Question Tutorial 9

12.2 Operating Exposure versus Transaction Exposure. What are the main differences and similarities
between operating exposure and transaction exposure? Which of the two exposures is more relevant
for long-term planning?
Operating exposure is far more important for the long-run health of a business than changes caused
by transaction or translation exposure. However, operating exposure is inevitably subjective because it
depends on estimates of future cash flow changes over an arbitrary time horizon. Thus, it does not
spring from the accounting process but rather from operating analysis. Planning for operating
exposure is a total management responsibility depending upon the interaction of strategies in finance,
marketing, purchasing, and production.
12.12 Currency Switching. Explain how currency switching can offset long-term exposure to a foreign
currency.
The essence of this approach is to create operating or financial foreign currency cash outflows to
match equivalent foreign currency inflows. Often debt is incurred in the same foreign currency in
which operating cash flows are received.
12.13 Currency Risk Sharing. Explain why suppliers are ready to get into currency risk sharing deals with
MNEs. How do such deals impact the financial position of both parties?
Contracts, including sales and purchasing contracts, between parties operating in different currency
areas can be written such that any gain or loss caused by a change in the exchange rate will be shared
by the two parties..
12.14 Back-to-Back Loans. Back-to-back loans have caused many of the banking crises in emerging
economies in the 1990s. What guarantees can firms obtain in order to use this type of foreign
exchange hedge?
Two firms in different countries lend their home currency to each other and agree to repay each
other the same amount at a later date. This can be viewed as a loan between two companies
(independent entities or subsidiaries in the same corporate family) with each participant both making a
loan and receiving 100% collateral in the other’s currency. A back-to-back loan appears as both a debt
(liability side of the balance sheet) and an amount to be received (asset side of the balance sheet) on
the financial statements of each firm.
12.15 Currency Swaps. Do currency swaps always hedge against foreign exchange exposure? What
other precautions are needed for effective hedging?
In terms of financial flows, the currency swap is almost identical to the back-to-back loan. However,
in a currency swap, each participant gives some of its currency to the other participant and receives
in return an equivalent amount of the other participant’s currency. No debt or receivable shows on
the financial statements as this is in essence a foreign exchange transaction. The swap allows the
participants to use foreign currency operating inflows to unwind the swap at a later date.
Problems
12.1 Mauna Loa Macadamia. Mauna Loa Macadamia, a macadamia nut subsidiary of Hershey’s with
plantations on the slopes of its namesake volcano in Hilo, Hawaii, exports macadamia nuts worldwide.
The Japanese market is its biggest export market, with average annual sales invoiced in yen to
Japanese customers of ¥1,200,000,000. At the present exchange rate of ¥125/$, this is equivalent to
$9,600,000. Sales are relatively equally distributed throughout the year. They show up as a
¥250,00,000 account receivable on Mauna Loa’s balance sheet. Credit terms to each customer allow
for 60 days before payment is due. Monthly cash collections are typically ¥100,000,000. Mauna Loa
would like to hedge its yen receipts, but it has too many customers and transactions to make it
practical to sell each receivable forward. It does not want to use options because they are considered
to be too expensive for this particular purpose. Therefore, they have decided to use a “matching” hedge
by borrowing yen.
a. How much should Mauna Loa borrow in yen?
b. What should be the terms of payment on the yen loan?
.
A Mauna Loa receives cash collections of one hundred million yen per month. This is the source of
repayment of any balance sheet hedge. If Mauna Loa wants to be covered for one year at a time, it
would need to borrow one year's cash flow plus interest, and convert the borrowed yen to US dollar
at once. A sample calculation would be:
1 month's (F = 100 , 000 , 000 =>
lyr's (F = # 100 000 000
, ,
x 12 = 1 , 200 000 000
, ,

i = 4% => Principal s int = 1 .

2 bil x (14 % ) = 1 248
.
bil

1 248 bil
5 = # 125/$ => Principal s int in $ =
.

