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?
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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.