Chapter 9

Measuring and
Managing Real
Exchange Risk
 Yixuan Rui

 Ph.D in finance

 Henry

 y.rui@unsw.edu.au
 9.1 How Real Exchange Rates Affect Real
Profitability
 The real profitability of an exporting firm
• Real profitability: the purchasing power of a firm’s nominal profits
• U.S. firm’s nominal profit = $ revenueU.S. + $ revenueU.K. – Firm’s $ costs
• Example: Apples Galore (A = Apples)
 $ RevenueU.S.= P(A,$) * Q(A,U.S.)

 $ RevenueU.K.= S($/£ ) * P(A,£) * Q(A,U.K.)

 $ Costs = C(A,$) * [Q(A,U.S.) + Q(A,U.K.)]

• Relative prices and components of real profit

 Divide nominal profit by price level in U.S.: P($), The average of current

prices across the entire spectrum of goods and services produced in

the economy.
P(A,$)  Q(A,U .S .) P(A,$)
 Real RevenueU.S.= P($)

P($)
 Q(A,U .S .)

P(A,$)
 Note P($)
is the relative price of apples in U.S.

 Real Costs = [C(A,$)/P($)] * [Q(A,U.S.) + Q(A,U.K.)]

 9.1 How Real Exchange Rates Affect Real Profitability
 Revenue: to keep relative prices constant, the firm must
ensure that the nominal price of apples increases at the
IU.S. , inflation.
 Costs: if its nominal average cost per unit increases at IU.S.,
its real average costs are constant and the Apples Galore’s
total real costs are the same when the same amount is
produced
 Firm’s reaction to exchange rate changes:
S ($ / GBP)  ( P( A, GBP)  Q( A,U .K .))
 Real revenueU.K.= P($)
 Real costs = C(A,$)/P($) * [Q(A,U.S.) + Q(A,U.K.)]
 Exchange rate pass-through: how do management
respond with regard to its pricing when real exchange rates
change.
 9.2 Real Exchange Risk at Exporters, Importers and
Domestic Firms

 Real exchange risk – profitability of a firm can change

because of fluctuations in real exchange rates
 The real exchange rate risk of a net exporter
 A competitive dilemma:
• Raise prices – lose market share
• Lower prices – lose profits

 Major factor that determines a firm’s response:

• Price elasticity of demand for its product
 9.2 Real Exchange Risk at Exporters,
Importers and Domestic Firms

Olympia Communication Exporters (OCE) manufactures cell phones in

Greece and sells them in the U.S. at $79. The company is selling 2M phones
per year.
S = $1.25/€.
Revenue€=$79 (per phone) * 2M * €1/$1.25 = €126,400,000
Interest Rate Parity Formula
InflationU.S. forecasted @ 5.5%
Fh/f = (1 + i h)
InflationU.K. forecasted @ 1% Sh/f (1 + i f)
Update the exchange rate by using inflation;
$1.3057/€ = $1.25/€ * 1.055/1.01
The change just offsets the inflation differential and leaves the real
exchange rate unchanged. If demand curve is constant in U.S., what $ price
should OCE charge to earn same real revenue?
The price should increase by 5.5%: $79/phone * 1.055 = $83.35/phone
Revenue would increase to: $83.35 * 2M * €1/$1.3057 = €127,670,981
 9.2 Real Exchange Risk at Exporters, Importers and
Domestic Firms
1 minute reading:

Trans-Malaysian Airlines (TMA) flies mostly domestic routes (Malaysia). It imports

its fuel from Singapore @ $3.50/gallon.

Last year TMA imported 250M gallons (S=MYR4/$). TMA’s nominal fuel costs:
3.5*250Million*4 = 3.5Billion MYR

Its revenue net of other costs was MYR4B.

Profit was therefore MYR0.5B.

 TMA is regulated and cannot raise prices above inflation rate (15% this
yr).

 What if fuel cost increases by U.S. inflation rate – 4%.

