $2,187.50) × ($0.30 $0.2125)

    + 0.50× ($2,500.00 $2,187.50) × ($0.20 $0.2125) + 0.25($750.00 $2,187.50)($0.15 $0.2125)

     = 17.7734 1.9531 + 22.4609 = 38.2813

    Cov(,) PS b = = 38.2813/0.002968 = 12,898 Var()S

    Eun/Resnick 4e 115

26 Which of the following conclusions are correct?

    a) most of the volatility of the dollar value of the Israeli asset can be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 236,717 ($) and 493,751 ($)

    respectively

    b) most of the volatility of the dollar value of the Israeli asset can not be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 236,717 ($) and 493,751 ($)

    respectively

    c) most of the volatility of the dollar value of the Israeli asset can not be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 493,751 ($) and 236,717 ($),

    respectively

    d) most of the volatility of the dollar value of the Israeli asset can be removed by hedging 222exchange risk because b[Var(S)] and Var(e) are 493,751 ($) and 236,717 ($)

    respectively

    Answer: d)

    Rationale: 222Var(P) = 0.25($3,000.00 $2,187.50) + 0.50($2,500.00 $2,187.50) + 0.25($750.00 $2,187.50)

     = 165,039 + 48,828 + 516,601 2 = 730,468 ($)

From the results to earlier questions we have the values:

    V(S) = 0.002968

     b = 12,898

    Therefore, using the Equation 9.2, we obtain

     2 V(P) = b Var(S) + Var(e) 2730,468 = (12,898) × 0.002968 + Var(e)

     Var(e) = 730,468 493,751 2 = 236,717 ($)

     2The expression “b Var(S)” represents the volatility of the dollar value of the asset that is related to

    random changes in the exchange rate. The expression “Var(e)” is the volatility in the dollar value of the asset that is independent of exchange rate movements.

Illustration of Operating Exposure

27 Consider a U.S.-based MNC with a wholly-owned Italian subsidiary. Following a depreciation

    of the dollar against the euro, which of the following conclusions are correct?

    a) The cash flow in euro could be altered due an alteration in the firm’s competitive position

    in the marketplace.

    b) A given operating cash flow in euro will be converted to a higher U.S. dollar cash flow.

    c) Answers a) and b)

    d) None of the above

    Answer: c)

Eun/Resnick 4e 116

    28 Consider a U.S.-based MNC with a wholly-owned Italian subsidiary. Following a depreciation

    of the dollar against the euro, which of the following describes the competitive effect of the

    depreciation?

    a) The cash flow in euro could be altered due an alteration in the firm’s competitive position

    in the marketplace.

    b) A given operating cash flow in euro will be translated to a higher U.S. dollar cash flow.

    c) Answers a) and b)

    d) None of the above

    Answer: a)

    29 Consider a U.S.-based MNC with a wholly-owned German subsidiary. Following a

    depreciation of the dollar against the euro, which of the following describes the conversion

    effect of the depreciation?

    a) The cash flow in euro could be altered due an alteration in the firm’s competitive position

    in the marketplace.

    b) A given operating cash flow in euro will be translated to a higher U.S. dollar cash flow.

    c) Answers a) and b)

    d) None of the above

    Answer: b)

    30 Consider a U.S.-based MNC with a wholly-owned French subsidiary. Following a depreciation

    of the dollar against the euro, which of the following best describes the mechanism of any

    effect of the depreciation?

    a) The change in the cash flow in euro due an alteration in the firm’s competitive position in

    the marketplace is in part a function of the elasticity of demand for the firm’s product.

    b) A given operating cash flow in euro will be translated to a higher U.S. dollar cash flow

    regardless of the firm’s hedging program.

    c) Answers a) and b)

    d) None of the above

    Answer: a)

Determinants of Operating Exposure

    31 Consider a U.S.-based MNC with a wholly-owned European subsidiary selling a product

    sourced in euro and priced in euro with inelastic demand. Following a depreciation of the dollar

    against the euro, which of the following is the most true?

    a) Since they have inelastic demand, the U.S. firm can just pass through the impact of the

    exchange rate change

    b) Since they have elastic demand, the U.S. firm cannot just pass through the impact of the

    exchange rate change

    c) Since the exchange rate movement was favorable to the U.S. firm, there is no impact on

    the firm’s position

    d) None of the above

    Answer: d)

Eun/Resnick 4e 117

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