= $9 984
,
,
000
# 125/$

Realistically, Mauna Loa would probably want to be covered for the long term. In that case, the 1.2
billion yen loan could be structured so that it could be renewed annually with interest reset annually.
This would only cover the foreign exchange and interest rate risk for a year at a time, but would
probably be acceptable to a bank lender. Also unknown are the expected sales for year 2 and beyond.

b . The loan should be repaid out of the monthly cash flow, with payments on principal only. The interest
payment one year hence has already been covered by borrowing both principal and interest up-front.
Note: Mauna Loa should not borrow 250 million yen to cover only its balance sheet exposure. Such a
loan would cover only the accounting exposure, and not the cash flow exposure (operating exposure).
12.2 Acuña Leather Goods. DeMagistris Fashion Company, based in New York City, imports leather
coats from Acuña Leather Goods, a reliable and longtime supplier, based in Buenos Aires, Argentina.
Payment is in Argentine pesos. When the peso lost its parity with the U.S. dollar in January 2002, it
collapsed in value to Ps4.0/$ by October 2002. The outlook was for a further decline in the peso’s
value. Since both DeMagistris and Acuña wanted to continue their longtime relationship, they agreed
on a risk-sharing arrangement. As long as the spot rate on the date of an invoice is between Ps3.5/$
and Ps4.5/$, DeMagistris will pay based on the spot rate. If the exchange rate falls outside this range,
DeMagistris will share the difference equally with Acuña Leather Goods. The risk- sharing agreement
will last for six months, at which time the exchange rate limits will be reevaluated. DeMagistris
contracts to import leather coats from Acuña for Ps8,000,000 or $2,000,000 at the current spot
rate of Ps4.0/$ during the next six months..
a. If the exchange rate changes immediately to Ps6.00/$, what will be the dollar cost of six months of
imports to DeMagistris?
b. At Ps6.00/$, what will be the peso export sales of Acuña Leather Goods to DeMagistris Fashion
Company?
a Bottom Top
The allowable range of exchange rate is Ps 3 .
5/$ Ps 4 5/$
.

Outside of this range the trading partners will share the extra risk
equally
New
exchange rate
-
Ps 6/$

Allowable exchange rate Ps 4 5/$ .

Difference to be shared Ps 1 .
5/$

DeMagistris' share = 0 5
.
x PS 1 . 5/$ =
↑30 . 75/$
Acura's share = 05 .
x Ps 1 5/$
.
= Ps 0 . 75/$
Therefore , DeMagistris will use the
following effective exchange rate after
risk-sharing : 4 5 + 0 75 =
. .
35 . 25/$
that 6m of import will still be Ps 8m
Assuming
=> DeMagistris's cost in U S
. .
dollars =
Ps 8m y =
$1 523 809 52
, ,
.

sales s therefore
However, the lower cost of
importing might lead to
higher DeMagistris' a
higher import total

than PS 8m
.

b
. The export sale of Acura would remain at Ps8m ,
unless the lower dollar cost
encourages DeMagistris
to import more from Acua
.

↑3 5/ PS4 5/$
A
.

&So .
Ps 6/$ b .
&S = Ps6/$
/ / / / ( //
I
1 I/II I

Peso export sale of Acura

hearing
T
Risk effective rate
↑
I

effective rate
25 =525s eg
= 4 5
.
+ .

. = $1 523 809 52
, ,
.
x Ps6/$ = Ps 9 142 , 857 12
, .

s8m
=> cost =
ps 5 52
Agen .
. .

Ini rate = Ps6/$ ,

$cost = Tig hop may color cho cty
 12.5 MacLoren Automotive. MacLoren Automotive manufactures British sports cars, a number of which
are exported to New Zealand for payment in pounds sterling. The distributor sells the sports cars in
New Zealand for New Zealand dollars. The New Zealand distributor is unable to carry all of the foreign
exchange risk, and would not sell MacLoren models unless MacLoren shared some of the foreign
exchange risk. MacLoren has agreed that sales for a given model year will initially be priced at a “base”
spot rate between the New Zealand dollar and pound sterling set to be the spot mid-rate at the
beginning of that model year. As long as the actual exchange rate is within ±5% of that base rate,
payment will be made in pounds sterling. That is, the New Zealand distributor assumes all foreign
exchange risk. However, if the spot rate at time of shipment falls outside of this range, MacLoren will
share equally (i.e., 50/50) the difference between the actual spot rate and the base rate. For the
current model year, the base rate is NZ$1.6400/£.
a. What are the outside ranges within which the New Zealand importer must pay at the then cur- rent
spot rate?
b. If MacLoren ships 10 sports cars to the New Zealand distributor at a time when the spot exchange
rate is NZ$1.7000/£, and each car has an invoice cost £32,000, what will be the cost to the distributor
in New Zealand dollars? How many pounds will MacLoren receive, and how does this compare with
MacLoren’s expected sales receipt of £32,000 per car?
c. If MacLoren Automotive ships the same 10 cars to New Zealand at a time when the spot exchange
rate is NZ$1.6500/£, how many New Zealand dollars will the distributor pay? How many pounds will
MacLoren Automotive receive?
d. Does a risk-sharing agreement such as this shift the currency exposure from one party of the
transaction to the other?
e. Why is such a risk-sharing agreement of benefit to MacLoren? Why is it of benefit to the New
Zealand distributor? 558 1 1 64 1 722
price of Risk-sharing band
.

