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Chapter 09 - The Foreign Exchange Market

The Foreign Exchange Market Chapter Outline OPENING CASE: Hyundai and Kia Face a Strong Won INTRODUCTION THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET Currency Conversion Insuring Against Foreign Exchange Risk Management Focus: Volkswagen’s Hedging Strategy THE NATURE OF THE FOREIGN EXCHANGE MARKET ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION Prices and Exchange Rates Interest Rates and Exchange Rates Investor Psychology and Bandwagon Effects Country Focus: Anatomy of a Currency Crisis Summary EXCHANGE RATE FORECASTING The Efficient Market School The Inefficient Market School Approaches to Forecasting CURRENCY CONVERTIBILITY FOCUS ON MANAGERIAL IMPLICATIONS Transaction Exposure Translation Exposure Economic Exposure Reducing Translation and Transaction Exposure Reducing Economic Exposure Management Focus: Dealing with the Rising Euro Other Steps for Managing Foreign Exchange Risk

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SUMMARY CRITICAL THINKING AND DISCUSSION QUESTIONS CLOSING CASE: The Curse of the Strong Dollar at ST Micro

Learning Objectives 1. Be conversant with the functions of the foreign exchange market. 2. Understand what is meant by spot exchange rates. 3. Appreciate the role that forward exchange rates play in insuring against foreign exchange risk. 4. Understand the different theories explaining how currency exchange rates are determined and their relative merits. 5. Be familiar with the merits of different approaches toward exchange rate forecasting. 6. Understand the differences between translation, transaction and economic exposure, and what managers can do to manage each type of exposure.

Chapter Summary This chapter focuses on the foreign exchange market. At the outset, the chapter explains how the foreign exchange market works. Included in this discussion is an explanation of the difference between spot exchange rates and forward exchange rates. The nature of the foreign exchange market is discussed, including an examination of the forces that determine exchange rates. In addition, the author provides a discussion of the degree to which it is possible to predict exchange rate movements. Other topics discussed in the chapter include exchange rate forecasting, currency convertibility, and the implications of exchange rate movements on business. Finally, the chapter concludes with a discussion of the implications of exchange rates for businesses. For instance, it is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Adverse changes in exchange rates can make apparently profitable deals unprofitable.

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Opening Case: Hyundai and Kia Face a Strong Won Summary The opening case explores the effect of changing exchange rates on the profits of two Korean automakers, Hyundai and Kia. Both companies are trying to expand their presence in the United States using a low cost pricing strategy. In doing so, the South Korean automakers reduce their margin per car, and so, are even more affected than other automakers by a weak dollar. To minimize the effects of a weak dollar, Hyundai and its affiliate Kia have both recently changed their strategy to include production in the United States. Discussion of the case can revolve around the following questions: Suggested Discussion Questions QUESTION 1: How do Hyundai and Kia use exchange rates in their daily activities? How did the weak dollar affect the profits of the two companies between 2005 and 2007? ANSWER: Hyundai and Kia are both South Korean companies that rely on the U.S. market for a significant share of their revenues. Each time the companies sell vehicles in the United States for dollars, the dollars must be converted to the South Korean currency, the won. In 2005, one U.S. dollar bought 1,050 won. By late 2007, the exchange rate had changed and one U.S. dollar bought just 918 won. The falling dollar meant lower profits for the two exporters. QUESTION 2: How can Hyundai and Kia limit the negative effects of exchange rates? Should the two companies continue to move away from exporting toward more production in the United States? Why or why not? ANSWER: Hyundai and Kia were particularly vulnerable to the weak U.S. dollar because of their reliance on exports. Production of the companies’ vehicles took place in South Korea, the cars were shipped to the United States, sold in U.S. dollars which were then converted back to won. In 2007, the won reached a 10 year high against the U.S. dollar. Even though unit sales were rising for the companies, their profits actually fell. By shifting some production to the United States, the two companies can limit their exposure to the weak dollar. Teaching Tip: To learn more about Hyundai and Kia, go to {http://www.kia.com/info.php} and {http://www.hyundaiusa.com/abouthyundai/overview/overview.aspx}. Lecture Note: To extend this case, explore how other Korean companies have benefited from a strong won. See {http://www.businessweek.com/globalbiz/content/mar2008/gb20080328_528490.htm? chan=search} and {http://www.businessweek.com/globalbiz/content/aug2007/gb20070820_297543.htm? chan=search}.

