Universal

Universal Circuits, Inc.

The manager of international finance of a major U.S. electronics company is concerned about the exposure of the firm to changes in exchange rates. Of particular concern is the exposure of operations to changes in real exchange rates. The teaching objectives include: 1) understanding operating exposure and contractual exposure; 2) understanding the issues in estimating operating exposure; 3) understanding possible actions to neutralize operating exposure; and 4) assigning responsibility for the management of operating exposure. After receiving a telex from the Controller of the Irish plant, who is an integral employee at Universal Circuits, we had to make a tough decision regarding his request to hedge against the US dollar depreciating. If the US dollar depreciates, manufacturing would be shifted from his Irish plant to the US plants, which in turn would negatively affect his potential bonus. We acknowledge this risk, which would be incurred to him, but also cannot afford for him to hedge against the company’s interest as a whole. The company uses the Irish plant itself as Universal’s hedge against foreign exchange risk, shifting manufacturing accordingly in order to take advantage of the lower cost of production. What we decided on was to strike a balance between putting the exchange rate risk on our employees and our shareholders. We plan to continue to follow Mr. Kriesler strategy of selective hedging, while incorporating Pierre Bourquin’s idea of dynamic strategy to reduce our economic exposure. In order to keep the Irish plant controller’s exposure to exchange rate risk at a minimum, we would like to implement a monthly valuation process to respond to a fluctuation of company sales and exchange rates. What we are aiming to do is to guarantee the Irish plant controller a small bonus if the Punt appreciates against the dollar and the manufacturing is shifted from Irish to US plants. We want to put a limited hedge on his exchange rate risk he faces, as his bonus is tied to the Irish plant’s manufacturing performance. But, we do not want to fully hedge, and reverse our company’s original hedge using the Irish plant for manufacturing. Based on our equation in appendix #1, the bonus will fluctuate (on a monthly basis) as dependent on the change in exchange rates and change in monthly sales. The greater the fluctuation in exchange rates, the larger the bonus will

Abstract The manager of international finance of a major U.S. electronics company is concerned about the exposure of the firm to changes in exchange rates. Of particular concern is the exposure of operations to changes in real exchange rates. The teaching objectives include:

1) understanding operating exposure and contractual exposure;

2) understanding the issues in estimating operating exposure; 3) understanding possible actions to neutralize operating exposure; and 4) assigning responsibility for the management of operating exposure.

Question and Answer QUESTION #1

Does the Universal Circuits’ Irish controller have a convincing argument for the weakness of the dollar? Why or why not? How would you interpret the evidence? The controller of the Irish division does have a valid point when stating that the U.S. dollar is in a vulnerable position due to the fact that its trade deficit is currently in excess of $100 billion and growing. (see Exhibit 1). While Universal Circuits’ chief financial officer, Joe Merrill, is correct when stating that the dollar is in the middle of its twenty-year range, he never mentioned which countries currency he was comparing it to. When compared to the Irish punt, which the controller and the company have a vested interest in it is clear that over the last twenty years the dollar has been decreasing in value. When one analyzes the data given in Exhibit 1, it is quite clear that since 1960 when the Punt/Dollar ratio was 0.36 it has since gone to 0.42 in 1970, to 0.53 in 1980 and finally 1.01 in present day (1984). This data plainly shows that the value of the dollar has been steadily going down relative to that of the Punt.

Another part of Exhibit 1 that indicates that the increasing trade deficit is weakening the dollar, primarily when comparing it to the Irish Punt, is the Relative Industrial Prices section. This section of the exhibit shows how, once again, over the course of the 20 years in the study the price for industrial activities has gone up in Ireland relative to U.S.A. According to relative price theory the cost of a certain good should be equivalent in all currencies. In relative purchasing power parity, the exchange rate between the home and foreign currency should adjust to indicate changes in the price levels of the two countries. In this specific scenario if the theory were to hold true for the ratio to be behaving the way the value of the currency must be acting in an appropriate manner. Therefore as the dollar depreciates and the relative costs incurred to.

