9-1
What is the
Another Perspective: To explore Hyundai and Kias strategies in greater depth, go to the
companies web sites at {http://www.hyundai.com} and {http://www.kia.com}.
LECTURE OUTLINE
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructors manual. The PPT slides include additional notes that can be viewed by
clicking on view, then on notes. The following provides a brief overview of each
Power Point slide along with teaching tips, and additional perspectives.
QUESTION 2: Two countries, Great 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%, what would you expect current interest rate to be in Britain?
ANSWER 2:
(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.
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?
ANSWER 3:
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.
Its rise 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.
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?
ANSWER 4: 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 a forward contract might 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.
QUESTION 5: You are the CFO of a US firm whose wholly owned subsidiary in Mexico
manufactures component parts for your US 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 5: Your financing and operating capital are in dollars, yet many of your costs
(labor) must be in peso. Your hard assets are all in peso, and their value will decline. On
the other hand, if the peso depreciates, then your dollars will go further. So perhaps
doing nothing is the best approach. If you are pretty sure that the peso will depreciate,
then you may want to avoid any major peso-denominated costs that you can until after
devaluation. That may mean holding back on shipments if possible, and you may want
any dollar-denominated purchases made before the devaluation. You may want to move
any peso-denominated major accounts into dollars before the devaluation.
CLOSING CASE: The Curse of the Strong Dollar at STMicro
Summary
The closing case explores the effect of a strong dollar on STMicro, a European
manufacturer of semiconductors. The majority of STMicros operations are located in
Western Europe. Accordingly, when the dollar was strong relative to the euro, STMicro
made a healthy profit, but saw its profit tumble when the value of the euro rose.
Discussion of the case can revolve around the following 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.
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. governments record budget deficit contributed to the demise of the
dollar relative to the euro. Many foreigners believed the U.S. 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?
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?
Hubbard points out that while the current problem began in the United States and spread
to other countries, the contributions to global liquidity and investments in the United
States came from foreign markets. He notes that today, risks are spread and diversified
around the world. Hubbard expects further intervention in the market. Hubbard believes
the current situation is actually a correction in the market that will more accurately price
risk. He notes that the correction took place very quickly as people became worried
about credit spreads.
Discussion Questions:
1. Why did the Federal Reserve recently pump money into financial markets? What
problems was it trying to address? Did it succeed?
2. Consider the recent move by the Federal Reserve to inject additional liquidity into
financial markets. The Federal Reserves efforts were just part of a worldwide effort to
reassure investors of the availability of credit. Why was it important for the Federal
Reserve to work in tandem with other central banks? Could the Federal Reserve have
corrected the problem by working alone?
2. Reflect on the global nature of world financial markets. What are the implications of
this interconnectedness? As an investor, how does this affect you?
4. Discuss the implications of global financial markets, and the potential for a worldwide
economic crisis.
INTEGRATING VIDEOS
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following:
Title 11: Chinese Currency Change
Summary
After more than a decade, the Chinese yuan is finally being decoupled from the U.S.
dollar. The yuan will now float against a basket of foreign currencies. China has been
under increasing pressure from the U.S. to make such a move. In fact, U.S. Treasury
Secretary John Snow has complained that continuing to peg the yuan to the dollar was
tantamount to subsidizing companies, and threatened retaliatory trade sanctions if China
failed to take corrective actions. Analysts, however, note that China is only revaluing the
yuan by two percent, so the net effect is negligible given that estimates have the yuan as
being undervalued by as much as 40 percent. China is reluctant to make a significant
change to the yuan because its economic policy centers on growing exports, and the
undervalued yuan amounts to a 33 percent subsidy to exporters. Eliminating the
subsidy results in a loss of competitiveness for Chinese exporters, and an increase in
competitiveness for American exporters.
The question now is whether China will take steps to further revalue its currency.
Analysts seem to believe that political pressure and internal pressures will force China to
continue to continue to revalue its currency, a move that could have repercussions in
other parts of Asia. There is also some concern that inflationary pressures will rise in the
U.S. if China makes any significant moves to revalue its currency.
Discussion Questions:
1. China, which has been under strong political pressure for some time to revalue its
currency, has finally agreed to do just that, only in a very small way. Is this move by
China a win for the U.S. or a win for China? What are the political implications of this
action?
2. Until now, Chinas currency valuation has represented a significant subsidy to Chinese
exporters, a situation that is seen in a negative light by American exporters. However, as
a beneficiary of cheap goods made in China, how do you feel about the U.S. efforts to
force China to raise its currency?
3. After more than a decade, the value of the yuan has risen relative to the dollar. While
the revaluation amounts to just a two percent difference at the moment, there is
speculation that the Chinese will continue to allow the yuan to rise. What effect will this
initial movement have on Chinese workers and consumers? What are the effects if the
yuan continues is ascent?
4. Chinas revaluation of the yuan was echoed in other parts of Asia. For example, in
India, the rupee appreciated, as did the Japanese yen. Consider the implications of
further currency revaluations for the Asian region.
Exercise 2
The Big Mac Index can be accessed by searching the term Big Mac Index at
{http://globaledge.msu.edu/ResourceDesk/}. The resource is located under the
globalEDGE category Money: Finance. Be sure to check the Resource Desk only
checkbox of the search function on the globalEDGE website.
Search Phrase: Big Mac Index
Resource Name: Economist: The Big Mac Index
Website: {http://www.economist.com/markets/bigmac/}
globalEDGE Category: Money: Finance