1) Describe the two companies, their industries, how each is involved in foreign operations, etc. Merck & Co.

, Inc. is a multinational company, doing business in over 100 countries. It discovers, develops, produces, and distributes human and animal health pharmaceuticals. The industry is highly competitive, with no company holding over 5% of the worldwide market. The major foreign competitors for the domestic industry are European and emerging Japanese companies. The leading U.S pharmaceutical companies generated 38% of their sales revenues overseas, and 37% of their total assets were located outside the U.S. The U.S pharmaceutical industry bills its customers in their local currencies; therefore the effects of exchange rates fluctuations are more immediate and direct. Merck is one of the leading U.S pharmaceutical companies, has overseas assets equal to 40% and half of its sales are overseas. For foreign operations involving, Merck has approximately 70 subsidiaries responsible for importing products at some stage of manufacturing, finishing, marketing, and distribution within the country of incorporation. Sales are denominated in local currency, and costs in a combination of local currency for overseas functions and in the U.S dollar for the basic manufacturing and research expenditures. Western Mining Corporation is one of the largest corporate groups and the largest gold producer in Australia. It produces 10% of the western worlds nickel, owns 44% of Aloca of Australia, and has producing interests in oil and gas, copper, uranium, and talc. The Australian mining industry needs major capital investments in very large scale minerals projects; most companies raised capital in the developing Euro-dollar market in the 60s and 70s, even during the early 1980s when Australian capital markets had developed sufficiently to finance a large portion of the investments. Most of the commodities in the industry produced locally and exported to the international market where the prices are denominated in U.S dollars. This means an exposing to exchange rate risks is very high on the long-term. Mining companies in Australia believe that borrowing in U.S dollars would provide a natural hedging against their U.S dollar revenue stream. In addition, when forward currency markets began to develop in the mid-1970s, such companies began to supplement the hedge provided by U.S dollar debt with forward exchange contracts. Western Mining Corporation is involved in foreign operations by exporting the products overseas, financing its investment projects from outside capital markets, and has a pricing for the their products denominated in the U.S dollars which means a major exposure to foreign exchange risk.

2) Describe how each company is exposed to exchange rate risk. Describe the similarities and differences in the nature of the companies exposure to exchange rate risk. Merck & Co., Inc. has operations in other countries outside the U.S, which means it holds assets overseas. Any adverse change in the dollar value affects the net assets value held by the Inc. overseas. Such kind of risk is known as translation exposures. Merck bills its customers in their local currencies with an exposure approximately of 40 currencies, and any adverse change in the dollar value of net revenues earned overseas affects the cash flows, at least in the short-term or impairs the companys ability to execute its strategic plan for growth. This kind of risk is called revenue exposures. Western Mining Corporation has operations in Australia, the process of extracting and treating minerals is done in Australia and then exports to the international markets. This means that Western does not have the translation exposures for the assets. Western bills its customers in U.S dollars because the prices are denominated in U.S.D, which means an exposure for revenue is existed and it leads to a major exchange risk for the company. Western Mining has a competitive exposure, where any depreciation in the competitors cost currency gives them a greater flexibility and a better competitive position. Finally, Western Mining relied more on the equity market to finance its capital expenditures especially the foreign capital markets, which means a more exposure to exchange risk by borrowing in foreign currencies. Similarities: Both companies have revenues overseas in foreign currencies, and both of them are exposed to the exchange rate risk. Differences: Merck & Co., Inc. has costs combinations of local currency (U.S.D) and other foreign currencies where it has operations for finishing, distributing and marketing the products. It has operations overseas, which means translation exposures are expected. Western Mining Corporation has operations in Australia, which means the costs are denominated in the local currency and there is no risk for the translation exposures. It finances its capital expenditures from foreign capital markets which mean a change in the value of foreign currency may increase the cost of serving foreign debts. Competitive exposure are possible for Western Mining since it has operations locally and the prices are unified world widely in U.S.D, which means a foreign competitors in other country may benefit from their currency depreciation by decreasing their costs and sell with a lower price, this affects the competitive position for Western Mining.

3) Describe all the possible ways of managing the kinds of exchange rate risk that these companies are exposed to. Then suggest out of the possible alternatives, which one would be the best and why. Merck & Co., Inc. 1- Resource allocation: by reviewing the companys global allocation of resources across currencies and in the process to determine the extent to which revenues and costs are matched in individual currencies. (Diversification of resources) 2- Hedging exposures with financial instruments: to decide which instrument is cost effective, if required. Merck followed five steps approach to measure the effects of adverse exchange movements, the potential impact on the strategic plans, determine whether the exposure needs to be hedged or not. If yes, which instruments are most effective and how to apply it? Finally evaluate different instruments to choose the most cost effective strategy to accommodate the risk tolerance profile. By following these five steps: 1) Exchange forecast, 2) Strategic Plan Impact, 3) Hedging Rationale, 4) Financial Instruments, 5) Hedging program. Merck could examine the exchange rate risk, and if the risk needs to be hedged, then determine which instrument is most cost effective: -Currency options -Forward foreign exchange contracts -Foreign currency debt -Currency swaps For Merck, it is not recommended to use the resource allocation alternative, since analysis revealed that the distribution of assets differs in some way from the sales mix, primarily because of the concentration of research, manufacturing, and headquarters operations in the U.S., so because few support functions seemed appropriate for relocations, then a move would had only a negligible effect on Mercks global income exposure. The second alternative seems more successful and effective. By applying these five steps Merck first forecast the adverse exchange rates and measure its effect on the strategic direction. This avoids Merck the cost of hedging if they find that the hedging is not required and then incurring additional costs. In addition, the 5 steps include identifying the possible financial instruments and the effectiveness of each one by using a mathematical model that prompt the best scenario.

