From the first e-Activity, determine whether or not the Big Mac Index supports t

Question

From the first e-Activity, determine whether or not the Big Mac Index supports the theory of PPP. Analyze the essential manner in which the IFE is reflected in the different prices on The Big Mac Index from country to country. Elaborate on the correlations between inflation and index prices, and the correlations between personal incomes and prices.

From the second e-Activity, examine the main effect that relative inflation and interest rates could have on the selected company’s translation and transaction exposures from subsidiaries abroad. Outline a plan that proposes key steps that an MNC could take in order to mitigate translation and transaction exposures on international operations. Recommend two (2) tools that an MNC could use in order to mitigate such exposures

Explanation / Answer

A) THE BIG MAC INDEX

The Big Mac Index was created by The Economist based on the theory of purchasing power parity (PPP). Over the long-term, the PPP theory states that the currecny excahnge rate should equal the prices of a basket of goods and services in different countries.THUS, what better then the price of BIG MAC reflects the number of local economic fatcors from its production to transportation.Hence, the resulting PPP metric is considered by many economists to be a reasonable measurement of real world purchasing power.

THE BIG MAC INDEX is calculated by diivding the price of a big amc in one country bt price of big mac in aqnother country in their respective local cuurencies. The resulting value is compared to official excahnge rate , betrween the two currencies, to determine if either currency is undervalued or over valued;according to the PPP theory. For e.g., suppose a big mac in US costs $1 and one in eurozone costs 2 euros. The big mac index valuation for EUR/USD would be 2.0, or , 2/1, which could be comapred to the EUR / USD exchange rate. IF THE EXCHANGE RATE was 1.5 , you could predict that euro was undervalued by 0.5 euros per US dollars. This index was not much needed in US but it became useful in other countries where reliable index are not reliable. So, the ECONOMIST use The Big Mac index to find that the average annual rate of burger inflaton was 19% comapared to countries official 10% rate of inflation , in Jan 11

The Big Mac Index is useful for travellers , giving a good idea about which countrys are wxpensive and which are not. The ECONOMIST claims that index has been a good predictor of movement in currency values, there is no clear bench mark to compare in order to evaluate how accurate it has been historically.

The Big Mac index is not perfect,at best but for some it can be useful. F or example, The Big Mac price is decided by McD and can greatly affect Big Mac index because it may differ in size, availability and ingredients.

Correlation between income and prices:-

The big mac is four times more expensive in Switzerland than in India. Comparing the price of a big mac in US with an Indian Maharaja Mac it was found that rupess was about 60 % undervalued compared to US big mac average of $4.20.The India equivalent cost is about 1.62 dollars . The currency that can purchase the next most number of big macs is the Ukrainian WHICH is about 50% undervalued , according to the index. A big mac in Ukraine is 2.11 dollar thats just 1 US 1 cent cheaper then in Hong Kong , which was 3rd runner up for most undervalued currency.

B) KEY STEPS THAT MNC CAN TAKE TO MITIGATE THE TRANSLATION AND TRANSACTION EXPOSURES:-

TRANSACTION EXPOSURE

This arises from the affect that exchange rate fluctuations have on a companies obligation to make or recieve payments denominated in foreign currency in future. This type of exposure is short term to medium term in nature.

TRANALATION EXPOSURE

This exposure arises from the affect of crrency fluctuations on a companies consolidated financial statements, particularly when it has foreign subsidiaries. This type of exposure is medium term to long term.

TOOLS THAT AN MNC COULD TAKE TO MITIGATE EXPOSURES:-

A) OPERATIONAL STATEGIES

1) Diversifying production facilities and markets for products: Diversification would mitigate the risk inherit in having production facilities or sales concentrated in one or two markets. Howevr , the drawback is that the company may have to forgo economies of school.

2) Sourcing flexibility:Having alternative sources for key inputs makes strategic sense , incase exchange rate move s makes inputs too expensive from one region.

3) Diversifying financing: Having access to capital markets in several major nations gives a company the flexibility to raise capital in the market with the cheapest cost of funds.

B) CUURENCY RISK MITIGATION STRATEGIES

1) Matching currency flows : It requires foreign currency inflows and outflows to be matched.

2) Curreny risk sharing agreements : It is a contractual arrangement in which 2 pparties involve in sale or purchase contract to agree to share the risk arising from exchange rate fluctations.

3) Back - to - back loans : I n this arrangement 2 companies in different countries arrange to borrow each others currencies for a defined period, after the which the borrowed amount are repaid. As each company makes loan in home currency and recieve collateral foreign currency back to back loan appears on both asset and liability side of balance sheet.

4) Currency swaps : In this 2 firms borrow in the market and currencies where each can get the best rate and then swap the proceeds.

For example consider a US firm with subsidaries and operations in several countries around the world. The companies largest export markets are Europe and Japan which constitute for 40% of its annual revenues. Management factored a decline of 3% of dollars vs thr euro and japanese yen for current and next 2 yrs. which was based on US budget deadlock and growing fiscal and current account deficit.

However, rapidly improving US economy triggered speculation that fed may tighten monetary policies and dollar has gained about 5% against euro and yen, thus the US firm was facesd with transaction exposure, (because of its large export sales) and translation exposure (as it has subsidaries worldwide). Recall that manangement expected dollar to decline about 3% against euro and yen but it has already gained 5% vs these currencies. This will obviously have a negative effect on companies sales and cashflows.

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