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Chapter Outline with Lecture Notes, Video Notes, and Teaching Tips INTRODUCTION A) This chapter has three main objectives. The first objective is to explain how the foreign exchange market works. The second objective is to examine the forces that determine exchange rates and to discuss the degree to which it is possible to predict exchange rate movements. The third objective is to map the implications for international business of exchange rate movements and the foreign exchange market. B) The foreign exchange market is a market for converting the currency of one country into that of another country. C) The exchange rate is the rate at which one currency is converted into another. D) Dealing in multiple currencies is a requirement of doing business internationally. Therefore, it is important to understand the risks involved and how varying exchange rates affect the attractiveness of different investments and deals over time. Firms can use the foreign exchange market to hedge the risk of adverse exchange rate changes, but doing so can prevent firms from benefiting from favorable changes. THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET A) The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates). Currency Conversion B) International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign currencies. Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country’s currency. Third, international businesses use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. Finally, currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Teaching Tip: XE.com {http://www.xe.com/} provides a real time currency cross-rate chart, and an option to do currency conversions.

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Insuring Against Foreign Exchange Risk C) A second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates, or foreign exchange risk. Spot Exchange Rates D) The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Spot rates change continually, and are determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. Forward Exchange Rates E) A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. A forward exchange rate occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. F) Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future. Management Focus: Volkswagen’s Hedging Strategy Summary This feature examines the effects of Volkswagen’s decision to not properly hedge its foreign exchange exposure in 2003. Volkswagen saw a 95 percent drop in its fourth quarter profits after an unexpected surge in the value of the euro left the company with losses of $1.5 billion. Traditionally, Volkswagen, which produced its vehicles in Germany and exported them to the United States, hedged some 70 percent of its foreign exchange exposure. However, in 2003, the company made the unfortunate decision to hedge just 30 percent of its exposure. Discussion of the feature can begin with the following questions:

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Suggested Discussion Questions 1. Explain how Volkswagen’s failure to fully protect itself against foreign exchange fluctuations had a negative effect on the company. What can Volkswagen and other companies learn from this experience? Discussion Points: Traditionally, Volkswagen hedged 70 percent of its foreign exchange exposure, but in 2003, the company was caught off guard by a sudden rise in the value of the euro against the dollar. Experts had failed to predict the rise in the euro, and Volkswagen, like other companies that failed to hedge their foreign exchange exposure, was hard hit. Volkswagen lost some €1.2 billion as a result of its decision to hedge just 30 percent of its foreign exchange exposure. Most students will recognize that the experiences of Volkswagen underscores the volatility of the foreign exchange market and the need for companies to take steps to protect themselves even if there are no anticipated changes in currency values. 2. Volkswagen saw its fourth quarter 2003 profits tumble 95 percent after losing €1.2 billion in currency losses after the euro rose relative to the U.S. dollar. Why was Volkswagen so vulnerable to the change in the value of the euro relative to the U.S. dollar? Discussion Points: Volkswagen was especially vulnerable to the rise of the euro against the U.S. dollar in 2003 because the company manufactured its cars in Germany and then exported them to the United States. When Volkswagen failed to adequately hedge its exposure to foreign exchange rate changes, and the euro-dollar relationship shifted, the company lost out. Most students will probably recognize that had Volkswagen produced some of its cars in the United States, the effects of the currency shift would have been much smaller. Teaching Tip: To learn more about Volkswagen, go to {http://www.volkswagen.com/vwcms_publish/vwcms/master_public/virtualmaster/en2/unternehm en/Weltweit.metanav.html}. Lecture Note: To extend this case, consider discussing Volkswagen’s recent challenge of whether, given the dollar’s value, to sell its popular Scirocco in the United States. Go to {http://www.businessweek.com/globalbiz/content/mar2008/gb20080310_608242.htm? chan=search}. Currency Swaps G) A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk.