 By how much will real profits fall if there is a 10% real appreciation of
the dollar relative to the ringgit (i.e., causing their costs to increase)?
 New price of fuel, after adjusting inflation: $3.50/gallon * 1.04 =
$3.64/gallon

 New spot rate: (MYR4/$ * 1.10 [appreciation of USD]) * (1.15/1.04)

[inflation differential] = MYR4.8654/$
 IRP FORMULA

 New cost: $3.64 * 250M gallons * MYR4.8654/$ = MYR4.428B

 New Profit = [Revenue * (1+Inflation)] – New cost = MYR4B * (1.15) -

MYR4.428B = MYR0.172B

 Instead of increasing by 15%, which they would have if there was no

real appreciation in the value of the $ (or equivalently, depreciation in
the ringgit), nominal profits have fallen by 65.6%!
 9.2 Real Exchange Risk at Exporters, Importers and
Domestic Firms

 Measuring real exchange risk exposure

 The present value of a firm’s profits
 Who doesn’t have real exchange risk?
 A completely domestic firm? Well, sort of – these firms may not face
forex risk in the short-term, but may very well in the longer-term.
 Example: a restaurant in Miami that does not deal with foreign currency
could suffer a drop in customers if the value of the Euro is weak.
 The demand from their patrons depends on the value of the dollar on the
FX mkts.
 Independent study: Sharing the Real Exchange Risk:
An Example

 Safe Air’s (SA) situation

 Small U.S. company that sells air tanks with “safe” air to fire
departments
 CEO needs to prove leadership since earnings are declining

 Metallwerke A.G.’s proposal

 German firm that manufactures similar product prepared to
manufacture tanks for SA
 Same or better quality of current supplier
 Lock in low dollar price
 Want a TEN year contract with indexing formula!
 Independent study: Sharing the Real Exchange Risk:
An Example
 The indexing formula allows for annual changes in the base dollar
price under the following contingencies:
 The base dollar price will be increased at the U.S. annual rate of inflation,
as indicated by the U.S. producer price index

 If the dollar depreciates relative to the euro, the percentage change in the
base dollar price will equal the U.S. rate of inflation plus an additional
percentage equal to on-half the rate of depreciation of the dollar relative
to the euro
 Independent study: Sharing the Real Exchange Risk:
An Example

 Basic data an analysis

 Some basic prices and notations (the zeros indicate current-period
values) related to the deal proposed by Metallwerke:
 Safe Air’s contractual base purchase price = B(0,$) = $400 per tank
 Safe Air’s other variable production costs = C(0,$) = $313 per tank
 Safe Air’s retail sales price = T(0,$) = $856 per tank
 Safe Air’s profit margin = M(0,$) = 20%
 U.S. price level = P(0,$) = $140 per U.S. general good
 Exchange rate = S(0,€/$) = €1.40/$
 German price level = P(0,€) = €100 per German general good
 Metallwerke’s profit margin M(0,€) = 20%
 Metallwerke’s production cost = C(0,€) = €238 per tank
Independent study: Profitability When the Price per Tank
Is Contractually Fixed at 400
 Independent study: Exhibit 9.2 Profitability Under
Metallwerke’s Proposed Contract. Note Safe air pay 5% more
at 420 when euro strengthens by 10%
 Independent study: Exhibit 9.3 Profitability Under a
Contract That Shares Real Exchange Risk

Safe Air loses some if $ falls Metallwerke trades off some

but gains some if $ rises profit when $ rises for a higher
profit when $ falls
 Independent study: 9.3 Sharing the Real Exchange
Risk:
An Example

 Analyzing contracts when inflation and real exchange rates are changing:
 Profits with a constant real exchange rate

