Lexington Co. is a U.S. firm. It has a subsidiary in India that produces computer chips and sells them to European countries. The chips are invoiced in dollars. The subsidiary pays wages, rent, and other operating costs in India’s currency (rupee). Every month, the subsidiary remits a large amount of earnings to the U.S. parent. This is the only international business that Lexington Co. has. The subsidiary wants to borrow funds to expand its facilities, and can borrow dollars at 9 percent annually or borrow rupee at 9 percent annually. Which currency should the parent tell the subsidiary to borrow, if the parent’s main goal is to minimize exchange rate risk? Explain.
The subsidiary should borrow dollars because it already has a new cash outflow position in rupee so that borrowing rupee would increase exposure.