Running head: EXCHANGE RATE RISK 1

Chapter 12 Integrative Problem - Exchange Rate Risk Management

Vogl Company is a U.S. firm conducting a financial plan for the next year. It has no

foreign subsidiaries, but more than half of its sales are from exports. Its foreign cash inflows to

be received from exporting and cash outflows to be paid for imported supplies over the next year

are shown in the following table:

Currency Total Inflow Total Outflow

Canadian dollars $32,000,000 $2,000,000
New Zealand
dollars $5,000,000 $1,000,000
Mexican pesos $11,000,000 $10,000,000
Singapore dollars $4,000,000 $8,000,000

The spot rates and one-year forward rates as of today are:

One-Year Forward
Currency Spot Rate Rate
C$ $0.90 $0.93
NZ$ $0.60 $0.59
MXP $0.18 $0.15
S$ $0.65 $0.64

Based on the information provided, determine the net exposure of each foreign currency in
dollars.

In order to determine the net inflow, one must subtract the outflow from the inflow, then

multiply the results by the spot rate.

Net Inflow
Spot
Currency (Total Inflow - Total Net Inflow
Rate
Outflow)
Canadian dollars $30,000,000 $0.90 $27,000,000
New Zealand
dollars $4,000,000 $0.60 $2,400,000
Mexican pesos $1,000,000 $0.18 $180,000
Singapore dollars $4,000,000 $0.65 $2,600,000
Running head: EXCHANGE RATE RISK 2

Assume that today's spot rate is used as a forecast of the future spot rate one year from

now... Explain.

Taking into consideration the Purchasing Power Parity (PPP), when exchange rates

fluctuate, the changes in value between two currencies will be fixed in the long run by the

purchasing power of these countries. Since all these currencies are tied to the dollar, the

movement experienced in the New Zealand dollar, the Singapore dollar and the Mexican peso,

will create an offsetting effect on all related currencies, to include the Canadian dollar.

Given the forecast of the Canadian dollar along with the forward rate of the Canadian

dollar, what is the expected increase or decrease in dollar cash flows that would result from

hedging the net cash flows in Canadian dollars? Would you hedge the Canadian dollar

position?

The expected Canadian dollar value using the forward rate is:

Net Inflow
Spot
Currency (Total Inflow - Total Net Inflow
Rate
Outflow)
Canadian dollars $30,000,000 $0.93 $27,900,000

By hedging the net cash flows in Canadian dollars, there is a gain of $900,000. There is a

positive financial motivation to hedge the Canadian dollar and make a profit.

Assume that the Canadian dollar net inflows may range from C$20,000,000 to

C$40,000,000 over the next year. Explain the risk of hedging C$30,000,000 in net inflows.

How can Vogl Company avoid such a risk? Is there any tradeoff resulting from your

strategy to avoid that risk?

If Vogl hedges C$30,000,000 and at the end of the period receives less than expected,

Vogl will have to buy Canadian dollars to make up the difference. The risk lies in what kind of
Running head: EXCHANGE RATE RISK 3

movement occurred in the exchange rate market for the Canadian dollar. If the exchange rate

increased, Vogl will see a decline in profits. The only way to avoid the risk is to accurately

predict the amount of Canadian dollars to be received in the future. Is this possible? Unlikely.

Most companies usually hedge a fixed amount of known inflows or outflows, which creates

restrictions in hedging, and still does not protect the company from exchange rates risk.

Vogl Company recognizes that its year-to-year hedging strategy hedges the risk only over a

given year, and does not insulate it from long-term trends in the Canadian dollar’s value...

Explain.

By establishing a subsidiary in Canada, Vogl has not eliminated its exposure to exchange

rate risk. Exchange rate risk is present when the parent company send goods from the U.S. to the

Canadian subsidiary. It is also present in case the Canadian subsidiary operations are not

profitable and the parent company needs to inject capital in to the subsidiary. Additionally,

profits generated by the Canadian subsidiary will have to be converted into dollars by the parent

company in the U.S.