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THE NATURE OF THE FOREIGN EXCHANGE MARKET A) The foreign exchange market is not located in any one place. Rather, it is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. The most important trading centers are London, New York, Zurich, Tokyo, and Singapore. Two significant features of the market are (1) it never sleeps, and (2) high-speed computer linkages between trading centers around the globe have effectively created a single market. B) The exchange rates quoted worldwide are basically the same. If different U.S. dollar/Japanese yen rates were being offered in New York and Tokyo, there would be an opportunity for arbitrage and the gap would close. An illustrative example can be done showing how someone could make money through arbitrage (buying a currency low and selling it high), and how this would affect the supply and demand for the currencies in both markets to close the gap. C) The U.S. dollar frequently serves as a vehicle currency to facilitate the exchange of two other currencies. ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION: A) At the most basic level, exchange rates are determined by the demand and supply for different currencies. Most economic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a country’s currency: the country’s price inflation, the country’s interest rate, and market psychology. Prices and Exchange Rates B) To understand how prices are linked to exchange rates, it is important to understand the law of one price. The Law of One Price C) The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. Purchasing Power Parity D) If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. A less extreme version of the PPP theory states that given relatively efficient markets – that is, markets in which few impediments to international trade and investment exist – the price of a “basket of goods” should be roughly equivalent in each country.

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Lecture Note: The Economist informally tests this theory every year using its “Big Mac Index.” To see the most recent example, go to {http://www.economist.com/markets/Bigmac/Index.cfm}. Money Supply and Price Inflation E) There is a positive relationship between the inflation rate and the level of money supply. When the growth in a country’s money supply is greater than the growth in its output, inflation will occur. A country with a high inflation rate will see a depreciation in its currency. F) Simply put, PPP suggests that changes in relative prices between countries will lead to exchange rate changes. The empirical tests suggest that this relationship does not hold in the long run, but not in the short run. While PPP assumes no transportation costs or barriers to trade and investment, it also assumes that governments do not intervene to affect their exchange rates – a topic for the next chapter. Empirical Tests of PPP Theory G) Extensive empirical testing of the PPP theory has not shown it to be completely accurate in estimating exchange rate changes. Interest Rates and Exchange Rates H) Interest rates also affect exchange rates. The Fisher Effect says that a country’s nominal interest rate (i) is the sum of the required real rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). i=r+I I) The International Fisher Effect states that for any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two countries. Stated more formally: (S1 - S2) / S2 x 100 = i $ - i ¥ where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the U.S. and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period. J) While interest rate differentials suggest future exchange rates, this appears to hold in the long run but not necessarily in the short run. Video Note: The iGlobe Bernanke: U.S. Economy Faces ‘Sluggish’ Growth Outlook explores the relationship between inflation, interest rates, and the U.S. dollar, and fits in well with this discussion.

