Week 4 Case Study: The Onwhaler Publishing Company ✓ Solved

Week 4 Case Study read The Case Onwhaler Publishing Companyand Answer T

Read the case on Whaler Publishing Company and answer the following questions. Case Study Questions: Perform these tasks for Whaler to determine these confidence intervals on the aggregate level of U.S. dollar cash flows to be received. Whaler uses the methodology described here, rather than simply combining the results for individual countries (from the previous chapter) because exchange rate movements may be correlated. Review the annual percentage changes in the four exchange rates. Do they appear to be positively correlated?

Estimate the correlation coefficient between exchange rate movements with either a calculator or a spreadsheet package. Based on this analysis, you can fill out the following correlation coefficient matrix. Would the aggregate dollar cash flows to be received by Whaler in this case be riskier than if the exchange rate movements were completely independent? Explain. One Whaler executive has suggested that a more efficient way of deriving the confidence intervals would be to use the exchange rates instead of the percentage changes as the scenarios, and to derive U.S. dollar cash flow estimates directly from them. Do you think this method would be as accurate as the method now used by Whaler? Explain.

Sample Paper For Above instruction

Introduction

The international operations of multinational corporations like Whaler Publishing Company expose them to currency exchange rate fluctuations, which can significantly impact their cash flows. Accurately estimating the risk associated with these cash flows is crucial for effective financial management. This paper analyzes Whaler's approach to assessing currency risk, specifically through correlation analysis of exchange rate movements, and evaluates the proposed alternative method suggested by one of its executives.

Analysis of Exchange Rate Movements and Correlation

Whaler examines four exchange rates pertinent to its operations, analyzing their annual percentage changes over a specified period. The first step involves assessing whether these changes tend to move together, indicating positive correlation. Visual inspection through scatterplots and correlation coefficients calculated via spreadsheets reveal that the exchange rates exhibit signs of positive correlation, meaning that when one rate appreciates or depreciates, others tend to do similar movements. This clustering of movements reflects underlying economic or geopolitical factors influencing multiple currencies simultaneously.

Calculating the correlation coefficients provides a quantitative measure of the degree of association. For example, if exchange rate A and B have a correlation coefficient of 0.75, it indicates a strong positive correlation, whereas a coefficient near zero implies negligible association. These coefficients help construct a correlation matrix, which captures the interdependencies among the various exchange rate movements.

Implications for Risk Assessment of Cash Flows

Considering the correlation matrix, the aggregate dollar cash flows are subject to the combined variability of individual currency movements. When exchange rates are positively correlated, the risk profile of the overall cash flows increases because adverse movements tend to occur simultaneously across multiple currencies, amplifying potential losses. This phenomenon makes the portfolio of currency exposures riskier compared to the scenario where exchange rate movements are independent. In the case of independence, the variability would tend to cancel out partially, reducing overall risk.

Mathematically, the variance of the aggregated cash flows depends on both individual variances and covariances, with positive covariances increasing the total variance. Therefore, the correlated movements heighten the uncertainty faced by Whaler, impacting its risk management strategies and financial planning.

Evaluation of the Alternative Method

The efficiency of risk estimation can also be explored through alternative approaches. One executive suggests bypassing percentage change scenarios in favor of directly using exchange rates to derive U.S. dollar cash flows. This method might seem more straightforward, as it considers actual exchange rate levels rather than relative changes. However, this approach could face limitations in capturing the variability and distributional characteristics of future exchange rates, especially given their stochastic nature.

Using percentage changes allows for better modeling of volatility and the probabilistic nature of currency movements. The percentage change methodology aligns with approaches like Monte Carlo simulations and bootstrapping, providing more robust confidence intervals. Directly using exchange levels may introduce bias or overlook the proportional variability inherent in currency movements, potentially leading to less accurate risk assessments.

In conclusion, while the proposed method might seem more intuitive, the current approach that utilizes percentage changes is likely more precise in capturing exchange rate volatility and, consequently, the risk profile of Whaler's dollar cash flows.

Conclusion

Understanding the correlation among exchange rate movements is vital for multinational firms like Whaler Publishing Company. Positive correlations increase the overall risk of currency exposures, necessitating more sophisticated risk management strategies. The current methodology based on percentage changes provides a nuanced view of potential variability, making it a preferred choice for estimating cash flow uncertainty. The alternative of using exchange rates directly, while seemingly simpler, may not offer the same accuracy in risk estimation, emphasizing the importance of considering volatility and correlation in foreign exchange risk analysis.

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