ER6eSM_Ch09.doc

CHAPTER 9 MANAGEMENT OF ECONOMIC EXPOSURE ANSWERS SOLUTIONS TO END OF CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. How would you define economic exposure to exchange risk? Answer: Economic exposure can be defined as the possibility that the firm’s cash flows and thus its market value may be affected by the unexpected exchange rate changes. 2. Explain the following statement: “Exposure is the regression coefficient.” Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s future cash flows and the market value to random changes in exchange rates. Statistically, this sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the regression coefficient. 3. Suppose that your company has an equity position in a French firm. Discuss the condition under which the dollar/euro exchange rate uncertainty does not constitute exchange exposure for your company. Answer: Mere changes in exchange rates do not necessarily constitute currency exposure. If the euro value of the equity moves in the opposite direction as much as the dollar value of the euro changes, then the dollar value of the equity position will be insensitive to exchange rate movements. As a result, your company will not be exposed to currency risk. 4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow. Answer: The competitive effect: exchange rate changes may affect operating cash flows by altering the firm’s competitive position. The conversion effect: A given operating cash flows in terms of a foreign currency will be converted into higher or lower dollar (home currency)amounts as the exchange rate changes. 5. Discuss the determinants of operating exposure. Answer: The main determinants of a firm’s operating exposure are (i) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (ii)