 Real cost per tank – increases in the base price that are larger (smaller)
than the U.S. rate of inflation increase (decrease) real imported part
costs
 Safe Air’s real revenue per tank
 Will remain the same only if SA is able to raise prices by rate of inflation
 Metallwerke’s real revenue per tank
 This is written in the contract as constant (but they would like this
changed!)
 Metallwerke’s real cost per tank
 This is constant as long as the cost of production rises at the German rate of
inflation
 Independent study: 9.3 Sharing the Real Exchange
Risk:
An Example

 If relative PPP does NOT hold (likely), both parties are exposed to
real exchange rate risk
 Designing a contract that shares the real exchange risk
 Let the base dollar price of the product increase one for one with the
U.S. inflation rate
 Adjust for changes in real exchange rate
 Increase base price by one-half of any real depreciation of the dollar
relative to the euro
 Decrease base price by one-half of any real appreciation of the dollar
relative to the euro
 Independent study: 9.3 Sharing the Real Exchange
Risk:
An Example

 Evaluating the proposal

 If relative PPP holds and IU.S.>IGermany (e.g., 10% and 5%, respectively,
the $ will depreciate relative to the €
 [1-d(€/$)] = [1+I(€)]/[1+I($)] = 1.05/1.1 = 0.0455
 Proposal suggests that the change in price be adjusted by inflation
plus half of the depreciation
 ∆Base price = 1 + (IU.S.+0.5d) = 1.1228 or an increase of 12.28%
 SA’s per tank cost: increase by 2.07% (=1.1228/1.10)
 M’s real per tank revenue: increase by 2.07% (=[(1-0.0455) *
(1+0.1228)]/(1+0.05))
 Independent study: 9.3 Sharing the Real Exchange Risk:
An Example

 Should the redesigned contract be adopted?

 Other factors affecting costs
 Wage pressure when the buying power of employees at SA is squeezed (i.e., when
domestic currency is weak in real terms relative to foreign currency)
 Solution: smaller increase in base price when $ is weak and smaller decrease
when the dollar is strong
 Competitiveness and pricing ability
 Demand is fairly elastic given budgets of fire departments! This means SA is not
able to increase prices above inflation
 Foreign competitors complicate matters in that they become aggressive when $ is
strong. Could fix this by allowing SA to receive >50% of benefit when $ is strong
 Relative bargaining strength – who gets what has a lot to do with who
has more bargaining power
 9.4 Pricing-to-Market Strategies

 Pricing to market
• Occurs when a producer charges different prices for the same good
in different markets
 Some examples of pricing-to-market strategies
• Luxury cars in the 1980s - $ very strong; European manufacturers
chose to keep prices high and fatten profits instead of gaining
market share
• Japanese consumer electronics - $ weak; Japanese manufactures
kept prices low to maintain market share
• French handbags: Louis Vuitton bags cost 40% more in Japan than in
Europe
 Pricing to market
by a monopolist
 A monopolist faces the linear demand curve
in domestic and foreign mkts. The domestic
demand curve:
 Q = 1000 – P.
 Similarly, the demand curve in the foreign
mkt:
 Q* = 1000 – P*
 Domestic revenue: P x Q
 Q = 1000 – P, Thus P = 1000 - Q
 P x Q = 1000 x Q – Q^2

 Foreign revenue: P* x Q*
 Q* = 1000 – P*, Thus P* = 1000 – Q*
 P* x Q* = 1000 x Q* – Q*^2
Domestic real value of revenue from foreign sales = Real Ex rate * foreign relative price *
foreign sales

Total cost = Marginal cost * quantity in domestic and foreign mkt = 500 x (Q + Q*)

Domestic real value of revenue:

RS x P* x Q*.

