Operating exposure- the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates. Operating exposure cannot be determined from accounting statements as transaction exposure. General Motors exports cars to Spain, but the strong dollar against the Euro hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from Italian and French car makers, such as Fiat and Renault, whose operating currencies are the Euro. What kind of measures would you recommend so that GM can maintain its market share in Spain?
The strong dollar puts GM at a disadvantage competitively, as the Italian and French car makers will be able to sell their cars cheaper in Euro terms. There are four strategies that GM can employ in an attempt to maintain its Spanish market share. The first strategy is to locate production facilities in a foreign country where costs are low due to either undervalued currency or underpriced factors of production. Secondly, they could employ a flexible sourcing policy for purchasing inputs for production. This will allow them to take advantage of favorable exchange rates, providing for an overall lower cost of production. Next, they should seek to establish product differentiation in the Spanish market. If GM is able to create a perception in the market that their product is different and better than that offered by their competitors the demand for GM cars will be less price sensitive. Lastly, they can invest in R&D in hopes of finding ways to lower production costs and enhance productivity. There are several other steps that GM could take to hedge against this foreign exchange risk, but these are the steps that would act to maintain market share specifically in Spain
Unable to predict currency due to fluctuations long-term (currencies moving in an unintended manner)
Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pounds will be worth $1.40. If the British economy slows down, on the other hand, the land will be worthless, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.
(a) Estimate your exposure b to the exchange risk.
E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580
On the Milan bourse, Fiat stock closed at EUR 14.67 per share on Tuesday, February 26, 2008. Fiat trades as an ADR on the NYSE. One underlying Fiat share equals one ADR. On February 26, the $/EUR spot exchange rate was $1.4889/EUR1.00. At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR?
b. By comparison, Fiat ADRs closed at $21.94. Do you think an arbitrage opportunity exists?
Yes, because in order for there to be no arbitrage opportunity, the shares would Need to close at the same price when adjusted for the exchange rate.
2. As an investor, what factors would you consider before investing in the emerging stock market of a developing country?
One of the factors an investor would consider is the measure of liquidity. A measure of liquidity for a stock market is the turnover ratio; that is, the ratio of stock market transactions over a period of time divided by the size of the stock market. Higher the turnover ratio means the more liquid the market is. Another factor is the measure of market concentration. The more concentrated a national equity market is on a few stock issues, the less opportunity a global investor has to include shares from that country in an internationally diversified portfolio. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than one national exchange, and (b) to source new equity capital from foreign investors as well as domestic investors. Cross-listing provides a means for expanding the investor base for a firm’s stock, thus potentially increasing its demand. Establishes name recognition of the company in a new capital market, thus paving the way for the firm to source new equity or debt capital from local investors as demands dictate. Brings the firm’s name before more investor and consumer groups. cross-listing into developed capital markets with strict securities regulations and information disclosure requirements may be seen as a signal to investors that improved corporate governance is forthcoming. It may mitigate the possibility of a hostile takeover of the firm through the broader investor base created for the firm’s shares.
Why might it be easier for an investor desiring to diversify his portfolio internationally to buy depository receipts rather than the actual shares of the company? ADRs are denominated in dollars, trade on a U.S. stock exchange, and can be purchased through the investor’s regular broker. Dividends received on the underlying shares are collected and converted to dollars by the custodian and paid to the ADR investor, whereas investment in underlying shares requires the investor to collect the foreign dividends and make a currency conversion. ADR trades clear in three business days as do U.S. equities. It varies in foreign countries. ADR price quotes are in US dollars. ADRs are registered securities that provide for the protection of ownership rights, whereas most underlying stocks are bearer securities. ADR investment can be sold by trading the depository receipt to another investor in the US stock market. ADRs frequently represent a multiple of the underlying shares, rather than a one-for-one correspondence, to allow the ADR to trade in a price range customary for U.S. investors. ADR holders give instructions to the depository bank as to how to vote the rights associated with the underlying shares.