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Investor Psychology and Bandwagon Effects K) Investor psychology and bandwagon effects can also influence exchange rate movements. Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can joint the bandwagon and move exchange rates based on group expectations. This is known as the bandwagon effect. While such changes can be important in explaining some short-term exchange rate movements, they are very difficult to predict. At times governmental intervention can prevent the bandwagon from starting, but at other times it is ineffective and only encourages traders. Country Focus: Anatomy of a Currency Crisis Summary This feature describes South Korea’s 1997 financial crisis. In the space of a few months Korea saw its economy and currency move from prosperity to critical lows. Much of the blame for Korea’s financial collapse can be placed with the country’s chaebol (large industrial conglomerates) that had built up massive debts as they invested in new factories. Speculators, concerned about the chaebol’s ability to repay their debts, began to withdraw money from the Korean Stock and Bond markets fueling a depreciation in the Korean Won. Despite government efforts to halt the fall in the currency, the won fell some 67% relative to the dollar. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. Discuss investor psychology and bandwagon effects and their role in accelerating Korea’s difficulties. Discussion Points: Studies show that the role of psychological factors is an important element in the strategies of currency traders. Moreover, expectations about the future of exchange rates tend to become self-fulfilling prophecies. When traders start to anticipate similar movements, the bandwagon effect of many traders all coming to the same conclusion actually has the effect of making speculation reality. Students will probably suggest that this appears to have contributed to South Korea’s situation where currency values fell very rapidly after foreign investors became alarmed when issues arose regarding the ability of South Korean companies to service their debt. 2. As a CEO of an American company, how does Korea’s situation affect your operations? Discussion Points: The situation in South Korea increased the risk for any company doing business with the nation. However, students should recognize that the effect on an American company depends on the company situation itself. For some companies, exports to South Korea may dry up if the South Korean buyer no longer exists or has significantly lower demand. However, for other companies exporting to South Korea, or actually operating in the country, the situation may actually increase opportunities as business that was formerly conducted by South Korean companies becomes available.

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3. In your opinion, did the Korean government take the right steps to ease the crisis? Explain your response. Discussion Points: Some students will probably claim that the Korean government made its first mistake in the early 1990s when it encouraged the country’s chaebol to increase capacity in expectation of greater exports. The chaebol borrowed heavily, and when demand did not materialize, were stuck with excess capacity, falling prices, and debt. Some students will probably argue that the South Korean government did not act quickly enough to half the drop in the won, and then began to make desperation moves without really anticipating the reaction of investors. Summary L) Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. Consequently, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates. EXCHANGE RATE FORECASTING A) A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid decision-making. Two schools of thought address this issue. One school, the efficient market school, argues that forward exchange rate do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services. The Efficient Market School B) Many economists believe the foreign exchange market is efficient at setting forward rates. An efficient market is one in which prices reflect all available information. There have been a large number of empirical tests of the efficient market hypothesis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services), some recent studies have challenged it. The Inefficient Market School C) An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates. If this is true, it may be worthwhile for international businesses to invest in forecasting services (and many do).

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Approaches to Forecasting D) Two approaches to forecasting exchange rates are fundamental analysis and technical analysis. Fundamental Analysis. E) Forecasters that use fundamental analysis draw upon economic theories to predict future exchange rates, including factors like interest rates, monetary policy, inflation rates, or balance of payments information. Technical Analysis F) Forecasters that use technical analysis typically chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves. CURRENCY CONVERTIBILITY A) Many currencies are not freely convertible into other currencies. A currency is said to be freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency. B) A currency is said to be externally convertible when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way. A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency. C) Free convertibility is the norm in the world today, although many countries impose some restrictions on the amount of money that can be converted. The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight (when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency). D) Countertrade refers to a range of barter like agreements by which goods and services can be traded for other goods and services. It can be used in international trade when a country’s currency is nonconvertible. Teaching Tip: The American Countertrade Association {http://www.globaloffset.org/}maintains a web site with information for those interested in countertrade. IMPLICATIONS FOR MANAGERS A) First, it is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Foreign exchange risk can be divided into three main categories: transaction exposure, translation exposure, and economic exposure.

