In the 1980s, a stronger dollar hurt Caterpillar’s competitive position, but in 2008, a stronger dollar did not seem to have the same effect. What had changed?
During the 1980s, Caterpillar’s manufacturing facilities were mainly concentrated in North America. All of its manufacturing plants were within one economic region. As a result, the company could be easily and wholesomely affected by the local economic conditions. For example, the rise and fall of the dollar directly affected revenue growth and loss of the company. When the dollar grew stronger during the 1980s, the revenue generated from exports was reduced due to weak foreign currencies. In other words, the export trade undertaken by caterpillars was significantly interfered with due to the reduced price of caterpillars bearing in mind that the selling price was based on various foreign currencies that had already been weakened by the strong dollar.
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Nonetheless, in 2008, there were myriads of investment portfolios in the United States from foreigners. For instance, the treasury bills were one of the common assets that investors targeted in America. The value of the dollar was pushed up by their demand to buy such assets. Hence, the foreign exchange markets were directly affected. Therefore, the cost of production was significantly reduced in spite of the harsh dollar. The competitive position of the caterpillar remained stable as 2008 progressed.
How did Caterpillar use strategy as a ‘real hedge’ to reduce its exposure to foreign exchange risk? What is the downside of its approach?
The company decided to locate some of its manufacturing subsidiaries outside North America so that it could cut down the losses associated with fluctuations in foreign currency. Caterpillar adopted a globalization strategy by establishing slightly over 100 manufacturing firms outside the United States.
A real hedging strategy was applied with the aim of minimizing risks associated with fluctuations in foreign exchange. The logic behind this logic was that there would be no need to export the company’s products since most production units would be located within countries of manufacturing the country’s products.
The worst impact of this strategy was that the revenue generated from sales was sometimes reduced due to the strengthening of the dollar. When foreign currencies were translated back to the dollar, the net gain was minimal and could sometimes lead to losses. Secondly, this strategy may fail to yield positive results especially when the dollar remains strong for a considerably long period. In any case, forecasting the market in terms of the foreign exchange rate is a cumbersome task that cannot be achieved easily.
Explain the difference between transaction exposure and translation exposure using the material in the Caterpillar case to illustrate your answer
When business entities take part in global trade, they are highly likely to face myriads of risks. For instance, when financial obligations are entered by trading partners, the rate of foreign exchange will definitely change. When such fluctuations are experienced, a business enterprise may end up incurring losses. This scenario is referred to as transaction exposure. For example, the company described in the case study made use of foreign producers to source its inputs although a sharp decline in the price of those goods was experienced later due to the unpredictable changes in exchange rates.
On the other hand, when foreign exchange rates vary with the passage of time, the income, liabilities, assets, or equities of a business entity may face quite a number of risks. This type of scenario is referred to as translation exposure. For example, the US-based caterpillar company faced translation exposure when it used to export its products to foreign nations.