Given the fact that P* x Q* = 1000Q* - Q*^2

RS x P* x Q* = RS x 1000Q* - RS x Q*^2
MR = MC: First-order derivative. Note, MR from the First order derivative of
the formula 1000 x Q – Q^2, where MC is the First order derivative from
the formula 500 x (Q+Q*)
Note: 250 is from 1000-2Q = 500, and 750 is from P =1000 – Q. Total
profit formula is: Domestic revenue + Foreign revenue - Cost
Exhibit 9.4 A Monopolistic Exporter

20% real appreciation of foreign currency

Monopolist will want to sell more in foreign market
 20% real appreciation of foreign currency:

 With the same process, we have revenue = RS x P* x Q* =

1.2 x P* x Q* = 1.2 x 1000 x Q* - Q* ^2

 By making MR = MC = 500, we could solve

1200 - 2.4 Q* = 500

 Q* = 291.7, P* = 1000 – 291.7 = 708.3

 Original price: 750
Exhibit 9.5 A Monopolistic Exporter When
RS=1.2

20% real appreciation of foreign currency

Monopolist will want to sell more in foreign market
 In order to sell 291.7 units, the price is
lowered to:
 P* = 1000 – 291.7 = 708.3

 Although the foreign currency appreciates by

20%, the monopolist only decrease the
relative price in foreign mkt by 1 – 708.3 /
750 = 5.6%.
A Monopolist with imported costs
 Q = 1000 – P, i.e., P = 1000 - Q
 Domestic and foreign costs:
 The cost of production involves a domestic
cost per unit of C and a foreign cost per unit
C*.

 Total real domestic costs:

 C x Q + RS x C* x Q
 Total revenue: P x Q = 1000 x Q – Q^2
MR: 1000 – 2Q; MC = C+ RS x C*
Exhibit 9.6 A Monopolist with Imported
Costs

20% Real depreciation of foreign currency

Monopolist will want to produce more in foreign market
 Suppose there is a 20% real depreciation of
the foreign currency, and the new real
exchange rate RS = 0.8.

 C = 250, C* = 200

MC = C+ RS x C* = 250 + 0.8 * 200 = 410

(V.S. 450)
MR = 1000 – 2Q = MC = 410, Thus Q = 295,
and P = 1000 – 295 = 705
 Monopolist’s MC: 1 - 410 / 450, falling by
8.9%

 Reduction in domestic price: 1 – 705 / 725

= 2.8%

 In this case, the Monopolist’s profit

increases, since the pass-through is not one
for one.
 9.5 Evaluating the Performance of a Foreign
Subsidiary

 Evaluation the performance of a foreign subsidiary – tough

because of the effect of real changes in foreign exchange
rate!
 Example: three Japanese subsidiaries operating in Thailand
• The neutral firm – RiceNoodle serves the Thai market with no export
revenues or foreign costs but has Japanese owners
• The net importer – ThaiComp imports personal computer parts from
Japan, assembles and sells mostly in Thailand
• The net exporter – WeRToys produces and mostly exports toys from
Japan to Thailand
 Exhibit 9.7 Operating Profit with a One-to-One Real Exchange Rate
Between the Baht and the Yen

THB1=JPY1
Exhibit 9.8 Actual Operating Profit After a 10% Real Appreciation of
the Yen
 Exhibit 9.9 Operating Profit After a 10% Real Appreciation of the
Yen: No Response by Managers

THB1.1=JPY1
Exhibit 9.10 Operating Profit After a 10% Real Appreciation of the
Yen: Managers Respond Optimally

*arrows indicate direction of change from levels in Exhibit 9.7

Exhibit 9.11 Actual Versus Optimal Operating Profit After a 10%
Real Appreciation of the Yen
Exhibit 9.12 Operating Profit After a 10% Real Depreciation of the
Yen: Managers Respond Optimally
 9.6 Strategies for Managing Real Exchange Risk

 Transitory versus permanent changes in real exchange rates – how

long is change supposed to persist?
 Production management
• Production scheduling – use inventory to avoid paying employees
overtime to meet excess demand
• Input sourcing – weighing ability to switch back and forth between
domestic/foreign suppliers and the value of long-term relationships
• Plant location
 Expand locations
 Shift production among existing locations
 9.6 Strategies for Managing Real Exchange Risk