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Transaction Exposure B) Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Translation Exposure C) Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is basically concerned with the present measurement of past events. Management Focus: Dealing with the Rising Euro Summary This feature describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper. Both companies supplied DaimlerChrysler with parts, however, SMS Elotherm, which manufactured its parts in Germany was hit hard by the dollar’s slide relative to the euro in the early 2000s. Keiper, which had opened a plant in Canada, was able to avoid the negative effects of the currency swing to a large extent. Discussion of the feature can revolve around the following questions: Suggested Discussion Questions 1. Could SMS Elotherm have taken steps to avoid the position it now found itself in? What were those steps? Why do you think the company did not take these steps? Discussion Points: SMS Elotherm signed a deal in late 2004, to sell parts to DaimlerChrsyler. The company anticipated making about €30,000 profit on each part. However, within days, the anticipated profit was just €22,000. SMS Elotherm, which had priced its parts in dollars, but had its costs in euros, faced transaction exposure. The company could have done several things to limit its exposure to exchange rates. One of the easiest strategies would have involved entering forward contracts to buy euros with the dollars it would receive from DaimlerChrysler. The company could have followed a similar strategy with options to buy euros. A more involved strategy would have been to diversify its manufacturing so costs were spread across more than one currency. Finally, the company might have negotiated a deal with DaimlerChrysler to price some of its sales in dollars and others in euros. 2. Why was Keiper weathering the rise in the euro better than SMS Elotherm? Discussion Points: Keiper was able to limit its exposure to the sudden shift in exchange rates because it had opened a plant in Canada where its parts were being made. While the company still encountered exchange rate exposure, because its costs were in Canadian dollars and its profits were in U.S. dollars, its exposure was not as great.

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3. In retrospect, what might Keiper have done differently to improve the value of its “real hedge” against a rise in the value of the euro? Discussion Points: Keiper’s decision to produce its parts in Canada proved to be a good one. However, Keiper, like SMS Elotherm, could have further limited its exposure to exchange rate changes by using forward contracts and options to hedge its profits in U.S. and Canadian dollars. Video Note: The iGlobe Dollar’s Falling Value Ripples through U.S. Economy examines how various U.S. companies are dealing with the falling dollar. The iGlobe provides an opportunity to extend the discussion of this feature, and also the Implications for Managers section. Economic Exposure D) Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs. Reducing Translation and Transaction Exposure E) In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements). F) A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Lead and lag strategies can be difficult to implement. Reducing Economic Exposure G) The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates. In general, reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce.

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Other Steps for Managing Foreign Exchange Risk H) To manage foreign exchange risk: (a) central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies; (b) firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand; (c) the need to forecast future exchange rates cannot be overstated; (d) firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position; (e) the firm should produce monthly foreign exchange exposure reports.

Critical Thinking and Discussion Questions 1. The interest rate on South Korean government securities with one-year maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The interest rate on U.S. government securities with one-year maturity is 7 percent and the expected rate of inflation is 5 percent. The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer. Answer: From the Fisher effect, we know that the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165. 2. Two countries, Britain and the US produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound. (a) According to PPP theory, what should the $/£ spot exchange rate be? (b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What should be the one year forward $/£ exchange rate? (c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10 percent, what would you expect current interest rate to be in Britain? Answer: (a) According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£. (b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or .67$/£. (c) Since the dollar is appreciating relative to the pound, and given the relationship of the international fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.

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3. Reread the Management Focus feature on Volkswagen in this chapter, then answer the following questions: a) Why do you think management at Volkswagen decided to hedge only 30 percent of their foreign currency exposure in 2003? What would have happened if they had hedged 70 percent of their exposure? b) Why do you think the value of the U.S. dollar declined against that of the Euro in 2003? c) Apart from hedging through the foreign exchange market, what else can Volkswagen do to reduce its exposure to future declines in the value of the U.S. dollar against the euro? Answer: a) When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure in 2003, the company essentially gambled that the euro would decline in value relative to the dollar. The company hoped that by saving the cost of the commission involved in selling a currency forward, it would increase its profit margin. This strategy of course, backfired. b) The appreciation of the euro relative to the U.S. dollar took many people by surprise. The rise of the euro has been attributed to record U.S. foreign trade deficits and pessimism about the future value of the dollar. c) In addition to using forward contracts, Volkswagen could use currency swaps, and lead and lag payables and receivables. 4. You manufacture wine goblets. In mid June you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in mid December. You expect the yen to rise from its present rate of $1=¥130 to $1=¥100 by December. You can borrow yen at 6% per annum. What should you do? Answer: The simplest solution would be to just wait until December, take the ¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100. In this case you would have $4,000 in mid-December. If the current 180 day forward rate is lower than 100¥/$, then it would be preferable since it both locks in the rate at a better level and reduces risk. If the rate is above ¥100/$, then whether you choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion. There is a third possibility also. You could borrow money from a bank that you will pay back with the ¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4,000 - 2,987 = $1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk. What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be ¥100 = $1.

