Solved: Fad Gadget has never worked so hard in his entire

Fad Gadget has never worked so hard in his entire life. It is near midnight, and he is still poring
over statistics and tables. Fad recently joined Smashing Pumpkins, a relatively young but fast-
growing British firm that produces and distributes an intricate device that turns fresh pumpkins
into pumpkin pie in about 30 minutes. Recently, the firm has started exporting to Zooropa.
Some of the largest and tastiest pumpkins are grown in Zooropa, and its population boasts the
highest per capita pumpkin consumption in the world. A recent analysis of the pumpkin market
in Zooropa has left the company’s senior managers very impressed with the profit potential.
Although Zooropa consists of 10 politically independent countries, their currencies are linked
through a system called the Currency Rate Linkage System (CRLS) that works exactly like the
former Exchange Rate Mechanism (ERM) of the EMS before the currency turmoil started in
September 1992. The anchor currency is the banshee of Enigma, the leading country in
Zooropa. Initial contacts with importers in Zooropean countries indicated that they typically insist
on payment in their own local currency. About a week ago, Cab Voltaire, the CEO of Smashing
Pumpkins, expressed concerns about this development and asked Fad to lead a research team
to further examine the present state of the currency system of Zooropa. Cab viewed the outlook
for the banshee relative to the pound quite favorably and did not predict any substantial
depreciation of the banshee against any other major currency. However, the precarious
economic situation of some of the countries in Zooropa and the growing importance of
speculative pressures in Zooropa’s currency markets last week suddenly made him suspicious
about the possibility of realignments within the system. He even doubted the long-term viability
of the system. Cab instructed Fad to examine the following issues:
• Which currencies in the system exhibit the highest realignment risk?
• If a currency realigns and gets devalued, what are the effects on our sales and profit margins
in this particular country? Can we take the realignment possibility into account in our pricing?
• Suppose a currency is forced to leave the CRLS. What are the effects on exchange rates,
interest rates, and the outlook for sales in that country? What is the likelihood of this occurring
for the different countries? Fad Gadget felt nervous. A meeting was scheduled with Cab the day
after tomorrow. He wanted to write a thorough and insightful report. At the last management
meeting, he had the uneasy feeling that some senior managers doubted his abilities. Some
managers were naturally suspicious of a young Australian newcomer with his MBA. His earring
and punk hairdo did not exactly help either.
His team of analysts had already assembled a table with relevant macroeconomic and financial
data. “If only I could use this to rank the different countries according to realignment risk,” he
thought. Place yourself in Fad Gadget’s shoes and see what your ranking is.
a) Realignment rankings
b) Effects of Realignments/Exits for the Firm
c) Incorporating Realignment Risk into Pricing/Hedging
d) Effects of devaluation/exits on exchange and interest rates

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ANSWER
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