Invoice 32 000 5%
. .

car =
, =
I / I /N / / / / / In

Assumption : S = N2$ 1 .
64/ = Base rate 15 % base
1 64 + 1 8
. .

a .
Outside range base rate = N2$1 6415 .
If S = N2$ 1 8/1 . => effective rate = 2 = N2$1 72/$ .

Upper band = N2$1 64/$x (1 + 5 %)

. = N2$1 .
722/$N2$cost of I car = 32 , 000 x 1 72. = N2$55 ,
040
55 040 ,

Lower band = N2$ 1 .

64/$x 11-5 % ) = N2$1 558/$- cost for McLoren
. = 1 8
.
= 30 577 7
, .

b
. S = N2$1 7/1 .
(within the band => Cost of 10 cars = 10 x 32 000
,
x N2$1 .
7/1 = N2$544 ,
000

c .
S= N2$1 65/E .
(within the band) => Cost of 10 cars = 10 x 32 ,
000 x N2$1 65/ . = N2$528 ,
000

Receipts to MacLoren in 1 = 10 x 32 000 ,

= 320 , 000

(within the band MacLoren receives [12 000/car)

,

d MacLoren
.
bears no risk within the 5%
range. The distributor carries all the risk within 5 %. If the exchange
rate falls outside 5% MacLoren shares the risk with contributor .
range ,

e .
Both parties in practice . The manufacturer has predictable ver w/in the
range ,
while the distributor
bears moderate level of within 5%
range . The distributor
will hopefully be able to
a
currency risk
provide stable to to the customer which will also benefit the manufacturer
a more
pricing pass on ,

through a more stable sustainable distributor sales outlet.

12.9 Hurte-Paroxysm Products, Inc. (A).
Hurte-Paroxysm Products, Inc. (HP) of the United States exports computer printers to Brazil, whose
currency, the reais (R$), has been trading at R$3.40/US$. Exports to Brazil are currently 50,000
printers per year at the reais-equivalent of $200 each.A rumor exists that the reais will be devalued to
R$4.00/$ within two weeks by the Brazilian government. Should the devaluation take place, the reais is
expected to remain unchanged for another decade.
Accepting this forecast as given, HP faces a pricing decision that must be made before any actual
devaluation: HP may either (1) maintain the same reais price and, in effect, sell for fewer dollars, in
which case Brazilian volume will not change; or (2) maintain the same dollar price, raise the reais price
in Brazil to compensate for the devaluation, and experience a 20% drop in volume. Direct costs in the
United States are 60% of the U.S. sales price. What would be the short-run (1-year) implication of each
pricing strategy? Which do you recommend?
Assumptions US $ price Exchange rate R$
I

price
Existing sales price unit $200 X R$3 4/$ . = R$680
If R$ ↓ in value ,
the new implied us $ price :

R$680
New $price if no reais price change =
$170 R$ 4/$ R$680
R$4/$
If the US$ price is changed to keep US $ price :

New reais price is current us$ price at new exchange rate $200 X R$ 4/$ = R$800

Direct cost unit in US ,

00 of price 60 %

Direct cost/unit in US $200 x 60% = $120 X R$ 3 4/$

.
= R$ 408

Unit volume 50 , 000

↓ in unit volume from PN -

20%

New lower unit volume 40 000 ,

Alternative 1 : Maintain same price in reais :

S
Sales rev = R$680 x 50 , 000 = $8 500
, ,
000
R$4/$
=> Contribution margin in $ = $8 ,
500 000
,
-
$6 , 000 000
,
= $2 500 000
, ,

Direct costs = $120 x 50 , 000 = $6 ,

000 , 000

Alternative 2 : Raise price in reais & accept lower volume :

S
Sales R$800 40 , 000
rev = x = $8 ,
000 , 000
R$4/$
=> Contribution margin in $ = $8 ,
000 000
,
-
$4 , 800 000 ,
= $3 ,
200 , 000

Direct costs = $120 x 40 , 000 = $4 800 , ,

000

Discussion :

Alternative 2 is more preferable. In the ST (1yr) ,

HP Products would be better off to increase its sales price in

reals in Brazil & accept the lower sales volume. The contribution margin if reais prices are raised is $3 200 000
, ,

whereas if the price in reais is left unchanged HP Product's contribution margin is only $2 500 000. , ,
This is a

short-run solution ,
and does not consider possible longer-run effects that might come from raising the local

smaller market share.

price and/or accepting a