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# Assignment on Manufactories Analysis

Drawing on what we know about the Fisher effect, the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won.

When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure in 2003, the company essentially gambled that the euro would decline in value relative to the dollar.

a) The company hoped that by saving the cost of the commission involved in selling a currency forward, it would increase its profit margin. This strategy of course, backfired. b) The appreciation of the euro relative to the U. S. dollar took many people by surprise. Its rise has been attributed to record U. S. oreign trade deficits and pessimism about the future value of the dollar.

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c) In addition to using forward contracts, Volkswagen could use currency swaps, and lead and lag payables and receivables. The simplest solution would be to just wait until December, take the ? 400,000 and convert it at the spot rate at that time, which you assume will be \$1=? 100.

In this case you would have \$4,000 in mid-December. If the current 180-day forward rate is lower than 100? /\$, then a forward contract might be preferable since it both locks in the rate at a better level and reduces risk.

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If the rate is above ? 00/\$, then whether you choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion. There is a third possibility also. You could borrow money from a bank that you will pay back with the ? 400,000 you will receive (400,000/1. 03 = ? 388,350 borrowed), convert this today to US\$ (388,350/130 = \$2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4,000 – 2,987 = \$1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2).

If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk. What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be ? 100 = \$1. Your financing and operating capital are in dollars, yet many of your costs (labor) must be in peso. Your hard assets are all in peso, and their value will decline. On the other hand, if the peso depreciates, then your dollars will go further.

So perhaps doing nothing is the best approach. If you are pretty sure that the peso will depreciate, then you may want to avoid any major peso-denominated costs that you can until after devaluation. That may mean holding back on shipments if possible, and you may want any dollar-denominated purchases made before the devaluation. You may want to move any peso-denominated major accounts into dollars before the devaluation. Summary The strong dollar in 2008 had negative impact on Caterpillar’s revenue but it had a favorable effect on Caterpillar’s costs.

Caterpillar had dramatically expanded its network of foreign manufacturing operations to protect itself against the exchange rate risk of dollar. In 2008, 102 of 237 manufactories of Caterpillar are located outside of North America. Although the revenues from operating in local currency and from exporting fell when the dollar strengthened, the costs of operating also declined, which helped to reduce the impact on profit margin. In addition, the price Caterpillar paid for inputs from foreign producers also fell. Thus, Caterpillar’s globalization strategy has reduced the impact of fluctuations in the value of the dollar on its profits.

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