Question

You are a US company which makes fashion accessories, particularly fashion sunglasses. Recently you decided to expand the company internationally and you are going to start first in the European Union (EU) which is one of the worlds largest markets. You will both produce some products there and also sell some products there. Your forecast for next year is below. In the forecast, any item marked as an EU item is actually the US dollar equivalent of Euro which has been translated at the EUR forward rate.

Question: What answer best represents the foreign exchange exposure in your forecast?

Spot EUR fx rate: 1.20 Forward EUR fx rate: 1.22 (all numbers expressed as $USD '000)

Cash Revenues

US revenues $5,000

EU revenues $2,000

Cash Costs

Corporate costs ($1,000)

Research & development ($500)

US capital investments ($100)

EU capital investments ($2,000)

US salaries ($2,000)

EU salaries ($1,000)

Possible answers:

$1,000

($1,000)

(820 Euro)

(1,000 Euro)

Please show step by step answers and reasonings

Thank you

Answer 1

Since the company is US based company, the expenses which needs to be incurred in euro would only be the exposure.

In the question, it was clearly mentioned that the euro salaries needs to be paid i.e, 1000$ ...that amount needs to be paid only in euro. Further, capital investment euro is...2000$ that amount also needs to be spent in euro. So, total euro exposure is 3000$ equivalent.

However, we have revenue in euro term for 2000$.

So, net exposure could be (3000-2000) i.e., $ 1,000$ equivalent. (Always the foreign currency exposure receivables and payables should be netted off).

Since this is translated at the forward rate of 1.22, the net exposure in euro terms is (1000$/1.22) = 820 euro payable.

So, the net exposure in foreign currency is payable 820 euro.

This represents the correct figure than the 1000$, as the exchange rates might get changed. But ultimately the euro figure will remain constant.

Hope it helps,

Thank u.