Pegging currency to gold and guaranteeing convertibility

This Lesson focuses on how companies choose to enter
foreign markets with their product or services. It is not as easy as it may appear from what you have learned so far in this course. Governments, culture, infrastructure such as electricity and roads, along with a trained work force are only a few of the considerations. This will also help you on your final paper!
Look at Chapters 09, 10, and 12 PowerPoint’s
Read: Chapters 09,10, and 12
(THESE CHAPTERS WILL BE VERY USEFUL IN YOUR FINAL PAPER TOO!!)
Then go to your business data bases and/ or current business or industry
news or articles and identify a company that is planning to launch their product or
services in any country. (such as a phone provider in another country, or a heavy equipment manufacturer, or perhaps a food or cosmetic line for example).
Once you have found a new product/ or service country
launch, you are to examine your article in terms of Chapters 09,10, and 12 and tie it into
at least 1 concepts learned in each of these 3 chapters. You are to cite and number each Chapter and the page numbers and concepts chosen and why you think they apply to your selection that you are focusing
on for your paper. Please be specific in how it applies (250-300 words for each of the 3 chapters).

As mentioned before, assignments in this on-line course also involve
interactions amongst the students in discussion boards each week where you are
to read and respond to at least 2 of your classmate’s posts which count as 10% of your grade for each assignment. This interaction is an important part of the course design which gives all of you the opportunity to see how all your classmates respond to the
same assignment so you can learn from one another…..your
opinions and civil divergent opinions are encouraged!

Introduction

Question: What is the foreign exchange market?

The foreign exchange market is a market for converting the currency of one country into that of another country
Question: What is the exchange rate?

The exchange rate is the rate at which one currency is converted into another
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The Functions of
the Foreign Exchange Market

Question: What is the purpose of the foreign exchange market?

The foreign exchange market
enables the conversion of the currency of one country into the currency of another

provides some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)

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Classroom Performance System

The rate at which one currency is converted into another is the

Exchange rate

Cross rate

Conversion rate

Foreign exchange market

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Classroom Performance System Answer: a

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Currency Conversion

International firms use foreign exchange markets

to convert export receipts, income received from foreign investments, or income received from licensing agreements
to pay a foreign company for products or services
to invest spare cash for short terms in money markets
for currency speculation (the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates)
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Internet Extra: To see real time currency conversions, go to XE.com {http://www.xe.com}.

Click on Quick Currency converter, and enter the currencies you want to convert.

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Insuring Against
Foreign Exchange Risk

The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm)
A firm that protects itself against foreign exchange risk is hedging
The market performs this function using
spot exchange rates

forward exchange rates

currency swaps

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Insuring Against
Foreign Exchange Risk

1. Spot Exchange Rates

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 are determined by the interaction between supply and demand, and so change continually
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Insuring Against
Foreign Exchange Risk

2. Forward Exchange Rates

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 is the exchange rate governing such a future transaction
Forward rates are typically quoted for 30, 90, or 180 days into the future
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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:

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/unternehmen/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}.

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Insuring Against
Foreign Exchange Risk

3. Currency Swaps

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
Swaps are used 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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Classroom Performance System

The rate at which a foreign exchange dealer converts one currency into another currency on a particular day is the

Currency swap rate

Forward rate

Specific rate

Spot rate

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Classroom Performance System Answer: d

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The Nature of the
Foreign Exchange Market

The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems
The market is always open somewhere in the world
If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage (the process of buying a currency low and selling it high)
Most transactions involve U.S. dollars on one side
The U.S. dollar is a vehicle currency
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Internet Extra: Companies can anticipate how currencies might move by following various economic and political indicators. To explore the effect of these indicators on exchange rates, go to {http://www.x-rates.com/}. Click on What Moves Rates.

Examine the effect of factors such as interest rates and geo-political tensions on exchange rates. What happens to a currency’s value of exchange rates or exports rise, or there is a threat of terrorism?

What factors should companies track to better predict what might happen to a currency’s value?

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Economic Theories of
Exchange Rate Determination

Question: What factors are important to future exchange rates?

Three factors that have an important impact on future exchange rate movements are
a country’s price inflation

a country’s interest rate

market psychology

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Prices and Exchange Rates

Question: How are prices related to exchange rate movements?

To understand how prices and exchange rates are linked, we need to understand the law of one price, and the theory of purchasing power parity
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Prices and Exchange Rates

The law of one price states that in competitive markets free of transportation costs and barriers to trade, 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 theory argues that given relatively efficient markets (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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Prices and Exchange Rates

PPP predicts that changes in relative prices will result in changes in exchange rates
When inflation is relatively high, a currency should depreciate
So, if we can predict inflation rates, we can predict how a currency’s value might change
The growth of a country’s money supply determines its likely future inflation rate
When the growth in the money supply is greater than the growth in output, inflation will occur
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Prices and Exchange Rates

Question: How well does PPP theory work?

Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run, but is relatively accurate in the long run
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Interest Rates and Exchange Rates

Question: How do interest rates affect exchange rates?

The Fisher Effect states 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 (l )
In other words, i = r + I
So, if the real interest rate is the same everywhere, any difference in interest rates between countries reflects differing expectations about inflation rates
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Interest Rates and Exchange Rates

The International Fisher Effect suggests 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 the two countries
In other words:
(S1 - S2) / S2 x 100 = i $ - i ¥

where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the US 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

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Investor Psychology and Bandwagon Effects

Question: How are exchange rates influences by investor psychology?

The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations
Governmental intervention can prevent the bandwagon from starting, but is not always effective
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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.

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.

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Summary

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates, but poor predictors of short term changes
So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates
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Classroom Performance System

All of the following impact future exchange rate movements except

A country’s price inflation

A country’s interest rate

A country’s arbitrage opportunities

Market psychology

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Classroom Performance System Answer: c

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Exchange Rate Forecasting

Question: Should companies invest in exchange rate forecasting services to help with decision-making?

The efficient market school argues that forward exchange rates are the best predictors of future spot exchange rates
Therefore, investing in forecasting services would be a waste of money
The inefficient market school argues that companies should invest in forecasting services
This school of thought does not believe that forward rates are the best predictor of future spot rates
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The Efficient Market School

An efficient market is one in which prices reflect all available information
If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates
Most empirical tests confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services, but some recent studies have challenged the theory
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The Inefficient Market School

An inefficient market is one in which prices do not reflect all available information
In an inefficient market, forward exchange rates are not the best predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting services
However, the track record of forecasting services is questionable
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Approaches to Forecasting

Question: How should exchange rate forecasts be prepared?

There are two approaches to exchange rate forecasting
fundamental analysis

technical analysis

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Approaches to Forecasting

1. Fundamental Analysis

Fundamental analysis draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates
2. Technical Analysis

Technical analysis focuses on trends and believes that past trends and waves are reasonable predictors of future trends and waves
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Currency Convertibility

Question: Are all currencies freely convertible?

A currency is freely convertible when both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency
A currency is externally convertible when only non-residents can convert their holdings of domestic currency into a foreign currency
A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
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Currency Convertibility

Question: Why do countries limit currency convertibility?

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).
In the case of a nonconvertible currency, firms may turn to countertrade (barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade
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Implications for Managers

Question: What does the foreign exchange market mean for international firms?

Firms must understand the influence of exchange rates on the profitability of trade and investment deals
This exchange rate risk can be divided into
Transaction exposure

Translation exposure

Economic exposure

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Transaction Exposure

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
It can lead to a real monetary loss
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Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company
it deals with the present measurement of past events
Gains and losses from translation exposure are reflected only on paper
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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.

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.

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Economic Exposure

Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates
It is concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs
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Reducing Translation
and Transaction Exposure

Question: How can firms minimize translation and transaction exposure?

Firms can
buying forward
using swaps
leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)
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Reducing Translation
and Transaction Exposure

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
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Reducing Economic Exposure

Question: How can a firm reduce economic exposure?

To reduce economic exposure firms need to distribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates
This requires that the firm’s assets are not overly 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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Classroom Performance System

The extent to which income from individual transactions is affected by fluctuations in foreign exchange values is

Translation exposure

Accounting exposure

Transaction exposure

Economic exposure

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Classroom Performance System Answer: c

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Other Steps for Managing
Foreign Exchange Risk

Question: Are there other strategies to manage foreign exchange risk?

To further manage foreign exchange risk, firms should
establish central control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

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Other Steps for Managing
Foreign Exchange Risk

distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand

attempt to forecast future exchange rates

establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position

produce monthly foreign exchange exposure reports

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Critical Discussion Question

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.

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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.

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Critical Discussion Question

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?

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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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Critical Discussion Question

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?

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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.

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Critical Discussion Question

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?

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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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Critical Discussion Question

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?

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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.

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Classroom Performance System Answer: a

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Internet Extra: To see real time currency conversions, go to XE.com {http://www.xe.com}.

Click on Quick Currency converter, and enter the currencies you want to convert.

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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:

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/unternehmen/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}.

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Classroom Performance System Answer: d

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Internet Extra: Companies can anticipate how currencies might move by following various economic and political indicators. To explore the effect of these indicators on exchange rates, go to {http://www.x-rates.com/}. Click on What Moves Rates.

Examine the effect of factors such as interest rates and geo-political tensions on exchange rates. What happens to a currency’s value of exchange rates or exports rise, or there is a threat of terrorism?

What factors should companies track to better predict what might happen to a currency’s value?

Multimedia Lecture Support Package to Accompany Basic Marketing

Lecture Script 6-*

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.

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.

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Classroom Performance System Answer: c

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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.

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.

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Classroom Performance System Answer: c

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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.

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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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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.

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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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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.