Selected Questions Chapter 11

Questions 1. Please answer the following questions. a. Define exposure, differentiating between accounting and economic exposure. What role does inflation play?

Answer. Accounting exposure Economic exposure Nominal exchange rate changes affect the home currency value of the transaction exposure component of economic exposure because these cash flows are fixed. But only real exchange rate changes‑‑inflation‑adjusted currency changes‑‑affect the firm's future sales revenues and costs, its operating cash flows.

b. Describe at least three circumstances under which economic exposure is likely to exist.

Answer. Circumstances in which a firm faces economic exposure include when the firm: 1. has entered into sales or purchase contracts denominated­ in a foreign currency. 2. is selling or buying abroad or it faces domestic competition from imports and the real exchange rate changes.

3. is operating in a foreign country whose government taxes nominal rather than real income.

c. Of what relevance are the international Fisher effect and purchasing power parity to your answers to parts a and b?

Answer. If PPP holds exactly, then the second situation involving exchange risk–a change in the real exchange rate–can never occur. Similarly, if the international Fisher effect holds continually, firms face no exposure on foreign currency‑denominated transactions.

In both cases, gains or losses on exchange rate changes are always offset, either by losses or gains due to offsetting changes in price levels or by price adjustments that reflect expected change rate changes.

e. Under what circumstances might multinational firms be less subject to exchange risk than purely domestic firms in the same industry? Myth: Multinational firms are more subject to exchange risk than are domestic companies?

Contrary to conventional wisdom, the MNC may be subject to less exchange risk than an exporter, given the MNC's greater ability to adjust its marketing and production operations on a global basis.

3. What marketing and production techniques can firms initiate to cope with exchange risk?

Answer. Market selection and market segmentation provide the basic parameters within which a company may adjust its marketing mix over time. Short‑term tactical responses include adjustments of pricing, promotional, and credit policies.

Product sourcing and plant location are the principal variables companies manipulate to manage competitive risks that can't be dealt with through marketing changes alone.

This could include building plants overseas, buying more components overseas, allocating production among plants in line with their changing relative costs, and designing new facilities to provide added flexibility in making substitutions among various sources of goods so as to be better able to respond to relative price differences among domestic and imported inputs.

4. What is the role of finance in protecting against exchange risk?

Answer. The role of financial management is to structure the firm's liabilities in such a way that, during the time strategic operational adjustments are underway, the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities. For example, a company that has developed a sizable export market should hold a portion of its liabilities in the currency of that country.

In this way, any shortfall in operating cash flows due to an exchange rate change will be offset by a reduction in the debt service expenses.