Professor Robert B.H. Hauswald
International Finance Kogod School of Business, AU
Please read the following general information carefully before you begin the exam:
- The midterm is an individual take-home exam: it is to be submitted in electronic format on the Canvas course website and by email to me and the course assistant by 11h59pm (23h59) on Monday, November 14. It is your responsibility to make sure that we receive the completed exam by email before the expiration of the time window: the Outlook and Canvas time stamp will decide any disputes in this regard.
- Submissions consist of your type-written answers and one Excel workbook containing your analyses, both zipped together in the same file; each question or part thereof that requires major calculations is to be presented on a separate worksheet with the bottom tab indicating the precise question number (e.g., 3.a). All file names need to contain 463 Midterm and your last name, e.g., 463midterm hauswald.xxx for the *.zip, *.doc, and *.xls files.
- This exam is an individual effort: no cooperation, discussion, joint work, outside help, etc. is permitted. Only clarifying questions will be answered. Be reminded that, as part of the honor code, you are not to share the contents or structure of this exam with anyone else, including your classmates not here today or those attending other sections of this course.
- By taking the exam early you engage yourself not to communicate any information about its make-up, content, etc. to anybody. Since the course grade distribution is fixed and you are graded on a curve, it is in your own best interest to adhere to this policy.
- Put your name and student ID number on each page of your answers. Your answers should be short and to the point, type-written and may contain pasted excerpts from your analytic spreadsheets together with careful explanations of the analysis and its underlying assump- tions.
- The midterm comprises 6 questions with optional bonus sections with a maximum total number of points of 600 (individual points given in the margin). The bonus parts should only be attempted after the rest of the question has been answered.
- Show your work but write to the point: explain each answer as fully and carefully as necessary. Label all diagrams and box intermediate and final results.
- Good Luck!
Although it is easy to find additional material related to the automotive industry, foreign exchange, international M&A, and risk management rest assured that all the relevant information has been carefully screened and consolidated in the present midterm materials. Hence, do not waste your precious time looking for additional material on the internet but, instead, rely on the data provided in these instructions, the case, and the data file.
- Instructions and questions (this document).
- Hauswald, R. (2020), “Risk Management at BMW AG,” KSB-AU 2020 (FIN-20-001).
- Data file including all the case exhibits, additional financial information, and relevant time series: Hauswald (2020), BMW Case Exhibits and Data.xlsx. Not all the data is relevant to this exam since the case also serves for other teaching purposes
- Background readings: Bartram et al. (2010), “Resolving the Exposure Puzzle: The Many Facets of Exchange Rate Exposure,” Journal of Financial Economics 95, No. 2, February 2010, pp. 148-173. In addition, you might want to consult various course materials pertaining to the technical and conceptual aspects of the exam. Case Questions In preparing your solutions, make sure to adhere to the presentational guidelines detailed in the above Instructions. In particular, present any analytic spreadsheets as succinctly as possible: do not print out reams of paper with Excel output. Throughout, you are free to make additional assumptions as need be but remember that you have to carefully motivate and document them. If you feel that information is missing or a question ambiguous, please send me email. It is easy to get carried away by case studies and write longwinded essays. Most questions are straightforward and do not require long answers or can be answered in tabular form or with simple calculations. If you find yourself writing long answers you probably are missing the point or have not carefully studied the case which contains all the necessary information for succinct, to-the-point answers. Just keep it short and spend more time on thinking through the questions and case rather than writing too much.
1. The Setting: BMW and the Global Automotive Industry. Analyze BMW AG and 100 the economic environment in which they are operating. Pay particular attention to the company’s performance from the early 1990s to the 2010s, its growth strategy, and the global financial markets which affect the Group.
(a) How well has the company been doing? Propose an appropriate metric and assess the Group’s overall performance since it embarked on its ambitious globalization plans.
- (b) What is BMW’s strategy? How has it expanded and grown internationally? How suc- cessful has this growth strategy been and how is it affecting the current performance of its major divisions?
