Question

Blades, Inc. Case

Forecasting Exchange Rates

Recall that Blades, Inc., the U.S.-based manufacturer of roller blades, is currently both exporting to and importing from Thailand. Ben Holt, Blades’ chief financial officer (CFO), and you, a financial analyst at Blades, Inc., are reasonably happy with Blades’ current performance in Thailand. Entertainment Products, Inc., a Thai retailer for sporting goods, has committed itself to purchase a minimum number of Blades’ Speedos annually. The agreement will terminate after three years. Blades also imports certain components needed to manufacture its products from Thailand. Both Blades’ imports and exports are denominated in Thai baht. Because of these arrangements, Blades generates approximately 10 percent of its revenue and 4 percent of its cost of goods sold in Thailand.

Currently, Blades’ only business in Thailand consists of this export and import trade. Holt, however, is thinking about using Thailand to augment Blades’ U.S. business in other ways as well in the future. For example, Holt is contemplating establishing a subsidiary in Thailand to increase the percentage of Blades’ sales to that country. Furthermore, by establishing a subsidiary in Thailand, Blades will have access to Thailand’s money and capital markets. For instance, Blades could instruct its Thai subsidiary to invest excess funds or to satisfy its short-term needs for funds in the Thai money market. Furthermore, part of the subsidiary’s financing could be obtained by utilizing investment banks in Thailand.

Due to Blades’ current arrangements and future plans, Holt is concerned about recent developments in Thailand and their potential impact on the company’s future in that country. Economic conditions in Thailand have been unfavorable recently. Movements in the value of the baht have been highly volatile, and foreign investors in Thailand have lost confidence in the baht, causing massive capital outflows from Thailand. Consequently, the baht has been depreciating.

When Thailand was experiencing a high economic growth rate, few analysts anticipated an economic downturn. Consequently, Holt never found it necessary to forecast economic conditions in Thailand even though Blades was doing business there. Now, however, his attitude has changed. A continuation of the unfavorable economic conditions prevailing in Thailand could affect the demand for Blades’ products in that country. Consequently, Entertainment Products may not renew its commitment for another three years.

Because Blades generates net cash inflows denominated in baht, a continued depreciation of the baht could adversely affect Blades, as these net inflows would be converted into fewer dollars. Thus Blades is also considering hedging its baht-denominated inflows.

Because of these concerns, Holt has decided to reassess the importance of forecasting the baht-dollar exchange rate. His primary objective is to forecast the baht-dollar exchange rate for the next quarter. A secondary objective is to determine which forecasting technique is the most accurate and should be used in future periods. To accomplish this, he has asked you, as the financial analyst at Blades, for help in forecasting the baht-dollar exchange rate for the next quarter.

Holt is aware of the forecasting techniques available. He has collected some economic data and conducted a preliminary analysis for you to use in your analysis. For example, he has conducted a time-series analysis for the exchange rates over numerous quarters. He then used this analysis to forecast the baht’s value next quarter. The technical forecast indicates a depreciation of the baht by 6 percent over the next quarter from the baht’s current level of $.023 to $.02162. He has also conducted a fundamental forecast of the baht-dollar exchange rate using historical inflation and interest rate data. The fundamental forecast, however, depends on what happens to Thai interest rates during the next quarter and therefore reflects a probability distribution. Based on the inflation and interest rates, there is a 30 percent chance that the baht will depreciate by 2 percent, a 15 percent chance that the baht will depreciate by 5 percent, and a 55 percent chance that the baht will depreciate by 10 percent.

Holt has asked you to answer the following questions:

1Considering both Blades’ current practices and future plans, how can it benefit from forecasting the baht-dollar exchange rate?

2. Use the fundamental forecasting techniques to forecast the future of the baht

Answer 1

1. By forecasting the baht-dollar exchange rate Blades will stand to benefit in several different ways. First of all it will allow Blades to hedge its cash flows based on the exchange rate forecast. As we know Blades is generating its cash flows primarily in Thai baht. These inflows are sensitive to the future baht-dollar exchange rate. Thus forecasts will enable Blades to hedge its cash flows.

Secondly when Blades establishes a subsidiary in Thailand then the earnings earned from this subsidiary will be remitted back to the parent. A forecast of future exchange rates will allow and enable Blades to making the right hedging decisions with regards to remittance.

2. Expected change in value of baht as per the fundamental forecast = 0.3*(-2%) + 0.15*(-5%) + 0.55*(-10%)

= -6.85%

Thus baht is expected to depreciate by 6.85% over the next quarter. Thus the forecasted value of baht = $0.023*(1-6.85%)

= $0.0214