Case Analysis: How to survive the Euro
The situation that the case presents is the mismanagement of foreign exchange risk by Paul Bannerman of General Mills in Europe. The strategy chosen by Mr. Bannerman generated a long lasting concern due to the firm’s dominating liabilities in Euros leading to significant losses. On February 16th 2004, he has to explain to the U.S. CFO the reasoning behind his strategy and what he is estimating for the rest of the year. Mr. Bannerman considered that it was extremely difficult to predict the persistent dollar devaluation and that the financial analysis had not predicted all those events.
Mr. Bannerman’s problem is that he only used the IFE and PPP forecasting models to determine the exchange rate but failed to compare the rate of return difference between Dollar y Euro deposits.
We will first describe and analyze different factors that influence the PPP (Purchasing Power Parity) and IFE (International Fisher Effect) forecasting methods used for exchange rates. Then, we will calculate the forecast of the Dollar/Euro exchange rate using Mr. Bannerman approach, and compare the rate of return difference between both currencies. We will finalize the analysis by proposing some other tools Bannerman could have used to develop his financial strategy and utilize it in the future.
In order to help Mr. Bannerman face this problem, we can look at four major factors that are used to determine exchange rates between the Dollar and the Euro. These factors are interest rates, inflation rates, level of income and macro policies. For the purpose of this study we have further analyzed the Interest Rates and Inflation Rates behavior. Additionally, we will evaluate the PPP and IFE methods which are two of the most widely used forecast methods to estimate the expected exchange rate on any currency.
For the IFE analysis we considered the quarterly interest rates in US...