To evaluate the effect of the toy company’s other major source of risk, exchange rates,
the managers must first determine how sales are related to exchange rates, and then explicitly link firm sales to exchange rates in their valuation model. Suppose that this
linkage results from the effect of the yen/dollar exchange rates on market prices in the
U.S., which in turn affect U.S. demand. A useful valuation model will specify how much
the U.S. market price will change for a given percentage movement in the yen/dollar
exchange rate, and then define how a shift in the market price will affect demand for the
product in the U.S. The toy company’s managers should also assess the probability of
large and small exchange rate movements, and whether or how exchange rate risk is
correlated to the expected life of the faddish toy.