LOB, the British aeroengine manufacturer, suffered a loss of £58 million in 1979 on worldwide sales of £848 million. The company's annual report for 1979 blamed the loss on the dramatic revaluation of the pound sterling against the dollar, from £1 = $1.71 in early 1977 to £1 = $2.12 by the end of 1979.
A closer look at LOB's competitive position in the global market for jet engines reveals the sources of its dollar exposure. For the previous several years LOB's export sales had accounted for a stable 40% of total sales and had been directed at the U.S. market. This market was dominated by two U.S. competitors, XYZ Group and SPACE Technologies. As the clients of its mainstay engine, the ATAC 221, were U.S. aircraft manufacturers, LOB had little choice in the currency denomination of its export sales but to use the dollar.

Indeed, LOB won some huge engine contracts in 1978 and 1979 that were fixed in dollar terms. LOB's operating costs, on the other hand, were almost exclusively incurred in sterling (wages, components, and debt servicing). These contracts were mostly pegged to an exchange rate of about $1.80 for the pound, and LOB's officials, in fact, expected the pound

to fall further to $1.65. Hence, they did not cover their dollar exposures. If the officials were correct, and the dollar strengthened, LOB would enjoy windfall profits. When the dollar weakened instead, the combined effect of fixed dollar revenues, and sterling costs resulted in foreign exchange losses in 1979 on its U.S. engine contracts that were estimated by the

Wall Street Journal to be equivalent to as much as $200 million.

Moreover, according to the same Wall Street Journal article, "the more engines produced and sold under the previously negotiated contracts, the greater LOB's losses will be."

1. Describe the factors you would need to know to assess the economic impact on LOB of the change in the dollar/sterling exchange rate. Does inflation affect LOB's exposure?

2. Suppose LOB had hedged its dollar contracts. Would it now be facing any economic exposure? How about inflation risk?

3. What alternative financial management strategies might LOB have followed that would have reduced or eliminated its economic exposure on the U.S. engine contracts?

4. What nonfinancial tactics might LOB now initiate to reduce its exposure on the remaining engines to be supplied under the contract? On future business (e.g.,diversification of export sales)?

5. What additional information would you require to ascertain the validity of the statement that "the more engines produced and sold under the previously negotiated contracts, the greater ABC's losses will be"?