Consider how your business would be exposed to exchange rate risk. Explain your
ID: 2651600 • Letter: C
Question
Consider how your business would be exposed to exchange rate risk. Explain your exchange rate risk, both transactions risk and economic risk by answering the following questions.
2. Is your business subject to transaction exposure? Explain how and why/why not. Is your business subject to economic exposure? Explain how and why/why not. GIVE EXAMPLES. Overall, do you think that the value of your business would be favorably or unfavorably affected with the expected future movement of the JPY/USD exchange rate? Explain your rationale.
3. Go to your data collected earlier to assess historical exchange rate movements (Yahoo.finance works for this) of the JPY/USD. Consider how the dollar cash flows from your services may have changed each year if exchange rates changed over each of the last 3 years. Specifically, assume that your annual revenue will be ¡30,000,000 (JPY) per year and determine the value of that amount in dollars based on the exchange rate today, one year ago, two years ago, and three years ago. Does it appear that your dollar revenue would have changed significantly due to exchange rate movements had you been in business during the last three years? Show your calculations! Assume that you expect the JPY/USD will change over the next year by the same degree as it changed over the past year. Given the futures price of the JPY, and the percentage change of the JPY/USD over the past year, would it be wise to sell futures to hedge the JPY/USD that will be converted to dollars one year from now? Explain why or why not.
Explanation / Answer
1. Exchange rate risk arises when a company's revenue increases or decreases due to fluctuations in the exchange rates between the currency in which it makes its payments and the currency in which it receives revenues.
Transaction risks arise when company's obligations to make or receive payments is affected by change in exchange rates.
Economic risk is caused by the change in exchange rates which in turn affects a company's future cash flows.
2. My business is that of providing consultancy services to my clients in the area of financial research. My income is dollar dominated whereas the expenses (and all other outflows) are in the home currency. I am exposed to transaction risk with references to my inflows. Only my inflows (revenues) change according to the change in exchange rates. Any fall in the value of my home currency vis a vis the dollar will increase my inflows.
I am also exposed to economic risk as change in exchange rates can alter my competitive position. Say for example, in future, the value of Japenese Yen has declined substantially vis a vis the dollar. Consultants in Japan offer lower billing rates in dollar terms as a result of this devaluation. The consultants can afford to lower their billing rates to the extent their currency has devalued or depreciated. This will reduce my competitiveness.
3. Annual revenue = JPY 30,000,000
Exchange rate today: 1 JPY = 0.00815059 USD
So my revenue today in dollar terms = 0.00815059*30,000,000 = $244,518
Exchange rate a year ago: 1 JPY = 0.00980 USD
So my revenue in dollar terms = 0.00980*30,000,000 = $294,000
Exchange rate 2 years ago: 1 JPY = 0.009980 USD
So my revenue in dollar terms = 0.009980*30,000,000 = $299,400
Exchange rate 3 years ago: 1 JPY = 0.01320 USD
So my revenue in dollar terms =0.01320*30,000,000 = $396,000
Source of exchange rates: http://www.xe.com/currencycharts/?from=JPY&to=USD&view=5Y
Over the last 1 year, the JPY has strengthened, causing a decline in my dollar revenues. If this trend continues in future, and JPY further appreciates in value, my dollar income will decline all the more.
The forward rate for JPY/USD is 0.011223. This means that it is expected that in future the value of JPY will decline and will thus increase my dollar earnings. So it does not make sense to sell futures, as my dollar income is poised for a possible gain in future.
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