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5. You are CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take? Answer: This question deals with the risk faced by businesses related to changes in exchange rates. If the peso depreciates as expected peso relative to the dollar, the dollar value of the company’s Mexican subsidiary would decrease substantially. This would then reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet, raising the apparent leverage of the firm, which could increase the firm’s cost of borrowing and limit its access to the capital market. Most students will suggest that the company explore the use of forward contracts and swaps to protect itself from the currency movement for individual transactions. In addition, the company may want to engage in a lead strategy and collect its foreign receivables early.

Closing Case: The Curse of the Strong Dollar at STMicro Summary The closing case explores the effect of the strong dollar on STMicro, the world’s sixth largest manufacturer of semiconductor chips, a commodity that is priced in dollars in world markets. In the early 2000s, STMicro, which has 70 percent of its costs denominated in euros, benefited from the strong dollar/weak euro relationship. However, when the euro began to rise relative to the dollar in 2003, STMicro’s profits began to tumble. Discussion of the case can revolve around the following questions: Suggested Discussion Questions QUESTION 1: In retrospect, could the fall in the value of the dollar against the euro have been predicted in 2003? ANSWER 1: Since its introduction, the euro has been volatile relative to the U.S. dollar. Most analysts were surprised in 2003 by the rapid rise in value of the euro relative to the dollar. However, given that a key reason for the rise in value of the euro was the record U.S. foreign trade deficit which created an outward flow of dollars, and a lower value for the dollar, some might argue that the trend should have been expected.

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QUESTION 2: What was the fundamental reason for the decline in the value of the dollar against the euro in 2003-2006? To what extent is the decline in the value of the dollar consistent with the theories of exchange rate determination discussed in this chapter? ANSWER 2: Investor psychology probably played a role in the decline of the dollar versus the euro in 2003-2006. Foreigners were pessimistic after the U.S. government announced that a weak dollar was acceptable since it helped firms trying to export. In addition, the U.S. government’s record budget deficit contributed to the demise of the dollar relative to the euro. Many foreigners believed the United States would have to finance its spending through an expansion in the money supply, which would lead to inflation, and cause a drop in the value of the dollar. QUESTION 3: Why do you think that STMicro did very little currency hedging? Was this wise? ANSWER 3: Hindsight is 20/20. During the early years of the euro, STMicro enjoyed high profits thanks to the weak euro and strong dollar. When the market began to shift, STMicro was unprepared. When the dollar fell, STMicro saw a negative impact on its profits. In the “good” years, the company was able to save the costs of currency hedging, however these costs savings were wiped out by the losses associated with the weak dollar. QUESTION 4: What strategy is STMicro now adopting to deal with possible future fluctuations in exchange rates? Is this a smart strategy? ANSWER 4: To deal with possible future fluctuations in exchange rates, STMicro is actively cutting costs by closing some European operations and cutting jobs. In addition, the company is shifting some production to Asia with the idea of being able to switch production between Asia and Europe as the situation warrants. It is not clear whether the company intends to do any currency hedging, but it could complement STMicro’s other strategies. Teaching Tip: Students can further explore STMicro’s current situation by going to its web site at {http://www.st.com/stonline/company/index.htm}.

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Chapter 09 - The Foreign Exchange Market

Continuous Case Concept As the world’s automakers search around the globe for the best suppliers for their parts, and at the same time, focus on new markets such as China and India, controlling for changes in exchange rates becomes an important part of their financial strategies. •

Ask students to identify the types of exposure to foreign exchange rates auto makers are likely to encounter.

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Then, ask students to develop a plan for controlling for the exposure. Discuss why a company might choose one hedging strategy over another. Many European companies have been dealing with exposure to the weak dollar and have implemented various hedging strategies. For example, in 2008 BMW announced that job cuts could be implemented to offset the effects of a rising euro, and Volkswagen is planning to build a plant in a country with a currency that is pegged to the U.S. dollar.

