Describe the exchange rate problems Toyota, Nissan,
and GM face while manufacturing in Britain and
propose a long-term strategy for these companies

Case Study
written within the seminar European Integration
of the course of study International Business
at the University of Applied Sciences Mainz

Submitted by: 

Johannes Hartmann

Submitted on: 06/14/2002

Content

ABBREVIATIONS II

FIGURES III

1. THEORETICAL BACKGROUND 1
1.1 Theories on exchange rate risks 1
1.2 Theory on Purchasing Power Parity 2

2. EXCHANGE RATES UK VERSUS CONTINENTAL EUROPE 3

3. IMPACT ON CARMAKERS 5
3.1 Exchange rate between home- and foreign currency 6
3.2 Exchange rate between Euro and Pound 6

4. LONG-TERM SOLUTION 8

BIBLIOGRAPHY 11

LIST OF APPENDICES 15

Abbreviations
BBC British Broadcasting Corporation
DM Deutsche Mark
EMU Economic and Monetary Union
EU European Union
GBP Great Britain Pound
GM General Motors
PP Purchasing Power
PPP Purchasing Power Parity
UK United Kingdom
US United States (of America)

Figures
Figure 1 - DM / Great Britain Pound 3
Figure 2 - Euro / Great Britain Pound 4

1. Theoretical background

Theories on exchange rate risks and the closely related theory of Purchasing Power Parity (PPP) provide the basis for the analysis of the exchange rate problems the three car producers face while manufacturing in the UK.

1.1 Theories on exchange rate risks

The exchange rate risk represents one of the most important risks for companies operating in international industries.¹ There are three kinds of exchange risks: transaction risk, translation risk and economic risk. Transaction exposure is the risk of changes in the value of currency occurring between the time of the settlement of the transaction and the maturity of it.² The second and most important type of exchange risk is economic risk. Economic exposure occurs when currencies, that are involved in the actual or potential competitive situation, become over- or undervalued.³ It can heavily affect current and future cash flows of domestic and foreign operations.⁴ The third type of risk is called translation exposure. It refers to the risk that exchange rate fluctuations may change the value of current assets and liabilities of the balance sheet of a foreign affiliate in case of consolidation.⁵

Whereas translation risk does not really hurt the company⁶ if the accounted assets remain in the country, transaction and economic exposures represent a real threat for the company, because they change current and future inflows – outflows of money.

Fortunately, strategies exist to help the firm to control those risks. In general, transaction risk can be controlled by financial hedging while economic risk can be reduced by operational hedging. Examples for financial hedging are forwardcontracts and options, which both provide the possibility to protect future cash flows of determined transactions against exchange rate fluctuations. Operational hedging means to build manufactures in several countries, in order to be less affected by fluctuation of the partner countries′ currencies.

1.2 Theory of Purchasing Power Parity

The theory of Purchasing Power Paritiy (PPP) states that the nominal exchange rate between two countries′ currencies should equal the ratio of the two countries′ overall price levels.⁷ In accordance to the theory a country′s currency thus must depreciate in case of an increasing domestic price level relative to a foreign country′s price level in order to return to PPP.⁸ If the exchange rate does not return to PPP the domestic currency is overvalued. This leads to an increase in the domestic currency′s purchasing power (PP) in the foreign market and simultaneously to a decrease in PP of the foreign currency in the domestic market.

Due to the decreased PP of the foreign currency, companies located in the country where the currency is overvalued suffer both from decreasing market share in the domestic market and from export cutbacks.⁹ Consequently, with regard to economic risk, exchange rate fluctuations only affect companies in case of an exchange rate deviating from PPP.

[....]

1 See: Punett, Betty J. / Ricks, David A., 1994, p. 305

2 See: Grosse, Robert / Kujawa, Duane, 1992, p. 447

3 Over- and undervaluation are expressions that will be explained under the point 1.2 "Theory of Purchasing Power Parity".

4 See: Czinkota, Michael R. / Ronkainen, Ilkka A. / Moffett Michael H., 1992, p.542

5 See: Grosse, Robert / Kujawa, Duane, 1992, p. 447

6 The translation risk will therefore be neglected in the following. 77 See: (Internet) OECD (editor) - About Purchasing Power Parity

8 See: (Internet) Pacific Exchange Rate Service (editor) - Purchasing Power Parity

9 Explanation for economic risk.