Chapter 10

Measuring Exposure to Exchange Rate Fluctuations

Answers to End of Chapter Questions

1. Why would an MNC consider examining only its “net” cash flows in each currency when assessing
its transaction exposure?

ANSWER: Consideration of all cash flows in a particular currency is not necessary when some
inflows and outflows offset each other. Only net cash flows are necessary.

2. Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash
flows are as follows for the next year:

Current Exchange
Currency Total Inflow Total Outflow Rate in U.S. Dollars
Danish krone (DK) DK50,000,000 DK40,000,000 $.15
British pound (£) £2,000,000 £1,000,000 $1.50
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.

ANSWER: The net exposure to each currency in U.S. dollars is derived below:

Net Inflows in Current

Foreign Currency Foreign Currency Exchange Rate Value of Exposure
Danish krone (DK) +DK10,000,000 $.15 $1,500,000
British pound (£) +£1,000,000 $1.50 $1,500,000

The krone and pound values move in tandem against the dollar. Both the krone and the pound
exposure show positive net inflows. Thus, their exposure should be magnified if their exchange
rates against the U.S. dollar continue to be highly correlated.

3. 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.

ANSWER: Currency variability—low level is desirable.

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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.

4. Are currency correlations perfectly stable over time? What does your answer imply about using
past data on correlations as an indicator for the future?

ANSWER: No! Thus, past correlations will not serve as perfect forecasts of future correlations.
Yet, historical data may still be useful if the general ranking of correlations is somewhat stable.

5. 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?

ANSWER: 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.

7. How should appreciation of a firm’s home currency generally affect its cash inflows? Why?

ANSWER: It should reduce inflows since the foreign demand for the firm’s goods is reduced and
foreign competition is increased.

8. How should depreciation of a firm’s home currency generally affect its cash outflows? Why?

ANSWER: It should increase inflows since it will likely increase foreign demand for the firm’s
goods and reduce foreign competition.

9. Fischer Inc., exports products from Florida to Europe. It obtains supplies and borrows funds
locally. How would appreciation of the euro likely affect its net cash flows? Why?

ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should
experience a strong demand for its products when the euro has more purchasing power (can obtain
dollars at a low price).

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

ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers
may switch to foreign products if the local currency strengthens.

13.

a) Present an argument for why translation exposure is relevant to an MNC.

ANSWER: It affects consolidated financial statements, which are often used by shareholders to
assess the performance of the MNC.

b) Present an argument for why translation exposure is not relevant to an MNC.

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 113

ANSWER: It does not affect cash flow, since it simply reflects the impact of exchange rate
fluctuation on consolidated financial statements.

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

ANSWER: The greater the percentage of business conducted by subsidiaries, the greater is the
translation exposure. The greater the variability of each relevant foreign currency relative to the
headquarter’s home (reporting) currency, the greater is the translation exposure. The type of
accounting method employed can also affect translation exposure.

16. 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?

ANSWER: The consolidated earnings will be increased due to the strength of the subsidiaries’
local currency (the euro).

17. Consider a period in which the U.S. dollar strengthens against most foreign currencies. How will
this affect the reported earnings of a U.S.-based MNC with subsidiaries all over the world?

ANSWER: The consolidated earnings will be reduced due to the weakness of the subsidiaries’
local currencies.

18. Walt Disney World built an amusement park in France that opened in 1992. How do you think this
project has affected Disney’s overall economic exposure to exchange rate movements? Explain.

ANSWER: 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 French currency weakens
against the dollar, the revenue will be converted to fewer dollars.

However, keep in mind that Walt Disney was already affected by movements in the French franc
and other major currencies before this park was built. When major currencies weaken against the
dollar, foreign tourism decreases and Walt 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.

19. Using the following cost and revenue information shown for DeKalb, Inc., determine how the
costs, revenue, and earnings items 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.

Revenue and Cost Estimates: DeKalb Inc.

(in millions of U.S. dollars and New Zealand dollars)
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New Zealand
U.S. Business Business
Sales $800 NZ$800
Cost of Goods Sold 500 100
Gross Profit $300 NZ$700
Operating Expenses 300 0

Earnings Before Interest and Taxes $ 0 NZ$700

Interest Expense 100 0

Earnings Before Taxes –$100 NZ$700

ANSWER:
(Figures are in millions)

NZ$=$.50 NZ$=$.55 NZ$=$.60

Sales
U.S. $ 800 $ 800 $ 800
New Zealand NZ$800 = 400 NZ$800 = 440 NZ$800 = 480
Total $ 1,200 $ 1,240 $ 1,280

Cost of Goods Sold

U.S. $ 500 $ 500 $ 500
New Zealand NZ$100 = 50 NZ$100 = 55 NZ$100 = 60
Total $ 550 $ 555 $ 560

Gross profit $650 $685 $720

Operating expenses $300 $300 $300

EBIT $350 $385 $420

Interest expenses $100 $100 $100

Earnings after taxes $250 $285 $320

Chapter 10: Measuring Exposure to Exchange Rate Fluctuations 115

The preceding table shows that DeKalb Inc. is adversely affected by a weaker New Zealand
dollar value. This should not be surprising 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.

20. 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?

ANSWER: 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.

21. 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?

ANSWER: If the peso strengthens, Longhorn will incur higher expenses when paying for the
Philippine materials. Because its competition is not affected in a similar manner, Longhorn
Company is at a competitive disadvantage when the peso strengthens.

22. 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?

ANSWER: If the Brazilian real strengthens, U.S. retail stores will likely have to pay higher prices
for the furniture from Brazil, and may pass some or all of the higher cost on to customers.
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.

23. Sooner Co. is a U.S. wholesale company that imports expensive high-quality luggage and sells it to
retail stores around the United States. Its main competitors also import high-quality luggage and
sell it to retail stores. None of these competitors hedge their exposure to exchange rate
movements. The treasurer of Sooner Co. told the board of directors that the firm’s performance
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would be more volatile over time if it hedged its exchange rate exposure. How could a firm’s cash
flows be more stable as a result of such high exposure to exchange rate fluctuations?

ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the
competition when the dollar weakened (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.

24. 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?

ANSWER: If purchasing power parity exists, a stronger Canadian 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.