Question 1
Exacta, s.a., is a major French producer, based in Lyon, of precision machine tools. About two-thirds of its output is exported. The majority of these sales are within the European Union. However, the company also has a thriving business in the United States, despite strong competition from several U.S. firms. Exacta usually receives payment for exported goods within two months of the invoice date, so that at any point in time only about one-sixth of annual exports to the United States are exposed to US Dollar currency risk.
The company believes that its North American business is now large enough to justify a local manufacturing operation, and it has recently decided to establish a plant in South Carolina. Most of the output from this plant will be sold in the United States, but the company believes that there should also be opportunities for future sales in Canada and Mexico.
The South Carolina plant will involve a total investment of $380 million and is expected to be in operation by the year 2015. Annual revenues from the plant are expected to be about $420 million and the company forecasts net profits of $52 million a year. Once the plant is up and running, it should be able to operate for several years without substantial additional investment.
Although there is widespread enthusiasm for the project, several members of the management team have expressed anxiety about possible currency risk. M. Pangloss, the finance director, reassured them that the company was not a stranger to currency risk; after all, the company is already exporting about $320 million of machine tools each year to the United States and has managed to exchange its dollar revenue for euros without any major losses. But not everybody was convinced by this argument. For example, the CEO, M. B. Bardot, pointed out that the $380 million to be invested would substantially increase the amount of money at risk if the dollar fell relative to the euro. M. Bardot was notoriously risk-averse on financial matters and would push for complete hedging if practical.
M. Pangloss attempted to reassure the CEO. At the same time, he secretly shared some of the anxieties about exchange rate risk. Nearly all the revenues from the South Carolina plant would be in U.S. dollars and the bulk of the $380 million investment would likewise be incurred in the United States. About two-thirds of the operating costs would be in dollars, but the remaining one-third would represent payment for components brought in from Lyon plus the charge by the head office for management services and use of patents. The company has yet to decide whether to invoice its U.S. operation in dollars or euros for these purchases from the parent company.
M. Pangloss is optimistic that the company can hedge itself against currency risk. His favoured solution is for Exacta to finance the plant by a $380 million issue of dollar bonds. That way the dollar investment would be offset by a matching dollar liability. An alternative is for the company to sell forward at the beginning of each year the expected revenues from the U.S. plant. But he realizes from experience that these simple solutions might carry hidden dangers. He decides to slow down and think more systematically about the additional exchange risk from the U.S. operation.
Questions
a. What would Exacta's true exposure be from its new U.S. operations, and how would it change from the company's current exposure?
b. Given that exposure, what would be the most effective and inexpensive approach to hedging?
Question 2
Discuss how diversification reduces risk. Comment on the beta of a portfolio with a large number of randomly selected stocks. (Hint: your discussion should include the increased importance of diversification post 2008 financial crisis.)