- (c) The automotive industry has always be at the forefront of globalization and risk man- agement. Reconcile the stylized facts that shareholder returns in this industry do not seem to systematically vary with FX rates with the significant foreign-currency exposures which global car manufacturers face. How can that be?
- (d) The academic literature identifies several factors which might have contribute to the neutralization of foreign-exchange exposure in global automotive operations. What are these factors and what is their relative importance in reducing or eliminating the con- sequences of foreign-currency exposures? You might want to consult Bartram et al. (2010).
- (e) For planning purposes, it is very important to estimate long-term equilibrium FX rates. Taking into account the evolution of the USD/EUR exchange rate during the 2000s, would you consider a range of $1.15 to 1.17/EUR to be an appropriate equilibrium rate? How would you define such an equilibrium FX rate?
2. Of Currencies and Competition: The Environment. The case references USD ex- change rates from the 1980s and 1990s in terms of Deutsch(e) Mark (DEM), Germany’s old national currency before the advent of European Monetary Union and the common currency Euro (EUR), which now is the official currency of 19 of the 27 member states of the European Union. With the introduction of the Euro in 1999, the official conversion rate for Deutsche Mark was set to 1.95583/EUR.
The euro was introduced to world financial markets as an accounting currency on 1 January 1999, replacing the former European Currency Unit (ECU) at a ratio of 1:1 (USD1.1743/ECU or EUR). Physical Euro coins and banknotes entered into circulation on January 01, 2002, thereby becoming the day-to-day operating currency of its original members, and by March 2002 it had completely replaced the former currencies.
- (a) What kind of quote is $0.34/DEM and $0.64/DEM in 1985 and 1992, respectively? What is the price of $1 in terms of DEM?
- (b) When the Euro was introduced, the official conversion rate for the DEM was fixed at DEM 1.95583/EUR. Assuming that the two quotes in (a) are average FX rates, what would have been the USD/EUR average exchange rate in 1985 and 1992, respectively?
- (c) In 1992, a BMW selling for DEM 50,000 in Germany sold in the United States for $32,000 taking into account various courtesy upgrades and possible discounts from MSRP. Com- pute the implied PPP exchange rate in terms of both DEM and USD. Is the USD over or undervalued? What can BMW do in light of the prevailing exchange rates in 1992 to make their cars more appealing to US customers?
- (d) Auto workers in the US made approximately $23.50 hourly on average in terms of wages 3
($15)andbenefits($8.50)intheearly1990s.1 HowmuchdidGermanautoworkersmake in USD and DEM during the same period using the average FX rate if $0.64/DEM in 1992? What is the USD/DEM break-even PPP exchange rate in terms of wage and benefit costs? What are the competitive implications for BMW?
- (e) Given your preceding analysis, advise BMW on their globalization strategy. What other problems can the company address through your recommended course of action?
- (f) Bonus problem. BMW estimates that in the 1990s the US will retain a cost advantage of about 30% over the German car industry in terms of hourly compensation (wages and benefits). Assuming that hourly compensation in the US car industry remains steady throughout the decade, what does this assumption imply for the German hourly compensation by the year 2000? What are the corresponding break-even FX rates in terms of the Euro?
3. Making Informed Decisions: Forecasting FX. Forecasting foreign-exchange rates is notoriously difficult, especially in the short-run. Propose a simple methodology based on prices and costs and assess how well BMW Group has been doing in this regard.
- (a) Define and give an example of absolute and relative purchasing power parity in the context of BMW’s North-American operations, respectively. How can BMW use PPP to improve on its FX forecasting?
- (b) Are implied forward rates good predictors of future spot rates? Investigate their predic- tive power or absence thereof in the context of BMW’s forecasts by computing implied forward rates, comparing them to the Group’s forecast, and assessing their quality as a predictor for future spot rates. All the necessary data are provided in the case exhibits.
- (c) Given the data provided in the case, what do you think about BMW’s forecasts and their reliance on PPP?
- (d) In light of BMW’s FX forecast, what seems the Finance division expect with regards to the USD in 2007? How will the forecast FX change affect BMW Group’s financial position?
