Risk Management Applications

There are about 300 million people in the nations that have officially adopted the euro and 500 million in the European Union (EU). The EU is designed to allow the free flow of goods, labor, services, and transit. In practice there are still some obstacles to the complete implementation of this concept.

You might notice that Switzerland is not on either list. That country has chosen to maintain its tradition of independence and neutrality.

· Rodney: If there are such advantages, why don't all the countries in the EU adopt the euro?

· Dad: Some countries have tried. They put the prospect to a vote and the people rejected the euro. Perhaps it is national pride. Other countries have leaders who are concerned about the promises made in the various countries' versions of Social Security. Unlike the United States, the population is declining in several countries and, just as here, the system is underfunded. Also, governments have different policies about taxing, spending, military expenditures, and international conflicts.For now, take a look at the exchange rate between the dollar and the euro at the end of the month specified ( Exhibit 7.5 ).This is quite a large range. In December 2001 $1,000 would buy €1,289. By June 2008, it would take $2,036 to purchase the same amount of euros.Let's do the math. Divide the euro amount by the exchange rate to get the dollar amount ( Exhibit 7.6 ).

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Exhibit 7.5 Amount of euros (€) purchased by one dollar ($)

Exhibit 7.6 Conversions between dollars and euros.

Lesson: One currency can eliminate some country risks, but the exchange rate risk still exists with other countries. Also, there may be added risks of different economic policies of countries within the European Union.

Currency Exchange Rates: A Case in China with Country Risk

Dad: Let's look at an investment from a business point of view.Consider the following case: A multinational corporation needs to invest in many countries and for periods of many years. We will look at an investment in China. There is a long history, but we will look only at relatively recent background. I'll pick a period with interesting times. Let's assume that the initial investment was made on October 23, 1995.China has been a special case because the government has taken steps to keep its currency stable compared to the U.S. dollar.

China is a manufacturing superpower. Assume that you are CFO of a small engine manufacturer, Small Co., looking to build a $100 million plant in China. Let's assume that your company requires a return of 10% on its investments in the United States and 16% on its investments in China. We will discuss the reasons for the 16% required return later in this section.