 Marketing management
• Pricing policies
• The frequency of price adjustments
• Market entry decisions
• Brand loyalty
Exhibit 9.13 A Checklist for Managers of
Real Exchange Risk
 Chapter 10

Exchange Rate
Determination and
Forecasting
 10.1 Parity Conditions and Exchange Rate
Forecasts

 The Fisher Hypothesis

• Interest rates and inflation
• Real rates of return – measures how much your purchasing power
has increased over time
• The ex post real interest rate
 1+rep = (1+i)/(1+π)
 Approximated by: rep = i- π
 i: nominal interest rate; π: inflation ;

• The ex ante real interest rate

 Expected real interest rate
 Expected rate of inflation
 Fisher hypothesis – decomposition of nominal int. rates
Exhibit 10.1 Average Long-Term Government Bond Yields
and Inflation Rates
 10.1 Parity Conditions and Exchange Rate
Forecasts
 The International Parity Conditions
• CIRP – Covered Interest Rate Parity
 Links forward rates, spot rates, and interest rate differentials
 Forward premium = (Forward rate – Spot rate) / Spot rate
• UIRP or Unbiasedness – Uncovered Interest Rate Parity
 Sometimes called International Fisher Effect/Relationship
 Links expected exchange rate changes and interest rate differentials
• PPP
 Links inflation rates and rates of changes in forex rates
 10.1 Parity Conditions and Exchange Rate
Forecasts

 International parity conditions

• CIRP, UIRP (or Unbiasedness) and PPP, and Fisher Hypothesis
• If they hold, real interest rates are the same every where
• Empirical studies suggest that beyond IRP, none hold in either long- or
short-run
 If International Fisher Relationship holds, the interest rates below would be
equal – closer in long-run, but why not equal?
• Significant deviations in PPP values
• Returns in different currencies can have different risk premiums
• Political risk and threat of capital control
 10.2 Currency Forecasting Techniques

 Fundamental exchange rate forecasting

• Uses fundamentals in econometric models (e.g., money supply, inflation,
productivity growth rates, current account)
 Technical analysis
• Using historical data to find patterns
• Academics criticize but a survey suggests this is used often by traders so
there might be something to it and other models have shortcomings so the
verdict is still out
 Fundamental analysis is flawed as well
 Forward rate may not be an unbiased predictor of the future spot rate, even in an
efficient market
 If enough of the trading world uses it, it will matter through trade pressure
Exhibit 10.3 Categories of Exchange Rate Forecasting
Techniques
10.5 Predicting Devaluations (Pegged Regimes)

 What causes a currency crisis?

• Macroeconomic conditions
 Government follows policies inconsistent with its currency peg –
speculative attack is unavoidable
• Government will exhaust reserves defending peg
 Growing budget deficits
 Fast money growth
 Rising wages and prices
 Currency overvaluation
 Current account deficits (caused by budget deficits combined
with currency overvaluation)
 10.5 Predicting Devaluations

• Self-fulfilling expectations
• Group of investors begin speculative attack
• Other investors see this and think that the currency will
collapse so they convert out of currency
• Contagion
• If group successfully attacks one currency, they might as
well try another
• If one currency is attacked, other currencies will
appreciate relative to that currency and their domestic
firms suffer a loss of competitiveness
• Other countries in similar position – obvious targets (e.g.,
Asian crisis)
 10.5 Predicting Devaluations

 Empirical evidence on the predictability of currency crisis

• 1991-1992: Currency turmoil in Europe

• 1994-1995: Mexican crisis and the Tequila effect
• 1997: The Southeast Asian crisis
Exhibit 10.7 A Rocky Start to EMU
Exhibit 10.8 Asian Exchange Rates
 Next Time
 Mid-term break

 Homework:
 Chapter 9: Questions 7-8, Problems 2-4
 Chapter 10: Questions 1-4, Problem 2

 Try to go through the lecture notes with the

text to prepare for the exam.