Fad Gadget has never worked so hard in his entire life. It is near midnight, and he is still poring over statistics and tables. Fad recently joined Smashing Pumpkins, a relatively young but fast-growing British firm that produces and distributes an intricate device that turns fresh pumpkins into pumpkin pie in about 30 minutes. Recently, the firm has started exporting to Zooropa. Some of the largest and tastiest pumpkins are grown in Zooropa, and its population boasts the highest per capita pumpkin consumption in the world. A recent analysis of the pumpkin market in Zooropa has left the company’s senior managers very impressed with the profit potential. Although Zooropa consists of 10 politically independent countries, their currencies are linked through a system called the Currency Rate Linkage System (CRLS) that works exactly like the former Exchange Rate Mechanism (ERM) of the EMS before the currency turmoil started in September 1992. The anchor currency is the banshee of Enigma, the leading country in Zooropa. Initial contacts with importers in Zooropean countries indicated that they typically insist on payment in their own local currency. About a week ago, Cab Voltaire, the CEO of Smashing Pumpkins, expressed concerns about this development and asked Fad to lead a research team to further examine the present state of the currency system of Zooropa. Cab viewed the outlook for the banshee relative to the pound quite favorably and did not predict any substantial depreciation of the banshee against any other major currency. However, the precarious economic situation of some of the countries in Zooropa and the growing importance of speculative pressures in Zooropa’s currency markets last week suddenly made him suspicious about the possibility of realignments within the system. He even doubted the long-term viability of the system. Cab instructed Fad to examine the following issues:

• Which currencies in the system exhibit the highest realignment risk?

• If a currency realigns and gets devalued, what are the effects on our sales and profit margins in this particular country? Can we take the realignment possibility into account in our pricing?

• Suppose a currency is forced to leave the CRLS. What are the effects on exchange rates, interest rates, and the outlook for sales in that country? What is the likelihood of this occurring for the different countries? Fad Gadget felt nervous. A meeting was scheduled with Cab the day after tomorrow. He wanted to write a thorough and insightful report. At the last management meeting, he had the uneasy feeling that some senior managers doubted his abilities. Some managers were naturally suspicious of a young Australian newcomer with his MBA. His earring and punk hairdo did not exactly help either.

His team of analysts had already assembled a table with relevant macroeconomic and financial data. “If only I could use this to rank the different countries according to realignment risk,” he thought. Place yourself in Fad Gadget’s shoes and see what your ranking is.

a)Realignment rankings

b)Effects of Realignments/Exits for the Firm

c)Incorporating Realignment Risk into Pricing/Hedging

d) Effects of devaluation/exits on exchange and interest rates