Discussion: Managing Foreign Currency Risk in Business. Real appreciation/depreciation of the Irish Punt, US Dollar, French Franc, Japanese Yen and Deutsche Mark The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency (Shapiro, 1999). This concept can be linked to the theory of Purchasing Power Parity (PPP), first introduced by Gustav Cassel in 1918 and defined as: e (home)/e (foreign) = p (home)/p (foreign) (formula 1) e = spot rate p = Inflation In absolute terms, it states that currencies should have the same purchasing power all over the world. Transportation costs, tariffs, quotas, restrictions and product differentiation are ignored though. The relative version of PPP states that the exchange rate between home and foreign currency will adjust to reflect changes in price levels of the two countries. So, if inflation in the US is 5% and 3% in the UK, then sterling must rise by 2% in order to equalise the dollar price of goods in the two countries. Vice versa, when calculating real appreciation or depreciation, it is necessary to adjust for inflation rates. Therefore, real appreciation or depreciation of a currency is that adjusted for inflation and is calculated using the following formula: e(real) = e(nominal)*[p(foreign)/p(home)] (formula 2) Similarly, the real interest rate must be adjusted to reflect inflation. The real interest rate, according to the Fisher effect, measures the exchange rate between current and future purchasing power. Together with (expected) inflation, it represents the nominal rate. This can be approximated by the equation r = a + i, where r is the nominal rate, i is the rate of inflation, and a is the real rate of interest. Based on these calculations, it clearly emerges that the US$ is overvalued by about 36% since the exchange rate differential is greater than the relative inflation between the USA and Ireland. We can thus assume that if PPP holds, the controller has a convincing argument with regards to his fears of the US$ weakening against the punt. But it is widely accepted that PPP generally does not hold for major currencies bought for investment purposes such as the US$, and that if it does hold, it will only do so over the long term (Shapiro, 1999).

2. Universal Circuits’ currency exposure.

Should the controller be concerned about the dollar’s exchange rate? Due to the US$ being the Irish’s subsidiary functional curr

1. Does Universal Circuit's Irish controller have a convincing argument for the weakness of the dollar? Why or why not? How do you interpret the evidence? The Irish controller certainly presented a very convincing argument. He argues that since the American trade deficit has been growing, the dollar will be likely to depreciate. From 1980 to 1984 the dollar appreciated against the punt by about 50% and interest rate averaged 12.6% during the same period. These high interest rates have caused the dollar to appreciate against other currencies and slowed down the high inflation rate (10% in 1981) during that same period of time. Irish controller’s main worry was that the dollar will be likely to depreciate. Over the last 2 years inflation has fallen to 5%, much lower than the 10% rate in 1981. A lower inflation rate could result in the US government lowering interest rates, which could cause the US dollar to decline. Increasing trading deficit, lower inflation, and lower interest rate signals a possible weakening dollar On the other there is a more optimistic view on the direction of the dollar. Despite the US worsening balance on current account, the US dollar will likely to appreciate in both nominal and real terms due to foreign capital inflows motivated by good performances in equity and real estate markets, high real interest rate, and long-run prospects for growth and profitability. In other words, despite its large trade deficit, the US is still seen as a safe and profitable market to invest. The point of the CFO of universal circuits is that no one really knows in which direction the dollar will go and therefore speculating on this issue was of no real interest to those in the manufacturing business. 2. In view of the fact that the dollar is the Irish subsidiary's functional currency, should the controller be worried about its exchange value? What is the nature of the foreign exchange exposures(s) faced by the Irish subsidiary? Why isn't the Does the Universal Circuits’ Irish controller have a convincing argument for the weakness of the dollar? Why or why not? How would you interpret the evidence? The controller of the Irish division does have a valid point when stating that the U.S. dollar is in a vulnerable position due to the fact that its trade deficit is currently in excess of $100 billion and growing. (see Exhibit 1). While Universal Circuits’ chief financial officer, Joe Merrill, is correct when stating that the dollar is in the middle of its twenty-year range, he never mentioned which countries currency he was comparing it to. When compared to the Irish punt, which the controller and the company have a vested interest in it is clear that over the last twenty years the dollar has been decreasing in value. When one analyzes the data given in Exhibit 1, it is quite clear that since 1960 when the Punt/Dollar ratio was 0.36 it has since gone to 0.42 in 1970, to 0.53 in 1980 and finally 1.01 in present day (1984). This data plainly shows that the value of the dollar has been steadily going down relative to that of the Punt.

Another part of Exhibit 1 that indicates that the increasing trade deficit is weakening the dollar, primarily when comparing it to the Irish Punt, is the Relative Industrial Prices section. This section of the exhibit

shows how, once again, over the course of the 20 years in the study the price for industrial activities has gone up in Ireland relative to U.S.A. According to relative price theory the cost of a certain good should be equivalent in all currencies. In relative purchasing power parity, the exchange rate between the home and foreign currency should adjust to indicate changes in the price levels of the two countries. In this specific scenario if the theory were to hold true for the ratio to be behaving the way the value of the currency must be acting in an appropriate manner. Therefore as the dollar depreciates and the.