Sharma Co. is a U.K. firm with a Chinese subsidiary that produces cell phones in

Question

Sharma Co. is a U.K. firm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan, which is stable against the pound. The cell phones sold to Japan are denominated in Japanese yen. Assume that Sharma Co. expects that the Chinese yuan will continue to stay stable against the pound. The subsidiary’s main goal is to generate profits for itself and it reinvests the profits. It does not plan to remit any funds to Sharma, the U.K. parent.

a.       Assume that the Japanese yen strengthens against the U.K. pound over time. How would this be expected to affect the profits earned by the Chinese subsidiary?

b.      If Sharma Co. had established its subsidiary in Tokyo, Japan instead of in China, would the subsidiary’s profits be more exposed or less exposed to exchange rate risk?

c.       Why do you think that Sharma Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers.

d.      If the Chinese subsidiary needs to borrow money to finance its expansion and wants to reduce its exchange rate risk, should it borrow U.K. pounds, Chinese yuan, or Japanese yen?

Explanation / Answer

Solution:

a) As Yen strengthens against UK pound, the goods sold to Japan by Chinese subsidary in Yen(strong currency) will inturn give more UK pound(weak currency) when those yen are converted to pound. The whole impact is that the subsidiary will have more pound or when converted to Chinese yuan, then more Yuan. Since Yuan is stable against Pound(i.e. no impact of Pound on yuan) increase in Pound means increase in Yuan. Hence it will inncrease profits of Chinese Subsidiary.

b) If the subsidiary was established in Japan instead of China then, the expenses will be paid in Yen instead of Yuan. Subsidiary's profits would be more exposed to exchange rate risk if the Pound and Yen are fluctuating against each other, else it will be less exposed to risk if the rates of both currencies are stable.

c) The major reason for establishing subsidiary in China instead of Japan is the Cost impact. Wages(Labour cost) and rent expenses are the Major costs in any organisation.These expenses when paid in Yuan, they are stable for the Parent Co. and Parent Company can easily compare the costs at consolidated level also. Further the impact of change in price of UK Pound is stable on Yuan. So it doesn't have much impact.

If it was Japan then fluctuation in UK currency market, i.e.with change in UK pound there would be impact on Yen also.

d) If Chinese Subisidiary wants to reduce its exchange rate risk it must buy Japanses Yen. The Chinese subsidiary company should see where it gets the best price for Yen and book the number of Japannse Yen required, so that in future if there is any change in price of Yuan v/s Yen it should have least impact. They can book a forward contract.

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