Western Mining Corporation. 1- Natural Hedging: Because commodities prices are denominated in U.S dollars, Western is exposed to significant, long term U.S exchange rate risk. Borrowing in U.S dollars would provide a natural hedge against U.S dollar revenue stream.

2- Exclusively borrowing in Australian dollars: Eliminate any exposure of Westerns liabilities to exchange rates. 3- Borrowing in a basket of currencies: To reduce the effect of adverse exchange rates for one currency, it is better to diversify the risk of serving debts in different foreign currencies. 4- Forward exchange contract: By selling forward future U.S dollar revenue stream. For Western Mining, Ill suggest to hedge the exchange rate risk by borrowing in foreign currencies not exclusively in Australian dollars, because till that moment there was no evidence that Australian dollar is predictably influenced by movements in commodity prices. In addition it is recommended that Western Mining enters to the forward exchange contracts, because sales of one year, two years, or ten years ahead cant be hedged solely by short-term U.S dollar debt and forward contracts are required to hedge this long-term risk.

4) Describe the exchange rate risk management strategies the two companies actually implemented. Compare and contrast their strategies and comment on the strengths and weaknesses of each companys strategy. Merck & Co., Inc. had applied the second alternative by following the five steps model to evaluate the expected exchange rates and then find the effects of movements on the strategic direction. By finding that exchange rates movements had a critical impacts on the long horizon plan of the company, it decided to hedge against the exposures by following decisions: Would Hedge for a multi-year period, using long term options to protect strategic cash flows. Would not use far-out-of-the-money options to reduce costs. Would hedge only on a partial basis and in effect, self-insure for the remainder.

Strengths: They calculated the probability of future exchange rate movements by taking into considerations different factors like, balance of payments accounts, government policies designed to manage exchange rates and making a summary of outside forecasters to develop a possible ranges for dollar strength weakness over the planning period. They figured out the effects of exchange rates movements on the strategic plan by converting the strategic plan into U.S dollars on an exchange neutral basis (spot exchange rate), and then compare these current finding with expected dollar strength or weaknesses.

They undertook into considerations while deciding whether to hedge or not multiple concerns. External concerns, like the effects on share price, investor clientele effects, and maintenance of dividend policy, as well as Internal concerns, like the large proportion of companys overseas earnings and cash flows and the potential effect of cash flow volatility on Mercks ability to execute the strategic plan. They used a computer model that simulates the effectiveness of a variety of strategies for hedging.

Weaknesses: They did not utilize the used system to measure the effect of reallocation. May be the reallocation is not cost effective enough, but still there is a chance to find the optimal distribution of resources that already are located overseas, not necessary the main functions of research and others in the headquarter. Relying only on currency options are not enough. Options incurring a premium cost. The company decided to hedge for a multi-year period, using long term options. The possibility of exchange rate movements is actually in both directions, and long term commitment options might not be in the interest of the company if the change was in unfavorable direction.

Western Mining Corporation decided to borrow partly in Australian dollars and partly in a basket of currencies that included the U.S dollar. (30% Australian dollars, 35% U.S dollars, 14% Yen, and 10.5% each in sterling and DM). They decided to discontinue the practice of selling forward U.S dollar revenues, except when actual sales had been made. Strengths: Western Mining had the opportunity to exploit differences in tax or regulation to achieve lower issuing costs or to use currency options combined with the short positions represented by debt to profit from taking a view on future currency movements. This strategy allowed the treasury department to monitor the cost of the debt continuously. They monitor both the cost and benefit of currency movements and interest costs, and then compare this total against what cost would been have if they borrow either solely in U.S dollars or solely in Australian dollars.

Weaknesses: They did not consider other financial instruments for hedging, like options. Even if they are incurring premium cost for options but still they can benefit from the both direction of exchange rates directions. Instead of making a forward contract just when sales have

happened, which leads to more transaction cost each time they entering a contract, they should have practiced currency options to hedge more effectively. Western Mining has competitive exposures, they should take into consideration that their competitive position may be affected by the exchange rates movement. To be reactive they should diversify their resources other than the financial one to other locations, thereby they can optimize the usage of resources. Reallocating resources doesnt mean the manufacturing, because the minerals are inside Australia, but other supplementary functions may be reallocated in order to achieve more effectiveness.

5) Write a brief conclusion. Hedging foreign exchange risk reduces the uncertainty of a firms future cash flows. Firms hedge foreign exchange risk by using instruments such as forward and futures foreign exchange contracts, interest rate and currency swap, and foreign currency options and by choosing to denominate assets and liabilities in foreign currencies. Hedging is valuable because it can reduce the future taxes that a firm expects to pay, lower the costs of financial distress, and improve the investment decisions the firm will face in the future. Finally, the impact of exchange rate volatility on a company depends mainly on the companys business structure, operations, its industry profile, and the nature of its competitive environment.