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Finally, ask students to consider what exchange rates mean to companies that draw a significant percentage of their revenues from foreign countries. How do the strategies of these companies differ from those of companies that can rely on their domestic market for the majority of their sales?

This feature ties in well with the discussion of both the opening case and especially, the closing case, as well as with the Management Focus on Dealing with the Rising Euro, and Volkswagen’s Hedging Strategy. The case can be used to supplement the closing case, or to extend the discussion of these other features. This feature could also be expanded into a mini-case by asking students to identify companies that have reported losses or gains due to exchange rate movements, and then, exploring the strategic responses of the firms involved.

globalEDGE Exercises Use the globalEDGE Resource Desk {http://globalEDGE.msu.edu/ResourceDesk/} to complete the following exercises.

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Chapter 09 - The Foreign Exchange Market

Exercise 1 You are assigned the duty of ensuring the availability of 100 million Japanese Yen for a payment scheduled for tomorrow. Your company possesses only US Dollars, so identify a website that provides real-time exchange rates, and find the spot exchange rate for Japanese Yen. How many dollars do you have to spend to acquire the amount of Yen required? Answer: The currency exchange rates can be accessed via a variety of sources. A list of these sources is available http://globaledge.msu.edu/ResourceDesk/ and can be accessed by searching the term “real-time exchange rates”. One resource listed under this search is the FX Street, located under the globalEDGE category “Money: Finance”. This site offers daily updated information about foreign exchange markets as forex news, market reports, forecasts, and real-time exchange rates and charts. A currency converter and historical tables are also available. Search Phrase: “Real-time Exchange Rates” Resource Name: FX Street Website: http://www.fxstreet.com globalEDGE Category: “Money: Finance”

Exercise 2 Your company imports olive oil from Italy to sell in the U.S. The exchange rate fluctuations over the past year have had significant impact on your bottom line. In preparing an annual report for your company, you would like to include a one-year currency chart showing the movement of the U.S. Dollar versus the Euro. Describe the pattern you see. Over the past year, has the Dollar gained or lost ground versus the Euro? Answer: The currency chart can be accessed by searching for the phrase “currency chart” at http://globaledge.msu.edu/ResourceDesk/. “XE” is a resource that provides up-to-date exchange rates and additional tools about the foreign exchange market, including currency charts. It can also be found under the globalEDGE category “Reference: Standards and Conversions.” Once on the XE website, click on “Tools” and then on “Currency Charts”. A java chart will start up. Select the EUR/USD currency pair under “File  Change Symbol”. And, under “Time Scale & Period”, select “Daily” and then “1 Year”. You can get a copy of the chart by grabbing a screen shot. Search Phrase: “Currency Chart” Resource Name: XE: Currency and Foreign Exchange Website: http://www.xe.com/ globalEDGE Category: “Reference: Standards and Conversions”

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Chapter 09 - The Foreign Exchange Market

Additional Readings and Sources of Information Dollar Daze in Europe http://www.businessweek.com/magazine/content/08_13/b4077046387061.htm?chan=search The Dollar: A Bottom at Last? http://www.businessweek.com/investor/content/may2008/pi2008054_589791.htm?chan=search The Euro’s Rise: Don’t Expect a Rate Cut http://www.businessweek.com/investor/content/mar2008/pi20080312_418100.htm?chan=search The U.S. Dollar Still Going Down http://www.businessweek.com/investor/content/feb2008/pi20080228_325729.htm?chan=search Will a Strong Euro Tie the ECB’s Hands? http://www.businessweek.com/investor/content/jul2007/pi20070720_461391.htm?chan=search Behind the Dollar’s Woes http://www.businessweek.com/globalbiz/content/mar2008/gb20080314_939558.htm?chan=search Could Japan Shrug Off the Dollar’s Dive? http://www.businessweek.com/globalbiz/content/mar2008/gb20080319_180083.htm?chan=search

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