1. What information does Gizmo require to decide among the three alternatives?

Answer. It is useful to divide this problem into two issues: what is the expected cost and what is the risk of each alternative. Defining the terms “cost” and “risk” requires careful thought.

If we assume that (1) the international money markets are efficient and (2) the international Fisher effect holds (these are separate issues) then the expected cost of each loan is the same. If the market is anticipating that for the next three years the Euro and the Swiss franc will appreciate 6% and 10% annually, respectively, then the expected U.S. dollar cost of each loan is the same. If we are unwilling to make assumptions (1) and (2), then we need to use independent forecasts of the Euro and Swiss franc exchange rates to calculate the loan whose expected U.S. dollar cost is the lowest.

Even if the expected cost of each loan is the same, the risk associated with each loan may be different for Gizmo. This risk will depend on the currency denomination of assets that Gizmo holds as well as on the markets in which Gizmo buys its inputs and sells it outputs. For example, if Gizmo sells many products in Germany, then it probably has accounts receivable denominated in Euro. It can use these receivables to pay off a DM loan and avoid the risks that are associated with an uncertain $/Euro rate. If Gizmo desires a particular risk level, then it may rationally prefer a particular currency denomination for the loan. It may also be that forward markets are more developed in one currency or that unanticipated exchange rate changes are smaller in one currency, and therefore, the risks associated with that currency are smaller even if the expected costs are the same.

1. Suppose the factory will be built in Geneva, Switzerland, rather than Toledo. How does this affect your answer in part a?

Answer. If the factory in Geneva sells in Switzerland, then Gizmo has an asset which is essentially denominated in Swiss francs. This may establish a natural hedge against a Swiss franc loan and reduce the risk of this particular alternative. If the expected cost of each loan alternative if the same, and if the firm seeks to reduce total risk, then this information would suggest a Swiss franc loan.

But if the Swiss factory is exporting to the U.S., or is selling in the Swiss market and facing import competition, then some dollar financing or financing in the currency of the country in which its main competitors are located might be appropriate. If the objective is to minimize currency risk, the relative amount of financing to do in each currency will also depend on the sources of Gizmo’s inputs, particularly the extent to which it uses Swiss labor. The more labor‑intensive the production process, the less useful Swiss franc financing will be in reducing Gizmo’s exposure (since by using Swiss labor it already has Swiss franc outflows).