- (e) Bonus problem. How does the Law of One Price provide information on BMW’s com- petitive position? Taking USD-based car makers as a reference, construct a numerical example to assess EUR-based BMW’s competitive position given current FX rates.
4. Global Operations and Foreign-Exchange Exposure. Analyze the different types of foreign exchange risk which BMW AG face in their operations and how they affect the Group.
(a) What is the difference between FX risk and exposure? Explain the difference in the context of BMW’s operations and risk-management efforts.
1See for instance https://www.bls.gov/opub/mlr/2019/article/earnings-of-production-workers-in-manufacturing- 1990-2018.htm and various other sources.
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- (b) What is the fundamental imbalance in terms of foreign currencies in BMW’s opera- tions which necessitate such an involved and comprehensive risk management approach? Analyze the origin, evolution, and effect of BMW’s various foreign exchange risks and exposures.
- (c) Define and give examples for the following types of foreign-exchange exposures: eco- nomic, contractual, competitive, operating, translation, and transaction exposure in the context of BMW’s operations. You may present your answer in tabular form and should pay attention to potential synonyms and double counting.
- (d) Analyze BMW’s economic and competitive exposure and investigate how it has changed over time. What is it and where does it stem from? How you would go about addressing their economic exposure? How would your solution benefit the Group beyond its current hedging strategy?
- (e) Explain what is meant by a money-market hedge and provide an example of its usefulness in the context of BMW’s decision problem.
- (f) Bonus problem. Define synthetic debt and give an example. How are risk management and funding related in addressing foreign-exchange exposures?
5. Corporate Risk Management: Policies and Implementation. Every good risk- management strategy relies on a sound dose of market assessment and opinion. As a result, corporate finance divisions and treasury groups typically start with detailed market analyses and forecasts to inform their strategic risk-management choices. Analyze BMW’s framework for managing financial risks and identify the economic and organizational reasons for their particular approach to FX hedging.
- (a) What risk factors does the Group face? Present examples of various the risks in tabular form distinguishing between financial and nonfinancial risks and identifying each risks’ origin. The table does not need to be exhaustive since most risks are nonfinancial.
- (b) Explain BMW’s approach to risk management in the context of FX rate forecasting and operations. What is their stated policy and how well have they been doing? Do you see any problems with BMW’s approach and implementation?
- (c) Why did BMW decide to consolidate FX risk management globally in its Munich group treasury? What principle are they implementing and what are its advantages for the Group?
- (d) Evaluate the advantages and disadvantages of various exchange-hedging instruments and techniques. Distinguish financial from nonfinancial risk management approaches.
- (e) Which financial hedges does BMW use? What nonfinancial hedges are available to them and how do they use them?
- (f) Bonus problem. What differences if any exist in BMW’s approach to FX exposure management in North America and Asia? 5
6. Hedging BMW’s USD Exposure. You are a senior analyst in BMW’s Finance Division asked to outline possible avenues to address the remaining risks and exposures arising from the North-American operations. However, first you provide some background and why this FX exposure might be different.
- (a) A country’s currency is often likened to its share price. What does BMW’s FX forecasting model suggest about their expectations for the American economy, the USD, and their need for hedging their USD exposure?
- (b) What is the best strategy of all listed above to minimize the expected USD exposure? How does it fit into BMW’s stated approach to risk management?
- (c) At the end of 2010, BMW has to address next year’s currency risk-management chal- lenges. Propose an estimate for (net) USD exposure in 2011 and design a money-market hedge for it. Describe the mechanics of the hedge and compute the implied forward rates on the basis of the provided numbers.
- (d) What are the dangers of leaving the exposure unhedged? Might there be any advantages to this course of action?
- (e) Exchange rate uncertainty does not necessarily mean that firms face exchange risk ex- posure. Why might this be the case?
- (f) Bonus problem. Although BMW do not speculate their Finance Division is not averse to exploiting arbitrage positions. Analyze the data in the case and determine what 1Y USD forward rates would offer arbitrage opportunities. Construct an example, present a detailed strategy, and compute its potential profits for a spot rate of EUR/USD 0.7454 and 1Y forward rate of USD/EUR 1. 3343.
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