2. Dow Chemical’s Exchange Rate Exposure

Since 1992,when the bands surrounding the exchange rates between European currencies were widened, U.S-based MNCs with European subsidiaries that sell to various European countries became more exposed to exchange rate risk. The bands were 2.5 percent in either direction from a specified exchange rate between two European currencies before 1992;in 1992 ,the exchange rate mechanism (ERM)in Europe was adjusted to allow for a 15 percent band in either direction. Dow Chemical Co. was one of many U.S. firms that had European  subsidiaries whose cash flows were affected .consider how a German subsidiary of Dow Chemical is affected if it accepted the European currency of choice by each European customer that imported products from that subsidiary .the German subsidiary would normally convert those payments into German marks ,which is what it needs to cover most of its operating expenses.

When the ERM bands were narrow .the exchange rate exposure of the German subsidiary was more limited .However ,when the bands widened ,the probability of a large decline in the value of the French franc or the Belgian franc against the German mark was much higher .Under these conditions ,the German mark cash flows received by the German subsidiary would be reduced, which makes it more difficult for the subsidiary to cover its expenses .Dow Chemical Co. attempted to reduce this exchange rate exposure by revising its pricing policy to price the products sold by its subsidiaries in Europe in a single currency ,the German mark .

(1)    How might  Dow Chemical benefit from pricing all of its European products in German marks?

(2)    Dow Chemical’s strategy (of pricing all of its European products in German marks) was announced shortly after the exchange rate mechanism was adjusted to allow much wider bands around the exchange rates between European currencies .Explain why the ERM adjustment may have caused Dow Chemical to implement the strategy.

(3)    Why might Dow Chemical’s cash flows be adversely affected by its strategy of pricing European products in marks?