chapter 9

Question 1

Exposure to currency risk can be properly measured by the sensitivities of

Answer 1

1) the future home currency values of the firms assets and liabilities and

2) The firms operating cash flows to random changes in exchange rates.

Question 2

operating exposure can be defined as

Answer 2

the extent to which the firms operating cash flows would be affected by random changes in exchange rates

Question 3

the competitive effect

Answer 3

a pound depreciation may affect operating cash flow in pounds by altering the firms competitive position in the marketplace

Question 4

the conversion effect

Answer 4

a given operating cash flow in pounds will be converted into a lower dollar amount after the pound depreciation

Question 5

A firms operating exposure is determined by

Answer 5

the structure of the markets in which the firm sources its inputs, suach as labor and materials, and sells its products

the firms ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing

Question 6

The firm can use the following strategies for managing operating exposure

Answer 6

1) selecting low cost production sites

Flexible sourcing policy

Diversification of the market

Product differentiation and R&D efforts

Financial hedging

Question 7

Even if hte firm has manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes

Answer 7

by sourcing from where input costs are low

Question 8

flexible sourcing policy

Answer 8

need not be confined just to materials and parts. Firms can also hire low-cost guest workers from foreign countries instead of high-cost domestic workers in order to be competitives

Question 9

Diversifying the market is

Answer 9

another way of dealing with exchange exposure

Reduced sales in mexico due to the dollar appreciation against the peso can be compensated by increased sales in ermany due to the dollar depreciation against the euro

Question 10

R&D activities can allow the firm to

Answer 10

maintain and strenthen its competitive position in the face of adverse exchange rate movements

Question 11

Financial hedging

Answer 11

can be used to stabilize the firms cash flows

For example the firm can lend or borrow foreign currencies on a long term basis. Or the firm can use currency forward or options contracts and roll them over if necessary.

Question 12

Five step procedure for financial hedging

Answer 12

1) exchange forecasting
2) Assessing strategic plan impact
3) Hedging rationale
4) Financial instruments
5) Hedging program

Question 13

Exchange forecasting

Answer 13

The first step involves reviewing the likelihood of adverse exchange movements

The treasury staff estimates possible ranges for dollar strength or weakness over the five year planning horizon. In doing so, the major factors expected to influence exchange rates, usch as the US trade deficit, capital flows, the us budget deficit, and government policies regarding exchange rates are considering

Question 14

Assessing strategic plan impact

Answer 14

once the future exchange rate ranges are estimated, cash flows and earnings are projected and compared under the alternative exchange rate scenarios, such as strong dollar and weak dollar

Question 15

Deciding whether to hedge

Answer 15

in deciding whether to hedge echange exposure, merck focused on the objective of maximizing long term cash flows and on the potential effect of exchange rate movements on the firms ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholder wealth.

Merck decided to hedge for two main reasons

1) The copany has a large portion of earnings generated oversears while a disproportionate share of costs is incurred in dollars

2) Volatile cash flows can adversely affect the firms ability to implement the strategic plan, especially invetments in R&D that form the basis for future growth.

Question 16

Selecting the hedging instruments

Answer 16

the objective was to select the most cost-effective hdeging tool that accommodated the companys risk preference. Among various hedging tools, such as forward currency contracts, foreign currency borrowing, and currency options, merck chose currency options because it was not willing to forgo the potential gains if the dollar depreciated against foreign currencies as it has been doing against major currencies since the mid eighties

Question 17

constructing a hedging program

Answer 17

having selected currency options as the key hedging vehicle the company still had to formulate an implementation strategy regarding the term of the hedge, the strike price of the currency options and the percentage of income to be covered. After simulating the outcomes of alternative implementation strategies under various exchange rate scenarios , merck decided to

1) hedge for a multiyear period using long dated options contracts, rather than hedge year by year, to protect the firms strategic cash flows

Not use far out of money options to save costs

Hedge only on a partial basis, with the remainder self insured